Managerial Accounting and Cost Concepts Chapter Two.

Managerial Accounting and Cost Concepts

Chapter Two

2-2

Learning Objective 1

Understand cost classifications used for assigning costs to cost

objects: Direct Costs and Indirect Costs

2-3Cost Classifications for assigning costs to cost

objects

• Cost Object: Anything for which cost data are desired-including products, customers, jobs and organizational subunits.

• Direct Cost: A cost that can be easily and conveniently traced to a specific cost object.

• Indirect Cost: A cost that cannot be easily and conveniently traced to a specific cost object.

2-4


Identify and give examples of each of the three basic

manufacturing cost categories.

2-5

The Product

DirectMaterials

DirectMaterials

DirectLaborDirectLabor

ManufacturingOverhead


Manufacturing Costs

2-6

Direct Materials

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

traced directly to it.

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

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Direct Labor

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

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

2-8

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

Manufacturing Overhead

Examples: Indirect labor and indirect materialsExamples: 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.

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Non-manufacturing Costs

Selling Costs

Costs necessary to secure the customer order and deliver the product to customer.

Administrative Costs

All costs associated with the general

management of an organization.

2-10


Understand cost classification used to

prepare financial statements: product

costs and period costs.

2-11

Product Costs Versus Period Costs

Product costs include all costs involved in

acquiring or making a product, consists of

direct materials, direct labor, and manufacturing

overhead.

Period costs are all the costs that are not product costs. All

selling and administrative

expenses are treated as period costs.

Inventory Cost of Good Sold

BalanceSheet

IncomeStatement

Sale

Expense

IncomeStatement

2-12

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.

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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.

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Classifications of Costs

DirectMaterialDirect

MaterialDirectLaborDirectLabor



PrimeCost

ConversionCost

Manufacturing costs are oftenclassified as follows:

2-15


Understand cost classifications used to predict cost behavior:

variable cost, fixed cost & mixed cost.

2-16

Cost Classifications for Predicting Cost Behavior

How a cost will react to changes in the level of activity within the relevant range. As the activity level rises or falls, a particular cost may rise or fall as well-or it may remain constant. Total variable costs

change when activity changes.

Total fixed costs remain unchanged when activity changes.

How a cost will react to changes in the level of activity within the relevant range. As the activity level rises or falls, a particular cost may rise or fall as well-or it may remain constant. Total variable costs

change when activity changes.

Total fixed costs remain unchanged when activity changes.

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Minutes Talked

Tota

l Lo

ng D

ista

nce

Tele

phone B

ill

Variable Cost

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.

Ex- Direct materials, Direct labor, variable elements of manufacturing overhead and variable elements of selling and administrative expenses

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Variable Cost

Your total long distance telephone bill is based on how many minutes you talk.

Minutes Talked

Tota

l Lo

ng

Dis

tan

ceTe

lep

hon

e B

ill

2-19

Variable Cost Per Unit

Minutes Talked

Per

Min

ute

Tele

ph

on

e C

harg

e

A variable cost is constant if expressed on a per unit basis. The cost per long distance minute talked is

constant. For example, 10 cents per minute.

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Fixed Cost

Fixed cost is a cost that remains constant in total, regardless of the changes in the level of activity. Your monthly basic

telephone bill probably does not change when you make more local calls.

Ex: straight-line depreciation, insurance, property taxes, rent, supervisor’s salaries, administrative salaries, and advertising.

Number of Local Calls

Mon

thly

Basi

c Te

lep

hon

e B

ill

2-21

Fixed Cost Per Unit

Number of Local Calls

Mon

thly

Basi

c Te

lep

hon

e

Bill

per

Loca

l C

all

The average fixed cost per unit becomes progressively smaller as the level of activity increases.

The average fixed cost per local call decreases as more local calls are made.

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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 remainsas activity level changes. the same over wide ranges

of activity.

Fixed Total fixed cost remains Average fixed cost per unit goesthe same even when the down as activity level goes up.

activity level changes.

2-23

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.

2-24

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.

2-25

Examples

Advertising and Research and Development

Examples

Depreciation on Equipment and

Real Estate Taxes

Types of Fixed Costs

Discretionary Fixed Costs

Usually arise from annual decisions by

management to spend on certain fixed cost.

Committed Fixed Costs

Organizational investment with multi-year planning horizon, cannot be significantly reduced in the short

term.

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RelevantRange

A straight line closely

approximates a curvilinear

variable cost line within the

relevant range.

A straight line closely

approximates a curvilinear

variable cost line within the

relevant range.

Activity

Tota

l C

ost

Economist’sCurvilinear Cost

Function

The Linearity Assumption and the Relevant Range

Accountant’s Straight-Line Approximation (constant unit

variable cost)

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Rent

Cost

in T

housa

nds

of

Dolla

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 change for a wide range of activity,

and then jumps to a new higher cost for

the next higher range of activity.

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.

2-28

Fixed Monthly

Utility Charge

Variable

Cost per KW

Activity (Kilowatt Hours)

Tota

l U

tilit

y C

ost

X

Y

A mixed cost contains both fixed and variablecomponents. Mixed costs are also known as semi-

variable costs. Consider the example of utility cost.

Mixed Costs

Total mixed cost

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Fixed Monthly

Utility Charge

Variable

Cost per KW

Activity (Kilowatt Hours)

Tota

l U

tilit

y C

ost

X

Y

Mixed Costs

Total mixed cost

The total mixed cost line can be expressed as an equation: Y = a + bX

Where: Y = the total mixed costa = 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

2-30

Mixed Costs Example

If your fixed monthly utility charge is $40, your variable cost is $0.03 per kilowatt hour, and your monthly activity level is 2,000 kilowatt hours, what is the amount of your

utility bill?

Y = a + bX

Y = $40 + ($0.03 × 2,000)

Y = $100$100

2-31

The Analysis of Mixed Costs

Each account is classified as eithervariable or fixed based on the analyst’s knowledge of how the account behaves.

Cost estimates are based on an evaluation of production methods, and material, labor and overhead requirements.

Account Analysis and the Engineering Approach

2-32


Analyze a mixed cost using scatter graph plot and the

high-low method.

2-33

Plot the data points on a graph (total cost vs. activity).

0 1 2 3 4

*

Mai

nten

ance

Cos

t1,

000’

s of

Dol

lars

10

20

0

***

**

**

*

*

Patient-days in 1,000’s

X

Y

The Scattergraph Method

2-34


Draw a line through the data points with about anequal numbers of points above and below the line.

0 1 2 3 4

*

Mai

nten

ance

Cos

t1,

000’

s of

Dol

lars

10

20

0

***

**

**

*

*


X

Y

2-35


Use one data point to estimate the total level of activity and the total cost.

Intercept = Fixed cost: $10,000

0 1 2 3 4

*

Mai

nten

ance

Cos

t1,

000’

s of

Dol

lars

10

20

0

***

**

**

*

*


X

Y

Patient days = 800

Total maintenance cost = $11,000

2-36


Make a quick estimate of variable cost per unit and determine the cost equation.

Variable cost per unit = $1,000 800

= $1.25/patient-day

Y = $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 cost Number of patient days

2-37

The High-Low Method

The variable cost per hour of

maintenance is equal to the change

in cost divided by the change in hours.

= $8.00/hour$2,400/

300

2-38

The High-Low Method

Total Fixed Cost = Total Cost – Total Variable Cost

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

Total Fixed Cost = $9,800 – $6,400

Total Fixed Cost = $3,400

2-39

The High-Low Method

Y = $3,400 + $8.00X

The Cost Equation for Maintenance

2-40

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 unitb. $0.10 per unit c. $0.12 per unitd. $0.125 per unit

2-41

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 unitb. $0.10 per unit c. $0.12 per unitd. $0.125 per unit

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 unitb. $0.10 per unit c. $0.12 per unitd. $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$

2-42

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 fixed portion of sales salaries and commissions?a. $ 2,000b. $ 4,000 c. $10,000d. $12,000

2-43

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 fixed portion of sales salaries and commissions?a. $ 2,000b. $ 4,000 c. $10,000d. $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

2-44

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 all of thedata points to estimatethe fixed and variablecost components of a

mixed cost.The goal of this method isto fit a straight line to thedata that minimizes the

sum of the squared errors.

2-45


• 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

the R2, which is a measure of the goodness

of fit of the regression line to the data points.

2-46

0 1 2 3 4

Tota

l Cos

t

10

20

0

Activity

****

**

****


R2 is the percentage of the variation in total cost explained by the activity.

R2 varies from 0% to 100%, andthe higher the percentage the better.

X

Y

2-47

Comparing Results From the Three Methods

The three methods just discussed provide slightly different estimates of the fixed and

variable cost components of the mixed cost.

This is to be expected because each method uses differing amounts of the data points to

provide estimates.

Least-squares regression provides the most accurate estimate because it uses all the data

points.

2-48


Prepare income statements for a

merchandise company using the traditional and

contribution formats

2-49

Let’s put our knowledge of cost behavior to work by preparing a contribution format income statement.

The Contribution Format

2-50


Total Unit

Sales Revenue 100,000$ 50$

Less: Variable costs 60,000 30

Contribution margin 40,000$ 20$

Less: Fixed costs 30,000

Net operating income 10,000$

The contribution margin format emphasizes cost behavior. Contribution margin covers fixed costs and provides for income.

2-51


Comparison of the Contribution Income Statement with the Traditional Income Statement

Traditional Approach Contribution Approach (costs organized by function) (costs organized by behavior)

Sales 100,000$ Sales 100,000$ Less cost of goods sold 70,000 Less variable expenses 60,000 Gross margin 30,000$ Contribution margin 40,000$ Less operating expenses 20,000 Less fixed expenses 30,000 Net operating income 10,000$ Net operating income 10,000$

Used primarily forexternal reporting.

Used primarily bymanagement.

2-52


Understand cost classifications used in

making decisions: differential costs,

opportunity costs, and sunk costs.

2-53

• Every decision involves a choice between at least two alternatives.

• Differential Cost: A difference in cost between any two alternatives is known as differential cost.

• Differential Revenue: A difference in revenues between any two alternatives is known as differential revenue.

• 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

2-54

Differential Cost and Revenue

Costs and revenues that differ among 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

2-55

Opportunity Cost

The potential benefit that is given up when one alternative is selected over another.

Example: If you werenot attending college,you could be earning$15,000 per year. Your opportunity costof attending college for one year is $15,000.

2-56

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.

2-57

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.

2-58

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.

2-59

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 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.

2-60

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 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.

2-61

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.

2-62

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.

2-63

End of Chapter 2

Managerial Accounting and Cost Concepts Chapter Two.

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