XCOSTMAN: PRELIMS

MODULE 1: BASIC COST MANAGEMENT CONCEPTS are all costs associated with production of goods.

COST MANUFACTURING COST:

• the value forgone or sacrifice of resources for
✓ Direct Materials
the purpose of achieving some economic
benefit which will promote the profit-making are all raw materials that become an integral part of the
ability of the firm. finished product and that can be conveniently and
• A cost is used when a resource is used for some economically assigned to specific units manufactured.
purpose. It is also an outlay or expenditure of
✓ Direct Labor
money to acquire goods and services that assist
in performing operations. are all labor costs related to time spent on products that
can be conveniently and economically assigned to
specific units manufactured.
COST POOLS
✓ Manufacturing Overhead
costs collected into meaningful groups. Cost pools may
be classified: is the third element of manufacturing cost, includes all
costs of manufacturing except direct materials and
1. by type of cost
direct labor.
2. by source
3. by responsibility ✓ Indirect Materials
COST OBJECT include materials and supplies used in the
manufacturing operation that do not become part of
any product, service or organizational unit to which cost
the product.
are assigned for some management purpose. Products
and services are generally cost objectives. Any item to ✓ Indirect Labor
which cost can be traced and that has a key role in
management strategy can be considered as cost object. also cannot be identified or traced to specific units
manufactured.
COST DRIVER
✓ Non-Manufacturing Costs
any factor that has the effect of changing the level of
total cost. The management of key cost drivers is include costs related to selling and other activities not
essential for a firm that competes on the basis of cost related to the production of goods.
leadership. NON-MANUFACTURING COSTS:
COST ASSIGNMENT ✓ Marketing Costs
• Cost assignment are all costs associated with the marketing or selling of a
is the process of assigning cost to cost pools or from product or all costs incurred by the marketing division
cost pools to cost objectives from the time the manufacturing process is completed
until the product is delivered to the customer or all
• Cost allocation costs necessary to secure customer orders and get the
finished product or service into the hands of the
is the assignment of indirect cost to cost pools.
customer.
• Allocation bases
✓ General and Administrative Costs
are cost drivers used to allocate cost.
include all executive, organizational and clerical costs
COST CLASSIFICATION: associated with the general management of the
organization rather than with the manufacturing,
• NATURE OR MANAGEMENT FUNCTIONS marketing or selling.
✓ Manufacturing Costs
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• TIMING OF RECOGNITION AS EXPENSE the cost of completed goods that have not been sold at
✓ Product Costs the end of the period.

include all costs that are involved in acquiring or making • TRACEABILITY TO COST OBJECTIVE
a product. ✓ Direct Costs (traceable; separable)

✓ Period Costs are costs that can be economically traced to a single

cost object.
are costs that are identified with accounting periods and
not included in product costs. ✓ Indirect Costs

• FINANCIAL STATEMENTS are costs that are not directly traceable to the cost
✓ Statement of Financial Position object.

Presented as part of Inventories (further divided • MANAGERIAL INFLUENCE

depending on whether a manufacturing or ✓ Controllable Costs
merchandising business)
costs that are subject to significant influence by a
✓ Statement of Income particular manager within the time period under
consideration.
Presented as part of the Cost of Goods Sold or
Operating Expenses ✓ Non-controllable Costs

• PREDICTING COST BEHAVIOR costs over which a given manager does not have a
✓ Cost Behavior significant influence.

refers to how a cost will react or respond to changes in • USED FOR PLANNING AND CONTROL
the business activity ✓ Standard Cost

✓ Variable Costs is a predetermined cost estimate that should be

attained; usually expressed in terms of cost per unit.
costs that change directly in proportion to changes in
activity (volume). ✓ Budgeted Cost

✓ Fixed Costs is used to represent the expected/planned cost for a

given period.
costs that remain unchanged for a given time period
regardless of change in activity (volume). ✓ Absorption Costing

✓ Semi-variable Costs is a method that includes all manufacturing costs in the

cost of a unit of product.
costs that contain both fixed and variable elements.
✓ Direct Costing
• TYPES OF INVENTORY
✓ Raw Materials Inventory is a type of product costing where fixed costs are
charged against revenue as incurred and are not
the cost of all raw material and production supplies that
assigned to specific units of a product manufactured.
have been purchased but not used at the end of the
period. ✓ Information Costs

✓ Work-in-process Inventory are costs of obtaining information.

the cost associated with goods partially completed at ✓ Ordering Costs

the end of the period.
are costs that increase with the number of orders
✓ Finished Goods Inventory placed for inventory.

✓ Out-of-pocket Costs
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 XCOSTMAN: PRELIMS
are costs that must be met with a current expenditure Cost Behavior
or cash outlay.
Cost behavior means how a cost will react as changes
• TIME-FRAME PERSPECTIVE takes place in the level of business activity. Managers
✓ Committed Costs who understand how costs behave are better able to
predict what costs will be under various operating
are costs that are inevitable consequence of incurrence
circumstances. An understanding of cost behavior
of a previous commitment.
under varying conditions is essential to adequate
✓ Discretionary Costs (Programmed; decision making in the planning and control of firm
Managed Costs) activity.

are costs for which the size or the time of incurrence is a Importance of Understanding Cost Behavior
matter of choice.
Planning requires that management make decisions
• TIME PERIOD based in part on expectations as to the future.
✓ Historical Costs (Past Costs) Control is the process of using feedback information for
are costs that were incurred in a past period. comparison with expectation and the implementation of
actions on the basis of that comparison.
✓ Future Costs
Cost analysis is an integral part of the planning and
are budgeted costs that are expected to be incurred in a control function. The key to effective cost production
future period. lies in an understanding of cost behavior patterns.
• ANALYTICAL PURPOSES Types of Cost Behavior Patterns
✓ Relevant Costs
• Variable Costs
are future costs that are different under one decision • Fixed Costs
alternative than under another decision alternative. ✓ Committed fixed costs
✓ Incremental Cost ✓ Discretionary fixed costs
• Mixed Costs
is the difference between two or more alternatives.
Variable Cost -Change in total as the level of activity
✓ Sunk Costs changes in the short run and within the RELEVANT
are past costs that have been incurred and are irrelevant RANGE
to a future decision. Relevant Range -Range activity within which
✓ Opportunity Cost assumptions relative to variable and fixed cost
behaviour are valid.
is the value of the best alternative forgone as the result
of selecting a different use of resource or by choosing a • *Variable cost PER UNIT is constant in the
particular strategy. relevant range

✓ Marginal Cost • *TOTAL Variable cost changes with respect to

the ACTIVITIY BASE
is the costs associated with the next unit or the next
project or incremental cost associated with an Activity base- Measure of whatever causes the
additional project as opposed to the discrete unit. incurrence of variable cost

✓ Value Added Costs FIXED COSTS - Costs that remain constant in total
regardless of the changes in the level of activity within
are costs that add value to the product. the relevant range
MODULE 7: COST ESTIMATION
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 XCOSTMAN: PRELIMS
*Fixed cost PER UNIT decreases as the level of activity
increases.
Committed fixed costs - Long-term in nature and cannot
be significantly reduced even for short periods of time
without impairing the profitability or long- run goals of
the organization.
Discretionary fixed costs- Usually arise from annual
decisions by management. Management is not locked
into a decision regarding such costs.
MIXED COSTS/SEMIVARIABLE COSTS -Contains both
variable and fixed cost elements.
Relationship between mixed cost and level of activity:
Y = a + bX
FIXED PORTION -Basic, minimum cost of just having a
service ready and available for use.
VARIABLE PORTION- Cost incurred for the actual
consumption of the service.
The Analysis of Mixed Costs
The fixed portion of mixed cost represents the basic,
minimum cost of just having a service ready and
available for use while the variable portion represents
the cost incurred for the actual consumption of the
service. The variable element varies in proportion to
the amount of service that is consumed.
METHODS FOR COST ESTIMATION
1. Account analysis method
2. Industrial Engineering method or Work
measurement method
3. Conference method
4. Quantitative analysis of current and past costs
relationships
– High-low method
– Regression analysis method
5. Scattergraph or Visual fit method
6. The least-squares regression method
Account Analysis Method
Account analysis is considered a very useful and easier
way to estimate costs. It makes use of the experience
and judgment of managers and accounts who are
familiar with company operations and the way costs
react to changes in activity level.
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Steps:
Review each cost account and identify as either variable
or fixed in relationship to some activity.
Each major class is itemized and each cost is divided into
variable and fixed component.
*Advantage: involves detailed examination
*Disadvantage: uses subjective, judgmental approach.
Industrial Engineering Method
The industrial engineering method estimates cost
functions by analyzing the relationship between inputs
and outputs in physical forms.
STEPS:
Study of physical relation between the quantities of
inputs and each unit of
output
Costs are assigned to each of the physical inputs to
estimate the cost of the outputs.
*Advantage: it can detail each step required to perform
an operation.
*Disadvantage: quite expensive to use.
Conference Method
Cost functions are estimated based on the analysis and
opinions about costs and drivers obtained from various
departments of an organization such as purchasing,
process engineering, manufacturing, employee relation
and so on. This information is used to determine the
selling price of the product, optimum product mix, and
evaluate cost improvements overtime.
The High-Low Method
It is based on costs observed at both the high and low
levels of activity within the relevant range.
Steps in Applying the High-Low Cost Estimation
1. Obtain relevant data on past costs and related
actual activity levels.
2. Estimate the variable cost per unit or rate using
the following equation:
 XCOSTMAN: PRELIMS
Variable cost rate or per unit = Cost at highest activity –
Cost at lowest activity /Highest activity – Lowest
activity
3. Compute the fixed cost as follows:
Fixed Cost = Total Cost at highest activity – [Variable
cost per unit x Highest activity stated in units]
Or
Fixed Cost = Total Cost at lowest activity – [Variable
cost per unit x Lowest activity stated in units]
Regression Analysis Method
It uses all available data to estimate the cost function. It
is a statistical method that measures the average
amount of change in the dependent variable (costs) that
is associated with a unit change of one or more
independent variables. Sample regression analysis
estimates the relationship between the dependent
variable and multiple independent variables. Multiple
regressions are used when the dependent variable is
caused by more than one factor. Although adding more
factors or variables make the computation more
complex, the principles involved are the same as in the
simple regression analysis.
Simple regression analysis- Estimates the relationship
between the dependent and one independent variable.
Multiple regression analysis – Estimates the
relationship between the dependent variable and
multiple independent variables.
Simple Regression analysis uses the following
estimated cost function or equation:
Y=a+bX
While multiple regression analysis uses the following
equations:
Y = a + b1 X 1 + b2 X 2……… + o
Where:
Y = costs to be predicted
X1 X 2 X3….. = independent variable on which the
prediction is to be based
a = fixed cost
b1b2b3…. = estimated coefficient of the regression
model
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o = residual term that includes the net effect of other
factors not in the model and measurement errors in the
dependent and independent variables.
Least-squares Regression Method
A statistical technique which is often used in separating
mixed costs into their fixed and variable components is
least-square regression. Basically, a line of regression is
determined by solving two simultaneous linear
equations which are based on the condition that the
sum of deviations above the line equals the sum of
deviation below the line.
The equation for the determination of straight line is:
Y = a + bX
The two linear equations that are used to solve for a
and b are:
Equation (1) EY = Na + bEx2
Equation (2) EXY = EXa + bEX2
Where:
Y = Total cost
a = Fixed cost
b = Variable cost rate X = measure of activity
N = number of observations
E = Greek letter signifying summation
Scatter graph or Visual Fit
This is a rough guide for cost estimation which plot the
cost against past activity levels. These activities are
referred to as predictors or independent variables (X),
or the right-hand-side of a regression equation. The cost
to be estimated may be called the dependent variables
(Y), or the left-hand-side of the regression equation.
The line is drawn, insofar as it is possible by visual
judgment, so that the distances of the observation
above the line are equal to the distances of the
observations below the line. This line called the line of
regression represents the data as a line of conditional
expected values.
Correlation Analysis
In the process of estimating and controlling costs,
management must evaluate whether o not the factor
selected for estimating cost behavior in suitable for that
purpose. Costs may or not react with changes in the
factor selected for cost analysis.
 XCOSTMAN: PRELIMS
r2 = 1 – (Estimated conditional standard deviation
measured from line of regression)2 / (Standard
deviation measured from the average of all data)2
The Learning Curve Theory
One assumption in estimating cost behavior is that the
cost of each input is a linear function of the quantity
assigned. However, the relationship between costs and
independent variables is not always linear.
Some of the Uses of Curves are as follows:
1. Preparing cost estimates for bidding purposes
2. Setting standards and budget allowances
3. Scheduling labor requirements
4. Evaluating performance by comparing progress
reports with the a accomplishments anticipated
under the learning curve
5. Setting incentive wage rates with due
consideration for the fact that labor times will
normally be reduced as the workman becomes
more experienced
Learning rate formula:
Average input quantity (cost) for the first 2 x units
Average input quantity (cost) for the first x units
MODULE 2: VARIABLE COSTING
Variable costing (Direct Costing)
is a method of recording and reporting costs which
regards only the variable manufacturing costs as the
variable manufacturing costs as product costs. Fixed
manufacturing costs are written off as period costs.
Absorption Costing
Absorption costing (also known as full, traditional,
conventional, and normal costing) is a method of
product costing in which all manufacturing costs, fixed
and variable, are treated as product or inventoriable
costs. This method is generally accepted for external
reporting purposes.
Comparison between Variable Costing and Absorption
Costing
As to treatment of the various operating costs
VARIABLE COSTING
• Product Costs
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Direct materials
Direct labor
Variable manufacturing overhead
• Period Costs
Fixed manufacturing overhead
Variable selling and administrative expenses
Fixed selling and administrative expenses
As to treatment of the various operating costs
ABSORPTION COSTING
• Product Costs
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead
• Period Costs
Variable selling and administrative expenses
Fixed selling and administrative expenses
As to net operating income
Net income is not affected by changes in production
under variable costing. Net income, however is affected
by the changes in production when absorption costing
is in use. Net income goes up under the absorption
approach in response to the increase in production for
a particular year and goes down when production goes
down. The reason for this effect can be traced to the
shifting of fixed manufacturing cost between periods
under the absorption costing method as explained
below.
As to amount of inventory
Inventory value under absorption costing would be
higher in amount than that under variable costing. The
inventory amount would carry a portion of fixed
overhead incurred during the period under absorption
costing.
Reconciliation of Net Income under Variable Costing
with Net Income under Absorption Costing
The reconciliation of the net income figures under the
two product costing methods may be done as follows:
Net income, Absorption costing
Add: Fixed overhead in ending inventory
Total
 XCOSTMAN: PRELIMS
Less: Fixed overhead in ending inventory DIFFERENCE IN NET INCOME UNDER ABSORPTION
Net income, Variable costing
AND VARIABLE COSTING
PRODUCT COST COMPONENTS
Variable and absorption costing methods of
ABSORPTION COSTING VARIABLE COSTING accounting for fixed manufacturing overhead result
in different levels of net income in most cases. The
Direct Materials Direct Materials differences are timing difference, i.e., when to
recognize the fixed manufacturing overhead as an
+ Direct Labor + Direct Labor
expense. In variable costing, it is expensed during
+ Variable FOH + Variable FOH the period when the fixed overhead is incurred,
while in absorption costing, it is expensed in the
+ Fixed FOH Product Product Cost
period when the units to which such fixed overhead
Cost
has been related are sold.
DISTINCTIONS BETWEEN PERIOD COSTS AND PRODUCT PRODUCTION EQUALS SALES:
COSTS
When production is equal to sales, there is no
• PERIOD COSTS change in inventory. Fixed overhead expensed
1. Cost that is charged against current revenue under absorption costing equals fixed overhead
during a time period regardless of the expensed under variable costing. Therefore,
difference between production and sales absorption costing income equals variable costing
volume. income.
2. Does not form part of the cost of inventory.
3. Reduces income for the current period by its PRODUCTION IS GREATER THAN SALES:
full amount.
When production is greater than sales, there is an
• PRODUCT COSTS
increase in inventory. Fixed overhead expensed
1. Cost that is included in the computation of a
under absorption costing is less than fixed
product cost that is apportioned between the
overhead expensed under variable costing.
sold and unsold units.
Therefore, absorption income is less than variable
2. An inventoriable cost. The portion of the cost
costing income.
that has been allocated to the unsold unite
becomes part of the cost of inventory. ACCOUNTING FOR DIFFERENCE INCOME
3. Reduces current income by the portion allowed
Change in inventory (Production less Sales)
to the sold units.
x Fixed FOH cost per unit
PRINCIPAL DIFFERENCES BETWEEN ABSORPTION AND Difference in income
VARIABLE COSTING METHODS

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