Costs Terms, Concepts and Classifications · PDF fileCosts Terms, Concepts and Classifications...

Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin

Costs Terms, Concepts and

Classifications

Chapter Two


2-2

Learning Objective 1

Identify and give examples Identify and give examples

of each of the three basic of each of the three basic

manufacturing cost manufacturing cost

categories.categories.


2-3

The ProductThe Product

Direct

Materials

Direct

Labor

Manufacturing

Manufacturing

Overhead

Manufacturing Costs


2-4

Direct Materials

Raw materials that become an integral part of the product and that can be conveniently traced

directly to it.

Example: A radio installed in an automobile Example: A radio installed in an automobile


2-5

Direct Labor

Those labor costs that can be easily traced to individual units of product.

Example: Wages paid to automobile assembly workers Example: Wages paid to automobile assembly workers


2-6

Manufacturing costs that cannot be traced directly to specific units produced.

Manufacturing Overhead

Examples: Indirect labor and indirect materials Examples: Indirect labor and indirect materials

Wages paid to employees who are not directly

involved in production work.

Examples: maintenance workers, janitors and

security guards.

Materials used to support the production process.

Examples: lubricants and

cleaning supplies used in the automobile assembly plant.


2-7

Non-manufacturing Costs

Selling

Costs

Costs necessary to get

the order and deliver

the product.

Administrative

Costs

All executive,

organizational, and

clerical costs.


2-8


Distinguish between Distinguish between

product costs and period product costs and period

costs and give examples costs and give examples

of each.of each.


2-9

Product Costs Versus Period Costs

Product costs include

direct materials, direct

labor, and

manufacturing

overhead.

Period costs include all

selling costs and

administrative costs.

Inventory Cost of Good Sold

Balance

Sheet

Income

Statement

Sale

Expense

Income

Statement


2-10

Quick Check

Which of the following costs would be considered a

period rather than a product cost in a manufacturing

company?

A. Manufacturing equipment depreciation.

B. Property taxes on corporate headquarters.

C. Direct materials costs.

D. Electrical costs to light the production

facility.

E. Sales commissions.


2-11

Quick Check

Which of the following costs would be considered a

period rather than a product cost in a manufacturing

company?

A. Manufacturing equipment depreciation.

B. Property taxes on corporate headquarters.

C. Direct materials costs.

D. Electrical costs to light the production

facility.

E. Sales commissions.


2-12

Classifications of Costs

Direct

Direct

Material

Direct Direct

Labor

Manufacturing Manufacturing

Overhead

Prime

Cost

Conversion

Cost

Manufacturing costs are often

classified as follows:


2-13 Comparing Merchandising and

Manufacturing Activities

Merchandisers . . .

Buy finished goods.

Sell finished goods.

Manufacturers . . .

Buy raw materials.

Produce and sell

finished goods.

MegaLoMart


2-14

Balance Sheet

Merchandiser

Current assets

Cash

Receivables

Prepaid Expenses

Merchandise Inventory

Manufacturer

Current Assets

Cash

Receivables

Prepaid Expenses

Inventories

• Raw Materials

• Work in Process

• Finished Goods


2-15

Merchandiser

Current assets

Cash

Receivables

Prepaid Expenses

Merchandise Inventory

Manufacturer

Current Assets

Cash

Receivables

Prepaid Expenses

Inventories

• Raw Materials

• Work in Process

• Finished Goods

Balance Sheet

Partially complete products – some material, labor, or

overhead has been added.

Completed products awaiting sale.

Materials waiting to be processed.


2-16


Prepare an income Prepare an income

statement including statement including

calculation of the cost of calculation of the cost of

goods sold.goods sold.


2-17

The Income Statement

Cost of goods sold for manufacturers differs only

slightly from cost of goods sold for merchandisers.

Manufacturing Company

Cost of goods sold:

Beg. finished

goods inv. 14,200$

+ Cost of goods

manufactured 234,150

Goods available

for sale 248,350$

- Ending

finished goods

inventory (12,100)

= Cost of goods

sold 236,250$

Merchandising Company

Cost of goods sold:

Beg. merchandise

inventory 14,200$

+ Purchases 234,150

Goods available

for sale 248,350$

- Ending

merchandise

inventory (12,100)

= Cost of goods

sold 236,250$


2-18

Basic Equation for Inventory Accounts

Beginning

balance to inventory

Additions

to inventory + + = = Ending

balance

Withdrawals Withdrawals

from

inventory + +


2-19

Quick Check

If your inventory balance at the beginning of the

month was $1,000, you bought $100 during the

month, and sold $300 during the month, what would

be the balance at the end of the month?

A. $1,000.

B. $ 800.

C. $1,200.

D. $ 200.


2-20

Quick Check

If your inventory balance at the beginning of the

month was $1,000, you bought $100 during the

month, and sold $300 during the month, what would

be the balance at the end of the month?

A. $1,000.

B. $ 800.

C. $1,200.

D. $ 200.

$1,000 + $100 = $1,100

$1,100 - $300 = $800


2-21


Prepare a schedule of cost Prepare a schedule of cost

of goods manufactured.of goods manufactured.


2-22

Schedule of Cost of Goods Manufactured

Calculates the cost of raw

material, direct labor and

manufacturing overhead

used in production.

Calculates the manufacturing

costs associated with goods

that were finished during the

period.


2-23

Manufacturing Work

Raw Materials Costs In Process

Beginning raw Direct materials

materials inventory

+ Raw materials

purchased

= Raw materials

available for use

in production

– Ending raw materials

inventory

= Raw materials used

in production

As items are removed from raw

materials inventory and placed into

As items are removed from raw

materials inventory and placed into

the production process, they are

called direct materials.

Product Cost Flows


2-24

Manufacturing Work


Beginning raw Direct materials

materials inventory + Direct labor

+ Raw materials + Mfg. overhead

purchased = Total manufacturing

= Raw materials costs

available for use

in production


inventory


in production

Conversion

costs are costs

direct material

into a finished

Conversion

costs are costs

incurred to

convert the

direct material

into a finished

product.

Product Cost Flows


2-25

Manufacturing Work


Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory

+ Raw materials + Mfg. overhead + Total manufacturing

purchased = Total manufacturing costs

= Raw materials costs = Total work in

available for use process for the

in production period


inventory


in production

Product Cost Flows

All manufacturing costs incurred All manufacturing costs incurred

during the period are added to the

beginning balance of work in

process.


2-26

Manufacturing Work


Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory

+ Raw materials + Mfg. overhead + Total manufacturing

purchased = Total manufacturing costs

= Raw materials costs = Total work in

available for use process for the

in production period

– Ending raw materials – Ending work in

inventory process inventory

= Raw materials used = Cost of goods

in production manufactured

Product Cost Flows

Costs associated with the goods that Costs associated with the goods that

are completed during the period are

transferred to finished goods

inventory.


2-27

Work

In Process Finished Goods

Beginning work in Beginning finished

process inventory goods inventory

+ Manufacturing costs + Cost of goods

for the period manufactured

= Total work in process = Cost of goods

for the period available for sale

– Ending work in - Ending finished

process inventory goods inventory

= Cost of goods Cost of goods

manufactured sold

Product Cost Flows


2-28

Manufacturing Cost Flows

Finished

Goods

Cost of

Goods

Sold

Selling and

Administrative

Period Costs Selling and

Administrative

Manufacturing

Overhead

Work in

Process

Direct Labor

Balance Sheet

Costs Inventories

Income

Statement

Expenses Material Purchases Raw Materials


2-29

Quick Check

Beginning raw materials inventory was $32,000.

During the month, $276,000 of raw material was

purchased. A count at the end of the month

revealed that $28,000 of raw material was still

present. What is the cost of direct material used?

A. $276,000

B. $272,000

C. $280,000

D. $ 2,000


2-30

Quick Check

Beginning raw materials inventory was $32,000.

During the month, $276,000 of raw material was

purchased. A count at the end of the month

revealed that $28,000 of raw material was still

present. What is the cost of direct material used?

A. $276,000

B. $272,000

C. $280,000

D. $ 2,000

Beg. raw materials 32,000$

+ Raw materials

purchased 276,000

= Raw materials available

for use in production 308,000$


inventory 28,000


in production 280,000$


2-31

Quick Check

Direct materials used in production totaled $280,000. Direct labor was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month?

A. $555,000

B. $835,000

C. $655,000

D. Cannot be determined.


2-32

Direct materials used in production totaled $280,000. Direct labor was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month?

A. $555,000

B. $835,000

C. $655,000

D. Cannot be determined.

Direct Materials 280,000$

+ Direct Labor 375,000

+ Mfg. Overhead 180,000

= Mfg. Costs Incurred

for the Month 835,000$

Quick Check


2-33

Quick Check

Beginning work in process was $125,000. Manufacturing costs incurred for the month were $835,000. There were $200,000 of partially finished goods remaining in work in process inventory at the end of the month. What was the cost of goods manufactured during the month?

A. $1,160,000 B. $ 910,000 C. $ 760,000 D. Cannot be determined.


2-34

Beginning work in process was $125,000. Manufacturing costs incurred for the month were $835,000. There were $200,000 of partially finished goods remaining in work in process inventory at the end of the month. What was the cost of goods manufactured during the month?

A. $1,160,000 B. $ 910,000 C. $ 760,000 D. Cannot be determined.

Quick Check

Beginning work in

process inventory 125,000$

+ Mfg. costs incurred

for the period 835,000

= Total work in process

during the period 960,000$

– Ending work in

process inventory 200,000

= Cost of goods

manufactured 760,000$


2-35

Quick Check

Beginning finished goods inventory was $130,000. The cost of goods manufactured for the month was $760,000. And the ending finished goods inventory was $150,000. What was the cost of goods sold for the month?

A. $ 20,000.

B. $740,000.

C. $780,000.

D. $760,000.


2-36

Quick Check

Beginning finished goods inventory was $130,000. The cost of goods manufactured for the month was $760,000. And the ending finished goods inventory was $150,000. What was the cost of goods sold for the month?

A. $ 20,000.

B. $740,000.

C. $780,000.

D. $760,000.

$130,000 + $760,000 = $890,000

$890,000 - $150,000 = $740,000


2-37


Understand the Understand the

differences between differences between

variable costs and fixed variable costs and fixed

costs.costs.


2-38 Cost Classifications for Predicting Cost

Behavior

How a cost will react to changes in the level of

How a cost will react to changes in the level of

activity within the relevant range.

Total variable costs change when activity changes.

Total fixed costs remain unchanged when activity changes.


2-39

Variable Cost

Your total long distance telephone bill is based

on how many minutes you talk.

Minutes Talked

To

tal L

on

g D

ista

nce

Tele

ph

one

Bill


2-40

Variable Cost Per Unit

Minutes Talked

Pe

r M

inu

te

Tele

ph

one

Charg

e

The cost per long distance minute talked is

constant. For example, 10 cents per minute.


2-41

Fixed Cost

Your monthly basic telephone bill probably

does not change when you make more local

calls.

Number of Local Calls

Mo

nth

ly B

asic

Tele

ph

one

Bill


2-42

Fixed Cost Per Unit


Month

ly B

asic

Tele

ph

one

Bill

per

Lo

ca

l C

all

The average fixed cost per local call decreases

as more local calls are made.


2-43 Cost Classifications for Predicting Cost

Behavior

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remains

as activity level changes. the same over wide ranges

of activity.

Fixed Total fixed cost remains Average fixed cost per unit goes

the same even when the down as activity level goes up.

activity level changes.


2-44

Quick Check

Which of the following costs would be variable with

respect to the number of cones sold at a Baskins &

Robbins shop? (There may be more than one

correct answer.)

A. The cost of lighting the store.

B. The wages of the store manager.

C. The cost of ice cream.

D. The cost of napkins for customers.


2-45

Quick Check

Which of the following costs would be variable with

respect to the number of cones sold at a Baskins &

Robbins shop? (There may be more than one

correct answer.)

A. The cost of lighting the store.

B. The wages of the store manager.

C. The cost of ice cream.

D. The cost of napkins for customers.


2-46


Understand the Understand the

differences between direct differences between direct

and indirect costs.and indirect costs.


2-47

Assigning Costs to Cost Objects

Direct costs

• Costs that can be easily and conveniently traced to a unit of product or other cost object.

• Examples: direct material and direct labor

Indirect costs

• Costs that cannot be easily and conveniently traced to a unit of product or other cost object.

• Example: manufacturing overhead


2-48


Define and give examples Define and give examples

of cost classifications used of cost classifications used

in making decisions: in making decisions:

differential costs, differential costs,

opportunity costs, and opportunity costs, and

sunk costs.sunk costs.


2-49

• Every decision involves a choice between at

least two alternatives.

• Only those costs and benefits that differ

between alternatives are relevant in a decision.

All other costs and benefits can and should be

ignored.

Cost Classifications for Decision Making


2-50

Differential Cost and Revenue

Costs and revenues that differ among Costs and revenues that differ among

alternatives. alternatives.

Example: You have a job paying $1,500 per month in

your hometown. You have a job offer in a neighboring

city that pays $2,000 per month. The commuting cost

to the city is $300 per month.

Example: You have a job paying $1,500 per month in

your hometown. You have a job offer in a neighboring

city that pays $2,000 per month. The commuting cost

to the city is $300 per month.

Differential revenue is:

$2,000 – $1,500 = $500

Differential cost is:

$300


2-51

Opportunity Cost

The potential benefit that is given up when

one alternative is selected over another.

Example: If you were

not attending college,

you could be earning

$15,000 per year.

Your opportunity cost

of attending college for

one year is $15,000.


2-52

Sunk Costs

Sunk costs have already been incurred and cannot be changed now or in the future. They should be ignored when making

decisions.

Example: You bought an automobile that cost

$10,000 two years ago. The $10,000 cost is sunk

because whether you drive it, park it, trade it, or sell

it, you cannot change the $10,000 cost.


2-53

Quick Check

Suppose you are trying to decide whether to drive

or take the train to Portland to attend a concert. You

have ample cash to do either, but you don’t want to

waste money needlessly. Is the cost of the train

ticket relevant in this decision? In other words,

should the cost of the train ticket affect the decision

of whether you drive or take the train to Portland?

A. Yes, the cost of the train ticket is relevant.

B. No, the cost of the train ticket is not relevant.


2-54

Quick Check




waste money needlessly. Is the cost of the train

ticket relevant in this decision? In other words,

should the cost of the train ticket affect the decision

of whether you drive or take the train to Portland?

A. Yes, the cost of the train ticket is relevant.

B. No, the cost of the train ticket is not relevant.


2-55

Quick Check




waste money needlessly. Is the annual cost of

licensing your car relevant in this decision?

A. Yes, the licensing cost is relevant.

B. No, the licensing cost is not relevant.


2-56

Quick Check




waste money needlessly. Is the annual cost of

licensing your car relevant in this decision?

A. Yes, the licensing cost is relevant.

B. No, the licensing cost is not relevant.


2-57

Quick Check

Suppose that your car could be sold now for

$5,000. Is this a sunk cost?

A. Yes, it is a sunk cost.

B. No, it is not a sunk cost.


2-58

Quick Check

Suppose that your car could be sold now for

$5,000. Is this a sunk cost?

A. Yes, it is a sunk cost.

B. No, it is not a sunk cost.


2-59 Summary of the Types of Cost

Classifications

• Financial reporting

• Predicting cost behavior

• Assigning costs to cost objects

• Decision making


Further Classification of Labor

Costs

Appendix 2A


2-61


(Appendix 2A)(Appendix 2A)

Properly account for labor Properly account for labor

costs associated with idle costs associated with idle

time, overtime, and fringe time, overtime, and fringe

benefits.benefits.


2-62

Idle Time

The labor costs incurred

during idle time are ordinarily

treated as manufacturing

overhead.

Machine

Breakdowns

Material

Shortages

Power

Failures


2-63

Overtime

The overtime premiums for all factory

workers are usually considered to be part

of manufacturing overhead.


2-64

Labor Fringe Benefits

Fringe benefits include employer paid

costs for insurance programs, retirement

plans, supplemental unemployment

programs, Social Security, Medicare,

workers’ compensation and

unemployment taxes.

Some companies

include all of these

costs in

manufacturing

overhead.

Other companies treat

fringe benefit

expenses of direct

laborers as additional

direct labor costs.


2-65


Understand how fixed and Understand how fixed and

variable costs behave and variable costs behave and

how to use them to predict how to use them to predict

costs.costs.


2-66

Summary of Variable and Fixed Cost Behavior


Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges

level within the relevant range. of activity.

Total fixed cost remains the

same even when the activity Fixed cost per unit goes

Fixed level changes within the down as activity level goes up.

relevant range.

Recall the summary of our cost behavior Recall the summary of our cost behavior

discussion from an earlier chapter.discussion from an earlier chapter.

Types of Cost Behavior Patterns


2-67

The Activity Base

A measure of what A measure of what

causes the

incurrence of a

variable cost

Units

d

Units

produce

d

Miles Miles

driven

Labor Labor

hours

Machine Machine

hours


2-68

Minutes Talked

To

tal L

on

g D

ista

nce

Tele

ph

one

Bill

True Variable Cost Example

A variable cost is a cost whose total dollar amount

varies in direct proportion to changes in the activity

level. Your total long distance telephone bill is

based on how many minutes you talk.


2-69









relevant range.





2-70

Minutes Talked

Pe

r M

inu

te

Tele

ph

one

Charg

e

Variable Cost Per Unit Example

A variable cost remains constant if expressed on

a per unit basis. The cost per minute talked is

constant. For example, 10 cents per minute.


2-71

Extent of Variable Costs

The proportion of variable costs differs across

organizations. For example . . .

A public utility withA public utility with A public utility withA public utility with

large investments inlarge investments in

equipment will tendequipment will tend

to have to have fewerfewer

variable costs.variable costs.

A manufacturing companyA manufacturing company A manufacturing companyA manufacturing company

will often have will often have manymany

variable costs.variable costs.

A merchandising companyA merchandising company

proportionproportion of variable costs,of variable costs,

A merchandising companyA merchandising company

usually will have a usually will have a highhigh

proportionproportion of variable costs,of variable costs,

like cost of sales.like cost of sales. proportionproportion of variable costs.of variable costs.

A service companyA service company

will normally have a will normally have a highhigh

proportionproportion of variable costs.of variable costs.


2-72

Examples of Variable Costs

1. Merchandising companies – cost of goods sold.

2.

3.

commissions, shipping costs, and clerical costs,

4.

1. Merchandising companies – cost of goods sold.

2. Manufacturing companies – direct materials,

direct labor, and variable overhead.

3. Merchandising and manufacturing companies –

commissions, shipping costs, and clerical costs,

such as invoicing.

4. Service companies – supplies, travel, and

clerical.


2-73

Volume

Cost

True Variable Cost

Direct materials is a true or proportionately variable

cost because the amount used during a period will

vary in direct proportion to the level of production

activity.


2-74

Step-Variable Costs

A resource that is obtainable only in large chunks (such

as maintenance workers) and whose costs increase or

decrease only in response to fairly wide changes in

activity is known as a stepstep--variable costvariable cost.

Volume

Cost


2-75

Step-Variable Costs

Small changes in the level of production are not Small changes in the level of production are not

likely to have any effect on the number of

maintenance workers employed.

Volume

Cost


2-76

Step-Variable Costs

Only fairly wide changes in the activity level will Only fairly wide changes in the activity level will

cause a change in the number of maintenance

workers employed

Volume

Cost


2-77

Relevant

Range

A straight line

approximates a

relevant range.

A straight line

closely

approximates a

curvilinear

variable cost

line within the

relevant range.

Activity

To

tal C

ost

Economist’s

Curvilinear Cost

Function

The Linearity Assumption and the Relevant Range

Accountant’s Straight-Line

Approximation (constant

unit variable cost)


2-78









relevant range.

Let’s look at fixed cost behavior on the next Let’s look at fixed cost behavior on the next

screens.screens.



2-79


Mo

nth

ly B

asic

Tele

ph

one

Bill

Total Fixed Cost Example

A fixed cost is a cost whose total dollar amount remains

constant as the activity level changes. Your monthly

basic telephone bill is probably fixed and does not

change when you make more local calls.


2-80









relevant range.





2-81


Month

ly B

asic

Tele

ph

one

Bill

per

Lo

ca

l C

all

Fixed Cost Per Unit Example

Average fixed costs per unit decrease as the activity

level increases. The fixed cost per local call

decreases as more local calls are made.


2-82

Examples Examples

Advertising and Research and Development

Examples

Examples

Depreciation on Equipment and

Real Estate Taxes

Types of Fixed Costs

Discretionary

May be altered in the short-term by current managerial decisions

Discretionary

May be altered in the short-term by current managerial decisions

Committed

Long-term, cannot be significantly reduced in

the short term.

Committed

Long-term, cannot be significantly reduced in

the short term.


2-83

The Trend Toward Fixed Costs

The trend in many industries is toward

greater fixed costs relative to variable costs.

As machines take overAs machines take over

As machines take overAs machines take over

many mundane tasksmany mundane tasks

previously performedpreviously performed

by humans, by humans,

““knowledge workersknowledge workers””

are demanded forare demanded for

their minds rathertheir minds rather

than their muscles.than their muscles.

Knowledge workersKnowledge workers

difficult to replace. Thedifficult to replace. The

these valued employeesthese valued employees

Knowledge workersKnowledge workers

tend to be salaried,tend to be salaried,

highlyhighly--trained andtrained and

difficult to replace. Thedifficult to replace. The

cost to compensatecost to compensate

these valued employeesthese valued employees

is is relatively fixedrelatively fixed

rather than variable.rather than variable.


2-84

Is Labor a Variable or a Fixed Cost?

The behavior of wage and salary costs can

differ across countries, depending on labor

regulations, labor contracts, and custom.

In France, Germany, China, and Japan, management has In France, Germany, China, and Japan, management has

little flexibility in adjusting the size of the labor force.

Labor costs are more fixed in nature.

In the management

has greater latitude. Labor costs are more variable in nature.

In the United States and the United Kingdom, management

has greater latitude. Labor costs are more variable in nature.


2-85

Rent C

ost

in T

housands

of D

olla

rs

0 1,000 2,000 3,000

Rented Area (Square Feet)

0

30

60

Fixed Costs and Relevant Range

90

Relevant

Range

Total cost doesn’t

range of activity, and

then jumps to a new

next higher range of

Total cost doesn’t

change for a wide

range of activity, and

then jumps to a new

higher cost for the

next higher range of

activity.


2-86


Example:Example: Office space is Office space is

increments of 1,000 square increments of 1,000 square

feet. As the business grows, feet. As the business grows,

Example:Example: Office space is Office space is

available at a rental rate of available at a rental rate of

$30,000 per year in $30,000 per year in

increments of 1,000 square increments of 1,000 square

feet. As the business grows, feet. As the business grows,

more space is rented, more space is rented,

increasing the total cost.increasing the total cost.

The relevant range of activity for a fixed cost

is the range of activity over which the graph

of the cost is flat.


2-87

How does this type How does this type

of fixed cost differ of fixed cost differ

from a stepfrom a step--variable variable

cost?cost?

Step-variable costs can be adjusted more

quickly and . . .

The width of the activity steps is much

wider for the fixed cost.



2-88

Quick Check

Which of the following statements about cost Which of the following statements about cost

behavior are true?

1. Fixed costs per unit vary with the level of

activity.

2. Variable costs per unit are constant within the

relevant range.

3. Total fixed costs are constant within the

relevant range.

4. Total variable costs are constant within the

relevant range.


2-89

Quick Check

Which of the following statements about cost Which of the following statements about cost

behavior are true?

1. Fixed costs per unit vary with the level of

activity.

2. Variable costs per unit are constant within the

relevant range.

3. Total fixed costs are constant within the

relevant range.

4. Total variable costs are constant within the

relevant range.


2-90

Fixed Monthly

Utility Charge

Variable

Cost per KW

Activity (Kilowatt Hours)

To

tal U

tilit

y C

ost

X

Y

A mixed cost has both fixed and variable

components. Consider the example of utility cost.

A mixed cost has both fixed and variable

components. Consider the example of utility cost.

Mixed Costs


2-91

Fixed Monthly

Utility Charge

Variable

Cost per KW

Activity (Kilowatt Hours)

To

tal U

tilit

y C

ost

X

Y

Mixed Costs

The total mixed cost line can be expressed

as an equation: Y = a + bX

Where: Y = the total mixed cost

a = the total fixed cost (the

vertical intercept of the line)

b = the variable cost per unit of

activity (the slope of the line)

X = the level of activity


2-92

Mixed Costs Example

If your fixed monthly utility charge is $40, your If your fixed monthly utility charge is $40, your

variable cost is $0.03 per kilowatt hour, and your variable cost is $0.03 per kilowatt hour, and your

If your fixed monthly utility charge is $40, your If your fixed monthly utility charge is $40, your

variable cost is $0.03 per kilowatt hour, and your variable cost is $0.03 per kilowatt hour, and your

monthly activity level is 2,000 kilowatt hours, monthly activity level is 2,000 kilowatt hours,

what is the amount of your utility bill?what is the amount of your utility bill?

Y = a + bX

Y = $40 + ($0.03 × 2,000)

Y = $100 $100


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Analysis of Mixed Costs

Each account is classified as eitherEach account is classified as either

variable or fixed based on the analyst’svariable or fixed based on the analyst’s

knowledge of how the account behaves.knowledge of how the account behaves.

Cost estimates are based on an Cost estimates are based on an Cost estimates are based on an Cost estimates are based on an

evaluation of production methods, and evaluation of production methods, and

material, labor and overhead material, labor and overhead

requirements.requirements.

Account Analysis and the Engineering ApproachAccount Analysis and the Engineering Approach


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Use a scattergraph plot to Use a scattergraph plot to

diagnose cost behavior.diagnose cost behavior.


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Plot the data points on a graph Plot the data points on a graph Plot the data points on a graph Plot the data points on a graph

(total cost vs. activity).(total cost vs. activity).

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Patient-days in 1,000’s

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The Scattergraph Method


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Draw a line through the data points with about anDraw a line through the data points with about an Draw a line through the data points with about anDraw a line through the data points with about an

equal numbers of points above and below the line. equal numbers of points above and below the line.

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Use one data point to estimate the total level of activity Use one data point to estimate the total level of activity Use one data point to estimate the total level of activity Use one data point to estimate the total level of activity

and the total cost. and the total cost.

Intercept = Fixed cost: $10,000

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Patient days = 800Patient days = 800

Total maintenance cost = $11,000Total maintenance cost = $11,000


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Make a quick estimate of variable cost per unit and Make a quick estimate of variable cost per unit and Make a quick estimate of variable cost per unit and Make a quick estimate of variable cost per unit and

determine the cost equation. determine the cost equation.

Variable cost per unit = $1,000

800 = $1.25/patient$1.25/patient--dayday

Y = $10,000 + $1.25XY = $10,000 + $1.25X Y = $10,000 + $1.25XY = $10,000 + $1.25X

Total maintenance at 800 patients 11,000$

Less: Fixed cost 10,000

Estimated total variable cost for 800 patients 1,000$

Total maintenance costTotal maintenance cost Total maintenance costTotal maintenance cost Number of patient daysNumber of patient days Number of patient daysNumber of patient days


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Analyze a mixed cost Analyze a mixed cost

using the highusing the high--low low

method.method.


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The High-Low Method

Assume the following hours of maintenance work and the total maintenance costs for six months.


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The High-Low Method

The The variable cost variable cost

equal to the change equal to the change

the change in hours.the change in hours.

The The variable cost variable cost

per hourper hour of of

maintenance is maintenance is

equal to the change equal to the change

in cost divided by in cost divided by

the change in hours.the change in hours.

= $8.00/hour$8.00/hour $2,400

300


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The High-Low Method

Total Fixed Cost = Total Cost Total Fixed Cost = Total Cost –– Total Variable CostTotal Variable Cost

Total Fixed Cost = $9,800 Total Fixed Cost = $9,800 –– ($8/hour ($8/hour ×× 800 hours)800 hours)

Total Fixed Cost = $9,800 Total Fixed Cost = $9,800 –– $6,400$6,400

Total Fixed Cost = Total Fixed Cost = $3,400$3,400


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The High-Low Method

Y = $3,400 + $8.00Y = $3,400 + $8.00XX

The Cost Equation for Maintenance


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Quick Check

Sales salaries and commissions are $10,000 when


80,000 units are sold, and $14,000 when 120,000

units are sold. Using the high-low method, what is

the variable portion of sales salaries and

commission?

a. $0.08 per unit

b. $0.10 per unit

c. $0.12 per unit

d. $0.125 per unit


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Quick Check





the variable portion of sales salaries and

commission?

a. $0.08 per unit

b. $0.10 per unit

c. $0.12 per unit

d. $0.125 per unit $4,000 ÷ 40,000 units

= $0.10 per unit

Units Cost

High level 120,000 14,000$

Low level 80,000 10,000

Change 40,000 4,000$


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Quick Check





the fixed portion of sales salaries and commissions?

a. $ 2,000

b. $ 4,000

c. $10,000

d. $12,000


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Quick Check





the fixed portion of sales salaries and commissions?

a. $ 2,000

b. $ 4,000

c. $10,000

d. $12,000

Total cost = Total fixed cost +

Total variable cost

$14,000 = Total fixed cost +

($0.10 × 120,000 units)

Total fixed cost = $14,000 - $12,000

Total fixed cost = $2,000


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Least-Squares Regression Method

A method used to analyze mixed costs if a

scattergraph plot reveals an approximately linear

relationship between the X and Y variables.

This method uses This method uses of theof the This method uses This method uses allall of theof the

data points to estimatedata points to estimate

the fixed and variablethe fixed and variable

cost components of acost components of a

mixed cost.mixed cost.

sum of the squared errorssum of the squared errors..

The goal of this method isThe goal of this method is

to fit a straight line to theto fit a straight line to the

data that data that minimizes theminimizes the

sum of the squared errorssum of the squared errors..


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• Software can be used to fit

a regression line through

the data points.

• The cost analysis objective

is the same: Y = a + bX

Least-squares regression also provides a statistic, called Least-squares regression also provides a statistic, called

the R2, which is a measure of the goodness

of fit of the regression line to the data points.


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2R2 is the percentage of the variation in total cost

explained by the activity.

R2 varies from 0% to 100%, and

the higher the percentage the better.

X

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Comparing Results From the Three Methods

The three methods just discussed provide The three methods just discussed provide

accurate estimate because it uses all the data accurate estimate because it uses all the data

The three methods just discussed provide The three methods just discussed provide

slightly different estimates of the fixed and slightly different estimates of the fixed and

variable cost components of the mixed cost.variable cost components of the mixed cost.

This is to be expected because each method This is to be expected because each method

uses differing amounts of the data points to uses differing amounts of the data points to

provide estimates.provide estimates.

LeastLeast--squares regression provides the most squares regression provides the most

accurate estimate because it uses all the data accurate estimate because it uses all the data

points.points.


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Prepare an income Prepare an income

statement using the statement using the

contribution format.contribution format.


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Let’s put our

knowledge of cost

behavior to work by

preparing a

contribution format

income statement.

The Contribution Format

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