What is cost estimation?

Costs arise from the acquisition and use of organizational resources such as raw materials, labor, outside services, equipment, and facilities. Organizations acquire and use resources to perform activities. When they do, the financial system records these costs.

Costing is designed to assess the amount of resources which were consumed to make a product or provide a service and focuses on the purpose of the resource consumption (what for?). The cost classifications on which it mostly relies (inventoriability and traceability) match this focus. By contrast, cost estimation is designed to assess the amount of resources which will be consumed depending on the level of activity. It is thus less interested in purposes and more interested in cost drivers (why?) and the cost classification on which it relies (cost behaviors) matches this different focus. The production of estimates is a core function of management accounting and supports a forward looking perspective.

In this chapter, I will introduce estimation techniques which build on an understanding of cost behavior and support all other management accounting techniques which are presented in other chapters. I will also discuss how estimates help achieve timeliness and relevance by sacrificing to some extent reliability and accuracy.

I have long debated about whether cost estimation should be addressed before costing. I finally settled for this order because costing makes a natural transition from financial accounting into management accounting. We will now venture further and further away from financial reporting into the realm of management. Moreover, costing illustrates nicely the dangers of cost estimation for financial reporting, the necessity of cost estimation for management, and the tensions resulting from their different purposes.

At the end of this chapter, you should be able to:

  • explain the purposes of cost estimation;
  • describe the process of cost estimation;
  • identify cost behaviors and express them with cost functions;
  • identify cost drivers;
  • estimate unit variable costs and fixed costs over a range of activity;
  • use estimates to make predictions;
  • assess the validity and reliability of estimates;
  • use estimates for cost control.

In Excel, you should be able to:

  • use basic computations;
  • draw scatter plots;
  • insert cost functions in scatter plots;
  • make a correlation table with the data analysis ToolPak;
  • use the SUMPRODUCT();
  • run a regression with the data analysis ToolPak.