MS04 - COST Behavior AND COST Classification PDF

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Calamba Review C enter - Laguna ( LCRC) 2F MMCO Building, 8000 Lakeview Ph3 Angela Street, Halang, Calamba City Laguna, Philippines Tel No. (02) 330-8617, (049) 523-6031; (02) 330- CPA REVIEW (May 2020 Batch)MAS Karim Abitago, CPAMS04 – COST BEHAVIOR AND COST CLASSIFICATIONTOPIC OUTLINELECTURE NOTES...

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LCRC :MS 04_COST BEHAVIOR AND COST CLASSIFICATION

BATCH MAY 2020

Cala Calamba mba Re Review view C Center enter - Laguna ( LCRC LCRC)) 2F MMCO Building, 8000 Lakeview Ph3 Angela Street, Halang, Calamba City Laguna, Philippines Tel No. (02) 330-8617, (049) 523-6031; (02) 330-6057 CPA REVIEW (May 2020 Batch) MAS

Karim Abitago, CPA

MS04

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COST BEHAVIOR AND COST CLASSIFICATION TOPIC OUTLINE Definitions Basic Concepts Cost Classification

Cost Behavior Patterns COST BEHAVIOR AND COST CLASSIFICATION

Account Analysis Conference Method

Methods in Segregating Mixed Costs

Engineering Method High-Low Method

Correlation Analysis

Scattergraph Method Least-square Method

LECTURE NOTES BASIC CONCEPTS Definitions Cost Behavior It is the study of how the firm’s costs respond to changes in activity levels with the company. Cost behavior is important in cost analysis in providing management with information to make rational and intelligent decisions regarding planning, coordinating and controlling operations. Cost Driver It is an item or event that has a cause and effect relationship with incurrence of a cost. Simply stated, it is the unit of an activity that causes the change in activity's cost. EXAMPLES: Machine hours, labor hours, no. of inspections, no. of deliveries, mileage. Cost Object It is anything for which cost is computed. Remember that anything that generates costs or has expenses associated with it can be considered a cost object. EXAMPLES: Products, departments, customers. Cost Pool Is a grouping of individual cost items. Cost allocations are then made from a cost pool. For example, the cost of the maintenance department is accumulated in a cost pool and then allocated to those departments using its services. Relevant Range It is a width or span of activities where the relationship of costs and the cost formula are valid, predictable and linear. What is the cost formula? Y=a+bx In Accounting In Mathematics Y= Total Cost / Mixed Cost Dependent Variable a= Total Fixed Cost Y Intercept / Intercept Parameter b= Variable Cost per Unit Slope x= Cost Driver / Activity Level Independent Variable NOTE: Based on the accounting equation, bx is the “TOTAL VARIABLE COST”. Cost Classifications According to Inventoriability (1) Product Costs – are manufacturing or inventoriable costs. These are costs involved in acquiring or making a product.

(2)

Period Costs – are all costs that are identified with accounting periods and not included in products costs.

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LCRC :MS 04_COST BEHAVIOR AND COST CLASSIFICATION

(1) (2) (3)

Inventoriable? Cost Flow Accounting Treatment

BATCH MAY 2020

PRODUCT COSTS vs. PERIOD COSTS PRODUCT COSTS YES Incurrence – Inventories – P/L Capitalized first (Inventories)

PERIOD COSTS NO Incurrence – P/L Expensed Outright

Direct Materials

Product Costs

Direct Labor

Indirect Materials

Factory Overhead

Indirect Labor Other Indirect Costs

Direct Materials (DM) – are materials that serve as integral part of a finished product and can be conveniently traced into it. Direct Labor (DL) – includes those labor costs that can be easily traced to particular products. Factory Overhead (FOH) – are all manufacturing costs except direct labor and direct materials. NOTE: All factory overhead costs are INDIRECT COSTS. RELEVANT FORMULAS: (a) PRIME COST = DM + DL

(b) CONVERSION COST = DL + FOH

According to Traceability (1) Direct Costs – Costs that can be economically traced to a single cost object. (2) Indirect Costs – Costs that are not directly traceable to the cost object. According to Time Frame Perspective (1) Committed Cost – Cost that is inevitable consequence of a previous commitment. EXAMPLES: Rent, taxes and licenses, depreciation (2) Discretionary Cost – A.K.A. Programmed or Managed Cost. These are costs for which the size or the time of incurrence is a matter of choice. EXAMPLES: Charitable contributions, research and development, marketing expenses. NOTE: Committed cost CANNOT be eliminated in a short-run basis but CAN be eliminated on a long-run basis. According to Controllability (1) Controllable Costs – These are costs which the incurrence or non-incurrence depends on the decision or control of a specific manager. (2) Non-controllable Costs – These are costs which the incurrence or non-incurrence DO NOT depends on the decision or control of a specific manager. NOTE: Controllability of a cost is dependent on the powers or authority delegated to the manager. According to Relevance (1) Relevant Costs – These are future costs which differ from one alternative to another. (2) Sunk Costs – These are past costs that are incurred and are irrelevant to a future decision. (3) Opportunity Costs – The value of the best alternative forgone as the result of selecting another alternative. According to Behavior (1) Variable Costs – Costs that change directly in proportion to changes in activity (volume). (2) Fixed Costs – Costs that remain unchanged for a given time period regardless of changes in activity. (3) Semi-variable or Mixed Costs – Costs that contain both fixed and variable component. NOTE: Direct materials and direct labor are generally variable costs. On the other hand, factory overhead are generally mixed costs except for indirect material and indirect labor (variable costs) and depreciation (fixed).

COST BEHAVIOR PATTERNS Cost Classification

Activity Levels / Cost Driver

↑

↓

↑

↓

CONSTANT

CONSTANT

Variable Costs: Per TOTAL Per UNIT Fixed Costs:

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LCRC :MS 04_COST BEHAVIOR AND COST CLASSIFICATION

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Per UNIT Mixed Costs:

↓

↑

Per TOTAL

↑ ↓

↓ ↑

Per UNIT

METHODS OF SEGREGATING MIXED COSTS (1) ACCOUNT ANALYSIS METHOD The account analysis approach requires that each individual cost is examined, and based on judgment is categorized as a fixed or variable cost. This requires the use of trend analysis, the past experience in judging whether a cost is fixed or variable. (2)

CONFERENCE METHOD It is an approach to cost estimation that pools together data, analyses, and knowledge from expert sources in order to make decisions about costs. In other words, this method looks at several different parts of an organization to get different perspectives about how to estimate costs.

(3)

ENGINEERING METHOD (INDUSTRIAL ENGINEERING METHOD) Industrial engineering method is a systematical way of examining the relationship between cost drivers and costs by analyzing the inputs coming into the company, the outputs that are created, and the work that goes into the process. In other words, it is a detailed look at the entire production process and how that process affects the costs of an organization. NOTE: Engineering method is the most costly method in analyzing and segregating costs.

(4)

SCATTERGRAPH METHOD (VISUAL FIT METHOD) It 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. 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. CAUTION IN USING THIS METHOD: Since the visual inspection DOES NOT involve any mathematical testing therefore this method should be applied with great care. NOTE: This method is considered the best in detecting outliers. (an outlier is a data point that differs significantly from other observations) The main question is how variable costs, fixed costs and mixed costs do look like in a graphical format?

Variable Cost per Total

Fixed Cost per Total /Variable Cost per Unit

Mixed Cost per Total

Fixed Cost per Unit NOTE: (1) – (4) are methods that use or employ judgment in segregating mixed costs. (5)

HIGH-LOW METHOD Is a crude technique or method of segregating mixed costs. This method utilizes only two points in doing a cost analysis making it a least accurate method. (This method provides only a reasonable cost estimate). Advantages: (a) Simple to use and uses less complex computations. (b) Lack of formality in cost estimation.

Management Advisory Services by Karim G. Abitago, CPA

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LCRC :MS 04_COST BEHAVIOR AND COST CLASSIFICATION

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Disadvantages / Limitations: (a) High Low Method assumes a linear relationship between cost and activity which is an over simplified analysis of cost behavior. (b) High Low Method is not representative of entire data as it is based on just 2 activity levels. Thus, outlier may be included in the computation. (c) High-low method does not account for the effect of inflation on a portion of financial data which could result in overestimation of the variable cost element of a mixed cost. STEPS IN APPLYING HIGH LOW METHOD: STEP 1: Identify the highest and lowest activity level or cost driver. NOTE: (1) What is being identified in high-low method as the highest and lowest point is just the cost driver. The highest and lowest cost is not identified separately. (2) What if there are 2 or more highest and lowest points? If you are on the high side, choose the point with the highest cost. If you are on the low side, choose the point with the lowest cost. STEP 2: Calculate variable cost per unit Variable cost per unit = (High TC – Low TC) / (High CD – Low CD) TC = Total Cost CD = Cost Driver STEP 3: Calculate total fixed cost Total Fixed Cost = High TC – (Variable cost per unit x High CD) or Total Fixed Cost = Low TC – (Variable cost per unit x Low CD) STEP 4: Formulate the cost equation that will be used in different level of activities WITHIN RELEVANT RANGE. (6) LEAST-SQUARE METHOD / LINEAR REGRESSION It is a statistical technique that may be used to estimate a linear total cost function for a mixed cost. This method is considered to be the most accurate since it derives the fixed and variable cost by means of statistical analysis. Advantages: (a) Incorporation of all data in the computation and not just 2 points. (b) Provides precise cost estimation. Disadvantages: (a) Outlier may be included in the computation. (b) More complex mathematical calculations. In using least-square method, the following equations are to be used: ∑y = n a + b ∑ x ∑xy = a ∑ x + b ∑ x2 CORRELATION ANALYSIS Correlation analysis is a method of statistical evaluation used to study the strength of a relationship between two, numerically measured, continuous variables Coefficient of correlation (r) – is a measure of the extent of linear relationship. The results extend from -1 to +1. If r is positive, there is a direct relationship between x and y. When r is negative, there is an inverse relationship between x and y. And when r is 0, there is no relationship at all between x and y. Coefficient of determination (r2) – represents the percentage of the total variation in the dependent variable. The results extend from 0 to +1. High r2 means that cost driver is highly related to the dependent variable. Standard Error of Estimate - is the measure of variation of an observation made around the computed regression line....