Republic of the Philippines

NUEVA VIZCAYA STATE UNIVERSITY

Bayombong, Nueva Vizcaya
INSTRUCTIONAL MODULE
IM No.:IM-ACCTG2-2NDSEM-2018-2019

College: College of Business Education

Campus : Bayombong Campus

DEGREE BSBA COURSE NO. ACCTG 2

PROGRAM
SPECIALIZATION Financial COURSE TITLE Managerial Accounting
Management
YEAR LEVEL 3rd Year TIME FRAME WK NO. 2-4 IM 02
NO.

I. UNIT TITLE/CHAPTER TITLE: COST CONCEPT, CLASSIFICATION & BEHAVIOR

II. LESSON TITLE :

Lesson 1: Cost Definition, nature and Concept
Lesson 2: Classification of Costs
Lesson 3: Cost Behavior
Lesson 4: Types of Cost Behavior pattern
Lesson 5: Cost Estimation Methods

III. LESSON OVERVIEW

At the most basic level, a cost may be defined as the value foregone or sacrifice of
resources for the purpose of achieving some economic benefit which will promote the
profit-making ability of the firm. It is also an outlay or expenditure of money to acquire
goods and services that assist in performing operations.

In managerial accounting, the term cost may be used in different ways because there
are many types of costs that may be classified differently according to the immediate
needs of management. For instance, external financial reports require the use of
historical cost data whereas decision making may require current cost data.

Accounting costs are classified in numerous ways. To prepare financial statements,

accountants must associate costs with specific time periods. The classification of costs
into product and period costs allows accountant to do that. Costs are classified
differently depending on the type of organization involved, that is, merchandising,
services, or manufacturing.

IV. DESIRED LEARNING OUTCOMES:

After studying the lesson, the student is expected to:

1. Explain the Cost concept.

2. Identify and enumerate the different classification of cost.
3. Explain the meaning of Cost behavior.
4. State the importance of understanding of cost behavior.
5. Enumerate and explain the basic cost behavior patterns.
6. Compute the variable cost rate and the fixed cost using the different methods.
7. Compare the strengths and weaknesses of the various cost estimation methods.

V. LESSON CONTENT

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Lesson 1. Cost Definition, Nature and Concept

Cost in accounting refers to monetary value of expenditure for raw materials, labor, and other
factory overhead incurred in producing a product.

In a business, cost expresses the amount of money that is spent on the production or creation
of a good or service. Cost does not include a mark-up for profit.

From a seller’s point of view, cost is the amount of money spent to produce a product or good. If
sellers sold their goods at the same price as they cost to produce, then they would break even.
This means that they would not lose money on their sales, but their company would not make a
profit either.

Therefore, the cost of a product from the buyer’s point of view can be called the price. This is
the amount charged for a product by the seller, and it includes both the cost to make the product
and the mark-up cost added by the seller to produce a profit

Cost pools are cost collected into meaningful groups. Cost pools may be classified
(1) By type of cost (labor cost in one pool, materials costs in another)
(2) By source (department 1, department 2 and so on)
(3) By responsibility (manager 1, manager 2 and so on)
And many more.

A cost object is any product, service or organizational unit to which costs are assigned for
some management purpose. Products and services are generally cost objects, while
manufacturing departments are considered either cost pools or cost objects, depending on
whether management’s main focus is on the costs of the products or for the production
department. Any item to where costs can be traced and that has a key role in management
strategy can be considered a cost object.

Cost assignment is the process of assigning costs to cost pools or from the cost pools to cost
objects.

Cost allocation is the assignment of indirect costs to costs pools.

Allocation bases are cost drivers used to allocate costs.

A critical first step for achieving a competitive advantage is to identify the key cost drivers in a
firm or organization. A cost driver is any factor that has the effect of changing the level of total
cost. The management of the key cost drivers is essential for a firm that competes on the basis
of cost leadership. For example, to achieve its low-cost leadership in manufacturing electronic
products. Sony Manufacturing watches carefully the design and manufacturing factors that drive
the costs in its products. For firms that are not cost leaders, the management of cost drivers
may not be as critical but focusing attention to the key cost drivers contributes directly to the
success of the firm. For example, an important cost driver for retailers is loss and damage to
merchandise so most retailers have careful procedures for handling, displaying and storing
merchandise.

Lesson 2: Classifications of Costs

Cost classifications are necessary for the development of cost information to serve the needs of
management. Understanding those concepts and classifications enables the managerial
accountant to provide appropriate cost data to the managers who need it.

A. COST CLASSIFIED BY NATURE

Manufacturing Costs
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Manufacturing costs are all the costs associated with production of goods. They are frequently
classified as direct materials, direct labor, and factory overhead. Since costs attach to the
product or groups of products as they are manufactured, expenditures, regardless of their
nature, usually are capitalized as inventory assets and do not become “expired costs” or
“expenses” until the goods are sold.

1. Direct Materials
All raw material costs that become an integral part of the finished product and that can be
conveniently and economically assigned to specific units manufactured.
Materials cost includes the invoice price plus other costs paid to the vendor, shipping costs,
sales taxes, duty, cost of delivery containers and pallets (less net of return refunds), and royalty
payment based on direct materials quantities. Trade discounts and cash discounts (if they
exceed reasonable interest rates) should reduce materials costs.

Materials costs should also include scrap, waste, and normally anticipated defective units that
occur in the ordinary course of the production process. Unanticipated quantities of scrap,
shrinkage, waste, or defective units should be included in manufacturing overhead or expensed
in the period incurred. Also, routine quality assurance samples that are destroyed as part of
testing should be classified as materials. However, non-routine quality assurance samples are
taken due to manufacturing problems and cost of marketing samples should not be added to
materials costs.

2. Direct Labor
All labor costs related to time spent on products that can be conveniently and economically
assigned to specific units manufactured.

3. Manufacturing Overhead
Manufacturing overhead, the third element of manufacturing cost, includes all costs of
manufacturing except direct materials and direct labor. Indirect materials, indirect labor, property
taxes, insurance, supervisor’s salaries, depreciation of factory building and factory equipment,
and power are examples of factory overhead. Costs of operating service departments are also
part of overhead. Service departments are those that do not work directly on manufacturing
products but are necessary for the manufacturing process to occur. An example is equipment-
maintenance departments.
Indirect materials. Indirect materials include materials and supplies used in the
manufacturing operation that do not become part of the product, such as oil for the
machinery and cleaning fluids for the custodian.

Indirect labor. Labor costs that cannot be identified or traced to specific units
manufactured. Examples include supervision, inspection, maintenance, personnel
and material building.

Other Manufacturing Overhead

To summarize, manufacturing costs include direct materials, direct labor and
manufacturing overhead. Direct labor and overhead are often called conversion
costs since they are the costs of “converting or transforming” raw materials into
finished products. Direct materials and direct labor are often referred to as prime
costs.

Other manufacturing overhead costs include overtime premiums and the cost of idle
time. An overtime premium is the extra compensation paid to employee who works
beyond the time normally scheduled.

Nonmanufacturing Costs
Nonmanufacturing costs generally include costs related to selling and other activities not related
to the production of goods.

Marketing Costs
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Marketing or selling costs include all costs associated with marketing or selling a
product or all costs incurred by the marketing division from the time the
manufacturing process is completed until the product is delivered to the customer or
all costs necessary to secure customer orders and get the finished product or service
into the hands of the customer. These costs also called order-getting and order-filing
costs. Examples of marketing costs are advertising, shipping, sales commissions
and storage costs.
General and Administrative Costs
General administrative costs include all executive, organizational and clerical costs
associated with the general management of the organization rather than with
manufacturing, marketing or selling.

B. COSTS CLASSIFIED ACCORDING TO THE TIMING OF RECOGNITION AS EXPENSE

An expense is defined as the cost incurred when an asset is used up or sold for the purpose of
generating revenue. The term product cost and period cost are used to describe the timing with
which various expenses are recognized.

1. Product Costs
Product costs include all the costs that are involved in acquiring or making a product. Also
called inventoriable costs, they are costs that “attach” or cling to the units that are produced and
are reported as assets until the goods are sold. In the case of manufactured goods, these costs
consist of direct materials, direct labor, and manufacturing overhead. So initially, product costs
are assigned to an inventory account on the balance sheet. When the goods are sold, the costs
are released from the inventory as expenses (typically called cost of goods sold) and matched
against sales revenue. This means that a product cost such as direct materials or direct labor
might be incurred during one period but not treated as an expense until a following period when
the completed product is sold.

2. Period Costs
Period costs are all the costs that are identified with the accounting periods and not included in
the product costs. These costs are expensed on the income statement in the period in which
they are incurred. Period costs are not included as part of the cost of either purchased or
manufactured goods. Examples of period costs include selling and administrative expenses
such as sales commissions, office rent, and transportation expenses.

C. COST CLASSIFIED ON FINANCIAL STATEMENTS

The financial statements prepared by a manufacturing company are more complex than the
statements prepared by a merchandising company. Manufacturing companies are more
complex business firms than merchandising companies because the manufacturing company
must produce its goods as well as market them. The production process gives rise to many
costs that do not exist in merchandising company. The manufacturing company’s product costs
include not only the cost of purchasing but also the cost of converting materials into saleable
products. These product costs are counted as assets until the product is sold and the revenue
from the sales is recorded on the income statement.

1. The Balance Sheet

The balance sheet or statement of financial position of a manufacturing company is similar to
that of a merchandising company. However, the inventory accounts differ between the two types
of companies.

A merchandising company has only one class of inventory called merchandise inventory. These
are goods purchased from suppliers that are awaiting resale to customers.

In contrast, manufacturing companies have three classes of inventories, namely, raw materials,
work in process and finished goods.

Raw materials are materials that are used to make a product.

Work in progress consists of units of product that are only partially complete and will require
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further work before they are ready for sale to a customer.

Finished goods consist of units of product that have been completed but have not yet been
sold to customers.
The overall inventory figure is usually broken down into these three classes of inventory in
footnote to the financial statements

2. The Income Statement

At first glance, the income statement of merchandising and manufacturing firms are very similar.
The only apparent difference is in the captions of some of the entries in the computation of cost
of goods sold.
The cost of goods sold for a merchandising company is determined as follows:
Beginning merchandise inventory P XX
Add: Purchases XX
Total available for sale XXXX
Less: Ending merchandise inventory XX
Cost of goods sold P XXXX

The cost of goods sold for a manufacturing company is determined as follows:

Beginning finished goods inventory P XX

Add: Cost of goods manufactured XX
Total available for sale XXXX
Less: Ending finished goods inventory XX
Cost of goods sold P XXXX

The cost of goods manufactured contains the three elements of product costs namely, raw
materials, direct labor and manufacturing overhead.

D.COST CLASSIFICATION FOR PREDICTING COST BEHAVIOR

Cost behavior refers to how cost will react or respond to changes in the business activity. As
the activity level rises and falls, a particular cost may rise and fall as well – or it may remain
constant. For planning purposes, manager must be able to anticipate which of these will
happen: and if a cost is expected to change, the manager must know by how much it will
change. To help make such distinction, costs are often categorized as variable, fixed or semi-
variable.
1. Variable Costs
Costs that change directly in proportion to changes in activity (volume). Direct labor and direct
materials are examples of variable costs.

2. Fixed Costs
Costs that remain unchanged for a given time period regardless of change in activity (volume.)
rent, insurance on property, maintenance, and repairs of buildings, and depreciation of factory
equipment are examples of fixed costs.

3. Semi-Variable Costs
Costs that contain both fixed and variable elements. Examples are social security taxes,
materials handling, personnel services, heat, light and power. These cost elements must be
divided into their proper elements.

E. COST CLASSIFIED BY TYPES OF INVENTORY

1. Raw Materials Inventory

The cost of all raw materials and production supplies that have been purchased but not used at
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the end of the period.

2. Work-In-Process Inventory
The cost associated with goods partially completed at the end of the period.
3. Finished Goods Inventory
Cost of complete goods that have not been sold at the end of the period.

F.COST CLASSIFICATION ACCORDING TO TRACEABILITY TO COST OBJECTIVE

1. Direct Costs(traceable; separable)

Costs that can be economically traced to a single cost object (i.e. product,
department or unit)
2. Indirect Costs
Costs that are not directly traceable to the cost object (i.e. product, department, etc.)

G. COSTS CLASSIFICATION ACCORDING TO MANAGERIAL INFLUENCE

1. Controllable Cost. Cost that is subject to significant influence by a particular manager within
the time period under consideration.
2. NoncontrollableCost. Cost over which a given manager does not have a significant
influence.

H. COST TERMINOLOGIES USED FOR PLANNING AND CONTROL

1. Standard Costs. A predetermined cost estimate that should be attained; usually

expressed on terms of costs per unit.

2. Budgeted Cost. Used to represent the expected/planned cost for a given period. For
example, a company plans to manufacture 1,000 units of product X, which has a
standard cost per unit of P4, would have budgeted cost for the period of P 4,000 for
product X.

3. Absorption Costing. A costing method that includes all manufacturing costs – direct
materials, direct labor, and both variable and fixed manufacturing overhead – in the cost
of a unit of product. It is also referred to as the full cost method.

4. Direct Costing. A type of product costing where fixed costs are charged against
revenue as incurred and are not assigned to specific units of product manufactured. Also
referred to as variable costing.

5. Information Costs. Costs of obtaining information.

6. Ordering Costs. Costs that increase with the number of orders placed for inventory.
7. Out-Of-Pocket Costs. Costs that must be met with a current expenditure or cash outlay.

I. COST CLASSIFICATION ACCORDING TO A TIME-FRAME PERSPECTIVE

1. Committed Cost. Cost that is inevitable consequence of previous commitment.

2. Discretionary Cost (programmed; managed cost)

Cost for which the size or the time of incurrence is a matter of choice.

J. COST CLASSIFIED ACCORDING TO TIME PERIOD FOR WHICH THE COST IS

INCURRED

1. Historical Costs (past costs). Costs that were incurred in a past period.
2. Future Costs. Budgeted costs that are expected to be incurred in a future period.

K. COST CLASSIFICATION FOR DECISION-MAKING AND OTHER ANALYTICAL

PURPOSES
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1. Relevant Costs. Future costs and a cost that varies between two alternatives.
2. Incremental Costs. The difference in cost between two or more alternatives. In evaluating a
given alternative, incremental costs is the additional revenue to determine the feasibility of this
particular alternative. To be an incremental cost, the cost must be a future cost and different
under various alternatives.
3. Sunk Costs. Past costs that have been incurred and are irrelevant to a future decision.
4. Opportunity Costs. The value of the best alternative foregone as the result of selecting a
different use of resource or by choosing a particular strategy.
5. Marginal Costs. Costs associated with the next unit or the next project or incremental cost
associated with an additional project as opposed to the next discrete unit.
6. Value Added Costs. Costs that add value to the product. These costs result from activities
that are necessary to satisfy the requirements of the consumer. Effort should be made to
eliminate those costs that do not add value to the product, such as storage and materials
handling.

Illustrative Problem on Cost Classification

Bettina Lazaro is the production manager of a ready-to-wear manufacturing outfit. A decision
needs to be made about the type of clothing material or fabric to be used to make a shirt. The
fabric that has been used in the previous production cost P40 per yard but it is not available
currently. Similar material from another supplier will cost P50 per yard.

The cost of the fabric can be classified as follows:

1. Time period
P40 – historical cost
P50 – future cost
2. Management function
The cost of the fabric is a manufacturing cost.
3. Accounting treatment
Whatever is paid for the fabric will be capitalized as a product cost and carried in
inventory until it is sold.
4. Traceability to product
The fabric is a direct cost because it represents a significant portion of the cost of
the product and can be traced to a specific unit of finished product.
5. Cost behavior
Both the P40.00 and P50.00 cost per yard are variable costs. As the number of
yards purchased increase, the total fabric cost increases proportionately.
6. Decision significance
The P50.00 cost is relevant because it can be compared with the price of other
fabrics of similar quality to select the best alternative. The P40.00 cost is
irrelevant.
7. Managerial Influence
The cost of the fabric to be acquired is a controllable cost since Ms. Cabrera has
the authority to make production decisions.
8. Others
The fabric is an out-of-pocket cost associated until producing additional skirts
which will involve cash outlay in its acquisition.

Lesson 3: Cost Behavior

Cost behavior means how a cost will react as changes take place in the level of business
activity. Managers who understand how costs behave are better able to predict what costs will
be under various operating circumstances. An understanding of cost behavior under varying
conditions is essential to adequate decision making in the planning and control of firm activity.

Importance of Understanding Cost Behavior

Planning requires that management make decisions based in part on expectations as to the
future. These expectations should be based on data relevant to the decision objectives,
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gathered and analyzed in a competent, unbiased fashion. Failure in this activity could mean
displacement costs due to unexpected events. Control is the process of using feedback
information for comparison with expectations and the implementation of actions on the basis of
that comparison.
Cost analysis is an integral part of the planning and control function. The key to effective cost
prediction lies in an understanding of cost behavior patterns.

Lesson 4: Types of Cost Behavior Patterns

1. Variable costs

Variable costs are those costs that change in total as the level of activity changes in the short
run and within the relevant range. To the economist, the short run is the time period long
enough to allow management to change the level of production or other activity within the
constraints of current total productive or operating capacity. Furthermore, the estimates of
variable and other costs are applicable only if the contemplated level of activity is within the
relevant range.

Relevant range is the range of activity within which assumptions relative to variable cost and
fixed cost behavior are valid. Variable cost per unit is assumed to remain constant within this
range. For a cost to be variable, it must be variable with respect to its activity base. An activity
base is a measure of whatever causes the incurrence of variable cost. An activity base is
sometimes referred to as cost driver. Some of the most common activity drivers are units sold,
units produced, direct labor-hours and machine hours. Other activity bases (cost drivers) might
include the number of miles driven by salespersons, the number of pounds of laundry cleaned
by a hotel, the number of calls handled by technical support staff at a software company, and
the number of beds occupied in a hospital.

Examples of Variable Costs

In a manufacturing company Direct materials
Direct labor
Some manufacturing overhead such as
indirect materials, materials handling
costs, energy costs, supplies
Distribution costs
Sales commission
In a merchandising company Cost of sales
Sales commission
In a service organization Direct labor and materials used to perform
the services such as auto repair and
consulting, supplies, travel

2. Fixed Costs

Fixed costs are costs that remain constant in total regardless of changes in the level of activity
within the relevant range. Fixed costs however may change due to some outside force, such as
price changes. Fixed cost per unit will react inversely with change in activity. Fixed costs
decrease per unit as the activity level rises and increase per unit as the activity level fall.

Types of Fixed Costs

Fixed costs are sometimes referred to as capacity costs, since they result from outlays
made for buildings, equipment, skilled professional employees, and other items needed
to provide the basic capacity for sustained operations. For planning purposes, fixed
costs can be viewed as being either committed or discretionary.

Committed fixed costs relate to the investment in facilities, equipment, and the basic
organizational structure of a firm. Examples of such costs include depreciation of
buildings and equipment, taxes on real estate, insurance, and salaries of top
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management and operating personnel. The two key characteristics of committed fixed
costs are that (1) they are long term in nature, and (2) they can’t be significantly reduced
even for short periods of time without seriously impairing the profitability or long-run
goals of the organization. Even if the operations are interrupted or cut back, the
committed fixed costs will still continue largely unchanged.

Discretionary fixed costs (often referred to as managed fixed costs) usually arise from
annual decisions by management to spend in certain fixed cost areas. Examples of
discretionary fixed costs include advertising, research, public relations, management
development programs, and internships for students. The most important characteristic
of discretionary fixed costs is that management is not locked into a decision regarding
such costs. They can be adjusted from year to year or even perhaps during the course
of a year if circumstances demand such a modification.

Fixed Costs and the Relevant Range

The concept of relevant range is also important in understanding fixed costs - particularly
discretionary fixed costs. The levels of discretionary fixed costs are typically decided at the
beginning of the year and depend on the support needs of planned programs such as
advertising and training. The scope of these programs will depend, in turn, on the overall
anticipated level of activity for the year. At very high levels of activity, programs are usually
broadened or expanded.

For example, if the company hopes to increase sales by 25%, it would probably plan for so
much larger advertising than if no sales increase were planned. So the planned level of activity
might affect total discretionary fixed costs. However, once the total discretionary fixed costs
have been budgeted, they are unaffected by the actual level of activity. For example, once the
advertising budget has been decided on and has been spent, it will not be affected by how
many units are actually sold. Therefore, the cost is fixed with respect to the actual number of
units sold.

Examples of Costs that are Generally Fixed:

Rent, insurance, property taxes, supervisory salaries, straight-line depreciation, administrative

salaries and advertising.

3. Mixed Costs(Semi-variable costs)

A mixed cost is one that contains both variable and fixed costs elements. Mixed costs are also
known as semi-variable costs.
Common examples of mixed or semi-variable costs include: maintenance costs, electric utility
costs.
The relationship between mixed costs and the level of activity also is expressed in the following
equation:
Y = a + bX
Where:
Y = the total mixed cost (the dependent variable)
a = the total fixed cost (the vertical intercept of the line)
b = the variable cost per unit of activity (the slope of the line)
X = the level of activity (the independent variable)

The independent variable is called also the explanatory variable or cost driver. In cost
estimation, we identify some independent variable (the activity) and the functional relationship
that permit computation of the corresponding value of the dependent variable (the costs).

Lesson 5: COST ESTIMATION

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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.
The basic idea in cost estimation is to estimate the relation between costs and the variables
(factors) affecting the costs.

Lesson 5: Cost Estimated Method

1. 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 accountants who are familiar with company
operations and the way costs react to changes on activity level.

The account analysis involves the following steps:

1. Review each cost account used to record the costs that are of interest. Each cost is
identified as either fixed or variable depending on the relationship between the cost and
some activity.
2. Each major class of manufacturing overhead or other mixed cost is itemized. Each
cost is then divided into its estimated variable and fixed components. This is done on the
basis of the experience and judgment of accounting and other personnel.

An advantage of account analysis is that it involves a detailed examination of the data base by
accountants and managers who are familiar with it. Other methods may overlook this expert
judgment in uncovering cost behavior patterns. A disadvantage of this method is that it uses
subjective, judgmental approach so that different analysts may provide different estimates of
cost behavior.

2. Industrial Engineering Method

The industrial engineering method estimates cost functions by analyzing the relationship
between inputs and outputs in physical forms. Engineering estimates indicate what costs should
be. This method is so named because it was first used on estimating manufacturing costs from
industrial engineers’ specifications of the required input to the manufacturing process for a unit
of manufactured output. This method is not just confined to manufacturing. Time-and-motion
studies have also been used in banks, fast food companies, government units, hospitals, and
many other nonmanufacturing operations.

Steps in Applying the Engineering Method of Estimating Costs

1. A study of the physical relation between the quantities of inputs (materials, labor, etc.)
and each unit of output (finished product) is done. This involves the following activities.
a. A detailed step-by-step analysis of each phase to each manufacturing process
together with the kinds of work performed, and time to perform each step is done.
(This is something part of time-and-motion study). This serves as a basis for
estimating direct labor time.
b. Engineering estimated of the materials required for each unit of production are
obtained from drawings and specifications sheets.
2. Costs are then assigned to each of the physical inputs (wages, material price,
insurance charges, etc.) to estimate of the outputs.

One advantage to the engineering approach is that it can detail each step required to perform
an operation. It therefore enables the company to review its manufacturing productivity and
identify specific strengths and weaknesses. Another is that it can be used to estimate costs for
totally new activities because it does not require data from prior activities in the organization.
A disadvantage that can be attributes to this method is that it can be quite expensive to use
because each activity is using engineering norms and expert engineers which are costly.
Another consideration is that engineering estimates are often based on optimal condition. It is
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IM No.:IM-ACCTG2-2NDSEM-2018-2019

also difficult to estimate the indirect costs of production.

3. Conference Method
Under the conference method, cost functions are estimated based on the analysis and opinions
about costs and their drivers obtained from various departments of an organization such as
purchasing, process engineering, manufacturing, employee relations and so on. This
information is used to determine the selling price of the product, optimum product mix and
evaluate cost improvements over time.

The conference method allows quick development of cost functions and cost estimates. Its
credibility is gained through the pooling of expert knowledge from each value-chain area. The
accuracy of the cost estimates however, is dependent largely on the objectivity, care, and the
detail taken by the people providing the inputs or information.

4. The High-Low Method

The high-low method of analyzing mixed costs 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 and identify the highest
point of activity and lowest point of activity.
2. Estimate the variable cost per unit or rate using the following equation.

Variable cost rate or per unit =Cost at highest activity – Cost at lowest activity
Highest activity- Lowest activity

Illustrative Problem I. Predictors, Inc.

Given:Data for the past 10 months were collected for Predictors, Inc. to estimate the variable
and fixed manufacturing overhead.

The following data on Total labor Cost and direct labor hours from January to October are
available. (The table below means that for the month of January, total direct labor hours
was 2,000 with a corresponding P50,000 labor costs.)

X Y
MONTH Direct Labor Hrs Total Labor Cost
(in php)
January 2,000 50,000
February 4,000 110,000
March 6,000 150,000
April 2,000 70,000
May 3,000 80,000
June 4,000 100,000
July 5,000 150,000
August 1,000 60,000
September 3,000 110,000
October 5,000 120,000

REQUIRED:
Determine the variable cost rate per hour and the fixed cost portion using the high-low method.

Solution:Predictors, Inc.

1. Variable cost rate or per unit = Cost at highest activity – Cost at lowest activity
Highest activity- Lowest activity
P 150,000 - P60,000
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= 6,000 hrs - 1,000 hrs

VC = P18 per hour

2. Fixed Cost:
at 6,000-hour level (Highest Activity) at 1,000-hour level (Lowest Activity)
FC = P150,000 – (P18 x 6,000) FC = P60,000 – (P18 x 1,000)
= P150,000 – P108,000 OR = P60,000 – P18,000
= P42,000 = P42,000

5. Least-Squares Regression Method

A statistical technique which is often used in separating mixed costs into their fixed and variable
components is least-squares 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 deviations 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) ∑Y = Na + b∑X
Equation (2) ∑XY = ∑Xa + b∑X2
Where:
Y = total cost
a = fixed cost
b = variable rate cost
X = measure of activity (e.g., hours, units)
N = number of observations(e.g., how many months or years)
∑ = Greek letter signifying summation

Illustrative Problem 2.
Lea manufacturing company has the following data available. Determine the estimated variable
cost per hour and the fixed cost associated to the total labor cost.

Solution: (Least-squares regression method)

Step 1. Multiply X(labor hrs) by Y(Labor cost) to compute the XY.
Step 2. Compute X2 by multiplying 20hrs by itself, (20 x 20 =400), (40 x 40 = 1600) and so on..
Step 3. Compute the sum of each column to get the sum at the bottom level of each column.
∑X = 350; ∑Y = 1,000 ; ∑XY = 39,600; ∑X2 = 14500

Month X Y XY X2
Hours Labor Cost (X*Y)
January 20 50 1000 400
February 40 110 4400 1600
March 60 150 9000 3600
April 20 70 1400 400
May 30 80 2400 900
June 40 100 4000 1600
July 50 150 7500 2500
August 10 60 600 100
September 30 110 3300 900
October 50 120 6000 2500
10 months ∑X = 350 ∑Y = 1000 ∑XY = 39600 ∑X2 = 14500

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Step 4. Prepare the equation 1 and equation 2.

Equation (1) 1000 = 10a + 350b

Equation (2) 39,600 = 350a + 14,500b

Step 5. To eliminate one unknown ( a ), and solve for b, multiply Equation 1 by 35 (least
common denominator of 10 and 350 from Equation 1 and Equation 2) and subtract the new
Equation 3 from Equation 2;
Equation (3) = 35 (1000 = 10a + 350b)

Equation (2) 39,600 = 350a + 14,500b

Equation (3) 35,000 = 350a + 12,250b
4,600 = 2,250b

Variable Costs rate or b = P2.04

Step 6: To solve for “a” (Fixed Costs) substitute the value of “b” to Equation 1.
Thus,
Equation 1: 1000 = 10a + 350 (2.04 )
1000 – 714 = 10a (transpose the product of 350 and 2.04)

a = -286
-10

a = P28.60 (Fixed Cost)

Lesson 6: Strengths and Weaknesses of Cost Estimation Methods

Each of the methods discussed have advantages and disadvantages. When deciding which to
use in practice, the cost of each method must be compared with the benefits. The strengths and
weaknesses of these methods are summarized as follows:

Method Strengths Weaknesses

Account Analysis Provides a detailed Subjective
expert analysis of the
cost behavior in each
amount
Engineering Method Based on studies of what Not particularly useful when
future costs should be the physical relation
rather than what past between inputs and outputs.
costs have been.
High-Low Method Simple to apply. Uses only two data points
which may not produce
accurate results.
Least-Squares Uses all of the The regression model
Regression Method observations of cost data. requires that several
The line is statistically fit relatively strict assumptions
to the observations. be satisfied for the result to
As measure of the be valid
goodness of fit of the line
to the observations is
provided.
Relatively easy to use
with computers and
sophisticated calculators.

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VI. LEARNING ACTIVITIES

A. Classifying Costs. Julita Shirt Shop manufactures T-shirts and decorates them with custom
designs for retail sale on premises. Several costs incurred by the company are listed below.
For each cost, indicate which of the following classifications best describes the cost. More
than one classification may apply to the same cost item.

Cost classifications

a. Administrative
b. Selling
c. Research & Development
d. Direct Material
e. Direct Labor
f. Manufacturing Overhead

Cost Items
1. Cost of fabric used in T-shirts.
2. Wages of shirt makers.
3. Cost of new sign in front of retail T-shirt shop.
4. Wages of employee who repairs the firm’s sewing machines.
5. Cost of electricity used in the sewing department.
6. Wages of T-shirt designers and painters.
7. Wages of sales personnel.
8. Depreciation of sewing machines.
9. Rent on Building. Part of the buildings first floor is used to make and paint T-shirts. Part
of it is used for the retail sales shop. The second floor is used for administrative offices
and storage of raw material and finished goods.
10. Cost of daily advertisements in local media.
11. Wages of designers who experiment with new fabrics, paints and T-shirt designs.
12. Cost of hiring a pilot to fly along the beach pulling the banner advertising shop.
13. Salary of owner’s secretary.
14. Administrative manager’s salary.
15. Cost of insurance for the production employees.

B. Love Ship, Inc., assembles customs sailboats from components supplied by various
manufacturers. The company is very small and its assembly shop and retail sales store are
housed in ta boathouse. Below are listed some of the costs that are incurred at the
company.

Required: For each cost, indicate whether it would most likely be classified as direct labor, direct
materials, manufacturing overhead, selling or an administrative cost.

C. The wages of employees who build the sailboats.

D. The cost of advertising in the local newspaper.
E. The cost of an aluminum mast installed in a sailboat.
F. The wages of the assembly shop’s supervisor.
G. Rent on the boathouse.
H. The wages of the company’s bookkeeper.
I. Sales commission paid to the company’s salespeople.
J. Depreciation on power tools.

VII. ASSIGNMENT

Problem 1. Cost Estimation

Ilang-Ilang Parcel Service operates a fleet of delivery trucks in a large metropolitan area. A
careful study by the company’s cost analyst has determined that if a truck is driven 120,000
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miles during a year, the average operating cost is 11.6 cents per mile. If a truck is driven only
80,000 miles during a year, the average operating cost increases to 13.6 cents per mile.

Required:

1. Using the high-low point method, determine the variable and fixed cost elements of the
annual cost of truck operation.
2. Express the variable and fixed costs in the form Y=a+bX.
3. If a truck were driven 100,000 miles during a year, what total cost would you expect to
be incurred?

Problem 2. Cost Estimation: Least Squares Method

HR Rental Car offers rental cars in an off-airport location near a major tourist destination in
Baguio. Management would like to better understand the behavior of the company’s costs. One
of those cost is the cost of washing cars. The company operates its own car wash facility in
which each rentals car that is returned is thoroughly cleaned before being released for rental to
another customer. Management believes that the cost of operating the car wash should be
related to the number of rental returns. Accordingly, the following data have been compiled:

Month Rentals Returns Car Wash

Costs
January 2,310 P 10,113
February 2,453 P 12,691
March 2,641 P 10,905
April 2,874 P 12,949
May 3,540 P 15,334
June 4,861 P 21,455
July 5,432 P 21,270
August 5,268 P 19,930
September 4,628 P 21,860
October 3,720 P 18,383
November 2,106 P 9,830
December 2,495 P 11,081

Required:

Using least-squares regression, estimate the fixed cost and variable cost elements of monthly
car wash costs. The fixed cost element should be estimated to the nearest peso and the
variable cost element to the nearest centavo.

VIII. EVALUATION (Quiz/Exam will be given via Google Classroom)

IX. REFERENCES

1. Barfiled, J., Raiborn, C., Kinney, M. (2013). Cost Accounting: Traditions &
Innovations, 5Th Edition. Singapore: Thomson Learnings Asia

2. Cabrera, Ma. Elenita Balatbat. (2013). Management Accounting- Concepts and

Applications, 2013 Edition. Conanan Educational Supply

3. Harina, Ricardo M. (2012). Management Accounting for Informed Business

Decisions. Madaluyong City, Philippines: National Bookstore

4. Morse, D., Zimmerman, J., (1997). Managerial Accounting, 1st Edition. USA:
McGraw-Hill/Irwin

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reproduced for educational purposes only and not for commercial distribution,”
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NUEVA VIZCAYA STATE UNIVERSITY
Bayombong, Nueva Vizcaya
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IM No.:IM-ACCTG2-2NDSEM-2018-2019

5. Weygandt, J., Kieso, D., Kimmel, P., (2005). Managerial Accounting: Tools for
Business Decision Making, 3rd Edition. USA: Susan Elbe

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