CHAPTER 2 - Cost Concepts and Cost Behavior Analysis

Learning Objectives
At the end of the chapter, the learner should be able to:
 Discuss what assumptions can be made about cost behavior, and why these assumptions are
necessary.
 Enumerate and define the different types of costs for different purposes.
 Classify the costs, and explain why such classifications are useful.
 Use the high-low method and least squares regression analysis in analyzing mixed costs.

Cost Defined

 Cost is cash or cash equivalent necessary to attain an objective such as acquiring goods or
services, performing a function or producing and distributing a product.
 Cost refers to the amount of resources given up in exchange for some goods or services.

Cost of Sales, Operating Expenses and Losses

 Cost of sales or costs of goods sold are those production costs incurred related to the units sold.
 Expenses are those incurred in selling goods, distributing goods and managing a business
(operating expenses).
 Both costs and expenses give benefits to the business.
 Losses do not give any benefit to the business.

Different Costs for Different Purposes (Classifications of Costs)

A. As to type
1. Product Costs
Product costs are those costs incurred to manufacture the product. Product costs of the units sold
are recognized as expense (as Cost of Goods Sold) while product costs of the unsold units
become the costs of inventory. Direct material, direct labor, and factory overhead are examples of
product costs.

Recall that cost of goods sold is an expense and ending inventory is an asset.
Where:
DM = Direct materials
DL = Direct labor
 FOH = Factory overhead

2. Period Costs
Period costs are non-manufacturing costs that include selling, administrative and research and
development costs. These costs are expensed in the period of incurrence and do not become part
of the cost of inventory.

B. As to function
1. Manufacturing Costs (same as product costs)
2. Non-manufacturing Costs (same as period costs)

C. As to traceability
1. Direct Costs
Direct costs are costs related to a particular cost object and can economically and effectively be
traced to that object. Examples are direct materials and direct labor.
Note that a cost object can be a product or a division in an entity. If a cost object is a product, for
instance, a chair, the wood which is a direct material can be traced directly that it is used solely to
manufacture the chair and not to other products.
Question:
All factory overhead items are indirect. True or False?

Answer:
False. Factory overhead can be direct and indirect costs depending on the cost object. If a cost
object is a division in an entity, for instance, the production department, the salary of the
supervisor of this department which is a factory overhead can be either direct or indirect costs. If
the cost object is one of the products they produce, the salary of the supervisor is indirect. But if
the cost object is the production department, the salary is considered a direct cost of the
department because it can be effectively traced that it is incurred solely in this department.

2. Indirect Costs
Indirect costs are also related to a cost object, but cannot practically, economically and effectively
be traced to such cost object. Cost assignment is done by allocating the indirect cost to the related
cost objects. Examples are "some" factory overhead items that cannot be economically and
effectively traced to a cost object (indirect factory overhead).
D. For decision-making
1. Relevant Costs - future costs that will differ under alternative courses of action.

2. Differential Costs - difference in costs between any two alternative courses of action.
a. Incremental Cost - increase in cost from one alternative to another.
b. Decremental Cost - decrease in cost from one alternative to another.

3. Opportunity Costs - income or benefit given up when one alternative is selected over another.

4. Sunk, Past or Historical Costs - already incurred and cannot be changed by any decision made
now or to be made in the future.

E. As to relation to an accounting period:

1. Capital Expenditures
Capital expenditures are those costs incurred to benefit several periods. Meaning to say, these
costs are for long-term purposes. Examples are costs to purchase non-current assets such as land,
building and equipment.
2. Revenue Expenditures
Revenue expenditures are those costs incurred to benefit only one period. Meaning to say, these
costs are for short-term purposes only. Examples are cost of goods sold and operating expenses.
These costs are called "Revenue" Expenditures because these are charged or deducted in the
revenue earned during the period to arrive at the profit or loss for the period.

E. As to behavior (Reaction to changes in Cost Driver)

1. Variable Cost
A variable cost is one that remains constant on a per-unit basis but varies in total with changes in
activity. Examples of variable costs include direct material and direct labor.
2. Fixed Cost
A fixed cost is one that remains constant in total but varies on a per-unit basis with changes in
activity. Examples of fixed costs include straight-line depreciation, insurance, and the supervisor's
salary.
a. Committed Fixed Cost
Committed fixed cost results from an organization's ownership or use of facilities and its
basic organizational structure (e.g., property taxes, depreciation). This is called committed
because an organization cannot avoid the incurrence of this type of cost. To illustrate, if an
organization purchased machinery, the depreciation of this asset is committed to be incurred
until the end of its useful life.

b. Discretionary Fixed Cost

 Discretionary fixed cost, on the other hand is a cost that can be cut back more easily in bad
economic times without doing serious harm to organizational goals and objectives. This is
called discretionary because the incurrence of this cost depends on the discretion of the
management, therefore, not committed. Examples are advertising costs and contributions to
charitable institutions.
3. Mixed Cost
Mixed cost is a combination of variable and fixed costs. Meaning to say, this cost is partly
variable and partly fixed. Example of this is the electricity bills that you receive monthly. These
bills are partly fixed and partly variable.

Cost Behavior
Cost behavior refers to the way costs change with respect to a change in the activity level (sometimes
called cost driver), such as production or sales volume, labor or machine hours etc. There are costs which
remain constant, some change directly or proportionately with the activity level, and others change in
different patterns.

Types of Cost Total amount Amount per unit

Decreases as production
1. FIXED Constant
increases
Increases as production
2. VARIABLE Constant
increases
Increases less proportionately Decreases less proportionately
3. MIXED (vs. total variable costs) as (vs. fixed cost per unit) as
production increases production increases

Cost Behavior Assumptions

A. Relevant Range Assumption
The relevant range is that range of activity over which a variable cost remains constant on a per-
unit basis and a fixed cost remains constant in total. Managers can review the various ranges of activity
and the related effects on variable cost (per-unit) and fixed cost (in total) to determine how a change in the
range will affect costs and, thus, the firm's profitability. For instance, a company sets the relevant range as
5,000 units to 15,000 units. 5,000 units means the lowest level of activity and 15,000 units is the highest
level of activity. At this range, the company can expect the assumptions for total fixed cost and variable
cost per unit. Any activity level below or above the relevant range can change those assumptions (e.g.,
total fixed costs or variable costs may change).
To explain further, using the relevant range 5,000 to 15,000 units, 15,000 units means the
maximum capacity or the maximum number of units the company can produce for a certain period. A
company desires to produce 20,000 units for the next period. Obviously, this will be impossible to happen
using its present machinery, facility, etc. Therefore, the company will be committed to purchase additional
machinery or rent additional facility to produce the additional 5,000 units. And if there is additional
machinery, there will be additional depreciation that results to additional fixed cost. Or if there is
additional facility to rent, there will also be additional rent expense that leads to additional fixed cost as
well.
B. 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. Meaning to say for example, prices of direct
materials and wages paid to direct labor are not expected to remain constant over a long period of time.
Therefore, variable costs per unit are not expected to remain constant over a long period of time even
within the relevant range.

C. 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.
Equation "Y= a + bX"
Y = total costs (dependent variable)
a = total fixed costs (y-intercept-vertical axis-intercept)
b = variable cost per unit (slope of the line)
X = activity or cost driver (independent variable)

Illustration: Variable, Fixed and Mixed Costs

Problem 1:
Pabebe Manufacturing Company has the following information available regarding costs at various levels
of monthly production:

Production Volume
14,000 units 20,000 units
Direct materials P 70,000 P 100,000
Direct labor 56,000 80,000
Indirect materials 21,000 30,000
Supervisor's salaries 12,000 12,000
Depreciation on plant assets 10,000 10,000
Maintenance 32,000 44,000
Utilities 15,000 21,000
Insurance on plant assets 1,600 1,600
Property taxes on plant assets 2,000 2,000
Totals P 219,600 P 300,600
Required:
1. Identify each cost as being variable, fixed or mixed cost.
2. Determine the variable cost per unit and the fixed cost per month.
3. Predict the total cost for a monthly production volume of 16,000 units.

Solution:

Direct materials Variable

Direct labor Variable
Indirect materials Variable
Supervisor's salaries Fixed
Depreciation on plant assets Fixed
Maintenance Mixed
Utilities Mixed
Insurance on plant assets Fixed
Property taxes on plant assets. Fixed

Discussion:
In the illustration above, two amounts are given for each type of cost for the two activity levels
(14,000 and 20,000 units). Among the three types of cost, fixed cost is the easiest one to identify. If a cost
remains constant in total even if there is a change in the cost driver (e.g., no, of units produced), it is
considered as fixed cost. For instance, the supervisor's salaries remain constant even when the number of
units produced increased from 14,000 units to 20,000 units. Hence, it is classified as fixed cost as well as
the depreciation, insurance and property taxes.
After identifying the fixed costs, the next step is to identify the variable costs. From the definition
and term used for this type of cost, this cost "varies" directly in proportion to the changes in cost driver
but its cost per unit remains constant. For instance, the cost of direct materials is classified as variable
because:
1. The change in its total cost is also the change in the cost driver. At 14,000 units, the total cost of
direct materials is P70,000 and at 20,000 units, its total cost is P100,000. The change in number
of units is an increase of 6,000 units or 42.86% (6,000/14,000) and the change in its total cost is
an increase of P30,000 or 42.86% (P30,000/P70,000). Notice that the percentage change in the
number of units and total costs are the same. It is one of the characteristics of variable costs.
2. Its unit cost remains constant regardless of the 6,000 units increase in the production. At 14,000
units, the cost of direct materials per unit is P5 (P70,000/14,000 units) and at 20,000 units, its cost
per unit is also P5 (P100,000/20,000 units).

Use the same procedures for direct labor and indirect materials and these costs will also be classified
as variable.
 Maintenance and utilities are not classified as fixed costs because their total costs have changed as a
result of the change in the number of units. They cannot also be classified as variable costs because their
costs per unit also changed as a result of the change in the number of units.

Cost per unit

@14,000 units @20,000 units
Maintenance P2.29 P2.20
Utilities P1.05 P1.07

Problem II:
Chicago Co. 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:
Variable P120
Fixed 600
Total
Cost per unit:
Variable
Fixed

Required: Based on the above data,

1. Complete the schedule on total and unit costs (Fill in the blanks).
2. Identify two specific costs that remain constant over the relevant range.
3. Identify two specific costs that are directly related with unit production.
4. Identify the specific cost that is inversely related with unit production.
5. Express the cost formula based on the line equation for "Y = a + bX"
6. If the company produces 90 units, then the total cost is expected to be P .

Solution and Discussions:

Step 1: Copy the fixed costs in the column of 100 units to 60 and 80 units because this will be the same
regardless of the number of units. Then compute for the fixed costs per unit for each level of activity by
dividing the total fixed costs to number of units.

Units produced and sold

60 80 100
Total costs:
Variable P120
Fixed 600 600 600
Total
Cost per unit:
 Variable
Fixed 10 7.5 6

Step 2: Compute for the variable cost per unit for each level of activity. Based on the discussion on the
previous problem, variable cost per unit remains constant regardless of the changes in the activity driver.
Therefore, even if the only given total variable costs is in the column of 60 units, the resulting variable
cost per unit will just be copied to the other columns. Then finally, compute for the total variable costs of
80 units and 100 units.

Cost Estimation: Segregation of Mixed Costs into Fixed and Variable Elements
1. High-Low Method 4. Engineering Method
2. Least-Squares Method 5. Account Analysis Method
3. Scattergraph (Scatter Diagram) Method

Equation "Y = a+ bX"

Y = total costs (dependent variable)
a = total fixed costs (y-intercept-vertical axis-intercept)
b = variable cost per unit (slope of the line)
X = activity or cost driver (independent variable)

High-Low Method
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 driver. For analysis purposes. the high-low
method usually produces a reasonable, not precise estimate. However, this method is criticized because it
ignores much of the available data by concentrating on only the extreme points.
Illustration: Separation of the Fixed and Variable Components of Mixed Costs

Problem 1:
Machine hours and electricity costs for Indiana Industries for 2016 were as follows: