Chapter 2

Cost Management Concepts

and Cost Behavior

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Cost Management Concepts

and Cost Behavior
Cost and Cost Management Concepts
Cost Behavior Analysis
Variable costing
Activity-based Costing
Cost Volume Profit Analysis

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Learning Objectives :
Explain why the appropriate derivation of a cost

depends on how the cost will be used

State the difference between variable costs and
fixed costs and why the difference is important
State what opportunity cost is and how opportunity
cost relates to convention costs
Analyze cost behavior
Learn the variable costing
Understand the difference between variable costing
and absorption full costing
Learn the basic concept of activity-based cost
management system

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2.1 Cost and Cost Management

Concepts
What does costs mean?
Cost is the monetary value of goods and services
expended to obtain current or future benefits
Cost objects
Product , service, project, customer, activities,
department, planning
Cost calculation
Cost collection
According to category of the cost to collect
Cost assignment
tracing or allocate to cost object

Cost concept

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Different costs for different purposes

There is no universal way to

compute the cost of something

External purposes : GAAP
Internal purposes
Planning:
Control:

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Cost concept: Flexible costs

& Capacity-related costs

Organizing costs based on the why they are

created
Flexible costs
Flexible resources
Variable costs
Capacity-related costs
Capacity-related resources
depend on how much of the capacity is acquired,
rather than on how much is used
Fixed costs

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Cost concept: Opportunity Cost

An opportunity cost is the sacrifice you make

when you use a resource for one purpose

instead of another.
Nature of Opportunity Costs
Opportunity costs are not necessarily as payments.
Opportunity costs are the estimated foregone benefits

from actions that could, but will not, be undertaken.

Opportunity costs is the sacrifice of the best alternative
for a given action

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Cost concept: Short -run Costs

and Long -run Costs
Short-run costs
Short run is the period over which a

decision maker can not adjust capacity

Short-run costs are actually flexible costs
Long-run costs are the sum of flexible costs
and capacity-related costs associated with a
cost object, which is most often a product

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2.2 Cost Behavior Analysis

Cost Behavior is referred to the relationship

between costs and cost driver, such as volume

or activity .
Fixed Costs ( Nonvariable Costs )
the total costs remain unchanged despite changes
of activity (output), Fig. ...
Capacity-related costs, e.g., with respect to net
sale, property taxes expense, depreciation expense
on a sales showroom, based on the straight-line
method of depreciation, advertisement expense ect.

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Variable Costs
Variable Costs
the total amount of costs vary proportionately
with changes in the volume of activity (output)
Flexible costs, e.g., with respect to net sale,
income taxes expense, a commission on all sales
to salespeople ect.

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Semivariable Costs
Semivariable Costs
the total amounts of costs have both a fixed and
variable portion , i.e., costs that respond to
changes in activity volume by less than a
proportionate amount. Fig.
Mixed Costs

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Cost Behavior Analysis

Cost Behavior Analysis Process
Step1: determine cost drivers
cost driver is that measure of physical activity
most highly associated with variations in cost.
( high relevant, concise,easy ).

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Cost Behavior Analysis

Cost Behavior Analysis Process

Step2: collect data of costs and cost drivers
Step3: mark data
Step4: determine costs function
Cost Behavior Analysis
to estimate the fixed and variable elements of
semivariable costs
Cost Behavior Patterns are Linear
Cost Behavior Patterns are Stair-Step
Cost Behavior Patterns are Curvilinear

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Cost Behavior Patterns are Linear

Assumption: there is one important primary cost driver,
i.e., y = a + bx
Account Classification
according to the account character,each account in the

accounting system is classify as being either fixed or

variable

Industrial Engineering Approach

Industrial engineers study the relationship between costs
and volume with the goal of determining the optimal work
method , considering the raw materials, the design of the
product or process, the process or order of work ,the tools,
the activity of each step etc.

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Cost Behavior Patterns are Linear

High-Low Method
Determining the fixed and variable elements

of semivariable costs only by the highest and

the lowest costs during a period
Formula: b = (Y2 Y1 ) / (X2 X1 )
a = Y1 bX1 = Y2 Bx2

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Cost Behavior Patterns are Linear

Scatter-diagram Method
Step1: establishing the reference frame - the vertical

axis represents the total costs, the horizontal axis is

the total units produced
Step2: plotted the costs incurred with the relative
output as the points;
Step3: using theses data points, a straight line can
be estimated by analysts eyes and it is shown in the
following figure

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Cost Behavior Patterns are Linear

Least Squares Method

A kind of mathematical technique called as

Regression Analysis
Y = a + bx + u
y = na + b x

(1)
xy = a x +b x (2)
a = ( y - b x ) / n
b = ( n xy - x y ) / [ nx - ( x ) ]

Correlation test

Least Squares Method

Correlation Test

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Coefficient of correlation r
Coefficient of determination r
r = ( n xy - x y )
{ [ nx - ( x ) ]. [ ny - ( y ) ]}
Standard error of estimate s
s = { 1/(n-2) ( y-ye ) }

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Cost Behavior Analysis Example 1

e.g.2.1 Fresno Processing companys total

overhead is fixed and that some portion may

varies with the changes of following factors:
direct labor hours or direct labor expense or
machine hours. Now Hreny Lee, manager of the
business, is considering using one of above factors
as the primary cost driver. Information pertaining
to overhead and direct labor hour, direct labor
costs, machine hour for the first six months of the
year is shown below:

Direct Direct labor Machine

Overhead
hour
labor hour expense
Jan. 60,000
Feb. 80,000
Mar.

90,000
Apr. 110,000
May
70,000
June 110,000

2,000
4,000
3,500
4,500
2,500
4,500

11,000
15,000
14,000
20,000
11,000
18,000

3,000
5,000
2,000
3,000
4,500
6,000

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Instruction :
1) Using the Scatter - diagram Method to

determine the primary cost driver

2) Using the Least Squares Method to determine
the primary cost driver
3) What else should be considered except the high
relevant when choosing the cost driver?

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Cost Behavior Analysis Example 2

e.g.2.2 Shown below are the monthly high and low

level of machine hours and of total manufacturing

overhead for Westinghouse Company:

Machine hours

the highest (Sept.)

the lowest (Feb.)

75,000
50,000
Overhead
176,250
142,500
Assume that the total overhead consists of fixed
portion, variable portion and semivariable portion.
Each portion of the overhead is classified in detail
at the highest point as below:

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the amount of variable cost

the amount of fixed cost
the amount of semivariable cost

75,000
60,000
41,250

the total amount of overhead

176,250
Instruction:
1) Using the given data, try to find the semivariable
portion behavior pattern of overhead by means of
High - Low Method;
2) In a month in which 65,000 or 85,000 machine
hours are used, try to estimate the amount of
overhead.

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Cost Behavior Analysis Example 3

e.g.2.3 ,

,
,
.

(exponential smoothing)
,,
:

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1) ,

2) ,22500

a), (b), (c)

3) 3 (),

?,

4)
?

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Cost Behavior Is Stair-Step

& Cost Behavior Is Curvilinear
Cost Behavior Is Stair-Step
Cost Behavior Is Curvilinear
Comment on Cost Behavior Analysis

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2.3 Variable Costing

Variable Costing is a costing method in which

only variable manufacturing costs are included in

product costs.

Traditional form of product costing known

as full absorption costing include both job

order costing and process costing .
These system are designed to absorb all
manufacturing costs into product costs.

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Costs Flow of Absorption Full Costing

Expenditures
Product Costs
(Manufacturing Costs)
Direct Direct
Materials Labor

Work in
Process
Goods

Period Expenses
(Nonmanufacturing Costs)

Manufacturing

Overhead

Finished
Goods

Selling Administration
Expense
Expense

Cost of
Goods sold
Selling

Net Profit
or Loss

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Criticisms of Absorption full Costing

Absorption full

costing create
incentive to
overproduce !

Variable Costing
( Direct Costing )

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Under the variable costing,

product costs contain only the

variable components, fixed
manufacturing costs are treated
as period costs and are written
off against income in the year
they are incurred.

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Costs Flow of Variable Cost System

Expenditures
Manufacturing Costs

Nonmanufacturing Costs

Fixed
Variable
Fixed
Man.
Man.
Man.
Mat. Lab. Overhead Overhead
Overhead
Dir.

Dir.

Work in
Process
Goods

Finished
Goods

Selling
Adm.
Expense Expense

Cost of
Goods Sold
Selling

Net
Profit
or Loss

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* Profit Evaluation
Sales
Less: Variable manufacturing cost
Manufacturing margin
Less: Variable administrative &
selling expense
Contribution margin
Less: Fixed manufacturing cost
Less: Fixed administrative &
selling expense
Profit

Sales
Less: Cost of goods sold
Gross profit on sales
Less: Administrative &
Selling expense
Profit

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Contribution Margin
Contribution Margin is the amount by which the

sales revenue earned exceeds the relative variable

costs incurred, i.e.,
Contribution Margin = Sales -Variable Costs
Unit Contribution Margin is the difference
between the price and the variable cost per unit, i.e.,
Unit Contribution Margin
= Unit Selling Price -Variable Cost per Unit

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Example on Variable & Absorption full

Costing
e.g.2.4 A

single homogeneous product is produced

in Allegheny Co. , and variable cost per unit does
not increase as production is expended. To
simplify the example, assume there are not
beginning inventories. Shown below are the data
about costs, price , sales and produce volume.

Price

11/ unit
Direct materials and labor
2/ unit
Variable manufacturing overhead
3/ unit
Fixed manufacturing overhead
40,000
Fixed selling and administrative expense
5,000
Variable selling and administrative expense 1/ unit

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Example on Variable & Absorption Costing

Year1
Sales
10,000 units
Production 10,000 units

Year2
Year3
10,000 units 10,000 unit
11,000 units 9,000 unit

Required:
Prepare the absorption costing and variable

costing income statements.

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Profit

Rule

when the number of units finished= the number of units sold,

the profit of variable costing = the profit of full costing

when the number of units finished >the number of units sold

the profit of variable costing < the profit of full costing

when the number of units finished < the number of units sold,

the profit of variable costing > the profit of full costing

Comments on Variable Costing

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Criticisms of Absorption Full Costing

Absorption full costing create incentive to

overproduce !
Absorption full costing provide inaccurate
product costs. Why ?
Its because of cost structures today
the composition of manufacturing costs and
each cost item represented proportion of
total manufacturing costs

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Criticisms of Absorption Full Costing

e.g.2.5 Nanticoke Electric has three groups of

customers: industrial, commercial, and residential

(both single-unit and multiple-unit dwellings). It
sells about 1,000,000,000 units of electricity each
month to its 455,000 customers. The selling price
of the electricity is about $0.50 per unit. A recent
costing study has determined that the full
manufacturing and distribution cost is about $0.30
per unit.

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Criticisms of Absorption Full Costing

The only other major costs are meter reading costs,

which amount to $5 per reading, and billing and

processing costs, which amount to $8 per bill.Each
customers meter is read monthly and bills are
prepared monthly. There are two ways to compute
the costs for each group shown as follow (e.g.3.12).
Do you think which one accurate is?

2.4 Activity-Based Costing

Business running as a sequence of activities

Product
Product
Design
Design
Production
Production
Research
Research
and
and
Development
Development
Securing
Securing raw
raw
materials
materials and
and
other
other resources
resources

Start

Marketing
Marketing

Distribution
Distribution

Customer
Customer
Service
Service

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P59

Types of Production Activities

ABC: Business running as a sequence of

activities , activities create costs

activity : a unit of work or task with specific goal

Types of Production Activities

Unit-related activities
Those activities whose volume or level is
proportional to the number of units produced or to
other measures, such as
Unit-related activities apply to more just
production activities, such as
Unit level costs

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Types of Production Activities

Batch-related activities
Those activities triggered by the number

of batches produced rather than by the

number of units manufactured.
Machine setups, issue purchase orders,...
Batch level costs

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Types of Production Activities

Product-sustaining activities
Those activities that support the production and sale

of individual products but are independent of actual

production production and batches.
Administrative efforts to maintain drawings and labor and

machine routings for each part

Product engineering efforts to maintain coherent
specification, such as

Product level costs

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Types of Production Activities

Business-sustaining activities
Those activities required for the basic

functioning of the business, independent

of production or sales volumes and mix.
Business-sustaining costs
Facility-sustaining costs

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Types of Production Activities

Customer-sustaining activities
Those activities that enable the company to

sell to an individual customer but are

independent of the volume and mix of
products sold and delivered to the customer
Sales calls and technical support provided
to individual customers
Customer costs

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Costs Flow of Activity-Based Cost System

activity cost
drivers
Unit level
costs

Expenditures

Batch level
costs

quantity
required of each
activity by each
product

Product level
costs

Product 1

Facility-sustaining
costs

Product 2

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2.5 Cost Volume Profit Analysis

CVP Analysis

Break even analysis

a discussion to the relationships among cost,
revenue and profit based on classifying cost into
fixed/variable categories
Profit
Revenue -Variable Costs -Fixed Costs
Contribution Margin - Fixed Costs

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Basic CVP Analysis Formulas

Supposed: profit,

p price
x volume
a fixed costs
b per-unit variable costs ,

then
= px bx a = ( p b ) x - a
the term profit in CVP analysis refers to operating

income, which is pretax ; costs including

manufacturing costs and operating expenses

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= px ( bx + a ) = ( p b ) x- a
Supposed: = 0

Break even analysis

Supposed: > 0 Target profit - even
analysis
Sales & Costs
Break-even point

Loss area

Sales line
Profit area
A
Costs line

B
D

x0

Volume

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Unit Contribution Margin &

Contribution Margin Ratio

Unit Contribution Margin is the difference

between the price and the variable cost per unit, i.e.,
Unit Contribution Margin = p - b
Unit Selling Price -Variable Cost per Unit
Contribution Margin Ratio is either dividing the
total contribution margin for the period by total
revenue or on a per-unit basis, i.e.,
Contribution Margin Ratio
Contribution margin / Revenue = ( p b )/p

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Useful CVP Analysis Formulas

- Unit Contribution Margin Model
= ( p b ) x- a
at the even point ( i.e., 0 ) ,
x = ( a + ) / (p b) 2
Sales line
Profit area

Sales & Costs

Break-even point

Costs line
B

Loss area

x0

Variable costs

Volume

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Useful CVP Analysis Formulas

- Contribution Margin Ratio Model
= ( p b ) x- a
at the even point ( i.e., 0 ) ,
px = ( a + ) / [ ( p b ) / p ] 3
Sales line
Profit area

Sales & Costs

Break-even point

px0

Costs line

Loss area

x0

Volume

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Example of Cost- Volume - Profit Analysis

e.g.2.6 A single homogeneous product is

produced in Allegheny Co. , and variable cost

per unit does not increase as production is
expended. To simplify the example, assume
there are not beginning inventories. Actual sales
volume is equal to Production volume and is
10,000 unit. The projected profit is 40000 .
Shown below are the data about costs, price

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Price

11/unit
Direct materials and labor
2/ unit
Variable manufacturing overhead 3/ unit Fixed
manufacturing overhead
40,000 Selling
and administrative expense :
Fixed,
5000
Variable,
1/ unit
Instruction: compute the break-even point and the
target profit -even point.

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Margin of Safety
The dollar amount by which the actual

sales volume exceeds the break-even sales

volume, i.e., Margin Safety in dollar
(actual revenue - break-even revenue)
Sometimes margin of safety is defined in
unit , i.e. , Margin Safety
Actual volume - Break-even volume

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Example of CVP Analysis

e.g.2.7

,
,,
,

,;
,
,,

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2007100,000

,2008,
:

2007
2008
100000
120000
90000
94000

10000
26000
10%
21.67%

2007 2008
100000 150000
90000 130000
10000 20000
10% 13.33%

2008

,
2008

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: 70 000/
10 000/
a. 2008
, ,

b. 2008
26 000
c.

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Profit & Change of Profit

Profit = Margin of Safety in dollar

Contribution Margin Ratio

= Margin of Safety in unit

Unit Contribution Margin
Change in Profit = Change in Sales Revenue
Contribution Margin Ratio

= Change in Sales unit

Unit Contribution Margin
Operating Leverage

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CVP Analysis for Sales Mix

= ( pi bi )xi - a
Average Contribution Margin Ratio

is the ratio computed by weighting

the contribution margin ratios of
each product line by the percentage
of total sales which that product
represents.

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Average Contribution Margin Ratio

Supposed: (+a) allocating rate is i ,

then i = 1,

Average Contribution Margin Ratio of the firm

= i [ ( pi bi ) / pi ]

Assumption:
i is the percentage ,which each products
sales accounting for total sales.
i is defined as sales mix

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CVP Analysis for Sales Mix

step1: Calculating the average

contribution
margin ratio;
step2: Determining the break-even point
of
the company;
step3: Determining the the break-even
point of each product.

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Example of Sales Mix CVP Analysis

e.g.2.8 White Co. makes and sells three

products: G, R, E. Fixed costs incurred last

year was 144,000, the data about costs,
prices and volume of each product are shown
G
R
E
as below:
Price per unit

4
8
10
Variable costs per unit 3
4
7
Volume of sales (unit) 20,000 40,000 60,000

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Instructions:
1) compute the break-even point of White

Co. and each product ;

2) compute the profit of White Co.
How about break-even point when sales
mix changes?
In generally, break-even point will be
changed with sales mix , no matter in unit
or in dollar .

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Profitability & Sales Mix

Profitability can be improved by shifting sales mix

to include more products with high contribution

margin ratios and less products with low
contribution margin ratios.
When the sales mix remains unchanged,
Change in Profit
Change in Sales Revenue of the Co.
Average Contribution Margin Ratio
Change in Sales unit of the Co.
Average Unit Contribution Margin

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CVP Sensitive Analysis

CVP sensitive analysis studies on the fluctuating

degree of profit according to its relative factors.

What-if analysis

is sensitive to price, costs and volume,

furthermore, each sensitivity is different:

d / dp = x
d / dx = p - b
d / db = - x
d / da = -1

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Assumptions Underlying Cost Volume

Profit Analysis
CVP analysis is a single-period analysis
Sales price per unit is assumed to remain

constant
Costs can be classified into fixed and variable
portion
The number of units produced is assumed to equal

the number of units sold during each period.

The sales mix is assumed to remain constant

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Example of CVP Analysis

e.g.2.92006
$400
,30
$300
,

,,

$2.50
30%2008
:

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2008

$95,000

$28,500

8,150

17,300

4,800

3,600

5,000

3,000

2,325
1,200

$73,875

$21,125
$6,338

$14,787

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(a),?
(b),?
(c)2008 $4800,
2008?
(d) $20000,
?
(e)

(f)2008

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Reviewfor 5th edition

Reading:
Chapter 2,3
Self-study:
p70, Exercises 2-22,2-25;
p75,Problems 2-36
Assignment
p73,Problems 2-33, 2-35;2-44
P76, Problems 2-39