ACT1107 - COST CONCEPTS AND COST BEHAVIOR

PART I: COST CONCEPTS

BASIC COST CONCEPTS AND TERMINOLOGIES

Any individual and/or organization engage in various activities during their day to day operations. These activities, no
matter of what the effort it may take, incur cost. Cost, in layman’s term, may be regarded as expenses which require
cash outlay. However, in accounting terms, cost pertains to a “resource given up” or a “resource to be given up” to
attain a specific objective.

Each activity that incurs cost can be measured in the form of a cost driver. A cost driver pertains to an activity measure
that directly has a cause and effect relationship with a certain cost.

As the company consistently incurs costs in its operations, accountants should be able to accumulate these costs in
order to help management in its functions. In accumulating costs, accounts will collect costs in certain cost pools
(which is a collection of costs).

As costs are already accumulated in cost pools, these cost pools are assigned to various cost objects in order to aid
management in its function. Cost object pertain to anything that accumulates cost or the final recipient of costs (e.g.
Various departments and/or products).

BASIC CLASSIFICATION OF COSTS

Costs, although most are measured in financial terms, can be classified into various classifications for it to become
operational in nature. Classification of costs normally depends on how the costs will be used by management.

1. As to nature of cost
a. Manufacturing Cost – these are cost incurred in relation to the manufacturing process or the production
of certain product.
b. Commercial Expenses – these are operating expenses of the business normally classified as Marketing,
Selling, and Administrative expenses.

2. As to timing of recognition of expenses

a. Product costs – these are cost included as part of the cost of an inventory (which is initially classified as an
asset but transferred to expense when sold).
b. Period costs – these are cost automatically charged to current operations.

3. As to controllability
a. Controllable Cost – these are costs that can be modified by a certain individual in an organization.
b. Non-controllable cost – these are cost that cannot be modified by a certain individual in an organization.

4. As to association with cost objects

a. Direct cost – these are cost that can easily be traced to a certain cost object.
b. Indirect cost – these are costs that cannot easily be traced to a certain cost object.

5. As to Management discretion
a. Committed cost – these are costs that a company is already bound to incur for certain period of time.
b. Discretionary cost – these are costs that a company can still opt not to incur.

6. As to importance in decision making process

a. Relevance costs – cost not yet incurred by the company and are differential between two alternatives.
b. Irrelevant costs – cost already incurred by the company or costs that are not differential between two
alternatives.
c. Differential costs – costs that differ between two alternatives at hand
d. Sunk costs – costs that are already incurred, historical costs.
e. Avoidable costs – costs that the company can save if another alternative has been chosen over the other.

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f. Unavoidable costs – costs that the company will continue to incur regardless of the alternative chosen.
g. Opportunity costs – cost of income that was not earned because another alternative has been chosen.
h. Out-of-pocket costs – costs that require cash outlay at the onset of incurrence

7. As to behavior (general classification)

a. Variable costs – cost that vary directly (in total) in relation to the cost driver; within the relevant range.
b. Fixed costs – costs that remains constant (in total) in relation to the cost driver; within the relevant range.
c. Mixed costs – cost the possess both the characteristics of a variable and a fixed cost.

PART II: COST BEHAVIOR

Cost behavior pertains to the association between cost and its related driver (activity). It pertains to how cost is
expected to change as its related cost driver changes. However, it must be noted that cost behavior works on the
following assumptions:

a. Relevant range assumption – relevant range is the level of activity where cost relationship are considered
valid. It is also the level of activity where cost relationship exhibit linear relationship. For it to be linea, the
following equation of a line must be observed:

Y = a + bx; where Y is the total cost at the specific level of activity

where a is the total fixed cost component
where b is the variable cost per unit
where x is the measure of the cost driver

b. Time period assumption – cost behavior is only considered valid for a certain period of time. It must be noted
that over the long run, behavior of certain costs might change as certain fixed costs may need to be change
in order to increase capacity or that certain variable costs may become fixed due to automation of certain
processes.

Example: Assembly department’s cost may become fixed as full automation happens.
Depreciation may change as new equipments are acquired.

CLASSIFICATION OF COSTS AS TO BEHAVIOR

In management accounting, the following cost classifications as to behavior are being used:
a) Variable cost – costs that vary directly in total as the activity changes but remains constant per unit.
b) Fixed cost – costs that remain constant in total regardless of changes in activity but varies inversely per unit.
c) Semi-variable (mixed) cost – hybrid (i.e. combination of fixed and variable) cost
d) Step-variable cost – costs that are closely classified as variable; characterized by small increments
e) Step-fixed cost – costs that remain constant for a period but is subsequently affected by the level of activity;
characterized by prolonged constant level of cost
f) Curvilinear cost – cost depicted by a curved graph (incorporating concepts of marginal cost)

COST ESTIMATION: SEGREGATING MIXED COST

Cost estimation is the process of determining cost behavior. Specifically, it pertains to the process of separating the
fixed and variable component of a mixed cost.

Account Classification Method (Account Analysis) – account classification method/ account analysis pertains to the
classification of cost whether it’s fixed, variable, or semi-variable based on the judgement of the accountant. Note that
the judgement is normally based on historical activity, company policies etc.

Scatter Graph Method – The scatter graph method involves the use of a visual fit line. It involves estimation of the
fixed and variable cost component by plotting the set of historical cost and activity data in a graph and visually fitting
a line that can denote the cost function for the given set of data. Note that the line should at least (1) be able to cut
the graph where points above and below the line are not significantly different, and (2) be close/near to most of the
points plotted in the graph.

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High-Low Method – The high-low method of segregating mixed cost makes use of two points within a data set to
determine the fixed and variable component of the mixed cost. Variable cost per unit (b) is computed by using the
highest and lowest point (based on activity level) in the given set of data. The formula is expressed as follows:

𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 (𝐻𝑖𝑔ℎ𝑒𝑠𝑡 𝑃𝑜𝑖𝑛𝑡) − 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 (𝐿𝑜𝑤𝑒𝑠𝑡 𝑃𝑜𝑖𝑛𝑡) 𝑏 =

𝑇𝑜𝑡𝑎𝑙 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 (𝐻𝑖𝑔ℎ𝑒𝑠𝑡 𝑃𝑜𝑖𝑛𝑡) − 𝑇𝑜𝑡𝑎𝑙 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 (𝐿𝑜𝑤𝑒𝑠𝑡 𝑃𝑜𝑖𝑛𝑡)

While total fixed cost component can be solved algebraically using either the highest or lowest point

Least Squares Regression Method – This method of cost estimation takes into consideration all the points in a given
data set. Note that the line representing the cost function generated through this method is called the least square
regression line. In computing for the least square regression, the two formulas must be utilized:

∑ 𝑌 = 𝑁𝑎 + 𝑏 ∑ 𝑋 and ∑ 𝑋𝑌 = ∑ 𝑋𝑎 + 𝑏 ∑ 𝑋2

Where b is the variable cost per unit

Where a is the total fixed cost per unit
Where x is the level of activity
Where Y is the total cost
Where N is the number of observation

Multiple Regression Method – This method of cost estimation takes into consideration all the points in a given data
set. However, as compared to least squares regression, multiple cost drivers are being taken into account in a multiple
regression method. Specifically, the cost formula can be referred to as follows:

Y = 𝑎 + 𝑏1𝑥1 + 𝑏2𝑥2

IMPORTANCE OF COST BEHAVIOR

Cost behavior helps management in planning as they can be able to make more realistic budget (i.e. in relation to its
association with a specific activity). Cost behavior also helps in control through the help of variance analysis (that is
comparison of actual cost vs. budgeted cost). In using cost behavior in planning and control, management should
consider the concept of relevant range which is the level of activity the entity is expected to operate and the level of
activity where cost behavior is considered valid.

COMMON PITFALLS IN COST ESTIMATION

1. Use of incomplete and inaccurate information
2. Failure to isolate outliers in the analysis
3. Lack of consideration in qualitative considerations

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