Pricing and costing

LESSON 1
COST CONCEPTS AND CLASSIFICATION

Costs are associated with all types of organizations –business, and non-business, service, retail and
manufacturing. Generally, the kinds of costs that are incurred and the way in which these costs are classified
will depend on the type of organization involved.

Cost define according to Oxford Advanced Dictionary is a price to be paid for a thing, that which is
used, needed or given to obtain a particular item. Simple, cost is the cash or cash equivalent value given for
goods or services with the anticipation of deriving value for the business operation.

Costs are incurred to produce future benefits in a profit making firm, future benefits usually mean
revenue. As costs are used up in the production of revenues, they are said to expire. Expired costs are called
expenses. In each period, expenses are deducted from revenues in the income statement to determine the
period’s profit. A loss is a cost that expires without producing any revenue benefit. The focus of cost accounting
is on costs, not expenses.

At the most basic level, a cost may be defined as the value forgone or sacrifice of resources for the
purpose of achieving some economic benefit which will promote the profit making ability of the firm. It is also
an outlay or expenditure of money to acquire goods and services that assist I performance operations.
In managerial accounting, the term cost may be used in different ways because there are many types
of costs that may be classified differently according to the immediate needs of management. For instance,
external financial reports require the use of historical cost data whereas decision making may require current
cost data.

Costs are the value, usually measured in monetary unit of;

a. Cash or value given
b. Property transferred
c. Capital, equity or stock issued
d. Services performed for customer or client
e. Owed from other entity for acquisition, and future acquisition, of goods or services

Cost data that are classified and recorded in a particular way for one purpose may be inappropriate for
another use.

Cost pools are costs collected into meaningful groups. It is grouping of individual cost, typically by
department or service center. Cost pools may be classified;
1. By type of cost (labor cost in one pool, materials cost in another)
2. By source (department 1, department 2 and so on)
3. By responsibility (manager 1, manager 2, and so on)

A cost object is any product, service or organizational unit to which costs are assigned for some
management purpose. Products and services are generally cost objects, while manufacturing departments are
considered either cost pools or cost objects, depending on whether management’s main focus is on the costs
of the products or for the production department. Any item to where cost can be traced and that has a key role
in management strategy can be considered a cost object.

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Cost assignment is the process of assigning costs to cost pools or from cost pools to cost objects.

Cost allocation is the assignment of indirect costs to cost pools.

Allocation bases are costs drivers used to allocate cost.

A critical first step for achieving a competitive advantage is to identify the key cost drivers in a firm or
organization. A cost driver is any factor that has the effect of changing the level of total cost. The management
of the key cost drivers is essential for a firm that competes on the basis of cost leadership.

CLASSIFICATION OF COSTS

Cost classifications are necessary for the development of cost information to serve the needs of
management. Understanding these concepts and classification enables that managerial accountant to provide
appropriate cost data to the managers who need it.

A. Costs Classified by Nature

Manufacturing Costs
Manufacturing costs are all costs associated with the production of goods. They are frequently
classified as direct materials, direct labor and factory overhead. Since cost attach to the product or
groups of products as they are manufactured, expenditures, regardless of their nature, usually are
capitalized as inventory assets and do not become “expired costs” or “expenses” until the goods are
sold.

Direct Materials
All raw materials costs that become an integral part of the finished product and that can be
conveniently assigned to specific units manufactured.
Materials cost includes the invoice price plus other costs paid to the vendor, shipping costs,
sales taxes, duty, cost of delivery containers and pallets (less net of return refunds), and royalty
payment based on direct materials quantities. Trade discounts and cash discounts (if they exceed
reasonable interest rates) should reduce materials costs.

Direct Labor
All labor costs related to time spent on products that can be conveniently and economically
assigned to specific units manufactured. Estimates of direct labor quantities and unit prices may be
sufficiently accurate to be considered “specifically identified” with a cost object.

Manufacturing Overhead
Manufacturing overhead, the third element of manufacturing cost, includes all costs of
manufacturing except direct materials and direct labor. Indirect materials, indirect labor, property
taxes, insurance, supervisor’s salaries, depreciation of factory building and factory equipment and
power are examples of factory overhead. Service departments are those that do not work directly on
manufacturing process to occur. An example is equipment-maintenance departments.
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Indirect materials. Indirect materials include materials and suppliers used in the manufacturing
operation that do not become part of the product, such as oil for the machinery and cleaning fluids for
the custodian.

Indirect Labor. Labor costs that cannot be identified or traced to specific units manufactured. Examples
include supervision, inspection, maintenance, personnel and material handling.

Other Manufacturing Overhead

To summarize manufacturing costs include direct materials, direct labor and manufacturing
overhead. “Direct labor and overhead are often called conversion costs since they are the costs of
“converting or transforming: raw material into finished products direct materials and direct labor are
often referred to as prime costs.

Other manufacturing overhead costs include overtime premiums and the cost of idle time. An overtime
premium is the extra compensation paid to an employee who works beyond the time normally
scheduled.

Nonmanufacturing Costs

Nonmanufacturing costs generally include costs related to selling and other activities not
related to the production of goods.

Marketing costs

Marketing or selling costs include all costs associated with marketing or selling a product or all
costs incurred by the marketing division from the time the manufacturing process is completed until
the product is delivered to the customer or all costs necessary to secure customer orders and get the
finished product or service into hands of the customer. These costs also called order-getting and order-
filling costs. Examples of marketing costs are advertising shipping, sales commission and storage costs.

General and administrative costs

General and administrative costs are usually identified with offices not directly related to
production, operation or selling include all executive, organizational and electrical costs associated with
the general management of the organization rather than with manufacturing, marketing or selling.
Examples of these costs are office supplies, salaries and wages of accounting staff and support
group other than operations and sales group, rental of offices not related to production and insurance
of office structure.

Production Costs in Service Industry Firms and Nonprofit Organizations

Service industry firms such as schools, hotels, banks, airlines, accounting firms, and automotive
repair shops and many nonprofit organizations are also engaged in production. What distinguishes
these enterprises from manufacturers is that a service is consumed. What distinguishes these
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enterprises from manufacturers is that a service is consumed as it is produced, whereas a
manufactured product can be stored in inventory while less commonly applied in service firms, the
same cost classifications used in manufacturing companies can be applied. For example, an automotive
repair shop produces repair services. Direct materials include such costs as new parts installed to
replace the worn out parts, paint and other materials used. Direct labor includes the wages paid to the
service crew. Overhead costs include depreciation of equipment and other tools used and rental
expense.

Recording and classifying costs is important not only for manufacturing firms but for service
industry firms, and nonprofit organizations as well. Cost analysis is necessary in pricing, banking and
insurance services, hotel and travel rental agencies, setting tuition fees in schools and many more. As
these organizations grow in number and in scope of business operations, applying managerial
accounting to their activities take an even greater importance.

B. Costs classified according to the Timing of Recognition as Expense

An expense is defined as the cost incurred when an asset is used up or sold for the purpose of
generating revenue. The terms product cost and period cost are used to describe the timing with which
various expenses are recognize.

Product Costs

Product costs include all the costs that are involved in acquiring or making a product. Also
called inventoriable costs, they are costs that “attach” or cling to the units that are produced and are
reported as assets until the goods are sold. In the case of manufactured goods, these costs consist of
direct materials, direct labor, and manufacturing overhead. So initially, product costs are assigned to an
inventory account on the balance sheet. When the goods are sold, the costs are released from
inventory as expenses (typically called cost of goods sold) and matched against sales revenue. This
means that a product cost such as direct materials or direct labor might be incurred during one period
but not treated as an expense until a following period when the completed product is sold.

Period Costs

Period costs are all the costs that are identified with accounting periods are not included in
product costs. These costs are expensed on the income statement in the period in which they are
incurred. Period costs are not included as part of the cost of either purchased or manufactured goods.
Examples of period costs include selling and administrative expenses such as sales commissions, office
rent and transportation expense.
C. Costs Classification on Financial Statements

The Financial statements prepared by a manufacturing company are more complex than the
statements prepared by a merchandising company. Manufacturing companies are more
complex business firms than merchandising companies because the manufacturing company
must produce its goods well as market them. The production process give rise to many costs
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that do not exist in a merchandising company. The manufacturing company’s product costs
include not only the cost of purchasing but also the costs are counted as assets until the
product is sold and the revenue from the sales is recorded on the income statement.

The Balance Sheet

The balance sheet or statement of financial position of a manufacturing company is similar to

that of a merchandising company. However, the inventory accounts differ between the two types of
companies.

A merchandising company has only one class of inventory called merchandise inventory. These
are goods purchased from suppliers that are awaiting resale to customers.

In contrast, manufacturing companies have three classes of inventories, namely , raw

materials, work in process and finished goods.

Raw materials are materials that are used to make a product

Work in process consists of units of product that are only partially complete and will require
further work because they are ready for a sale to a customer.

Finished goods consists of units of product that have been completed but have not yet been
sold to customers.

The overall inventory figure is usually broken down into these three classes of inventory in
footnote to the financial statements.
The Income Statement

At first glance, the income statement of merchandising and manufacturing firms are very similar. The
only apparent difference is in the captions of some of the entries in the computation of cost of goods sold.

D. Cost classification for predicting Cost Behavior

Cost behavior refers to how a cost will react or respond to changes in the business activity. As
the activity level rises and falls, a particular cost may rise and fall as well—or it may remain
constant. For planning purposes, a manager must be able to anticipate which of these will
happen, and if a cost is expected to change, the manager must know by how much it will
change. To help make such distinction, costs are often categorized as variable, fixed or semi-
variable.
Variable Costs

Costs that change in total as activity changes (the change in total is directly
proportionate to change in volume of production). However the cost per unit is not affected
even the volume of production increases or decreases.

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Examples of variable costs are materials for goods, direct labor and electricity. These
cost do not change abruptly unless these are changes as to market prices.

Fixed Costs

Costs that remain unchanged for a given time period regardless of change in activity (volume). Rent,
insurance on property, maintenance and repairs of buildings and depreciation of factory equipment are
examples of fixed costs.

Cost Effect in Total Effect in Total Effect in Unit Effect in Unit as

Cost as Cost as Cost as production
production production production decreases
activity activity increases
increases decreases
Variable Increases Decreases None None
Fixed None None Decreases Increases

Semi-variable Costs

Costs that contain both fixed and variable elements. Examples of social security taxes, materials handling,
personnel services, heat, light and power. These cost elements must be divided into their proper elements.

E. Costs classified by Types of inventory

Raw Materials Inventory

The cost of all raw materials and production supplies that have been purchased but not used at
the end of the period.

Work-in-process Inventory

The cost associated with goods partially completed at the end of the period.

Finished Goods Inventory

Cost of completed goods that have not been sold at the end of the period.

F. Costs classification according to Traceability to Cost Objective

Direct costs (traceable, separable)

Costs that can be economically traced to a single cost object (i.e. product, department or unit)

Indirect costs
Costs that are not directly traceable to the cost object (i.e.product, department, etc.)

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G. Costs classification according to Managerial Influence

Controllable cost
Cost that is subject to significant influence by a particular manager within the time period
under consideration.

Noncontrollable costs
Cost over which a given manager does not have a significant influence.

H. Cost Terminologies Used for Planning and Control

Standard Costs
A predetermined cost estimate that should be attained, usually expressed in terms of costs per
unit.

Budgeted Cost
Used to represent the expected/planned cost for a given period. For example, a company plans
to manufacture 1,000 units of product X, for the period of P 4,000 for product X.

Absorption Costing
A Costing method that includes all manufacturing costs – direct materials, direct labor, and
both variable and fixed manufacturing overhead—in the cost of a unit of product. It is also referred to
as the full cost method.

Direct Costing
A type of product costing where costs are charged against revenue as incurred and are not
assigned to specific units of product manufactured. Also referred to as variable costing.

Information Costs
Costs of obtaining information.

Ordering Costs
Costs that increase with the number of orders placed for inventory.

Out-of-pocket Costs
Costs that must be met with a current expenditure or cash outlay.
I. Cost classification according to a Time-frame Perspective

Committed Cost
Cost that is inevitable consequence of a previous commitment.

Discretionary cost (programmed, managed cost)

Cost for which the size or the time of incurrence is a master of choice.

J. Costs classified according to Time period for Which the Cost is Incurred
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Historical Costs (past costs)

Costs that were incurred in a past period.

Future costs
Budgeted costs that are expected to be incurred in a future period.

K. Costs classification for Decision-making and other Analytical Purposes.

Relevant Costs
Future costs that are different under one decision alternative than under another decision
alternative.

Incremental Costs
The difference in a cost between two or more alternatives. In evaluating a given alternative,
incremental cost is the additional revenue to determine the feasibility of this particular alternative. To
be an incremental cost, the cost must be a future cost must be different under various alternatives.

Sunk Costs

Past costs that have been incurred and are irrelevant to a future decision.

Opportunity Costs

The value of the best alternative foregone as the result of selecting a different use of resource
or by choosing a particular strategy.

Marginal Costs

Costs associated with the next unit or the next project or incremental cost associated with an
additional project as opposed to the next discrete unit.

Value Added Costs

Costs that add value to the product. These costs result from activities that are necessary to
satisfy the requirements of the customer. Effort should be made to eliminate those costs that do not
add value to the product, such as storage and materials handling.

FINANCIAL STATEMENT PREPARATION IN MANUFACTURING, MERCHANDISING AND SERVICE BUSINESS

Income Statement for Business

Different companies have different ways of naming their accounts included in their Income Statement.
However it should have the basic objects such as revenue, cost of goods sold and general and administrative
expenses.
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Income statement is also known as statement of operations or statement of revenue and expenses, for
manufacturing, merchandising and service kind of activities.
Though the account title may be different from company to company the costs classification are fairly similar
A. Costs for Manufacturing

Manufacturing costs will be considered significantly in this chapter since these type of costs can be
found mostly in other business industry.

Manufacturing costs can be categorized as direct materials, direct labor and manufacturing overhead.

Direct materials are raw materials or parts that go directly into the final product. An example of this is
wood or lumber that composed the major part of a chair manufactured by a furniture company.

Direct labor are labor costs that are directly associated in the production of unit. An example of this is
the carpentry contracted for a single chair.

Manufacturing overhead may be defined as an indirect labor or direct materials that are used in the
final product but could not be identified directly. Example of this type of costs are sand paper, nails and
paints for chair.

Illustration

Microchip Corporation, a semi-conductor company, had gross sale of Php 20,000,000 for the year 2014.

In the conduct of the business, the Company incurred 55% for raw materials and 15% for direct labor
based on total revenue.

There was no beginning or ending inventory as the Company is a startup company.

The general and administrative costs are 5% of cost of goods sold, while the selling expenses are 10%
of gross sales.

MICROCHIP CORPORATION
Income Statement
For the Year Ended 2018
Revenue Php 20,000,000.00
Cost of Goods Sold:

Beginning Inventory
Add: Raw Materials 11,000,000.00
Direct Labor 3,000,000.00
Cost of Goods Manufactured 14,000,000.00
Less: Ending Inventory
Cost of Goods Sold -_____
14,000,000.00
Gross Profit Php 6,000,000.00

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Less: Expenses
General and Adm Exp 700,000.00
Selling Expenses 2,000,000.00
Net Income Php
3,300,000.00

Management Accountants analyze manufacturing costs further to help the decision makers in
identifying items that may be controllable and uncontrollable, fixed and variable or committed and
discretionary.

MANUFACTURING BUSINESS
Statement of Cost of Goods Sold
Raw Materials Inventory-Beginning Balance Xxxx
Add: Purchases Xxx
Raw Materials available for use Xxxx
Less: Ending Raw Materials Xxx
Raw Materials used in production Xxx
Add: Direct Labor
Manufacturing Overhead xxx
Total Costs xxx
Add: Work in Process-Beg xxx
Total Goods Place in Process xxx
Less:Work in Process -End xxx
Cost of Goods Manufactured xxx
Add: Finished Goods-Beg xxx
Cost of Goods Available for Sale xxx
Less: Finished Goods -End xxx
Cost of Goods Sold xxx

Cost of goods manufactured – these are the total manufacturing cost completed for the current
period. This cost is represented by total direct material, direct labor and overhead.

Cost of Goods sold -this is the cost attached to actual units sold.

Sample Problem
Activity Amount in Pesos
Beginning Inventory of Iron sheets 650,000.00
Purchases for October 2,500,000.00
Raw Materials in Warehouse ???
Upon counting the remaining inventory 500,000.00
Raw materials used in production ???
Labor for the month of October 623,000.00
Grease, nails and electricity 250,000
Total Manufacturing Costs ???
Work in progress-Sept 31, 2015 ???
Total Goods in Process 1,250,000.00
Ending work in progress-counted 4,000,000.00
Cost of Goods Manufactured ???

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Finished Goods-Sept 30, 2015 2,500,000.00
Cost of Goods Available for Sale ???
Finished Goods-Oct 31, 2015 1,000,000.00
Cost of Goods Sold ???

Note: Just fill the data below from the given data above.

Manufacturing
Schedule of Cost of Goods Sold
For the Month of October 2015
Raw Materials Inventory-Beg.
Add: Purchases
Raw Materials available for use
Less: Ending raw materials
Raw materials used in production
Add: Direct Labor
Manufacturing OH
Total Manufacturing Cost
Add: Work in Process - beg
Total Goods Put in Process
Less: Work in Process-End
Cost of Goods Manufactured
Add: Finished Goods-Beg
Cost of Goods Available for Sale
Less: Finished Goods -end
Cost of Goods Sold

B. Cost for Merchandising

Illustration:
New Trading Company, a retailer of household cleaning chemicals, sold P 10,000,000 worth of
dishwashing liquid product for the year 2016.

To obtain the 2016 revenue, New Trading Company, purchased P 2,000,000 worth of product and used
P 900,000 of labor.

The Company started in 2016 and all the stocks were sold by December 31, 2016.

Therefore the beginning and ending inventory was zero.

The general and administrative expenses are 5% of cost of goods sold, while the selling expenses are
10% of gross sales.

New Trading Company

Income Statement
For the Year Ended 2016
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Sales P 10,000,000
Cost of Goods Sold
Beg Inventory -
Add: Direct Materials 2,000,000
Direct Labor 900000
Cost of goods available for sale 2,900,000
Less: Ending Inventory -
Cost of Goods Sold 2,900,000
Gross Profit 7,100,000
Less: Expenses
General and Adm Exp. 145,000
Selling Expenses 1,000,000 1,145,000
Net Income P 5,955,000

Sample format of Statement of Cost of Goods Sold for Manufacturing and Merchandising Business

Manufacturing Business Merchandising Business

Statement of cost of Goods sold Statement of Cost of Goods Sold
Raw Materials Inventory-Beg Inventory- Beg
Add: Purchases Add: Purchases
Raw Materials available for use Cost of goods available for sale
Less: Raw Materials-End Less: ending inventory
Raw materials used in production Cost of Goods Sold
Add: Direct Labor
Add: Manufacturing Overhead
Total Manufacturing Cost
Add: Work in process -Beg
Total goods put in process
Less: work in process -end
Cost of Goods Manufactured
Add: Finished goods- beg
Cost of Goods available for sale
Less: finished Goods-End
Cost of Goods Sold

C. Cost for Service Business

The income statement for service-type of business is somewhat similar to the income statement of
manufacturing and retail organization. They may only differ in cost of goods sold.

Service organization may not have finished goods inventory but they may have construction in progress
which is similar to work in progress.

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Sample Illustration of Income Statement for Service Business.

Believe Consulting Services Inc., provides services such as system improvement to willing company. For
the year 2018 they accumulated P 10,000,000 revenue.

The cost of providing this service are as follows:

Project Engineers P 2,000,000
Supplies and materials P 3,000,000

The general and administrative expenses are 5 % of cost of goods sold, while the selling and
administrative expenses are 10% of gross revenue.

Believe Consulting Services Inc.

Income Statement
For the Year Ended 2018
Revenue P 10,000,000
Cost of Services or Expenses
Supplies and materials P 2,000,000
Professional Fee ( Project Engineers) 3,000,000 5,000,000
Gross Profit P 5,000,000
Less: Expenses
General and Adm expenses 250,000
Selling expenses 1,000,000 1,250,000
Net Profit P 3,750,000

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LESSON 2
COST BEHAVIOR ANALYSIS AND USE

Definitions of Cost Behavior

Cost Behavior means how a cost will react as changes take place in the level of business
activity. Managers who understand how costs behave are better able to predict what costs will be
under various operating circumstances. An understanding of cost behavior under varying conditions is
essential to adequate decision making in the planning and control of firm activity.

Cost behavior is associated with learning how costs change when there is a change in an
organization’s level of activity. The costs which vary proportionately with the changes in the level of
activity are referred to as variable costs. The costs that are unaffected by changes in the level of activity
are classified as fixed costs.

Importance of Understanding Cost Behavior

Planning requires that management make decisions based in part on expectations as to the
future. These expectations should be based on data relevant to the decision objectives, gathered and
analyzed in a competent, unbiased fashion. Failure in this activity could mean displacement costs due
to unexpected events. Control is the process of using feedback information for comparison with
expectations and the implementation of actions on the basis of that comparison.

Cost analysis is an integral part of the planning and control function. The key to effective cost
prediction lies in an understanding of cost behavior patterns. The understanding of cost behavior is
very important for management’s efforts to plan and control its organization’s costs. Budgets and
variance reports are more effective when they reflect cost behavior patterns.

The understanding of cost behavior is also necessary for calculating a company’s break-even
point and for any other cost-volume-profit analysis.

Importance of cost segregation

All costs are considerably important in pricing the company’s product or services. Decision
makers want to know the minimum cost they could pass on through their customers.

Business owners and the Management may also use the cost analysis in coming up with a
decision for plant expansion or producing goods that may be less profitable.
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Types of Cost Behavior Patterns

1. Variable Costs
Variable costs are those costs that change in total as the level of activity changes in the short
run and within the relevant range. To the economist, the short run is the time period long enough to
allow management to change the level of production or other activity within the constraints of current
total productive or operating capacity. Furthermore, the estimates of variable and other costs are
applicable only if the contemplated level of activity is within the relevant range. Relevant range is the
range activity within which assumptions relative to variable cost and fixed cost behavior are valid.
Variable cost per unit is assumed to remain constant within this range. For a cost to be variable, it must
be variable with respect to its activity base. An activity base is sometimes referred to as a cost driver.
Some of the most common activity drivers are units sold, units produced, direct labor-hours and
machine hours. Other activity bases (cost-drivers) might include the number of miles driven by
salespersons, the number of pounds of laundry cleaned by a hotel, the number of calls handled by
technical support staff at a software company, and the number of beds occupied in a hospital.

Example of Variable Costs

In a Manufacturing Company Direct Materials

Direct labor
Some manufacturing overhead such as
Indirect materials, materials handling costs,
Energy costs, supplies
Distribution costs
Sales commission
In a Merchandising Company Cost of sales
Sales commission
In a Service Organizations Direct labor and materials used to perform
The services such as auto repair and consulting
supplies, travel.

The Idea
Variable costs in total are affected by increases and decreases in production or activities, but
the cost per unit are NOT affected.

To illustrate the behavior of this cost:

The total cost are affected as unit of production level increases. For a single unit of chair the Company
incurs P 200 of materials and labor, and as the unit increases the total materials and labor cost also
increases.

2. Fixed Costs

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Fixed costs are costs that remain constant in total regardless of changes in the level of activity
within the relevant range. Fixed costs however may change due to some outside force, such as price
changes. Fixed cost per unit will react inversely with change in activity. Fixed costs decrease per unit as
the activity level rises and increase per unit as the activity level fall.

Types of Fixed Costs

Fixed costs are sometimes referred to as capacity costs, since they result from outlays made for
buildings, equipment, skilled professional employees, and other items needed to provide the basic
capacity for sustained operations. For planning purposes, fixed costs can be viewed as being either
committed or discretionary.

Committed fixed costs relate to the investment in facilities, equipment, and the basic
organizational structure of a firm. Examples of such costs include depreciation of buildings and
equipment, taxes on real estate, insurance and salaries of top management and operating personnel.
The two key characteristics of committed fixed costs are that (1) they are long term in nature, and (2)
they can’t be significantly reduced even for short periods of time without seriously impairing the
profitability or long-run goals of the fixed costs will still continue largely unchanged.

Discretionary fixed costs (often referred to as managed fixed costs) arise from annual decisions
by management to spend in certain fixed cost areas. Examples of discretionary fixed costs include
advertising, research, public relations, management development program, and internships for
students. The most important characteristic of discretionary fixed costs is that management is not
locked into a decision regarding such costs. They can be adjusted from year to year or even perhaps
during the course of a year if circumstances demand such a modification.

Fixed costs in total are NOT affected by increase or decreases in production or activities, but
the cost per unit are affected INVERSELY proportionate in changes in level of activities.
Total fixed costs are not affected by increase in activity level. For example, the rental of
production or plant space shall remain at P 20,000 regardless if the company produces 1 or 6 chairs.

However, under fixed costs concept the cost per unit increases as production decreases. Fixed cost per
unit decreases as production increases.

For example, if we will compute the per unit of cost in elation to rental it will inversely affected by
increases and decreases in activity level.

Rental per Month Production Effect in per unit Production Effect in per unit
Increases Decreases
20,000.00 1 20,000.00 6 3,333.33
20,000.00 2 10,000.00 5 4,000.00
20,000.00 3 6,666.67 4 5,000.00
20,000.00 4 5,000.00 3 6,666.67
20,000.00 5 4,000.00 2 10,000.00

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20,000.00 6 3,333.33 1 20,000.00

Fixed costs may be subdivided into several classifications such as committed fixed costs, the example of
which are salaries of executives, government permit, taxes and insurance. These costs cannot be
avoided immediately.

There are also discretionary fixed costs which may be deferred for future use, such as promotional
materials and research and development for existing product.

Mixed or semi variable costs

Mixed or semi variable cost may be a combination of variable and fixed cost. These costs are
usually segregated for more appropriate analysis.

Example of mixed cost is commission scheme, wherein the company provides sale commission
in absolute amount, say P 5,000 for the first 5 units of product and 5% for each unit sold thereafter.

To fully reclassify the mixed costs into variable and fixed costs we consider the formula below.

Total Mixed Cost = Total Fixed cost + (Variable cost per unit x Activity Level)
Algebraically, this formula is represented as:

Y = total mixed or semi-variable costs

a = total fixed cost
b = variable cost per unit
X = level of activity

To further illustrate let us consider the following scenario:

A mining company pay taxes every month, regardless of production, amounting to P 25,000 and P 10
for excess of 25,000 tons.

Assuming the company extracted 30,000 of coal for the month of December.

Let us compute for the mixed cost.

a = total fixed cost P 25,000

b = variable P 10
x = level of activity (30,000 tons less 25,000 tons = 5,000)
y = P 25,000 + (P 10 x 5,000)
y or total mixed cost = P 75,000

In case there are missing items or figure you may use compute the missing item algebraically.

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Let us consider the following case.

The Vida Mining Company wants to know their variable cost per unit for their production of 30,000
tons of coal. Their total cost if P 75,000, and they are paying fixed taxes monthly of P 25,000 and P x in
excess of 25,000 tons.

Using the formula, Y = a + bX, solve the problem

Step 1

Y = P 25,000
a = P 25,000
b = X (missing)
X = 5,000 (30,000 – 25,000 tons)

Step 2

P 75,000 = P 25,000 + (P x * 5,000 tons)

Step 3

P 75,000 – 25,000 = 5,000x

Step 4

X = P 50,000 /5,000 tons

X = P 10 – variable cost per unit

Methods of Estimation

There are several ways to estimate or analyze mixed costs. One is using the account analysis
approach where in the analysts will list down all the cost associated with the product and identify them
as either fixed or variable.

The Analysis of Mixed Costs

The fixed portion of mixed cost represents the basic, minimum cost of just having a service ready and
available for use while the variable element varies in proportion to the amount of service that is
consumed.

How does management go about in estimating the fixed and variable components of a mixed
cost?

The basic idea in cost estimation is to estimate the relation between costs and the variables
(factors) affecting the costs.
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This chapter discusses the methods of estimating the relation between cost behavior and
activity levels that are commonly used in practice as well as a brief overview of the theory and some
important considerations for their application. These are:

1. Account Analysis method

2. Industrial engineering Method or work measurement method
3. Conference Method
4. Quantitative Analysis of Current and Past Costs Relationship
a. high low method
b. regression analysis method
1. scatter graph or visual fit method
2. the least-squares regression method

It is possible that the results will differ from method to method. Consequently, more than one
approach is often applied so that results can be compared. Line managers should apply their own best
judgment, modifying the estimates submitted by the controller’s staff, a final step in the estimation
process.

Account Analysis Method

Account analysis is considered a very useful and easier way to estimate costs. It makes use of
the experience and judgment of managers and accountants who are familiar with company operations
and the way costs react to changes in activity level.

The account analysis involves the following steps:

1. Review each cost account used to record the costs that are of interest. Each cost is identified as
either fixed or variable depending on the relationship between the cost and some activity.
2. Each major class of manufacturing overhead or other mixed cost is itemized. Each cost Is then
divided into its estimated variable and fixed components. This is done on the basis of the
experience and the judgment of accounting and other personnel.

An advantage of account analysis is that it involves a detailed examination of the data base by
accountants and managers who are familiar with it. Other methods may overlook this expert judgment
in uncovering cost behavior patterns. A disadvantage of this method is that it uses subjective,
judgmental approach so that different analysis may provide different estimates of cost behavior.

The cost approaches are using estimation such as the high low method or an algebraic approach.

Industrial Engineering Method

The industrial engineering method estimates cost functions by analyzing the

relationship between inputs ad outputs in physical forms. Engineering estimates indicate what costs
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should be. This method is so named because it was first used in estimating manufacturing costs from
industrial engineers’ specifications of the required input to the manufacturing process for a unit of
manufactured output. This method is not just confined to manufacturing. Time-and-motion studies
have also been used in banks, fast food companies, government units, hospitals, and many other
nonmanufacturing operations.

Steps in Applying the Engineering Methods of Estimating Costs

1. A study of the physical relation between the quantities of inputs (material, labor, etc) and each unit
of output (finished product) is done. This involves the following activities.

a. A detailed step-by-step analysis of each phase of each manufacturing process together with
the kinds of work performed, and time to perform each step is done. (This is sometimes part of
time-and-motion study). This serves as a basis for estimating direct labor time.
b. Engineering estimates of the materials required for each unit of production are obtained from
drawings and specifications sheets.

2. Costs are then designed to each of the physical inputs (wages, material price, insurance charges,
etc.) to estimate the cost of the outputs.

One advantage to the engineering approach is that it can detail each step required to perform an
operation. It therefore enables the company to review its manufacturing productivity and identity
specific strengths and weaknesses. Another advantage is that it can be used to estimate costs for
totally new activities because it does not require data from prior activities in the organizations.

A disadvantage that can be attributed to this method is that it can be quite expensive to use
because each activity is using engineering norms and expert engineers which are costly. Another
consideration is that engineering estimates are often based on optimal condition. It is also difficult to
estimate the indirect costs of production.

Conference Method

Under the conference method, cost functions are estimated based on the analysis and opinions
about costs and their drivers obtained from various departments of an organization such as purchasing,
process engineering, manufacturing, employee relations and so on. This information is used to
determine the selling price of the product, optimum product mix and evaluate cost improvements over
time.

The conference method allows quick development of cost functions and cost estimate. Its
credibility is gained through the pooling of expert knowledge from each value—chain area.
High-Low method

In this approach you need to analyze the lowest activity level and he highest activity level within the
relevant range.

You may also consider ignoring the period with the abnormal outcome.
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Steps in Applying the High-low Cost Estimation

1. Obtain relevant data on past cost and related actual activity levels.
2. Estimates the variable cost per unit or rate using the following equation:

Cost at highest activity – cost at lowest activity

Variable cost rate per unit = _____________________________________
Highest activity-lowest activity

3. Compute the fixed cost as follows:

Fixed cost = total cost at highest activity - variable cost / unit x Highest activity
stated in units

Or

Fixed cost = total cost at lowest activity - variable cost / unit x lowest activity
stated in units

Illustrative Problem 1. Geenie Inc.

Given:
Data for the past 10 months were collected for Geenie Inc. to estimate the variable
and fixed manufacturing overhead.

The following data on supplies cost and direct labor hours from January to October
are available.

X Y
Direct Labor Hours Supplies Cost
20 P 50
40 110
60 150
20 70
30 80
40 100
50 150
10 60
30 110
50 120

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Required: determine the variable cost rate per hour and the fixed cost portion using the
high-low method.

Solution: Geenie Inc.

1. Variable Cost rate per hour = P 150 - 50

60 -10
= P 100 / 50
=2

2. Fixed Cost
FC = P 150- (2 x 60) or FC = P 50 – (2x10)
= P 150 – 120 = P 50-20
= P 30 = P 30

Regression Analysis

Regression analysis uses all available data estimate the cost functions. It is a statistical method
that measures the average amount of change in the dependent variable (costs) that is associated with
a unit change of one or more independent variables (cost drivers such as number of units produced,
machine hours, etc). Simple regression analysis estimates the relationship between the dependent
variable and one independent variable, while regression analysis estimates the relationship between
the dependent variable and multiple independent variables. Multiple regressions are used when the
dependent variable is caused by more than one factor. Although adding more factors or variables make
the computation more complex, the principles involved are the same as in the simple regression
analysis.

Sample regression analysis uses the following estimated cost function or equation:

Y = a + bx

While multiple regression analysis uses the following equation:

Y = a + b1X1 + b2X2……..+ u

Where:
Y = costs to be predicted (dependent variable)
X, X1, X2… = independent variable on which the prediction is to be used
a = fixed cost
b, b1, b2 …. = estimated coefficients of the regression model

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u = residual term that includes the net effect of the other factors not in the model and
measurement errors in the dependent and independent variables.

Least-square Regression Method

A statistical technique which is often used in separating mixed costs into their fixed and variable
components is least-squares regression. Basically, a line of regression is determined by solving two
simultaneous linear equations which are based on the condition that the sum of deviations above the
line equals the sum of deviations below the line.

The equation for the determination of a straight line is:

Y = a + bx

The two linear equations that are used to solve for a and b are:

Equation (1) ∑Y = Na + b∑X

Equation (2) ∑XY = ∑Xa + b ∑X2
Where:
Y = total cost
a = fixed cost
b = variable cost rate
X = measure of activity (e.g. hours, units)
N = number of observations
∑ = Greek letter signifying summation
Using the data in Illustrative Problem 1 (Geenie inc.), determine the variable cost rate and the
fixed cost under the Least-squares regression method.

Solution : Geenie Inc (Least-square regression method)

X Y XY X2
20 P 50 1,000 400
40 110 4,400 1,600
60 150 9,000 3,600
20 70 1,400 400
30 80 2,400 900
40 100 4,000 1,600
50 150 7,500 2,500
10 60 600 100
30 110 3,300 900
50 120 6,000 2500
2=
∑X = 150 ∑X = 1,000 ∑XY = 39,600 ∑X 14,500

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Equation (1) 1,000 = 10a + 350b

Equation (2) 39,600 = 350 a + 14,500b

To eliminate one unknown (a), and solve for b, multiply Equation1 by 35 (least common
denominator) and subtract the new Equation 3 from Equation 2:

Equation (2) 39,600 =350a +14,500b

Equation (3)
(Equation 1 x 35) 35,000 = 350a + 12,250b
4,600 = 2,250

Variable cost rate or b = P 2.04

To solve for a (fixed cost) substitute the value of b to Equation 1. Thus,

1,000 = 10a + 350b

1,000 – 714 = 10a
a = -286
-10
a = P 28.60

Scatter Graph Method

This is a rough guide for cost estimation which plot the cost against past activity levels. These
activities are referred to as predators (x) or independent variables, or the right-hand-side of a
regression equation. The cost to be estimated may be called the dependent variables (y) or the
left-hand-side of the regression equation. The line is drawn, insofar as it is possible by visual
judgment, so that the distances of the observations below the line. This line called the line of
regression represents the data as a line of conditional expected values.
The steps involved in the used of scatter are as follows:

1. On a graph, plot actual cost (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 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.
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Using the data in Illustrative Problem I (Geenie Inc.), determine the variable cost rate and
fixed cost under the Scatter graph method.

Solution: Geenie Inc. (under Scatter graph method)

Variable Cost rate (b) = P110 – P70

40 – 20
= P 40

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20
= P 2 per hour

Fixed cost (a) is P30 which is where the line of regression begins.
Strengths and Weaknesses of Cost Estimation Methods

Each of the methods discussed have advantages and disadvantages. when deciding which to use in
practice, the cost of each method must be compared with the benefits. The strengths and
weaknesses of these methods are summarized as follows:

Method Strength Weaknesses

Account Analysis Provides a detailed expert subjective
analysis of the cost behavior in
each account.
High-low Method Simple to apply Uses only two data points
which may not produces
accurate results.
Scatter graph Method Uses all observations of cost The fitting of the line to the
data. Relatively easy to observations is subjective.
understand and apply. Difficult to do where several
independent variables are to
be used.
Least-squares Regression Uses all of the observations of The regression model requires
Method cost data. The line is that several relatively strict
statistically fit to the assumptions be satisfied for
observations. A measure of the results to be valid.
the goodness of fit of the line
to the observations is
provided. Relatively easy to
use with computers and
sophisticated calculators.

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LESSON 3
SYSTEM DESIGN: ACTIVITY BASED COSTING

Costing method in different industry become sophisticated as need arises. One costing method
developed overtime, and several manufacturing firm becomes interested with is Activity Based
Costing, popularly known as ABC. This method allocates overhead costs to various cost pool or
centers.

Activity Based Costing (ABC) is a costing method that is designed to provide managers with cost
information for strategic and other decisions that potentially affect capacity and therefore “fixed”
costs ABC is ordinarily used as a supplement to, rather than as a replacement for the company’s
usual costing system.

Most organizations that uses activity-based costing have two costing systems-the official costing
system that is used for preparing external financial reports and the activity-based costing system
that is used for internal decision making and for managing activities.

Activity-based costing is best explained by walking through its various steps. They are:

1. Identify costs. The first step in ABC is to identify those costs that we want to allocate. This is
the most critical step in the entire process, since we do not want to waste time with an
excessively broad project scope. For example, if we want to determine the full cost of a
distribution channel, we will identify advertising and warehousing costs related to that
channel, but will ignore research costs, since they are related to products not channels.

2. Load secondary pools. Create cost pools for those costs incurred to provide services to other
parts of the company, rather than directly supporting a company’s products or services. The
contents of secondary cost pools typically include computer services and administrative
salaries, and similar costs. These costs are later allocated to other cost pools that more directly
relate to products and services. There may be several of these secondary cost pools, depending
upon the nature of the costs and how they will be allocated.

3. Load primary cost pools. Create a set of cost pools for those costs more closely aligned with the
production of goods or services. It is very common to have separate cost pools for each
product line, since costs tend to occur at this level. Such costs can include research and
development, advertising, procurement and distribution. Similarly, you might consider creating
cost pools for each distribution channel, or for each facility. If production bathes are of greatly
varying lengths, then consider creating cost pools at the batch level, so that you can
adequately assign costs based on batch size.

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4. Measure activity drivers. Use a data collection system to collect information about the activity
drivers that are used to allocate the costs in secondary cost pools to primary cost pools, as well
as to allocate the costs in primary cost pools to cost objects. It can be expensive to accumulate
activity driver information, so use activity drivers for which information is already being
collected, where possible.

5. Allocate costs in secondary pools to primary pools. Use activity drivers to apportion the costs in
the secondary cost pools to the primary cost pools.

6. Charge costs to cost objects. Use an activity driver to allocate the content of each primary cost
pool to cost objects. There will be a separate activity driver for each cost pool. To allocate
costs, divide the total cost in each cost pool by the total amount of activity in the activity
driver, to establish the cost per unit of activity. Then allocate the cost per unit to the cost
objects, based on their use of the activity driver.

7. Formulate reports. Convert the results of the ABC system into reports for management
consumption. For example, if the system was originally designed to accumulate overhead
information by geographical sales region, then report on revenues earned in each region, all
direct costs and the overhead derived from the ABC system. This gives management a full cost
view of the results generated by each region.

8. Act on the information. The most common management reaction to an ABC report is to reduce
the quantity of activity drivers used by each cost object. Doing so should reduce the amount of
overhead cost of being used.

We have now arrived at a complete ABC allocation of overhead costs to those cost objects that
deserves to be charged with overhead costs. By doing so, managers can see which activity
drivers need to be reduced in order to shrink a corresponding amount of overhead cost. For
example, if the cost of a single purchase order is $100, managers can focus on letting the
production system automatically place purchase orders, or om using procurement cards as a
way to avoid purchase orders. Either solution results in fewer purchase orders and therefore
lower purchasing department costs.

Uses of Activity Based Costing

The fundamental advantage of using ABC system is to more precisely determine how overhead
is used. Once you have an ABC system, you can obtain better information about the following
issues:

 Activity costs. ABC is designed to track the cost of activities, so you can use it to see if
activity costs are in line with industry standards. If not, ABC is an excellent feedback tool
for measuring the ongoing cost of specific services as management focuses on cost
reduction.
 Customer profitability. Though most of the costs incurred for individual customers are
simply product costs, there is also an overhead component, such as unusually high
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customer service levels, product return handling and cooperative marketing agreements.
An ABC system can sort through these additional overhead costs and help you determine
which customers are actually earning you a reasonable profit. This analysis may result in
some unprofitable customers being turned away, or more emphasis being placed on these
customers who are earning the company its largest profit.
 Distribution cost. The typical company uses a variety of distribution channels to sell its
products, such as retail, internet, distributors and mail order catalogs. Most pf the
structural cost of maintaining a distribution channel is overhead, so if you can make a
reasonable determination of which distribution channels are using overhead, you can make
decisions to alter how distribution channels are used or even to drop unprofitable
channels.
 Make or buy. ABC provides a comprehensive view of every cost associated with the in-
house manufacture of a product, so that you can see precisely which costs will be
eliminated if an item is outsourced, versus which costs will remain.
 Margins. With proper overhead allocation from an ABC system, you can determine the
margins of various products, product lines and entire subsidiaries. This can be quite useful
for determining where to position company resources to earn the largest margins.
 Minimum price. Product pricing is really based on the price that the market will bear, but
the marketing manager should know what the cost of the product is, in order to avoid
selling a product that will lose a company money on every sale. ABC is very good for
determining which overhead costs should be included in this minimum cost, depending
upon the circumstances under which products are being sold.
 Production facility cost. It is usually quite easy to segregate overhead costs at the
plantwide level, so you can compare the costs of production between different facilities.

Clearly, there are many valuable uses for the information provided by an ABC system.
However, this information will only be available if you design the system to provide the specific
set of data needed for each decision. If you install a generic ABC system and then use it for the
above decisions, you may find that it does not provide the information that you need.
Ultimately, the design of the system is determined by a cost-benefit analysis of which decisions
you want it to assist with, and whether the cost of the system is worth the benefit of the
resulting information.

Problems with Activity Based Costing

Many companies initiate ABC projects with the best of intentions, only to see a
very high proportion of the projects either fail or eventually lapse into disuse. There are several
reasons for these issues, which are:

 Cost pool volume. The advantage of an ABC system is the high quality of information that it
produces, but this comes at the cost of using a large number of cost pools—and the more
cost pools there are, the greater the cost of managing the system. To reduce this cost, run
an ongoing analysis of the cost to maintain each cost pool, in comparison to the utility of
the resulting information. Doing so should keep the number of cost pools down to
manageable proportions.
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 Installation time. ABC systems are notoriously difficult to install, with multi-year installation
being the norm when a company attempts to install it across all product lines and facilities.
For such comprehensive installation, it is difficult to maintain a high level of management
and budgetary support as the months roll by without installation being complied. Success
rates are much higher for smaller, more targeted ABC installations.
 Multi-department data sources. An ABC system may require data input from multiple
departments, and each of those departments may have greater priorities than the ABC
system. Thus, the larger the number of departments involved in the system, the greater
the risk that data inputs will fail over time. This problem can be avoided by designing the
system to only need information from the most supportive managers.
 Project basis. Many ABC projects are authorized on a project basis, so that information is
only collected once, the information is useful for a company’s current operational
situation, and it gradually declines in usefulness as the operational structure changes over
time. Management may not authorize funding for additional ABC projects later on, so ABC
tends to be “done” once and then discarded. To mitigate this issue, build as much of the
ABC data collection structure into the existing accounting system, so that the cost of these
projects is reduced, at a lower cost, it is more likely that additional ABC projects will be
authorized in the future.
 Reporting of unused time. When a company asks its employees to report on the time spent
on various activities, they have a strong tendency to make sure that the reported amounts
equal 100% of their time. However, there is a large amount of slack time in anyone’s work
day that may involve breaks, administrative meetings, playing games on the Internet, and
so forth. Employees usually mask these activities by appointing more time to other
activities. These inflated numbers represent misallocations of costs in the ABC system,
sometimes by quite substantial amounts.
 Separate data set. An ABC system rarely can be constructed to pull all of the information it
needs directly from the general ledger. Instead, it requires a separate database that pulls in
information from several sources, only one of which is existing general ledger accounts.it
can be quite difficult to maintain this extra database, since it calls for significant extra staff
for which there may not be an adequate budget. The best work-around is to design the
system to require the minimum amount of additional information other than that which is
already available in the general ledger.
 Targeted usage. The benefits of ABC are most apparent when cost accounting information
is difficult to discern, due to the presence of multiple product lines, machines being used
for the production of many products, numerous machine setups, and so forth—in other
words, in complex production environment. If a company does not operate in such an
environment, then it may spend a greater deal of money on an ABC installation, only to
find that the resulting information is not overly valuable.

The broad range of issues noted here should make it clear that ABC tends to follow a
bumpy path in many organizations, with a tendency for its usefulness to decline over time.
Of the problem mitigation suggestions noted here, the key point is to construct a highly
targeted ABC system that produces the most critical information at a reasonable cost. If
that system takes root in your company, then consider a gradual expansion, during which
you only expand further if there is a clear and demonstrable benefit in using so. The worst

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thing you can do is to install a large and comprehensive ABC system, since it is expensive,
meets with the most resistance, and is the most likely to fail over the long term.

Advantages of Activity-Based Costing (ABC):

1. Product cost determination under activity-based costing is more accurate and reliable
because it focuses on the cause and effect linkage of costs and activities in the context
of producing goods.
2. Fixation of selling price for multi-products under activity-based costing is fair and
correct because overheads are allocated on the basis of relevant cost drivers.
3. Control of overheads consisting of fixed and variable becomes possible by controlling
and monitoring activities. Linkage between cost and activities are clearly identified in
activity-based costing and thus provides opportunities to control overhead costs.
4. Sufficient information can be obtained to make decisions about the profitability of
different product lines.
5. Fair allocation of overheads occupy a considerable portion in the total cost
components.
6. Provides reasonably accurate information for decision making.
7. Gives more responsibilities to various cost centers for their costs.
8. Provides information which products are highly profitable by associating costs that
matters.

Disadvantages or Limitations of Activity-Based Costing (ABC)

1. Difficult to identify the overall activities that influence costs.

2. Not easy to select the most suitable cost drive.
3. Difficult to evaluate cost on the basis of activities.
4. Not suitable for small manufacturing concerns
5. It can be expensive to use in terms of administrative costs in segregating costs per cost
centers.
6. This involves expert judgment, as there may be costs that will be included in the
product even though it will not affect the decisions.

Most users of traditional cost allocation may transfer to activity based costing if they
have multiple products that have complex processes. One example of this is for a
manufacturer of semiconductor items, wherein there are great volume of raw
materials for various shapes and sizes of microchips.

Applications and Uses to Manufacturing and Merchandising

In manufacturing, ABC system can be used to identify cost of product, from design to its marketable
condition.

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For example, the product development of the company may consider number of product
development.

In merchandising nature, ABC system can be used to identify cost of services by including all resources
that may affect decision.

For example, the customer order taking may spend resources that should be considered in taking
orders.

Consider the information below.

Industry Activity How to measure

Manufacturing Product Development Number of product developed
Includes all resources used to
develop a product, such as
materials, labor and overhead
Merchandising Ordering online Number of orders received
Includes all costs that need to take
orders such as salary and utilities.

To apply the above information in systematic approach let us consider the following:

Step 1

We need to define business activities:

Manufacturing Merchandising

Cost pool: Product Development Cost Pool: Customer Ordering

Cost pool is a “dumping” account where all costs related to the activities are accumulated.

Step 2

Trace all costs related to the cost pool.

Supposed the costs for each activities are as follows:

Manufacturing Merchandising

Cost pool: Product Development Cost pool: Customer Ordering

Indirect labor 10% Labor 5%

Depreciation of machine 10% Depreciation of equipment 10%
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Supplies 10% Supplies 15%
Delivery costs 10%
 The percentages represents the resources spent for each activities.

Step 3

Apply costs to activity pools.

Activities Manufacturing Merchandising

Product Production Total Customer Others Total
Development Order
Indirect 25,000 50,000 75,000 3,250 61,750 65,000
Labor
Depreciation 2,500 22,500 25,000 5,600 50,400 56,000
Supplies 1,500 13,500 15,000 7,800 44,200 52,000
Delivery 7,500 67,500 75,000
Cost

The cost of product development and the customer order represents the percentages identified above (total
cost x respective percentages).

Organization-sustaining activities – involves cost related to general organizational items such as networking
system and audit fees for annual report.

Step 4

Identify the activity rates and the cost per unit.

Activities Manufacturing Merchandising

Product Production Total Customer Others Total
Development Order
Indirect 25,000 50,000 75,000 3,250 61,750 65,000
Labor
Depreciation 2,500 22,500 25,000 5,600 50,400 56,000
Supplies 1,500 13,500 15,000 7,800 44,200 52,000
Delivery 7,500 67,500 75,000
Cost

Suppose the product development has 120 activities Suppose the customer order has 120 activities
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Indirect labor 25,000/120 Indirect labor 3,250/120

Unit cost per development P 208.33 Unit cost per order P 27.08

Other activities on the table are computed in similar manner.

ABC system may be organized into:

 Unit-level activities – are done every time there is production activity. The cost should be
proportional to the number of units produced. An example is the diesel fuel for a
manufacturer of chocolates.
 Batch-level activities – are done every time a batch is processed. An example is the cost of
placing the equipment into use every time there is a production, like heating or spinning
reserve for hydropower plant. This does not consider whether there is one unit or several
units to produce.
 Product-level activities – this pertains to products, regardless of unit or batch produced. An
example is the cost of promotion and salaries and wages of brand manager.
 Customer-level activities – this pertains to specific customer or client. An example is cost of
placing customer service.
 Organization-sustaining activities – involves cost related to general organizational items
such as networking of information system and audit fees for annual report.

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LESSON 4
VARIABLE COSTING

CONCEPT

In addition to the concept of variable costing that was presented in earlier section, this cost is significant in
understanding the pattern of cost.

Variable costs vary from industry to industry. For example, a company with heavy capitalization may have few
variable costs such as hydro power plant. Most of the cost of this kind of company is related to capital
investment for turbine and building.

Merchandising companies usually have higher variable costs such as for retail companies where goods are
stocked and waiting for orders. They are spending significant amount on security for warehouses, warehouse
space and electricity to keep the goods in saleable condition.

VARIABLE COSTING

Variable costing is a method of inventory costing in which all variable manufacturing costs are included as
inventoriable costs. In variable costing method, all fixed manufacturing costs are excluded from inventoriable
costs. They are instead treated as costs of the period in which they are incurred. Variable costing is a method of
recording and reporting costs that regards only those manufacturing costs, which tend to vary directly with the
volume of activity as product costs. Variable costing is also known as “Marginal Costing” or “direct Costing”.

Product cost under variable costing

Direct material + Direct labor + Variable Manufacturing costs

Period cost under variable costing

Fixed manufacturing costs + General and Administrative cost + Selling and Distribution costs

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Absorption Costing

Absorption costing is the method of inventory costing in which all variable manufacturing costs and all fixed
manufacturing costs are included in inventoriable costs. In absorption costing method, inventory “absorbs” all
manufacturing costs. Absorption costing is also known as “conventional Costing” or “Full costing”.

Product cost under absorption costing

Direct material + Direct Labor + Variable manufacturing costs + Fixed manufacturing costs.

Period costs under absorption costing

General & administrative costs + Selling and distribution costs

Advantages of Variable Costing System

The major advantages of variable costing are summarized as follows:

1. Variable costing is easy to understand and use. It is applicable to standard costing and budgetary
control.
2. The valuation of closing stock on the basis of variability of cost will not facilitate the transfer of part of
fixed cost to next period.
3. No need of computation of unit fixed cost, over and under absorption of fixed overhead because
contribution margin over and above the fixed cost is the profit margins.
4. In variable costing system, profit is calculated on the basis of sales volume rather than production
units.
5. Variable costing system assists management to take rationale decision analyzing the effects of sales
and production policy.
6. Variable costing system concentrates management on controlling the controllable costs i.e. Direct costs
avoids the tension of allocating the fixed cost without taking any basis.
7. Variable costing assist to management for taking rational decision regarding profit planning and cost
control.

Disadvantages or Limitations of Variable Costing System

The major drawbacks of variable costing system are as follows:

1. Difficulty in segregating overhead cost into fixed and variable cost

2. It is not justified to exclude fixed manufacturing overhead from inventories.
3. Wide fluctuation in profits due to seasonal demand
4. Variable costing is not useful for long term planning and decision making
5. Variable costing is not acceptable for external reporting purpose.

Advantages and Disadvantages of Absorption Costing System

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Advantages of Absorption Costing System

1. Absorption costing recognizes fixed costs in product cost. As it is suitable for determining price of the
product. The pricing based on absorption costing ensures that all costs are covered.
2. Absorption costing will show correct profit calculation than variable costing in a situation where
production is done to have sales in future (e.g. seasonal production and seasonal sales)
3. Absorption costing conforms with accrual and matching accounting concepts which requires matching
costs with revenue for a particular accounting period.
4. Absorption costing has been recognized for the purpose of preparing external reports and for stock
valuation process.
5. Absorption costing avoids the separating of costs into fixed and variable elements.
6. The allocation and apportionment of fixed factory overhead to cost centers makes manager more
aware and responsible for the cost and services provided to others.

Disadvantages of Absorption Costing System

1. Absorption costing is not useful for decision making. It considers fixed manufacturing overhead as
product cost which increase the cost of output. As a result, it does not help in accepting specially
offered price for the product. Various types of managerial problems relating to decision making can be
solved only with the help of variable costing system.
2. Absorption costing is not helpful in control of cost and planning and control functions. It is not useful in
fixing the responsibility for incurrence of costs. It is now practical to hold a manager accountable for
costs over which he/she has not control.
3. Some current product costs can be removed from the income statement by producing for inventory. As
such, managers who are evaluated on the basis of operating income can temporarily improve
profitability by increasing production.

Comparison Between Variable Costing and Absorption Costing

The heart of the difference between variable costing and absorption costing for financial accounting is the
accounting for fixed manufacturing costs. All variable manufacturing costs are inventoriable product costs
under the both method. But fixed manufacturing costs are treated differently. Under variable costing, fixed
manufacturing costs are treated as expenses of the period. Under absorption costing, fixed manufacturing
costs are inventoriable costs. They are then deducted as the cost of goods sold when sales occur.

Since fixed manufacturing costs are excluded in inventoriable product costs under variable costing, it shows
a lesser inventory value. In other words, the value of inventory is understated under variable costing.
Unlike that, under absorption costing, product costs are inflated by fixed manufacturing costs. Therefore,
inventories are over-stated in absorption costing. There is a direct relation between the difference in the
value of inventory or asset and the net income of the period. Inventory is a current asset. As the size of an
asset increases profit also increases and vice-versa.

Variable costing are usually used internally by most companies for decision making. Absorption costing on
the other hand is used internally and externally.
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To compare the two concepts, consider the following data.

A clothing company manufacture and sell 2,000 units of jacket for the year 2018.

Cost per unit:

Direct Materials P 10
Direct Labor 10
Variable Manufacturing Overhead 1
Fixed Manufacturing Overhead 25

In Variable costing the product In absorption costing the product

cost is: cost is:
Direct materials P 10 P 10
Direct Labor 10 10
Variable Manufacturing Overhead 1 1
Fixed Manufacturing Overhead 0 25
Total Product cost P 21 P 46

Variable costing considers only variable costs as part of product costs. It does not consider fixed costs as
product costs.

Absorption costing considers all production costs, variable and fixed, as part of product costs as long as used
for production or directly related to business core operations. It allocates a portion of fixed manufacturing
costs to each unit of product.

Needless to say, variable costs and absorption costing income varies depending on production and selling
activities.

To summarize the difference in treating costs in variable and absorption costing , we may refer to table below.

Variable Costing Absorption Costing

Product Cost Direct Materials Product Cost
Product Cost Direct Labor Product Cost
Product Cost Variable Production or Manufacturing Overhead Product Cost
Period Cost Fixed Production or Manufacturing Overhead Product Cost
Period Cost Selling and Administrative (Fixed and Variable) Period Cost

Income Statement under Variable and Absorption Costing

A clothing company sold 2,000 t-shirts at P 100 each.

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The cost of manufacturing each shirt were as follows:

Direct Materials P 20
Direct Labor P 10
Variable Manufacturing Overhead P 5
Fixed Manufacturing Overhead P 10,000 in total
Fixed selling expenses P 20,000
Variable Administrative Expenses P 5

The ending inventory was 500 t-shirts and the units produced were 2,500

Cost per unit Variable costing Absorption costing

Direct materials P 20 P 20
Direct labor 10 10
Variable Manufacturing OH 5 5
Fixed MOH - 4
Total product cost P 35 P 39

Income Statement under variable and absorption costing shall look like:

Consideration Variable Costing Absorption Costing

Sales 2000@ P 100 P 200,000.00 P 200,000.00
Less: Cost of Goods sold 2,500 T-shirt
Direct Materials 50,000.00 50,000.00
Direct Labor 25,000.00 25,000.00
Variable MOH 12,500.00 12,500.00
Fixed MOH - 10,000.00
Less: ending Inventory 500 t-shirts 17,500.00 19,500.00
Cost of Goods Sold 70,000.00 78,000.00
Contribution Margin/Gross 130,000.00 122,000
Margin
Less: Expenses
Fixed MOH 2,500 t-shirts 10,000.00 -
Fixed Selling Exp 20,000.00 20,000.00
Variable Adm Exp 2,000 tshirt 10,000.00 10,000.00

Net Income 90,000.00 92,000.00

There was a difference of P 2,000 which can de explained by dissecting the ending inventory and the product
costs.

Under variable costing the P 4 fixed manufacturing overhead was deferred for the next period.

Under absorption costing the P 4 fixed manufacturing overhead was released from inventory.

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Reconciliation of Net Income

To reconcile the income under variable and absorption costing let us consider the above example:

Variable Costing Net Income P 90,000.00

Less: Fixed Manufacturing Overhead – released from inventory
P 4 per unit x 500 shirt-ending inventory 2,000.00
Absorption costing Net Income P 92,000.00

Effects on Income

Changes in Production Effects on Inventory Impact on Net Income Impact on Net Income
and sales under absorption Costing under Variable Costing

Production is equal to No changes in inventory Equal equal

sales
Production is greater Inventory shall increase Higher Lower
than sales
Production is less than Inventory shall decrease Lower Higher
sales

Reconciling the differences in Net Operating Income under Variable costing and Absorption Costing

Absorption Costing

Income reported under variable costing and absorption costing are different. It is only the different value of
inventory under the two costing income statements that changes the amount of the net income. Except the
value of inventory, we do not find any other differences. As the size of inventory increases or decreases during
the year, the reported income differs under variable and absorption costing. This results from the fixed
overheads that are included in the inventory valuation under absorption costing but are expended immediately
under variable costing. Under absorption costing this period’s factory overheads are postponed to the next
year whereas under variable costing it is expended during the same year.

Difference in net income = (Change in the size of inventory units) x (difference in product cost per unit)

The difference in net income is the same as the difference in the size of inventory value. So with a change in the
size of inventory, profit also change.

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LESSON 5
PRICING DECISIONS

Introduction

Pricing is a major decision that a manager should make it must be a price that is not only acceptable to the
owner for the fair return of his investment but also acceptable to the consumers who will buy the product.
There are companies that do not have a problem on pricing decision because their product is in competition
with other identical products that already exist. Because of competition, the company has to price their
product with minimal plus or minus based on the price of the identical products in order to compete. On the
issue of competition, since prices are dictated by the competition, the manager should focus on cost without
sacrificing the quality of the product sold.

The price set for the product should be more than enough to cover the expenses to be spent in operating the
product so that there will be a profit.

Trading or Manufacturing Concern Enterprise

Cost-Plus Pricing

1. Absorption coting Approach – requires the identification of the cost of manufacturing a product and a
markup based on the cost must cover the estimated selling and administrative expenses that should
come up with a satisfactory profit.

For example:

Cost structure
Direct materials 15.00
Direct labor 10.00
Variable manufacturing OH 5.00
Fixed manufacturing OH 8.00
Total P 38.00

Sample problem for Cost Plus Pricing Approach

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The fixed manufacturing overhead of P 240,000 is based on the premise of 30,000 units volume
capacity. Assuming that the policy of the company is to markup their product by 30%, the selling price
of the product will be computed as follows:

Direct materials 15.00

Direct labor 10.00
Variable manufacturing OH 5.00
Fixed manufacturing OH 8.00
Total 38.00
Plus 30% markup 11.40

The selling price of the product P 49.40

Computation of Selling Price Using Cost Plus Pricing Approach

The proforma income statement is shown below showcases the result of the 30% markup pricing policy of
the company. The company is earning 3.08% of sales (45,600/1,482,000)

Grande Corporation
Income Statement
December 31, 2018

No. of units Selling price Amount

Sales 30,000 49.40 1,482,000.00
Less: Cost of the product 30,000 38.00 1,140,000.00
Gross Margin 342,000.00
Less: Selling and administrative exp 296,400.00
Net Income P 45,600

How to Compute the Percentage of Markup (under Absorption Costing)

Desired return on asset employed + Selling and Administrative Expenses

Volume in units x unit measuring cost

 Desired return on asset employed is the return of investment (ROI)

 Selling and administrative expenses are the costs to sell and maintain the office administration.
 Volume in units is the estimated volume of production that the company may produce
 Unit measuring cost is the cost of materials, labor and overhead (fixed and variable)

Assume the following information:

1 Volume in units 125,000

2 Required worth of assets to be used in producing the product 2,500,000
3 Direct materials 18

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4 Direct labor 12
5 Factory overhead 8
6 Selling and Administrative Expenses 800,000
7 Return on investment 30%

To apply the formula:

(30%) (2,500,000) + 800,000

125,000 ÷ 38

= 750,000 + 800,000
4,750,000

= 1,550,000
4,750,000
= 32.63%

To compute for the selling price:

Unit cost 38
Add: mark up (unit cost
markup) 12.40

Proposed selling price P 50.40

Computation of Markup:

Unit cost of P38 multiplied by 32.63% (as computed above) is equal to P 12.40. Based on the computation, the
manager should personally assess the market condition if the price is also acceptable to potential consumers of
the product.

Supposing the price is lower than the market condition, it is highly recommended to offer this as introductory
price and later on adjust to fit market condition.

How about if the price is higher than the market condition/ then it is highly recommended to adjust the
owner’s return on investment. For example, the market condition requires the product to be priced at P 48.

Compute to have a return on investment of 18%:

(18%) (2,500,000) + 800,000

125,000 x 38

= 450,000 + 800,000

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4,750,000

= 1,250,000
4,750,000

= 26.32

TO COMPUTE FOR THE SELLING PRICE:

Unit cost 38
Add: markup 10
Proposed selling price P 48

Computation of Markup:

Unit cost of P 38 multiplied by 26.32% is equal to P10.

Thus at 18% return on investment (ROI), the price of the product is still higher. Try to reduce or increase the
ROI further and observe the result. After increasing or decreasing, confirm with the owners if the resulting ROI
is already acceptable to them. It is favored if the price set is acceptable to both the owner and the consumer of
the product.

2. The Variable costing Approach- requires identifying the variable cost of the product

For example

Cost structure
Direct materials P 15
Direct labor 10
Variable MOH 5
Variable Selling & Administrative Exp. 6
Total P 36

Assuming that the policy of the company is to markup the product based on 30% of the cost, the selling price
computed as follows:

Direct materials P 15
Direct labor 10
Variable MOH 5
Variable Selling & Administrative Exp. 6
Total P 36
Plus markup of 30% 10.80

Selling price of the product P 46.80

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3. Target costing approach – the previous approaches (Absorption and Variable Costing Approaches)
were based on the premise that the product has already been developed and thus selling price has to
be strategically planned to meet the consumers’ acceptability and the owner’s return on investment
requirement. But under the target costing approach, the company will be working in a reverse
scenario. The company should first establish and estimated selling price of the product based on
market conditions then establish the cost component and the desired markup to meet the owner’s
profit expectation.

For example:

Units Selling Price

Estimated Sales 500,000 20 P 10,000,000.00
Less: desired profit of 5%
the owner 500,000.00
Target cost of the
product P 9,500,000.00

After getting the target cost of the product, the company can then establish the cost or unit of the
product.

Target cost of the product P 9,500,000.00

Estimated number of units 500,000.00
Cost per unit P 19

Cost Computation Per Unit

Remember that the P 19 cost of the product includes the variable and fixed costs as well as the selling
and administrative expenses. Therefore, the next step will be to identify the two mentioned
components.

Cost per unit 19.00

Cost to produce 80% 15.20

Selling and administrative expenses 20% P 3.80

Computation of Selling and Administrative Expenses

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Based on the above information, the company can now establish the four cost components like: the
direct materials, direct labor, variable manufacturing cost and the fixed manufacturing cost.

Unit cost to produce the product 15.20

Estimated direct materials 45% 6.84

Estimated direct labor 30% 4.56
Estimated variable manufacturing costs 15% 2.28
Estimated fixed manufacturing cost 10% 1.52
Total 100% 15.20

Computation of the various cost component using the Target Costing Approach

Now that there is a detailed costing per unit, the company will start to:

1. Scout for suppliers who can supply quality raw materials at a price range within the target
estimated for direct material cost.

Strategies:
a. Canvass for suppliers
b. Accredit suppliers to have an assurance of steady supply of raw materials
c. Establish direct good relationship with suppliers. Owners should have direct access to the
suppliers to avoid future manager/owner/supplier problem.

2. Look for labor that meets the required targeted estimated direct labor cost. Prepare labor strategy
whereby the company can achieve labor cost without labor violations to avoid disputes and labor
problems as soon as the company starts to manufacture.

Strategies:
a. Outsourcing
b. Advertising for labor requirement

3. Look for facilities that will fit with the variable and fixed manufacturing overhead costs.

Above all, the company should be God abiding thus business ethics comes in all aspects of doing
business. We should learn how to pray to the Creator of everything for with God nothing is
impossible Luke 1:37

Psychological Pricing

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Psychological pricing is a system of setting the price of a company’s product slightly lower than the rounded
prices. For instance, if the price is P 100, the psychological price is P 99 or if the price is P 1,000, the
psychological price is P 999. This is based on the belief that generally consumers tend to process the prices
from leftmost digit to the right. The effect of this psychological pricing system is that the consumers thought
the price is cheaper that it is actually is (Accounting tools 2015).

Advantages of psychological pricing:

1. By using this pricing strategy, the price is shifted into a lower price category with little effect into the
overall performance of the product sold.
2. With the small reduction of price, more quantity will be sold and therefore the overall impact will
increase sales figures.
3. The cashier will have a difficulty in cheating because the figures are not rounded. Generally, people can
easily cheat on rounded figures.
For example:
P 1,000 can be reported as P 100 just by eliminating one zero in the amount, or P 100,000 can be
reported as P 10,000 again by eliminating one zero.

Disadvantage of psychological pricing:

1. Sometimes, it is difficult to make calculations. Although nowadays, technology has helped us out on
this concern.
2. There are people or customers that understand psychological pricing and are difficult to persuade to
buy the product.
3. Businessmen investing on brand equity could have difficulty on applying psychological pricing.

Whether this psychological pricing works or not, one could observe that in actual situations,
psychological pricing is at work and is successful in persuading consumers to loyalty patronage.

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LESSON 6
STANDARD COST AND OPERATING PERFORMANCE MEASURES

Nature and Rationale of Standard Cost

Standard cost are benchmarks use in measuring the performance of an entity, department or cost
centers. In business sense, we may use budget as one of the standards to measure the usage of
Company resources.

For example Medical Clinic would set standard in using their solutions to test complete blood count
having 5 tests for a single bottle. If they would not establish standard, the Laboratory Technicians
might use them sparingly or unauthorized which may lead to profit loss.
Users of Standard Cost

Majority of businesses are using standard costing system in their daily activities. Manufacturing,
merchandising and service industries are developing their own standards. Even though several
companies are in similar industry or businesses, they may have different set of standards as set by
their own management.

Non-profit organization may also use standards. For example, they may use standards in organizing
how many work force they need in their operation or project.

Accountants encounters standard costing in any line of business and in every department of an
organization.

Benefits and Limitations of Standard Cost

The standard costing helps Managers, Purchasers, Engineers, Operation Personnel in:

1. Providing convenience in determining what prices of materials and labor are acceptable to
continue their operations.
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2. Providing objective overview of what can be earned with certain level of activities. A good
standard costing system can identify the reasonable charges per product, if you will deduct this
from the selling price you will get the reasonable margin.
3. Avoiding wastages of materials and labor

The limitations on the other hand are:

1. They may be standards costs that set by management, that are not attainable.
2. Does not encourage creativity amongst Personnel as even wastages are measured.

Standards for Direct Materials

Standard setting for materials are usually set by highly technical people such as Engineers and Industrial
Engineers since they are equipped with knowledge of material measurement and identification.

We may look direct materials in two ways:

1. Setting up standard price

2. Setting up standard quantity

For example, let us discuss a souvenir manufacturer that specializes in bronze.

The Production Personnel gathered the following costs:

Extraction costs P 5
Bronze per gram 5
Delivery costs 5
Standard cost per gram 15

Suppose a single necklace needs several grams of bronze to complete:

Raw bronze (in grams) 25

Wastage while minting 3
Rejects 2
Standard quantity per piece 20 grams

There shall be a quantity variance of P 5; standard of 15 grams less 20 grams for actual production. This is
unfavorable variance since you are using more materials than what was set.

To further discuss the variances associated with materials let us consider the following example.

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The Sunflower Company produce necklaces for the week. They have standard costs of P 15 per gram of bronze,
and they need 20 grams per necklace.

The price variance shall be computed as follows:

Favorable Variance Unfavorable Variance

Standard Price – P 15 P 15.00 P 15.00
Actual Price (let us consider as higher and lower
than standard costs)
Difference 10.00 20.00
P 5.00

X Actual quantity – 2 necklaces each necklace needs 50.00 50.00

20 grams of good bronze; the wastages are
Considered in here
Price Variance P 250.00

The standard price remains at P 15. If the standard costs is higher than actual we have favorable variance, if
actual cost is higher than standard cost we have unfavorable variance.

Direct Labor Standards

Direct labor for majority of companies, are usually pre-determined rate as established by Management or
Planners.

The concern on direct labor analysis, for the purpose of this section, is on variances which may be divided into:

Spending Variance

Favorable Variance Unfavorable Variance

Standard Rate – P 15 P 15.00 P 15.00
Actual rate (let us consider as higher and lower
Than standard costs) 10.00 20.00
Difference 5.00
X Actual Hours – 2 necklaces each 8.00 8.00
Necklace needs 4 hours of production time
Spending Variance P 40.00

Spending variance may be caused by specialized skills needed by the project. In our example above the jewelry
company requires an expert to produce a necklace.

Another consideration in higher labor rate is the changes in the labor market. There may be rapid changes in a
particular industry that needs to be looked at:

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Efficiency Variance

Favorable Variance Unfavorable Variance

Standard Hour per necklace P 4.00 P 4.00
Actual Hour spent 3.00 5.00
Difference 1.00
X Standard rate P 15.00 P 15.00
Efficiency Variance P 15.00

The causes of efficiency variance may be due to breakage of machine, insufficient raw materials or low quality
materials that may require the workers to wait too long. These scenarios may lead to unfavorable variance.

Favorable variance may be brought by effective processes which may allow the production to finish early.

Standards for Overhead

The other cost that needs to analyze by the company are the variable manufacturing overhead.

We may use the basic formula we had used for direct materials and direct labor in analyzing variable overhead.

Variable overhead spending variance = Actual Hours x ( Actual Rate – Standard Rate)

Variable overhead efficiency variance = Standard Rate x (Actual Hours – Standard Hours)

Causes of Variance and Responsibility

Favorable variance for materials may be brought by effective processes, which is responsibility of
production people and the Management or because of high quality materials that minimize wastages,
which is responsibility of Management and Purchasing.

Unfavorable variance on materials may be due to low quality material that may cause wastages which
is responsibility of Purchasing.

Favorable variances for direct labor may be brought by effective planning of work and processes
which are responsibilities of production people and the Management.

Unfavorable variances on labor may be due to untrained staff, which is responsibility of production
people or reworks due to poor quality materials, which is responsibility of Purchasing.

PRACTICE SET

New iron Company sets standard materials and unit prices for their products.

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Unit Cost Stainless Chromed

Iron Sheets 2 meters 2 meters
Molding of Iron Sheets 5 hrs. 2 hrs.
Cost of Iron sheet per unit P 2,500.00
Labor cost per unit 80.00
Indirect materials 200.00
Rental per month 60,000.00
Rent for equipment per month 100,000.00
Processed product 2,000.00 3,000.00
Standard quantity for use 4,000.00 6,000.00

However the actual cost sheet presented to the Management bears the following

COST SHEET FOR THE MONTH OF NOVEMBER 2018

UNIT COST Stainless Chromed

Iron Sheets 2.5 meters 1.75 meters
Molding of iron sheets 6 hrs. 2.5 hrs.
Cost of iron sheet per unit P 2,000.00
Labor cost per unit 80.00
Overtime-required 24 hours 20.00
Indirect materials 150.00
Rental per month 60,000.00
Rent for equipment per month 100,000.00
Processed product 2,000.00 3,000.00
Actual quantity used 5,000.00 7,500.00

Materials Price Variance Stainless Chromed

Actual Price x Actual Quantity P 10,000,000.00

Less: Standard Price x Actual Quantity 12,500,000.00
Variance P 2,500,000.00

The result is favorable variance because the actual was lower than what was set. This maybe due to volume
discount.

Note: (Actual Quantity – Standard Quantity) x Standard Price

If the actual price is lower than what was set it is favorable.
If the price set is higher than actual, it is unfavorable.
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The variances may be due to discount on purchases because of volume.

BIBLIOGRAPHY

Cabrera, Ma. Elenita B., CPA Management Accounting Concepts and Applications 2014 edition, GIC enterprises
& Co., Inc. Manila Philippines

Pascual, Marilou, Ph. D; Fronda, Jennifer G., Ph. D, Macaso, Mark Edrian P., MBA, Vilalcorte, Rhea M., MBA,
Pricing and Costing (for classroom discussion) 2019 edition

http://www.accountingcoach.com

http://www.allbusiness.com

http://www.accountingtools.com/activity-based-costing

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