UNIVERSITY OF SAN JOSE-RECOLETOS

CPA REVIEW CENTER

INTEGRATED MANAGEMENT SERVICES MR. EDMAN P. FLORES, MBA, CPA

Module 2: Cost terms, concepts and behavior

1. Nature and classification of costs

• Association with cost object
– Direct costs - are costs that is conveniently and economically traceable to a particular cost object.
– Indirect costs - are costs that cannot be economically traced to a particular cost object; but instead must be
allocated to the cost object
It is important to realize that a particular cost may sometimes be a direct cost and sometimes an indirect cost. It
depends on the cost object we are trying to cost.
For example, the salary of the machining department supervisor is a direct cost of that department or cost center
because it can be specifically identified with the department. However, it is an indirect cost of each of the cost units
processed in the machining department because it cannot be specifically identified with any particular cost unit.
• Reaction to changes in activity
– Variable cost - a cost that varies in total in direct proportion to changes in activity; it is constant on a per unit
basis.
– Fixed cost - a cost that remains constant in total within a specified range of activity.
– Mixed cost - a cost that has both a variable and a fixed component; it changes with changes in activity, but
not proportionately. Example: Telephone bills (fixed line rental plus variable cost per call).
– Step cost - a cost that increases in distinct amounts because of increased activity. Step variable costs have
small steps and step fixed costs have large steps.
Examples:
1. Warehousing costs (as more space is required, more warehouses must be purchased or rented)
2. Supervisors’ wages (as the number of employees increases, more supervisors are required).
• Classification on the financial statements
– Unexpired cost - is an asset.
– Expired cost - is an expense or a loss that is shown on the income statement.
– Product cost - a cost associated with making or acquiring the products or providing the services that directly
generate the revenues of an entity.
– Period costs - are related to business functions other than production, such as selling and administrative
costs; period costs are expensed in the current accounting period.

Test your understanding 1

1. Identify whether the following costs are direct materials, direct labor or factory overhead and whether they are direct
or indirect for the production of toy cars.

Cost DM, DL, FOH? Direct or Indirect?

Rent of the factory
Supervisors’ salaries
Oil for lubricating machines
Wages of factory workers involved in production
Depreciation of equipment

2. Which of the following would be classed as indirect labor?

a. Assembly workers
b. A stores assistant in a factory storeroom
c. Plasterers in a building company
d. An audit clerk in an accountancy firm

3. Direct costs are:

a. costs which can be identified with a cost center but not a single cost unit
b. costs which can be identified with a single cost unit or cost center
c. costs which can be attributed to an accounting period
d. none of the above

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4. A company has a mix of variable, mixed, fixed and stepped fixed costs.

Total cost at different activity levels:

Cost 1,000 units 3,000 units 5,000 units 7,000 units
1 P19,000 P33,000 P47,000 P61,000
2 P1,920 P5,760 P9,600 P13,440
3 P7,000 P7,000 P7,000 P7,000
4 P12,500 P12,500 P17,000 P17,000

Cost per unit at different activity levels:

Cost 1,000 units 3,000 units 5,000 units 7,000 units
1 P19.00 P11.00 P9.40 P8.71
2 P1.92 P1.92 P1.92 P1.92
3 P7.00 P2.33 P1.40 P1.00
4 P12.50 P4.17 P3.40 P2.43

Identify the behavior for each of the above costs.

Cost 1:
Cost 2:
Cost 3:
Cost 4:

5. The term "relevant range" as used in cost accounting means the range over which
a. costs may fluctuate. c. cost relationships are valid.
b. production may vary. d. relevant costs are incurred.

6. In relationship to changes in activity, variable overhead changes

in total per unit
a. no no
b. no yes
c. yes yes
d. yes no

7. In relationship to changes in activity, fixed overhead changes

in total per unit
a. yes yes
b. no no
c. no yes
d. yes no

8. Which of the following defines variable cost behavior?

Total cost reaction Cost per unit reaction
to increase in activity to increase in activity
a. remains constant remains constant
b. remains constant increases
c. increases increases
d. increases remains constant

9. A(n) ________ cost increases or decreases in intervals as activity changes.

a. historical cost b. fixed cost c. step cost d. budgeted cost

10. When the number of units manufactured increases, the most significant change in unit cost will be reflected as a(n)
a. increase in the fixed element. c. decrease in the variable element.
b. increase in the mixed element. d. decrease in the fixed element.

2. Separating mixed costs

The total cost of a mixed cost is:

Total costs = Total fixed costs + (Variable cost per unit × Activity level)

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To be able to predict costs at different activity levels it is necessary to separate the fixed cost element from the variable
cost element. The high-low method and linear regression analysis can be used to approximate the variable cost per unit
and the total fixed cost.

The High-Low Method

The high-low method is a technique used to determine the fixed and variable portions of a mixed cost; it uses only the
highest and lowest levels of activity and related costs within the relevant range.

Step 1: Select the highest and lowest activity levels, and their associated costs.

Step 2: Calculate the variable cost (VC) per unit:

Step 3: Calculate the fixed cost by substitution, using either the high or low activity level:
Fixed cost = Total cost at activity level – (Variable cost per unit × Activity level)

Step 4: Use the total fixed cost and the variable cost per unit values from steps 2 and 3 to calculate the estimated cost
at different activity levels:
Total costs = Total fixed costs + (Variable cost per unit × Activity level)

Assumptions of the high-low method are as follows:

• the only thing causing any change in cost is the change in activity
• the cost under consideration is potentially semi-variable (i.e. it has both fixed and variable elements)
• the linear model of cost behavior is valid i.e. y = a + bx.

Advantages and limitations of the high-low method:

The main advantage of the high-low method is that it is easy to understand and easy to use.

The limitations of the high-low method are as follows:

• it relies on historical cost data and assumes this data can reliably predict future costs
• it assumes that activity levels are the only factor affecting costs
• it uses only two values (highest and lowest) to predict future costs and these results may be distorted because of
random variations which may have occurred
• bulk discounts may be available for purchasing resources in large quantities.

Linear regression analysis

A linear relationship can be expressed in the form of an equation which has the general form y = a + bx

where y is the total cost = fixed cost + variable cost (dependent on the activity level)
x is the activity level (the independent variable)
a is the fixed cost per period (the intercept)
b is the variable cost per unit (the gradient)

Suppose a cost has a cost equation of y = P5,000 + 10x, this can be shown graphically as follows:

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Linear regression analysis, also known as the 'least squares technique', is a statistical technique that analyzes the
association between dependent and independent variables. It 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. It can be used
to determine the fixed and variable portions of a mixed cost. The linear regression analysis is used to develop an
equation that predicts the unknown value of a dependent variable (cost) from the known values of one or more
independent variables (activities).

The linear regression formula is as follows:

Example

The transport department of ABC Company operates a large fleet of vehicles. These vehicles are used by the various
departments of the company. Each month a statement is prepared for the transport department comparing actual results
with budget. One of the items in the transport department's monthly statement is the cost of vehicle maintenance. This
maintenance is carried out by the employees of the department. To facilitate control, the transport manager has asked
that future statements should show vehicle maintenance costs analyzed into fixed and variable costs.

Data from the six months from January to June inclusive are given below.
Month Vehicle maintenance cost Vehicle running hours
January 680,000 2,100
February 790,000 2,800
March 725,000 2,200
April 810,000 3,000
May 745,000 2,600
June 750,000 2,500

Required:
1. Analyze the vehicle maintenance costs into fixed and variable costs, based on the data given, utilizing the linear
regression analysis.
2. Prepare a budget for total maintenance cost if the level of activity is 2,750 hours.

Solution

1. If y = a + bx, where y represents costs and x represents running hours (since costs depend on running hours) then b
= (nΣxy – ΣxΣy)/ (nΣx2 – (Σx)2), when n is the number of pairs of data, which is 6 in this problem.

X y xy x^2
Hours Php Php Php

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 January 2,100 680,000 1,428,000,000 4,410,000
February 2,800 790,000 2,212,000,000 7,840,000
March 2,200 725,000 1,595,000,000 4,840,000
April 3,000 810,000 2,430,000,000 9,000,000
May 2,600 745,000 1,937,000,000 6,760,000
June 2,500 750,000 1,875,000,000 6,250,000
Σ 15,200 4,500,000 11,477,000,000 39,100,000

nΣxy = 6 x 11,477,000,000 = 68,862,000,000

ΣxΣy = 15,200 x 4,500,000 = 68,400,000,000
nΣx2 = 6 x 39,100,000 = 234,600,000
(Σx)2 = 15,200 x 15,200 = 231,040,000

Variable cost per hour, b = (nΣxy – ΣxΣy) / (nΣx2 – (Σx)2)

= (68,862,000,000 – 68,400,000,000 / (234,600,000 – 231,040,000)
= 129.78
Fixed cost, a = Σy/n - bΣx/n
= (4,500,000/6) / (129,78 x 15,200/6) = 750,000 – 328,776
= 421,224

2. Total maintenance cost at 2,750 hours = P421,224 + (P129.78 x 2,750)

= P778,119

Test your understanding 2

11. ABC Manufacturing Company wants to develop a cost estimating equation for its monthly cost of electricity. It has
the following data:
Month Cost of Electricity Direct Labor Hours
January P67,500 1,500
April 75,000 1,700
July 85,000 2,000
October 72,500 1,600

Using the high-low method, what is the best equation?

a. Y = P7,500 + P35X
b. Y = P7,500 + P50X
c. Y = P15,000 + P35X
d. Y = P20,000 + P35X

12. Mavericks Machine Works had the following data regarding monthly power costs:
Month Machine hours Power cost
Jun 300 P680
Jul 600 720
Aug 400 695
Sept. 200 640

Assume that management expects 500 machine hours in October. Using the high-low method, calculate
October’s power cost using machine hours as the basis for prediction.

a. P700 b. P705 c. P710 d. P1,320

13. The following production and total cost information relates to a single product organization for the last three months:

Month Production volume Total costs

1 1,200 P666,000
2 900 P582,000
3 1,400 P682,000

The variable cost per unit is constant up to a production level of 2,000 units per month but a step up of P60,000 in
the monthly total fixed cost occurs when production reaches 1,100 units per month.

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 What is the total cost for a month when 1,000 units are produced?
a. P542,000
b. P550,000
c. P590,000
d. P602,000

14. An organization has the following total costs at three activity levels

Activity level (units) 4,000 6,000 7,500

Total cost P40,800 P50,000 P54,800

Variable cost per unit is constant within this activity range and there is a step up of 10% in the total fixed costs when the
activity level exceeds 5,500 units.

What is the total cost at an activity level of 5,000 units?

a. P44,000
b. P44,800
c. P45,400
d. P46,800

15. In the standard regression equation y = a + bx, the letter y is best described as a(n)
a. Dependent variable.
b. Independent variable.
c. Constant coefficient.
d. Variable coefficient.

16. If the relationship between production costs and output is connected by the linear relationship y = 47,000 + 75x,
what is 47,000?
a. Total production costs
b. The fixed production costs
c. The number of units produced
d. The production cost if 75 units are produced

17. ABC Company would like to estimate the variable and fixed components of its maintenance costs and has compiled
the following data for the last five months of operations.

Labor Hours Maintenance Cost

January 160 P30,850
February 130 P27,650
March 180 P29,800
April 190 P31,150
May 110 P26,600

Using linear regression analysis, the estimated variable cost per labor hour for maintenance is closest to:
a. P94
b. P76
c. P55
d. P98

18. The regression analysis results for ABC Co. are shown as y = 2,250 + 90x. The budget calls for production of 100
units. What is ABC’s estimate of total costs?
a. P5,295
b. P7,155
c. P11,235
d. P11,250

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19. Your boss would like you to estimate the fixed and variable components of a particular cost Actual data for this cost
over four recent periods appear below.

Activity Cost
Period 1 25 P18,150
Period 2 22 P17,250
Period 3 23 P17,400
Period 4 20 P16,100

Using the linear regression analysis, what is the cost formula for this cost?
a. Y = P8,225 + P400X
b. Y = P0.00 + P765.55X
c. Y = P8,018 + P409.18X
d. Y = P11,296 + P263.5X

20. Multiple regression differs from simple regression in that it

a. Provides an estimated constant term.
b. Has more dependent variables.
c. Allows the computation of the coefficient of determination.
d. Has more independent variables.

PRACTICE TEST

1. The distinction between direct and indirect costs depends on whether a cost
a. is controllable or non-controllable.
b. is variable or fixed.
c. can be conveniently and physically traced to a cost object under consideration.
d. will increase with changes in levels of activity.

2. If there is no "a" value in a linear cost equation, this is an indication that the cost is
a. fixed. b. mixed. c. variable. d. either fixed or mixed.

3. If the level of activity increases,

a. variable cost per unit and total fixed costs increase.
b. fixed cost per unit and total variable cost increase.
c. total cost will increase and fixed cost per unit will decrease.
d. variable cost per unit and total cost increase.

4. Weaknesses of the high-low method include all of the following except

a. only two observations are used to develop the cost function.
b. the high and low activity levels may not be representative.
c. the method does not detect if the cost behavior is nonlinear.
d. the mathematical calculations are relatively complex.

5. A fixed cost that would be considered a direct cost is:

a. a cost accountant’s salary when the cost objective is a unit of product.
b. the rental cost of a warehouse to store inventory when the cost objective is the Purchasing Department.
c. a production supervisor’s salary when the cost objective is the Production Department.
d. Board of Directors’ fees when the cost objective is the Marketing Department.

6. An organisation has the following total costs at three activity levels:

Activity level (units) 8,000 12,000 15,000

Total cost P204,000 P250,000 P274,000

Variable cost per unit is constant within this activity range and there is a step up of 10% in the total fixed costs when
the activity level exceeds 11,000 units.

What is the total cost at an activity level of 10,000 units?

a. P220,000
b. P224,000
c. P227,000
d. P234,000

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7. A manufacturing company has four types of cost (identified as T1, T2, T3 and T4).

The total cost for each type at two different production levels is:

Cost type Total cost for 125 units Total cost for 180 units
T1 1,000 1,260
T2 1,750 2,520
T3 2,475 2,826
T4 3,225 4,644

Which two cost types would be classified as being mixed?

a. T1 and T3
b. T1 and T4
c. T2 and T3
d. T2 and T4

8. Aquatic Motor Company is exploring different prediction models that can be used to forecast indirect labor costs. One
independent variable under consideration is machine hours. Following are matching observations on indirect labor
costs and machine hours for the past six months:
Month Machine hours Indirect labor costs
1 300 P20,000
2 400 P24,000
3 240 P17,000
4 370 P22,000
5 200 P13,000
6 225 P14,000

In a high-low model, which months' observations would be used to compute the model's parameters?

a. 2 and 5 b. 1 and 6 c. 2 and 6 d. 4 and 5

9. A company incurs the following costs at various activity levels:

Total cost Activity level

250,000 5,000
312,500 7,500
400,000 10,000

Using the high‐low method what is the variable cost per unit?
a. P25
b. P30
c. P35
d. P40

10. The management of Casablanca Manufacturing Corporation believes that machine-hours is an appropriate measure
of activity for overhead cost Shown below are machine-hours and total overhead costs for the past six months:
Machine- Overhead
Hours Cost
Jan 150,000 P339,000
Feb 140,000 P328,000
Mar 160,000 P350,000
Apr 130,000 P319,500
May 170,000 P362,500
Jun 200,000 P400,000

Assume that the relevant range includes all of the activity levels mentioned in this problem.

If Casablanca expects to incur 185,000 machine hours next month, what will the estimated total overhead cost be
using the high-low method?
a. P212,750 b. P359,750 c. P382,750 d. P381,700

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11. In describing the cost formula equation, Y = a + bX, which of the following is correct:
a. “Y” is the independent variable.
b. “a” is the variable cost per unit.
c. “a” and “b” are valid for all levels of activity.
d. in the high-low method, “b” equals the change in cost divided by the change in activity.

12. Your boss would like you to estimate the fixed and variable components of a particular cost Actual data for this cost
over four recent periods appear below.
Activity Cost
Period 1 .................. 25 P363
Period 2 .................. 22 P345
Period 3 .................. 23 P348
Period 4 .................. 20 P322

Using the least-squares regression method, what is the cost formula for this cost?

a. Y = P164.50 + P8.00X
b. Y = P0.00 + P15.31X
c. Y = P160.36 + P8.18X
d. Y = P168.08 + P5.27X

13. A professional organization is planning to conduct a series of one-day continuing education programs in various
cities. The projected costs related to these programs are

Promotional advertising P1,250 per program

Instructor’s fee P750 per program
Instructional materials P12 per participant
Hotel Charges:
Room rental and setup fee P400 per program
Continental breakfast P10 per participant
Lunch P25 per participant
Refreshment breaks P8 per participant
The hotel requires a P200 nonrefundable deposit on the room rental and setup fee 75 days prior to the program. At
about the same time, the promotional advertising materials are developed, prepared, and mailed to potential
participants, and a 20% payment is made to ensure the services of an instructor. The instructor keeps this 20%
payment even if the program is canceled and receives the balance of the fee at the conclusion of the program. The
remaining hotel fees and charges, as well as the cost of instructional materials, are paid at the conclusion of the
program.
The capacity for each program is 100 persons, but past attendance for similar programs has averaged 80 persons.
The cost-estimating equation for calculating the costs for a one-day continuing education program is

a. P79 times the number of participants.

b. P85 times the number of participants.
c. P800 plus (P55 times the number of participants).
d. P2,400 plus (P55 times the number of participants).

14. Connix Company would like to estimate the variable and fixed components of its maintenance costs and has
compiled the following data for the last five months of operations.

Labor Maintenance
Hours Cost
January 160 P617
February 130 P553
March 180 P596
April 190 P623
May 110 P532

Using the least-squares regression method, the estimated variable cost per labor hour for maintenance is closest to:
a. P1.88 b. P1.52 c. P1.09 d. P1.96

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15. The regression analysis results for ABC Co. are shown as y = 90x + 45. The standard error (S ) is 30 and coefficient
of determination (r ) is 0.81. The budget calls for production of 100 units. What is ABC’s estimate of total costs?
a. P3,090
b. P4,590
c. P9,030
d. P9,045

Questions 16 & 17 are based on ABC Company, which derived the following cost relationship from a regression analysis
of its monthly manufacturing overhead cost:
C = P80,000 + P12M
where C = monthly manufacturing overhead cost
M = machine hours

The standard error of the estimate of the regression is P6,000.

The standard time required to manufacture one six-unit case of ABC’s single product is 4 machine hours. ABC applies
manufacturing overhead to production on the basis of machine hours and its normal annual production is 50,000 cases.

16. ABC’s estimated variable manufacturing overhead cost for a month in which scheduled production is 5,000 cases
would be:
a. P80,000. b. P320,000. c. P240,000. d. P360,000.

17. ABC’s predetermined fixed manufacturing overhead rate would be:

a. P1.60 machine hour. c. P3.20 machine hour.
b. P4.00 machine hour. d. P4.80 machine hour.

Questions 18 through 20 are based on the following information. In preparing the annual profit plan for the coming year,
James Company wants to determine the cost behavior pattern of the maintenance costs. James has decided to use linear
regression by employing the equation y = a + bx for maintenance costs. The prior year’s data regarding maintenance
hours and costs, and the results of the regression analysis are as follows.
Hours of Maintenance
Activity Costs
January 480 P 4,200
February 320 3,000
March 400 3,600
April 300 5,820
May 500 4,350
June 310 2,960
July 320 3,030
August 520 4,470
September 490 4,260
October 470 4,050
November 350 3,300
December 340 3,160
4,800 P 43,200

Average 400 P3,600

Average cost per hour P9.00

a P684.65
b P7.2884
Standard error of a 49.515
Standard error of b 0.12126
Standard error of the estimate 34.469
r2 0.99724

18. In the standard regression equation y = a + bx, the letter b is best described as a (n):
a. independent variable. c. dependent variable.
b. constant coefficient. d. variable coefficient.

19. The letter x in the standard regression equation is best described as a (n):
a. independent variable. c. dependent variable.
b. constant coefficient. d. variable coefficient.

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20. Based upon the data derived from the regression analysis, 420 maintenance hours in a month would mean the
maintenance costs (rounded to the nearest peso) would be budgeted at:
a. P3,780. b. P3,600. c. P3,790. d. P3,746.

21. The marketing manager of ABC Company has learned the following about a new product that is being introduced by
ABC. Sales of this product are planned at P1,000,000 for the first year. Sales commission expense is budgeted at 8%
of sales plus the marketing manager's incentive budgeted at an additional 1/2%. The preparation of a product
brochure will require 20 hours of marketing salaried staff time at an average rate of P1,000 per hour, and 10 hours,
at P1,500 per hour, for an outside illustrator's effort. The variable marketing cost for this new product will be
a. P80,000
b. P85,000
c. P100,000
d. P105,000

22. Which one of the following is correct regarding a relevant range?

a. Total fixed costs will not change.
b. Total variable costs will not change.
c. Actual fixed costs usually fall outside the relevant range.
d. The relevant range cannot be changed after being established.

23. A manufacturing company estimates semi-variable costs by using the high-low method with machine hours as the
cost driver. Recent data are shown below.

Period Mixed Costs Machine Hours

1 P1,000,000 22,000
2 P1,200,000 30,000
3 P 960,000 23,600

If 29,000 machine hours were budgeted for the next period, estimated semi -variable costs would total
a. P1,162,500.
b. P1,170,000.
c. P1,175,000.
d. P1,212,200.

24. An organization has the following total costs at three activity levels:

Activity level (units) 16,000 24,000 30,000

Total cost P408,000 P500,000 P548,000

Variable cost per unit is constant within this activity range and there is a step up of 10% in the total fixed costs when
the activity level exceeds 22,000 units.

What is the total cost at an activity level of 20,000 units?

a. P440,000
b. P448,000
c. P454,000
d. P468,000

25. Your boss would like you to estimate the fixed and variable components of a particular cost. Actual data for this cost
over four recent periods appear below.

Activity Cost
Period 1 50 P3,630
Period 2 44 P3,450
Period 3 46 P3,480
Period 4 40 P3,220

Using the least-squares regression method, what is the cost formula for this cost?
a. Y = P1,195 + P50X
b. Y = P1,645 + P40X
c. Y = P1,580 + P41X
d. Y = P2,275 + P26X

---NOTHING FOLLOWS---

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