Cost Estimation Techniques

There are many types of costs that businesses incur during the business process. The three types of costs are fixed costs, variable costs, and mixed costs. "Variable Costs are those costs associated with production that changes directly with the amount of production, e.g., the direct material or labor required to complete the build or manufacturing of a product" (VentureLine, 2007b). A fixed cost is the opposite and does not change depending on the amount of production or sales (VentureLine, 2007s). An example of a fixed cost is lease or rent costs of the building that the company uses. Mixed costs are a combination of fixed and variable costs because they "consist of a fixed component and a variable component" (Accounting Coach, 2006).

Costs must be estimated for proper decision making because improper decisions can be made. There are three main methods used to estimate costs: high-low method, visual fit, and least square regression (Alvis, 2006). "Use of the high-low method requires the use of only two past data observations: the highest level of activity (such as the number of units produced during a time period) and the associated total production cost incurred at that level, and the lowest level of activity and its associated cost" (Alvis, 2006).

The visual fit method or "scatter-graph method requires that all recent, normal data observations be plotted on a cost (Y-axis) versus activity (X-axis) graph" (Alvis, 2006). A line is then drawn that is a best fit for the data points (Alvis, 2006). When the line is extended to cross the Y-axis, there is a "fairly accurate estimate of fixed costs for the period" (Alvis, 2006). The slope can also be calculated to give another reasonably accurate estimate of the variable cost per product (Alvis, 2006).

The least square regression method is more complicated than the other two methods I described. It uses even more information, requiring "the use of thirty or more past data observations" (Alvis, 2006). The data observations include the level of activity of the product and the total production costs for each of the products (Alvis, 2006). This method is the most statistically accurate, but the required software can be an obstacle to the whole process.

If costs are not estimated properly the company will suffer in many ways. One way would be that they do not budget enough money to cover costs because of underestimation of the needed funds to keep the business running. Another is overestimation because monetary funds will be overabundant and could have been used for other projects to make the company more profitable. References

Accounting Coach. (2006, July 5) What are mixed costs?. Retrieved February 2, 2007, from Accounting Coach Web site: http://blog.accountingcoach.com/mixed-costs-fixed-costs-variable-costs/

Alvis, J.M. (2006) Cost accounting. Retrieved February 2, 2007, from http://www.referenceforbusiness.com/management/Comp-De/Cost-Accounting.html

VentureLine. (2007a). Accounting terms-accounting dictionary-accounting glossary. Retrieved January 26, 2007, from VentureLine Web site: http://www.ventureline.com/glossary_F.asp

VentureLine. (2007b). Accounting terms-accounting dictionary-accounting glossary. Retrieved January 26, 2007, from VentureLine Web site: http://www.ventureline.com/glossary_V.asp