COSTS AND COST CONCEPTS

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.
— the monetary measure of the amount of resources given UP of used for some purpose;
- the monetary value of goods and services expended to obtain current or future benefits.

Cost Pool— an account in which 2 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.
Examples: work in process, factory overhead control

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 pcs, yet basis for cost allocation; any factor or activity that has a direct cause-effect
relationship.
Examples: production, sales, number of hours

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 (non-eliminable) to produce the

products
Example: assembling the different component parts of the product

NON VALUE-ADDING ACTIVITIES — activities that do not make the product or service
more valuable to the customer
Example: moving materials and equipment parts from/to the
stockroom or a workstation

DIFFERENT COSTS FOR DIFFERENT PURPOSES

A. AS TO TYPE
1. PRODUCT COSTS— costs incurred to manufacture the product
o Product costs of the units sold during the period are recognized as expense (cost of goods
sold) in the income statement.
o Product costs of the unsold units become the costs of inventory and treated as asset in the
balance sheet.
2. PERIOD COSTS - 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.
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 promotion 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. Examples are
warranty, repairs costs, and costs incurred in receiving/entertaining/acting on customer’s
complaints.
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 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 by such cost object. Cost assignment is done by allocating the indirect
cost to the related cost objects.

D. FOR DECISION-MAKING
1. RELEVANT Costs. - future costs that will differ under alternative courses of action.
2. DIFFERENTIAL Costs — difference in 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 COSTS — already incurred and cannot be changed by any
decision made now or to be made in future.

E. AS TO BEHAVIOR (REACTION TO CHANGES IN COST DRIVER)

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.
Example: depreciation buildings and equipment
b. Discretionary or Managed Fixed Costs - usually arise from periodic (may be annual, etc.)
decisions by management to spend in certain fixed costs area such as research,
advertising, maintenance contracts. Discretionary fixed costs may be changed by
management from period to period or even during (within) the period, if circumstances
demand such change.
 Examples: research and development costs, advertising expense, maintenance costs provided
by service contractor.
3. Mixed Cost - this cost has both a variable and a fixed component
4. Step Cost — when activity changes, a step cost shifts upward or downward by a certain
interval or step.
o Step Variable Costs – have small steps
o Step Fixed Costs – have large steps

ANALYSIS OF MIXED COSTS

MIXED COSTS OR TOTAL COSTS — have variable and fixed costs components

TC = FC + VC
where: TC = Total cost
FC = Total fixed cost
VC = Total variable cost
Total variable cost varies directly with the activity level or cost driver.
VC = variable cost per cost driver x cost driver or VC = bx

where: VC = Total variable cost

b = variable cost per cost driver
x = cost driver
Example: If the cost driver is number of units and variable cost per unit is P5, then VC = 5x

The total or mixed cost function may be expressed as:

TC = FC + bx

LINEARITY ASSUMPTION- within the relevant range, there is a strict linear relationship
between the cost and cost driver. Costs may therefore be shown graphically as straight lines.

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

TYPES OF COSTS AS TO BEHAVIOR:

1. FIXED COST -— in total: constant within the relevant range as activity output changes; per
unit: changes as activity level changes
2. VARIABLE COST — in total: varies indirect proportion to changes in activity output; per
unit: remains constant
3. MIXED COST — has both fixed and variable components.

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.
- a range of activity that reflects the company’s normal operating range. Within this relevant
range, the aforementioned cost behavior is valid, ie.:
TOTAL AMOUNT PER COST DRIVER
VARIES DIRECTLY WITH
VARIABLE COST CONSTANT
COST DRIVER
VARIES INVERSELY
FIXED COSTS CONSTANT
WITH COST DRIVER

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.

MULTIPLE REGRESSION ANALYSIS - this is used when the dependent y (cost, for example)
is caused by more than one factor. In other words, the dependent variable (cost) is related to
more than one independent variable (units, machine hours, etc.)

CORRELATION ANALYSIS

Correlation — measure of the co-variation between the dependent and independent variables
o If all plotted points fall on the regression line, there is perfect correlation
 o If correlation between the cost and cost driver is high and the past relationship between
such variables will continue in the future, then the cost. driver chosen will be useful for
predicting future levels of the costs being analyzed.

Coefficient of Correlation (denoted by r) - measure of the extent of the linear relationship

between two variables

Coefficient of Determination (denoted by), is computed by squaring the value of r. It represents

the percentage of the total variation in the dependent variable y that ‘is explained or accounted
for by the regression equation.

A very high r2 means that the values in the regression equation explain virtually the entire
amount of the total cost. The variables are highly correlated, i.e., the cost driver selected is
highly related to the dependent cost.

Standard Error of the Estimate - the standard deviation about the regression line

Estimated values computed using the regression equation may differ from the actual costs. The
differences are called Prediction errors or errors of estimate.

The standard error of estimate is calculated to serve as a confidence interval or acceptable range
of tolerance, for use in exercising control over the costs. By comparing a cost Variance with the
standard error of estimate, management can decide
whether to investigate such variance or not.

o If r2=1, the standard error = 0.

o A small value of the standard error indicates a good fit,
EXERCISES:
1. Consider the following costs that were incurred during the current year.

a. Advertising costs of Jobilee.

b. Straight-line depreciation on factory machinery of Samsang
c. Wages of assembly-line personnel of Toyotha.
d. Delivery costs on customer shipments of Huawey.
e. Newsprint consumed in printing the Manila Star.
f. Plant insurance costs of Bhench Gharments.
g. Glass costs incurred in light-bulb manufacturing of Omnay.
h. Tire costs incurred by Yunday.
i. Sales commissions paid to the sales force of Myfone.
j. Wood Glue consumed in the manufacture Libiran furniture.
k. Hourly wages of refinery security guards employed by Muscovado Corporation.
l. The salary of a financial vice president of Alexis Corporation.

REQUIRED; Evaluate each of the preceding and determine whether the cost is (a) a product cost
or a period cost, (b) variable or fixed in terms of behavior, and (c) for the product costs only,
whether the cost is properly classified as direct material, direct labor, or
manufacturing overhead. Item h is done as an example:

h. Tire costs: Product cost, variable, direct material

2. Athena Toy Company incurred the following costs during 2021. The company sold all of its
products manufactured during the year.

Direct Material P4,500,000

Direct Labor 3,300,000
Manufacturing overhead
Utilities (primarily electricity) 210,000
Depreciation of PPE 345,000
Insurance 240,000
Supervisory salaries 450,000
Property taxes 315,000
Selling costs:
Advertising 292,500
Sales commissions 135,000
Administrative costs
Salaries of top management & staff 558,000
 Office supplies 60,000
Depreciation on building & equipment 120,000

During 2021, the company operated at about half of its capacity, due to a slowdown in the
economy. Prospects for 2022 are slightly better. Jared Lowes, the marketing manager, forecasts
30 percent growth in sales over the 2021 levels.
REQUIRED: Categorize each of the costs listed above as to whether it is most likely variable or
fixed. Forecast the 2022 cost amount for each of the cost items listed above.

3. A Company, doing business in the city of Makati, reports the following total costs at two
levels of production:

Cost Item 2,000 units 5,000 units

Depreciation P5,000 P5,000
Materials 10,000 25,000
Labor 4,000 10,000
Factory Supplies 8,000 10,000
Factory suupervisors’ salaries 10,000 10,000
Insurance 3,000 3,000
Maintenance 5,000 19,000
Rent 20,000 20,000
Electricity 5,500 16,250

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

4. Pampanga Meat Company produces one of the best meat products in Pampanga. The
company’s controller used the account-classification method to compile the following
information.

a. Depreciation schedules revealed that monthly depreciation on buildings and equipment is

P21,000.
b. Inspection of several invoices from meat-packers indicated that meat costs the company
P1.20 per kilo of meat produced.
c. Wage records showed that competition for production employees costs P0.85 per kilo of
meat. produced.
d. Payroll records showed that supervisory salaries total P11,000 per month.
e. Utility bills revealed that the company incurs, utility costs of P5,000 Per month plus
P0.25 per kilo of meat produced

REQUIRED:
1. Classify each cost item as variable, fixed, or semi- -variable.
2. Write a cost formula to express the cost behavior of the firm’s production costs, (Use the form
Y= a + bX where Y denotes production cost and X denotes quantity of meat produced
 5. Bodywow Fitness, Inc. operates a chain of fitness centers in Metro Manila. The firm’s
controller is accumulating data to be used in preparing its annual profit plan for the coming
year. The cost behavior pattern of the firm’s equipment maintenance costs must be determined.
The accounting staff has suggested the use of an equation, in the form of Y = a + bx, for
maintenance costs. Data regarding the Maintenance pus and costs for Last year are as follows:

January 525 P4,710

February 505 4,310
March 310 2,990
April 495 4,200
May 315 3,000
June 485 4,215
July 315 2,950
August 405 3,680
September 475 4,100
October 345 3,250
November 350 3,260
December 50 400

REQUIRED:
1. Using the high-low method of cost estimation, estimate the behavior of the maintenance costs
incurred by Bodywow Fitness, Inc. Express the cost behavior pattern in equation form.
2. Compute the predicted maintenance cost at 600 hours of activity.

6. Konti’s Cakes is a small one-person company that provides elaborate and imaginative
wedding cakes to order for very large wedding receptions. The owner of the company would like
to understand the cost structure of the company and has compiled the following records of
activity and costs incurred. The owner believes that the number of weddings catered is the best
measure of activity.
Month Weddings Costs Incurred
January 3 P3,800
February 2 3,600
March 6 4,000
April 9 4,300
May 12 4,500
June 20 5,200

REQUIRED:
a. Using the high-low method, estimate the variable cost per wedding and the total fixed cost per
month. (Round off the variable cost per wedding to the nearest centavo and the total fixed cost to
the nearest peso.)
b. Using the least-squares regression method, estimate the variable cost per wedding and the total
fixed cost per month. (Round off the variable cost per wedding to the nearest centavo and the
total fixed cost to the nearest peso.)
7. The method of least squares was used to develop a cost equation to predict the cost of
maintenance. Monthly data for the past four years were used for the regression.

The following computer output was received:

Intercept P5,000
Slope 10
Coefficient of correlation 0.90

The driver used was “number of maintenance hours.”

REQUIRED:
1. What is the cost formula?
2. Using the cost formula, predict the cost e of maintenance if 650 maintenance hours are to be
worked next month.
3. What percentage of the variability in maintenance cost explained by number of maintenance
hours? Do you think the equation will predict well? Why or why not
4. Using the results from the regression equation, predict the cost of maintenance of next year if
7,500 maintenance hours are predicted.

8. Jayson Company is making plans for the introduction of a new product, which has a target
selling price of P7 per unit. The following estimates of manufacturing costs have been
Derived for 6 million units, to be produced during the first year:

Direct material: P6,000,000

Direct labor: P2,100,000 (at P14 per hour)

Overhead costs have not yet been estimated, but monthly data on total production and overhead
for the past 12 months have been analyzed by using least-squares regression. The major
overhead cost driver is direct labor hours, with the following results:

Computed values:
Fixed overhead cost: P3,200,000
Coefficient of independent variable: P2.25
REQUIRED:
a. Prepare the company's regression equation (Y = a + bx) to estimate overhead.
b. Calculate the predicted overhead cost at an activity level of 6,300,000 units.
c. What is North's dependent variable in this case?
d. How can the company evaluate the “quality” of its regression equation?

9. Charger Corporation has three costs: A, which is variable; B, which is fixed; and C, which is
semi-variable. The company uses the high-low method and extracted the following data
accounting records:
 At 180,000 hours of activity, Cost A totaled P2,610,000.
  At 140,000 hours, the low point during the period, Cost C totaled P1,498,000; at 200,000
hours, the high point, Cost C's fixed portion amounted to P1.75 per hour.
 At 160,000 hours of activity, the sum of Costs A, B, and C amounted to P8,162,000.

REQUIRED:
A. Compute the variable portion (total} of Cost C at 140,000 hours of activity.
B. Compute Cost C (total) at 160,000 hours of activity.
C. Compute Cost B (total) at 160,000 hours of activity.

10. Cleo Company wants to determine the factors that are associated with overhead. The
controller for Cleo 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 P20,000
Rates of variability:
Direct labor hours (H) P 10
Number of setups (S) P500
Number of purchase orders (P) P8
Number of observations (n) 50

REQUIRED:
1. Write out the cost formula for monthly overhead for Cleo Company.
2. If Cleo budgets the following for next month, what is the budgeted overhead cost?
 Direct labor hours 200
 Number of setups 30
 Number of purchase orders 150
3. Suppose that Cleo’s engineers expect the number of setups to decrease by 10 percent. How
much overhead cost would be saved for the following month?

11. The chief statistician of Valenzuela Company has developed the formula:

Y = P150,000+ 3L + 5M

Where: Y = total monthly manufacturing overhead cost

L = labor hours
M = machine hours

The measure of goodness of fit is good and no evidence of multicolinearity exists. The company
will use 15,000 labor hours and 4,000 machine hours next month.

REQUIRED:
1. Determine the total manufacturing overhead costs that Valenzuela should incur next month.
2. Valenzuela makes a product that has P12.00 in materials costs. It requires two hours of labor
time and 30 minutes of machine’ time. Laborers earn P15 per hour:
What is the product’s per unit variable manufacturing cost?
3. Suppose that Valenzuela could reduce the labor time for the product described in requirement
2 by 30 minutes, to 1.50 hours. Machine time will remain the same. By how much would the per
unit variable manufacturing cost fall?