MODULE ON AE 212

COST ACCOUNTING and CONTROL

TABLE OF CONTENTS

Lesson 1 – COST ACCOUNTING FUNDAMENTALS 6

Learning Objectives
Introduction
Cost Accounting: Information for Decision Making
Accounting and the Value Chain
Accounting Systems
Comparison of Financial Accounting and
Management Accounting
Relationship of Cost Accounting to other Fields of Study
Scope of Modern Cost Accounting
Cost Management Framework
Organizational Environment
Ethical Issues and Guidelines
Review Questions and Exercises

Lesson 2 – COST TERMS, CONCEPTS AND CLASSIFICATIONS 15

Learning Objectives
Introduction

Nature of Cost, Cost Pools, Cost Objects and Cost Drivers

Classifications of Costs
Review Questions, Exercises and Problems

Lesson 3 – COST BEHAVIOR: ANALYSIS AND USE 30

Learning Objectives
Definition of Cost Behavior
Importance of Understanding Cost Behavior
Types of Cost Behavior Patterns
Cost Estimation
Strengths and Weakness of Cost Estimation Methods
The Learning Curve Theory
Review Questions, Exercises and Problems

Lesson 4 – COST-VOLUME-PROFIT RELATIONSHIPS 43

Learning Objectives
The Basics of Cost-Volume-Profit (CVP) Analysis
Significance of Cost-Volume-Profit Analysis
CVP Analysis for Break-even Planning
CVP Analysis for Revenue and Cost Planning
Assumptions and Limitations of CVP Analysis
Sensitivity Analysis of CVP Results
Review Questions, Exercises and Problems
 p.2
Lesson 5 – ACCOUNTING FOR COST FLOWS
Learning Objectives
Introduction
Application of Cost Accounting to the Various Business
Sectors of the Economy
Production, Marketing and Administrative Costs
Inventory Accounts
Flow of Costs in a Merchandising Company
Flow of Costs in a Manufacturing Company
Cost Accounting Model for a Manufacturing Company
Flow of Costs in a Service Organization
Review Questions, Exercises and Problems

Lesson 6 – SYSTEMS DESIGN: JOB-ORDER COSTING

Learning Objectives
Introduction
Systems Choice: Job-Order Versus Process Costing
Cost Measurement: Actual, Normal or Standard Costing
Comparison of Job-Order Costing against Process Costing
Overhead Assignment Under Normal Costing: Volume-
Based or Activity Based
Job-Order Costing System
Summary of Accounting Procedures using Job-Order
Costing in a Manufacturing Company
Application of Job-Order Cost Accounting Procedures
Review Questions, Exercises and Problems

Lesson 7 – SYSTEMS DESIGN: PROCESS COSTING SYSTEM;

COST ALLOCATION
Learning Objectives
Concept and Application
A Cost-Benefit Comparison of Job-Order Costing and
Process Costing
Steps in Process Costing
Process Costing Methods
Illustration of Process Costing
Cost Allocation
Accounting for Joint Product Costs and By-Products
Methods of Allocating Joint Costs to Joint Products
Accounting for By-Products
Review Questions, Exercises and Problems

Lesson 8 – OPERATION COSTING, JUST-IN-TIME SYSTEM AND

BACKFLUSH COSTING
Learning Objectives
Hybrid Costing System
Operation Costing
Just-In-Time System and Backflush Costing
Financial Benefits of JIT
 Major Features of JIT Production System`
Review Questions, Exercises and Problems p.3

Lesson 9 – ACTIVITY-BASED COSTING AND MANAGEMENT

Learning Objectives
Activity-Based Costing
Advantages and Limitations of ABC System
Design of an Activity-Based Costing
Steps in Designing an ABC System
Application of Activity-Based Costing
Activity-Based Management
Opportunity Costing Concepts
Review Questions, Exercises and Problems

Lesson 10 – STANDARD COSTS AND OPERATING PERFORMANCE

MEASURES
Learning Objectives
Rationale of Standard Costs
Uses of Standard Costs
Benefits of Standard Costs
Limitations of Standard Costs
How Standards are Set
Setting Direct Material Standards
Setting Labor Standards
Setting Overhead Standards
Standard Cost Flows
Treatment of Variances
Operating Performance Evaluation
Factory Overhead Variance Analysis
Review Questions, Exercises and Problems
 p.4

INTRODUCTION

The main and primary objective of accounting is to provide financial information about an
economic entity to different types of users. First we have internal users- managers for planning,
controlling and decision making. Then we have external users – the government, those who
provide funds and those who have various interests in the operations of the entity.

Cost Accounting is an expanded phase of general or financial accounting which informs

management promptly with the cost of rendering a particular service, buying and selling a
product, and producing a product. It is the field of accounting that measures, records, and
reports information about costs.

All types of business entities – manufacturing, merchandising, and service businesses – require
information systems which provide the necessary financial data. Because of the nature of the
manufacturing process, the information systems of manufacturing entities must be designed to
accumulate detailed cost data relating to the production process. Thus, it is common today for
small, medium, and large manufacturing companies to have structured costs accounting
systems. These systems should show what costs were incurred and where and how these costs
were utilized. Cost accounting today is recognized as being essential to efficient cooperation of
business and industry.

In order to appreciate the importance of an efficient cost system, it is necessary to understand

the nature of the manufacturing process. In many ways, the activities of a manufacturing
organization are similar to those of a merchandising business. Both are concerned with
purchasing, storing, and selling goods; both must have efficient management and adequate
sources of capital; both may employ hundreds or thousands of workers. In the manufacturing
process itself, we see the distinction between the two: merchandisers, such as SM buy items in
marketable form to be resold to their customers; manufacturers, such as PHILACOR, must
make the goods they sell. Once the merchandising organization has acquired and stored goods,
it is ready to carry out the marketing function. The purchase of materials by a manufacturer,
however, is only the beginning of a long, and sometimes complex, chain of events that will
eventually produce a finished article ready for sale.

The manufacturing process involves the conversion of raw materials into finished goods through
the application of labor and the incurrence of various factory expenses. The manufacturer must
make a major investment in physical facilities, such as factory buildings and warehouses, and
acquire many specialized types of machinery and equipment. In order to carry out the
manufacturing process, the manufacturer must purchase appropriate quantities of raw
materials, supplies and parts, and build up a work force to convert these resources into finished
goods. Once the goods are completed and are ready for sale, the manufacturer performs
basically the same functions as the merchandiser in storing and marketing the goods. The
methods of accounting for sales, cost of goods sold, and selling and administrative expenses
are also similar to those of the merchandising organization.

Although cost accounting developed originally in manufacturing business to satisfy

management’s need for product cost information, cost accounting information is useful for all
types of activities in all types of organizations. Cost accounting is essential not only for profit-
seeking entities but also for not-for-profit organizations such as governmental agencies,
churches, and charities.
p.5

LESSON 1

COST ACCOUNTING FUNDAMENTALS

INTRODUCTION

Modern cost accounting is more than a list of numbers to be totaled, sorted and stored. It is a
major player in management decision making. From providing information for planning new
products to evaluating the success of the latest marketing campaign, cost accounting plays a
major role.

The study of modern cost accounting yields insights into what managers and accountants do in
an organization. Managers use cost accounting information to choose strategy, to communicate
it, and determine how best to implement it. They also use this information to coordinate their
decisions about designing, producing and marketing a product or service.

This book describes the process and the challenges faced and how cost accounting can provide
the financial and nonfinancial information that help managers decide how to best deal with those
challenges.

COST ACCOUNTING: INFORMATION FOR DECISION MAKING

Creation of Value in Organization

Our discussion shall start with concepts of value creation and the value chain because in cost
accounting, our goal is to assist managers in achieving the maximum value for their
organization. One of the fundamental services of cost accounting is measuring the effects of
decisions on the value of the organization. As providers of information (accountants) or as the
users of information (managers), we have to understand how the information can and will be
used to increase value. Designing accounting systems that accomplish this goal, therefore
becomes an important task of cost accounting.

The Value Chain

The value chain is the se of activities that transform raw resources into the goods and services
that end users purchase and consume and the treatment or disposal of any waste generated by
them. For example, the value chain for gasoline starts from the search and drilling for oil,
through refining the oil into gasoline, to the distribution of gasoline to retail outlets or stations
and finally, to the treatment of emissions produced by cars.

Much of our decision about cost accounting shall deal on the part of the value chain that
comprises the facilities of a single organization or firm. However, an important objective of
modern cost accounting is to ensure that the entire value chain is as efficient as
possible. It is necessary for the firm to coordinate with vendors and suppliers and with
distributors and customers to achieve this objective. The cost accounting system provides much
of the information necessary for this coordination.

p.6
Value-Added Activities

The value-added activities that the firms in the chain perform are those activities that customers
perceive as adding utility to the goods or services they purchase. The value chain comprises
activities from research and development through the production process to customer service.
Managers evaluate these activities to determine how they contribute to the final products and
services, quality and cost.

Business Functions in the Value Chain

The six business functions in which management/cost accountants provide information to help
managers make decisions are:
1. Research and development – involves generating and experimenting with
ideas related to new products, services or processes.

2. Design of products, services or processes – concerned with detailed planning and

engineering of products, services or processes. Cost accounting are becoming more
involved in designing CIM systems data bases corresponding to cost accounting
needs. The ideal is for cost accountants, engineers and systems designers to develop
a flexible production process responding to changing market needs.

3. Production – involves acquiring, coordinating and assembling resources to produce a

product or deliver a service. Cost accountants work closely with production personnel
to measure and report manufacturing costs. the efficiency of the production
department
in scheduling and transforming material into finished units is evaluated for
improvements.

4. Marketing – deals with promoting and selling products or services to customers or

prospective customers.

5. Distribution – delivering products or services to customers.

6. Customer service – involves providing after sale support to customers.

ACCOUNTING AND THE VALUE CHAIN

Cost accounting continues to experience dramatic changes. Developments in information

technology (IT) have nearly eliminated manual bookkeeping. Emphasis on cost control is
increasing in banks, hospitals, manufacturing industries (from computers to automobiles),
airlines, school districts and many other organizations that have traditionally not focused on it.
Cost accounting has become a necessity in virtually every organization, including fast-food
outlets, professional organizations and government agencies.
One reason for this rapid change is that managers at each stage of the value chain require
information on the performance of products, services, suppliers, customers and employees.

Managers of the activities and cost accountants must work together at each stage to make
decisions that increase firm value. Because these processes themselves have undergone great
change in recent years, cost accountants and cost accounting methods must continuously adapt
to changes in business areas.

Cost Accounting in Research and Development

Lean manufacturing techniques are not simply about production. Companies partner with
suppliers in the development stage to ensure cost-effective designs for products. Product
engineers need cost accounting information to make decisions about alternative materials.

Cost Accounting in Design

An important activity in product development is design. Product designers must write detailed
specifications on a product’s design and manufacture. This is often referred to as design for
manufacturability (DFM). The design of a product can have a significant impact on the cost to
manufacture it. Designs that are complex might add additional functions, which, while making a
product more desirable, may also require complex and expensive manufacturing processes.
Cost accountants help designers understand the trade-off by using methods such as activity-
based costing, which considers the activities or processes that will be required to bring a
product to market.

Cost Accounting in Purchasing

Companies now partner with suppliers to increase the efficiency in the supply chain. Partnering
requires information on the performance of partners to ensure the relationship adds value.
Performance measures are being used to evaluate the performance of key suppliers and
business partners.

the use of cost accounting methods such as target costing, activity-based costing, performance
measures and incentive systems that support teamwork helps firms manage their partnerships
to keep the supply chain “lean” and add value throughout the chain.

Cost Accounting in Production

Operations managers and financial accountants use cost information in the production stage to
understand and report the costs of the multiple products produced. One of the most important
developments in production, associated with lean manufacturing, is the use of just-in-time (JIT)
methods. Using just-in-time methods, companies produce or purchase units just in time for use,
keeping inventories at a minimum. If inventories are low, accountants can spend less time on
inventory valuation for external reporting and more time on managerial activities.

Modern cost accounting systems have helped managers better understand the relative costs so
that appropriate inventory policies can be set and targeted improvements sought.
The production process is not limited to manufacturing. Service firms, such as banks, insurance
companies, and theme parks, produce or provide services demanded by customers. Efficient
use of capacity (employees) in providing services is critical in increasing value. Managers look
to cost accounting information to help them understand and plan capacity.
p.7
Cost Accounting in Marketing

Marketing managers require cost accounting information to understand the profitability of

different customer groups. Advances in accounting information systems that capture data at
various levels of detail have made possible customer relationship management (CRM), which
allows firms to target more precisely those customers who are profitable by assessing the costs
to serve a customer along with the revenues a customer generates.

Cost Accounting in Distribution

Managers use accounting information to determine where in the supply chain value-added
activities will take place. Cost accountants work with managers to estimate whether it is more
efficient (less costly) to perform an activity in the firm or to have another firm perform the
service. This is referred to as outsourcing. Firms frequently consider activities in the
distribution stage for outsourcing. As business becomes more global, specialized information on
markets, regulations, and customs is critical to the speed of delivery. As a result, cost
information often identifies specialized companies as being more efficient in distributing
products, as opposed to handling distribution internally.

Cost Accounting in Customer Service

Many companies have adopted the concept of total quality management (TQM), which means
that the organization is managed to excel on all dimensions and the customer ultimately defines
quality. The customers determine the company’s performance standards according to what is
important to them (which is not necessarily what is important to product engineers, accountants,
or marketers). Companies can indicate the high quality to consumers through the product
warranty. Cost accountants help managers make decisions about quality in two ways. First,
cost of quality (COQ) systems identify the costs associated with producing defective units as
well as the lost sales associated with poor quality products. Second, they provide information on
the projected warranty claims, which can be compared to the increase in revenues estimated
from offering a longer or more comprehensive warranty.

How Value is Created in the Organization

The trends described in the preceding section in the way organizations do business, create
exciting times in cost accounting and excellent future opportunities for one to make important
contributions to organizations. Keep in mind that these new methods are not ends in
themselves. They are tools to help one add value to organizations and their employees,
customers, shareholders and communities.

ACCOUNTING SYSTEMS
A distinction is often made in practice between financial accounting, management accounting
and cost accounting.

Management Accounting measures and reports financial and nonfinancial information that
help managers make decisions to fulfill the goals of an organization. Managers use
management accounting information to choose, communicate and implement strategy.

Financial Accounting provides reports directed to external parties. It measures and records
business transactions and provides financial statements that are based on International
Financial Reporting Standards (IFRS). These reports are directed towards investors,
government regulators, creditors and other parties of the organization.

Cost Accounting is the subfield of accounting that records, measures and reports information
about costs. a cost is a sacrifice of resources and generally represented in the accounting
system by outlay of cash or promises to pay cash in the future or the expectation of the value of
an asset.

Cost accounting provides information to management accounting and financial accounting. it

measures and reports financial and other information related to the organization’s acquisition
and consumption of resources.

Reports such as balance sheets, income statements, and statements of cash flow are common
to both management accounting and financial accounting. most companies adhere to Financial
Accounting and Reporting Standards for their basic internal financial statements. Why?
Because accrual accounting provides a uniform way to measure an organization’s financial
performance for internal and external purposes. However, management accounting is more
wide-ranging than financial accounting’s emphasis on financial statements. Management
accounting embraces more extensively such topics as the development and implementation of
strategies and policies, budgeting, special studies and forecasts, influence on employee
behavior, and nonfinancial information.

COMPARISON OF FIANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTING

Financial accounting involves the systematic recording of business transactions, governed by

a body of international financial reporting standards (IFRS) leading to the preparation of
financial statements for the use of various interested parties, internal as well as external.

Management accounting is concerned with providing financial information to persons within the
organization to enable them to make informed judgments and effective decisions which further
the organization’s goals.

Figure 1.1 summarizes of the significant differences between Financial Accounting and
Management Accounting.

The differences between financial accounting and managerial accounting in terms of their
respective user groups should not be overemphasized. Financial accounting reports are aimed
primarily at external users, and managerial accounting reports are aimed primarily at internal
users. However, managers also make significant use of financial accounting reports, and
external users occasionally request financial information that is generally considered
appropriate for internal users. For example, creditors may ask a management to provide them
with detailed cash-flow projections.

p.8

Figure 1.1: Financial Accounting and Management Accounting Compared

Accounting

*Recording
*Organizing Financial and
*Summarizing Operational Data
*Reporting
___________________________________________
I I I
Financial Management
Accounting Accounting

*Reports to various interested *Reports to managers within the

parties (external and internal): organization for:
Owners } Planning
Lenders } external Directing and motivating
Tax authorities } Controlling
Regulators } Performance evaluation
Managers } internal

*Emphasis is on summaries of *Emphasis is on future-oriented

financial consequences of past data needed in decision-making
activities.

*Objectivity and verifiability of data *Relevance is emphasized.

are emphasized.

*Precision of information is *Timeliness of information is

required. required.

*Only summarized data for the entire *Detailed segment reports about
entire organization are prepared. departments, products, customers,
and employees are prepared.

*Must follow IFRS. *Need not follow IFRS.

*Mandatory for external reports. *Not mandatory

Figure 1.2 shows the relationship of Modern Cost Accounting System to Uses of Cost
Information.
 p.9
Figure 1.2: Relationship of Modern Cost Accounting System to Uses of Cost Information

Cost Accounting System

I
Contractual and regulatory
requirements (e.g., income
tax reporting)
_____________________

Decision Making Planning & Performance

Evaluation

By internal Managerial By internal

managers Accounting managers

By external readers of Financial By external readers of

financial statements Accounting financial statements

RELATIONSHIP OF COST ACCOUNTING TO OTHER FIELDS OF STUDY

Cost accounting interfaces with many other fields of study. Consequently, you will discover
concepts in this book that are discussed in other books also. One of the primary uses of cost
accounting – valuing inventory and cost of goods sold for external reporting to shareholders – is
part of financial accounting. cost accounting is closely related to microeconomics. Some think of
differential cost analysis, in particular, as a form of applied microeconomics. Cost accounting
provides data for use in decision models for finance, operations management, and marketing.
Cost accounting also relates to motivational behavior because it is used in planning and
performance evaluation. Finally, tools from statistics, mathematics, and computer sciences are
used to perform cost analyses.

SCOPE OF MODERN COST ACCOUNTING

While the traditional role of cost accounting to record full product cost data for external reporting
and pricing remains important, cost accounting for decision making, planning and performance
evaluation has gained importance in recent decades. Consequently, cost accounting must
actively work with management to determine what accounting information is needed.

A costing system typically accounts for costs in two basic stages, namely:
a. Cost accumulation
b. Cost assignment
 Cost Accumulation involves the collection of cost data in some organized way by means of
an accounting system. For example, a book publisher that purchases rolls of newsprint for
printing books accumulates the cost of individual rolls bought in any one month to obtain the
total monthly cost of paper.

p.10
Cost assignment. Beyond accumulating costs, the costing system traces direct costs and
allocates indirect costs to designated cost objects (such as the different books the publisher
publishes). This process enables the managers to calculate total costs and unit costs of
products and service and use this information for pricing, product mix and cost management
decisions.

The scope of cost accounting has broadened to include application of mathematical and
statistical techniques to cost analysis, consideration of how accounting affects managerial
decisions models used in finance, economics, and operations management; and examination of
the motivational impact of accounting.

Cost accounting is no longer restricted to manufacturing companies. It is now used in virtually

every organization, including banks, schools, fast-food outlets, professional organizations,
hospitals and government agencies.

COST MANAGEMENT FRAMEWORK

Managers worldwide are becoming increasingly aware of the importance of the quality and
timeliness of products and service sold to their external customers. In turn, accountants are
becoming increasingly sensitive to the quality and timeliness of accounting information required
by managers.

While the accounting system provides information (e.g., product costs, downtime) for
management decisions, cost management refers to active use of this information to plan and
control costs.

Cost management requires managers to actively seek ways to reduce costs. Much cost
management occurs well before the accounting system recognizes costs. for example, the
product design stage often offers more cost management opportunities than controlling
manufacturing operations.

Primary Applications of Cost Accounting Systems

The primary applications of cost accounting systems are as follows:

I. Cost accounting system provide data (e.g., financial statements) for compliance with
reportorial, contractual and regulatory requirements.

Costs are used by outsiders, such as shareholders or creditors to evaluate performance

of top management and make investment decisions about the organization we say costs
are used for financial accounting purposes.
 Government agencies and commissions such as the Bureau of Internal Revenue (BIR),
Social Security System, Securities and Exchange Commission (SEC) and so forth require
periodic reports for tax and other multiple compliance purposes.

p.11
Cost accounting has moved from an emphasis of on inventory and cost of goods sold
valuation for external financial reporting to an emphasis on cost uses for managerial
purpose in recent years. While cost accounting still provides data essential for
external financial reporting. It has also recently achieved a very crucial role in management.

II. Obtaining information for planning and control and performance evaluation

When costs are used inside the organization by managers to plan and evaluate
performance of operations or personnel or as a basic of decision making, we say
costs are used for managerial accounting purposes.

One of the most commonly used tool for planning and control is budgeting. a budget forces
management to look forward, to translate strategy into plans, to coordinate and
communicate
within the firm and to provide a benchmark for evaluating performance.

Managers at the end of a reporting period compare actual results to planned performance.
The reasons for the differences between actual and planned performance are analyzed and
the information provided by these variances and other nonfinancial measures as feedback
to
a. Promote learning and future improvement.
b. Control and evaluate the performance of various decisions, departments and managers.

III. Analyzing the Relevant Information for Making Decision

Business managers are constantly faced with problems of deciding what products to sell,
what production methods to use., whether to make or buy component parts, what prices
charge, what channels of distribution to use, whether to accept special orders at special
prices, and so forth. Decision making is often a difficult task that is complicated by the
existence of numerous alternatives and massive amounts of data, some of which may be
relevant while others are not.

Management and cost accountants help managers identify what information is relevant
and what information is irrelevant when making decisions.

ORGANIZATIONAL ENVIRONMENT

The cost accounting function is typically the responsibility of the controller. In most corporations,
the controller is the chief accounting officer. In some firms, the controller has the rank of
corporate vice president and reports directly to the company president. In others, the controller
and the treasurer may both report to a financial vice president who is responsible for both
accounting and financial affairs.

The chief accounting officer, the controller is responsible for both external and internal
accounting reports. External reports include published financial statements and reports to taxing
authorities like the Bureau of Revenue Service and regulatory bodies like the Securities and
Exchange Commission (SEC), Bangko Sentral ng Pilipinas, Insurance Commission and so
forth.

p.12
Internally, the controller is responsible for supplying management with accounting data for
planning, performance evaluation, and decision making and for overseeing the company’s
internal control system. In addition, the controller maintains all cost and other accounting
records, including inventories, receivables, payables, and fixed asset accounts.

All managers in the organization, not just financial professionals, use cost accounting
information. Because our focus is on cost accounting and decision making, we will often be
viewing a decision from an operational manger’s perspective.

As a financial or operational manager in an organization, you will work closely with many
financial professionals. Figure 1.3 shows the list of the typical financial titles in organizations
and examples of their activities. If you work in the accounting or finance function in an
organization, you are likely
to have one of these jobs. Whatever your job, you will work in cross-functional teams of people
from many areas such as engineering, production, marketing, finance and accounting.

Figure 1.3: Key Financial Managers in an Organization

Major Responsibilities
Title and Primary Duties Example Activities
*Chief Financial Officer *Managers entire *Signs off on financial
(CFO) finance and statements
accounting function *Determines policy on
debt versus equity
financing
*Treasurer *Manages liquid assets *Determines where to
*Conducts business invest cash balances
with banks and other *Obtains line of credit
financial institutions
*Oversees public
issues of stock and debt
*Controller *Plans and designs *Determines cost
information and accounting policies
incentive systems *Maintains the
accounting records
*Internal auditor *Ensures compliance *Ensures that
with laws, regulations procurement rules are
 and company policies followed
and procedures *Recommends policies
*Provides consulting and procedures to
and auditing services reduce inventory
within the firm losses
*Cost accountant *Records, measures *Evaluates
estimates, and products and
analyzes costs processes
*Works with financial *Recommends cost-
and operational effective methods to
manager to provide distribute products
relevant information
for decisions p.13

ETHICAL ISSUES AND GUIDELINES

We have discussed decisions that one makes in using or preparing cost accounting information.
The design of cost system is ultimately about the assignment of costs to various activities,
products, projects, corporate units, and people. How that is done affects prices, reimbursement,
and pay.

As can be learned from current events involving embezzlement, channel staffing and so forth,
the design of the cost accounting system has the potential of being misused to defraud
customers, employees or shareholders. As a user or preparer of cost information, one has to be
aware of the implication the way in which information is used. More importantly, one needs to be
aware of when the system has the potential for abuse.

As professional accountant, managers or business owners, he/she will face ethical situations on
an everyday basis. Many accountants, managers and business owners have found themselves
in serious trouble because they did small things, none of which appeared seriously wrong, only
to find that these small things added up to big trouble.

If you know the warning signs of potential ethical problem, you will have a chance to protect
yourself and set the proper moral tone for your company and your professions at the same time.

The Code of Conduct

Management accountants which include cost accountant have important ethical responsibilities
that are related to competence, confidentiality, integrity and objectivity.

In a nutshell, the accountant has the responsibility to comply with the Standards of Ethical
Conduct for Practitioners of Management Accounting and Financial Management issued
by the Institute of Management Accountants (IMA).

In this Code, it is stated that management (and cost) accountants have a responsibility to
maintain the highest levels of ethical conduct. They also have a responsibility to maintain
professional competency, refrain from disclosing confidential information, and maintain integrity
and objectivity in their work. These standards recommend that accountants faced with ethical
conflicts follow the established policies that deal with them.
The IMA guidelines suggest that when faced with an ethical dilemma, just answer the following
questions:
 Will my actions be fair and just to all parties concerned?
 Would I be pleased to have my closest friends and relation learn of my actions?

p.14

LESSON 2

COST TERMS, CONCEPTS AND CLASSIFICATIONS

INTRODUCTION

Lesson 1 indicated that managerial accounting deals with the information managers need for
making decisions and for planning and performance evaluation. From an accounting point of
view, this information often relates to the costs of the organization.

An understanding of cost terms and concepts provides the foundation of how to best use the
information provided as well as to avoid misuse of that information. This chapter discuss cost
concepts and terms expressed in accounting information for internal and external reporting.

Anyone who used accounting information must also have a broad perspective and
understanding of the system that provides the data. In Lesson 1, we provide an overview of cost
flows by showing how costs are accumulated in the accounting systems of merchandising,
manufacturing and service organization.

NATURE AND COST, COST POOLS, COST OBJECTS AND COST DRIVERS

COST

Cost – 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.

A cost is incurred when a resource is used for some purpose. It is also and outlay or
expenditure of money to acquire goods and services that assist in performing operations. A
costing system accounts for costs in two basic steps, namely, cost accumulation and cost
assignment.

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 accountants to do that.
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.

Costs are also classified differently depending on the type of organization involved, that is,
merchandising, service or manufacturing. Cost data that are classified and recorded in a
particular way for one purpose may be inappropriate for another use.

p.15

COST POOLS

Cost Pools – are costs collected into meaningful groups.

Classification of cost pools:

1. by type of cost (labor cost in one pool, material cost in another).
2. by source (department 1, department 2 and so on)
3. by responsibility (manager 1, manager 2 and so on)

COST OBJECT

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.

Figure 2.1 provides examples of several different types of costs objects.

Figure 2.1: Examples of Cost Objects

Cost Object I Illustration

Program I An athletic program of a university
Department I A department within a DENR that studies air emissions
I standards
Activity I A test to determine the quality level of television set
Brand Category I All soft drinks sold by Pepsi-Cola bottling company with
I “Pepsi” in their name
Customer I All products purchased by Landmark (the customer)
I From Purefoods, Inc.
Project I A special sportscar assembled by Toyota Motors
Service I An airline flight from NAIA to Hongkong
Product I A motorcycle
COST DRIVERS

Cost driver – is any factor that has the effect of changing the level of total cost.

A critical first step for achieving a competitive advantage is to identify the key cost drivers in a
firm or organization. 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
p.16
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. Figure 2.2 presents examples of cost drivers in each of the business functions in
the Value Chain.

Figure 2.2: Examples of Cost Drivers of Business Functions in a Value Chain

Business Function Cost Driver

Research *Number of research projects
*Manpower hours on a project
*Technical difficulties of projects
Design of products, services *Number of products in design
and processes *Number of parts per product
*Number of engineering hours
Production *Number of units produced
*Direct manufacturing labor costs
*Number of setups
*Number of engineering change orders
Marketing *Number of advertisements run
*Number of sales personnel
*Peso sales
Distribution *Number of items distributed
*Number of customers
*Weight of items distributed
Customer service *Number of service calls
*Number of products serviced
*Hours spent servicing products

Cost Accumulation and Cost Assignment

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

Cost allocation – is the assignment of indirect costs to cost pools. Allocation bases are cost
drivers used to allocate costs.
CLASSIFICATION OF COSTS

Cost classifications are necessary for the development of cost information to serve the needs of
management. Understanding these concepts and classifications enables the managerial
accountant to provide appropriate cost data to the managers who need it. Basic cost
classification and terminologies are presented in Figure 2.3.

p.17
Figure 2.3: Cost Classifications

Cost Data

*Nature or Management Function

- Manufacturing costs
- Nonmanufacturing costs

*Timing of Recognition as Expense

- Product (inventoriable) costs
- Period costs

*Financial Statements
- Statement of Financial Position (Inventory costs)
- Income Statement (Cost of Sales/Other Operating Costs)

*Cost Behavior
- Variable costs
- Fixed costs
- Semivariable costs

*Types of Inventory
- Raw materials inventory
- Work in process inventory
- Finished goods inventory
- Merchandise inventory

*Traceability to Cost Objective

- Direct costs
- Indirect costs

*Managerial Influence
- Controllable costs
- Noncontrollable costs

*Planning and Control

- Standard costs
- Budgeted costs
- Absorption costing/Full costing
 - Direct costing/Variable costing
- Information costs
- Ordering costs
- Out-of-pocket-costs

*Time Frame/Commitment to Cost Expenditure

- Committed costs
- Discretionary costs

p.18
*Period of Incurrence
- Historical costs
- Future costs

*Decision Making and Other Analytical Purposes

- Relevant costs (Future/Differential)
- Sunk costs
- Opportunity costs
- Marginal costs
- Value-added costs

A. Costs classified by Nature or Management Function

Manufacturing Costs

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.

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 cost 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, nonroutine
 quality assurance samples are taken due to manufacturing problems and cost of
marketing samples should not be added to materials costs.

Direct Labor

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

Estimates of direct labor quantities and unit prices may be sufficiently accurate to be
considered “specifically identified” with a cost object.

p.19
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 handling.

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 material into finished
products. Direct materials and direct labor are often referred to as prime costs.

Other manufacturing overhead costs include overtime premiums and he cost of idle time.
An overtime premium is the extra compensation paid to an 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

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.

p.20
Production Costs in Service Industry Firms and Nonprofit Organizations

Service industry firms such as schools, hotels, banks, airlines, accounting firms, and
automotive repair shops and many nonprofit organizations are also engaged in
production. What distinguishes these enterprises from manufacturers is that a service is
consumed as it is produced, whereas a manufactured product can be stored in
inventory while less commonly applied in service firms, the same cost classifications
used in manufacturing companies can be applied. For example, an automotive repair
shop produces repair services. Direct materials include such costs as new parts
installed to replace the worn out part, paint and other materials used. Direct labor
includes the wages paid by the service crew. Overhead costs include depreciation of
equipment and other tools used and rental expense.

Recording and classifying costs is important not only for manufacturing firms but for
service industry firms and nonprofit organizations as well. Cost analysis is necessary in
pricing, banking and insurance services, hotel and travel rental agencies, setting tuition
fees in schools and many more.

As these organizations grow in number and in scope of business operations, applying

managerial accounting to their activities take an even greater importance.

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 terms product cost and period cost are used to describe the timing
with which various expenses are recognized.

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 statement of financial position. When the goods
are sold, the costs are released from 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.

Period Costs

Period costs are ll the costs that are identified with accounting periods and not included in
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.

p.21

C. Costs classification 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 a 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.

The Statement of Financial Position

The 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
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 process consists of units of product that are only partially complete and will require
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.
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 Pxx

Add: Purchases xx
Total available for sale Pxx
Less: Ending merchandise inventory xx
Cost of goods sold Pxx

p.22

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

Beginning finished goods inventory Pxx

Add: Cost of goods manufactured xx
Total available for sale Pxx
Less: Ending finished goods inventory xx
Cost of goods sold Pxx

The cost of goods manufactured contains the three elements of product costs namely direct
materials, direct labor and manufacturing overhead (Figure 2.4).

Illustrative Statements of a Merchandising Company

Figure 2.4 shows the income statement and current assets section of the statement of financial
position of a Merchandising Company.

Figure 2.4
ABC Trading Company
Income Statement
For the Year Ended December 31,20__

Sales P1,000,000
Cost of goods sold:
Beginning inventory P100,000
Add purchases 650,000
Goods available for sale 750,000
Ending inventory 150,000 600,000
Gross margin P 400,000
Less operating expenses:
Selling expense P100,000
Administrative expense 200,000 300,000
Net Income P 100,000
 ABC Trading Company
Current Assets Section of the Statement of Financial Position
December 31,20__

Current assets:
Cash P 10,000
Accounts receivable 60,000
Merchandise inventory 150,000
Prepaid expenses 5,000
Total current assets P 225,000

p.23
Illustrative Statements of a Manufacturing Company

Figure 2.5 shows the income statement and current assets section of the statement of financial
position of a Manufacturing Company.

Figure 2.5

XYZ Company
Income Statement
For the Year Ended December 31, 20__

Sales P1,500,000
Cost of goods sold:
Beginning finished goods inventory P125,000
Add cost of goods manufactured 850,000
Goods available for sale P975,000
Ending finished goods inventory 175,000 800,000
Gross margin 700,000
Less operating expenses:
Selling expense P250,000
Administrative expense 300,000 550,000
Net income P 150,000

XYZ Company
Statement of Cost of Goods Manufactured
For the Year Ended December 31, 20__

Direct materials
Direct materials inventory, Jan. 1, 20__ P 30,000
Purchases of direct materials 210,000
Total direct materials available 240,000
Direct materials inventory, Dec. 31, 20__ P 15,000
Direct materials used P225,000
 Direct labor 250,000
Manufacturing overhead
Indirect materials P 35,000
Factory utilities 70,000
Factory supervision 70,000
Property taxes on factory equipment 20,000
Factory maintenance and repairs 20,000
Depreciation of plant and equipment 90,000
Total manufacturing overhead 305,000
Total manufacturing costs P780,000
Work in process inventory, Jan. 1, 20__ 130,000
Total P910,000
Work in process inventory, Dec. 31, 20__ 60,000
Cost of goods manufactured P850,000

p.24
XYZ Company
Current Assets Section of the Statement of Financial Position
December 31, 20__

Current Assets:
Cash P 15,000
Accounts receivable 100,000
Inventories:
Raw materials P 15,000
Work in process 60,000
Finished goods 175,000 250,000
Prepaid expenses 10,000
Total current assets P375,000

Illustrative Statements of a Service Company

Figure 2.6 shows the income statement and the current assets section of the statement of
financial position of a service company.

Figure 2.6

EFG Consulting Company

Income Statement
For the Year Ended December 31, 20__

Revenues
Fees for professional service P500,000
Less: Direct costs
Employees compensation & fringe benefits 245,000
Contribution to Indirect Cost 255,000
Less: Indirect costs
Rent of office facilities 30,000
Training and research 20,000
 Personnel recruiting 10,000
Professional insurance and litigation 6,000
Other 25,000
Total 91,000
Operating income P164,000

EFG Consulting Company

Current Assets Section of the Statement of Financial Position
December 31, 20__
Current Assets:
Cash P 25,000
Accounts receivable 63,000
Unbilled services, at estimated billable rate 50,000
Prepaid expenses 14,000
Total current assets P152,000
p.25

D. Cost classification for predicting Cost Behavior

Cost behavior refers to how a cost will react or respond to changes in the business activity.
As the activity level rises and falls, a particular cost may rises and falls as well – or it may
remain constant. For planning purposes, a 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.

Variable Costs

Costs that change directly in proportion to changes in activity (volume). Direct labor and
direct
materials are examples of variable costs.

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.

Semivariable Costs or Mixed Costs

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

Lesson 3 presents a more thorough discussion o these costs.

E. Costs classified by Types of Inventory

 Raw Materials Inventory
The cost of all raw material and production supplies that have been purchased but not
used at the end of the accounting period.

Work-in-process Inventory
The cost associated with goods partially completed at the end of the accounting period.

Finished Goods Inventory

Cost of completed goods that have not been sold at the end of the accounting period.

Merchandise Inventory
Cost of purchased merchandise by retailers/ wholesalers that have not been sold at the
end of the accounting period.

p.26

F. Costs classification according to Traceability to Cost Objective

Direct costs (traceable; separable)

Costs that can be economically traced to a single cost object (i.e. product, department or
unit).

Indirect costs

Costs that are not directly or easily traceable to the cost object (i.e. product, department,
etc.)

G. Costs classification according to Managerial Influence

Controllable cost

Cost that is subject to significant influence by a particular manager within the time period
under consideration.

Noncontrollable cost

Cost over which a given manager does not have a significant influence.

H. Costs Terminologies Used for Planning and Control

Standard Costs

A predetermined cost estimate that should be attained; usually expressed in terms of costs
 per unit.

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 P4,000 for product X.

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.

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.

p.27

Information Costs
Costs of obtaining information.

Ordering Costs
Costs that increase with the number of orders placed for inventory.

Out-of-pocket Costs
Costs that must be met with a current expenditure or cash outlay.

I. Costs classification according to a Time-frame Perspective

Committed Cost
Cost that is the inevitable consequence of a previous commitment.

Discretionary Cost (programmed; managed cost)

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

J. Costs classified according to a Time Period for Which the Cost is Incurred

Historical costs (past costs)

Costs that were incurred in a past period.

Future costs
Budgeted costs that are expected to be incurred in a future period.

K. Costs classifications for Decision-making and other Analytical Purposes

Relevant Costs
 Future costs that are different under one decision alternative than under another decision
alternative.

Incremental Costs

The difference in cost between two or more alternatives. In evaluating a given alternative,
incremental cost is additional cost to determine the feasibility of this particular alternative. To
be an incremental cost, the cost must be a future cost and be different under various
alternatives.

Sunk Costs

Past costs that have been incurred and are irrelevant to a future decision.

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.

p.28

Marginal Costs

Costs assigned with the next unit or the next project or incremental cost associated with an
additional project as opposed to the next discrete unit.

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 Classifications

Bettina Cabrera 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
P40.00 – historical cost
P50.00 – 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 increases, 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 has the authority

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.
p.29

LESSON 3

COST BEHAVIOR: ANALYSIS AND USE

DEFINITION OF 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,
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.

This lesson reviews and discusses in greater depth variable costs, fixed costs and mixed costs
which were introduced in Lesson 2.
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 a cost driver. Some of the most common
activity divers 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 a technical
support staff at a software company, and the number of beds occupied in a hospital.

p.30

Figure 3.1: Variable Cost Behavior

(Refer to textbook for the illustration)

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 cost decrease per unit as the activity level rises and increase per unit as the activity
level fall. The concept of a fixed cost is shown in graphic form in Figure 3.2.

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 management and
operating personnel. The two key characteristics of committed 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
operations are interrupted or cut back, the committed fixed costs will still continue largely
unchanged.

p.31

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
much larger advertising costs 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.
 Figure 3.2: Fixed Cost Behavior

(Refer to textbook for the illustration)

Examples of Costs that are Generally Fixed:

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

administrative
salaries and advertising.

3. Mixed Costs (Semivariable Costs)

A mixed cost is one that contains both variable and fixed cost elements. Mixed costs are
also known as semivariable costs. Figure 3.3 shows the behavior of mixed costs in relation
to volume. Note that the total cost line slopes upward as the variable cost element is added
to the fixed cost element.

Figure 3.3: Mixed Cost Behavior

(Refer to textbook for the illustration)

Common Examples of Mixed or Semivariable Costs include: Maintenance Costs, Electric

Utility Costs.
p.32

The relationship between mixed cost and the level of activity also be 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 cos 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).

COST ESTIMATION

The Analysis of Mixed Costs

A 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.
 How does management go about in estimating the fixed and variable components of a mixed
cost?

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

This lesson discusses the methods of estimating the relation between cost behavior and
activity levels that are commonly used in practice as well as a brief overview of the theory
and some important considerations for their application.
These are:
1. Account Analysis method
2. Industrial Engineering method or Work Measurement method
3. Conference method
4. Quantitative Analysis of Current and Past Costs Relationships
a. High-low method
b. Regression Analysis Method
1) Scattergraph or Visual fit method
2) The Least-squares Regression method

It is possible that results will differ from method to method. Consequently, more than one
approach is often applied so that results can be compared. Line managers should apply their
own best judgment, modifying the estimates submitted by the controller’s staff, a final step in
the estimation process.

p.33

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 in 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.
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 in 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 (material, 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 of each manufacturing process together with the
kinds of work performed, and time to perform each step is done. (This is sometimes part of time-
and-motion study). This serves as a basis for estimating direct labor time.
b. Engineering estimates 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 the cost 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 advantage 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.
p.34

A disadvantage that can be attributed 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 also difficult to estimate the
indirect costs of production.

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.

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.

2. Estimate the variable cost per unit or rate using the following equation.

Variable cost rate = Cost at highest activity – Cost at lowest activity

or per unit Highest activity – Lowest activity

3. Compute the fixed cost as follows:

Total Cost at Variable Highest

Fixed Cost = highest – cost X activity stated
activity per unit in units

or

Total Cost at Variable Lowest

Fixed Cost = lowest – cost X activity stated
activity per unit in units

The fixed cost represents the intercept on the graph because it represents the costs that would
be incurred at a zero activity level given existing capacity “if the relationship plotted is valid from
the data points back to the origin”

p.35

Illustrative Problem 1. Kristal Lane, Inc.

Given:

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

The following data on supplies cost and direct labor hours from January to October are
available.

X Y
Direct Labor hours Supplies Cost
20 P 50
40 110
60 150
20 70
30 80
40 100
50 150
10 60
30 110
 50 120
Required:
Determine the variable cost rate per hour and the fixed cost portion using the high-low-
method.

Solution:
1. Variable cost rate per hour = P150 - P60
60 - 10

= P 90
50

= P 1.80
˭˭˭˭˭˭
2. Fixed Cost:
at 60-hour level at 10-hour level
FC = P150 – (P1.80 x 60) FC = P60 – (P1.80 x 10)
= P150 - P108 OR = P60 - P18
= P 42 = P42
˭˭˭˭ ˭˭˭˭

Regression Analysis Method

Regression analysis 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 (cost drivers such as
number of units produced, machine hours, etc.). Simple regression analysis estimates the
relationship between the dependent variable and one independent variable; while multiple
regression analysis estimates the relationship between the dependent variable and multiple
independent variables.
p.36

Multiple regression is used when the dependent variable (i.e., cost) 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 uses the following estimated cost function or equation:

Y = a + bX

while multiple regression analysis uses the following equation:

Y = a + b1X1+b2X2 ……………. +u

where:
Y = costs to be predicted (dependent variable)
X,X1,X2,… = independent variables on which the prediction is to be based
a = fixed cost
b,b1,b2,…. = estimated coefficients of the regression model
u = 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-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 a straight line is:

Y = a + bX

The two linear equations that are used to solve for a and b are:
Equation (1) ƩY = Na + bƩX
2
Equation (2) ƩXY = ƩXa + bƩX

Where:
Y = Total cost
a = Fixed cost
b = Variable cost rate
X = measure of activity (e.g., hours, units)
N = number of observations
Ʃ = Greek letter signifying summation

Using the data in Illustrative Problem 1 (Kristel Lane, Inc.), determine the variable cost rate and
the fixed cost under the Least-squares regression method.

p.37

Solution: Kristal Lane, Inc. (Least-squares regression method)

2
X Y XY X
20 P 50 1,000 400
40 110 4,400 1,600
60 150 9,000 3,600
20 70 1,400 400
30 80 2,400 900
40 100 4,000 1,600
50 150 7,500 2,500
10 60 600 100

50 120 6,000 2 2,500

ƩX = 350 ƩY = 1,000 ƩXY = 39,600 ƩX = 14,500
˭˭˭ ˭˭˭˭ ˭˭˭˭˭ ˭˭˭˭˭

Equation (1) 1,000 = 10a + 350b

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

To eliminate one unknown (a), and solve for (b), multiply Equation 1 by 35 (least common
denominator) and subtract the new Equation 3 from Equation 2:

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

Equation (3)
[Equation 1 x 35] 35,000 = 350a + 12,250b
4,600 = 2,250b

Variable cost rate or b = P2.04

˭˭˭˭

To solve for a (Fixed cost) substitute the value of b to Equation 1. Thus,

1,000 = 10a + 350 (2.04)

1,000 – 714 = 10a
a = -286
-10
a = P28.60
˭˭˭˭˭˭˭˭

Scattergraph 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 Kristal Lane (X) or independent variables, 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
judgement, 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. P.38
The steps involved in the use of Scattergraph are as follows:

1. On a graph, plot actual costs (on vertical axis) during the period under study against
the volume levels (on horizontal axis).
2. The line of best fit is then drawn by visual inspection of the plotted points, the line
representing the trend shown by the majority of the points.
3. The fixed cost is estimated by extending the left end of the line to the vertical axis.
4. The variable cost rate or slope of the cost line is determined by dividing the difference

between any two level of activities by the difference in costs corresponding to the same
level of activities.

Using the data in Illustrative Problem 1 (Kristal Lane, Inc.), determine the variable cost rate
and the fixed cost under the Scattergraph method.

Note: Refer to textbook for solution to Kristal Lane, Inc. (under the Scattergraph method).

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 expert Subjective

analysis of the cost behavior
in each account
Engineering Method Based on studies of what Not particularly useful when
future costs should be the physical relation between
rather than what past costs inputs and outputs is indirect.
have been.
High-low Method Simple to apply. Uses only two data points
which may not produce
accurate results.
Scattergraph Method Uses all the observations of The fitting of the line to the
cost data. observations is subjective.
Relatively easy to Difficult to do where
understand and apply. several independent
variables are to be used.
Least-squares Regression Uses all the observations The regression model
Method of cost data. requires that several
The line is statistically fit to relatively strict assumptions
the observations. be satisfied for the results
A measure of the goodness to be valid.
of fit of the line to the
observations is provided.
Relatively easy to use with
computers and
sophisticated calculators. P.39

Correlation Analysis

In the process of estimating and controlling costs, management must evaluate whether or not
the factor selected for estimating cost behavior is suitable for that purpose. Costs may or may
not react with changes in the factor selected for cost analysis.

The degree of correlation between the level of activity and costs may be measured by the
“coefficient of determination”, most frequently designated as r2. To compute for this, the
equation is: 2
r2 = 1 - (Estimated conditional standard deviation measured from line of regression)
(Standard deviation measured from the average of all data)2

a. Estimated conditional standard deviation measured from the line of regression:

₂
√ Ʃ(Y −Ȳ )
n−2
 Y = actual cost
Ȳ = line of regression cost
n = number of items of data

b. Standard deviation measured from average of all data:

₂
√ Ʃ(Y −Ȳ )
n

Y = actual cost
Ȳ = average cost
n = number of items of data

If r2 expressed as a percentage will be relatively high, the correlation is good. It means that the
costs follow the factor selected.

Using the data in Illustrative Problem 1 (Kristel Lane, Inc.), evaluate the degree of correlation
between the direct labor hours and suppliers cost by solving for r2 or coefficient of
determination. 2
Note: Refer to textbook for continuation of computation on Correlation Analysis.

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.

As a worker performs a certain task, a systematic, nonlinear relationship has been found. The
learning curve theory, also called the improvement curve theory is based on the proposition that
as workers gain experience in a task, they need less time to complete the job and productivity
increases.

p.40

Case studies have shown that learning often follows a pattern: as the cumulative number of
units manufactures is doubled the cumulative average time that it takes to make a unit is
advised by a constant percentage. If the rate of reduction is 20%, the learning curve is referred
to as an 80% curve. The learning curve is a power function, and if plotted on double logarithmic
paper will appear as a straight line.

Some of the Uses of the Learning 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 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.
In solving learning curve problems, the following steps may be followed:
1. Double the cumulative quantity
2. Multiply the cumulative average by the learning curve percentage
3. Multiply the cumulative average by the cumulative quantity

For example, a worker can finish one unit of product in two hours and a 20% learning curve is
applicable. The cumulative time schedule will be shown as follows:

Cumulative Cumulative Average Predicted Total Hours to

Quantity Worker-Hours per unit Perform Task
1 2.0 2.0
2 1.6 (2.0 hrs x 80%) 3.2 (2 x 1.6 hrs)
4 1.3 (1.6 hrs x 80%) 5.2 (4 x 1.3 hrs)
8 1.0 (1.3 hrs x 80%) 8.0 (8 x 1 hr )
16 0.8 (1.0 hr x 80%) 12.8 (16 x 1.8 hrs)
32 0.6 (0.8 hrs x 80%) 19.2 (32 x 0.6 hrs)
64 0.5 (0.6 hrs x 80%) 32 (64 x 0.5 hrs)

Learning Rate. The reduction in time varies 10 and 40 percent depending on the repetitiveness
of labor operations, with 20% being a common reduction. In calculating the learning rate that
applies to the specific situation, data on manufacturing the first two lots of a product can be
used. The formula to compute for the Learning Rate is

Average input quantity (cost) for the first 2 x units

Average input quantity (cost) for the first x units

Example: Assume that for a project, the first lot of four units required for a total of 4,000 direct
labor-hours. The second lot of four more units requires an additional 2,800 direct labor hours.
Learning rate for this operation is calculated as follows:
(4000 = 2800) / 8 = 850 average direct labor hours = 85%
4000 / 4 1000 average direct labor hours

p.41

Illustrative Problem II. Speed, Inc.

Speed, Inc. manufactures complex units of motorboats. Fabricating these units require a high
degree of technical skill. However, employees have an opportunity to learn how to produce the
units more effectively. In estimating direct labor-hours, a 70% learning curve can be used.
Completing one prototype unit required 1,200 labor hours at a cost of P18,000.

1. The cumulative average worker-hours per unit for a total of 2 units is

a. 2,400 c. 840
b. 1,200 d. 1,680

2. The cumulative average worker-hours per unit for a total of 8 units is

a. 9,600 c. 3,293
b. 6,720 d. 412
 3. The estimated direct labor cost for an order of seven additional units, after completing
one unit is
a. P 49,620 c. P31,620
b. P 144,000 d. P18,000

Solution: Speed, Inc.

Cumulative Cumulative Average Total

Units Hours per unit Hours
1 1,200.0 1,200 @ 15
2 840.0 (1,200 x 0.70) 1,680
4 588.0 ( 840 X 0.70) 2,532
8 411.6 ( 588 X 0.70) 3,293

Direct labor cost for 8 units (3,293 X P15) P49,620

Less: Direct labor cost for the 1st unit 18,000
Direct labor cost for 7 additional units P31,620
˭˭˭˭˭˭˭
Answers:
1. c 2. d 3. C

p.42
LESSON 4

COST-VOLUME-PROFIT RELATIONSHIPS

THE BASICS OF COST-VOLUME-PROFIT (CVP) ANALYSIS

Managers are constantly faces with decisions about selling price, variable costs and fixed costs.
to be able to choose from among the alternative actions, it is necessary to have a good estimate
of the probable costs that would result from each choice. Furthermore, management needs to
know the costs that are likely to be incurred under normal operating conditions and how they
might vary if conditions change.
Among the most frequently asked questions that require cost estimates and short-run decisions
are:
1) How many units will be manufactured?
2) What is the company’s break-even sales?
3) Should the selling price be changed?
4) Should the company spend more on advertising?
5) What profit contribution can be realized if the organization performs as expected for
the period?
6) Should the product be sold as is or should it be processed further?
7) What would be the effects of the following changes in the next period?
a) Increase or decrease in the cost of materials?
b) Increase or decrease in the efficiency of production?

Long-run decisions such as buying new plant and equipment will also hinge on predictions of
the resulting cost-volume-profit relationships.

Managers, in making their decisions affecting the business operations must understand the
interrelationship of cost, volume and profit through the use of the information and analysis that
the cost accounting department will provide to them. They need to understand which costs
would stay the same.

SIGNIFICANCE OF COST-VOLUME-PROFIT ANALYSIS

Cost-volume-profit (CVP) analysis is one of the most powerful tools that managers have at their
command. It helps them understand the interrelationship between cost, volume, and profit in an
organization by focusing on interactions between the following five elements:

1. Prices of products
2. Volume or level of activity within the relevant range
3. Variable costs per unit
4. Total fixed costs
5. Mix of products sold

p.43
If the above items are known, the following relationships may be established:

a) Contribution Margin per unit or marginal income per unit

This is the excess of unit selling price over unit variable costs and the amount each unit
sold contributes toward
1) covering fixed costs
2) providing operating profits

Formula:
CM per unit = Unit selling price – unit variable costs

b) Contribution Margin Ratio

 This is the percentage of contribution margin to total sales. This ratio is computed as
follows:
CM ratio = Contribution Margin
Sales

The CM ratio is very useful in that it shows how the contribution margin will be affected
by the given peso change in total sales. For instance, if a company’s CM ratio is 40%, it
means that for each peso increase in sales, total contribution margin will increase by
P0.40. net income likewise will increase by P0.40 assuming that there are no changes in
the fixed costs.

The CM ratio is particularly valuable in those situations where the manager must make
trade-offs between change in selling price and change in variable costs.

CVP ANALYSIS FOR BREAKEVEN PLANNING

The starting point in many business plans is to determine the break-even point.

Break-even point is the level of sales volume where total revenues and total expenses are
equal, that is, there is neither profit or loss. This point can be determined by using CVP analysis.
Break-even point can be computed as follows:

1) Break-even point (units) = Total Fixed Costs____

Contribution Margin per unit

2) Break-even point (peso) = Total Fixed Costs____

1 - VariableCosts
Sales

3) a) Break-even sales Total Fixed Costs

for multi-products = Weighted Average
firm (combined units) Contribution Margin

b) Weighted Contribution Unit CM x No. of units + Unit CM x No. of units

Margin per unit = per Mix per Mix_____
Total number of units per Sales Mix

4) a) Break-even sales for

multi-products firm = Total Fixed Costs
(combined pesos) Weighted CM ratio

b) Weighted CM ratio = _Total Weighted CM (P)__

Total Weighted Sales (P)

CVP ANALYSIS FOR REVENUE AND COST PLANNING

CVP can be used to determine the level of sales needed to achieve a desired level of profit. in
revenue planning, CVP analysis assists managers in determining the revenue required to
achieve a desired profit level. The equation that may be used to compute for target sales
follows:

Sales (units) = Total Fixed Costs + Desired Profit

Contribution Margin Per Unit

Or

Sales (P) = Total Fixed Costs + Desired Profit

Contribution Margin Ratio

Break-even Graph

Under the graphical approach, sales revenue, variable costs and fixed costs are plotted on the
vertical axis while volume is plotted on the horizontal axis. The break-even point is the point
where the total sales revenue line intersects the total cost line.

Illustrative Problem 4.1. Computation of Break-even Point and Construction of Break-

even
Graph and Profit-Volume Graph

MNO Corporation provided the following information:

Total Per Unit
Net Sales P500,000 P10
Variable Costs 300,000 6
Contribution Margin 200,000 4
Fixed Costs 150,000 3
Net Profit P 50,000 P1
˭˭˭˭˭ ˭˭
A. Computation of Break-even Point
1. Break-even Point (units) = P150,000 = 37,500 units
P10 - P6

2. Break-even Point (P) = P150,000 = P375,000

40%

B. Construction of Break-even Graph

Prepare the break-even graph. Refer to textbook for illustration.

C. Construction of Profit-Volume Graph

This chart focuses more directly on how profits vary with changes in volume. Profits are plotted on the
vertical axis while units of output are shown on the horizontal axis. Using the data in Illustrative
Problem
4.1 – MNO Corporation, the P/V Graph may be prepared as follows:
Prepare the profit-volume graph. Refer to textbook for illustration.

ASSUMPTIONS AND LIMITATIONS OF CVP ANALYSIS

CVP analysis constitutes a very important tool for management planning. Certain underlying
assumptions upon which it rests, however, place definite limitations on the conclusions which
can be drawn from its results. Whenever the underlying assumptions of CVP analysis do not
correspond to a given situation, the limitations, of the analysis must be clearly recognized if the
break-even tool is to be useful and educational.

In summary, the following static assumptions will limit the precision and reliability of a given
break-even analysis:

Assumption/Limitation Comment
1. The analysis is valid for a limited 1. Failure to observe these limits
range of values – the “relevant” – would lead to working with
and a limited period of time. unrealistic data.

2. All costs can be categorized as fixed 2. Semi-variable costs present a

or variable. problem that can be solved by
segregating fixed and variable
portion.

a. Variable costs change a. There is a danger that linear

proportionate with volume cost and revenue relationship
within the relevant volume may be used when
range. Nonlinearities are significant.
b. Fixed costs are constant within b. Non-linear curves often have
the relevant volume range. optimum quantities; linear
ones do not.

3. Revenues change proportionately 3. Price is constant for all volumes

with volumes with selling price within the relevant range.
remaining constant.

4. There is a constant product mix. 4. Data should be adjusted for any

Shifts in product mix.

5. Changes in volume alone are 5. There are other factors affecting

responsible for changes in costs costs and revenues, but they are
and revenues. lessened if narrow time and volume
limits are applied.

6. There is no significant change in 6. Data should be adjusted if

inventories (i.e., in physical units, inventories change markedly.
sales volume equals production
volume).

7. Operation leverage questions can be 7. This should be supported with

 dealt with in the CVP framework. capital budgeting approaches that
consider the time value of money.

8. The analysis is deterministic and 8. Uncertainly and a probabilities

appropriate data can be found. approach can be introduced. This
will change decisions in some cases.

Illustrative Problem 4.2. Break-even Analysis

The Income Statement for one of Manhattan Company’s product shows:

Sales (100 units at P100 a unit) P10,000

Cost of goods sold:
Direct labor P1,500
Direct materials used 1,400
Variable factory overhead 1,000
Fixed factory overhead 500 4,400
Gross profit P 5,600
Marketing expenses:
Variable P 600
Fixed 1,000
Administrative expenses:
Variable 500
Fixed 1,000 3,100
Operating income P 2,500
˭˭˭˭˭˭˭
REQUIRED: (1) Compute the break-even point in units.
(2) If sales increase by 25%, how much will be the new operating income?
(3) Compute the new break-even point in pesos if fixed factory overhead
will increase by P1,700.

Solution: Manhattan Company

(1) Break-even point = P500 + P1,000 + P1,000

P50
= 50 units
˭˭˭˭˭˭˭˭˭˭

(2) Current Net Income P2,500

Add: Incremental contribution
Margin (25 units x P50) 1,250
Operating Income P3,750
˭˭˭˭˭˭

(3) Break-even point = P2,500 + P1,700

50%
= P8,400
˭˭˭˭˭˭˭˭

Illustrative Problem 4.3. CVP Analysis with Changes in Cost Structure

The Don Company sold 100,000 units of its product at P20 per unit. Variable costs are P14 per
unit (manufacturing costs of P11 and marketing costs of P3). Fixed costs are incurred uniformly
throughout the year and amount to P792,000 (manufacturing costs of P500,000 and marketing
costs of P292,000).

REQUIRED: Compute
1. The break-even point in units and in pesos.
2. The number of units that must be sold to earn an income of P60,000 before income
tax.
3. The number of units that must be sold to earn an after-tax income of P90,000.
Income tax rate is 40%.
4. The number of units required to break-even if there is a 10% increase in wages and
Salaries. Labor cost constitutes 50% of variable costs and 20% of fixed costs.

Solution: Don Company

(1) BEP (units) = P792,000

P6
= 132,000 units
˭˭˭˭˭˭˭˭˭˭˭˭˭˭˭˭˭˭

BEP (P) = P792,000

30%
= P2,640,000
˭˭˭˭˭˭˭˭˭˭˭˭˭˭˭
(2) Desired net income P 60,000
Add: Fixed costs 792,000
Contribution margin P852,000
Divided by: contribution margin/unit P6
Total number of units 142,000
˭˭˭˭˭˭˭˭˭˭˭˭˭

(3) Desired net income after tax P 90,000

˭˭˭˭˭˭˭˭˭˭˭˭˭

Desired net income before tax

(P90,000 ÷ 60%) P150,000
Add: Fixed costs 792,000
Contribution margin P942,000
Divided by: contribution margin/unit P6
Total number of units 157,000
˭˭˭˭˭˭˭˭˭˭˭˭˭
(4) BEP = P792,000 + [(20% x P792,000) x 10%]
P5.30
= 152,423 units
˭˭˭˭˭˭˭˭˭˭˭˭˭˭˭˭˭˭
 Computation of Contribution Margin/unit:
Selling price per unit P20.00
Variable cost per unit:
Materials, overhead and
marketing (50% x P14) P7.00
Labor (50% x P14 x 110%) 7.70 14.70
Contribution margin per unit P 5.30
˭˭˭˭˭˭˭˭˭

Illustrative Problem 4.4. CVP Analysis for a Multi-Products Firm

Lor, Inc. produces only two products, A and B. these account for 60% and 40% of the total sales
pesos of Lor’s respectively. Variable costs as a percentage of sales pesos are 60% for A and
85% for B. Total fixed costs are P150,000. There are no other costs.

REQUIRED: Compute
1. The weighted contribution margin ratio.
2. The break-even point in sales pesos.
3. The sales pesos necessary to generate a net income of P9,000 if total fixed costs will
increase by 30%.

NOTE: Refer to textbook for the solution.

Illustrative Problem 4.5. CVP Analysis for Multi-Products Firm

The Insular Corporation sells two products, D and W at a rate of 2 units and 3 units respectively.
the following data are available:
D W
Unit Selling Price P10 P5
Unit Variable Costs 6 3
Total Fixed Cost P420,000

REQUIRED: Determine:
1. Weighted contribution margin per unit.
2. Break-even point in units (combined).
3. Weighted contribution margin ratio.
4. Break-even point in sales pesos (combined).

5. Break-even point sales pesos for:

1. Product D
2. Product W

NOTE: Refer to textbook for the solution.

Illustrative Problem 4.6. Preparation of Break-even Graph

The Maling Company had the following income statement when 10,000 units were sold:

MALING COMPANY
 Income Statement
Sales P20,000
Expenses:
Variable expenses P12,000
Fixed expenses 6,000 18,000
Net Income P 2,000
˭˭˭˭˭˭˭˭˭˭˭
REQUIRED:
(a) Prepare a break-even graph for the company.
(b) From the graph, how many units must be sold to break-even?
(c) What is the margin of safety in units?

NOTE: Refer to textbook for the solution.

Illustrative Problem 4.7. Preparation of Profit-Volume Graph

The Solimansing Company had the following revenue and cost data when 2,000 units were
sold:
Selling price per unit P12.00
Variable cost per unit 6.00
Fixed cost per unit 4.50

REQUIRED:
(a) Prepare a profit-volume graph for the company.
(b) Determine the break-even point from the graph.
(c) From the graph, determine how many units must be sold to generate a net income
of P3,000.

NOTE: Refer to textbook for the solution.

SENSITIVITY ANALYSIS OF CVP RESULTS

To examine the sensitivity of profits to changes in sales, either of the measures may be used:
the margin of safety or operating leverage.

Margin of Safety

Margin of safety measures the potential effect of the risk that sales will fall short of planned
levels. This is the excess of actual or budgeted sales over break-even sales and indicates the
amount by which sales could decrease before losses are incurred.

The margin of safety can also be used as a ratio, a percentage of sales:

Margin of safety ratio = Margin of Safety____

Actual or Planned Sales
The margin of safety ratio is useful for comparing the risk of two alternative products, or for
assessing the riskiness in any given product. The product with a relatively low margin of safety
ratio is the riskier of the two products and therefore usually requires more of management’s
attention.

Illustrative Problem 4.9. Margin of Safety

Amflor Manufacturing Company’s budget for the coming year revealed the following unit data:
Budgeted net income for the year P875,000
Unit costs:
Variable Fixed
Manufacturing cost P14.00 P12.00
Selling cost 2.50 5.50
General cost 0.25 __7.00
Total P16.75 P24.50
˭˭˭˭˭˭˭˭˭ ˭˭˭˭˭˭˭˭˭
Unit selling price P 50

REQUIRED:
1. Determine the budgeted sales volume in units.
2. Determine the margin of safety in peso amount and percentage.

NOTE: Refer to textbook for the solution.

Operating Leverage

The potential effect of the risk that sales will fall short of planned levels as influenced by the
relative proportion of fixed to variable manufacturing costs can be measured by operating
leverage. Operating leverage is the ratio of the contribution margin to profit or

Operating Leverage = Contribution Margin______

Profit or Net Operating Income

A higher value of operating leverage indicates a higher risk in the sense that a given change in
sales will have a relatively greater impact on profit. When sales volume is strong, it is desirable
to have a high level of leverage, but when sales begin to fall, a lower level of leverage is
preferable.

Illustrative Problem 4.10. Operating Leverage

These sales and cost data (000s) are for two companies in the transportation industry:

Company A Company B
Percent of Percent of
Amount Sales Amount Sales
Sales P100,000 100% P100,000 100%
Variable costs 60,000 60 30,000 30
Contribution margin 40,000 40% 70,000 70%
Fixed costs 30,000 60,000
Net income P 10,000 P 10,000
˭˭˭˭˭˭˭˭˭˭˭˭ ˭˭˭˭˭˭˭˭˭˭˭

REQUIRED:
1. Calculate the operating leverage for each company. If sales increase, which company
benefits more? How do you know?
2. Assume sales rise 10 percent in the next year. Calculate the percentage increase in profit for
each company. Are the results what you expected?

NOTE: Refer to textbook for the solution.

ASSESSMENT

Course Requirements:
1. Reaction paper, portfolio, etc.
2. Grading System
 Prelim/Midterm/Final Exam 33.3%
  Quizzes 33.3%
 Group or individual paper, presentation, portfolio 33.4%

REFERENCES

1. Cabrera, Elenita Balatbat; et al,

Cost Accounting and Control,
2018-2019 Ed., Manila, Philippines,
GIC Enterprises & Co., Inc.
2. De Leon, Norma D., et al,
Cost Accounting and Control,
2019 Ed., Manila, Philippines,
GIC Enterprises & Co., Inc.