LESSON 2 COST CONCEPTS, CLASSIFICATION AND BEHAVIOR

In this lesson, the learner will be able to:

• Define and identify the key cost concepts.
• Identify how are costs be classified to its appropriate use and why are such classifications useful.
• Distinguish between manufacturing and non-manufacturing costs.
• Distinguish between product costs and period costs.
• Distinguish between direct and indirect costs.
• Distinguish between controllable and non-controllable costs.
• Understand how cost behavior affects planning and controlling functions of management and distinguish the three major kinds of cost
behavior – variable, fixed and mixed.
• Define the relevant range and explain its significance in cost behavior analysis.
• Formulate cost function and know its purpose.
• Identify costs relevant to decision making.

COST - the monetary amount of the resources given up or sacrificed to attain some objective such as acquiring goods and services.
When notified by a term that defines the purpose, cost becomes operational (e.g., acquisition cost; production cost; cost of goods sold).

COST BEHAVIOR
Cost behavior is the relationship between cost and activity-------- as to how costs react to changes in an activity like production. As
production increases, some costs remain the same (i.e., fixed) while some costs increase or decrease (i.e., variable). Consider the
following (assuming activity is based on production):

COST TOTAL amount PER UNIT amount

1. FIXED Constant Decreases as production increases (
Inverse relationship)
2. VARIABLE Increases as production increases (direct Constant
relationship)
3. MIXED (Semi- variable) Increases less proportionately (vs Total Decreases less proportionately (vs
variable costs) as production increases unit fixed costs) as production
increases

Example:
AAA Company manufactures and sells a Single product. A partially completed schedule of the company's total and per unit costs over a
relevant range of 60 to 100 units produced each year is given below:

Units Produced (Activity or cost driver)

(I) 60 Units (II) 80 Units (III) 100 Units
TOTAL COSTS
(A) Variable Costs P120 ? 160 ? 200
(B) Fixed Costs ? P600 600 ? P600
(C) TOTAL COSTS ? 720 ? 760 ? 800

PER UNIT COSTS

(D) Variable Costs ? P2 P2 ?P2
(E) Fixed Costs ? P10 ? P7.5 ? P6
REQUIRED:
1. Determine the correct amounts of those with (?) mark.
2. Which two (2) specific costs remain constant over the relevant range?
3. Which two (2) specific costs are directly related with production?
4. Which specific cost is inversely related with production?
5. Express the cost formula based on the line equation form 'Y =a + bX.' Y=600 + 2(X)
6. If the company produces 90 units, then how much is the expected total costs? P780

FIXED COST (b/ Y intercept) VARIABLE COST (m/ Slope)

MIXED COST

Where:
[Y] - the total costs (dependent variable)
[b] -the total fixed costs (verticai/y-axis intercept)
[m] - the variable cost per unit (slope of the line)
[x] the activity or cost driver (independent variable)
[mx] the total variable costs

COST BEHAVIOR ASSUMPTIONS and LIMITATIONS

1. RELEVANT RANGE Assumption

Relevant range refers to the range of activity within which the cost behavior patterns are valid. Any level of activity outside this range
(outlier) may show a different cost behavior pattern.

2. TIME Assumption

The cost behavior patterns identified are true only over a specified period of time. Beyond this, the cost may show a different cost
behavior pattern.

3. LINEARITY Assumption

The cost is assumed to manifest a linear relationship over a relevant range despite its tendency to show otherwise over the long run.

COST ESTIMATION: SEGREGATING VARIABLE AND FIXED COSTS

• HIGH-LOW POINTS Method

• SCATTERGRAPH (Scatter Diagram) Method
• LEAST-SQUARES REGRESSION Method
• Other Cost Estimation Methods

1. HIGH-LOW POINTS Method

The fixed and variable portions of the mixed costs are computed from two sampled data points the highest and lowest points based on
activity or cost driver.

Variable cost per unit (b) = Change in Cost% (YH -YL)

Change In Activity (XH - XL)
Example:
The controller of BBB Hospital would like to come up with a cost formula that links Admitting Department cost to the number of patients
admitted during a month. The Admitting Department's costs and the number of patients admitted during the past nine months follow:
MONTH NUMBER OF PATIENTS (Activity) X COST Y
April 18 15,600
May 19 15,200
June 17 13,700
July 15 14,600
August 15 14,300
September 11 13,200
October 11 12,800
November 48 72,500
December 16 14,000

REQUIRED: Using the high-low method, determine:

1.Variable cost per unit P300
2. Annual fixed costs P9,500 x 12 months= P114,000
3. Monthly cost function Y= 9,500 + 300X
4. Department's estimated cost assuming 14 patients will be admitted next month. P13,700

2. SCATTERGRAPH (Scatter Diagram) Method

All observed costs at different activity levels are plotted on a graph.' Based on sound judgment, a regression line is then fitted to the
plotted points to represent the line function.

Example:
The CCC Company provides you the following overhead cost data for eight production runs.

Required: Determine the cost function from the data provided by CCC Company using scatter graph method of mixed cost analysis.

As can be seen the costs

are not plotted from
ZERO the pivot point, but
from an upper point,
which shows that at zero
activity level there exists
a cost of 10,000. This is
the point where
regression line cuts y-axis
and which represents the
total fixed cost of 10,000.
The slop of the
regression line (i.e.,
variable cost per unit) can
be found out as follows:
 Variable cost per unit = (y2 – y1)/(x2 – x1)
= (34,000 – 10,000)/(1,800 – 0)
= 24,000/1,800
= 13.33

The cost function on the basis of data provided by CCC Company is as follows:
y = 10,000 + 13.33x

3. LEAST-SQUARES REGRESSION Method

Least-squares method is a statistical technique that investigates the association between dependent and independent variables. This
method determines the line of best fit for a set of observations by minimizing the sum of the squared deviations between cost line and
the data points.
*If there is only one independent variable, the analysis is known as SIMPLE REGRESSION
*If the analysis involves multiple independent variables, it known as MULTIPLE REGRESSION.

Example: DDD Company's total overhead costs at various levels of activity are presented below:
Month Machine Hours Total Overhead Costs
March 500 970
April 400 851
May 600 1,089
June 700 P 1,208

The breakdown of the overhead costs in April at 400 machine-hour level of activity is as follows:

Supplies (Variable) P 260

Salaries (Fixed) 300
Utilities (Mixed) 291
Total P 851

REQUIRED:
1. How much of June's overhead cost of P 1,208 consisted of utilities cost? 453

April (400 hours) June (700 hours)

Supplies (Variable) 260 455 (260/400x700)
Salaries (Fixed) 300 300 fixed
Utilities (Mixed) 291 453 1208-455-300
Total Costs 851 1,208

2. Using high-low method, determine the cost function for utilities cost.
291= X + (.54 ) (400)
vc= 453-291 = 0.54 X= 291- (.54x400)
700-400 X=75
y= 75 + 0.54x

3. Using high-low method, determine the cost function for total overhead

y= (300 + 75 ) + (.65 + 0.54) x

y= 375 + 1.19x

4. Using least-squares method, determine the cost function for total overhead cost

Month Hours (X) Total Costs (Y) XY X2

March 500 970 485,000 250,000
April 400 851 340,400 160,000
May 600 1,089 653,400 360,000
June 700 1,208 845,600 490,000
Ex=2,200 Ey=4,118 Exy= 2,324,400 Ex2= 1,260,000

B= (4 x 2324400) – (2200 x 4118) A= 4118- (1.19 x 2200)

(4 x1260000) – (2200 x2200) 4

B= 238,000 A= 1,500
200,000 4

B= 1.19 (VC/unit) A= 375 (total fixed cost)

y= 375 + 1.19x

5. What would be the total overhead costs if operating level is at 200. Not applicable because 200 is outside the relevant range.

Other Cost Estimation Methods:

Industrial Engineering Method - based on the relationship between inputs and outputs in physical forms; engineering estimates indicate
what and how much costs should be.
Account Analysis Method -each account is classified as either fixed or variable based on experience and judgment of accounting and
other qualified personnel in the organization.

Conference Method - costs are classified based on opinions from various company departments such as purchasing, process
engineering, rnanufacturing, emoloyee relations and so on.

CORRELATION ANALYSIS

Correlation- The closeness of the linear relationship between the cost and the activity

CORRELATION ANALYSIS is used to measure the strength of linear relationship between two or more variables.

The correlation between two variables can be seen by drawing a scatter diagram:
*If the points seem to torm a straight line, there is a high correlation.
*If the points form a random pattern. there is a low correlation or no correlation at all.

COEFFICIENT OF CORRELATION (r) measures the relative strength of linear relationship between two (2) variables. Its value ranges
from -1.0 to + 1:

‘r” Linear relationship Scatter Diagram

-1.0 Inverse Downward sloping line
0 None No apparent pattern (ramdom points)
+1.0 Direct Upward sloping line

Looking at the following scatter diagrams, we can conclude that:

 Which of these correlation coeffiicients represents strongest relationship between two variables?
a. +0.50
b. -0.80
c. -0.05
d. +1.05 XXXXX

COEFFICIENT OF DETERMINATION (r2 or r squared) is the proportion of the total variation in Y that is accounted for by the regression
equation, regardless of whether the relationship between X and Y is direct or inverse. It is a measure of “goodness of fit'” in the
regression. The higher the r2, the more confidence one can have in the estimated cost formula.

Step 1: Find the correlation coefficient, r (it may be given to you in the question).

Example, r = 0.543. r=1.0

Step 2: Square the correlation coefficient.

0.5432 = .295 r= 1 x 100= 100%

Step 3: Convert the correlation coefficient to a percentage.

.295 = 29.5%
ACTIVITY

1. With x axis representing the number of entity’s output of units produced and the y axis representing costs of production, the following
coordinate points were observed:
• A (0, 0)
• B (1, 5,000)
• C (100, 5,000)
• D (101, 7,500)
• E (200, 7,500)
• F (201, 10,000)
• G (300, 10,000)

What cost behavior does these aforementioned coordinates show? (C)

(A) Variable Costs
(B) Mixed Costs
(C) Step Costs
(D) Fixed Costs

2. The following cost equations were the results of the analyses of the entity’s maintenance costs of segment i on year t at x machine
hours, which are originally mixed costs that needed splitting as to their variable and fixed components:
2020 y i,t = 23,000 + 0.87x i,t
2021 y i,t = 23,000 + 0.87x i,t
2022 y i,t = 27,000 + 0.64x i,t
2023 y i,t = 30,000 + 0.64x i,t

What can we infer from the equations above? C

(A) Total variable maintenance cost for 2023 is higher than that of 2021 assuming a same level of x.
(B) Total fixed maintenance cost for 2022 is lower than that of 2021 at any level of production.
(C) Total variable maintenance cost for 2023 is lower than that of 2020 assuming a same level of x.
(D) Total fixed maintenance cost for 2020 is higher than that of 2022 at any level of production.

3. The cost behavior method that may use in-house time and motion studies to determine the activities and amounts for cost behavior
analysis. B

(A) Account analysis method

(B) Industrial engineering method
(C) Regression analysis
(D) High-low method

4. In the fast-paced world of business, the management team at TechTrek Inc. faces a daunting challenge. As the company strives for
growth and profitability, understanding cost behaviors becomes paramount. With fierce competition and constant market fluctuations,
mastering cost analysis is the key to steering the company toward success. The team knows that a deep understanding of cost
behaviors will be essential in making strategic decisions that will drive TechTrek forward. The following detailed production report was
provided to you as follows:
Which of the following interpretations corresponds with the conventions of cost behavior? D
(A) Columns A, B, E, and F all represent variable costs.
(B) Columns A, B, C, and D are production costs while columns E, F, and G are administrative costs.
(C) Should column C represent fixed production costs such as factory rent, then column F represents variable production cost per unit
and column G represents the total production costs at all levels of production.
(D) If column D is possibly mixed costs, say maintenance, then the detailed splitting is seen in columns E and F – variable components
and fixed components, respectively.

5. These are benefits forgone in choosing one alternative over another alternative. D
(A) Production Cost
(B) Sunk Cost
(C) Relevant Cost
(D) Opportunity Cost

Problem Solving:
AAA Company is preparing a flexible budget for next year and requires a breakdown of the factory maintenance cost into the fixed and
variable elements. The maintenance cost and machine hours (the selected cost driver) for the past 6 months are as follows:

1. If AAA Company uses the high low method of analysis, the estimated variable rate of maintenance cost per machine hour is
_________________ 5.33

2. Using the information provided above , the average annual fixed maintenance cost amounts to ____________ 49,920