MAS-02 Cost terms, concepts and behavior

Cost
Cost is the monetary amount of the resources given up to attain some objective such as acquiring goods and services. When
notified by a term that defines the purpose, cost becomes operational.

Cost Terms
It is important that we familiarize ourselves with the different cost terminologies that we will be using in analyzing the
behaviour of costs.

1. Out-of-pocket costs – involve an actual outlay of cash.

2. Marginal costs – the sum of costs necessary to affect a one-unit increase in the activity level.
3. Opportunity cost – the foregone benefit or lost opportunity of the path not taken. Anytime you choose not to do one
thing instead of another because of a limit on your time or money, you incur an opportunity cost.
4. Direct vs. Indirect costs
a. Direct costs – costs that can be easily and conveniently traced to a unit of product or other cost object.
b. Indirect costs – costs that cannot be easily and conveniently traced to a unit of product or other cost object.
5. Variable vs. Fixed costs
a. Variable costs – the costs that change, in total, in direct proportion to changes in activity level.
i. Total Variable Costs (TVC) increases as Production increases
ii. Unit Variable Cost is constant regardless of Production
b. Fixed costs – the costs that do not change in total regardless of the activity level, at least within some
reasonable range of activity.
i. Total Fixed Costs (TFC) remains constant as Production increases
ii. Unit Fixed cost decreases as Production increases

Note: There is also a combination of both called Mixed Costs. It contains a fixed portion that is incurred
even when the facility is unused, and a variable portion that increases with usage
i. Total Mixed Costs increases less proportionately, as opposed to total variable costs, as
production increases.
ii. Unit Mixed Cost decreases less proportionately, as opposed to fixed cost per unit, as production
increases.

6. Manufacturing vs. Nonmanufacturing costs

a. Manufacturing costs – include all costs incurred to produce the physical product.
i. Direct Materials – major material inputs that can be physically and conveniently traced directly to the
final product.
ii. Direct Labor – the cost of labor that can be physically and conveniently traced to the final product.
iii. Manufacturing Overhead – includes all costs other than direct materials and direct labor that must be
incurred to manufacture a product.
b. Nonmanufacturing costs – all other costs incurred not related to the production of the physical product.
i. Marketing or selling costs – costs necessary to get the order and deliver the product.
ii. General and administrative costs – All executive, organizational and clerical costs.

7. Relevant vs. Irrelevant costs

a. Relevant cost – has the potential to influence a decision. The requisites are:
i. It must differ between the decision alternatives. Costs that differ between the alternatives are called
differential costs
ii. It must be incurred in the future rather than the past. Cost incurred in the past are called sunk costs.
b. Irrelevant cost – costs that will not influence a decision.

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MAS-02 Cost terms, concepts and behavior
Cost Behavior
Costs are usually classified according to their reaction to changes in activity like production. This classification of costs is
proven to be useful and relevant in management decision-making. Relate to variable and fixed costs.
Cost Behavior Assumptions

1. Relevant Range Assumption

 This refers to the range of activity within which the cost behaviour patterns are valid.
2. Time Assumption
 The cost behaviour patterns identified are true only over a specified period of time.
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 (Segregation of mixed costs into fixed and variable costs)
The main point in cost estimation is the segregation of mixed costs into fixed and variable in order to determine the cost
behaviour for each product in relation to total cost. Take note of the slope formula to be used in linear approaches to analyze
mixed costs:
Y = a + bX
Where: Y = Total cost
a = Total fixed cost
b = Variable cost per unit
X = Number of activity / units

1. High-Low Method
The fixed and variable elements of the mixed costs are computed from two sampled data points which are the highest
and lowest points as to activity level or cost driver. The difference in cost divided by the difference in activity is the
variable rate. Once the variable rate is found, the fixed portion is determinable.

Difference in cost
Variable cost per activity (b) =
Difference in activity
It is a simple approach that uses the two most extreme data points to determine the slope of the line (variable cost per
unit) and the intercept (total fixed cost).

Exercise 1. High-Low Method. ABC Condotel would like to come up with a cost formula that links admitting department
costs to the number of guests admitted during a month. The admitting department’s cost and the number of guests admitted
during the past nine months follow:

Month # of guests admitted Admitting

Department’s Cost
January 36 Php37,440
February 38 36,480
March 34 32,880
April 30 35,040
May 30 34,320
June 22 31,680
July 20 30,720
August 25 34,000
September 32 33,600

Required: Determine the following:

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MAS-02 Cost terms, concepts and behavior
 1. Variable cost per activity.
2. Fixed cost.
3. Monthly cost function.
4. Estimated cost if the number of guests admitted for October is 42 guests

2. Scattergraph (Scatter Diagram) Method

All observed costs at various 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. It provides a visual representation of the relationship between
total cost (y) and activity level (x). It is a useful step in analyzing cost behaviour because it helps determine the nature
of the relationship and whether the linearity assumption is valid.

3. Least-Squares Regression Method

This 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 squares of the vertical
deviations between actual points and the regression line.

The following formulas to calculate unit variable cost (b) and total fixed cost (a) are:

nΣxy - Σx * Σy Σy - bΣx
Unit variable cost (b) = Total fixed cost (a) =
nΣx2 - (Σx)2 n

𝑤ℎ𝑒𝑟𝑒:n is the number of pairs of activities and total costs used in the calculation
∑y is the sum of total costs of all data pairs
∑x is the sum of the activities of all data pairs
∑xy is the sum of the products and activities of all data pairs
∑x2 is the sum of squares of activities of all data pairs

Exercise 2. High-Low Method and Least Squares Regression. ABC Company’s total overhead costs at various levels of
activity are presented below:

Month Machine Hours Total Overhead Costs

January 1,400 Php2,910
February 1,120 2,550
March 1,680 3,120
April 1,960 3,264

To determine the proper cost function, the breakdown for the February costs are provided as well. This breakdown is
common to every month of operations.
Supplies Php784
Salaries 900
Utilities 866
Total Php2,550

According to the cost accountant, the supplies expense is variable, the salaries are fixed and the utilities are mixed.

Required:
1. Determine the utilities cost for the month of April.
2. Using the high-low method, determine the cost function for utilities cost.
3. Using the high-low method, determine the cost function for total overhead cost.
4. Using least-squares method, determine the cost function for total overhead cost.

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MAS-02 Cost terms, concepts and behavior
 5. What would be the total overhead cost if the machine hours for the month of May totalled 1,500 hours using
a. High-low method.
b. Least-squares regression method.

Correlation Analysis
1. 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:
a. If the points seem to form a straight line, there is a high correlation
b. If the points for a random pattern, there is a low correlation or no correlation at all

2. Coefficient of Correlation (r) measures the relative strength of linear relationship between 2 variables. The range of
the coefficient is from -1 to 1
a. If r = -1, there is a perfect inverse relationship between the activity and the cost
b. If r = 0, there is no linear relationship
c. If r = 1, there is a perfect direct relationship between activity and the cost

3. Coefficient of Determination (r2)

It is the proportion of the total variation in Y that is explained or accounted for by the regression equation, regardless
of whether the relationship between activity and cost is direct or inverse. It is a measure of ‘goodness of fit’ in the
regression. The higher the coefficient of determination, the more confidence one can have in the estimated cost formula.

Exercise 3. Correlation analysis. ABC Company uses the regression analysis to develop a model for predicting
overhead costs. Two different cost drivers, machine hours and number of direct materials needed, are under
consideration as the independent variable. Relevant data are presented below:

Machine hours Coefficient Direct materials weight Coefficient

Y – intercept 2,500 Y – intercept 4,600
b 4.00 b 3.50
r2 0.70 r2 0.55

What regression equation should the company use that would give more accurate information?
A. Y = 4,600 + 4.00X
B. Y = 2,500 + 4.00X
C. Y = 4,600 + 3.50X
D. Y = 2,500 + 3.50X

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MAS-02 Cost terms, concepts and behavior