Mindanao State University
College of Business Administration and Accountancy
DEPARTMENT OF ACCOUNTANCY
Marawi City
COST SEGREGATION AND ESTIMATION
Accounting 142
THE NEED TO SEGREGATE AND ESTIMATE COSTS
Most often than not, firms incur costs that are mixed in
nature. Seldom would firms incur purely variable cost or
purely fixed cost. However, for planning and controlling
purposes, the mixed cost classification is not relevant. Mixed
costs must, therefore, be segregated into their variable and
fixed cost components.
To achieve this objective, an examination of the past
relationships of costs and level of activity (the cost driver)
must be made to establish a reasonable segregation of
costs into their variable and fixed components. This
relationship can also be used to develop predictions of
future costs by expressing such a relationship into a cost
function. This process is referred to as cost estimation.
APPROACHES AND TECHNIQUES IN COST SEGREGATION
There are various cost segregation techniques available for
use by an entity. Each approach has its own advantages
and disadvantages.
 CONFERENCE METHOD
In the conference method, estimates of cost functions are
derived from analysis and opinions about cost relationships
by individuals from various departments. This method can
be done quickly but may not be as reliable as those that
are based on other methods.
 ACCOUNT ANALYSIS
In account analysis, analysts estimate variable and fixed
cost behaviors of a particular cost by analyzing ledger
accounts and designating them as containing fixed costs,
variable costs or mixed costs. This method is a widely used
approach but for it to be reliable, it must be performed by
individuals who understand operations.
In making the analysis, information gathered are evaluated
from two sources namely:
A. Managerial policies with respect to the cost.
B. Historical activity of the cost.
Further, all costs are classifiable as either fixed or variable. If
a cost shows semi-variable or semi-fixed behavior, the
analyst either:
A. Makes a subjective estimate of the variable and
fixed portions of the cost
B. Classifies the account according to the
preponderant behavior.
 ENGINEERING APPROACH
The engineering approach to cost segregation uses the
analysis and direct observation of processes to identify the
physical relationship between inputs and outputs and then
quantifies an expected cost behavior. Though considered
the most reliable method, the engineering approach is time
consuming and costly.
Time and motion studies as well as other analyses are used
to assess the overhead relationships to the manufacturing
process. Once quantities and time are determined, the
costs related to those amounts are established using
appropriate materials prices, labor rates and overhead
rates.
 HIGH-LOW METHOD
In high-low method, estimate of cost functions are derived
by computing for the slope for the variable rate based on
the highest and lowest observations. It is assumed that semi-
variable costs have fixed and variable cost components.
The fixed component is considered the basic or minimum
cost of just having a service ready and available for use.
The variable element varies in proportion to the amount of
service that is consumed.
The high-low method makes use of the cost function: Y = a
+ bx. To be able to get the values of a and b in the cost
formula, two representative points in the line are taken and
the assumption in this theory is that the highest and lowest
points are the representative points of the total activity.
This method also makes use of the various levels of activity
incurred for a certain type of semi-variable cost. It is
assumed that the highest and the lowest points possess the
same amount of total fixed costs (represented by y) and
same variable cost per unit (represented by x).
Graphical Approach
This approach to the high-low method involves the
following steps:
A. Plot the data on a graph. In algebra, the values in x
and y are called variables. The y values are the
dependent variables since the amount of costs
incurred during the period depends on the cost
driver or level of activity for the period. The x values
are the independent variables since they cause
the variation in costs.
B. Draw a straight line through the points
corresponding to the low and high cost drivers or
activity levels.
C. Compute the slope of the line which represents the
variable cost per unit by using the following
formula:
y high – y low
b=
x high – x low
D. The y-intercept, the point where the straight line
touches the y-axis, represents the fixed cost.
E. Develop the cost function using the equation for
the straight line, y = a + bx.
Algebraic Method
This approach to the high-low method involves the
following steps:
A. Choose the periods with the highest and lowest
activity levels.
B. Get the differences in the costs and the cost drivers
between the highest and lowest data points.
C. Determine the variable cost per cost drivers by
using the following formula:
Difference in costs
b=
Difference in cost drivers
D. Determine fixed costs at any data point by
subtracting total variable cost from the total or
mixed cost. Total variable cost can be computed
by multiplying the cost driver by the variable cost
per cost driver.
F. Develop the cost function using the equation for
the straight line, y = a + bx.
In using the high-low method, the following guidelines
should be considered by the analyst:
A. High-low point method is the simplest method but it
relies heavily on the assumption that the other data
points lie on a straight line between the highest
and lowest points. It defeats the sampling objective
by considering only two samples and entirely
disregarding the rest of the samples.
B. Do not select data points distorted by abnormal
conditions, i.e. abnormally or extraordinarily high
and low points.
C. If the periods of highest or lowest activity levels are
not the same as those having the highest or lowest
cost levels, the activity level should govern the
selection because the activity level is the cost
driver.
 D. To determine the fixed cost, the data to be used
should only be either the highest or the lowest
activity and not any other data point for the
assumption to hold.
 SCATTER-GRAPH METHOD
Also known as the visual fit technique, the scatter-graph
method is a rough guide for cost estimation which plots the
cost against past activity levels. A visual judgment is thus
used to draw a line at the center of both the distances of
the observations below and above the line.
The line of regression represents the data as a line of
conditional expected values; the line fitted to the plotted
points.
The line of best fit must not go below the fixed cost line or it
will defeat the definition of a semi-variable cost. Further, the
line should cut across the points to achieve the least
deviation from all the points.
To derive the values of a and b, derive two points nearest
the line and solve the equation using the algebraic solution
for two linear variables. This follows the same principle as
the high-low method but does not necessarily use the
highest and lowest points as the representative values.
 LEAST SQUARES METHOD
Also known as the simple regression analysis, the least
squares method technique is designed primarily to achieve
accuracy in determining the line of regression which is
difficult to attain under the statistical scatter-graph method.
It is considered a method that estimates the relationship
between the dependent variable and one independent
variable with a measure of probable error. Unlike in a
scatter-graph where the line is fitted by visual inspection,
the least squares method uses mathematical formulas to fit
the regression line.
Regression is defined as a method for fitting a curve (not
necessarily a straight line) through a set of points using
some goodness-of-fit criterion. The least squares method is
also called a simple regression because it involves only one
dependent variable. A regression analysis with multiple
variables is known as multiple regression analysis.
The objective is to come up with the cost function: Y = a +
bx. The values of a and b may be computed by solving
simultaneously the following equations:
Equation 1: ∑y = na + b∑x sum of deviations above
the line
Equation 2: ∑xy = ∑xa + b∑x2 sum of deviations below
the line
where: a – the total fixed cost; b – the variable cost rate; y
– total cost; n – total number of observations; x – activity
level; ∑ – summation.
Alternatively, the value of a and b can be directly
computed using the following formula:
∑y – b∑x n(∑xy) – ∑x∑y
a= b=
N n∑x2 – (∑x) 2
 CORRELATION ANALYSIS
Correlation analysis is a method of establishing the
relationship or the correlation between two variables – the
dependent variable and the independent variable. If the
variables move with each other, they have a direct
relationship (positive correlation). If the variables move in
opposite directions, they have an inverse relationship
(negative correlation).
The coefficient of correlation, denoted by “r”, mathematically
measures the extent by which two variables are related
linearly. The following conclusions are useful in correlation
analysis:
A. If all plotted points fall on the regression line, there is
perfect correlation.
B. If correlation between the cost and cost driver is
high and the past relationship between such
variables will continue in the future, then the cost
driver chosen will be useful for predicting future
levels of the costs being analyzed.
C. The value of the coefficient of correlation ranges
from -1 to + 1. When r = 0, there is no correlation.
When r = +1 or when r = -1, there is perfect
correlation.
D. When r is positive, there is a positive or direct
relationship between the dependent (y) and
independent (x) variables. That is, the value of y
increases when the value of x increases. The
regression line slopes upward to the right.
E. When r is negative, there is a negative or inverse or
indirect relationship between the variables. The
value of y decreases as the value of x increases.
The regression line slopes downward to the right.
F. It is a trap to assume that because correlation is
found, there is a causal relationship. For example,
the sales of ice-cream correlate (i.e. go up and
down with) people buying sunglasses. One does
not cause the other. In this case, they both have a
common cause, that is, a sunny weather. At best,
correlation can indicate a potential relationship,
which may be confirmed by other methods.
Another measure in correlation analysis is the coefficient of
determination, denoted by “r2”. The coefficient of
determination represents the percentage of the total
variation in the dependent variable (y) that is explained or
accounted for by the regression equation. It is computed
by squaring the value of “r”. The higher the value of r 2, the
better the relationship explains the variation in the
dependent variable (y).
If the regression line passed through every point on the
scatter plot exactly, it would be able to explain all of the
variation. The further the line is from the points, the less it is
able to explain. In cost estimations, a high r 2 means that the
cost analyst can be relatively confident in the cost
predictions based on the estimated cost behavior pattern.
In summary, the coefficient of correlation shows the
direction of the relationship (which could be + or –) while
the coefficient of determination shows the strength of the
relationship (which is always +).
Standard Error of Estimate
The standard error refers to the standard deviation about
the regression line. Estimated values computed using the
regression equation may differ from the actual costs as
estimated values are based on samples. The differences
are called prediction errors.
The standard error of estimate is calculated to serve as a
confidence interval or acceptable range of tolerance, for
use in exercising control over the costs. It indicates how
much the estimated value is likely to be affected by
random factors. By comparing a cost variance with the
standard error of estimate, management can decide
whether to investigate such variance or not. The following
conclusions are useful in the use of the standard error of
estimate:
A. If r2 = 1, the standard error = 0.
B. A small value of the standard error indicates a
good fit.