COLLEGE OF BUSINESS AND ACCOUNTANCY

Topic: COST CLASSIFICATION AND BEHAVIOUR

Cost Types

• Variable: Costs that vary with activity levels over the relevant range.
• Fixed: Costs that do not vary with activity levels over the relevant range.
• Mixed: Costs that have both a fixed and a variable component.
• Relevant range: The relevant range is the range of output levels for which
• estimated cost behaviors patterns remain unchanged.
• Product: Costs that are identifiable with a product or service.
• Period: Costs that are expensed directly to the income statement.

Cost Classifications

• Financial presentation: Presentation of costs according to IRFS.

• Decision-related: Classification of costs according to the decision being made. For example, costs
included in a make or buy decision are only those costs relevant to the decision.

Cost Function:

• A mathematical description of the relationship between cost behavior and activity levels.
• Cost functions are used to model past relationships and are used to estimate future costs.
• A simple cost function equation:
y = a + bx
y = the total cost to be predicated is called the dependent variable
x = the activity level assumed to drive costs in the short run is called the independent variable.
a = the cost that is fixed over the relevant range (constant)
b = variable cost per unit (slope)
bx = the total variable cost

Approaches to Cost Estimation

High Low Method

The fixed and variable portions of the mixed costs are computed from two sampled data points – the highest
and lowest points based on activity or cost driver.

𝐶ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝐶𝑜𝑠𝑡𝑠 (𝐻𝑦 − 𝐻𝑦)

𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡 (𝑏)
𝐶ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 (𝐻𝑥 − 𝐿𝑥)

Least Square Regression Method

Least square method is a statistical technique that investigates the association between dependent and
independent variables. The method determines the line of best fit for a set of observations by minimizing the
sum of the squared deviations between cost line and data points.

• If there’s only one independent variable, the analysis is known as SIMPLE REGRESSION.
• If the analysis involves multiple independent variables, it is known as MULTIPLE REGRESSION.

𝑛 ∑ 𝑋𝑌 − (∑ 𝑋)(𝑌)
𝑏= 2
𝑛 ∑ 𝑋 − (∑ 𝑋) ²

∑𝑌 − 𝑏∑𝑋
𝑎=
𝑛
Other Cost Estimation Methods:

1. Scattergraph (Scatter Diagram) Method

All observed costs at different activity levels are plotted on a graph. Based on sound judgement, a
regression line is then fitted to the plotted points to represent the line function.

2. Industrial Engineering Method

The management accountant develops a cost for the materials, labour and overhead cost for a
product or service based on knowledge of similar products.
Based on the relationship between the output and input in physical forms; engineering estimates
indicate what and how much cost should be.
For example, the cost of making a hamburger would be estimated by identifying the cost of raw
material, the amount of labour required to make the hamburger and an allocation of overhead.

3. Account Analysis Method

The management accountant reviews all general ledger accounts and classifies as fixed,
variable or mixed. The classifications are made based on knowledge of the production
process, industry/company experience and review of cost behaviour over several time
periods.
Each account is classified as either fixed or variable based on experience and judgement of
accounting and other qualified personnel in an organization.

ILLUSTRATION #1

Mondler Inc. employed several maintenance engineers to keep the equipment running in peak condition.
Over the past eight months, Mondler incurred the following maintenance cost for these engineers. Plant
activity is best measured by direct labor hours.

Month Direct Labor Hours Maintenance Cost

January 1,700 14,300
February 1,900 15,200
March 1,800 16,700
April 1,600 14,000
May 1,500 14,300
June 1,300 13,000
July 1,100 12,800
August 1,400 35,200

USING THE HIGH LOW METHOD, DETERMINE:

1. Variable Cost per Unit

2. Total fixed cost
3. Monthly Cost Function
4. Maintenance cost assuming 2000 direct labor hours will be used next month.

SOLUTION:

1. b=
(𝐻𝑦−𝐻𝑦) 2. y = a + bx 3. The monthly cost function
(𝐻𝑥−𝐿𝑥) 15,200 = a + 3(1,900) is: y = 9,500 + 3x
15,200−12,800 15,200 = a + 5,700
b= 15,200 – 5,700 = a
1,900−1,100
a = 9,500
b=
2,400
or 4. y = a + bx
800
12,800 = a + 3(1,100) y = 9,500 + 3(2,000)
b=3 12,800 = a + 3,300 y = 9,500 + 6000
12,800 – 3,300 = a y = 15,500
a = 9,500
ILLUSTRATION #2

Data concerning Unagi Company's activity for the first six months of the year appear below:

Month Machine Hours Electrical Cost

January 4,000 3,120
February 6,000 4,460
March 4,800 3,500
April 5,800 5,040
May 3,600 2,900
June 4,200 3,200

USING THE HIGH LOW METHOD, DETERMINE:

1. Variable Cost per Unit

2. Total fixed cost
3. Determine estimated electrical cost assuming 5000 hours will be used.

SOLUTION:

1. b=
(𝐻𝑦−𝐻𝑦) 2. y = a + bx 3. y = a + bx
(𝐻𝑥−𝐿𝑥)
4,460 = a + .65(6,000) y = 560 + .65(5,000)
(4,460−2,900) 4,460= a + 3,900 y = 560 + 3250
b= 4,460 - 3900 = a y = 3,810
(6,000−3,600)
a = 560
1,560
ILLUSTRATION
b = 2,400 #3 or
2,900 = a + .65(3,600)
Assumeb the local franchise of
= .65 2,900 = a + 2,340
2,900 - 2340 = a
a = 560

ILLUSTRATION #3

CentralPerk produces bottles of ice cold latte. The activity levels and the attached costs are shown below:

USING THE LEAST SQUARES REGRESSION METHOD, DETERMINE:

1. Determine the cost function.

2. Calculate the total cost at activity levels of 6,000 and 10,000 bottles.
SOLUTION:

n=7

∑x = 17,310

∑y = 306,080

x2 = 53,368,900

xy = 881,240,300

Computation of variable cost per unit (b):

The value of ‘b’ (i.e., per unit variable cost) is $11.77 which can be substituted in fixed cost formula to find the
value of ‘a’ (i.e., the total fixed cost).

Computation of total fixed cost (a):

1. y = 14,620 + 11.77x

2. y = 14,620 + 11.77(6,000)
y = 85,240

3. y = 14,620 + 11.77(12,000)
y = 155,860

--------------------------------------------------------Nothing follows----------------------------------------------------------------

Reference: CMA Ontario; February 2011