The presentation describes Elements of cost and classification, cost estimation approaches and method, break even analysis, steps and limitation with examples

1. Cost Estimation
Unit III
Characteristics of Forecasts, Forecasting Horizons, Steps to Forecasting, Forecasting Methods, Seasonal
Adjustments, Forecasting Performance Measures,
Cost Estimation, Elements of cost, Computation of Material Variances Break‐Even Analysis
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2. Classification of Cost
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Cost According to Elements
Expenses/
OverheadsMaterial Cost Labour Cost
Material cost : Cost of material traceable to one unit of product
Labor cost : Cost of human resource involvement
Expenses/ overheads : Cost associated with direct /indirect overheads;
design, administrative, production, sales/service, distribution

3. Classification of Cost
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Cost According to Behaviour
Variable CostFixed Cost Semi Variable Cost
Fixed Cost: Fixed in short run and long run
Variable Cost: Varies with volume and constant per unit
Semi variable Cost: fixed for one level of activity and variable for another

4. Classification of Cost
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Cost According to Functions
Administration
Cost
Production
Cost
Selling/ promotion/
Distribution Cost
R & D Cost

5. Classification of Cost
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Cost According to
Management Decisions
Differential
Cost
Marginal
Cost
Opportunity
Cost
Replacement
Cost
Imputed
Cost
Sunk
Cost
Marginal Cost is the cost added by producing one extra unit of a product.
Differential cost is the difference between the cost of two alternative decisions
opportunity cost refers to a benefit that could have been, but not received due to
choosing other alternative.
Sunk cost: is the cost of abandoned plant less salvage value. Not relevant for decision
making
Imputed Cost or Notional Cost :Actually not incurred (interest on own capital, rent on
owned building, etc.) but taken into account in capital budgeting decisions.
Replacement Cost : Cost of replacing equipment at current market price.

6. Classification of Cost
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Cost According to Expenses
Direct Cost Indirect Cost
• Physical assets
• Maintenance and operating costs
• Materials
• Direct labor
• Scrapped and reworked product
• Direct supervision of personnel
• Utilities
• IT systems and networks
• Purchasing
• Management
• Taxes
• Legal functions
• Warranty and guarantees
• Quality assurance
• Marketing and publicity

7. Cost Estimation
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Cost Estimation : is finding relationship between activities and cost
Cost estimation is done to
• Manage cost
• Making cost decisions
• Plan and set standards
Cost estimation results in reduced costs

8. Cost Estimation: simple model
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• This model ignores other cost behaviours and other cost drivers
• This model only takes into account the fixed and variable cost
TC=F+ Q.V
Where TC= Total cost
F =Fixed cost
Q =Quantity produced
V = Variable cost per unit
Total Cost TC
Fixed Cost F
Variable Cost V
Quantity Q
Cost

9. Cost Estimation: Unit Method
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• Unit method is Commonly used for preliminary stage estimates
• Total cost estimate TC is per unit cost (CU) times number of units (N)
TC=Cu × N
Example
• Cost to operate a car at Rs 5/Km for 500 km: TC = 5 × 500 = Rs 2500/-
• Cost to build a 100 m2 house at Rs 3000/m2: TC=3000× 100 = Rs 3 lac
Cost factors must be updated time to time
In case of several cost components, cost estimate components are
added to determine total cost estimate
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10. Cost Estimation: Cost Indexes
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Cost Index is ratio of cost today to cost in the past
• It Indicates cost changes over time & account for inflation
• Index is dimensionless
• WPI (Wholesale Price Index) is a good example
Cost estimate using index can be made as
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11. Cost Estimation: Cost-Capacity Equation
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Cost Capacity equation is also called power law and sizing model
Where C1= Cost at capacity Q1
C2= Cost at capacity Q2
Exponent x defines relation between capacities
If x = 1, relationship is linear
x < 1, economies of scale (larger capacity is less costly than linear)
x > 1, diseconomies of scale
x
Q
Q
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12. Cost Estimation: Cost-Capacity
Combined with Cost Index
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Example: A 1 hp water pump cost was Rs 3000 five years ago
when the cost index was 120. Estimate the cost of a 2 hp water
pump today when the cost index is 250. The exponent for a 1 hp
motor pump is 0.9.
Solution: Let C2 represent the cost estimate today
C2 = 3000(2/1)0.9(250/120) = Rs 11,663/-
Cost-capacity equation can be combined cost index (It/I0) to adjust
for effect of time (inflation)
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13. Cost Estimation: Factor Method
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• Factor method is especially useful in estimating total plant cost
• Both direct and indirect costs can be included
Total plant cost estimate TC is overall cost factor (h) times total cost of
major equipment items (CE) TC = h × CE
The cost factor is commonly the sum of a direct cost component
and an indirect cost component, i.e h = 1 + Σfi , for i components,
Example:
A packaging machine is expected to cost 2 crore with installation.
The cost factor for direct costs of machine in ready to operate
condition is 0.45. A cost factor of 0.15 is used to cover indirect cost.
What will the cost of the packaging machine ?
Solution: h = 1 + 0.45 + 0.15 = 1.6
TC = 1.6*2 crore= 3.2 crore
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14. Cost Estimation: Indirect Costs
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Indirect costs (IDC) are incurred in production, processes and service
delivery that are not easily tracked and assignable to a specific
function. Indirect costs (IDC) are shared by many functions because
they are necessary to perform the overall objective of the company
Indirect costs make up a significant percentage of the overall costs in
many organizations – 25 to 50%. Few indirect cost examples
• IT services
• Quality assurance
• Human resources
• Management
• Safety and security
• Purchasing; contracting
• Accounting; finance; legal
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15. Cost Estimation Approach
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Equipment and
capital Recovery
Direct material
Direct labour
Maintenance
and operation
Indirect Cost
Direct
Cost
+
+
+
+
+
Total Cost
+Desired Profit
Price
Bottom Up Approach
After Design stage

16. Cost Estimation Approach
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Equipment and
capital Recovery
Direct material
Direct labour
Maintenance
and operation
Indirect Cost
Direct
Cost
+
+
+
+
+
Total Cost
+Desired Profit
Price
Bottom Up Approach
After Design stage
Equipment and
capital Recovery
Direct material
Direct labour
Maintenance
and operation
Indirect Cost
Direct
Cost
+
+
+
+
+
Target Cost
+Allowed Profit
Market Price
Top down Approach: Design to cost
Before design stage

17. Computation of Material Variances
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• Material Cost Variance(MCV) : Material cost variance is the
difference between actual cost and standard cost.
favourable material variance  actual cost < standard cost
Unfavourable material variance  actual cost > standard cost
direct material cost variance: MCV = (RSQ x SP) - (AQ x AP)
where, revised standard quantity (RSQ) = (SQ/SO x AO)
SQ = Standard Quantity, SO = Standard Output , AO = Actual Output
SP = Standard Price,
AQ = Actual Quantity, AP = Actual Price

18. Computation of Material Variances
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Example
- Standard quantity of material Q for 400 units of output is fixed as 700 kg.
- Standard price per kg. of material Q is estimated to be Rs 350/-
- Actual quantity of material Q was 700 kg.
- Actual price of material was Rs 315/kg.
- Actual output was 300 units.
Solution,
Revised standard quantity (RSQ) = (SQ/SO) x AO
=700/400 x 300 = 550 units.
Material Cost Variance(MCV) =(SQxSP)-(AQxAP)
=(550x350)-(700x315)= - 28000/-
Since, the resulting figure is negative the variance is denoted as unfavourable

19. Break Even Analysis
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A decision maker needs to know which quantity should be sold before
entity starts making the profit. Break even analysis determines whether
a particular quantity of sales will result in profit or losses
Total Cost TC
Fixed Cost F
Variable Cost V
Quantity
Cost
Revenue
Break even
Quantity Q
Steps of break even chart
•Draw fixed cost line
•Draw variable cost line
•Draw Total cost line by adding the two
•Draw Revenue line
•The point of intersection of revenue line
and total cost line is break even point

20. Break Even Analysis
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Example: Manufacturing of a engineering product requires fixed cost
of Rs 42 lac for 1 lac quantity. Variable cost per product unit is Rs 30/-
for material, Rs 15/- for labour, and Rs 5/- for other overheads. Selling
price of the product is Rs 120/- Determine the quantity beyond which
firm starts making profit (break even quantity)
Fixed Cost = 50 lac
Variable cost / unit = 30+15+5= Rs 50/-
Total Cost = 4200000 + 50 x Q
Revenue = 120 x Q
Break even quantity B: 120 x B = 4200000 + 50 x B
B = 60000

21. Break Even Analysis: Limitations
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Break even analysis make some assumptions
•Selling price remains constant
•Variable cost is proportional to quantity produced
•Fixed cost remains constant
•All quantity produced is sold
These assumptions are not realistic mostly, and are limitations of
breakeven analysis