STRATEGIC COST MANAGEMENT Chapter 1

Appendix 1.1.

Expenses Segregation Techniques

The cornerstone of marginal costing and, to a great extent, managerial accounting, is the economic concept
that expenses are classified and classifiable as fixed and variable. This assumption is not readily true in
practice. Multifarious accounts are not classifiable as to either purely fixed expense or purely variable
expense. These “mixed costs” should be segregated as to their fixed and variable components.

There are three (3) popular methods used in separating the fixed from variable costs of a mixed account.
All of them have their technical origin from the field of statistics. They are the following:

1. High-low method
2. Scattergraph method
3. Least-squares method

High-low method

The high-low method is the traditional method of costs segregation. In statistics, it is called as the “range
analysis.” The principle used in the high-low method resides on the assumption that any change in total
costs is attributable to the change in variable costs.

Variable cost rate is computed by dividing the change in costs over the related change in base (e.g., unit of
measure such as direct labor hours, direct labor costs, machine hours, units of production, number of
shipments, set-up time, and other activity basis). After the variable cost rate is calculated, the total of fixed
costs is determined by getting the difference between the total costs and variable costs. This process is
sequentially presented below:

1. Compute the variable cost rate.

VCR = in costs / in Units where:

VCR = Variable cost rate
= Change
Units= represents direct labor hours, machine
hours, units produced, direct labor
costs, set-up hours, etc.
2. Compute the total fixed costs

TFC = TC – TVC where:

TFC = Total fixed costs
TC = Total costs
TVC = Total variable cost
3. Estimate the costs of a given level of activity.
TC = TFC +UVC (units) where:
TC = Total costs
TFC = Total fixed costs
UVC = Unit variable cost
To illustrate, let us assume the following:
Sample Problem 1.3. High-low Method
The total maintenance costs of Silver Company in the last four months are presented as follows:
Month Machine hours Maintenance costs
January 7,200 P 450,000
February 6.800 422,000
March 7,000 440,000
April 6,400 418,000

The company expects to use 7,400 machine hours n May.

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Required:
1. Variable cost rate.
2. Total fixed costs.
3. Budgeted maintenance cost in the month of May.

Solutions/ Discussions:
1. The highest level of activity happened in the month of January and the lowest level of activity
occurred in April. Their hours and costs are tabulated below:

Machine Maintenance
hours costs
Highest 7,200 P 450,000
Lowest 6400 418,000
Difference 800 P 32,000

The total maintenance cost changes because of its variable cost components. The difference in
costs amounting to P 32,000 is attributable to change in variable costs.

The variable cost rate is computed as:

VCR = in Costs / in Base = P 32,000/ 800 machine hours
= P 40 per MH

2. The total fixed cost is computed as (TFC = TC – TVC):

Machine Maintenance Total variable Total fixed

hours costs cost cost
High 7,200 P 450,000 P 288,000 P 162,000
Low 6400 418,000 256,000 162,000

(*) Total variable costs = NO. of machine hours x P 40 per MH

High = 7,200 hrs. x P 40 = P 288,000
Low = 6,400 hrs. x P 40 = 256,000

Take note the total fixed costs remains the same regardless of the levels of activity.

3. The budgeted maintenance costs at 7,400 machine hours would be:

Variable costs (7,400 MH x P 40) P 296,000

Fixed costs 162,000
Budgeted costs P 458,000

The high-low method has its own share of limitations. It is inapplicable when the
relationship between costs and unit (or base) is inverse or negative. When the activity level increases
but the total cost decreases, or when the activity level decreases but total cost increases, the use of
other statistical methods, such as statistical method and least-squares method are more appropriate.

Scattergraph method

Scattergraph or “visual fit analysis” plots the observation on a graph, make an analysis on the plotted
observation, and draws conclusions on the relationships between the “Y” (cost) and the “X” (base) variables.
This method uses the principles found in a regression line. A regression line is a straight line that depicts
the relationships of two variables – one is independent (“X”) and the other is dependent (“Y”). A regression
line is normally expressed in the equation:

Y = a + bx where:
Y = dependent variable, the value to be determined
a = constant, or point of intercept
b = variable coefficient of x, or the slope
x = independent variable, the normally given value
The equation is a perfect resemblance of total cost where:
TC = FC + VC
TC = FC + (UCM) Units sold . . . . . . . . . Y = a + bx

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Relating, we have:
Y = Total cost
a = Fixed cost
b = variable cost rate
x = no. of units sold (or other basis)

The scattergraph method provides the plotting of the observations on a graph to analyze the relationship of
“X” and “Y” variables. Normally, “X” represents the horizontal line or the units of measure and “Y”
represents the vertical line or the amount. To use this model in segregating fixed and variable elements of
costs, the following steps are to be followed:
a. Draw the “X” (horizontal) and Y (vertical) axes in the graph. Scale the axes.
b. Plot the observed data on the graph.
c. Determine the behavior of the plotted observations on the graph.
d. Draw a straight line in the middle of the plotted observation following the depicted relationship
between “X” and “Y”, where the total differences of the points above the line is equal to the
differences of the points below the line.
e. The point of origin (or point of intercept) is the value of “a”.
f. Compute “b” by choosing two “Y” values as Y1 and Y2. Determine the values of X1 and X2 from
the vertical line corresponding the points of Y1 and Y2.
g. The value of “b” equals the difference in the values of “Y” divided by the difference in the values of
“X”.
h. Assign the computed values of “a” and “b” in the regression line equation.

Let us illustrate the process using the following data:

Sample Problem 3.4. Scattergraph Method

Etoy Company is analyzing the fixed and variable components of its material handling cost in relation to
number of shipments received. The following data were taken from the historical records of the company:

No. of shipments Materials No. of shipments Materials

Months Months
received handling costs received handling costs
January 50 P 45,000 July 45 P 45,000
February 60 52,000 August 55 54,000
March 90 70,000 September 65 50,000
April 70 55,000 October 80 60,000
May 40 37,000 November 75 58,000
June 60 58,000 December 70 60,000

Using the scattergraph technique, (1) compute the fixed costs and the variable cost rate, and (2) express the
regression line equation.
Solutions/ Discussions:
 The observation are plotted in the graph and the regression line drawn following the trend of the
observation in the graph where the total differences of the points above the regression line is equal to
the total differences of the points below the graph, as shown below:
Fig. 1.6. Scattergraph

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 The regression line, Y = a + bx, is drawn at the middle of the observations plotted in the graph. The
point of origin, or point of intercept, is the value of “a”, which amounts to P 20,000.
 Next, we have to compute the value of “b”. To do this, we have to discretionarily choose two (2) points
(i.e., Y1 and Y2) in the vertical line of Y. Say Y1 = P 60,000, and Y2= P 40,000. Correspondingly, X1 =
75, and X2 = 37.5. These values are determined in the graph using a visual fit method. Let us now show
the chosen values in the graph and identify the slope (“b”).

Fig 1.7. Computing the “b” value using the Scattergraph Method

The value of “b” is the slope which depicts the increase in the value of Y depending on the change in the
value of “x”. In more understandable term, “b” is the variable cost rate. Therefore, b is computed as
follows:

b = Change in costs / Change in units where:

b = (Y1 – Y2) / X1 – X2) Change in cost = (Y1 – Y2) = Y
b= Y/ X Change in units = (X1 – X2) = X

If Y1 = 60,000 X1 = 75
Y2 = 40,000 X2 = 37.5

Then
b = (60,000-40,000) / (75-37.5)
b = 20,000 / 37.5
b = 533.33

Finally, the regression (linear) equation can be expressed as follows:

Y = a + bx
Y = 20,000 + 533.33x

Least-squares method

The least squares method extends the regression line to the other quadrants in the holistic quadrant
analysis. By doing so, additional two formulas are derived and to be used in determining the values of “a”
and “b”. The complete formulas used in the least-squares method follow

Table 1.3. Least Square Equations

Least Squares Equations Direct Formula

Equation 1. Y = a + bx a = y - bx
Equation 2. ∑𝑌 = na + b∑ 𝑥

Equation 3. ∑ 𝑋𝑌 = ∑ 𝑥a + b∑ 𝑥 2

We will use equations 2 and equation 3 in solving the values of “a” and “b”. To do this we have to know the
values of …. ∑ 𝑌, ∑ 𝑥, ∑ 𝑋𝑌, and ∑ 𝑥 2. . We may also use the direct formulas to determine the values of “a”
and “b”.

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To illustrate, consider the next sample problem.

Sample Problem 3.5. Least-Squares Method

The chief finance officer of Frank Dean Corporation is analyzing the relationship of its electricity costs and
the number of batches produced. The following data are assembled for this purpose.

Electricity
Month No. of Batches Month No. of Batches Electricity Cost
Cost
January 4 P 22,000 May 3 P 21,000
February 7 30,000 June 6 29,000
March 5 25,000 July 8 36,000
April 2 15,000

Determine the total fixed cost and variable cost rate of electricity using the least-squares method by using
the:
1. Equation method
2. Direct formula method

Solutions/ Discussions:

1. Use the two additional equations in the regression line – equation 2 and equation 3. The number of
batches is the “x” and the electricity cost is the “Y”. The value of ∑ 𝑌, ∑ 𝑥, ∑ 𝑋𝑌, and ∑ 𝑥 2, are
determine in the table shown below:

X Y XY X2
4 P 22,000 P 88,000 16 Σ𝑋 = 35
7 30,000 210,000 49 Σ𝑌 = 178,500
5 25,000 125,000 25 Σ𝑋𝑌 = 979,500
2 15,000 30,000 4 Σ𝑋 2 = 203
3 21,500 64,500 9 n=7
6 29,000 174,000 36
8 36,000 288,000 64 x = Σ𝑥/𝑛
Σ = 35 178,500 979,500 203 y = Σ𝑦/𝑛
y = 25,500 n = 7

The mnemonic “XY” is the number of batches multiplied by electricity cost, and x2 is the number
of batches multiplied by itself. By using equation 2 and equation 3 of regression line, we have:

∑𝑌 = na + b∑ 𝑥 178,500 = 7a + b35 (Eq. 1)

∑ 𝑋𝑌 = ∑ 𝑥a + b∑ 𝑥 2 979,500 = 35a + b203 (Eq. 2)

In equation 1, “n” is the number of observation. In our illustration, we have 7 observations from
the month of January to the month of July.

To compute the value of “a” and “b” using the equations above, we may choose to use the
elimination method or the substitution method. This discussion presents the use of the elimination
method.

 Compute for the value of “b”. We would first eliminate “a” to compute the value of “b”. To
eliminate “a”, the coefficient of “a” in the first equation amounting to 7 should be made -35. To do
this, we have to multiply 7 by the eliminating factor -5 (which is the factor of 35/7, then make it
negative). The entire equation 1 should be multiplied by the eliminating factor -5 to maintain its
equality. Doing this, we will have:

Eq. 1: [ 178,500 = 7a +b35] – 5

Eq. 2: 979,500 = 35a + b203
892,500 = -35a – b175
87,000 = + b 28
b = 87,000/28
b = 3,107

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 Compute for the value of “a”. Substitute value of “b” in any of the equations to compute the value
of “a”. Using equation 1, the value of “a” is determined as:
Eq. 1 178,500 = 7a +(3,107) 35
Substituting the value of “b” 178,500 = 7a + 108,745
69,755 = 7a
a = 9,965

 Develop the regression equation. Based on the computed values of “b” and “a”, the regression
equation shall now be:
y = 9,965 + 3,107x

 By using the direct formula in computing “b” and “a”, we have:

b = ∑ 𝑥y - n (x) (y) and

∑ 𝑥 2 - n (x) 2
a = y–bx
b = 979,500 – 7(5)(25,500)
a = 25,500 – (3,107) (5)
203 – 7 (5)2
a = 9,965
b = 979,500 – 892,500
203 – 7 (25)

b = 85,000
28

b = 3,107

Coefficient of correlation (r) and coefficient of determination (r2)

Coefficient of correlation (r) reflects the relationship between two variables, the dependent variable “Y” and
the independent variable “X”. Fitting the regression line in the scattergraph would guide us in determining
the values of “a” and “b”. Using the additional equations of regression line would help us in determining the
accurate values of “a” and “b”.

The issue here is the relationship of Y to X. The question is, what is the degree of correlation between the
value of “Y” and “X”? Is their correlation positive, negative, or no correlation at all? There is a danger in
the possibility of using an “X” value in determining the value of “Y” when in truth the said “X” value has no
relationship or significant relationship with the “Y” value. Therefore, determining the correlation of “X”
and “Y” is extremely important in planning and controlling activities on account of reliability and accuracy.

In determining the degree of relationship between “X” and “Y”, we have to calculate the coefficient of
correlation (“r”) and coefficient of determination (r2).

The coefficient of correlation is easier to interpret because it represents the percentage of the dependent
variable (“Y”) variance that is explained by the independent variable (“X”). That is, the change in “Y” value
is related to “X” value. The coefficient of correlation and coefficient of determination are mathematical
measures of covariation between “X” and “Y” variables. They measure the extent to which the two variables
are related linearly.

The formula for the r and r2 are as follows:

The value of r2 must be within the range of -1.00 to + 1.00. Positive 1.00 means perfect positive correlation,
negative 1.00 indicates perfect negative correlation, 0 indicates no correlation between “X” and “Y” values.
The strength or weakness of the relationship between “Y” and “X” is based on the value of computed r2
which may be interpreted based on the following table:

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Table 1.5. “r2” Value Interpretation Guide

r2 value interpretation guide

+ 1.00 Perfect positive correlation
Very high positive correlation
+0.75w
High positive correlation
+0.50
Low positive correlation
+0.25
Very low positive correlation
0 No correlation
Very low negative correlation
-0.25
Low negative correlation
-0.50
High negative correlation
-0.75
Very high negative correlation
-1.00 Perfect negative correlation

The following observations depict the several “X” and “Y” relationships:

Fig. 3.8. Degrees of Correlation Between “X” and “Y” Variables

Sample Problem 1.6. Coefficient of Correlation and Coefficient Determination

To illustrate the computation of “r” and “r2”, using the same data of Frank Dean Corporation in sample
problem 1.5, compute for the r and r2. The data are treated further as follows:

x y (x-x) (x-x)2 (y-y) (y-y)2 (x-x) (y-y)

4 P 22,000 -1 1 -3,500 12,250,000 3,500
7 30,000 2 4 4,500 20,250,000 9,000
5 25,000 0 0 -500 250,000 0
2 15,000 -3 9 10,500 10,250,000 31,500
3 21,500 -2 4 -4,000 16,000,000 8,000
6 29,000 1 1 3,500 12,250,000 3,500
8 36,000 3 9 10,500 110,250,000 31,500
35 P 178,500 28 281,500,000 87,000

x = Σ𝑥/𝑛 = 35/7 = 5
y = Σ𝑦/𝑛 = 178,500/7 = 25,500

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Then “r” and “r2” are determined as follows:

87,000
r = (28)(281,500,000)

r = 0.0799
2
r = 0.9603
Based on the computed r2, we may say that the value of “Y” has a very high positive correlation with the
value of “X”.
The standard error of estimate (s’)

After determining the correlation of X and Y, the next issue is the standard error of estimate (s’).

The issue on standard error of estimate arises because the predicted Y value (Y) is based on samples and
are treated using statistical sampling techniques. Therefore, Y is not an exact measure of the predicted value
of Y. The samples chosen from the entire population represent the general behavior of the population and
do not speak for the specific behavior of each of the occurrence or phenomena. The results of the sampling
techniques do not indicate absolute conformity of the predicted Y value in relation to the actual Y value.
Because the predicted Y value is based on samples taken from a given population and not on the entire
population itself. At the most, sampling technique is an intellectual leverage of understanding the whole
(i.e., population) by studying its parts (i.e., samples).

The s’ determines the acceptable variance from the regression line (“Y”). The s’ indicates how much the
estimated value, b, is likely, to be affected by random factors. The standard error is the actual data points
standard deviation from the regression line. A small s’ indicates a good fit between X and Y values. The
standard error is computed as follows:

S’ = Σ (𝑌 − 𝑌1 )2 / n – 2
where:
s’ = standard error of estimate
Y’ = predicted value of Y (e.g., Y’=a + bx)
The “n” is reduced by 2 as an acceptable measure of estimate in compensating the inaccuracies of small
sampling analysis.

Standard variance (or confidence interval)

The predicted Y value (“Y”) is expected not to be in accordance with the actual Y value (Y). There is always
a variance between and Y and Y’. But, there must be a standard (or acceptable) variance of Y and Y’, as
illustrated below:

The standard variance of Y, also called as confidence interval, is computed as follows:

SV = (t-value) (s’) 1 +1/n + (X – x)2- / Σ (𝑋 − 𝑥)2

Where:
SV = standard variance, or standard deviation or confidence interval
t – value = given on a prepared t-value distribution table
s’ = standard error of estimate
X = actual X value
x = average X value
n = number of samples or observation

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The t-value
The t-value is used in small sample analysis. For a large sample analysis, the z-value is used as shown at the
bottom of the t-value distribution table. The t-value is computed as follows:
t-value = 𝛽 coefficient/𝑠’
The t-value of the 𝛽 coefficient measures how large the values of the estimated coefficient is relative to its
standard error of estimate. If the t-value is greater than 2.0, the relationship between X and Y cannot be
attributed to chance alone.
The t-value distribution table is reprinted on the following page:
Desired confidence level
Degrees of freedom 90% 95% 98% 99.8%
1 6.314 12.706 3.657 318.310
2 2.920 4.303 9.925 22.326
3 2.343 3.182 5.841 10.213
4 2.132 2.776 4.604 7.173
5 2.015 2.571 4.032 5.893
6 1.943 2.447 3.707 5.208
7 1.895 2.365 3.499 5.785
8 1.860 2.306 3.355 4.501
9 1.833 2.262 3.250 4.297
10 1.812 2.228 3.169 4.144
11 1.796 2.201 3.106 4.025
12 1.782 2.179 3.055 3.930
13 1.771 2.160 3.012 3.852
14 1.761 2.145 2.977 3.787
15 1.753 2.131 2.947 3.733
20 1.725 2.086 2.845 3.552
25 1.708 2.060 2.787 3.450
30 1.697 2.042 2.750 3.385
40 1.684 2.021 2.704 3.307
50 1.671 2.000 2.660 3.232
120 1.658 1.980 2.617 3.160
z 1.645 1.960 2.576 3.090
Sample Problem 3.7. The Standard Error of Estimate and the Standard Variance
To illustrate the computation of s’ and t-value, let us adapt to the same data of Frank Dean Corporation
where the values are:
X = Number of batches
Y = Electricity cost
a = 9,965
b = 3,107
x = 5
Σ (𝑋 − 𝑋) 2
= 28
n = 7
Required:
1. The standard error of estimate. 3. The upper limit and lower limit of Y’
2. The standard variance.
Solutions/ Discussions
1. The other relevant data in the circulation of s’ and standard deviation are determined below:
X Y Y’ (Y-Y’) (Y-Y’)2
4 22,000 22,393 -393 154,449
7 30,000 31,714 -1,714 2,937,796
5 25,000 25,500 -500 250,000
2 15,000 16,719 -1,179 1,390,041
3 21,500 19,286 2,214 4,901,796
6 29,000 28,607 393 154,449
8 36,000 34,821 1,179 1,390,041
11,178,572

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Y’ = 9,965 + 3,107 x
e.g., if X = 4, then:
Y = 9,965 + 3,107 (4) = 22,393

Using the data above, the standard error of estimate is calculated as follows:
S’ = Σ (𝑌 − 𝑌 ′ )2 / n – 2
= 11,178,572 / (7-2)
= 1,495

2. To compute for the standard deviation, the following steps should be followed:

Procedures Applications
1. Determine the degree of freedom (df), df = 7-2
where, df = n-2 df = 5
2. Identify the desired confidence level. Say, a confidence level of 95%
3. Refer to the t-value distribution table. Referring to the t-value table, given a df of 5 and
confidence level of 95%, the t-value is 2.571.
4. Determine the actual value of X. Assume the actual number of batches is 9.
5. Compute the standard deviation using SV = ?
the formula. SV = (t-value) (s’)1 + 1/n _ (X-x)2 / Σ(X − x)2
= (2.571) (1,495)1 + 1/7 + (9-5)2 / 28
= (3,844) (1.2857)
= 4.942
The predicted value of Y is P 37, 928 [ i.e., Y’ = 9,965 +3,107 (9)]. At an actual activity of X (i.e., 9
batches), the predicted cost is between P 42,870 (i.e., P 37,928 +4,942) at the upper end and P 32,986
(i.e., P 37,928 – P 4,942) at the lower end.
Again, Y’ = a + bx

If the actual value of Y falls within the range of standard variance (e.g., P 32,986 to P 42,870), the variance
between actual and plan values is considered normal. If the actual value of Y falls outside the range of
standard variance, the variance is considered exceptional and such should be attended to by top
management.

Reference:

Franklin T. Agamata, CPA, MBA

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