 Hello and welcome to this session. This is Professor Farhad in which we would look at cost estimation, a topic that's typically covered in cost accounting as well as managerial accounting and the CPA exam, BEC section. As always, I would like to remind you to connect with me on LinkedIn. If you haven't done so, please subscribe to my channel. I have 1,800 plus accounting, auditing, tax, finance, as well as Excel tutorials. If you like my lectures, please like them and share them. If they benefit you, it means they might benefit other people, share the wealth and check out my website, farhadlectures.com, to complement and supplement your accounting as well, finance courses. So why do we have to do this cost estimation? Well, we're doing cost estimation not based on past costs because we already know the costs that are already incurred. What we're looking for is cost estimation for the future. So what we need to know is how much something's going to cost us. That's what managers wants to know. How much something's going to cost us in the future because past cost is already known. So remember that we need to know for this session how costs behave within the relevant range. And we also need to remember the total cost formula, the total cost equal to the fixed cost F4 fixed, fixed cost plus variable. So V is for variable times whatever output we are using. We also need to know how costs behave in terms of one unit and in terms of total cost. Let's start with fixed cost. Well, fixed cost remain the same even when the activity level changes within the relevant range. So if we have a relevant range and we already should know about this, fixed cost in total stays the same. Now what happened to fixed cost per unit? Well, fixed cost per unit decreases goes down as the activity level goes up. So if you are spending $1,000 on your rent regardless and you are producing 1,000 units, your fixed cost per unit is a dollar. Well, if you are spending $1,000 of rent, which is a fixed cost and you are producing 2,000 units, your production per unit now becomes 50 cent. And if you could produce 10,000 units using the same rental property, then your cost becomes 10 cent per pennies. So fixed cost per unit decreases. Let's talk about variable cost. Variable cost per unit stay the same. Variable cost per unit stay the same. So if you have a variable cost equal to two dollars, so per unit, each unit you produce will cost you two dollars. However, variable cost in total changes. And obviously this is if you produce one unit equal to two dollars. What happened if you produce two units? Well, it's equal to four dollars. What happened if you produce three units equal to six dollars? So notice in total as the activity goes up, as the activity goes up, your total variable cost will change, but the two dollar per unit stays the same. Again, we're always discussing this within the relevant range. So we need to we need to use this understanding in order to predict future cost. So you want to make sure you understand the difference between variable and fixed cost. There are three methods that we can use to estimate our future cost. One is the engineering estimates. Two is accounting analysis. Three is some statistical method, including regression method. Now we have three methods. What does that mean? It means we don't have a specific answer in the answer. Yes, results were likely differ from method to method. We have three methods. Now, what should you do if you want to be a little bit to have more confidence, to have more confidence, use more than one method, then compare the results. Well, there are large differences between, you know, the account analysis versus the statistical method, then we suggest or the suggestion is you do more analysis because there should not be large differences. There should be differences, but not very large. If it's large, it means you have to change some assumptions that you are making. Now, if the estimates are similar, that's excellent news. You'll have more confidence in the results. So what I'm going to do, I'm going to go over each method separately. In this session, I will go over this method and this method. In the next session, I will go over the statistical method, high, low and regression, specifically regression. Engineering, when is the engineering method is used? It's used almost exclusively when we have a new product or a new activity for the first time. What does that mean? It means we have no data available to use. So it's what we're going to be using is our best estimate because it's better off if we have data. But if it's a new product, we don't have any data for that new product. And we could use the data of similar product or our experience with previous product, that's good. So how do we do this engineering estimate? It's based on the amount and cost of work for a task. So how much did it cost us in terms of time and money? So we have to first identify the input. What are we using for this product? What type of material, labor, electricity, overhead, so on and so forth. Then we estimate the time and cost for each activity in producing the item. This is what we do. What do we, how do we do? So how do we estimate? We use what's called time motion study, basically by observing workers, by observing workers. What are the advantages and disadvantages of this method? The advantages, it's forcing you to examine each step. Then you may want to compare those steps to other activities. So you'd learn more about your process by going through the engineering method, the disadvantage of this method, it's very expensive. It takes time to do so. And you will need expertise and specialists, whatever we are doing. So they understand the procedures and they might be able to help us streamline the operation better. And it's also performed under optimal conditions, not normal factory conditions. So when we do this analysis, we assume everything is working at an optimal level and we estimate the cost based on that. When we actually start to produce things, that may not be the case. The second method we're going to be using is account analysis. And this implies we are using some type of accounting record because we're examining the accounts. So step one is to review each account involved in total cost or whatever accounts are involved in our costs. Basically, we're using all data. We need to look at this account. Then categorize each activity as either fixed or variable using our best judgment. Now, why do we say using our best judgment? Because oftentimes it's very difficult to determine whether something is fixed cost or variable cost. Sometime it could be mixed. Sometime you have to break it down. So that's why it's important to use our best judgment. The best way to illustrate this concept is to take a look at an example. And this example involved data from JKR Innovation Center. And we're assuming 720 labor hours for this particular month. And this is the data that we have. So we collected all our costs. We have the fixed cost column, the variable cost column and the total. Remember, fixed plus variable equal to the total. And we have rent, utilities, administrative costs, supply leases, permits and others. And they already broke them down for you. Remember that total cost, this column, total equal to variable plus fixed cost. This is the total cost formula. Now what we can do is we could compute variable cost per hour. How do we do so? Well, if we add up all our variable cost at up to twenty two thousand thirty two dollars will take our total variable cost divided by the number of hours we work this month, we assume on average, our variable cost per unit is thirty dollars and sixty cent. Now it's easy to have the formula for this for this center. And the formula is fixed cost, which is equal to twenty one thousand seven fifty six plus thirty dollars and sixty cent times the activity will give us forty three thousand seven eighty eight. Now this is for one month, but how does this month help us? Well, it will help us in order to predict future month total cost. For example, how about if a particular month we spent nine hundred and sixty hours, what should be our total cost based on our formula? Well, we'll do the same thing. It's fixed cost. Remember fixed cost will always be fixed, which is twenty one thousand seven fifty six plus variable cost per unit, which is thirty dollars and thirty dollars and sixty cent multiplied by the level of activity here nine hundred and sixty hours. We estimate that if we spent nine hundred and sixty labor hour for a particular month, our total cost should be fifty one thousand one thirty two. All what it does, it help us predict. Is it going to be exactly fifty one one thirty two? No. But if we predict and it's close to that amount, it means our analysis is correct. If we were if we were way off, we have to determine why recompute our analysis and maybe create a new formula. Now, let's what are the advantages and disadvantages of this account analysis? Well, here, managers are comfortable with these figures. Why? Because you are using variable cost and fixed cost as well as accountant because we collected this data. We have confidence in the input and the data. Disadvantages is managers are biased. They might try to treat some certain cost fixed certain cost variable because they might have an agenda to earn a bonus or to create a budget slack to create some sort of a budget slack. It means, you know, they need more resources for their department. So they may monkey with the numbers. Now, the best way to kind of look at this account analysis is to take a look at another example to see how this all fits together. Let's take a look at Brown's basket. Make decorative baskets for sale at a local craft shops. Mary Brown, the owner has collected the following information on cost based on two years of operation and had asked you to analyze the behavior of her overhead. Okay, that's fine. Mary summarized the monthly data as two years total. So what happens? We have two years worth of data. And obviously, the more data you have, the more comfortable you are going to be because if you have a data for a particular month or a particular quarter, certain businesses, they're seasonal. So sometimes they have a lot of sales. Sometimes they don't have a lot of sales. Sometimes they may even, you know, they go flat, they go up, you know, they go down. So if you happen to select this month, it may not be representative of when we are in a peak season. So it's better to have as much data as possible. And that's true for everything. The more data you have, the better decision you should come up with, the better outcome your decision outcome should be better off with more data. So this is what we have in direct material. Labor leases all that information. This is for two years. And it also provided us with how many labor hour, direct labor costs, machine hours, and how many units we produce, which is baskets. And this is based on two years worth of data. That's pretty good. After the visit in the workshop and discussing the operation with Mary, you determined that three costs in direct material, indirect labor and the power to run the machines are variable. So simply put, after you looked at the data, you determined that in indirect material, let me highlight them, indirect material, indirect labor and the power to run the machines, those are variable. And everything else is fixed costs. Now we can break down the fixed and the variable, prepare three analysis of the overhead cost using the account analysis method, calculate the monthly average of fixed costs and the variable rate per direct labor hour, machine hour and unit of output. So the first thing you want to do is to compute your total variable cost and your total fixed cost. This is your total variable cost, 27,200 plus 44,300 plus 18,500. If we add up all the variable costs, the variable costs should add up to exactly 90,000. Now you'll do the same thing with the fixed cost, which is lease, utilities, insurance, maintenance and depreciation. Now utilities, it might be variable, but they want us to consider it fixed. That's okay. They will add up to 115,100. So this is the fixed cost and the variable cost. So what is the average monthly fixed cost? Well, how do we know this? Well, what happened is, is we're going to take our total cost, our total cost for two years and our monthly average will be for two years divided by 24,000. It's $4,796. So this is our fixed cost per month. Now we need to know our variable cost per, Mary wanted per direct labor hour, machine hours and unit output. Well, per direct labor hours, per direct labor hours, we need to find out how many direct labor hours we incurred. We incurred 12,000 direct labor hours. So our variable cost is 90,000 divided by direct labor hours, which is 12,000, which will give us $7.50 per direct labor hour. So simply put, every one labor of hours we input, we should incur a variable cost of $7.50. Well, what about if we want to know per machine hours? Our machine hours is 14,400. We'll do the same thing, variable cost of 90,000 divided by the machine hours for two years, 14,400. On average, it seems we are consuming $6.25 per machine hour. What is the variable cost per of unit produced? Well, we need to find out how many units we produced. We produced 20,000 units, same exact concept. We'll take 90,000 divided by unit produced of 20,000. For every unit produced on average, it costs us $4.50. So this is how we figured out our variable cost per direct labor hour, per total, I'm sorry, machine hours and per unit. If you like this recording, please like it and share it. And don't forget to visit my website, farhatlectures.com for additional resources for this course as well as your other courses. Good luck, stay safe and study hard.