WESTERN MINDANAO STATE UNIVERSITY

College of Liberal Arts

Accountancy Department

Chapter 1
COST CLASSIFICATION AND ALLOCATION

LEARNING OBJECTIVES
After studying this chapter, you should be able to…
1. Describe the nature of management advisory services.
2. Explain the nature of cost, cost pools, cost objectives and cost drivers.
3. Identify and explain the various classifications of costs.

Management Advisory Services – refer to that area of accounting work concerned with providing advice and technical assistance to
help clients improve the use of their resources to achieve their goals.
Management Consultant – a person who is qualified by education, experience, technical ability, and temperament to advise or assist
businessmen on a professional basis in identifying, defining, and solving specific management problems involving the organization,
planning, direction, control, and operation of the firm.
Characteristics of MAS
1. Services are rendered for the management rather than for third parties.
2. Involves problem solving.
3. Relates to the future.
4. Broad in scope.
5. Involves varied assignments.
6. Engagements are usually non-recurring.
7. Engagements require highly qualified staff.
8. Human relations play a vital role in each engagement.
Cost and Cost Concepts
Cost – a measurement, in monetary terms, of the amount of resources used for some purpose. When notified by a term that defines
the purpose, cost becomes operational, e.g., selling cost, acquisition cost, variable cost, etc.
Cost Pool – an account in which a variety of similar costs are accumulated prior to allocation to cost objects it is a group of costs
associated with an activity. Example: overhead account.
Cost object – the intermediate and final disposition of cost pools. Example : product, job, process
Cost driver – a factor that causes a change in the cost pool for a particular activity. It is used as a basis for cost allocation; any factor
or activity that has a direct cause-effect relationship
Activity – any event, action, transaction, or work sequence that incurs costs when producing a product or providing a service.

Illustration:
Lynn’s manufacturing plant has several different departments that make vary different products. One department manufactures
sunglasses. The sunglasses department’s operations can be divided up into three main pools: design, molding, and assembly. The
total costs for the department are $50,000.

Using the activity cost pools, Lynn comes up with the following cost drivers: factory square footage used, maintenance hours,
machine hours, labor hours, and number of units produced. Lynn can analyze these three different pools in relation to the cost
drivers and allocate the $50,000 total costs appropriately between the three pools.

Classifications of Costs
A. As to Function
1. Manufacturing Costs – all costs incurred in the factory to convert raw materials into finished goods.
a. Direct Materials – raw materials cost that becomes integral part of the finished product and that can be conveniently
and economically assigned to specific units manufactured.
b. Direct Labor – all labor costs related to time spent on products that can be conveniently and economically assigned to
specific units manufactured.
c. Manufacturing Overhead – all other costs incurred in the factory aside from direct materials and direct labor.
B. As to Timing of Recognition as Expense

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 1. Product Costs – costs that “attach” or cling to the units that are produced and are reported as assets until the goods are
sold.
2. Period Costs – costs that are recognized as expense in the income statement on the period in which the cost was
incurred.
C. As to Traceability to Cost Object
1. Direct Costs – costs that are related to a particular cost object and can economically and effectively be traced to the cost
object.
2. Indirect Costs – costs that are related to a cost object, but cannot practically, economically, and effectively be traced to
that cost object.
D. As to Managerial Influence
1. Controllable Costs – costs that are subject to significant influence by a particular manager within the time period under
consideration
2. Noncontrollable Costs – costs over which a given manager does not have significant influence.
E. As to Time-Frame Perspective
1. Committed Costs – costs that are inevitable as consequence of a previous commitment
2. Discretionary Costs – costs for which the size or the time of incurrence is a matter of choice
F. For Decision Making
1. Relevant Costs – future costs that will differ under alternative courses of action.
2. Differential Costs – difference in costs between any two alternative courses of action.
3. Opportunity Costs – income or benefit given up when one alternative is selected over another.
4. Sunk Costs – costs already incurred and cannot be changed by any decision made now or to be made in the future.
G. As to Behavior
Cost Behavior – describes how a cost behaves or changes as the amount of cost driver changes.
Types of costs as to behavior:
1. FIXED COST – in total; constant within the relevant range as activity output changes; per unit: changes as activity level
changes
2. VARIABLE COST – in total; varies in direct proportion to chages in activity output; per unit:remains constant
3. MIXED COST – has both fixed and variable components.
Illustration:
WMSU Company, doing business in the city of Zamboanga, reports the following total costs at wo levels of production:

Cost Item 2,000 units 5,000 units Answers

Rent P20,000 P20,000 Fixed
Notes:
Direct materials 24,000 60,000 Variable FIXED COST:
Direct labor 16,000 40,000 Variable
Indirect materials 6,000 20,000 Mixed - TOTAL COST = CONSTANT
Indirect labor 10,000 10,000 Fixed - PER UNIT = CHANGES
Insurance 25,000 25,000 Fixed
Maintenance 5,200 14,000 Mixed VARIABLE COST:
Depreciation 8,000 8,000 Fixed
- TOTAL COST = CHANGES
Power 8,000 23,000 Mixed
- PER UNIT = CONSTANT

REQUIRED: Classify each cost as variable, fixed, or mixed.

Assumptions:
1. Relevant Range Assumption
- Relevant range refers to the band of activity within which the identified cost behavior patters are valid. Any level of activity
outside this range may have a different cost bahavior pattern.
- Outlier - behaviors in the cost that is outside of the relevant range and should never be used in estimating costs as they
may either overstate or understate the estimation. However, the determination of outliers are circumstantial and will
depend on the professional judgment.
2. Time Period Assumption
- The cost behavior patterns identified are true only over a specified period of time. Beyond this, the cost may show a
different behavior.
3. Linearity Assumption
- Within the relevant range, there is a strict linear relationship between the cost and cost driver. Costs may therefore be
shown graphically as straight lines.
The Total Cost Function
Y = a + bx
where: Y = total cost
a = total fixed cost
b = variable cost per cost driver
x = activity level or cost driver

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Segregation of Fixed and Variable Elements of Mixed Costs:
1. High-Low Points Method – the fixed and variable elements of the mixed costs are computed from two data points (period) –
the high and low periods as to activity level or cost driver.

2. Statistical Scattergraph Method – various costs (the dependent variable) are ploted on a vertical lime (y-axis) and
measurement figures (cost drivers or activity levels) are plotted on a horizontal line (x-axis). A straight line is drawn through
the points and, using this line, the rate of variability and the fixed cost are computed.

Steps involved in the use of Scattergraph:

a. On a graph, plot actual costs (on vertical axis) during the period under study against the volume levels (on horizontal axis)
b. The line of best fit is then drawn by visual inspection of the plotted points, the line representing the trend shown by the
majority of the points.
c. The fixed cost is estimated by extending the left end of the line to the vertical axis.
d. The variable cost rate or slope of the cost line is determined by dividing the difference between any two levels of activities
by the difference in costs corresponding to the same level of activities.

3. Account Analysis Method - an account is classified as either variable or fixed based on the analyst’s prior knowledge2 of
how the cost in the account behaves. The total fixed cost is the sum of the costs for the accounts that have been classified as
fixed. The estimated variable cost per unit is estimated by dividing the sum of the costs for the accounts that have been
classified as variable by the total activity.

4. Engineering Approach - involves a detailed analysis of what cost behavior should be based on the industrial engineer’s
evaluation of the production methods to be used, the materials specifications, labor requirements, equipment usage,
production efficiency, power consumption, and so on.

5. Conference Method - each representative of different departments is convened to discuss the estimated costs that the
departments will incur during the year and to be sorted out as to either depending on the production (variable) or not (fixed).

6. Method of Least Squares (Regression Analysis) – mathematically determines a line of best fit ot a linear regression line
through a set of plotted points so that the sum of the squared deviations of each actual plotted point from the point directly
above or below it on the regression line is at minimum. This method uses the following equations in computing for the values
of unit variable cost and fixed cost:

Equation 1: ∑Y = na + b∑x
Equation 2: ∑xy = a∑x + b∑x2

Alternative:

b = (n∑xy - ∑x∑y) / (n∑x2 – (∑x)2)

a = (∑y - b∑x) / n

COST FORMULE: y = a + bx
Where: “y” denotes total cost. It is called the dependent variable because it is dependent on the value of another variable, the
activity level x.
“a” is an estimate of the fixed cost.
“b” is an estimate of the variable cost.

Multiple Regression Analysis - is a statistical method of separating fixed and variable cost which is used when the
dependent variable (cost) is caused by more than one factor/independent variable.
Illustration:

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 JPIA is a small one-person company that provides elaborate and imaginative wedding cakes to order for very large wedding
receptions. The owner of the company would like to understand the cost structure of the company and has complied the following
records of activity and costs incurred. The owner believes that the number of wedding catered is the best measure of activity.
Month Weddings Costs Incurred
January 3 P3,800
February 2 P3,600
March 6 P4,000
April 9 P4,300
May 12 P4,500
June 20 P5,200

REQUIRED:
a. Using the HIGH-LOW METHOD, estimate the variable cost per wedding and the total fixed cost per month (Round off variable
cost per wedding to the nearest centavo and the total fixed cost to the nearest peso)
b. Using the least-squares regression method, estimate the variable cost per wedding and the total fixed cost per month. (Round
off variable cost per wedding to the nearest centavo and the total fixed cost to the nearest peso)

SOLUTION:
a. Variable Cost per unit = (5,200 – 3,600)/(20 – 2)
= 88.89
Fixed Cost
Using the highest, Using the lowest,
= 5,200 – (20 x 88.89) = 3,600 – (2 x 88.89)
=P3,422 = P3,422

b.

Month(n) Weddings(x) Costs Incurred(y) xy x2 Totals

January 3 P3,800 11,400 9 n=12
February 2 P3,600 7,200 4 ∑x= 52
March 6 P4,000 24,000 36 ∑y= P25,400
April 9 P4,300 38,700 81 ∑xy= P239,300
May 12 P4,500 54,000 144 ∑x2=674
June 20 P5,200 104,000 400

By using the formula,

b = (n∑xy - ∑x∑y) / (n∑x2 – (∑x)2)
b = [(12*239,300) – (52*25,400)] – [(12*674) – (52)2]
b = 85.52

a = (∑y - b∑x) /n
a = (25,400 – 85.52*52)/6
a = 3,492

Summary of Strengths and Weaknesses of the Methods

Method Strengths Weaknesses

• Provides a detailed expert analysis of the cost • Subjective
Account Analysis
behavior in each account
• Based on studies of what future costs should be • Not particularly useful when the physical relation
Engineering Method
rather than what past costs have been. between inputs and outputs is indirect.
• Uses all observations of cost data. • The fitting of the line to the observations is
Scatter graph • Relatively easy to understand and apply subjective.
Method • Difficult to do where several independent
variables are to be used.
• Simple to apply. • Uses only two data points which may not
High-Low Method
produce accurate results.
Least Squares • Uses all the observations of cost data. • Requires several relatively strict assumptions be
Regression Method • The line is statistically fit to the observations. satisfied for the results to be valid.
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 • A measure of the goodness of fit of the line to the
observations is provided.
• Relatively easy to use with computers and
sophisticated calculators.

Correlation Analysis

Correlation – measure of the co-variation between the dependent and independent variables. • If all plotted points fall on the
regression line, there is a perfect correlation. • 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.

Measures of Correlation Coefficient of Correlation (r) – measure of the extent of the linear relationship between two variables.
Points of consideration:
• Range of values of r: from -1 to 1
• When r = 0, no correlation exists
• When r = 1, there is a positive perfect relation. Positive correlation denotes direct relationship between two variables.
• When r = -1, there is a perfect negative correlation. Negative correlation denotes indirect relationship between the variables.

Coefficient of Determination (r2) – represents the percentage of the total variation in the dependent variable y that is explained or
accounted for by the regression equation. It is a measure of how well the regression line represents the data. If the regression line
passes exactly through every point on the scatter plot, it would be able to explain all of the variation.

Standard Error of Estimates – the standard deviation about the regression line. It serves as a confidence interval or acceptable range
of tolerance, for use in exercising control over the costs.
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PRACTICE EXERCISES

THEORIES:

1. Cost behavior analysis is a study of how a firm's costs

A. relate to competitors' costs.
B. relate to general price level changes.
C. respond to changes in activity levels within the company.
D. respond to changes in the gross national product.

2. The term “relevant range” as used in cost accounting means the range over which
A. costs may fluctuate C. production may vary
B. cost relationships are valid D. relevant costs are incurred

3. Most operating decisions by management focus on a narrow range of activity which is called the:
A. relevant range of production. C. optimal level of production.
B. strategic level of production. D. tactical operating level of production.

4. An item or event that has a cause-effect relationship with the incurrence of a variable cost is called a
A. mixed cost. C. direct cost.
B. predictor. D. cost driver.

5. If a predetermined overhead rate is not employed and the volume of production is increased over the level planned, the cost per unit
would be expected to
A. Decrease for fixed costs and remain unchanged for variable costs.
B. Remain unchanged for fixed costs and increase for variable costs.
C. Decrease for fixed costs and increase for variable costs.
D. Increase for fixed costs and increase for variable costs.

6. Which of the following describes the behavior of the variable cost per unit? Variable cost:
A. Varies in increasing proportion with changes in the activity level.
B. Varies in increasing proportion with changes in the activity level.
C. Remains constant with changes in the activity level.
D. Varies in direct proportion with the activity level.

7. A cost that remains constant on a per unit basis in a given period despite changes in the level of activity should be considered a(an):
A. variable cost. C. fixed cost.
B. prime cost. D. overhead cost.

8. Malayan Company’s average cost per unit is the same at all levels of volume. Which of the following is true?
A. MALAYAN must have only variable costs.
B. MALAYAN must have only fixed costs.
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 C. MALAYAN must have some fixed costs and some variable costs.
D. MALAYAN’s cost structure cannot be determined from this information.

9. Depreciation expense based on the number of units produced is classified as what type of cost?
A. Out-of-pocket cost. C. Variable cost.
B. Marginal cost. D. Fixed cost.

10. When production increases, variable manufacturing costs react in which of the following ways?
A. B. C. D.
Unit variable cost decreases remains same remains same increases
Total variable cost decreases Increases decreases Increases

11. When the number of units manufactured increases, the most significant change in unit cost will be reflected as a(n)
A. increase in the fixed element. C. increase in the mixed element.
B. decrease in the variable element. D. decrease in the fixed element.

12. As volume increases,

A. total fixed costs remain constant and per-unit fixed costs increase.
B. total fixed costs remain constant and per-unit fixed costs decrease.
C. total fixed costs remain constant and per-unit fixed costs remain constant.
D. total fixed costs increase and per-unit fixed costs increase.

13. Which of the following best describes a fixed cost?

A. It may change in total when such change is unrelated to changes in production.
B. It may change in total when such change is related to changes in production.
C. It is constant per unit of change in production.
D. It may change in total when such change depends on production within the relevant range.

14. If activity increases, which of the following statements about cost behavior is true?
A. Fixed cost per unit will increase C. Fixed cost per unit will decrease
B. Variable cost per unit will increase D. Variable cost per unit will decrease

15. An increase in the activity level within the relevant range results in:
A. an increase in fixed cost per unit.
B. a proportionate increase in total fixed costs.
C. an unchanged fixed cost per unit.
D. a decrease in fixed cost per unit.

16. A cost that remains constant in total but varies on a per-unit basis with changes in activity is called a(n)
A. expired cost. C. variable cost.
B. fixed cost. D. mixed cost.

17. Which of the following statements regarding fixed costs is incorrect?

A. Expressing fixed costs on a per unit basis usually is the best approach for decision-making process.
B. Fixed costs expressed on a per unit basis will react inversely with changes in activity.
C. Assumptions by accountants regarding the behavior of fixed costs rest heavily on the concept of the relevant range.
D. Fixed costs frequently represent long-term investments in property, plant, and equipment.

18. Lamang Company changed its cost structure by increasing fixed costs and decreasing its per-unit variable costs. The change:
A. Increases risk and increases potential profit.
B. Increases risk and decreases potential profit.
C. Decreases risk and decreases potential profit.
D. Decreases risk and increases potential profit.

19. A management’s preference for a very low degree of operating leverage might indicate that:
A. an increase in sales volume is expected.
B. a decrease in sales volume is expected.
C. the firm is very unprofitable.
D. the firm has very high fixed costs.

20. The increased use of automation and less use of the work force in companies has caused a trend towards an increase in
A. both variable and fixed costs.
B. fixed costs and a decrease in variable costs.
C. variable costs and a decrease in fixed costs.
D. variable costs and no change in fixed costs.

21. Costs that increase as the volume of activity decreases within the relevant range are
A. Average cost per unit. C. Total fixed costs.

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 B. Average variable cost per unit. D. Total variable costs.
22. Which costs will change with an increase in activity within the relevant range?
A. Total fixed costs and total variable cost.
B. Per unit fixed costs and total variable cost.
C. Per unit variable cost and per unit fixed cost.
D. Per unit fixed cost and total fixed cost.

23. Which of the following best describes the relationship between fixed costs per unit and variable costs per unit, as total volume
increases?
A. Fixed cost per unit stays the same and variable cost per unit stays the same.
B. Fixed cost per unit stays the same and variable cost per unit increases.
C. Fixed cost per unit increases and variable cost per unit increases.
D. Fixed cost per unit decreases and variable cost per unit stays the same.

24. Within the relevant range, the difference between variable costs and fixed costs is:
A. variable costs per unit fluctuate and fixed cost per unit remains constant.
B. variable cost per unit is constant and fixed cost per unit fluctuates.
C. both total variable cost and total fixed cost are constant.
D. both total variable cost and total fixed cost fluctuate.

25. Which of the following methods is used to estimate costs?

A. Account analysis C. Engineering method
B. High-low method D. All of the above

26. For analysis purposes, the high-low method usually produces a(n)
A. reasonable estimate. C. overstated estimate.
B. precise estimate. D. understated estimate.

27. The high-low method is criticized because it

A. is not a graphical method.
B. is a mathematical method.
C. ignores much of the available data by concentrating on only the extreme points.
D. does not provide reasonable estimates.

28. The high-low method may give unsatisfactory results if

A. the data points all fall on a line. C. the points are not representative.
B. volume of activity is heavy. D. volume of activity is light.

29. The equation(s) required for applying the least squares method in the computation of fixed and variable production costs could be
expressed as
A. xy = ax + b x2 C.  y = na + b x
B. y = a + bx2 D. xy = ax + b x2
xy = na + b x y = na + bx

30. Weaknesses of the high-low method include all of the following except
A. Only two observations are used to develop the cost function.
B. The high and low activity levels may not be representative.
C. the method does not detect if the cost behavior is nonlinear.
D. the mathematical calculations are relatively complex.

31. Which of the following methods may be used to estimate costs by using time-and-motion studies to approximate labor time?
A. Regression analysis C. Engineering method
B. Account analysis D. High-low method

32. The cost estimation method that gives the most mathematically precise cost prediction equation is
A. the high-low method C. the scatter-diagram method
B. the contribution margin method D. regression analysis

33. Regression analysis is better than the high-low method of cost estimation because regression analysis:
A. is more mathematical. C. fits its data into a mathematical equation.
B. uses all the data points, not just two. D. takes more time to do.

34. In regression analysis, what does the variable "X" stand for in the model Y = a + bX + e?
A. The amount of the dependent variable, the cost to be estimated.
B. The regression error, which is the distance between the regression line and the data point.
C. The value for the independent variable, the cost driver for the cost to be estimated; there may be one or more cost drivers.
D. The unit variable cost, also called the coefficient of the independent variable.

35. A cost-predicting equation determined through regression analysis

A. always gives close predictions.

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 B. will not work any better than one obtained using the high-low method.
C. can be used only for costs that vary with sales of production.
D. could be severely affected by outliers.

36. In the cost equation TC = F + VX, the X term is:

A. total fixed costs. C. unit variable cost.
B. total variable costs. D. activity units.

37. The closeness of the relationship between the cost and the activity is called
A. correlation C. spurious
B. regression analysis D. manufacturing overhead

38. R-squared is a measure of

A. the spurious relationship between cost and activity
B. the fixed cost component
C. the variable cost per unit of activity
D. how well the regression line accounts for the changes in the dependent variable

39. The principal advantage of the scatter-diagram method over the high-low method of cost estimation is that the scatter-diagram
method
A. includes cost outside the relevant range.
B. considers more than two points.
C. can be used with more types of costs than the high-low method.
D. gives a precise mathematical fit of the points to the line.

40. The major objective of preparing a scatter-diagram is to

A. develop an equation to predict future costs.
B. perform regression analysis on the results.
C. determine the relevant range.
D. find the high and low points to use for the high-low method of estimating costs.

PROBLEMS:

1. Nite Corporation has developed the following flexible budget formula for annual indirect labor costs:
Total Cost = P480,000 + P5.00 per machine hour
Operating budgets for the current month are based upon 20,000 machine hours of planned machine time. Indirect labor costs
included in this planning budget are:
A. P 48,333 C. P580,000
B. P100,000 D. P140,000

2. Harem Company uses an annual cost formula for overhead of P72,000 + P1.60 for each direct labor hour worked. For the upcoming
month Karla plans to manufacture 96,000 units. Each unit requires five minutes of direct labor. Harem Company’s budgeted overhead
for the month is
A. P 12,800 C. P 84,800
B. P 18,800 D. P774,000

3. Total production costs for Jordan, Inc. are budgeted at P2,300,000 and P2,800,000 for 50,000 and 60,000 units of budgeted output,
respectively. Because of the need for additional facilities, budgeted fixed costs for 60,000 units are 25 percent more than budgeted
fixed costs for 50,000 units. How much is Jordan’s budgeted variable cost per unit of output?
A. P 7.50 C. P30.00
B. P16.00 D. P62.50

4. Irma Company manufactures office furniture. During the most productive month of the year, 3,500 desks were manufactured at a
total cost of P84,400. In its slowest month, the company made 1,100 desks at a cost of P46,000. Using the high-low method of cost
estimation, total fixed costs in August are:
A. P56,000 C. P17,600
B. P28,400 D. P38,400

5. Palm, Inc. has a total of 2,000 rooms in its nationwide chain of hotels. On the average, 70 percent of the rooms are occupied each
day. The company’s operating cost is P21 per occupied room per day at this occupancy level, assuming a 30-day month. This P21
figure contains both variable and fixed cost elements. During October, the occupancy dropped to only 45 percent. A total of P792,000
in operating costs were incurred during the month.

What would be the expected operating costs, assuming that the occupancy rate increases to 60 percent during November?
A. P1,056,000 C. P 756,000
B. P 846,000 D. P 829,500

6. The Shepherd Company’s president would like to know the estimated fixed and variable components of a particular cost. Actual data
for this cost for four recent periods appear below.
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 Activity Cost
Period 1 24 P174
Period 2 25 179
Period 3 20 165
Period 4 22 169
Using the least-squares regression method, what is the cost formula for this cost?
A. Y = P 0.00 + P7.55X C. Y = P103.38 + P3.00X
B. Y = P110.44 + P2.70X D. Y = P113.35 + P0.89X

B. P2.57. D. P2.85.

7. The Overland Company wants to develop a cost estimating equation for its monthly cost of electricity. It has the following data:
Month Electricity Cost Direct Labor Hours
January P6,750 1,500
April 7,500 1,700
July 8,500 2,000
October 7,250 1,600
Using the high-low method, what is the best equation?
A. Y = P 750 + P5.00X C. Y = P 750 + P3.50X
B. Y = P1,500 + P3.50X D. Y = P1,500 + P5.00X

8. The following information is available for maintenance costs:

Month Production Volume Maintenance Costs
June 150,000 P500,000
July 230,000 620,000
August 380,000 800,000
September 120,000 480,000
October 270,000 710,000
Using the least squares, the estimate of the fixed portion of maintenance costs (rounded to thousand pesos) is
A. P131,000 C. P332,000
B. P321,000 D. P115,000

9. Tomas Ocampo has just been appointed chairperson of the Accountancy Department of ADEB College. In reviewing the
department’s cost records, Tomas has found the following total cost associated with MAS Part 2 subject over the last several terms:
Semester/Term Number of Subjects Offered Total Cost
AY2004, First Semester 4 P10,000
AY2004, Second Semester 6 14,000
AY2004, Summer 2 7,000
AY2005, First Semester 5 13,000
AY2005, Second Semester 3 9,500
Tomas knows that there are some variable costs, such as amounts paid to student assistants, associated with the course. He would
like to have variable and fixed cost components separated for planning purposes.
Using the least-squares method, what is the variable cost per section of MAS?
A. P1,750 C. P1,200
B. P1,500 D. P 900

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