COST CONCEPTS AND ANALYSIS

TYPES OF COSTS ACCORDING TO BEHAVIOR PATTERN

Cost behaviour refers to the way costs respond to changes in volume or activity. Managers use assumptions about
cost behavior in almost every decision they make.
A. When planning ,managers use cost behaviour to determine how many units of products or services must be sold
to generate a targeted amount of profit and how changes in planned activities will affect operating income.
B.When performing duties, managers use cost behavior to determine the impact of their decision on operating
income.
C. When evaluating and reporting on performance, managers analyze how changes in costs and sales affect
profitability.

Variable cost –A variable cost is one whose total peso amount varies or changes in direct proportion to changes in
the activity level (cost driver).Variable costs are constant per unit.
Fixed cost–A fixed cost remains constant in total peso amount within the relevant range. Fixed cost per unit
becomes progressively bigger as the number of units produced decreases.
Step-Variable cost– Is a cost which exhibits the behaviour of both variable and fixed costs. It behaves as fixed cost
for a certain range of activity until the next jump to another range of activity.
Mixed costs–A mixed cost is one that contains both variable and fixed cost elements.

ANALYSIS OF MIXED COSTS

Mixed costs are a combination of variable and fixed cost components. For cost planning and control purposes,
mixed costs must be divided into their variable and fixed components.
Account analysis–Using this method; costs are classified by looking at its name and then checking this judgement
by scanning the amount for that cost for several periods. If amounts in the account for cost vary only a little from
period to period, then it is likely that the cost is fixed. If it varies considerably, It is probably variable or mixed.
Engineering approach –This method is used in manufacturing firms or for repetitive, standard activities. Under this
method, engineering study the material and labour requirements of products related operations then make per
unit estimates of the costs that should vary with production. This is also called a time and motion study.
The high-low method – The high-low method analyzes changes a two levels of activity (the high end and the low
end) within the relevant range. The changes in cost and activity are calculated for these two levels of activity.
Dividing the change in cost by the change in activity determines the variable cost element portion of the mixed
cost. Once this is determined, the fixed portion is computed by subtracting the variable element times either the
high or low level of activity from respectively, total cost at either the high or low level of activity.

The computation of the amounts of variable and fixed costs is based on the following cost model:
Y= a + bX

Where: Where:
Y – dependent variable (total costs) Y= Total cost at high level
A – Y-intercept(fixed cost) Y= Total cost at low level
B – scope parameter (variable cost per unit of measure)
X – Independent variable X= High-level activity
X= Low- level activity

Using the high-low method, the variable cost is computed- Fixed cost is computed
b=(Y-Y)÷(X-X) a=Y-bX

Let us assume that Friends Company incurred the following costs during the past six months:
Illustration 14: Total costs of Friends Company over the past six months
Month Vales Production Total Cost
July 10,000 $44,000
August 15,000 $60,000
September 23,000 $85,000
October 21,000 $75,000
November 19,000 $70,000
December 28,000 $98,000
The lowest level of production was in July and the highest level of production was in December. The
difference between the number of units produced and the difference between the total cost at the highest
and lowest levels of production are shown below:
Production Total Cost
Highest Level 28,000 units $98,000
Lowest Level 10,000 units $44,000
Difference 18,000 units $54,000

As the total fixed cost does not change with changes in the production volume, the difference in the total
costs represents the change in the total variable costs. So, if we divide the difference in the total costs by
the difference in the production levels, we will have an estimate of the variable cost per unit:
Variable Cost per Unit = $54,000 ÷ 18,000 units = $3

The variable cost per unit is $3. The fixed cost will be the same at both the highest and lowest levels of
production because fixed costs don't change. In order to estimate the fixed costs, we have to subtract the
estimated total variable cost from the total cost:
Total Cost = Variable Cost per Unit x Units of Production + Fixed Cost
Highest level:

$98,000 = $3 x 28,000 + Fixed Cost

Fixed Cost = $14,000

Lowest level:

$44,000 = $3 x 10,000 + Fixed Cost

Fixed Cost = $14,000

The Scattergraph method – The scattergraph method involves a construction of a graph that considers all the
observations. A regression line is fitted to the plotted points. This method provides better estimation of the cost
relationship because all the observations are included in the analysis. However, it may yield imprecise results
because the determination of the regression is made visually.
The least-squares method– It is a more objectives and precise method of fitting a regression line to all the cost
data because this method mathematically computes the variable and fixed cost components.
This method uses the following equations in computing for the values of unit variable cost and fixed cost:

TERMINOLOGIES
Relevant range -Refers to the range of activity within a particular cost relationship is valid. It means within a
particular range, the amount of variable cost per activity unit remains constant; in other ranges, the total fixed
cost does not change.
Activity driver (activity base) – An activity driver or activity base is a measure of whatever causes the incurrence of
a variable cost. A measure of activity is relevant only if it actually causes the cost.
Common cost drivers:
Number of units produced or sold
Number of machine hours
Number of direct labor hours
Correlation-Is the closeness of the relationship between the cost driver and the cost.For a cost prediction formula
to be useful, the correlation must be fairly high.
Spurious Correlation- Instances wherein strong relationship appears although no casual relationship exists.
Outlier-Is an out of line observation and must be ignored.
Product costs-These are manufacturing costs incurred to produce units of output.
Period costs-These are costs that are immediately recognized as expense during the period they are incurred.
Incremental cost-The difference in total cost that result from selecting one choice instead of another.
Opportunity cost- The profit or benefit forgone by selecting one choice instead of another alternative. It is usually
relevant but is not part of traditional accounting records.
Imputed cost-It is a cost which does not entail any peso outlay but which is relevant to the decision-making
process.
Avoidable cost- This is a cost that may be saved by not adopting an alternative.
Postponable cost –This is a cost that may be shifted to the future with little or no effect on current operations.
Sunk cost-It is a cost that cannot be avoided because it has already been incurred. It is a historical cost that cannot
be changed by any decision.
Common cost- It is a cost common to all choices in question and not clearly or practically allocable to any of
them.
Controllable cost- Cost that is likely to respond to the amount of attention devoted to them by specified manager.
Discretionary cost- A cost that management decides to incur in the current period to enable the company to
achieve objectives.
Committed cost-A cost that is govern mainly by past decisions that established the present levels of operating and
organizational capacity and that only change slowly in response to small changes in capacity.

References: Management Advisory Services hand outs (CPAR Dagupan)

http://simplestudies.com/accounting-cost-behavior.html/page/6

QUIZ

I. The Lakeshore Hotel’s guest-days of occupancy and custodial supplies expense over the last several months
were:
Month Guest-days of Occupancy Custodial Supplies Expense
March 4,000 P7,500
April 6,500 8,250
May 8,000 10,500
June 10,500 12,000
July 12,000 13,500
August 9,000 10,750
September 7,500 9,750

Guest-days is a measure of the overall activity at the hotel. For example, a guest who stays at the hotel for three
days is counted three guest-days.
Required:
1. Using the high-low method, estimate a cost formula for custodial supplies expense.

2. Using the cost formula you derived above, what custodial supplies expense would you expect to be incurred at
an occupancy level of 11,000 guest-days?

II. Hoi Chong Transport operates a fleet of delivery trucks in Northern Luzon. The company has determined that is a
truck is driven 105,000 kilometer during a year; the average operating cost is P11.40 per kilometer. If a truck is
driven only 70,000 kilometers during a year, the average operating cost increases to P13.40 per kilometer.

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 cost portion in the for Y = a + bx

3. If a truck were driven 80,000 kilometers during a year, what total cost would you expect to be
incurred?

III. Laco Company acquired its factory building about 20 years ago. For a number of years the company has rented
out a small. Unused part of the building. The renter’s lease will expire soon. Rather than renewing the lease, Laco
Company is considering using the space itself to manufacture a new product. Under this option, the unused space
will continue to be depreciated on a straight-line basis, as in past years.
Direct materials and direct labor cost for the new product would be P50 per unit. In order to have a place to store
finished units of the new product, the company would have to rent a small warehouse nearby. The rental cost
would be P2,000 per month. It would cost the company an additional P4,000 each month to advertise the new
product. A new product supervisor would be hired to oversee production of the new product who would be paid
P3,000 per month. The company would pay a sales commission of P10 for each unit of product that is sold.
 Complete the chart below by placing an “X” under each column heading that helps to identify the costs listed to
the left. There can be “X’s” placed under more than one heading for a single cost. For example, a cost might be a
product cost, anopportunity cost, and a sunk cost; there would be an “X” place under each of these headings on
the answer sheet opposite the cost.

Opportunity Sunk Variable Fixed Production Selling & Differential

Cost Cost Cost Cost Cost Admin Cost Cost
Rent on unused
factory space
Depreciation on
the factory
space
Direct material
and direct labor
Rental cost of the
small warehouse
Advertising cost
Production
supervisor’s
salary
Sales
commissions
*Between the alternatives of (1) renting the space out again or (2) using the space product the new product