For business accounting purposes, cost estimation methods provide a way for companies to anticipate the costs involved in business operations and new undertakings. Cost estimation methods consider the different factors that impact production processes and how these factors vary under different conditions. The methods used can vary depending on the types of factors analyzed and the type of information each method uncovers.
Cost estimation methods come in handy when companies undertake new projects that require increases in production levels and inventory. Companies looking to introduce new product lines or integrate existing operational processes can use cost estimation methods to determine the most cost effective means for carrying out a particular plan. Cost estimation models consist of identified factors, such as equipment, personnel and production material, that affect how much a particular activity or project costs. Information gathered through cost estimation analysis helps managers make decisions that directly impact a business’ bottom line.
Cost types play a pivotal role within any cost estimation method when it comes to determining the potential cost increases or decreases associated with a particular activity or project. The three general categories or types of costs include fixed, variable and mixed costs. Fixed costs, such as equipment depreciation or employee wages, remain the same regardless of whether an increase or change in production levels occurs. Variable costs, such as raw materials or overhead costs, may increase or decrease based on the level or activity of production taking place. Mixed costs include a combination of fixed and variable costs, such as equipment depreciation versus how an increase in production activity may warrant additional equipment maintenance or repair costs.
Calculating Variable & Fixed Costs
Methods for estimating costs rely on three basic assumptions when analyzing the fixed and variable cost rates involved with a particular project. Identifying fixed costs makes it possible to determine the rates of any variable or mixed costs. All costs fall within either fixed or variable rate categories when working within a particular range or production period. The third assumption looks for the one factor that influences any changes in cost rates that take place. One approach, known as the high-low method, compares the difference in cost between the highest level of production activity and the lowest level. Using this method, analysts determine variable cost rates by dividing the difference in total cost between the two production rates by the difference in production activity between the two levels.
With each product made, a company must determine how many product sales must occur before a company breaks-even in terms of production costs. One cost estimation method, known as the equation method, allow analysts to calculate break-even requirements when considering operational costs and profit margins. The equation method computes profit as equal to sales total minus any variable or fixed expenses. By rearranging the equation to solve for sales total, analysts can determine the break-even (or profit equals $0 point) by inputting variable and fixed cost amounts. The resulting sales total will equal the sum of variable and fixed costs using a profit margin of $0.