Cost Concepts, Terms,

and Classifications

PROFESSOR: JOHN ANTHONY M. LABAY, CPA, MBA

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I. DISCUSSION

Cost accounting is an expanded phase of the general or financial accounting of a business

concern which provides management promptly with the cost of producing or selling each article
or of rendering a particular service". In other words, cost accounting is a step further to and a
refinement of financial accounting in which cost of manufacturing and selling each product or
job or rendering service is determined, not at the time of accounting period but at the time when
the product is manufactured, or any service is rendered. In simple words, costing is a systematic
procedure for determining the unit cost of output produced or services rendered. It provides for
an analysis of the expenditure which enables the management to know not only the total cost
but also its constituents.

In short, cost accounting is the process of accounting for cost, which begins with regarding and
classifying of incomes and expenditures and ends with the preparation of periodical statements
and reports for ascertaining and controlling costs.

As predicted today, cost accounting may be defined as the process of measuring, analyzing,
computing, and reporting the cost, profitability, and performance of operations.

Cost management is the process of planning and controlling the t of a business. Cost
management is a form of management accounting that allows a business to predict impending
expenditures to help reduce the chance of going over budget. It includes activities such as
planning, estimating, budgeting, financing, funding, managing, and controlling costs so that
the project can be completed within the approved budget.

Cost management is a method of reducing operating or production expenses in order to provide

less expensive products or services to consumers. In other words, it’s the process management
uses to analyze its production and streamline its operations to keep costs low and manage
expenses in the future. Cost management is a continuous process that takes place during the
project to determine and control the resources needed to perform activities or create assets:

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Resource Planning
In the initial phase of a project, the required resources to complete the project activities need
to be defined. Historical information of comparable projects can be used to define which
physical resources are needed. Just think of the required time, material, labor, equipment, etc.
Once the resource types and quantities are known the associated costs can be determined.

Cost Estimating
Several Cost Estimating methods can be applied to predict how much it will cost to perform
the project activities. The actual cost of previous, similar projects can serve as a basis for
estimating the current project. Estimates can be refined when more information becomes
available during the course of a project. Eventually, this results in a detailed unit cost estimate
with a range of accuracy.

Cost Budgeting
The cost estimate together with a project schedule forms the input for cost budgeting. The
budget gives an overview of the periodic and total costs of the project. The cost estimate defines
the cost of each work package or activity, whereas the budget allocates the costs over the time
period when the cost will be incurred. A cost baseline is an approved time-phased budget that
is used as a starting point to measure actual performance progress.

Cost Control
Cost Control is concerned with measuring variances from the cost baseline and taking effective
corrective action to achieve minimum cost overruns. Procedures are applied to monitor
expenditures and performance against the progress of a project. All changes to the cost baseline
need to be recorded and the expected final total costs are continuously forecasted.

When actual cost information becomes available, an important part of cost control is to explain
what is causing the variance from the cost baseline. Based on this analysis, corrective action
might be required to avoid cost overruns. Tight cost control gives a company considerable
influence over its cash flows and reported profits. As a cost controller, you have to actively
expedite the scope of work and analyze its progress.

Thus, while cost control seems to ‘limit’ itself to controlling the project during execution, the
effectiveness of it is determined by how well cost management processes are implemented and
connected. If our people work on each step of cost management separately, without alignment
and sharing of information, you might be ‘controlling’ your project, but you are not doing cost
management.

Starting a project with cost management in mind will help you avoid certain pitfalls that may
occur otherwise. If expectations of the project are not clearly defined at first or are changed
during the course of the project, cost overruns will be more likely. If costs are not fully
researched before the project, they may be underestimated, which might give false indications
about the project’s success.

A peso gained in revenue is a very good thing, but remember only a small portion, in the end,
reaches the earnings. A peso saved from cost, however, goes directly to the bottom line.
Focusing on understanding and managing costs is a path to ensuring long-term value creation.

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Purpose of Cost Accounting

1. Identifying and measuring financial and other information related to the acquisition or
consumption of an organization’s resources
2. Providing users of economic information (managers) useful reports and access to needed
information
COST TERMS, CONCEPTS, AND CLASSIFICATIONS

The work of manager focuses on (1) planning, which includes setting objectives and outlining
how to attain these objectives and (2) control, which includes the steps to take to ensure that
objectives are realized. To carry out these planning and control responsibilities, managers need
information about the organization. From an accounting point of view, this information often
relates to the costs of organization.

The term cost is used in many different ways in managerial accounting. The reason is that there
are many types of costs, and these costs are classified differently according to the immediate
need of management. For example, managers may want cost data to prepare external financial
reports, to prepare planning budgets, or to make decisions. Each different use of cost data
demands a different classification and definition of cost. For example, the preparation of
external financial reports requires historical cost data, whereas decision making may require
predictions about future costs.

Generally speaking, by cost, we mean total amount of money or other resources foregone or
sacrificed to produce something or to achieve some objective. Word expense is also used to
denote almost the same meaning. The difference between these two is that when benefit of
resources given up can be realized in future, we refer to them as cost. But where resources
given up have no future potential benefit, we call them as expense. “A cost is an unexpired
expense, and an expense is an expired cost” is a simple and common way to distinguish
between these two.

Cost
An amount that has to be paid or given up in order to get something. In business, cost is usually
a monetary valuation of (1) effort, (2) material, (3) resources, (4) time and utilities consumed,
(5) risks incurred, and (6) opportunity forgone in production and delivery of a good or service.
All expenses are costs, but not all costs (such as those incurred in acquisition of an income-
generating asset) are expenses.

Cost Object
A cost object is anything for which cost data are desired. Examples of possible cost objects are
products, product lines, customers, jobs, and organizational subunits such as departments or
divisions of a company.

Cost Assignment
Cost assignment is a designation of cost object to aid in decision making.

Cost Behavior
Cost behavior is the way in which a cost reacts or responds to changes in the level of business
activity.

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Cost Driver
Cost driver is a factor, such as machine-hours, beds occupied, computer time, or flight-hours,
which causes overhead costs.

Relevant Range
The range of activity within which assumptions about variable and fixed cost behavior are
valid.

Cost Classifications for Financial Reporting

Manufacturing and Non-manufacturing

Manufacturing firms are involved in acquiring raw materials producing finished goods and
then administrative, marketing and selling activities. All these activities require costs to be
incurred. These costs are normally classified by manufacturing companies as manufacturing
and non-manufacturing costs.

Manufacturing Costs
Manufacturing costs are those costs that are directly involved in manufacturing of products
and services. Examples of manufacturing costs include raw materials costs and salary of labor
workers. Manufacturing cost is divided into three broad categories by most companies.
1. Direct materials cost
2. Direct labor cost
3. Manufacturing overhead cost.

Direct Materials Cost

The materials that go into final product are called raw materials. This term is somewhat
misleading since it seems to imply unprocessed natural resources like wood pulp or iron ore.
Actually, raw materials refer to any materials that are used in the final product; and the finished
product of one company can become raw material of another company. For example, plastic
produced by manufacturers of plastic is a finished product for them but is a raw material for
Compaq Computers for its personal computers. Direct Materials are those materials that
become an integral part of the finished product and that can be physically and conveniently
traced to it.

Direct Labor Cost

The term direct labor is reserved for those labor costs that can be essentially traced to individual
units of products. Direct labor is sometime called touch labor, since direct labor workers
typically touch the product while it is being made. The labor cost of assembly line workers, for
example, is a direct labor cost, as would the labor cost of carpenter, bricklayer and machine
operator. Direct Materials cost combined with direct labor cost is called prime cost.
In equation form:
Prime Cost = Direct Materials Cost + Direct Labor Cost

Manufacturing Overhead Cost

Manufacturing overhead, the third element of manufacturing cost, includes all costs of
manufacturing except direct material and direct labor. Examples of manufacturing overhead
include items such as indirect material, indirect labor, maintenance and repairs on production

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equipment and heat and light, property taxes, depreciation, and insurance on manufacturing
facilities. Indirect materials are minor items such as solder and glue in manufacturing
industries. These are not included in direct materials costs. Indirect labor is a labor cost that
cannot be trace to the creation of products or that can be traced only at great cost and
inconvenience. Indirect labor includes the labor cost of janitors, supervisors, materials
handlers, and night security guards. Costs incurred for heat and light, property taxes, insurance,
depreciation and so forth associated with selling and administrative functions are not included
in manufacturing overhead. Studies have found that manufacturing overhead averages about
16% of sales revenue. Manufacturing overhead is known by various names, such as indirect
manufacturing cost, factory overhead, and factory burden. All of these terms are synonymous
with manufacturing overhead. Manufacturing overhead cost combined with direct labor is
called conversion cost.
In equation form:
Conversion Cost = Direct Labor Cost + Manufacturing Overhead Cost

Non-manufacturing Costs
Non-manufacturing costs are those costs that are not incurred to manufacture a product.
Examples of such costs are salary of salesperson and advertising expenses. Generally non-
manufacturing costs are further classified into two categories.
1. Marketing and Selling Costs
2. Administrative Costs

Marketing or Selling Costs

Marketing or selling costs include all costs necessary to secure customer orders and get the
finished product into the hands of the customers. These costs are often called order getting or
order filling costs. Examples of marketing or selling costs include advertising costs, shipping
costs, sales commission, and sales salary.

Administrative Costs
Administrative costs include all executive, organizational, and clerical costs associated with
general management of an organization rather than with manufacturing, marketing, or selling.
Examples of administrative costs include executive compensation, general accounting,
secretarial, public relations, and similar costs involved in the overall, general administration of
the organization as a whole.

Product Cost Versus Period Cost

In addition to the distinction between manufacturing and non-manufacturing costs, there are
other ways to look at costs. Costs can also be classified as either product cost or period cost.
To understand the difference between product costs and period costs, we must first refresh our
understanding of the matching principle from financial accounting. The matching principle is
based on the accrual concept and states that costs incurred to generate particular revenue should
be recognized as expense in the same period that the revenue is recognized. This means that if
a cost is incurred to acquire or make something that will eventually be sold, then the cost should
be recognized as an expense only when the sale takes place-that is, when the benefit occurs.
Such costs are called product costs.

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Product Costs
For financial accounting purposes, product costs include all the costs that are involved in
acquiring or making product. In the case of manufactured goods, these costs consist of direct
materials, direct labor, and manufacturing overhead. Product costs are viewed as "attaching"
to units of product as the goods are purchased or manufactured and they remain attached as the
goods go into inventory awaiting sale. So initially, product costs are assigned to an inventory
account on the balance sheet. When the goods are sold, the costs are released from inventory
as expense (typically called Cost of Goods Sold) and matched against sales revenue. Since
product costs are initially assigned to inventories, they are also known as inventoriable costs.
The purpose is to emphasize that product costs are not necessarily treated as expense in the
period in which they are incurred. Rather, as explained above, they are treated as expenses in
the period in which the related products are sold. 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 all the costs that are not included in product costs. These costs are expensed
on the income statement in the period in which they are incurred, using the usual rules of
accrual accounting that we learn in financial accounting. Period costs are not included as part
of the cost of either purchased or manufactured goods. Sales commissions and office rent are
good examples of period costs. Both items are expensed on the income statement in the period
in which they are incurred. Thus, they are said to be period costs. Other examples of period
costs are selling and administrative expenses.

Cost Classifications for Predicting Cost Behavior (Variable and Fixed Cost)

Cost behavior refers to how a cost will react or respond to changes in the level of business
activity. As the level of activity rises and falls, a particular cost may rise and fall as well--or it
may remain constant. Quite frequently, it is necessary to predict how a certain cost will behave
in response to a change in activity. For planning purposes, a manager must be able to anticipate
which of these will happen; and if a cost can be expected to change, the manager must know
by how much it will change. To help make such distinctions, costs are often characterized as
variable or fixed.

Variable Cost
A variable cost is a cost that varies, in total, in direct proportion to changes in the level of
activity. The activity can be expressed in many ways, such as units produced, units sold, miles
driven, beds occupied, hours worked and so forth. Direct material is a good example of variable
cost.

The cost of direct materials will vary in direct proportions to the number of units produced.
When we speak the term, variable cost we mean that the total cost raises and falls as the activity
rises and falls. One interesting aspect of variable cost is that a variable cost is constant if
expressed on a per unit basis. For a cost to be variable, it must be variable with respect to
something. That something is its activity base. An activity base is a measure of whatever causes
the incurrence of variable cost. An activity base is sometimes referred to as cost driver. Some
of the most common activity bases are direct labor hours, machine hours, units produced, and
units sold. 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
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number of calls handed by technical support staff at a software company, and the number of
beds occupied in a hospital. To plan and control variable costs, a manger must be well
acquainted with the various activity bases within the firm.

Fixed Cost
A fixed cost is a cost that remains constant, in total, regardless of changes in the level of
activity. Unlike variable costs, fixed costs are not affected by changes in activity.
Consequently, as the activity level rises and falls, the fixed costs remain constant in total
amount unless influenced by some outside forces, such as price changes. Rent is a good
example of fixed cost. Fixed cost can create confusion if they are expressed on per unit basis.
This is because average fixed cost per unit increases and decreases inversely with changes in
activity. Examples of fixed cost include straight line depreciation, insurance property taxes,
rent, supervisory salary etc.

Mixed Cost or Semi-variable Cost

A mixed cost is one that contains both variable and fixed cost elements. Mixed cost is also
known as semi variable cost. Examples of mixed costs include electricity and telephone bills.
A portion of these expenses are usually consisting line rent. Line rent normally is fixed for each
month. Variable portion consists of units consumed or calls made. The relationship between
mixed cost and level of activity can be expressed by the following equation or formula:
Y = a + bX

In this equation,
Y = The total mixed cost
a = The total fixed cost
b = The variable cost per unit
X = The level of activity

The equation makes it very easy to calculate what the total mixed cost would be for any level
of activity within the relevant range. A characteristic of mixed cost that needs to be understood
is that we usually have to separate fixed and variable components of the total mixed cost.

Cost Classifications for Assigning Costs to Cost Objects (Direct and Indirect Cost)

Costs are assigned to objects for a variety of purposes including pricing, profitability studies,
and control of spending. A cost object is anything for which cost data are desired including
products, product lines, customers, jobs, and organizational subunits. For the purpose of
assigning costs to cost objects, costs are classified as direct cost and indirect cost.

Direct Cost
A direct cost is a cost that can be easily and conveniently traced to the particular cost object
under consideration. A cost object is anything for which cost data is required including
products, customers’ jobs, and organizational subunits.

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Indirect Cost
An indirect cost is a cost that cannot be easily and conveniently traced to the particular cost
object under consideration. To be traced to a cost object such as a particular product, the cost
must be caused by the cost object.

A common cost is a cost that is incurred to support a number of costing objects but cannot be
traced to them individually. A common cost is a particular type of indirect cost.

Cost Classification for Decision Making (Decision Making Costs):

Costs can be classified for decision making. Costs are important feature of many business
decisions. For the purpose of decision making, costs are usually classified as differential cost,
opportunity cost, and sunk cost. It is essential to have a firm grasp of the concepts differential
cost & differential revenue, opportunity cost, and sunk cost.

Differential Cost and Differential Revenue

Decisions involve choosing between alternatives. In business, each alternative will have certain
costs and benefits that must be compared to the costs and benefits of the other available
alternatives. A difference in cost between any two alternatives is known as differential cost. A
difference in revenue between any two alternatives is known as differential revenues.
Differential cost includes both cost increase (incremental cost) and cost decrease (decremental
cost). In general, the difference (cost and revenue) between alternatives are relevant in decision
making. Those items that are the same under all alternatives can be ignored.

Opportunity Cost
Opportunity cost is the potential benefit that is given up when one alternative is selected over
another.

Sunk Cost
A sunk cost is a cost that has already been incurred and that cannot be changed by any decision
made now or in future.

Summary of Cost Classifications:

for Financial Reporting

Manufacturing Costs
1. Direct materials cost
2. Direct labor cost
3. Manufacturing overhead cost.

Non-manufacturing Costs
1. Marketing and Selling Costs
2. Administrative Costs

for Predicting Cost Behavior

Variable Cost
Fixed Cost
Mixed Cost

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for Assigning Costs to Cost Objects

Direct Cost
Indirect Cost

for Decision Making

Differential Cost
Opportunity Cost
Sunk Cost

COST OF GOODS MANUFACTURED AND SOLD

Merchandising and Manufacturing Company

Merchandising and manufacturing firms, both prepare financial statement reports for creditors,
stockholders, and others to show the financial condition of the firm and the firm's earnings
performance over some specified intervals. Merchandising companies simply purchase goods
and resale them to customers. Financial statement reports are therefore simple in case of
merchandising companies. The financial statements prepared by manufacturing companies are
more complex than the statements prepared by a merchandising company. Manufacturing
companies are more complex organizations than merchandising companies because the
manufacturing companies 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, and somehow
these costs must be accounted for on the manufacturing company's financial statements.

The balance sheet or statement of financial position of a manufacturing company is similar

to that of a merchandising company. However, the inventory accounts differ between two types
of companies. A merchandising company has only one type of inventory-goods purchased from
suppliers that are awaiting resale to customers. In contrast manufacturing companies have three
classes of inventories – raw materials, work-in-process, and finished goods.

Inventory Accounts:
Merchandising Company
• Merchandise Inventory
Manufacturing Company
• Raw Materials Inventory
• Work-in-Process Inventory
• Finished Goods Inventory

The income statements of merchandising and manufacturing firms are very similar. The only
apparent difference is in the labels of some of the entries in the computation of cost of goods
sold.

Basic Equation for Inventory Accounts

Beginning balance + Additions to inventory = Ending balance
+ withdrawals from inventory

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At the beginning of the period, the inventory contains some beginning balances. During the
period, additions are made to the inventory through purchases or other means. The sum of the
beginning balance and additions to the account is the total amount of inventory available.
During the period, withdrawals are made from inventory. Whatever is left at the end of the
period after these withdrawals is the ending balance.

Schedule of Cost of Goods Manufactured

At first glance the schedule of cost of goods manufactured (below comparative income
statements) appears complex and perhaps even intimating. However, it is all quite logical. The
schedule of cost of goods manufactured contains the three elements of cost – direct materials,
direct labor, and manufacturing overhead. The direct material cost is not simply the cost of
materials purchased during the period rather is the cost of materials used during the period. The
purchase of raw materials is added to the beginning balance to determine the cost of the
materials available for use. The ending materials inventory is deducted from this amount to
arrive at the amount of materials used during the period. This is further explained by the
following equation:

Materials available for use = Beginning balance of materials + materials purchased during the
period

The sum of three cost elements (materials, labor and overhead) is the total manufacturing cost.
See the following equation:
Manufacturing cost = Direct materials + Direct labor + Manufacturing overhead

This manufacturing cost is not equal to the cost of goods manufactured. Some of the materials,
direct labor and manufacturing overhead costs incurred during the period relate to goods that
are not yet completed. The cost of goods manufactured consists of the manufacturing costs
associated with the goods that were finished during the period. Consequently, adjustments need
to be made to the total manufacturing cost of the period for the partially completed goods that
were in process at the beginning and at the end of the period. Beginning work in process
inventory must be added to the total manufacturing cost and ending work in process inventory
must be deducted to arrive at the cost of goods manufactured.

This is further explained by the following equation:

Cost of goods manufactured = Manufacturing cost + Beginning balance of work in process
inventory − Ending balance of work in process inventory

Cost of Goods Sold in a Merchandising Company

Beginning merchandising inventory + Purchases = Ending merchandising inventory + Cost of
goods sold
OR
Cost of goods sold = Beginning merchandising inventory + Purchases − Ending
merchandising inventory

To determine the cost of goods sold in a merchandising company, we only need to know the
beginning and ending merchandising inventory account and the purchases. Total purchases

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can be easily determined in a merchandising company by simply adding together all purchases
from suppliers.

Cost of Goods Sold Equation in a Manufacturing Company

Beginning finished goods inventory + Cost of goods manufactured = Ending finished goods
inventory + Cost of goods sold
OR
Cost of goods sold = Beginning finished goods inventory + Cost of goods manufactured −
Ending finished goods inventory

To determine the cost of goods sold in a manufacturing company, we need to know the cost of
goods manufactured and the beginning and ending balances of finished goods inventory
account. The cost of goods manufactured consists of the manufacturing costs associated with
goods that were finished during the period. The cost of goods manufactured figure is derived
from the schedule of cost of goods manufactured below the comparative income statements.

Computation of Cost of Goods Sold:

Merchandising Company
Merchandise Inventory, beg. xx
Purchases xx
Cost of Goods Available for Sale xx
Merchandise Inventory, end. (xx)
Cost of Goods Sold xx
Manufacturing Company
Cost of Goods Manufactured xx
Finished Goods, beginning xx
Cost of Goods Available for Sale xx
Finished Goods, ending (xx)
Cost of Goods Sold xx

Complete Cost of Goods Sold Statement for Manufacturing Company:

Raw Materials, beginning xx
Purchases xx
Raw Materials Available for Use xx
Raw Materials, ending (xx)
Indirect Materials (xx)
Direct Materials Used xx
Direct Labor xx
Manufacturing Overhead xx
Total Manufacturing Cost xx
Work in Process, beginning xx
Cost of Goods Put into Process xx
Work in Process, ending (xx)
Cost of Goods Manufactured xx
Finished Goods, beginning xx
Cost of Goods Available for Sale xx
Finished Goods, ending (xx)
Cost of Goods Sold xx

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COST BEHAVIOR ANALYSIS

Cost behavior refers to how a cost will react or respond to changes in the level of business
activity. As the level of activity rises and falls, a particular cost may rise and fall as well--or it
may remain constant. Quite frequently, it is necessary to predict how a certain cost will behave
in response to a change in activity. For planning purposes, a manager must be able to anticipate
which of these will happen; and if a cost can be expected to change, the manager must know
by how much it will change. To help make such distinctions, costs are often characterized as
variable or fixed.

Cost Classifications for Predicting Cost Behavior

1. Variable Cost
2. Fixed Cost
3. Mixed Cost

Variable Costs
A variable cost is a cost whose total peso amount varies in direct proportion to changes in the
activity level. An activity base (also called a cost driver) is a measure of what causes the
incurrence of variable costs. As the level of the activity base increases, the total variable cost
increases proportionally. A unit produced (or sold) is not the only activity base within
companies. A cost can be considered variable if it varies with activity bases such as miles
driven, machine hours, or labor hours. Variable costs remain constant if expressed on a per unit
basis.

Examples of variable costs

1. Merchandising companies – cost of goods sold.
2. Manufacturing companies – direct materials, direct labor, and variable overhead.
3. Merchandising and manufacturing companies – commissions, shipping costs, and
clerical costs such as invoicing.
4. Service companies – supplies, travel, and clerical.

Types of Variable Costs

True variable costs
The amount used during the period varies in direct proportion to the activity level. The overage
charge on a cell phone bill was one example of a true variable cost. Direct material is another
example of a cost that behaves in a true variable pattern.

Step-variable costs
A resource that is obtainable only in large chunks and whose costs change only in response to
fairly wide changes in activity. For example, maintenance workers are often considered to be
a variable cost, but this labor cost does not behave as a true variable cost. Small changes in the
level of production are not likely to have any effect on the number of maintenance workers
employed. Only fairly wide changes in the activity level will cause a change in the number of
maintenance workers employed.

Fixed Costs
A fixed cost is a cost whose total peso amount remains constant as the activity level changes.
For example, your cell phone bill probably includes a fixed amount related to the total

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minutes allowed in your calling plan. This amount does not change when you use more or less
allowed minutes. Average fixed costs per unit decrease as the activity level increases. For
example, the fixed cost per minute used decreases as more allowed minutes are used.

Types of Fixed Costs

Committed Fixed Costs
These costs are long-term in nature (i.e., greater than one year). These costs cannot be
significantly reduced even for short periods of time without seriously impairing the profitability
or long-run goals of the organization. Examples of committed-fixed costs include depreciation
on buildings and equipment and real estate taxes.

Discretionary Fixed Costs

These costs usually arise from annual decisions by management to spend in certain fixed cost
areas. These costs can be cut for short periods of time with minimal damage to the long-run
goals of the organization. Examples of discretionary fixed costs include advertising and
research and development. A cost may be discretionary or committed depending upon
management’s strategy.

Mixed Costs
A mixed cost is one that contains both variable and fixed cost elements. Mixed cost is also
known as semi-variable cost. Cost volume formula is a cost accounting relation used to estimate
production cost of a given number of units of a product. A linear cost volume formula is of the
following form:
y = a + bx
In the above equation,
y - stands for total production cost;
a - for total fixed cost;
b - for variable cost per unit; and
x - for number of units

Total Fixed Cost is the sum of pure fixed cost, such as rent on factory building and property
taxes; and the fixed component of mixed costs, such as total fixed cost on delivery trucks i.e.
straight-line depreciation expense.

Variable Cost per Unit is the sum of pure variable cost per unit, such as material cost per unit;
and the variable component of mixed cost, such as variable cost per unit on delivery trucks i.e.,
fuel expense.

The relevant range is that range of activity within which the assumptions made about cost
behavior are valid.

For this purpose, mixed costs are split into their fixed and variable components by using any
of the following techniques:
1. High-Low Method
2. Scatter Graph Method
3. Least-square Regressions Method

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High-Low Method
High-Low method is one of the several techniques used to split a mixed cost into its fixed and
variable components. Although easy to understand, high low method is relatively unreliable.
This is because it takes two extreme activity levels (i.e. labor hours, machine hours, etc.) from
a set of actual data of various activity levels and their corresponding total cost figures. These
figures are then used to calculate the approximate variable cost per unit (b) and total fixed cost
(a) for the cost volume formula:
y = a + bx

Variable Cost per Unit

Variable cost per unit (b) is calculated using the following formula:
y2 − y1
Variable Cost per Unit =
x2 − x1
Where,
y2 is the total cost at highest level of activity;
y1 is the total cost at lowest level of activity;
x2 are the number of units/labor hours etc. at highest level of activity; and
x1 are the number of units/labor hours etc. at lowest level of activity
In other words, variable cost per unit is equal to the slope of the cost volume line (i.e. change
in total cost ÷ change in number of units produced).
Total Fixed Cost
Total fixed cost (a) is calculated using the following formula:
Total Fixed Cost = y2 − bx2 = y1 − bx1
Scatter Graph Method
Scatter graph method is a graphical technique of separating fixed and variable components of
mixed cost by plotting activity level along x-axis and corresponding total cost (mixed cost)
along y-axis. A regression line is then drawn on the graph by visual inspection. The line thus
drawn is used to estimate the total fixed cost and variable cost per unit. The point where the
line intercepts y-axis is the estimated fixed cost, and the slope of the line is the average variable
cost per unit. Since the visual inspection does not involve any mathematical testing therefore
this method should be applied with great care.
Procedures:
Step 1: Draw scatter graph
Plot the data on scatter graph. Plot activity level (i.e., number of units, labor hours etc.) along
x-axis and total mixed cost along y-axis.
Step 2: Draw regression line
Draw a regression line over the scatter graph by visual inspection and try to minimize the total
vertical distance between the line and all the points. Extend the line towards y-axis.
Step 3: Find total fixed cost
Total fixed is given by the y-intercept of the line. Y-intercept is the point at which the line cuts
y-axis.
Step 4: Find variable cost per unit
Variable cost per unit is equal to the slope of the line. Take two points (x1,y1) and (x2,y2) on
the line and calculate variable cost using the following formula:
y2 − y1
Variable Cost per Unit = Slope of Regression Line =
x2 − x1

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Least-Squares Regression Method

A mixed cost can be split into variable and mixed components by a statistical technique called
simple linear regression analysis. This technique mathematically calculates the y-intercept and
the slope of a straight line that ideally fits through a set of points on a graph. In least-squares
method, the ideal fitting of the regression line is achieved by minimizing the sum of squares of
the distances between the line and all the points on the graph.

In cost behavior analysis, the cost volume formula "y = a + bx", is equivalent to regression line.
Its y-intercept (a) and slope (b) represent the total fixed cost and variable cost per unit
respectively, can be calculated by solved following simultaneous linear equations of least-
squares regression analysis:

Comparing Results from the Three Methods

The three methods just discussed provide slightly different estimates of the fixed and variable
cost components of the mixed cost. This is to be expected because each method uses differing
amounts of the data points to provide estimates. Least-squares regression provides the most
accurate estimate because it uses all the data points.

The Contribution Approach Income Statement

The contribution approach provides an income statement format geared directly to cost
behavior. This approach separates costs into fixed and variable categories. It is used as an
internal planning and decision-making tool.
Sales XX.
Variables Costs (XX)
Contribution Margin XX.
Fixed Costs (XX)
Net Operating Income XX.

The contribution approach differs from the traditional approach. The traditional approach
organizes costs in a functional format. Costs relating to production, administration, and sales
are grouped together without regard to their cost behavior. It is used primarily for external
reporting purposes.

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II. PROBLEMS

Problem 1: Listed below are costs found in various organizations.

1. Property taxes, factory.
2. Salesperson’s commissions.
3. Supervisor’s salary, factory.
4. Depreciation, executive autos.
5. Wages of workers assembling computers.
6. Insurance, finished goods warehouses.
7. Advertising costs.
8. Microchips used in producing calculators.
9. Shipping costs on mechandise sold.
10. Magazines subscriptions, factory lunchroom.
11. Billing costs.
12. Executive life insurance.
13. Fringe benefits, assembly-line workers.
14. Yarn used in sweater production.
15. Wages of receptionist, executive offices.

Required:
For each cost item, indicate whether it would be variable or fixed with respect to the number
of units produced and sold; and then whether it would be a selling cost, an administrative cost,
or a manufacturing cost. If it is a manufacturing cost, indicate whether it would be treated as a
direct material, direct labor, or manufacturing/factory overhead.

Problem 2: Various costs associated with the operation of factories are given below:
1. Electricity to run production equipment.
2. Rent on a factory building.
3. Cloth used to make drapes.
4. Production superintendent’s salary.
5. Wages of laborers assembling a product.
6. Depreciation of air purification equipment used to make furniture.
7. Janitorial salaries.
8. Peaches used in canning fruit.
9. Lubricants for production equipment.
10. Sugar used in soft-drinks production.
11. Property taxes on the factory.
12. Wages of workers painting a product.
13. Depreciation on cafeteria equipment.
14. Insurance on a building used in producing helicopters.
15. Cost of rotor blades used in producing helicopters.

Required:
Classify each cost as either variable or fixed with respect to the number of units produced and
sold. Also indicate whether each cost would typically be treated as a direct cost or an indirect
cost with respect to units of product.

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Problem 3: Ofi Manufacturing had the following data for the period just ended:
Work in process, Jan. 1 P 21,000
Work in process, Dec. 31 40,000
Finished goods, Jan. 1 70,000
Finished goods, Dec. 31 61,000
Direct materials used 126,000
Direct labor 260,000
Factory depreciation 80,000
Sales 945,000
Advertising expense 52,000
Factory utilities 27,000
Indirect materials 19,000
Indirect labor 35,000

Required:
A. Calculate Ofi's cost of goods manufactured.
B. Calculate Ofi's cost of goods sold.

Problem 4: The following selected information was extracted from the 2019 accounting records
of Tina Products:
Raw materials used P 284,000
Direct labor 178,000
Indirect labor 35,000
Selling and administrative salaries 250,000
Building depreciation* 330,000
Other selling and administrative expenses 80,000
Other factory costs 620,000

*Seventy percent of the company's building was devoted to production activities; the remaining
30% was used for selling and administrative functions.

Tina's beginning and ending work-in-process inventories amounted to P306,000 and P245,000,
respectively. The company's beginning and ending finished-goods inventories were P450,000
and P440,000, respectively.

Required:
A. Calculate Tina's manufacturing overhead for the year.
B. Calculate Tina's cost of goods manufactured.
C. Compute the Tina's cost of goods sold.

Problem 5: Malou Manufacturing currently produces 1,000 axles per month. The following per
unit data apply for sales to regular customers:
Direct materials P 200
Direct manufacturing labor 30
Variable manufacturing overhead 60
Fixed manufacturing overhead 40
Total manufacturing costs P 330

The plant has capacity for 2,000 axles.

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Required:
A. What is the total cost of producing 1,000 axles?
B. What is the total cost of producing 1,500 axles?
C. What is the per unit cost when producing 1,500 axles?

Problem 6: Various cost and sales data for Edith Company for the just completed year appear
in the worksheet below:
1. Finished goods inventory, beginning P 20,000
2. Finished goods inventory, ending 40,000
3. Administrative expenses 110,000
4. Manufacturing overhead 105,000
5. Purchases of raw materials 125,000
6. Raw materials inventory, beginning 9,000
7. Raw materials inventory, ending 6,000
8. Direct labor 70,000
9. Work in process inventory, beginning 17,000
10. Work in process inventory, ending 30,000
11. Sales 500,000
12. Selling expenses 80,000

Of the P105,000 of manufacturing overhead, P15,000 is variable P90,000 is fixed.

Required:
A. Prepare a schedule of cost of goods manufactured.
B. Prepare an income statement.

Problem 7: Find total fixed cost, variable cost per unit, total cost of producing 30,000 units
from the following cost volume formula:
y = P43,000 + 6x

Problem 8: Ando Company wants to construct a cost volume relation between its factory
overhead cost and number of units produced. The volume and the corresponding total cost
information of the factory for past eight months are given below:
Month Units FOH
1 1,520 P36,375
2 1,250 38,000
3 1,750 41,750
4 1,600 42,360
5 2,350 55,080
6 2,100 48,100
7 3,000 59,000
8 2,750 56,800

Use (A) high-low method; (B) scatter graph method; and (C) least-squares method to analyze
its factory overhead (FOH) costs and build a cost volume formula.

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Problem 9: The Richard House, Inc., is a large retailer of winter sports equipment. An income
statement for the company’s Ski Department for a recent quarter is presented below:
The Richard House, Inc.
Income Statement –Ski Department
For the Quarter Ended March 31
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 150,000
Cost of goods sold . . . . . . . . . . . . . . . . . . 90,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . 60,000
Selling and administrative expenses:
Selling expense . . . . . . . . . . . . . . . . . P 30,000
Administrative expense . . . . . . . . . . 10,000 40,000
Net operating income . . . . . . . . . . . . . . . P 20,000

Skis sell, on the average, for P750 per pair. Variable selling expenses are P50 per pair of skis
sold. The remaining selling expenses are fixed. The administrative expenses are 20% variable
and 80% fixed. The company does not manufacture its own skis; it purchases them from a
supplier for P450 per pair.

Required:
A. Prepare a contribution format income statement for the quarter.
B. For every pair of skis sold during the quarter, what was the contribution toward covering
fixed expenses and toward earning profits?

Problem 10: The Company manufactures and sells a single product. A partially completed
schedule of the company’s total and per unit costs over the relevant range of 30,000 to 50,000
units produced and sold annually is given below:
Units Produced and Sold
30,000 40,000 50,000
Total costs:
Variable costs . . . . . . . . . . . P180,000 ? ?
Fixed costs . . . . . . . . . . . . . 300,000 ? ?
Total costs . . . . . . . . . . . . . . . . . P480,000 ? ?

Cost per unit:

Variable cost . . . . . . . . . . . . ? ? ?
Fixed cost . . . . . . . . . . . . . . ? ? ?
Total cost per unit . . . . . . . . . . ? ? ?

Required:
A. Complete the schedule of the company’s total and unit costs above.
B. Assume that the company produces and sells 45,000 units during the year at a selling price
of P16 per unit. Prepare a contribution format income statement for the year.

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III. ASSESSMENT

Exercise 1: The selected amounts that follow were taken from Sharon Corporation's accounting
records:
Raw material used P 27,000
Direct labor 35,000
Total manufacturing costs 104,000
Work-in-process inventory, 1/1 19,000
Cost of goods manufactured 100,000
Cost of goods available for sale 175,000
Finished-goods inventory, 12/31 60,000
Sales revenue 300,000
Selling and administrative expenses 125,000
Income tax expense 18,000
Required:
Compute the following:
A. Manufacturing overhead.
B. Work-in-process inventory, 12/31.
C. Finished-goods inventory, 1/1.
D. Cost of goods sold.
E. Gross margin.
F. Net income.

Exercise 2: Vangie Inc. had the following activities during the year:
Direct materials:
Beginning inventory P 40,000
Purchases 123,200
Ending inventory 20,800
Direct manufacturing labor 32,000
Manufacturing overhead 24,000
Beginning work-in-process inventory 1,600
Ending work-in-process inventory 8,000
Beginning finished goods inventory 48,000
Ending finished goods inventory 32,000

Required:
A. What is the cost of direct materials used?
B. What is cost of goods manufactured?
C. What is cost of goods sold?
D. What amount of prime costs was added to production?
E. What amount of conversion costs was added to production?

Exercise 3: Selected account balances for the year ended December 31 are provided below
for Melody Company:
Selling and Administrative salaries . . . . . . . . . . . . . . . . . . . . P110,000
Purchases of raw materials . . . . . . . . . . . . . . . . . . . . . . . . . . P290,000
Direct Labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?
Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P80,000
Manufacturing overhead . . . . . . . . . . . . . . . . . . .. . . . . . . . . . P270,000
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Sales commissions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P50,000

Inventory balances at the beginning and end of the year were as follow:
Beginning of the year End of the year
Raw materials . . . . . . . . . . . . . . P40,000 P10,000
Work in process . .. . . . . . . .. . . ? P35,000
Finished goods . . . . . . . . . . . . . P50,000 ?

The total manufacturing costs for the were P683,000; the goods available for sale totaled
P740,000; and the cost of goods sold totaled P660,000.

Required: Prepare a schedule of costs of goods manufactured and the costs of goods sold
section of the company’s income statement for the year.

Exercise 4: The So Nice Hotel’s guest-days of occupancy and custodial supplies expense
over the last seven months were:
Guest-Days of Custodial Supplies
Month Occupancy Expense
March . . . . . . . . . . 4,000 P 7,500
April . . . . . . . . . . . 6,500 8,250
May . . . . . . . . . . . 8,000 10,000
June . . . . . . . . . . 10,500 12,000
July . . . . . . . . . . . 12,000 13,500
August . . . . . . . . 9,000 10750
September . . . . . 7,500 9,750

Guest-days is measure of the overall activity at the hotel. For example, a guest who stays at the
hotel for three days is counted as three guest-days.

Required:
A. Using the high-low method, estimate a cost formula for custodial supplies expense.
B. Using the cost formula you derived above, what amount of custodial supplies expense
would you expect to be incurred at an occupancy level of 11,000 guest-days?

Exercise 5: Abie Rental Car offers rental cars in an off-airport location near a major tourist
destination in Manila. Management would better understand the behavior of the company’s
costs. One of those costs is the cost of washing cars. The company operates its own car wash
facility in which of each rental car that is returned is thoroughly cleaned before being released
for rental to another customer. Management believes that the costs of operating the car wash
should be related to the number of rental returns. Accordingly, the following data have been
compiled:
Rental Car Wash
Month Returns Costs
January . . . . . . . . . . . . . 2,380 P10,825
February . . . . . . . . . . . . 2,421 11,865
March . . . . . . . . . . . . . . 2,586 11,332
April . . . . . . . . . . . . . . . 2,725 12,422
May . . . . . . . . . . . . . . . 2,968 13,850
June . . . . . . . . . . . . . . . 3,281 14,419
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July . . . . . . . . . . . . . . . . 3,353 14,935

August . . . . . . . . . . . . . 3,489 15,738
September . . . . . . . . . . 3,057 13,563
October . . . . . . . . . . . . 2,876 11,889
November . . . . . . . . . . 2,735 12,683
December . . . . . . . . . . 2,983 13,796

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

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