COSTS AND COST CONCEPTS MANAGEMENT ADVISORY SERVICES

Cost - a measurement, in monetary terms, of the amount of resources used for some purpose. When
notified by a term that defines the purpose, cost becomes operational, e.g., selling cost,
acquisition cost, variable cost, etc.

Cost Pool - an account in which a variety of similar costs are accumulated prior to allocation to cost
objects. It is a group of costs associated with an activity. Example: overhead account.

Cost object - the intermediate and final disposition of cost pools.

Example: product, job, process

Cost driver - a factor that causes a change in the cost pool for a particular activity. It is used as a
basis for cost allocation; any factor or activity that has a direct cause-effect relationship

Activity - any event, action, transaction, or work sequence that incurs costs when producing a
product or providing a service.
Value-adding Activities – activities that are necessary to produce the products
Non-Value-Adding Activities – activities that do not make the product or services valuable
to customers.

COSTS CLASSIFICATION
A. As to type
1. Product Costs – costs incurred to manufacture a product.
2. Period Costs – costs that are expensed in the period of incurrence and do not become
part of the cost of inventory.

B. As to function
1. Manufacturing Costs – all costs incurred in the factory to convert raw materials into
finished goods.
2. Non-manufacturing Costs – all costs which are not incurred to transform raw
materials into finished goods.

C. As to traceability to cost object

1. Direct Costs – costs that are related to a particular cost object and can economically
and effectively be traced to that cost object.
2. Indirect Costs – costs that are related to a cost object but cannot practically,
economically and effectively be traced to such cost object.

D. As to behavior
1. Fixed Costs - in total: constant within the relevant range as activity output changes;
per unit: changes as activity level changes.
a. Committed Fixed Costs – long-term in nature and cannot be eliminated even
for short period of time without affecting the profitability or long-term goals
of the firm.
b. Discretionary Fixed Costs – arise from periodic decision by management to
spend in certain fixed cost area and may be changed by management from
period to period or even during (within) the period, if circumstances
demand such change.
2. Variable Costs - in total: varies in direct proportion to changes in activity output; per
unit: remains constant
3. Mixed Costs - has both fixed and variable components.

E. For decision-making
1. Relevant Costs – future costs that will differ under alternative courses of actions.
2. Differential Costs – difference in costs between any two alternative courses of action.
3. Opportunity Costs – income or benefit given up when one alternative is selected over
another.
4. Sunk/Past/Historical Costs – costs that are already incurred and cannot be changed by any
decision made now or to be made in the future.

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COST BEHAVIOR

COST BEHAVIOR - describes how a cost behaves or changes as the amount of cost driver changes.

COST BEHAVIOR ASSUMPTIONS:

1. Relevant Range Assumption
Relevant range refers to the band of activity within which the identified cost behavior
patterns are valid. Any level of activity outside this range may have a different cost
behavior pattern.
2. Time Period Assumption
The cost behavior patterns identified are true only over a specified period of time.
Beyond this, the cost may show a different behavior.

SEGREGATION OF FIXED AND VARIABLE ELEMENTS OF MIXED COSTS:

1. High-Low Points Method - the fixed and variable elements of the mixed costs are computed
from two data points (periods)—the high and low periods as to activity level or cost driver.

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

3. Method of Least Squares (Regression Analysis) - mathematically determines a line of best fit
or a linear regression line through a set of plotted points so that the sum of the squared
deviations of each actual plotted point from the point directly above or below it on the
regression line is at minimum.

This method uses the following equations in computing for the values of unit variable cost
and fixed cost:

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

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

CORRELATION ANALYSIS

Correlation – measure the co-variation between the dependent and independent variable.

Coefficient of Correlation (r) – the measure of the extent of the linear relationship between two
variables.

Coefficient of Determination (r 2) – represents the percentage of the total variation in the

dependent variable y that is explained or accounted for by the regression equation.

Standard Error of Estimate – the standard deviation about the regression line, which serve as the
confidence interval or acceptable range of tolerance, for use in exercising control over the
costs.

Exercises:

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1. Classify the following costs as fixed, variable, or semivariable
a. Depreciation – straight line method f. Rent
b. Direct materials g. Repairs to machinery
c. Factory insurance h. Value added tax
d. Electricity i. Superintendence
e. Indirect materials j. Washroom supplies

2. Under which subheading of the elements of cost should each of the following costs be
classified?
a. Sandpaper used in furniture manufacturing f. Inspector’s salary
b. Depreciation of factory g. Legal expenses
c. Earnings of machinist h. Lubricating oil
d. Supervisor’s wages i. Bags in flour mills
e. Milk to make ice cream j. Wages of factory crane operator

3. Ryan V. Company reports the following total costs at two levels of

production:
Cost Item 2,000 units 5,000 units
Indirect labor P1,000 P2,000
Property taxes 5,000 5,000
Direct labor 16,000 40,000
Direct materials 12,000 30,000
Depreciation 10,000 10,000
Utilities 2,000 3,500
Maintenance 3,000 6,000

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

4. Lemsolano Company wants to find an equation to estimate monthly utility

costs. Lemsolano has been in business for one year and has collected the following
cost data for utilities:
Month Electricity Kwh used Telephone Telephone Water bill Gallons of
Bill Bill Minutes water
Used used
January P360 1,200 P92.00 1,100 P60 30,560
February P420 1,400 P91.20 1,060 P60 26,800
March P549 1,830 P94.80 1,240 P60 31,450
April P405 1,350 P89.60 980 P60 29,965
May P588 1,960 P98.00 1,400 P60 30,568
June P624 2,080 P98.80 1,440 P60 25,540
July P522 1,740 P93.40 1,170 P60 32,690
August P597 1,990 P96.20 1,310 P60 31,222
September P630 2,100 P95.60 1,280 P60 33,540
October P615 2,050 P93.80 1,190 P60 31,970
November P594 1,980 P91.00 1,050 P60 28,600
December P633 2,110 P97.00 1,350 P60 34,100

REQUIRED:
1. Which of the preceding costs is variable? Fixed? Mixed? Explain.
2. Using the high-low method, determine the cost function of each cost.
3. Combine the preceding information to get a monthly utility cost function for Lemsolano
4. Next month, Lemsolano expects to use 2,200 Kwhs of electricity, make 1,500 minutes of telephone
calls, and use 32,000 gallons of water. Estimate total cost of utilities next month.

5. Meemon Company manufactures and sells a single product. A partially

completed schedule of the company’s total and per unit costs over the relevant
range of 30,000 and 50,000 units produced and sold annually is given below:
Units produced and sold 30,000 40,000 50,000
Total Costs:

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 Variable costs P150,000 ? ?
Fixed costs 300,000 ?
Total P450,000 ? ?

Cost per unit:

Variable cost ? ? ?
Fixed cost ? ? ?
Total ? ? ?
Required:
a. Complete the schedule of the company’s total and unit costs above.
b. Compute income, assuming that the company produces and sells 38,000 units during a year
at a selling price of P14 per unit.

6. Solcayde Company is a distributor that has an exclusive franchise to sell a

particular product made by another company. Solcayde Company’s income
statements for the last two days are given below:
This year Last year
Units sold 200,000 160,000
Sales revenue P1,000,000 P800,000
Less: Cost of goods sold 700,000 560,000
Gross margin 300,000 240,000
Less: Operating expenses 210,000 198,000
Net Operating Income P90,000 P42,000

Operating expenses are a mixture of fixed costs and variable and mixed costs that vary with
respect to the number of units sold.

REQUIRED:
a. Estimate the company’s variable operating expenses per unit, and its total fixed operating
expenses per year.
b. Compute the company’s contribution margin for this year.
c. Compute operating income if sales is 180,000 units.

7. Fitzgerald Manufacturing has been using activity-based costing to determine the cost of
product X-678. One of the activities, “Inspection,” occurs just before the product is finished.
Fitzgerald inspects every 10th unit, and has been using “number of units inspected” as the cost
driver for inspection costs. A significant component of inspection costs is the cost of the testkit used
in each inspection.

PdGeorge, the line manager, is wondering if inspection labor-hours might be a better cost driver for
inspection costs. PdGeorge gathers information for weekly inspection costs, units inspected, and
inspection labor-hours as follows:

Week Units Inspected Inspection Labor Inspection Costs

Hours
1 1,400 190 P3,700
2 400 70 1,800
3 1,700 230 4,500
4 2,400 240 5,900
5 2,100 210 5,300
6 700 90 2,400
7 900 110 2,900

REQUIRED:
1. Explain why number of units inspected and inspection labor-hours are plausible cost drivers of
inspection costs.
2. Using the method of least squares, determine the cost formulas for inspection costs using the
units inspected and inspection labor hours as the cost drivers.
3. Plot the regression line for units inspected and inspection costs, and the regression line for
inspection labor hours and inspection costs. Based on the graphs, which cost driver of inspection

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costs would you choose? Explain.
4. PdGeorge expects inspectors to work 140 hours next period and to inspect 1,100 units. Using the
cost driver you chose in requirement 3, what mount of inspection costs should PdGeorge budget?
Explain any implications of PdGeorge choosing the cost driver you did not choose in requirement 3
to budget the to budget inspection costs

8. Nyamnyam Transport operates a fleet of delivery trucks in Luzon. The company has
determined that if the truck is driven 105,000 kilometers during a year, the average operating costs
is P11.40 per kilometer. If the truck is driven only 70,000 km during a year, the average operating
costs increases to P13.40 per km.

REQUIRED:
1. Using the high-low method, estimate the variable and fixed cost elements of the annual cost of the
truck operation.
2. Express the variable and fixed costs in the form Y = a + bX
3. If a truck were driven 80,000 km during a year, what total cost would you expect to be incurred?

9. An analysis of past janitorial costs indicates that the average janitorial cost is P10.00 per
machine hour at an activity level of 15,000 machine hours and P15.00 per machine hour at an
activity level of 10,000 machine hours. Assuming that his activity is within the relevant range, what
is the total expected janitorial cost if the activity level is 13,000 machine hours?

10. The Mix! Company uses the high-low method to estimate the cost function.
The information for 2015 is provided below:
Machine Labor Costs
hours
Highest observation of cost driver 500 P6,000
Lowest observation of cost driver 140 1,680
What is the total cost for 320 hours?

11. Goljess Company is a manufacturing company whose total factory overhead

costs fluctuate considerably from year to year according to increases and
decreases in the number of direct labor-hours worked in the factory. Total factory
overhead costs at high and low levels of activity for recent years are given below:
LOW HIGH
Direct labor hours 50,000 75,000
Total factory overhead costs P14,250,000 P17,625,000
The factory overhead costs above consist of indirect materials, rent, and maintenance. The company
has analyzed these costs at the 50,000-hour level of activity as follows:

Indirect materials (Variable) P5,000,000

Rent (Fixed) 6,000,000
Maintenance (Mixed) 3,250,000
Total overhead costs P14,250,000

To have data available for planning, the company wants to break down the maintenance cost into its
variable and fixed cost elements.

REQUIRED:
1. Estimate how much of the P17,625,000 factory overhead cost at the high level of activity consists
of maintenance costs.
2. By means of the high-low method, estimate a cost formula for maintenance.
3. Express the company’s total overhead costs in the linear equation form Y = a + bX.
4. What total overhead costs would you expect to be incurred at an operating activity level of 70,000
direct labor hours?

12. Rover Company manufactures a single product. The company keeps careful
records of manufacturing activities from which the following information has been
extracted:
March-Low June-High

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 Number of units produced 6,000 9,000
Cost of goods manufactured P168,000 P257,000
Work in process inventory, beginning P9,000 P32,000
Work in process inventory, ending P15,000 P21,000
Direct materials cost per unit P6 P6
Direct labor cost per unit P10 P10
Manufacturing overhead cost, total ? ?

The company’s manufacturing overhead consists of both variable and fixed cost elements. To have
data available for planning, management wants to determine how much of the overhead cost is
variable with units produced and how much of it is fixed per month.

Required:
1. For both March and June, estimate the amount of manufacturing overhead cost added to
production. The company had no underapplied or overapplied overhead in either month.
2. Using the high-low method, estimate a cost formula for manufacturing overhead. Express the
variable portion of the formula in terms of a variable rate per unit of product.
3. If 7,000 units are produced during a month, what would be the cost of goods manufactured?
(Assume that the work in process inventories do not change and there is no underapplied or
overapplied overhead cost for the month.)

13. Velman Company wants to determine the factors that are associated with
overhead. The controller for Velman constructed a multiple regression equation
using the following independent variables: direct labor hours, number of setups,
and number of purchase orders. The analysis was run using the past 50 months of
data. From the printout, the following data were obtained:
Parameter Estimate
Intercept P5,000
Rates of variability
Direct labor hours (H) P10
Number of setups (S) P900
Number of purchase orders (P) P20
Number of observations 50

r2 = 0.95

REQUIRED:
1. Write out the cost formula for monthly overhead for Velman Company.
2. If Velman budgets the following for next month, what is the budgeted overhead cost?
Direct labor hours 400
Number of setups 30
Number of purchase orders 150
3. Suppose that Velman’s engineers found a way to reduce the number of setups by 20 percent How
much would be saved in overhead cost for the following month?

No CPA ever became one by just dreaming. Action needs to be done.

-end-

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