What is Cost Estimation: Definition and Example

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Pratibha Devasenapathy | Jan-13-2020

Definition

Cost Estimation is a statement that gives the value of the cost incurred in the manufacturing of finished goods. Cost estimation helps in fixing the selling price of the final product after charging appropriate overheads and allowing a certain margin for profits. It also helps in Inventory Reports drawing conclusions regarding the cost of production and in determining the necessity to introduce cost reduction techniques in order to improve the manufacturing process.

Cost estimation takes into consideration all expenditure involved in the design and manufacturing along with all related service facilities such as machines setting; tool making as well as a portion of sales marketing and administrative expenses or what we call overhead costs.

Example and Methods

Isn’t it absolutely annoying to pay expenses each month, without knowing the amount that you’re going to write the cheque for? Being able to estimate business costs accurately can help you plan for the future and see trouble on the horizon. There are many ways to estimate costs, and each one is a different blend of difficulty and accuracy. Knowing some of these basic methods may help you choose the right one for your firm.

Least Squares Regression

A perfect amalgamation of accuracy and ease of use, least squares regression, analyses past data using mathematical estimation, to determine the variable and fixed components of a cost and provides an equation that can be used to predict future expenses. While this sounds complicated, the mathematics are built into most commercial spreadsheet programs, so adoption is as simple as entering your bill history and clicking a few buttons.

High-Low Method

This is a quick and an easy way to estimate costs that still hold accuracy. This method takes into consideration the highest and lowest levels of activity to calculate the fixed and variable components of the cist, but also ignore all the data that isn’t on the extremes. If the highest and lowest levels of expense are representative of the costs you are estimating, then you're in good shape. If not, this method can overestimate or underestimate costs.

Scattergraph

Another quick and easy method to estimate costs is the Scattergraph method. While it might be the quickest and the easiest method to get your expenses estimates, the values derived post calculations might not be that accurate. To use the scattergraph method, you simply plot the cost vs. the level of activity on a graph and draw what you think is the best-fit line through the points. Once you've determined the best-fit line, the slope of the line is the variable cost per unit, and the fixed cost is the point where the line crosses the y-axis. The problem with the scattergraph method is that each person has a different idea of how to draw the best-fit line, giving each person a somewhat different estimate of the cost.

Statistical Modelling

For the largest of small businesses, statistical modelling can be a very accurate method of cost estimation. Industry-specific models are able to predict such complex variables in cost computations as hotel vacancy, food costs, and stock-based compensation expense. While these methods can be very accurate, the cost of implementation can be high, which puts them out of reach for many small firms.

While all these methods might cater to different models, with TallyPrime you need not worry about which method to use to calculate your cost estimates. Our cutting-edge technology and simple reports give you a consolidated estimation of each inventory at one go.

To view the cost estimation of a particular finished product, select the relevant Stock Group which will display the stock consumption details and cost thereof for each of the stock items falling under that Group. Cost estimation, however, is easier said than done. An accurate estimation method can be the difference between a successful plan and a failed one.

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