OUR LADY OF THE PILLAR COLLEGE – CAUAYAN

Cauayan City, Isabela

Foundations of Management Accounting

A. Costs in Managerial Accounting

Cost - a measurement, in monetary terms, of the amount of resources given up or used for some purpose.
When
notified by a term that defines the purpose, cost becomes operational. (e.g., selling cost, acquisition cost,
fixed cost, etc.)
- the monetary value of goods and services expended to obtain current or future benefits.

Some Cost Terms Used in Managerial Accounting

Cost Object – anything for which cost is computed; the intermediate and final disposition of cost pools.
(e.g., a product, a product line, a job, a process, a segment of the organization)

Cost Driver – any variable, such as a level of activity or volume, that usually affects costs over a period of time;
a factor that causes a change in the cost pool for a particular activity, and used as basis for cost allocation.
(e.g., production, sales, number of orders, amount of square footage, number of machine hours, number of
employees, etc.)

Cost Pool – a grouping of individual cost items; an account in which a variety of similar costs are accumulated
prior to allocation of cost objects; it is a group associated with an activity; the overhead cost allocated to a
distinct type of activity or related activities. (e.g., work in process, factory overhead control)

Activity – an event, action, transaction, task, or unit of work with a specified purpose

Value-Adding Activities – activities that are necessary (non-eliminable) to produce the products
(e.g., assembling the different component parts of the product)

Non-Value-Adding Activities – activities that do not make the product or service more valuable to the
customer (e.g., moving materials and equipment parts from/to the stockroom or a workstation)

Levels of Activity Centers (Hierarchy of Activity Levels)

In contrast to traditional volume-based costing which recognizes only unit-level costs, i.e., volume
driven or driven by units of output, this hierarchy provides managers and accountants a structured way of
thinking about the relationships between activities and the resources they consume.
In order to achieve greater accuracy in overhead cost allocation, the following table presents the four
(4) different levels of activities that will be recognized and, from them, developing specific activity cost pools
and their related cost drivers:

Level of Activity Types of Activities Examples of Costs

1. Unit-Level – These are Machine-related:
performed for each unit of Drilling, cutting, milling, Direct material, depreciation of
production. trimming, pressing machines, power costs, machine
maintenance
Labor-related:
Assembling, painting, sanding, Direct labor, fringe benefits,
sewing payroll taxes
2. Batch-Level – These are Equipment setups Labor setup costs
performed for each batch of Purchase ordering Purchasing clerical costs
products rather than each unit. Inspection Material handling costs
Material handling Quality control costs
3. Product-Level – These are Product design Design costs
performed in support of an entire Engineering changes Product engineering costs
product line, but are not always Inventory changes Inventory carrying costs
performed every time a new unit
or batch of products is produced.
4. Facility-Level – These are Plant management Building depreciation
required to support or sustain an Personnel administration Heating, air conditioning
entire production process. Training Property taxes
Security Insurance

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 Failure to recognize this hierarchy of activities is one of the reasons that volume-based cost allocation causes
distortions in product costing. The resources consumed by batch-, product-, and facility-level supporting
activities do not vary at the unit level, nor can they be controlled at the unit level. Only modifying these
activities can control them.
Different Costs for Different Purposes (Classifications of Costs)

1. As to Type
a. Product Costs – costs incurred to manufacture the product
i. Product costs of the units sold during the period are recognized as expense (cost of goods sold) in the
income statement.
ii. Product costs of the unsold units become the costs of inventory and treated as asset in the balance sheet.

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

2. As to Function
a. Manufacturing Costs – all the costs incurred in the factory to convert raw materials into finished goods
i. Direct Manufacturing Costs – materials and labor
ii. Indirect Manufacturing Costs – the manufacturing overhead or factory overhead costs

b. Non-Manufacturing Costs – all costs which are not incurred in transforming materials to finished goods

i. Research and Development – incurred in designing and bringing new products to the market
ii. Marketing Costs – advertising and promotion expenses
iii. Distribution Costs – costs incurred in delivering the products to the customers
iv. Selling Costs – salaries and commission of sales staff and other selling expenses
v. After-sales costs – costs incurred in dealing with customers after sales. (e.g., warranty, repairs costs,
and costs incurred in receiving/entertaining/acting on customers’ complaints)
vi. General and Administrative Costs – all the non-manufacturing costs that do not fall under categories ( i)
to (v).

3. As to Traceability/Assignment to Cost Object

a. Direct Costs – costs that are related to a particular cost object and can economically and effectively be
traced to that cost object.

b. Indirect Costs – costs that are 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.
4. For Decision-Making
a. Relevant Costs – future costs that will differ under alternative courses of action

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

c. Opportunity Costs – income or benefit given up when one alternative is selected over another

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

5. As to Behavior (Reaction to Changes in Cost Driver)

a. Variable Cost – within the relevant range and time period under consideration, the total amount varies
directly to the change in activity level or cost driver, and the per unit amount is constant.
i. Semivariable costs that increase at an increasing rate
ii. Semivariable costs that increase at a decreasing rate

b. Fixed Cost – within the relevant range and time period under consideration, the total amount remains
unchanged, and the per unit amount varies inversely or indirectly with the change in the cost driver.
i. Committed Fixed Costs – long-term in nature and cannot be eliminated even for short period of time
without affecting the profitability or long-term goals of the firm. (e.g., depreciation of buildings and
equipment)
ii. Discretionary or Managed Fixed Costs – usually arise from periodic (may be annual, etc.) by
management to spend in certain fixed costs area such as research, advertising, maintenance contracts.
Discretionary fixed costs may be changed by management from period to period or even during
(within) the period, if circumstances demand such change. (e.g., advertising expense, research and
development costs, maintenance costs provided by service contractors)

c. Mixed Cost – this cost has both a variable and a fixed component.

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 d. Step Cost – when activity changes, a step cost shifts upward of downward by a certain interval or step.

i. Step Variable Costs – have small steps

ii. Step Fixed Costs – have large steps

Cost Behavior Assumptions

1. The Relevant Range Assumption

- Relevant range refers to the band of activity within which the identified cost behavior patterns are
valid. Any level of activity outside this range may have different cost behavior patterns.
- A range of activity that reflects the company’s normal operating range. Within this relevant range,
the cost behavior patterns are valid.

2. The Time Period Assumption

- Time period states that cost behavior patterns identified are true only over a specific period of time.
Beyond this, the cost may show a different behavior. That is, some costs classified as fixed may no
longer be fixed in the long run. A directly/purely variable cost may show a semivariable cost
behavior pattern beyond a period of time under consideration. Or a variable cost may even shift to
be a fixed cost or vice-versa, due to some circumstances that may occur in the business.

3. Linearity Assumption

- within the relevant range, there is a strict linear relationship between the cost and cost driver. Costs
may therefore be shown graphically as straight lines.

The Cost Function (Analysis of a Mixed Cost)

Mixed Costs or Total Costs (TC) have Variable (VC) and Fixed (FxC) cost components, as shown below:

TC = VC + FxC

Since total variable cost varies directly with the activity level or cost driver, then

VC = variable cost per activity level/cost driver x cost driver

or

VC = bX ; where VC is total variable cost, b is variable cost per activity level/cost driver, and x
is cost driver.

And, since Total Cost (TC), denoted as Y, is linearly related to the activity level or cost driver, the cost
function (cost formula) may be expressed as:

Y = bX + a ; where a is the total fixed cost.

Moreover, the description of each variable in the equation in algebra and managerial accounting is as
follows:
Y = is the dependent variable or the total cost
X = is the independent variable or the activity level/cost driver
b = is the slope or the variable cost per activity level/cost driver
a = is the Y-intercept or the total fixed cost

Methods of Segregating/Separating the Fixed and Variable Components of a Mixed Cost

1. High-Low Method
The cost components are computed from two data points. The data points, taken from historical data, represent
the highest and lowest activity levels during the period under consideration.

 Do not select data points distorted by abnormal conditions (abnormally or extraordinarily

high and low points).

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  If the periods of highest or lowest activity levels are not the same as those having the
highest or lowest cost levels, the activity level should govern the selection because the
activity level is the cost driver.

The following procedures are to be followed if the graphical approach is used under the high-low method:

a. Plot the data on a graph: the costs on the vertical (Y) axis and the activity level/cost driver on the
horizontal (X) axis;
b. Draw a straight line through the points corresponding to the low and high cost drivers or activity
levels;
c. Compute the slope of the line. This slope represents the variable cost per activity level/cost
driver;
d. The Y-intercept (the point where the straight line touches the Y-axis) represents the fixed cost.
e. Develop the cost function using the equation for the straight line, Y = bX + a.

2. Scattergraph Method
The scattergraph method is a more accurate way of separating the variable and fixed cost components of mixed
costs than the high-low points method. In high-low, only two points are used, unlike in scattergraph method
where all the points, except the abnormally high and low data where they can be seen when a scattergraph is
drawn, are considered. The method, however, is subjective: results of the analysis may differ. No two analyses
are likely to draw exactly the same regression line on the same scattergraph.

The following procedures are to be followed:

a. Plot the points on a graph;

b. Draw a straight line through the points:
 Instead of just fitting the line to the high and low points, all the points are considered.
Through visual inspection of the data points, the line is drawn through them, making that
the line is representative of all the points, not just the high and low points. To do this, the
line may be drawn so that approximately equal number of points fall below and above it.
 The line fitted to the plotted points is called regression line.
c. Get two (2) points from the regression line and determine the slope, or the variable cost per
activity level/cost driver;
d. The Y-intercept is the fixed cost.

3. The Least-Squares Regression Method

The least squares regression method uses mathematical formulas to fit the regression line, unlike in scattergraph
where the line is fitted by visual inspection. The procedures involve a computation of a regression line that
minimizes the sum of squared errors or deviations (the vertical distance between the plotted points and the
regression line).

The procedures are as follows:

a. The objective is to come up with the cost function Y = bX + a;

b. The values of a and b may be computed by solving simultaneously the following equations:

ΣY = na + bΣX
ΣXY = aΣX + bΣX²

Alternatively, a and b may be computed as shown below:

n(ΣXY) - ΣXΣY ΣY - bΣX -- --

b = −−−−−−−−−−− ; a = −−−−−−−− or a=Y–b(X)
n(ΣX²) - (ΣX)² n

4. Multiple Regression Analysis

This is used when the dependent variable (cost, for example) is caused by more than one factor. In other words,
the dependent variable (cost) is related to more than one independent variables (units, machine hours, etc.)

Correlation Analysis

Correlation – measure of the co-variation between the dependent and independent variables

 If all plotted points fall on the regression line, there is perfect correlation.
 If correlation between the cost and cost driver is high and the past relationship between
such variables will continue in the future, then the cost driver chosen will be useful for
predicting future levels of the costs being analyzed.

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 Coefficient of Correlation (denoted by r) – measure of the extent of the linear relationship between two
variables

Range of Values of r: from -1 to +1 r = -1 ≤ 0 ≤ +1

r = 0 (zero), there is no correlation

r = +1 (positive), there is perfect correlation. There is a positive or direct relationship between the
dependent (Y) and independent (X) variables. That is, the value of Y increases when the value of X
increases. The regression line slopes upward to the right.

r = -1 (negative), there is perfect correlation. There is a positive or direct relationship between the dependent
(Y)
and independent (X) variables. That is, the value of Y increases when the value of X increases. The
regression line slopes upward to the right.

Coefficient of Determination (denoted by r²) – is computed by squaring the value of r. It represents the
percentage
of the total variation in the independent variable Y that is
explained or accounted for by the regression equation.

Standard Error of the Estimate – the standard deviation about the regression line

Estimated values computed using the regression equation may differ from the actual cost. The
differences are called prediction errors or errors of estimate.

The standard error of estimate is calculated to serve as a confidence interval or acceptable range of
tolerance, for use in exercising control over the costs. By comparing a cost variance with the standard error of
estimate, management can decide whether to investigate such variance or not.

 If r² = +1, the standard error is equal to 0.

 A small value of the standard error indicates a good fit.