LEARNING PACKET 2

TOPIC: Cost Concepts, Classification and Behavior

I. CONCEPT NOTES

Nature of Cost

Definition of Cost and Other Related Terms

Cost – amount of resources sacrificed (given up or used) in order to obtain some present or future economic
benefits which will promote the profit-making ability of the enterprise.
Cost Object – anything for which cost is computed or assigned. (e.g. a product, a product line, a business unit)
Cost Drivers – any variable/factor that usually affects cost over a period of time. (e.g. production, number of hours
worked)
Cost Pool – a grouping of similar cost items. (e.g. factory overhead, advertising cost)
Activity – an event, action, transaction, task or unit of work with a specified purpose.
Value-adding Activities – activities that are necessary to produce a product.
Non-value-adding Activities – activities that do not make the products more valuable to the customer.

Classifications of Cost

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.
2. Non-Manufacturing Costs – all costs which are not incurred in transforming materials to finished goods.
a. Selling/Marketing/Distribution Costs – all costs associated with marketing or selling a product.
b. General and Administrative Costs – all executive, organizational and clerical costs associated with the
general management of the organization rather than with manufacturing, marketing or selling.

As to Timing of Recognition as Expense

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.

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.

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.

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.

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

As to Behavior
1. Variable Costs – costs which change in total amount directly in proportion to the change in the activity
level but remain constant on a per unit basis within the relevant range and time period under consideration.
 2. Fixed Costs – costs for which the total amount remain constant but changes inversely to the change in
activity level on a per unit basis within the relevant range and time period under consideration.
3. Mixed Costs – costs which have both variable and fixed component.
4. Step Costs – costs that do not change steadily with changes in activity volume, but rather at discrete points.
a. Step-variable Costs
b. Step-fixed Costs

Cost Behavior Analysis

Definition of Relevant Terms

Cost Behavior – refers to how cost reacts to changes in the level of business activity.
Relevant Range – a range of activity that reflects the company’s normal operating range.

Cost Behavior Assumptions:

1. Relevant Range Assumption
Relevant range refers to the band of activity within which the identified cost behavior patterns are valid.
Any level of activity outside this range may have a different cost behavior pattern.
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

Methods of Separating Mixed Cost

Account Analysis Method

In Account Analysis, an account is classified as either variable or fixed based on the analyst’s prior
knowledge 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.

Engineering Approach
The 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.

Conference Method
In a 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).

(Statistical) Scattergraph Method

Scattergraph Method is a separation method where cost and past activity levels are plotted against a graph,
where costs are plotted on the vertical axis (considered as dependent variable), while the corresponding
activity levels are plotted on the horizontal axis (considered as independent variable).
Steps involved in the Use of Scattergraph:
1. On a graph, plot actual costs (on vertical axis) during the period under study against the volume levels (on
horizontal axis)
2. 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.
3. The fixed cost is estimated by extending the left end of the line to the vertical axis.
4. 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.

High-Low Method
High-Low Method is a simple cost separation method by analyzing the change in cost between the high and
low activities. This method is based on the rise-over-run formula for the slope of a straight line.
Formula:
 Δ
Cost of the Highest Activity Level - Cost of the Lowest Activity Level
Y
b= =
Δ
Highest Activity Level - Lowest Activity Level
X

Least Squares Regression Method

The Least Squares Regression Method uses mathematical formulas to fit the regression line, unlike in
scattergraph where the line is fitted by visual inspection. This method involves the computation of a
regression line that minimizes the sum of squared errors or deviations (the vertical distance between the
plotted points and the regression line).
Formula:
(1
Σy = na + bΣx
)
(2
Σxy = aΣx + bΣx2
)

Alternative Formulas:
nΣxy - ΣxΣy
b =
nΣx2 - (Σx)2

Σy - bΣx
a =
n

Multiple Regression Analysis

The 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.

Summary of Strengths and Weaknesses of the Methods

Method Strengths Weaknesses
Provides a detailed expert analysis of the Subjective
Account Analysis
cost behavior in each account
Based on studies of what future costs Not particularly useful when the
Engineering Method should be rather than what past costs physical relation between inputs and
have been. outputs is indirect.
Uses all the observations of cost data. The fitting of the line to the observations
Relatively easy to understand and apply is subjective.
Scattergraph 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.
Uses all of the observations of cost data. Requires several relatively strict
The line is statistically fit to the assumptions be satisfied for the results
observations. to be valid.
Least Squares
A measure of the goodness of fit of the
Regression Method
line to the observations is provided.
Relatively easy to use with computers
and sophisticated calculators.

Correlation Analysis
-analyzes the relationship between costs and their cost drivers assuming that they are dependent and independent
variables respectively
-it checks whether the relationship is both:
1. Linear (whether a straight line can be made if all points are plotted)
2. Strong ( whether all points are near the straight line)

Why the need to understand? Simply we want to know the cost driver that best affects the costs. We want to use the
cost driver that best predicts the costs.

2 Concepts of Correlation Analysis

Coefficient of Correlation
● describes the kind of linear relationship the costs and cost driver has
● It is denoted by r
● We will not anymore study the computation, but rather only the interpretation
● -1<r<+1
● If r=0, there is no correlation
● If r=-1, there is perfect negative correlation (as cost driver increase, costs decrease)
● If r=+1, there is perfect positive correlation (as cost driver increase, costs increase)

Coefficient of Determination
● Describes the strength of the relationship between costs and cost driver
● Percentage of how reactive costs are in response to change in cost driver
● Denoted by r2
● The higher the r2, the stronger the relationship between the cost driver and costs
● Used to ultimately assess which cost driver is best for cost estimation

II. CHECKING FOR UNDERSTANDING

1. Classify the following costs for an auto manufacturer as either direct materials, direct labor, manufacturing
overhead, or period costs.

a. Steel used in automobiles i. Depreciation on assembly plant

b. Assembly department employee wages j. Plant manager's salary
c. Utility costs used in executive building k. CEO's salary
d. Travel costs used by sales personnel l. Depreciation on executive building
e. Cost of shipping goods to customers m. Salary of marketing executive
f. Property taxes on assembly plant n. Tires installed on automobiles
g. Glass used in automobiles o. Advertising
h. Maintenance supplies
Classify the above costs as Direct Material, Direct Labor, Manufacturing Overhead, or Period Cost

2. Marquess Corporation has provided the following partial listing of costs incurred during May:
Marketing salaries P39,000
Property taxes, factory P8,000
Administrative travel P102,000
Sales commissions P73,000
Indirect labor P31,000
Direct materials P197,000
Advertising P145,000
Depreciation of production equipment P39,000
Direct labor P78,000
a. What is the total amount of product cost listed above?
b. What is the total amount of period cost listed above?

3. A partial listing of costs incurred at Boylen Corporation during March appears below:
Direct materials P181,000
Utilities, factory P10,000
Sales commissions P69,000
Administrative salaries P99,000
Indirect labor P32,000
Advertising P75,000
Depreciation of production equipmentP28,000
Direct labor P120,000
Depreciation of administrative equipment P49,000
Determine the amount for Direct Material, Direct Labor, Overhead, Product Cost, Period Cost, Prime Cost,
and Conversion Cost.
4. The following data have been collected for four different cost items.
Cost Item Cost at 100 units Cost at 140 units
W P8,000 P10,560
X P5,000 P 5,000
Y P6,500 P 9,100
Z P6,700 P 8,580
Determine whether each cost item is variable, fixed or mixed.

5. Hoyden Co. determined in its budget for the coming period that its labor cost will total (P5 x direct labor
hours) plus P50,000.
a. Express Hoyden Co’s labor cost as a cost equation
b. How much is Hoyden Co’s labor cost if it incurs 20,000 direct labor hours.

6. A controller is interested in analyzing the fixed and variable costs of indirect labor as related to direct labor
hours. The following data have been accumulated:
Month Labor Cost Hours
March P2,880 425
April 3,256 545
May 2,820 440
June 3,225 560
July 3,200 540
August 3,200 495
a. Using the high-low method, determine the cost equation
b. Determine the projected total cost at 4,000 hours.

7. Below is an examination of last year’s financial statements of Mickey Company. Labor hours and production
costs for the last four (4) months of the year, which are representative for the year, were as follows:
Month Labor Hours Total Production Costs
September 250 P 2,000
October 350 2,500
November 450 3,000
December 350 2,500
a. Using the least squares method, calculate the monthly fixed and variable components of the
total production costs.
b. Using the estimates made in letter a, compute the total cost for 300 labor hours.

8. M. Munda Company produces and sells rattan baskets. The number of drifts produced are the
corresponding total production costs for six months, which are representatives for the year, are as follows:
Month Units Produced Production Costs
April 500 P 4,000
May 700 8,000
June 900 6,000
July 600 7,500
August 800 8,500
September 550 7,250
Determine the cost equation using the high-low method
Using the least squares method, the variable production cost per unit is approximately
a. P 5. c. P0.27.
b. P10. d. P3.74.
Using the least squares method, the monthly fixed production cost is approximately
a. P 1,500. c. P 4,350.
b. P18,000. d. P52,200.

9. KleenCar operates a car spa. Incoming cars are put on an automatic conveyor belt. Cars are washed as the
conveyor belt carries the car from the start station to the finish station. After the car moves off the conveyor
belt, the car is dried manually. Workers then clean and vacuum the inside of the car. Carl serviced 80,000
cars in 2013. He reports the following costs for 2013:
Car wash labor P 90,000
Soap, cloth, and supplies 40,000
Water 24,000
Electric power to move conveyor belt 64,000
Depreciation 70,000
Salaries* 150,000
Office Rent 30,000
Flyers for ads 5,000
 * Salaries are composed of 60% operation and 40% administrative

Required:
1. Classify the costs as to:
a. Function
b. Timing of recognition
c. Traceability
d. Behavior

10. An analysis of past janitorial costs indicates that the average janitorial cost is P1.50 per machine hour at an
activity level of 40,000 machine hours and P1.20 per machine hour at an activity level of 50,000 machine
hours. Assuming that this activity is within the relevant range, what is the total expected janitorial cost if
the activity level is 45,000 machine hours?

11. The Mix Company uses the high-low method to estimate the cost function. The information for 2012 is
provided below:
Machine-hours Labor Costs
Highest observation of cost driver 500 P15,000
Lowest observation of cost driver 220 6,600

What is the total cost for 400 hours?

12. M. Munda Company produces and sells rattan baskets. The number of drifts produced are the
corresponding total production costs for six months, which are representatives for the year, are as follows:

Month Units Produced Production Costs

April 500 P 4,000
May 700 8,000
June 900 6,000
July 600 7,500
August 800 8,500
September 550 7,250

Required: Solve for the variable and fixed cost component using:
a.) High- Low Method
b.) Least- Squares Regression

13. Makina Company's total overhead costs at various levels of activity are presented below:

Month Machine Hours Total Overhead Costs

April 140,000 P198,000
May 120,000 174,000
June 160,000 222,000
July 180,000 246,000

Assume that the total overhead costs above consist of utilities, supervisory salaries, and maintenance. The
breakdown of these costs at the 120,000 machine-hour level of activity is:
Utilities (V) P 48,000
Supervisory salaries (F) 21,000
Maintenance (M) 105,000
Total overhead costs P 174,000
V= variable; F = fixed; M = mixed

Makina Company's management wants to break down the maintenance cost into its basic variable and fixed
cost elements.

Required:
1. As shown above, overhead costs in July amounted to P246,000. Determine how much of this
consisted of maintenance cost.
2. By means of the high-low method, estimate a cost formula for maintenance.
3. Express the company's total overhead costs in the linear equation form Y = a + bX.
4. What total overhead costs would you expect to be incurred at an operating activity level of 150,000
machine-hours?