MODULE 2

BASIC COST MANAGEMENT CONCEPTS

Cost behavior refers to how a cost will change as the level of activity changes. Managers who understand
how cost behave can predict how costs will change under various alternatives. Conversely, attempting to
make decisions without thorough understanding of cost behavior patterns can lead to disaster. 1

Cost – (1) The monetary measure of the amount of resources given up or used for some purpose. (2) The
monetary value of goods and services expanded to obtain current or future benefits. 2

Some Cost Terms Used in Managerial Accounting3

• Cost Object – anything for which cost is computed.
• Cost Driver – any variable, such as level of activity or volume that usually affects costs over a period
of time.
• Cost Pool – a grouping of individual cost items; an account in which a variety of similar costs are
accumulated.
• Activity – an event, action, transaction, task, or unit of work with a specified purpose
• Value-Adding Activities – activities that are necessary (non-eliminable) to produce the product.
• Non-Value-Adding Activities – activities that do not make the product or service more valuable to the
customer.

Different Costs for Different Purposes4

A. As to Type

1. Product Cost – costs incurred to manufacture the product

• Product cost of the units sold during the period are recognized as an expense (cost of goods
sold) in the income statement.
• Product cost of the unsold units become the costs of inventory and treated as asset in the
balance sheet.

2. Period Cost – the non-manufacturing costs that include selling, administrative, and research and
development costs. These costs 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 the costs incurred in the factory to convert raw materials into finished
goods.
a. Direct Manufacturing Costs- materials and labor
b. Indirect Manufacturing Costs – the manufacturing overhead or factory overhead costs.

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 2. Non-Manufacturing Costs – all costs which are not incurred in transforming materials to finished
goods.
a. Research and Development – incurred in designing and bringing new products to the market.
b. Marketing Costs – advertising and promotional expenses.
c. Distribution Costs – costs incurred in delivering the products to the customers.
d. Selling Costs – salaries and commission of sales staff and other selling expenses
e. After-sales Costs – costs incurred in dealing with customers after sales.
f. General and Administrative Costs – all the non-manufacturing costs that do not fall under
categories (a) to (e).

C. As to Traceability / Assignment to Cost Object

1. Direct Cost – costs that are related to a particular cost object and can economically and effectively
traced to that cost object.
2. Indirect Cost – costs that are related to a cost object, but cannot practically, economically and
effectively be traced to such cost object. Cost assignment is done by allocating the indirect cost
to the related cost objects.

D. For Decision-Making
1. Relevant Cost – future costs that will differ under alternative courses of action.
2. Differential Costs – difference is costs between any two alternative courses of action.
a. Incremental Cost – increase in cost from one alternative to another.
b. Decremental Cost – decrease in cost from one alternative to another.
3. Opportunity costs – income or benefit given up when one alternative is selected over another.
4. Sunk/Past or Historical Cost – already incurred and cannot be changed by any decision made now
or to be made in the future.

E. As to Behavior
1. Variable Cost – within the relevant range and time period under consideration, the total amount
varies directly to the change in activity level or cost driver, and the per unit amount is constant.

2. Fixed Cost – within the relevant range and time period under consideration, the total amount
remains unchanged, and the per unit amount varies inversely or indirectly with the change in the
cost driver.
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 – usually arise from periodic decisions by management to spend in
certain fixed costs area such as research, advertising, maintenance contracts. Discretionary
fixed cost may be changed by management from period to period or even during the period,
if circumstances demand such change.

3. Mixed Cost – this cost has both variable and fixed component.

4. Step Cost – when activity changes, a step cost shifts upward or downward by a certain interval or
step.
Analysis of Mixed Costs5

Mixed Costs or Total Costs – have variable and fixed costs component.

TC = FC + VC

Where TC = Total Cost

FC = Total Fixed Cost
VC = Total Variable Cost

The variable cost varies directly with the activity level or cost driver.

VC = variable costs per cost driver x cost driver or

VC = bx

Where VC = Variable Cost

b = Variable Cost per Cost Driver
x = Cost Driver

The Cost Function6

Since the total cost is linearly related to the activity level or cost driver, the cost function maybe express
as:

Y = a + bx

Where Y = Total Cost

a = Total Fixed Cost
b = Variable cost per cost driver
x = Activity Level or Cost Driver

Separation of the Fixed and Variable Components of Mixed Costs7

1. High-low Method
2. Scattergraph Method
3. Least Square Regression Method
Sample Quiz

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