Strategic Cost

Management
Cost Classification by Function
 Manufacturing costs - incurred in the factory to convert raw
materials into finished goods. It includes cost of raw materials used
(direct materials), direct labor, and factory overhead.
 Prime Costs- DM & DL
 Conversion Costs- DL & FOH

 Non-manufacturing costs - not incurred in transforming materials

to finished goods. These include selling expenses (such as
advertising costs, delivery expense, salaries and commission of
salesmen) and administrative expenses (such as salaries of
executives and legal expenses).
Classification of Cost according to Timing
of Charge against Revenue
 Product costs - are inventoriable costs. They form part of inventory
and are charged against revenue, i.e. cost of sales, only when sold.
All manufacturing costs (direct materials, direct labor, and factory
overhead) are product costs.
 Period costs - are not inventoriable and are charged against
revenue immediately. Period costs include non-manufacturing costs,
i.e. selling expenses and administrative expenses.

Balance
sts Sheet CO
o GS
ctc “inventory”
du
Pro Income
Expenditure Statement
s Period costs
Classification of Cost by Nature/
Traceability
 Direct costs are costs that can be directly and easily traced to
(or identified with) a product, process, or department.
 Direct Materials
 Direct Labor
 Indirect costs, on the other hand, are costs that are not
traceable to any particular product, process, or department, but
which are common in a number of products, processes, or
departments.
 Indirect Materials
 Indirect Labor
 Other Factory Overhead
 According to Relevance to Decision
Making
1. Relevant cost - cost that will differ under alternative courses of action. In other
words, these costs refer to those that will affect a decision.
2. Standard cost - predetermined cost based on some reasonable basis such as past
experiences, budgeted amounts, industry standards, etc. The actual costs incurred
are compared to standard costs.
3. Opportunity cost - benefit forgone or given up when an alternative is chosen
over the other/s. Example: If a business chooses to use its building for production
rather than rent it out to tenants, the opportunity cost would be the rent income that
would be earned had the business chose to rent out.
4. Sunk costs - historical costs that will not make any difference in making a
decision. Unlike relevant costs, they do not have an impact on the matter at hand.
5. Controllable costs - refer to costs that can be influenced or controlled by the
manager. Segment managers should be evaluated based on costs that they can
control.
Classification of Cost by Variability or Behavior
Sales
Less: Variable Cost
 Fixed costs
Contribution Margin
 Variable costs Less: Fixed Cost
 Mixed costs Profit

𝑃 50
𝑉𝐶𝑢= =𝑃 5
10𝑢.
 Classification of Cost by Variability or Behavior

In Total Per Unit

Variable Cost constant
Fixed Cost constant
Mixed Cost
Less proportionately than TVC Less proportionately than FC
Mixed Costs
 To analyze cost behavior when costs are mixed, the cost must be
split into its fixed and variable components.
 Several methods, including scatter diagrams, the high‐low
method, and least‐square regression, are used to identify the
variable and fixed portions of a mixed cost, which are based on
the past experience of the company.
 Underlying Assumptions

L R
T Time

Relevant Range

Linearity

Costs are assumed to manifest a linear relationship over a relevant range despite its
tendency to show otherwise over the long run.
Relevant Range
The definitions of fixed cost and variable cost assumes the
company is operating or selling within the relevant range (the
shaded area in the graphs) so additional costs will not be
incurred.

Variable cost per unit

Hi-Lo Method

Once the variable cost per unit is determined:

Fixed cost = Highest activity cost – (Variable cost per unit x Highest
activity units)
or
Fixed cost = Lowest activity cost – (Variable cost per unit x Lowest
activity units)

The resulting cost model after using the high-low method would be as follows:
 Cost model = Fixed cost + Variable cost x Unit activity
y = a + bx
 Hi-Lo Method

FC
VC

𝐶h𝑎𝑛𝑔𝑒𝑖𝑛 𝑦
𝑉𝐶𝑢=
𝐶h𝑎𝑛𝑔𝑒 𝑖𝑛𝑥
Hi-Lo Method

Using the high activity cost: TC= FC +VC

FC= TC-VC
Fixed cost = $371,225 – ($74.97 x 4,545) = $30,486.35
FC=371,225-(74.97)(4545
Using the low activity cost:
TC= FC +VC
Fixed cost = $105,450 – ($74.97 x 1,000) = $30,480
FC= TC-VC
FC=105,450-(74.97)(1000
Cost model for hotel = a + bx
= $30,480 + $74.97x

Therefore, the anticipated costs for September would be:

September costs = $30,480 + ($74.97 x 3,000)
= $255,390
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 (i.e. mixed cost) along y-axis.

Step 1: Draw scatter graph

Step 2: Draw regression line
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.
Scatter Graph Method
Example: Company A decides to use scatter graph method to split its
factory overhead (FOH) into variable and fixed components. Following is
the data which is provided for the analysis.

7
5
6 8
4
2 3
1
Scatter Graph Method
Fixed Cost = y-intercept = $18,000
7 To calculate slope we will take two points
5
on line: (0,18000) and (3500,68000)
6 8
4
2 3
1
$14.2857

Cost function
y = a + bx
= $18,000 + $14.2857 x No.
of units
Least Square Regression
 is a statistical technique that may be used to estimate a linear
total cost function for a mixed cost, based on past cost data. The
function can then be used to forecast costs at different activity
levels, as part of the budgeting process or to support decision-
making processes.
Least Square Regression
Least Square Regression
Hi-Lo Method
Find the value of b, a and provide the cost function.

Variable cost per unit =

Using the high activity cost:

Fixed cost = 15 – ( 1.57 x 9 ) = 0.87

Using the low activity cost:

Fixed cost = 4 – (1.57 x 2) = 0.86
Cost model
y= a + bx
y= 0.87 + 1.57x
Least Square Method
Find the value of b, a and provide the cost function.

y= 0.30 + 1.52 x
Hi-Lo Method
Scorpio Company's activity for the first three months of 2024 are as
follows:
Machine Hours Electrical
Cost
January 2,100
P2,400
February 2,600
P2,900
March 2,900
P3,200
𝑃 3,200 − 𝑃 2,400 800
𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑚𝑎𝑐h𝑖𝑛𝑒 h𝑜𝑢𝑟 = = =𝑃 1
2,900 − 2,100 800
Using the high-low method, how much is the cost per machine hour?
 CORRELATION ANALYSIS
 Correlation Analysis is used to measure the strength of linear
relationship between two or more variables

Simple Regression Analysis – a study of relationship with only 1 independent

variable.
Multiple Regression Analysis – a study of relationship with multiple (two or more)
independent variables.
 CORRELATION ANALYSIS
COEFFICIENT OF CORRELATION (r) – measures the relative strength of linear
relationship between two variables.

where r = -1 to +1

COEFFICIENT OF DETERMINATION () – the proportion of the total variation in Y

that is explained by the regression equation, regardless of whether the
relationship between X and Y is direct or inverse. It is a measure of the
“goodness of fit” in the regression. The higher the , the more confidence one
can have in the estimated formula.
= 0 to +1
CVP Analysis
CVP Analysis
 Cost-volume-profit (CVP) analysis is used to determine how changes in costs
and volume affect a company's operating income and net income

 Underlying Assumptions
o Sales price per unit is constant.
o Variable costs per unit are constant.
o Total fixed costs are constant.
o Everything produced is sold.
o Costs are only affected because activity changes.
o If a company sells more than one product, they are sold in the same mix.

 CVP analysis requires that all the company's costs, including manufacturing,
selling, and administrative costs, be identified as variable or fixed.
Contribution Margin
 The contribution margin represents the amount of income or profit the
company made before deducting its fixed costs. Said another way, it is
the amount of sales available to cover (or contribute to) fixed costs.
 Once fixed costs are covered, the next dollar of sales results in the
company having income.
Break-even Point
 The break‐even point represents the level of sales where net income
equals zero. In other words, the point where sales revenue equals total
variable costs plus total fixed costs, and contribution margin equals
fixed costs.
 This income statement format below is known as the contribution
margin income statement and is used for internal reporting only.
Break‐even point in dollars.
 The break‐even point in sales dollars of $750,000 is calculated by
dividing total fixed costs of $300,000 by the contribution margin ratio of
40%.

BE Sales Dollars=

$750,000
Break‐even point in units
 The break‐even point in units of 250,000 is calculated by dividing fixed
costs of $300,000 by contribution margin per unit of $1.20.

BE Sales units =

250,000 units
EXAMPLE 1
TOTAL PER UNIT
Sales (20,000 units) P 1,200,000 P 60

Variable Costs (900,000) 45

Contribution Margin 300,000 15

Fixed Costs (240,000)

Net Income P 60,000

1. Compute for the Contribution Margin Ratio and Variable Cost Ratio

2. Compute for the Break even point in Peso Sales.

3. Compute for the Break even point in units.

 CM ratio and VC ratio
TOTAL PER
UNIT
Sales (20,000 P P 60 VC Ratio = = = 0.75 = 75%
units) 1,200,000
Variable Costs 45
(900,000) CM Ratio = = = 0.25 = 25%
Contribution 300,000 15
Margin
Fixed Costs Note: CMR and VCR should always add up to
(240,000) 1 or 100%.
Net Income P 60,000
Break even point in sales
TOTAL PER
UNIT
Sales (20,000 units) P P 60
1,200,000
Variable Costs 45
(900,000)
Contribution Margin 300,000 15

Fixed Costs
(240,000)
Net Income P 60,000

BEPS = = = P960,000
Break even point in units
TOTAL PER
UNIT
Sales (20,000 units) P P 60
1,200,000
Variable Costs 45
(900,000)
Contribution Margin 300,000 15

Fixed Costs
(240,000)
Net Income P 60,000

BEPu = = = 16,000 units

Illustration at 16,000 units (P960,000)

TOTAL PER UNIT

Sales (16,000 P 960,000 P 60
units)
Variable Costs (720,000) 45
Contribution 240,000 15
Margin
Fixed Costs (240,000)
Net Income P 0
EXAMPLE 2

1. Compute for the Contribution Margin Ratio and Variable Cost Ratio

2. Compute for the Break even point in Peso Sales.

3. Compute for the Break even point in units.

CM ratio and VC ratio

VC Ratio = = = 42.50%

CM Ratio = = = 57.50%

Note: CMR and VCR should always add up to

1 or 100%.
Break even point in sales

BEPS = = = P130,434.78
Break even point in units

BEPu = = = 6,521.74 units

Illustration at 6,521.74 units
(P130,434.78)
Target Income Calculation
 A manager may be more interested in learning the necessary sales level to
achieve a target profit.

Target Income results when:

Sales = Total Variable Costs + Total Fixed Costs + Target Income

To find the number of Units to Achieve a Target Income:

To find the dollar level of sales to achieve a target net income

 Margin of Safety
 is the difference between actual or expected sales and sales at the break-even
point

a. The formula for stating the margin of safety in pesos is:

b. The formula for determining the margin of safety ratio is:

Margin of Safety Ratio

 The higher the dollars or the percentage, the greater the margin of safety.
 Degree of Operating Leverage
 Measures the sensitivity of profit to changes in sales
 DOL factor
 Degree of Operating Leverage

Company A Company B
Sales 30,000 30,000
Variable Cost 10,000 10,000

Contribution Margin 20,000 20,000

Fixed Cost 5,000 10,000
Profit 15,000 10,000

Company A Operating leverage is highest in

companies that have a high proportion
of fixed operating costs in relation to
Company B variable operating costs.
 Degree of Operating
Leverage

 Companies with high operating leverage can make more

money from each additional sale if they don't have to increase
costs to produce more sales.

 However, if fixed costs are high, a company will find it difficult

to manage short-term revenue fluctuation, because expenses
are incurred regardless of sales levels.

 Companies with high risk and high degrees of operating

leverage find it harder to obtain cheap financing.
CVP Graph