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written by | April 29, 2022

What is Cost Estimation? Methods and Examples

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For a business to run smoothly, it is important to understand the concept of cost estimation. Cost estimation is a method that helps approximate the cost of manufacturing or producing a good, considering the costs of capital, labour, transportation charges, marketing and sales costs, and the substantial profit margin. Cost estimation also helps analyse inventory reports, draw inferences regarding the cost of manufacturing, and decide the requirement to introduce cost deduction tools to improve the production process.

Did you know?

Cost estimates are used to bid on new businesses from eventual clients and improve their job and budget planning process.

Cost Estimation Definition

Cost estimation refers to an assertion or statement that provides the value of the cost sustained in the manufacturing or producing a finished good. This process facilitates determining the selling price of the finished or final product after deducting reasonable fixed costs and leaving substantial profit margins. 

Cost estimation considers any expenditure incurred in designing and producing a good or product and any associated service provisions such as physical capital, tool production, marketing and sales costs, administrative expenditure, and other overhead costs.

Cost Estimation Example

The following example of cost estimation would help to make its meaning better understandable:

The cost estimation of a refrigerator would be:

Cost of raw material: ₹15,000

Cost of labour: ₹5,000

Cost of painting: ₹1,000

Cost of electricity required in manufacturing: ₹500

Cost of transportation: ₹1,000

Cost of marketing: ₹1,000

Total estimated cost or cost estimation: ₹23,800. 

Also Read: Everything You Need to Understand About Inventory Control

Types of Cost Estimation

The following are the methods to calculate cost estimation:

Least Squares Regression

This method or type of cost estimation analyses previous data using a mathematical approximation to decide the fixed and variable units of a cost and gives forth an equation that can be used to estimate future costs or expenses. This method certainly is a perfect confluence of ease and accuracy found in most commercial spreadsheet systems.

High-Low method

This method considers the lowest and highest stages of an activity to estimate the variable and fixed costs, simultaneously ignoring the median data. This type of cost estimation has a short drawback in the form of overestimation or underestimation when the lowest and highest levels of expenses indicate the estimated costs. 

Scatter Graph

This method is appropriated by subtly plotting the cost in various stages of activity on a graph and drawing the best-fit line across the points. The slope of the line becomes the variable cost per unit, whereas the line crossing the y-axis becomes the fixed cost. Even though this type of cost estimation is the easiest and the fastest, the resultant values might not be accurate. The drawback here arises due to the subjective understanding of the nature of the graph by every person. 

Statistical Modelling

This cost estimation is mainly helpful to small businesses in accurately determining the costs. Apart from this, there are industry-centric models too that estimate such complicated variables in cost calculations as food costs, stock-based compensation expenditure etc. The drawback of cost estimation is the high value of implementation, which makes it difficult for small businesses to afford this system. 

What is Estimating and Costing?

Estimating and costing are used to calculate or measure the various quantities and the presumed expenditure on a specific work or project. Estimating and costing provides an approximation of the cost of the job, and therefore its viability can be assessed. It also gives an estimate of the time required to complete the work. 

The purpose of estimating and costing

  • It helps invite quotations and tenders and to arrange for contracts.
  • It is also essential for controlling expenses during the implementation of the work. 
  • It also determines whether or not the suggested plan matches the fund reserve available. 

Also Read: Bill of Materials Definition, Examples, Format and Types

Advantages of Cost Estimation

The following are the advantages or merits of cost estimation:

  • Accurate planning: Cost estimation helps predict future expenses accurately, which helps determine the cost of manufacturing a product.
  • Increased profit margins: Advance information on expected expenditure helps in regulating costs. Hence, it helps in increasing profit margins in the long run.
  • Efficient and improved resource management: Increased insights into the expenses helps in proper allocation and implementation of the fund or money reserve at hand sanctioned for manufacturing a particular product. It also helps mobilise the required skills, capital, etc., to produce a good within the available budget.
  • Built a reputation in business: Better management of funds, resources, and efficient production of goods at the end leads to a stronger reputation built amongst the market contenders. Thus, it is helpful for a business to grow satisfactorily. 

Conclusion

Cost estimation as a method in businesses is essential as it helps with greater accurate planning, increased and improved profit margins, improvised resource management, stronger customer relationship and a better reputation in the business. It is an efficient tool to calculate approximate costs and expenses of manufacturing or producing an article or goods, which facilitates keeping a check on the expenditure and improves profit margins in the long run. The purpose of estimating and costing is quite clear in regard to giving a future perspective about fund management and cost bearing. 
Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.

FAQs

Q: What is a high-low method of cost estimation?

Ans:

The high-low cost estimation method takes into account the lowest and highest stages of an activity to estimate the variable and fixed constituents of the cost. It also simultaneously ignores the median data. This type of cost estimation has a short drawback in the form of overestimation or underestimation when the lowest and highest levels of expenses indicate the estimated costs.

Q: What is a drawback of scatter graphs and statistical modelling?

Ans:

A drawback of the scattergraph method of cost estimation is the subjective understanding of the nature of the graph by every person. On the other hand, a drawback of the statistical modelling method of cost estimation is the high implementation value, which at times makes it difficult for small businesses to afford this system.

Q: What is estimating and costing?

Ans:

Estimating and costing are used to calculate or measure the various quantities and the presumed expenditure on a specific work or project. Estimating and costing provides an approximation of the cost of the job, and therefore its viability can be estimated. It also gives an estimate of the time required to complete the work.

Q: What is cost estimation?

Ans:

Cost estimation refers to an assumption that provides the value of the cost sustained in the manufacturing or production of a finished good. This process facilitates determining the selling price of the finished or final product after deducting suitable fixed costs and leaving substantial profit margins.

Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.
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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.