Cost functions have to do with the total cost involved in a venture, allowing for both fixed costs as well as variable costs related to the anticipated output quantity of a production process. While a cost function can be determined using historical data, it is also possible to develop a cost function estimation on the front end of a venture, using available data to project what the ultimate cost function will be. There are a few different ways to go about arriving at a cost function estimation, with each one providing a logical approach that will work for various situations.
With any type of cost function estimation, the first step is to gather relevant data. This means identifying every fixed cost associated with the project, as well as arriving at a logical amount for each variable cost involved. From there, identifying the quantity of production that is achieved at those levels of expense can make it possible to come up with a cost function estimate for a future period.
One approach to cost function estimation is known as the engineering approach. Here, the idea is to base the estimation on historical data, making certain allowances for changes in the variable costs. Typically, this approach focuses on data accumulated from within the organization and may or may not allow a great deal of information about the economy in general to influence the results.
A cost function estimation may also be conducted using a method known as the survivorship approach. This process involves the inclusion of data relevant to not only the history of the company, but also the industry in which that company functions. With this approach, attention is given to the strength of the firms participating in the industry, how long they’ve been in business, and who has and has not experienced growth over a specific period of time. This approach allows the company to identify with what is happening with companies of similar size and structure with similar levels of revenue generation, and come up with a workable estimate of what is likely to happen in the future.
A cost function estimation may also be developed using a statistical approach. Here, the emphasis is on reviewing historical data as it relates to a series of defined time periods, and may include information collected from one or more firms as the means of arriving at future costs for both fixed and variable expenses. The approach relies on using the collected data in a way that makes certain assumptions, such as whether production will remain the same for the upcoming period under consideration, or if there will be some shift upward or downward in order to meet emerging changes in consumer demand.
The activity of cost function estimation is helpful for any type of business operation. Even small companies will operate with a series of fixed and variable costs related to their output, and must project how those costs will related to production in the future. While this type of estimation is only a projection, responsibly assessing the available data can help owners and others to arrive at an estimate that is highly likely to be very close to the actual costs that are eventually incurred.