UNIVERSITY OF SAINT LOUIS

Tuguegarao City

SCHOOL OF ACCOUNTANCY, BUSINESS and HOSPITALITY

Short Term
A.Y. 2022-2023

COURSE LEARNING MODULE

MATH 1033 (Mathematical Analysis of Management)
AY 2022-2023

Lesson 5 and 6: Managerial Accounting and Cost Concepts

Topics: The Analysis of Mixed Costs

Traditional and Contribution Format Income Statement
Cost Classifications for Decision Making

Learning Outcomes: At the end of this module, you are expected to:

1. Understand cost classifications used for decision making;

2. Analyze a mixed cost using high-low method;
3. Prepare income statements for a merchandising company using the contribution format.

LEARNING CONTENT

Introduction:

This module explains that in managerial accounting the term cost is used in many different ways. It is the
continuation of the modules last week. It will focus on cost classifications for predicting cost behavior and for
making decisions.

Lesson Proper:

THE ANALYSIS OF MIXED COSTS

Mixed costs are very common. For example, the overall cost of providing X-ray services to patients at
the Harvard Medical School Hospital is a mixed cost. The costs of equipment depreciation and radiologists’ and
technicians’ salaries are fixed, but the costs of X-ray film, power, and supplies are variable. At Southwest Airlines,
maintenance costs are a mixed cost. The company incurs fixed costs for renting maintenance facilities and for
keeping skilled mechanics on the payroll, but the costs of replacement parts, lubricating oils, tires, and so forth,
are variable with respect to how often and how far the company’s aircraft are flown.

The fixed portion of a mixed cost represents the minimum cost of having a service ready and available for use.
The variable portion represents the cost incurred for actual consumption of the service, thus it varies in proportion
to the amount of service actually consumed.

Managers can use a variety of methods to estimate the fixed and variable components of a mixed cost such as
account analysis, the engineering approach, the high-low method, and Ieast-squares regression analysis. In
MATH 1033-Mathematical Analysis of Management | 1
account analysis, an account is classified as either variable or fixed based on the analyst’s prior knowledge of
how the cost in the account behaves. For example, direct materials would be classified as variable and a building
lease cost would be classified as fixed because of the nature of those costs. The engineering approach to cost
analysis involves a detailed analysis of what cost behavior should be, based on an industrial engineer’s
evaluation of the production methods to be used, the materials specifications, labor requirements, equipment
usage, production efficiency, power consumption, and so on.

For purposes of our discussion, we will just focus on the high-low method.

The High-Low Method

The high-low method is based on the rise-over-run formula: for the slope of a straight line. As previously
discussed, if the relation between cost and activity can be represented by a straight line, then the slope of the
straight line is equal to the variable cost per unit of activity.

To analyze mixed costs with the high-low method, begin by identifying the period with the lowest level of activity
and the period with the highest level of activity. The period with the lowest activity is selected as the first point in
the above formula and the period with the highest activity is selected as the second point. Consequently, this
formula can be used:

Variable Cost = Cost of High Level activity – Cost of Low level activity
High activity level – Low activity level

OR

Variable Cost = Change in cost

Change in activity

Therefore, when the high-low method is used, the variable cost is estimated by dividing the difference in cost
between the high and low levels of activity by the change in activity between those two points.

To illustrate, we use the Brentline Hospital example, using the high-low method, we first identify the periods with
the highest and lowest activity-in this case, June and March.

Month Activity level: Patient-Days Maintenance Cost Incurred

January 5,600 $7,900
February 7,100 $8,500
March 5,000 $7,400
April 6,500 $8,200
May 7,300 $9,100
June 8,000 $9,800
July 6,200 $7,800

We then use the activity and cost data from these two periods to estimate the variable cost component as follows:

Month Patient-Days Maintenance Cost Incurred

High activity level (June). . . . 8000 $ 9800
Low activity level (March). . . 5000 7400
Change . . . . . . . . . . . . . . . . 3000 $ 2400

MATH 1033-Mathematical Analysis of Management | 2

 Variable Cost = Change in cost
Change in activity
= $ 2,400
3000 patient-days
= $0.80 per patient-day

Having determined that the variable maintenance cost is 80 cents per patient-day, we can now determine the
amount of fixed cost. This is done by taking the total cost at either the high or the low activity level and deducting
the variable cost element. In the computation below, total cost at the high activity level is used in computing the
fixed cost element:

Fixed cost element = Total cost - Variable cost element

= $9,800 - ($0.80 per patient-day X 8,000 patient-days)

= $3,400

Both the variable and fixed cost elements have now been isolated. The cost of maintenance can be expressed
as $3,400 per month plus 80 cents per patient-day, or as

Y = $3,400 + $0.80X

The data used in this illustration are shown graphically in Exhibit 1-7. Notice that a straight line has been drawn
through the points corresponding to the low and high levels of activity. In essence, that is what the high-low
method does-it draws a straight line through those two points.
Exhibit 1-7 High-Low Method of Cost Analysis

Sometimes the high and low levels of activity don’t coincide with the high and low amounts of cost. For example,
the period that has the highest level of activity may not have the highest amount of cost. Nevertheless, the costs
at the highest and lowest levels of activity are always used to analyze a mixed cost under the high-low method.
The reason is that the analyst would like to use data that reflect the greatest possible variation in activity.

The high-low method is very simple to apply, but it suffers from a major (and sometimes critical) defect-it utilizes
only two data points. Generally, two data points are not enough to produce accurate results. Additionally, the
periods with the highest and lowest activity tend to be unusual. A cost formula that is estimated solely using data
from these unusual periods may misrepresent the true cost behavior during normal periods. Such a distortion is
MATH 1033-Mathematical Analysis of Management | 3
evident in Exhibit 1-7.The straight line should probably be shifted down somewhat so that it is closer to more of
the data points. For these reasons, least-squares regression will generally be more accurate than the high-low
method.

TRADITIONAL AND CONTRIBUTION FORMAT INCOME

STATEMENTS
In this section, we discuss how to prepare traditional and contribution format income statements for a
merchandising company. Merchandising companies do not manufacture the products that they sell to customers.
For example, Lowe’s and Home Depot are merchandising companies because they buy finished products from
manufacturers and then resell them to end consumers.

The Traditional Format Income Statement

Traditional income statements are prepared primarily for external reporting purposes. The left-hand side
of Exhibit 1-9 shows a traditional income statement format for merchandising companies. This type of income
statement organizes costs into two categories cost of goods sold and selling and administrative expenses. Sales
minus cost of goods sold equals the gross margin. The gross margin minus selling and administrative expenses
equals net Operating income.
Exhibit 1-9 Comparing Traditional and Contribution Format Income Statement for Merchandising Companies

Traditional Format Contribution Format

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,000
Cost of Goods Sold . . . . . . . . . . . . . . . . . . 6,000 Variable Expenses:
Gross Margin . . . . . . . . . . . . . . . . . . . . . . . 6,000 Cost of goods sold . . . . . . . $ 6,000
Selling and Administrative Expenses: Variable Selling . . . . . . . . . 600
Selling . . . . . . . . . $3,100 Variable Administrative . . . 400 7,000
Administrative. . . . 1,900 5,000 Contribution Margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Net Operating Income . . . . . . . . . . . . . . . . $ 1,000 Fixed Expenses:
Fixed Selling . . . . . . . . . . . $ 2,500
Fixed Administrative . . . . . 1,500 4,000
Net Operating Income . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000

The cost of goods sold reports the product costs attached to the merchandise sold during the period. The selling
and administrative expenses report all period costs that have been expensed as incurred. The cost of goods
sold for a merchandising company can be computed directly by multiplying the number of units sold by their unit
cost or indirectly using the equation below:

Cost of Goods sold= Beginning

Ending merchandise
merchandise Purchases -
inventory
inventory +

For example, let’s assume that the company depicted in Exhibit 1-9 purchased $3,000 of merchandise inventory
during the period and had beginning and ending merchandise inventory balances of $7,000 and $4,000,
respectively. The equation above could be used to compute the cost of goods sold as follows:

MATH 1033-Mathematical Analysis of Management | 4

 Cost of Goods sold= Beginning Purchases - Ending merchandise
merchandise
inventory
inventory +

= $4000
$7000 + $3000 -

= $6000

Although the traditional income statement is useful for external reporting purposes, it has serious limitations
when used for internal purposes. It does not distinguish between fixed and variable costs. For example, under
the heading “Selling and administrative expenses,” both variable administrative costs ($400) and fixed
administrative costs ($1,500) are lumped together ($1,900). Internally, managers need cost data organized by
cost behavior to aid in planning, controlling, and decision making. The contribution format income statement has
been developed in response to these needs.

The Contribution Format Income Statement

The crucial distinction between fixed and variable costs is at the heart of the contribution approach to
constructing income statements. The unique thing about the contribution approach is that it provides managers
with an income statement that clearly distinguishes between fixed and variable costs and therefore aids planning,
controlling, and decision making. The right-hand side of Exhibit 1-9 shows a contribution format income
statement for merchandising companies.

The contribution approach separates costs into fixed and variable categories, first deducting variable expenses
from sales to obtain the contribution margin. For a merchandising company, cost of goods sold is a variable cost
that gets included in the “Variable expenses” portion of the contribution format income statement. The
contribution margin is the amount remaining from sales revenues after variable expenses have been deducted.
This amount contributes toward covering fixed expenses and then toward profits for the period.

The contribution format income statement is used as an internal planning and decision making tool. Its emphasis
on cost behavior aids cost-volume-profit analysis (such as we shall be doing in a subsequent chapter),
management performance appraisals, and budgeting. Moreover, the contribution approach helps managers
organize data pertinent to numerous decisions such as product-line analysis, pricing, use of scarce resources,
and make or buy analysis. All of these topics are covered in later chapters.

COST CLASSIFICATIONS FOR DECISION MAKING

Costs are an important feature of many business decisions. In making decisions, it is essential to have a
firm grasp of the concepts differential cost, opportunity cost, and sunk cost.

Differential Cost and Revenue

Decisions involve choosing between alternatives. In business decisions, each alternative will have costs
and benefits that must be compared to the costs and benefits of the other available alternatives. A difference in
costs between any two alternatives is known as a differential cost. A difference in revenues (usually just sales)
between any two alternatives is known as differential revenue.

A differential cost is also known as an incremental cost, although technically an incremental cost should refer
only to an increase in cost from one alternative to another; decreases in cost should be referred to as
decremental costs. Differential cost is a broader term, encompassing both cost increases (incremental costs)
and cost decreases (decremental costs) between alternatives.
MATH 1033-Mathematical Analysis of Management | 5
The accountant’s differential cost concept can be compared to the economist’s marginal cost concept. In
speaking of changes in cost and revenue, the economist uses the terms marginal cost and marginal revenue.
The revenue that can be obtained from selling one more unit of product is called marginal revenue, and the cost
involved in producing one more unit of product is called marginal cost. The economist’s marginal concept is
basically the same as the accountant’s differential concept applied to a single unit of output.

Differential costs can be either fixed or variable. To illustrate, assume that Natural Cosmetics, Inc., is thinking
about changing its marketing method from distribution through retailers to distribution by a network of
neighbourhood sales representatives. Present costs and revenues are compared to projected costs and
revenues in the following table:

Retailer Sales Differential Costs

Distribution Representatives and Revenues
(present) (proposed)
Sales (variable) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $700,000 $800,000 $100,000
Cost of goods sold (variable) . . . . . . . . . . . . . . . . . . . . 350,000 400,000 50,000
Advertising (fixed) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 45,000 (35,000)
Commissions (variable) . . . . . . . . . . . . . . . . . . . . . . . . 0 40,000 40,000
Warehouse Depreciation (fixed) . . . . . . . . . . . . . . . . . 50,000 80,000 30,000
Other Expenses (fixed) . . . . . . . . . . . . . . . . . . . . . . . . 60,000 60,000 0
Total Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 540,000 625,000 85,000
Net Operating Income . . . . . . . . . . . . . . . . . . . . . . . . $160,000 $175,000 $ 15,000

According to the above analysis, the differential revenue is $100,000 and the differential costs total $85, 000,
leaving a positive differential net operating income of $15,000 in favor of using sales representatives.

In general, only the differences between alternatives are relevant in decisions. Those items that are the same
under all alternatives and that are not affected by the decision can be ignored. For example, in the Natural
Cosmetics, Inc., example above, the “Other expenses” category, which is $60,000 under both alternatives, can
be ignored because it has no effect on the decision If it were removed from the calculations, the sales
representatives would still be preferred by $15, 000. This is an extremely important principle in management
accounting that we will revisit in later chapters.

Opportunity Cost and Sunk Cost

Opportunity cost is the potential benefit that is given up when one alternative is selected over another.
For example, assume that you have a part-time job while attending college that pays $200 per week. If you
spend one week at the beach during spring break without pay, then the $200 in lost wages would be an
opportunity cost of taking the week off to be at the beach. Opportunity costs are not usually found in accounting
records, but they are costs that must be explicitly considered in every decision a manager makes. Virtually every
alternative involves an opportunity cost.

A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or
in the future. Because sunk costs cannot be changed by any decision, they are not differential costs. And
because only differential costs are relevant in a decision, sunk costs should always be ignored.

To illustrate a sunk cost, assume that a company paid $50, 000 several years ago for a special purpose machine.
The machine was used to make a product that is now obsolete and is no longer being sold. Even though in
hindsight purchasing the machine may have been unwise, the $50,000 cost has already been incurred and
cannot be undone. And it would be folly to continue making the obsolete product in a misguided attempt to
MATH 1033-Mathematical Analysis of Management | 6
“recover” the original cost of the machine. In short, the $50,000 originally paid for the machine is a sunk cost that
should be ignored in current decisions.

*** END of LESSON***

REFERENCES

Textbook

Brewer, P., et.al. (2016). Introduction to managerial accounting. International edition 2016. 7th edition.
McGraw-Hill/Irwin.

MATH 1033-Mathematical Analysis of Management | 7