COST 

- the monetary amount of the resources given up or sacrificed to attain some objective such as acquiring
goods and services. When notified by a term that defines the purpose, cost becomes operational (e.g.,
acquisition cost; production cost, cost of goods sold).

COST BEHAVIOR

Cost behavior is the relationship between cost and activity - as to how costs react to changes in an
activity like production. Managers who understand how costs behave are better able to predict what
costs will be under various operating circumstances.

IMPORTANCE OF UNDERSTANDING COST BEHAVIOR

Planning requires that management make decisions based in part on expectations as to the future.
These expectations should be based on data relevant to the decisions objectives, gathered and analyzed
in a competent, unbiased fashion. Failure in this activity could mean displacement costs due to
unexpected events. 

Control is the process of using feedback information for comparison with expectations and the
implementation of actions on the basis of that comparison.

Cost Analysis is an integral part of the planning and control function. The key to effective cost prediction
lies in an understanding of cost behavior patterns.

COST BEHAVIOR ASSUMPTIONS AND LIMITATIONS

RELEVANT RANGE Assumption

Relevant range refers to the range of activity within which cost behavior patterns are valid. Any level of
activity outside this range may show a different cost behavior pattern.

TIME Assumption 

The cost behavior patterns identified are true only over a specified period of time. Beyond this, the cost
may show a different cost behavior pattern.

LINEARITY Assumption

The cost is assumed to manifest a linear relationship over a relevant range despite its tendency to show
otherwise over the long run.
TYPES OF COST BEHAVIOR PATTERNS

As production increases, some costs remain the same (i.e., fixed) while some costs increase or decrease
(i.e., variable). Consider the following:

COSTS TOTAL AMOUNT PER UNIT AMOUNT

FIXED Constant Decreases as production increases

(i.e., inverse relationship

VARIABLE Increases as production increases (direct Constant

relationship)

MIXED  Increases less proportionately (vs. total Decreases less proportionately (vs. unit
variable costs) as production increases fixed costs) as production increases
(Semi-
variable)

1. 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.

2. 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.

 Committed Fixed Costs - long term in nature and cannot be eliminated even for a short period
of time without affecting the profitability or long-term goals of the firm. example: depreciation
of buildings and equipment

 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. examples: research and
development costs, advertising expense, maintenance costs provided by service contractors.

3. Mixed Cost - this cost has both a variable and a fixed component. Examples of social security taxes,
materials handling, personnel services, heat; light, and power. These cost elements must be divided into
their proper elements.

4. Step Cost - when activity changes, a step cost shifts upward or downward by a certain interval or step.
COST ESTIMATION: SEGREGATING VARIABLE & FIXED COSTS

1. HIGH-LOW POINTS Method 

The fixed and variable portions of the mixed costs are computed from two sampled data points - the
highest and lowest points based on activity or cost driver. 

Steps in applying the high-low cost estimation

a. Obtain relevant data on past costs and related actual activity levels.

b. Estimate the variable cost per unit or rate using the following equation.

c. Compute the fixed cost as follows:

EXAMPLE PROBLEM:
 2. SCATTERGRAPH (Scatter Diagram) or Visual Fit Method

All observed costs at various activity levels are plotted on a graph. Based on sound judgement, a
regression line is then fitted to the plotted points to represent the line function.

The steps involved in the use of Scattergraph are as follows:

a. On a graph, plot actual costs (on vertical axis) during the period under study against the volume
levels (on horizontal axis).

b. The line of best fit is then drawn by visual inspection of the plotted points, the line representing
the trend shown by the majority of the points.

c. The fixed cost is estimated by extending the left end of the line to the vertical axis.

d. The variable cost rate or slope of the cost line is determined by dividing the difference between
any two levels of activities by the difference in costs corresponding to the same level of
activities.
EXAMPLE PROBLEM

Variable cost rate (b) = (110 - 70) / (40 - 20)

                                       = 40 / 20

                                       = 2 per hour

Fixed cost (a) is P30 which is where the line of regression begins.

3. LEAST-SQUARES REGRESSION Method 

Least-squares method is a statistical technique that investigates the association between

dependent and independent variables. This method determines the line of best fit for a set of
observations by minimizing the sum of the squared deviations between cost line and the data
points.

 If there is only one independent variable, the analysis is known as SIMPLE REGRESSION.

If the analysis involves multiple independent, it is known as MULTIPLE REGRESSION

A) Industrial Engineering Method

 based on the relationship between inputs and outputs in physical forms;

engineering estimates indicate what and how much costs should be. Engineering
estimates indicate what costs should be. This method is so named because it was
first used in estimating manufacturing costs from industrial engineers’ specifications
of the required input to the manufacturing process for a unit of

Steps in Applying the Engineering Method of Estimating Costs

 1. A study of the physical relation between the quantities of inputs (material, labor, etc.)
and each unit of output (finished product) is one. This involves the following activities.

 a. A detailed step-by-step analysis of each phase of each manufacturing process

together with the kinds of work performed, and time to perform each step is done. (This
is sometimes part of time-and-motion study). This serves as a basis for estimating direct
labor time.

 b. Engineering estimates of the materials required for each unit of production are
obtained from drawings and specifications sheets.

 2. Costs are then assigned to each of the physical inputs (wages, material price,
insurance charges, etc.) to estimate the cost of the outputs. 
 B) Account Analysis Method

 each account is classified as either fixed or variable based on experience on judgment of

accounting and other qualified personnel in the organization.

 Account analysis is considered a very useful and easier way to estimate costs. It makes use
of the experience and judgment-of managers and accountants who are familiar with
company operations and the way costs react to changes in activity level.

The account analysis involves the following steps:

1. Review each cost account used to record the costs that are of interest. Each cost is
identified as either fixed or variable depending on the relationship between the cost and some
activity.

2. Each major class of manufacturing overhead or other mixed cost is itemized. Each
cost is then divided into its estimated variable and fixed components. This is done on the basis
of the experience and judgment of accounting and other personnel.

An advantage of account analysis is that it involves a detailed examination of the data base by
accountants and managers who are familiar with it. Other methods may overlook this expert judgment
in uncovering cost behavior patterns. A disadvantage of this method is that it uses a subjective,
judgmental approach so that different analysts may provide different estimates of cost behavior. 

C) Conference Method

 costs are classified based on opinions from various company departments such as
purchasing, process engineering, manufacturing, employee relations and so on.

This information is used to determine the selling price of the product, optimum
product mix and evaluate cost improvements over time.

The conference method allows quick development of cost function and cost
estimates. Its credibility is gained through the pooling of expert knowledge from each
value-chain area. The accuracy of the cost estimates however, is dependent largely on
the objectivity, care, and the detail taken by the people providing the inputs or
information.

CORRELATION ANALYSIS

 is used to measure the strength of linear relationship between two or more

variables. 

 The correlation between two variables can be seen by drawing a scatter diagram:

 If the points seem to form a straight line, there is a high correlation.

  If the points form a random pattern, there is a low correlation or no correlation at
all.

COEFFICIENT OF CORRELATION (r) measures the relative strength of linear relationship between
two (2) variables. Its value ranges from -1.0 to + 1.0.

 If r = -1.0, there is perfect inverse linear relationship between X and Y.

 If r = 0, no linear relationship.

 If r = +1.0, there is perfect direct relationship between X and Y.

COEFFICIENT OF DETERMINATION (r2) is the proportion of the total variation in Y that is

accounted for by the regression equation, regardless of whether the relationship between X and Y is
direct or inverse. It is a measure of ‘goodness of fit’ in the regression. The higher the r2, the more
confidence one can have in the estimated cost formula. 

R2 = 0 to1 Σ x2

STANDARD - a measure of acceptable performance established by management as a guide in making

economic decisions. A standard is a benchmark or “norm” for measuring performance. In managerial
accounting, standards relate to the cost and quantity of inputs used in manufacturing goods and
providing services.

STANDARD COST - pre-determined unit cost which is used as a measure of performance.

QUANTITY Standard - indicates the quantity of raw materials or labor time required to produce a unit of
product. This is normally expressed per unit of output (e.g., 3 pieces per unit)

COST Standard - indicates what the cost of the quantity standard should be. This is normally expressed
per unit of input (e.g., P 2.00 per piece). 

STANDARD VS. BUDGET

1. Both standards and budget are predetermined costs.

2. Primary difference  ; a standard is a unit amount, whereas a budget is a total amount 

 A standard may be regarded as the budgeted cost per unit of product

3. In accounting, except in the application of manufacturing overhead to jobs and processes,

budget data are not journalized in cost accounting systems, whereas standard cost may be
incorporated into cost accounting systems.
 BUDGETS STANDARDS

Purpose Budgets are statements of expected Standards pertain to what costs should be
costs. given a certain level of performance.

Emphasis Budgets emphasize cost levels that Standards emphasize the levels to which costs
should not be exceeded. should be reduced.

Coverage Budgets are set for all departments - Standards are set only for the production or
sales, administration & manufacturing. manufacturing division of the firm.

Analysis When actual data differ from the budget, Material amounts of variance are reviewed
it may be an indication of either good or and investigated so that necessary corrective
bad performance. actions are implemented.

USES OF STANDARD COSTS

1. Manufacturing firms

2. Service firms

3. Non-profit organizations

ADVANTAGES OF STANDARD COSTS

Standard costs:

1. Facilitate management planning;

2. Promote greater economy and efficiency by making employees more “cost-conscious”;

3. Are useful in setting selling prices;

4. Contribute to management control by providing basis for evaluation and cost control;

5. Are useful in highlighting variances in management by exception;

 Management by exception - the practice of giving attention only to those situations in which
large variances occur, so that management may have more time for more important
problems of the business, not just routine supervisions of subordinates.

6. Simplify costing of inventories and reduce clerical costs.

STANDARD COSTING CONTROL LOOP

1. Establishing standards

2. Measuring actual performance

3. Comparing actual performance with standard or compute variance

4. Analyze the variance

5. Investigate

6. Taking corrective action or decisions; when needed

SETTING STANDARD COSTS

Standards should be set so that they encourage efficient operations.

Ideal vs.Normal Standards:

Ideal Standards -  based on the optimum level of performance under perfect operating conditions.

Normal Standards - based on an efficient level of performance that are attainable under expected
operating conditions

STANDARD COST COMPONENTS

1. Standard Price or Rate - the amount that should be paid for one unit of input factor

2.  Standard Quantity - the amount input factor that should be used to make a unit of product 

 Both standards relate to the input factors: materials, direct labor and factory overhead

Materials:

Price Standard - based on the delivered costs of materials plus an allowance for receiving and handling

Quantity Standard -  establishes the required quantity plus an allowance for waste and spoilage

Standard Cost of Materials per Unit of Product 

= Standard Quantity per unit of product x Standard Price per Unit of Materials
Labor:

Price Standard - based on current wage rates and anticipated adjustments (e.g. C.O.L.A)

Quantity Standard - based on required production time plus an allowance for rest periods cleanup,
machine setup and machine downtime

Standard Labor Cost per Unit of Product 

= Standard Time (Hours) per Unit x Standard Labor Rate per Hour

Manufacturing overhead:

 A standard predetermined overhead rate is used on an expected standard activity index such as
standard direct labor hours or standard direct labor cos

Variances:

Static budget variance = actual results - static (master) budget amounts

Static budget refers to the budget that is set at the beginning of a budgeting period and that is geared to
only one level of activity - the budgeted level of activity.

Flexible budget variance = actual results - budgeted amounts for the actual level of activity

A flexible budget is geared to all levels of activity within the relevant range and is used to plan and
control spending. The flexible budget will show the costs formula for each variable cost and total cost
( possibly including fixed cost) at various levels of activity.

Variance Computation and Analysis

Variance = Actual costs (AC) - Standard Costs (SC)

AC > SC : Unfavorable (debit balance)

AC < SC : Favorable (credit balance)

For Materials:

Actual Materials Cost      ← Actual Quantity (AQ) x Actual Price (AP)

Less :  Standard Materials Cost ← Standard Quantity (SQ) x Standard Price (SP) or

  Actual Production x Standard Materials Cost per Unit

Materials Cost Variance

Analysis:

Price Variance (or Rate, Budget, Spending Variances) 

PV = (actual price - standard price) x actual quantity

 AQ x  ΔP = Actual quantity x Difference in prices

Quantity Variance (or Usage or Efficiency Variances) 

QV = (actual quantity - standard quantity) x standard price

 ΔQ x SP = Difference in quantities X Standard price

For Labor:

Actual Labor Cost      ←  Actual Hours (AH) x Actual Rate (AR)

Less : Standard Labor Cost  ← Standard Hours (SH) x Standard Rate (SR) or

      Actual production x Standard Labor Cost per Unit

Labor Cost Variance

Analysis:

Price Variance (or Rate, Budget, Spending Variances) 

PV = (actual rate - standard rate) x actual time

ΔRate x  AT = Difference in rate x Actual Time

Time Variance (or Usage or Efficiency Variances) 

TV = (actual time - standard time) x standard rate

 SR x ΔTime = Standard Rate x Difference in Time

IMPORTANT NOTES ON MATERIAL and LABOR VARIANCE ANALYSIS

1. Material PRICE Variance is also known as

Material spending variance, material money variance, material rate variance

2. Material QUANTITY Variance is also known as 

Material usage variance, material efficiency variance

3. Material USAGE Variance is a quantity variance while material price usage variance is a price
variance.
 4. Labor RATE Variance is also known as 

Labor price variance, labor spending variance, labor money variance

5. Labor EFFICIENCY Variance is also known as 

Labor hours variance, labor usage variance, labor time variance

6. Labor efficiency variance excludes idle time spent in the production. If any, idle time is
separately explained through the Idle time variance, which is regarded as unfavorable.

IDLE TIME VARIANCE = Idle time X standard labor rate

FOR FACTORY OVERHEAD:

Variance Computation:

Actual Variable Factory Overhead*

Less: Standard Variable Factory Overhead**

Variable Factory Overhead Variance

*Actual Time x Actual Variable Factory Overhead Rate

** Standard Time x Standard Variable Factory Overhead Rate

Variable overhead variances

a. The variable overhead spending variances computed as follows when the variable overhead rate
is expressed in terms of direct labor-hours:

Variable overhead spending variance 

= (Actual overhead rate - Standard overhead rate) x Actual input hours

b. The variable overhead efficiency variance is computed as follows when the variable overhead rate is
expressed in terms of direct labor-hours:

Variable overhead efficiency variance 

= (Actual hours — Standard hours allowed) x Variable Overhead rate

Fixed Overhead Variances in a Standard Cost System.

Variance Computation:

Actual Fixed Factory Overhead

Less: Standard Fixed Factory Overhead*

Fixed Overhead Variance

*Standard Time x Standard Fixed Factory Overhead Rate

a. Budget Variance. The budget variance is the difference between the actual fixed overhead costs
incurred during the period and the budgeted fixed overhead costs contained in the flexible budget. This
variance is very useful in that it indicates how well spending on fixed items was controlled.

Fixed Overhead Spending or Budget Variance

= Actual Fixed Overhead - Budgeted Fixed Overhead

b. Volume Variance. The volume variance is the difference between the total budgeted fixed overhead
and the fixed overhead applied to production. Alternatively, it can be expressed as the difference
between the denominator level of activity and the standard hours allowed for the output of the period,
multiplied by the fixed portion of the predetermined overhead rate.

Volume or Capacity Variance

= Fixed portion of the predetermined overhead rate (Denominator hours - Standard hours allowed for
the actual output) or

= Budgeted Fixed Overhead - Standard Fixed Overhead

The volume variance occurs because the denominator level activity differs from the  standard hours
allowed for production. Thus, an unfavorable variance means that the company operated at an activity
level below the denominator level of activity.

Conversely, a favorable variance means that the company operated at an activity level greater than the
denominator level of activity.

TOTAL FACTORY OVERHEAD VARIANCE ANALYSIS AND COMPUTATION:

Variance Computations: 

Actual Factory Overhead

Less : Standard Factory Overhead*

Factory Overhead Variance

* Standard Time x Standard Factory Overhead Rate

Under and Overapplied Overhead. 

The sum of the four manufacturing overhead variances—variable overhead spending, variable overhead
efficiency, fixed overhead budget, and fixed overhead volume — equals the under or overapplied
overhead for the period.

* When production process involves combining several materials in varying proportions, materials
quantity variance is supplemented by:

Materials variance = Actual Materials Cost - Standard Materials Cost 

Mix variance: 

Total actual quantities at standard prices 

Less:   Total actual input at average standard input cost (TAI x ASIC)

            Mix variance

Yield variance: 

Total actual input at average standard input cost (TAI x ASIC) 

Less:   standard cost (AOutput x ASOC)

Yield variance

or

Actual output 

Less:  expected output from actual input

Yield difference

x Average standard output cost

Yield Variance

Managers must constantly make decisions. Managers often select the course of action that maximizes
expected operating income over the period affected by the decision. To do this, they analyze relevant
information. Relevant information is the expected future data that differ among alternative courses of
action.

Decision - Making - is the process of choosing from at least two alternatives. For business entities,
management must choose in favor of the option that maximizes the company profit.

This selection process is not automatic: rather, it is a conscious procedure.The steps are outlined as
follows:

1. Define strategies: business goals and tactics to achieve them.

2. Identify the alternative choices or courses of action.

3. Collect and analyze the relevant data on the choices.

4. Choose the best alternative to achieve goals.

SHORT - TERM DECISION ALTERNATIVES

1. Make or buy a part or a product

2. Accept or reject a special order

3. Sell or process further a product line 

4. Continue or shutdown a business segment 

5. Choosing the best product combination

6. Selecting a change in profit factors

7. Utilization of scarce resources

LONG - TERM cases, e.g., capital investment decisions.

TYPICAL DECISION-MAKING PROCESS

1. Defining the problem.

2. Specifying the objective and criteria. 

3. Identifying the alternative courses of action.

4. Evaluating the possible consequences of the alternatives.

5. Collecting the data needed to make a decision.

6. Choosing the best alternative and making the decision.

7. Evaluating the results of the decision. 

FACTORS CONSIDERED IN DECISION MAKING

 Qualitative Factors - factors that cannot be expressed effectively in numerical terms.

 Quantitative Factors - factors that can be expressed in monetary or other numerical units.

Quantitative approaches in decision making: 

1) TOTAL approach - the total revenues and costs are determined for each alternative, and the results
are compared to serve as a basis for the decision to make. 

2) DIFFERENTIAL approach - only the differences or changes in costs and revenues are considered.

NOTE : In decision-making cases that involve a conflict between qualitative and quantitative factors,
quality usually prevails over quantity.

TERMINOLOGIES USED IN SHORT-TERM DECISION MAKING 

RELEVANT COSTS

Future costs that are different among alternatives; it is considered as the avoidable costs of a particular
decision.

DIFFERENTIAL COSTS 

Increases (increments) or decreases (decrements) in total costs that result from selecting one alternative
instead of another. [Relevant]

AVOIDABLE COSTS 

Costs that will be saved or those that will not be incurred if a certain decision is made. [Relevant]
OPPORTUNITY COSTS 

Income sacrificed or benefit foregone when a certain alternative is chosen over another alternative.
[Relevant]

SUNK COST/ HISTORICAL COST

Costs that are incurred already and cannot be avoided regardless of what decision is made [Irrelevant]

SHUTDOWN COSTS 

Usual costs that a company will continue even if it decides to discontinue or shutdown the operation of
a company segment. [Irrelevant]

JOINT COSTS 

Cost incurred in simultaneously manufacturing two or more (joint) products that are difficult to identify
individually as separate types of products until the products reach a certain processing stage known as
the split-off point. [Irrelevant]

FURTHER PROCESSING 

Cost incurred beyond the split-off point as separated joint products are to be processed further.
[Relevant]

SPLIT-OFF POINT 

The earliest stage in the production where joint products can be recognized as distinct and separate
products.

BOTTLENECK RESOURCES

Any particular resource or operation where the capacity is less than the demand placed upon it.

SHORT-TERM DECISION MAKING GUIDELINES

Basic rule: choose the action that will yield the BEST PROFIT POSITION.

Highest revenues + Lower Costs = Highest possible profit

Nature of Description Decision Guidelines

Alternatives

Make or Buy a Should a part or product be Choose the option that has the lower cost.
part/product manufactured (in-sourced) or In most cases, fixed costs are irrelevant.
bought (outsourced) from an Consider opportunity costs, if any.
outside supplier?

Accept or Reject a Should a special order that Accept the order when the additional
 special order requires a price lower than the
regular selling price be
accepted?
Continue or Should a business segment,
Shutdown a business which may be a product line, a
segment department or a branch, be
continued or discontinued?
Sell or Process Should a product, after
Further a product undergoing the joint process, be
sold at the split-off point or be
processed further?
Best product Which product(s) should be
combination produced and sold when there is
(Optimization of a given limited resource or
Scarce Resources) bottleneck operation?
Change in Profit Should any of the profit factors
Factors such as selling price, unit sales,
variable cost, fixed cost and
sales mix be manipulated to
increase profit?
MAKE or BUY (Outsourcing Decision)
 Is a management decision about whether an item should be made internally or bought from an
outside supplier. To put idle capacity to use, firms often consider manufacturing a part or
subassembly they are currently purchasing. 
revenue from the special order exceeds
additional cost, provided the regular
market will not be affected. In most cases,
fixed costs are irrelevant.
Continue if the segment's avoidable
revenue is greater than its avoidable
costs; otherwise; consider shutting down
the segment. Since allocated fixed cost is
usually unavoidable, it is considered
irrelevant.
Process further if additional revenue from
processing further is greater than further
processing costs. Joint costs, since already
incurred prior to the split-off point, are
considered sunk costs and irrelevant.
Identify and measure the constraint on the
limited resource(s). Rank the product(s)
according to the highest contribution
margin per unit of limited resources.
Identify the factor to change and the
amount of contemplated change. Change
the profit factor if it will cause an
improvement on the company’s overall
profit position.
ACCEPT OR REJECT (Special Order Decision)

 Managers often must evaluate whether a special order should be accepted, or if the order is
accepted, the price that should be charged. A special order is a one time order that is not
considered part of the company’s ongoing business. Managers may be asked to consider
accepting a special order for their product at a reduced price to make use of the excess or idle
facilities. Such orders are worth considering, provided they will not affect regular sales of the
same product.
SPECIAL ORDER PRICING

SHUTTING DOWN OPERATIONS

 Over time, consumers’ preferences change. Some products become obsolete and dropped from
product lines, others are developed to replace them. When management is considering
dropping a product line or customer group, the only relevant costs are those that a company
would avoid by dropping the product or customer. An important factor in deciding whether to
add or drop a product is the decision’s effect on operating income.
 1. What will be the new company profit (loss) if Cebu Branch is eliminated?

a. P 260,000

b. P 140,000

c. (P 40,000)

d. (P 70,000)

2. What will be the decrease in company profit if Cebu Branch is closed and 20% of its traceable
fixed expense would remain unchanged while Davao sales would decrease by 20%?

a. P 352,000

b. P 280,000

c. P 136,000

d. No decrease; profit will increase

PRODUCT ELIMINATION POINT

SELL OR PROCESS FURTHER

 Firms that produce several end products from a common input are faced with the problem of
deciding how the joint product cost of that input is going to be divided among joint products.
Joint product cost is used to describe those manufacturing costs that are incurred producing the joint
products up to the split-off point.

Split-off point is that point in the manufacturing process at which the joint product can be recognized as
separate products.

Joint product costs are irrelevant in decisions regarding what to do with a product from the split off
point forward because they have already been incurred and therefore are sunk costs. Costs incurred
after the split-off point for the benefit of only one particular product are called separable costs. They are
relevant costs in the sell-or-process-further decision.
In a sell-or-process-further decision, it will always be profitable to continue processing a joint product
after the split-off so long as the incremental revenue from such processing exceeds the incremental
processing costs

BEST PRODUCT COMBINATION

 When a capacity becomes pressed because of a scarce resource, the firm is said to have a
constraint. Because of the constrained scarce resource, the company cannot fully satisfy
demand, so the manager must decide how the scarce resource should be used. Fixed costs are
usually unaffected by such choices, so the manager should select the course of action that will
maximize the firm’s total contribution margin. This is based on the assumption that the product
choices as short-run decisions because we have adopted the definition that in the short-run
capacity is fixed, while in the long-run, capacity can be changed.
PROJECT FEASIBILITY STUDY (Project Study or Feasibility Study)

 Is a systematic gathering and analysis of data which aims to find out the viability of the proposed
business undertaking. Generally, it involves:

A. Collection of data which are relevant and necessary to all aspects of the undertaking, 
B. Evaluation and analysis of the data gathered, and
C. Formulation of recommendation.

USERS OF THE FEASIBILITY STUDY 

 PROJECT PROPONENTS/ PROMOTERS/ ORGANIZERS OF NEW PROJECTS

The study would serve as a basis for selecting good ventures, for implementing activities and
for formulating long-range plans.

 CREDITORS 

  The study would serve as a basis in deciding whether to grant financing and for determining the
and terms thereof.

  INVESTORS

The study to decide whether to invest in the project or not.

 MANAGEMENT OF EXISTING FIRMS

The study would help in ascertaining the feasibility of expansions programs, in deciding on the
possibility of taking over existing business, as well as the extent of the capital outlay required

 GOVERNMENT INSTRUMENTALITIES 

The study would help to ensure that the project meets necessary legal requirements  and would
help determine the extent of government incentives that may be granted. 

 GENERAL PUBLIC

The study would aid in minimizing the risk of business failures, reducing waste of valuable
resources, and thereby accelerating economic growth.

MAJOR ASPECTS PARTS OF THE FEASIBILITY STUDY 

The major aspects of a typical Project Feasibility Study are briefly described as follows:

MANAGEMENT

 assists in the selection of the business structure, personnel set-up, and internal policies of the
enterprise for an effective operation.
MARKETING 

 involves the study of the present and future demand and supply for the product, competition,
selling price, and marketing plans for the product.

TECHNICAL 

 aims to choose the process to be used, plant capacity, layout, machinery . design, materials and
other technical factors to attain cost minimization and profit maximization. 

TAXATION 

 covers the study of tax effects as well as legal tax saving measures and other government
incentives applicable to the project.

LEGAL 

 determines legal capacity and restrictions to do business so that legal requirements are met and
possible incentives and protection are availed of.

FINANCIAL 

 quantifies the result of marketing, technical, management, taxation and legal aspects and
expresses the profitability of the project in peso terms. 

FINANCING SOURCES 

 determine possible internal and  external sourcing terms, and condition of financing. 

ECONOMIC BENEFITS OR SOCIAL DESIRABILITY

 involves the study of the project’s contribution to the national economy as a whole.

PROFITABILITY

 Weighs the ratio of capital outlay in relation to profit that can be obtained.

FEASIBILITY STUDY GUIDELINE 

(from the University of the Philippines Institute of Small-Scale Industries)

I. SUMMARY OF PROJECT

A. Name of firm 

B. Location: head office/ factory 

C. Brief description of the project

1. History of business

2. Nature or kind of industry

3. Type of organization

4. Officers of the business and their qualifications

II. ECONOMIC ASPECTS

A. GENERAL MARKET DESCRIPTION

1. MARKET DESCRIPTION - a brief description of the market to include the following:

a. areas of dispersion

b. methods of transportation and existing rate transportation

c. channels of distribution and general trade practices

2. DEMAND

a. Consumption for the past ten years 

b. Major consumers of the product 

c. Projected consumption for the next five years

3. SUPPLY

a. Supply for the past ten years, classified as to source - imported or locally produced. For imports,
‘specify the form in which goods are imported, the prices and the brand.

For locally produced goods, the companies producing them, their production capacities, brands, and
market shares shall be specified. 

b. Factors affecting trends in past and future supply.

4. COMPETITIVE POSITION

a. Selling price — Include a price study indicating the past domestic and import prices, the high and low
prices within the year, and the effect of seasonality, if any.

b. Competitiveness of the quality of the product

B. MARKETING PROGRAM

1. Description of present marketing practices of competitors

2. Proposed marketing program of the project describing the selling organization, the terms of
sales, channels of distribution, location of sales outlets, transportation and warehousing
arrangements, and their corresponding costs

3. Promotion and advertising plans, including costs

4. Packaging
C. PROJECTED SALES

Expected annual volume of sales for the next five years considering the demand, supply, competitive
position, and marketing program

D. CONTRIBUTIONS TO THE PHILIPPINE ECONOMY

1. Net annual amount of dollars earned or saved, and basis used

2. Labor employed

3. Taxes paid

III. TECHNOLOGICAL FEASIBILITY 

A. PRODUCTS

1. Description of the product(s), including specifications , their physical, mechanical, and chemical
properties

2. Uses of the product(s)

B. MANUFACTURING PROCESS

1. Description of the process showing detailed flowchart, indicating material and energy
requirements at each st and normal duration of the process.

2. Alternative processes considered and justification for adopting such processes

3. Technological assistance used and contracts, if any

C. PLANT SIZE AND PRODUCTION SCHEDULE

1. Rated annual ard daily capacity per shift, operating dav per year, indicating factors used in
determining capacity

2. Expected production volume for the next five years, considering start-up and technical factors

D. MACHINERY AND EQUIPMENT

1. Machines and equipment layout indicating the floor plan

2. Specifications of the machinery and equipment required indicating rated capacities of each
piece

3. List of machineries and equipment to be bought a origin as to local or imported

4. Quotations from suppliers, machinery guarantees, delivery dates, terms of payments and other
arrangements.
 5. Comparative analysis of alternative machinery and equipment in terms of cost, reliability,
performance, and spare parts available.

E. PLANT LOCATION

1. Location map of the plant

2. Desirability of location in terms of distance from the source of raw materials and market and
other factors and a comparative study of different locations, indicating advantages and
disadvantages (if new project)

F. PLANT LAYOUT 

Description of the plant layout, drawn to scale

G. BUILDING AND FACILITIES

1. Types of building and costs of erection

2. Floor area involved

3. Land improvements, such as roads, drainage, etc., and their respective costs

H. RAW MATERIALS

1. Description and specifications of their physical, mechanical, and chemical properties

2. Current and prospective costs of raw materials, terms of payment, and long-term contracts, if
any

3. Availability and continuity of supply and current and prospective sources |

4. Material balance or material process chart

I. UTILITIES 

Electricity, fuel, water, steam, and supplies indicating the uses, quantity required, availability, and
tentative sources and cost

J. WASTE DISPOSAL

1. Description and quantity ‘of waste to be disposed of 

2. Description of the waste disposal method

3. Methods used in other plants

4. Cost of waste disposal 

5. Clearance from proper authorities or compliance with legal requirements

K. PRODUCTION COST

Detailed breakdown of production costs, indicating the elements of cost per unit of output
L. LABOR REQUIREMENTS

Detailed breakdown of the direct and indirect labor ang supervision required for the manufacture of the
product(s indicating compensation, including fringe benefits

IV. FINANCIAL FEASIBILITY

A. FOR EXISTING PROJECTS 

1. Audited financial statements (balance sheet, income statement, cash flow statement) for past
three years reflect the following:

i. aging of receivables

ii. schedule of fixed assets showing the capital cost estimated useful life, and depreciation method
used

iii. schedule of liabilities, tax assessments, and other pending claims or litigation against the
applicant, if any

iv. financial trends and ratio analysis

v. elements of production, selling, administrative, and financial expenses

2. Financial projections for the next five years (balance sheet, income statement, cash flow statement)

3. Supporting schedules to the financial projections, stating assumptions used:

a. collection period of sales

b. inventory levels 

c. payment period of purchases and expenses

d. elements of production cost, selling, administrative, and financial expenses

4. Financial analysis to show the rate of return on investment, return on equity, break-even volume, and
price analysis

B. FOR NEW PROJECTS

1. Total project cost (fixed and working capital)

2. Initial capital requirements

3. Pre-operating cash flows relative to the project timetable 

4. Financial projections of the five years of operations to include balance sheets, income
statements, cash flows 

5. Supporting schedule to the financial projections to include:

 i. collection on sales

ii. inventory levels

iii. payment period for purchases and expenses 

iv. elements of production cost, selling, administrative, and financial expenses

6. Financial analysis showing return on investment, return on equity, break-even volume, and price
analysis

FINANCIAL STUDY

STEPS IN FINANCIAL STUDY

Conducting the financial study involves the following steps:

a. Determine the specific financing requirements of the project with respect to types and cost of
the assets to be acquired.

b. Identify the alternative sources of financing, including the terms and conditions, the effective
cost, and the maximum amount of financing from each source.

c. Ascertain the desirable debt-equity ratio, i.e., the relationship between the financing that can be
obtained from creditors and financing that can be provided by the stockholders.

d. Establish the project's financial policy. .

MAJOR PARTS OF THE FINANCING STUDY

1. Statement of assumptions

2. Projected financial statements

3. Possible sources of outside financing

4. Details of various amounts contained in the projected financial statements 

5. Analysis of financial projections

* STATEMENT OF ASSUMPTIONS

ASSUMPTIONS — statements about the possible future behavior of certain factors affecting a project.

EXAMPLES OF ASSUMPTIONS MADE IN FEASIBILITY STUDIES

1. Sales volume, selling price, and distribution media 

2. Plant location, capacity, and requirements

3. Taxes
 4. Foreign exchange rate and price level changes 

5. Project timetable

PROJECTED FINANCIAL STATEMENTS

1. Projected balance sheet 

2. Projected income statement 

3. Projected cash flow statement

The projected financial statements are used to evaluate the results of the financial projections as to the
project's profitability, liquidity, and solvency, as well as its ability to withstand difficulties. The evaluation
is enhanced by preparing/ determining the following, among others:

A. TO MEASURE PROFITABILITY

1. Common-size projected financial statements 

2. Rate of return on investment

a. discounted rate of return

b. accounting rate of return

c. profitability index

3. Cost-Volume-Profit (CVP)/Break-even analysis 

4. Earnings per share

B. TO MEASURE LIQUIDITY

1. Current ratio 

2. Acid test ratio 

3. Payback period 

4. Cash break-even

C. TO MEASURE FINANCIAL LEVERAGE 

1. Debt-to-equity ratio 

2. Equity-to-assets ratio 

3. Debt-service break-even point

4. Times interest earned

POSSIBLE SOURCES OF FINANCING

INTERNAL SOURCE OF FINANCING - funds obtained within the fim principally through earnings and
depreciation.

EXTERNAL SOURCE OF FINANCING - funds furnished by owners (equity and creditors (debt).

CLASSIFICATION OF FUNDS 

1. Short-term funds - will be needed for one year or less

Possible sources:

 Trade credit 

 Commercial banks and other financial institutions

 Advances from customers 

 Loans derived from relatives, friends, director stockholders, and officers

2. Intermediate funds — will be needed between one to five years

3. Long-term funds — will be needed for five years or more

Possible sources:

 Issuance of capital stocks

 Issuance of bonds

 Retention of earnings

 Depreciation

 Suppliers / Manufacturers of machinery and equipment

 Long-term loans from banks and other institutions

Factors to consider when obtaining long-term funds:

1. Control

 Common stocks may have voting rights

 Preferred stocks are usually non-voting

Creditors share no direct participation in the management of the firm, except to the extent that
restrictions are included in loan agreements

2. Cost 

 Flotation costs of stocks and bonds 

 Dividend requirements when shares of stocks are issued.

 Dividends are not tax deductible

 Interest expense on loans is tax deductible

3. Risk

 Debt financing entails greater risk than equity financing because debt obligations have definite
maturity dates and interest is a fixed charge which must be paid even when profits decline.

 Long-term bonds entail less risk than short-term notes because short-term notes must be
renewed periodically and renewals are subject to the uncertainty of future interest rates and
availability of funds.

SENSITIVITY ANALYSIS

Feasibility Studies involve projected data, developed under specific assumptions, Uncertainty is
therefore an unavoidable element.

Sensitivity analysis can be used to minimize the effect of uncertainty. It is used to determine the impact
of a change in a factor(s) influencing a projected result.

Example;

How will profit change if the projected sales volume is changed by 5%, 10%, 15% 20%?

How will profit change if the projected capacity level is changed by = 10%, + 20%, or + 30%?

ATTRIBUTES OF A GOOD FEASIBILITY STUDY 

A good feasibility study must be:

1. COMPREHENSIVE

The study must have adequate information to meet the needs of the user or users, areas covered must
be clearly defined and well-investigated.

2. OBJECTIVE

It must present/reflect both the positive and negative implications.

 3. SIMPLE

The report should be easy to understand. If technical terminologies are indispensable, explanations
should likewise be included.

LIMITATIONS/CONSTRAINTS IN FEASIBILITY STUDY PREPARATION

Forecast is the primordial basis of feasibility study and as such, tk basic limitations may exist.

1. Unavailability of required and necessary information. 

2. Incompetence or inexperience of the one making the judgment resulting in erroneous

conclusions ineffective recommendations.

3. The fact that the study is based on forecasts cannot be denied. Any significant change in the business
environment usuel renders results of forecasts not coinciding with actual events.