STRATEGIC COST MANAGEMENT (STCM)

STCM 02 : Cost Terms, Concepts and Behavior

Prepared by: R. Pascual

Intended Learning Outcomes:

✓ Differentiate expenditures, costs and expenses

✓ Understand the importance of controlling expenses
✓ Discuss the classification of expenses on manager’s, economist’s and accountant’s perspective.
✓ Define and describe fixed, variable, and mixed costs.
✓ Explain the use of resources and activities and their relationship to cost behavior.
✓ Explain how several methods of cost estimation can be used.
✓ Separate mixed costs into their fixed and variable components using different methods.

Lecture Notes:

Controlling Expenses

Management accounting is about profit management. As it considers expenses as a vital component, it should be
understood and intelligently managed. The accounting for the accumulation, preparation and presentation of expenses to
serve as a basis for management decisions is the pioneering area of management accounting.

The end-point of operating performance is to generate maximum profit out of the available resources for use.
Mathematically, profit increases when sales increase and expenses decrease, or both.

Traditional management accounting provides intelligent information to managers in order to reduce expenses and increase
profit. Reducing expenses requires a thorough understanding of it in line with the planning and controlling functions of
management. In recent years, management accounting has been critically supplying relevant information to strategic
management thereby necessitating the accumulation, processes and reporting of information not only that of operating
concerns but of the financing and investing activities, both quantitatively or otherwise.

Cost Concepts

The use of the term “costs” includes costs and expenses.

Managing costs means knowing their nature, behavior and other characteristics. Costs may mean differently to different
people.

ACCOUNTANT’S PERSPECTIVE

Capital expenditure vs Operating expenditures

Capital expenditures are investing outlays normally requiring large amount of funds and resources having a long-term impact
to business profitability and growth. These expenditures would create probable future economic value and benefit and,
therefore are capitalized as assets. These costs are converted to expense once their related income has been generated.
Example of capital expenditure are those used in long-term projects, classified as long-term assets, and recognized as
expense once consumed in the production and sale of a product or used in the administration and functions of business.

Operating expenditures are outlays or consumption used to directly support the normal operating activities of the business.
They are expensed in the period the statement of profit or loss is presented because of the following reasons:

I. Immediate recognition such as advertising, salaries and research

II. Associating cause and effect, such as cost of sales and
III. Rational and systematic allocation such as depreciation

Costs vs Expenses vs Losses

Costs are traditionally classified in relation to the functional activities of the business, that is according to the place and
purpose of their use.
Costs of goods manufactured, recorded as inventory, are those incurred in producing goods and services. Examples are
direct materials, direct labor and factory overhead. Costs of goods sold are production costs relating to the units sold,
already expensed in the period their corresponding revenue is earned.

There are expenses incurred in distributing the goods and managing a business. Those paid or incurred in the marketing
promotions and shipping activities are “distribution expenses”. Those relating to systems and control, government
compliance and other corporate costs incurred to manage the business are referred to as “administration expenses”.

Both costs and expenses give benefits to the business.

Losses are reduction in the value of assets without the benefit to the business leasing to the impairment of equity. Examples
are loss on sale of equipment, loss on inventory obsolescence loss on shortages, spoilage and loss on uncollectible.

Product cost vs Period cost

Costs may be classified as their relation to the product

Product costs are those incurred in the process of producing the product. They are inventoriable and deferred as assets
while units are unsold. Once sold, the cost of inventory is transferred to the cost of goods sold and classified as expense.
Direct materials, Direct Labor and Factory overhead are “product costs”. Direct materials and Direct Labor are called
“prime costs”. Direct Labor and Factory Overhead are called “conversion costs”. Direct materials, direct labor and
variable factory overhead are called “variable production costs”.

Period costs are those incurred outside of the production activities. They are incurred to administer a business, sell or
distribute a product, attend to customers needs which are not directly related to the production activities. They are instantly
expensed once incurred or recognized as an expense when consumed.

Direct product cost vs. Indirect product cost

Costs are further classified as to their degree of relation to the product.

Direct product costs are those that are directly identified with the finished goods or services or those that are directly
attributable in the process of making them (i.e. converting materials into finished goods). Direct materials and direct labor
are direct product costs. Factory overhead is an indirect product cost.

MANAGER’S PERSPECTIVE

Relevant cost vs. Irrelevant cost

Cost may be classified according to their use in the decision-making process.

Costs that are useful in making decisions are relevant costs, otherwise, they are irrelevant. Relevant costs have two
characteristics, differential and future. Differential costs vary from one alternative to another while future costs are
estimated expenditures relating to a prospective activity.

Managers have at least two alternatives in making decision, otherwise there is no decision to be hardly made at all. When
a cost remains the same regardless of a choice to be made, that cost is not differential and irrelevant. Relevant costs are
not only differential costs but have a future value as well. Costs that are not to be incurred in the future are irrelevant.
Management decisions deal to the future not in the past. The future could be influenced or directed, while the past cannot,
it can only be admired or remembered.

Direct Segment Cost vs Indirect Segment Cost

Costs may be classified as to their relation to the business segment or unit.

Direct departmental costs are those that are directly identified with the department, process segment or activity regardless
of whether they are variable or fixed costs.

Indirect department costs are those that are not directly identified with a department or a business unit. They are sometimes
referred to as “allocated costs”, “common costs”, or plainly “unavoidable costs”. The litmus test on whether a cost is direct
or indirect to a business unit is when the said business unit ceases it operations. Direct department costs are avoided upon
the cessation of business unit operations while indirect department costs continuously persist despite cessation of business
operations thereof.

Avoidable cost vs. Unavoidable cost

Cost may be classified in relation to the occurrence of an activity.

Avoidable costs are those not incurred once an activity is not performed. They normally become savings on the part of the
business. These savings are considered an inflow in the economic sense and are referred to as “imputed costs”

Unavoidable costs remain to be incurred regardless of the option a manager chooses. They remain constant, they do not
change, and are irrelevant in short-term decisions. Comon examples of unavoidable costs are rent, depreciation, interest,
property taxes and all other committed fixed costs.

Controllable vs Uncontrollable cost

Costs may be classified in relation to the authority of the given manager.

Controllable costs are those which incurrence, or non-incurrence, can be influenced or decided upon by a manager. The
influence or decision-making power of a manager depends on the scope, nature and extent of authority granted to him by
the organization. The concept of controllability is related to the organizational structure of an organization.

Non-controllable costs are those outside of the decision power or influence of a given manager in a specific situation.

Planned cost vs Actual cost

Costs may be classified in relation to its incurrence in a future undertaking.

Planned costs relate to future occurrence and are referred to in multifarious names such as projected costs, estimated
costs, budgeted costs, applied costs and standard costs.

Actual costs are expenditures already incurred and recorded in the accounting books. The difference between the planned
cost and actual cost is called “planning gap” or “planning variance”.

Budgeted cost vs. Standard cost

Costs may be classified in relation to the level of activity being considered for estimation.

Budgeted costs are those expected to be incurred at the budgeted level of activity. Standard costs are those expected to
be incurred at “any level of activity”. The level of activity being used in computing the standard cost may be actual or
estimated units.

Budgeted costs and standard costs use the same predetermined standard rates. The difference between the budgeted cost
and standard cost is the level of activity used in their measurement, and is called “capacity variance”

Out-of-pocket-cost vs. Non-cash costs

Cost may be classified in relation to cash

Out-of-pocket-cost (OPCs) are those that incurred and paid in cash. OPCs require cash payments. Those that are not paid
in cash are non-cash costs.

Sunk Cost vs. Future Cost

Cost may be classified according to their period of incurrence.

Sunk costs are those that have been incurred in the past and can no longer be changed. They are historical and irrelevant
in short-term decisions.

Future costs are to be incurred in the upcoming periods. They are relevant and are of value in making decisions. They affect
the upcoming activities where the manager should plan, organize, direct and control. They are sometimes called as “planned
costs”, budgeted costs” or estimated costs”.
ECONOMIST’S PERSPECTIVE

Explicit cost vs. Implicit Cost

Costs may be classified according to the manner on how they are stipulated.

Explicit costs are those already incurred or intended to be incurred (i.e. budgeted). Theu are already recorded or to be
recorded in the accounting books. Implicit costs are theoretical costs. They are assumed and not recognized in the
accounting books. Two classical examples of imputed costs are opportunity costs and imputed costs.

Opportunity cost vs. Imputed cost

Opportunity costs are benefits given up in favor of another choice. In each decision, there is always a beneficial alternative
(or choice) not followed but could had been followed. The benefit sacrificed in favor of the alternative chosen is an
opportunity cost.

Imputed costs are those not incurred but are implied in a given decision.

Opportunity costs and imputed costs are not recorded in the financial books because they are not actually incurred, they
are only theoretical. But they are relevant in decision making.

Incremental cost vs Marginal cost

Costs may be classified in relation to a particular product.

Incremental costs represent total increase in fixed costs. Marginal cost is an increase in cost per unit. Decremental costs
are decreases in costs.

Variable cost vs. Fixed cost

Costs may be classified in relation to quantity or level of activity. In the following discussions, we assume the level of
production and sales to be equal.

Costs are classified as fixed or variable with regard to their behavior in relation to and the changes in, the volume of activity
level.

Fixed costs are those remain constant in total but inversely changes on a per unit basis in relation to the changes in the
level of quantity, volume or activity. Variable costs change in total in direct proportion to changes in the level of production
and sales bit is constant on a per-unit basis.

Fixed costs could either be committed or discretionary.

Committed fixed costs are those incurrences have been committed by the business in the past by reason of contract,
acquisition or arrangement. Examples are rental expense, interest expense, insurance expense, depreciation, property
taxes etc. Discretionary (or engineered) fixed costs are those which incurrence is assured but the amount may change
depending on the discretion or value judgment of the manager. Examples are advertising expense, repairs and maintenance
of buildings, executive training costs etc. For academic purposes, all fixed costs, whether committed or discretionary, should
be treated as constant in total.

Variable costs vary directly in proportion to the change in the volume of activity. Hence, total variable costs change.

Fixed costs and variable costs are normally expressed in their constant terms. Hence, fixed costs are normally expressed
in total and variable costs are expressed on a constant rate per measurement basis.

Cost Classifications for Predicting Cost Behavior

COST – 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 (e.g., acquisition cost; production cost; cost
of goods sold).

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.
COST BEHAVIOR ASSUMPTIONS

➢ 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 may show a different cost behavior pattern.

➢ 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.

➢ 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 Sensitivity Sample problem 1

Peppa Company provides the following costs structure on its product Piglet:

Total fixed costs P20,000

Unit variable cost P 2

What will happen to fixed costs and variable costs, per total and per unit, if production levels are zero, 5,000 units, 10,000
units and 15,000 units?

Solutions/Discussions:

(A) (B) (C) (D) (E) (F) (G)

Unit
Production Total Fixed Variable Unit Fixed
level Total variable costs cost Cost Cost Total Costs Unit Cost
0 0 20,000 2 n.a. 20,000 n.a.
5,000 10,000 20,000 2 4.00 30,000 6.00
10,000 20,000 20,000 2 2.00 40,000 4.00
15,000 30,000 20,000 2 1.33 50,000 3.33
Changes Increases as
Constant; inversely; production
Changes directly; regardless of the decreases as increases due Decreases as
What increases as production levels of production to variable production
happened? increases production Constant increases costs increases

Costs Behavior and Control Drivers

Costs Fixed Costs Variable Costs

Constant, regardless of levels of Changes, in direct proportion to the
Total costs production and sales change un the volume of activity level
Changes, decreases as production Constant, regardless of levels of
Unit Costs increases and vice versa production and sales
Increase production to reduce unit Reduce variable cost rate to reduce
How to control? fixed costs, that is why, fixed cost is total variable costs, that is why,
related to volume variable cost is related to rate or
spending
Cost Sensitivity Sample problem 2

Mimiyu 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 and sold each year is given below.

Units Produced and Sold

60 80 100
TOTAL COSTS:
(A) Variable costs ₱120 ₱ ₱
(B) Fixed costs 600
(C) Total costs ₱ ₱ ₱
COSTS PER UNIT:
(D) Variable costs ₱ ₱ ₱
(E) Fixed costs ₱ ₱ ₱

REQUIRED: Based on the above data,

1) Complete the schedule by writing the correct amount in the blanks.

2) Identify two (2) specific costs that remain constant over the relevant range.
3) Identify two (2) specific costs that are directly related with production.
4) Identify the specific cost that is inversely related with production.
5) Express the cost formula based on the line equation form ‘Y = a + bX’.
6) If the company produces 90 units, then how much is the expected total costs?

SOLUTION:

Requirement 1:

Units Produced and Sold

60 80 100
TOTAL COSTS:
(A) Variable costs ₱120 ₱ 160 ₱ 200
(B) Fixed costs 600 600 600
(C) Total costs ₱ 720 ₱ 760 ₱ 800
COSTS PER UNIT:
(D) Variable costs ₱2 ₱2 ₱ 2
(E) Fixed costs ₱ 10 ₱ 7.50 ₱6

MIXED COSTS

These are costs which could not be perfectly classified as pure fixed costs neither pure variable cost. These costs contain
both the fixed and the variable components. They are called “mixed costs”.

Mixed costs could either be semi-variable costs, semi-fixed costs or step costs.
Semi-variable costs change in total but not in direct proportion to changes in the level of production and sales. Semi-
fixed costs are constant in a given level of activity but changes, not in constant way, when a new level of activity is
reached. Step costs are constant within a given range of activity and vertically shoots up as it reaches a given level of
activity. Examples of mixed costs are electricity, water, repairs and maintenance.

Mixed costs should be segregated as to their fixed and variable components to be of value in determining the economic
profit and in the field of management accounting.

EXPENSE SEGREGATION TECHNIQUES

The main point in cost estimation is the segregation of mixed costs into fixed and variable in order to determine the cost
behavior for each product in relation to total cost.
 MIXED COST
(Semi-Variable Cost)
Y=a+bX
Where: [Y] – the total costs (dependent variable)
[a] – the total fixed costs (y-intercept/vertical axis-intercept)
[b) – the variable cost per unit (slope of the line)
[X] – the activity or cost driver (independent variable)

There are three (3) popular methods used in separating the fixed from variable costs of a mixed account. All of them have
their technical origin from the field of statistics. They are the following:
1. High-low method
2. Scattergraph method
3. Least-square method

High-Low Method

The high-low method is the traditional method of costs segregation. In statistics, it is called as the “range analysis”. Variable
cost rate is computed by dividing the change in costs over the related change in base. (e.g. unit of measurement such as
direct labor hours, machine hours, number of shipments and other activity basis). After the variable cost rate is calculated,
the total fixed costs is determined by getting the difference between the total costs and variable costs.

The fixed and variable elements of the mixed costs are computed from two sampled data points the highest and lowest
points as to activity level or cost deliver.

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐶𝑜𝑠𝑡𝑠 (𝑌𝐻 − 𝑌𝐿 )

𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 (𝒃) =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 (𝑋𝐻 − 𝑋𝐿)

Sample Problem High-Low Method

The controller of SUREDEAD 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 are given in the following table:

Month Number of Patients Admitted (X) Admitting Department’s 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) The variable cost per unit.
2) The annual fixed costs.
3) The admitting department’s monthly cost function.
4) Total estimated costs, if number of patients admitted for the month is 20.
SOLUTION:

1. The first step in the high-low method is to identify the periods of the lowest and highest activity. Those periods are May
(19 patients admitted) and June (11 patients admitted).

Note: Ignore Outlier - Outlier refers to abnormal activity in the data given which can be found in the month of NOVEMBER.

The second step is to compute the variable cost per unit using those two data points:

Month Number of patients admitted (X) Admitting Department's Cost (Y)

High Activity Level (May) 19 15,200
Low Activity Level (October) 11 12,800
Change 8 2,400

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐶𝑜𝑠𝑡𝑠 (𝑌𝐻 − 𝑌𝐿 )

𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 (𝒃) =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 (𝑋𝐻 − 𝑋𝐿)

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐶𝑜𝑠𝑡𝑠 (15,200 − 12,800)

𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 (𝒃) =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 (19 − 11)
2, 400
𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 (𝒃) =
8
𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝒄𝒐𝒔𝒕 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕 (𝒃) = 𝑷𝟑00

2. The third step is to compute the fixed cost element by deducting the variable cost element from the total cost at either
the high or low activity. In the computation below, the high point of activity is used:

Fixed cost element = Total cost - Variable cost element

= P15,200 - (P300 per patient admitted x 19 patients admitted)

= P9,500

3. The cost formula is Y = P9,500 x P300X.

4. Total estimated costs, if number of patients admitted for the month is 20 is computed as follows:

Y = P9,500 x P300X

= P9,500 x P300(20)

= P9,500 x P6,000

= P15,500

Scatter graph (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.

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

• If there is only one independent variable, the analysis is known as SIMPLE REGRESSION.
• If the analysis involves multiple independent variables, it is known as MULTIPLE REGRESSION.
Other Cost-Estimation Methods

A. Industrial Engineering Method – based on the relationship between inputs and outputs in physical
forms; engineering estimates indicate what and how much costs should be.
B. 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.
C. Conference Method – costs are classified based on opinions from various company departments such
as purchasing, process engineering, manufacturing, employee relations and so on.

CORRELATION ANALYSIS

Correlation analysis is used to reassure 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 form a straight line, there is a high correlation.

• If the points from a random pattern, there is a low correlation or no correlation at all.

Coefficient of Correlation (r) measure the relative strength of linear relationship between 2 variables.

The range of the coefficient ‘r’ is from – 1.0 to + 1.0:

• If r = -1.0, there is perfect inverse linear relationship between X and Y.

• If r = 0, no linear relationship.
• If r = +1.0, there is perfect direct relationship between X and Y.

Coefficient of Determination (𝐫 𝟐 )

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 X and Y is direct or inverse. It is measure of ‘goodness of fit’ in the regression.
The higher the r 2 , the more confidence one can have in the estimated cost formula.

SUMMARY OF THE LESSON

Cost behavior is the way in which a cost changes in relation to changes in activity output. The time horizon is
important in determining cost behavior because costs can change from fixed to variable, depending on whether the decision
takes place over the short run or the long run. Variable costs are those which change in total as activity usage changes.
Usually, we assume that variable costs increase in direct proportion to increases in activity output. Fixed costs are those
which do not change in total as activity output changes. Mixed costs have both a variable and a fixed component. In this
lesson, we have discussed ways in which managers classify costs. How the costs will be used—for assigning costs to cost
objects, preparing external reports, predicting cost behavior, or decision making—will dictate how the costs are classified.

For purposes of assigning costs to cost objects such as products or departments, costs are classified as direct or
indirect. Direct costs can be conveniently traced to cost objects. Indirect costs cannot be conveniently traced to cost objects.

For external reporting purposes, costs are classified as either product costs or period costs. Product costs are
assigned to inventories and are considered assets until the products are sold. At the point of sale, product costs become
cost of goods sold on the income statement. In contrast, period costs are taken directly to the income statement as expenses
in the period in which they are incurred.

For purposes of predicting how costs will react to changes in activity, costs are classified into three categories—
variable, fixed, and mixed. Variable costs, in total, are strictly proportional to activity. The variable cost per unit is constant.
Fixed costs, in total, remain the same as the activity level changes within the relevant range. The average fixed cost per
unit decreases as the activity level increases. Mixed costs consist of variable and fixed elements and can be expressed in
equation form as Y = a + bX, where X is the activity, Y is the total cost, a is the fixed cost element, and b is the variable cost
per unit of activity.

You are blessed!

Sir P