Group 1

STRATEGIC COST
MANAGEMENT
Cost terms and Concepts
Reporting Objectives:
At the end of this report, you should be able to:

1. identify cost terms or terminologies.

2. Learn the concepts and;
3. Track the flow of cost for different types of industries.
 COST TERMINOLOGIES
COST
 Monetary amount that must be paid to acquire goods and services or resource sacrificed to
achieve a specific objective.
COST OBJECT
 Anything for which a separate measurement of cost is needed or desired.
COST POOL
 The amount of money spent on an 'activity', for instance, customer service or manufacturing.
COST DRIVER
 A factor that causes a change in the cost pool for a particular activity. Cost drivers are the direct
cause of a business expense.
ACTIVITY
 Any event, action, transaction, or work sequence that incurs costs when producing a product or
providing a service
DIFFERENT TYPES OF COST PER CATEGORY

ACCORDING TO MANAGEMENT FUNCTION

A. Manufacturing cost – costs incurred to convert raw materials into finished goods.
Classifications of manufacturing costs
1. Direct material costs
2. Direct labor cost
3. Manufacturing overhead/Factory overhead
B. Non-manufacturing cost – all cost that are not part of manufacturing costs.

Sales xx
Cost of sales (xx)
Gross profit xx
Operating expenses (xx)
Operating income xx
ACCORDING TO TIMING OF CHARGE AGAINST REVENUE
A. Product cost / Inventoriable costs – this costs are used to value inventory of
manufactured goods or merchandise until the good are sold.
B. Period costs – these cost are identified with the period of time in which
they are incurred rather than with units purchased or produced.
Sales xx
Cost of sales (xx)
Gross profit xx
Operating expenses (xx)
Operating income xx
ACCORDING TO TRACEABILITY
A. Direct costs – those that can be traced directly to a particular cost object such as a product ,
department, or branch.
B. Indirect costs – those that are not directly traceable to a particular cost object. They are also
called common or joint costs.

ACCORDING TO BEHAVIOR
A. Variable costs – vary in total in direct proportion to changes in activity level.
B. Fixed costs – cost that remain constant in total regardless of changes in activity.
C. Mixed costs/semi-variable costs – costs that are vary in total but not in proportion to change
in activity level.

Sales xx
Cost of sales (xx)
Gross profit xx
Operating expenses (xx)
Operating income xx
ACCORDING TO CONTROLLABILITY
A. Controllable costs – refer to costs that can be influenced by the managers.
B. Uncontrollable costs – refer to costs that cannot be influenced by the managers.
ACCORDING TO RELEVANCE TO DECISION MAKING
A. Relevant cost – cost that will differ among alternative courses and will affect the future.
B. Standard cost – predetermined cost based on some reasonable bases such as experiences,
budgeted amounts, industry standard and etc…
C. Opportunity cost - benefit forgone or given up when an alternative is chosen over the
other/s
D. Sunk cost – historical costs or costs that are incurred in the past and will not make any
difference in making decision.
E. Out-pocket costs – those that require the payment of cash or other asset as a result of their
incurrence.
F. Differential cost – the amount by which the costs differ under alternative actions.
G. Marginal cost – extra cost incurred when one additional unit is produced
H. Incremental cost - total additional cost associated with the decision to expand output or
to add a new variety of product etc.
I. Avoidable cost - cost that is not incurred if the activity is not performed.
J. Unavoidable cost - costs that is still incurred even if the activity is not performed.
K. Committed cost - costs that result from an organization’s ownership or use of facilities
and its basic organization structure.
L. Discretionary cost - arises as a result of management decision to spend particular
amount of money for some purpose.
M. Average cost per unit - total cost, for whatever quantity is manufactured, divided by the
number of units manufactured.
Flow of costs
 Service
Cost of
Direct Labor
Services

Period
Other costs Costs
 Cost Behavior
SPLITTING MIXED COST- HIGH-LOW METHOD
Reporting Objectives:

At the end of this report, you should be able to:

1. Analyze the behavior of costs

2. Separate fixed and variable components of a mixed costs using
high-low method.
 Analysis of Cost Behavior
1. Variable costs- vary in total in direct proportion to changes in activity level (DM, DL,
Sales commission based on sales)
2. Fixed costs- costs that remain constant in total regardless of changes in activity level
(rent, insurance, and dep’n using the straight-line method)
3. Mixed costs/Semi-variable costs- costs that vary in total but not in proportion to change
in activity level. It basically includes a fixed and variable portion. (electricity expense
that has minimum charge on a fixed amount plus variable charges based on additional
usage.)
What are the step costs?
Step cost refers to the behavior of the total cost of an activity at various levels of the activity.
When a step cost is plotted on a graph (with the total cost represented by the y-axis and the
quantity of the activity represented by the x-axis.)
 1.Step Variable Cost - a cost that generally varies with the level of
activity, but which tends to be incurred at certain discrete points and to
involve large changes in amounts when such a point is reached.
Conversely, a truly variable cost will vary continually and directly in
concert with the level of activity. (compensation of a quality assurance
(QA) worker in an assembly area of a production).

2. Step Fixed Cost - cost that does not change within certain high and low
thresholds of activity, but which will change when these thresholds are
breached. When the cost changes as a result of a threshold breach, a new
set of a high and low activity thresholds will then apply, within which
fixed cost will not change appreciably.
 Methods of Segregating Fixed and Variable Elements of Mixed
Costs
1. High-Low Points Method- the fixed and variable elements of the mixed costs are
computed from two data points (periods)- the high and the low periods as to activity level
or cost driver.

2. Statistical Scatter Graph Method- various costs (the dependent variable) are plotted on a
vertical line (y-axis) and measurement figures (cost drivers or activity levels) are plotted on
a horizontal line (x-axis). A straight line is drawn through the points and, using this line, the
rate of variability and fixed cost are computed.

3. Method of Least Squares (Regression Analysis)- mathematically determines a line of best

fit or a linear regression line through a set of plotted points so that the sum of the squared
deviations of each actual plotted point from the point directly above or below it on the
regression line is at minimum.
Cost Behavior Assumptions:

1. Relevant Range Assumption- relevant range refers to the band of activity within which the identified
cost behavior patterns are valid. Any level of activity outside this range may have a different cost
behavior pattern.

2. Time Period Assumption- the cost behavior patterns identified are true only over a specified period of
time. Beyond this, the cost may show a different behavior.

FORMULA: to calculate the total cost of a product at a certain level of activity or cost driver.
y=a + bx
Where:
y= total costs
a= fixed cost
b= variable cost per unit
x= cost driver or level of a activity

High-Low Method

Variable Cost Per Unit = Total cost of highest activity – Total cost of lowest activity

Highest activity unit – Lowest activity unit

ILLUSTRATION: The table below depicts the activity for a cake bakery for each of the 12months
of a given year.

MONTH CAKE BAKE (units) TOTAL COST (P)

January 115 P 5,000
February 80 P 4,250
March 90 P 4,650
April 95 P 4,600
May 75 P 3,675
June 5 P 230
July 85 P 4,400
August 70 P 3, 750
September 115 P 5,100
October 130 P 5,550
November 110 P 5,100
December 125 P 5, 700
 REQUIREMENTS: Solve for:

a. Variable cost per unit b. Fixed cost c. Total cost at 120 units

STEP 1: Identify the highest and lowest volume of activity together with their corresponding cost.
Highest = October Units = 130 Cost = 5,550
Lowest = August Units = 70 Cost = 3,750

STEP 2: Substitute the identified highest and lowest volume of activity together with their
corresponding cost to the formula to compute for the variable cost per unit.

VARIABLE COST PER UNIT = Total cost of highest activity – Total cost of lowest activity
Highest activity unit – Lowest activity unit

VARIABLE COST PER UNIT = 5,550 – 3,750

130 – 70

VARIABLE COST PER UNIT = 1,800

60

VARIABLE COST PER UNIT = 30

 STEP 3: Use the cost function y= a +bx to compute for fixed cost. You can
plug in the units and cost of either the highest or lowest volume of activity in
the cost function to fixed cost.

First, let us use the highest units and its cost to compute for fixed cost:
y= a + b x
5,550= a+30 (130)
5,550 = a+ 3, 900
5,550- 3, 900 = a
a= 1, 650
Now, let us use the lowest units and its cost to compute for fixed cost:
y=a+bx
3,750 = a + 30 (70)
3, 750 – 2, 100 = a
a= 1, 650
 STEP 4: With the computed variable cost per unit and fixed cost, write the cost
function for the problem above. The cost function of the problem would be:
y= 1,650 +30x
We can solve the cost of any volume of activity within the relevant range with the cost function above.
Lets try to compute the cost of 120 units.
y= 1,650 + 30x
y= 1,650 + 30 (120)
y= 1,650 + 3,600
y= 5,250
ADVANTAGE OF HIGH- LOW METHOD
The main advantage of high- low method is ease of calculation. The separate between variable and
fixed cost will not require any complex data or calculation. We only need the total production and total
mixed cost.
DISADVANTAGE OF HIGH-LOW METHOD
The high-low method only takes into account the highest and lowest figure and ignore the whole data.
The variable and fixed cost may not fit together when we apply to the rest of the year.
 Splitting Mixed Cost- Scatter Graph and
Least Squares Regression Method

Reporting Objectives:

At the end of this report, you should be able to:

1. Predict total costs using scatter graph method.

2. Separate fixed and variable components of a mixed costs using regression
method
 Scatter Graph Method
 The scatter graph method is used to segregate mixed costs and is more
accurate than the high-low method.

 Scatter-graph method segregates costs visually.

 By plotting the relevant data, the fixed and variable cost components
can be determined from specific points on the graph.
 Illustration:

The following data was gathered for five production runs of ABC Company. Estimate the cost
function using the scatter graph method.

Batch Units (x) Total Cost (y)

1 680 P 29,000
2 820 P 34,000
3 570 P 27,500
4 660 P 29,000
5 750 P 31,900
 Step 1:
Plot the data points
in a graph .
 Step 2:
Estimate the
line of best fit.
 Step 3:
Determine the
total fixed
costs.

a= P 12,000
 Step 4:
Compute for the variable cost per
unit.
The variable cost per unit or slope is
computed using any two data points in
the line of best fit.
Let us use coordinates that we can
easily determine: x=0, y=12,000 and
x=900, y=36,000 (approximately).
b= y2-y1= 36,000-12,000 = 24,000
x2-x1 900-0 900
b = $ 26.67 per unit
Step 5: Write the cost function. The cost
function of the problem would be
y= 12,000 + 26.67x
We can solve the cost of any volume of
activity within the relevant range with the
cost function above.
Let’s try to compute the cost of 650 units.
y= 12,000 +26.67x
y= 12,000 + 26.67 (650)
y= 12,000 + 17,333.33
y= 29,333.33
 ADVANTAGE OF SCATTER GRAPH METHOD
- More reliable since it considers all data points

DISADVANTAGE OF SCATTER GRAPH METHOD

- Drawing the line of best line fit involves objective estimation
which needs a more accurate method: computing for the fixed and
variable costs mathematically through linear regression
 Correlation Analysis
- A method used to study how closely the variables are related.
- Correlation is a measure that describes the strength and direction of a
relationship between two variables.

Coefficient of Correlation (r)

- The numerical measure of the degree of association between two
continuous variables
- Coefficient value is always between -1 and 1
- Measures both the strength and direction of the linear relationship
between the variables.
Strength
The larger the absolute value of the coefficient, the stronger the relationship:

-1 & 1
-indicates a perfect linear relationship
- rarely observed
0
- no linear relationship between the variables
- more likely to get with two sets of random numbers
Between 0 and 1/-1
-represent a scale of weak, moderate, and strong relationships
Direction
The coefficient sign (plus or minus) indicates the direction of the relationship.
• Positive coefficients
- represents direct correlation
- produce an upward slope on a graph
• Negative coefficients
- represents inverse correlation
-produce a downward slope on a graph

Coefficient of determination
- commonly known as “goodness of fit” or r-squared
- is a statistical measurement that examines how differences in one variable can be
explained by the difference in a second variable.
Correlation Coefficient Value Direction and Strength of
(r) Correlation
-1 Perfectly negative
-0.99 to -0.8 Strongly negative
0.79 to -0.5 Moderately negative
0.49 to -0.2 Weakly negative
0 No Association
0.2 to 0.49 Weakly positive
0.5 to 0.79 Moderately positive
0.8 to 0.99 Strongly positive
1 Perfectly positive
 Least Squares Regression Method
Formula:

∑ 𝑦=𝑛𝑎+𝑏𝛴 𝑥 2
∑ 𝑥 𝑦=𝑎𝛴 𝑥+𝑏𝛴 𝑥
Where:
y= total costs a= fixed cost n= number of data

x= cost driver or level of activity b= variable cost per unit

 STEPS
Step 1:
Solve for the value of each variable in the two equations from the previous
slide.
*NOTE: If there is a presence of an outlier, the outlier will be IGNORED.

Step 2:
Substitute the value of each variable in the equation and solve for
variable cost per unit.
Step 3:
Solve for the value of fixed cost.
Step 4:
Within the computed variable cost per unit and fixed cost, write the
cost function for the problem.
ADVANTAGE OF LEAST SQUARES REGRESSION ANALYSIS

• It considers all the data and not just the extreme points or the highest
and lowest points.
• More reliable method of separating mixed costs than high-low
method.
DISADVANTAGE OF LEAST SQUARES REGRESSION ANALYSIS
• It involves lengthier and complicated procedure of calculations and
analysis than high-low method.
Thank you!