Managerial Accounting

and Cost Concepts

Chapter 2
Learning Objective 1

Understand cost
classifications used for
assigning costs to cost
objects: direct costs
and indirect costs.
Assigning Costs to Cost Objects
Direct costs Indirect costs
• Costs that can be • Costs that cannot be
easily and conveniently easily and conveniently
traced to a unit of product traced to a unit of product
or other cost object. or other cost object.
• Examples: direct material • Example: manufacturing
and direct labor overhead

Common costs
Indirect costs incurred to support a number of
cost objects. These costs cannot be traced to
any individual cost object.
Learning Objective 2

Identify and give

examples of each of
the three basic
manufacturing cost
categories.
Classifications of Manufacturing
Costs
Direct
Direct Direct
Direct Manufacturing
Manufacturing
Materials
Materials Labor
Labor Overhead
Overhead

The Product
Direct Materials
Raw materials that become an integral part
of the product and that can be
conveniently traced directly to it.

Example:
Example: A
A radio
radio installed
installed in
in an
an automobile
automobile
Direct Labor
Those labor costs that can be easily traced
to individual units of product.

Example:
Example: Wages
Wages paid
paid to
to automobile
automobile assembly
assembly workers
workers
Manufacturing Overhead
Manufacturing costs that cannot be easily traced
directly to specific units produced.

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

Materials used to support the Wages paid to employees who

production process. are not directly involved in
production work.
Examples: lubricants and cleaning Examples: maintenance workers,
supplies used in the automobile janitors, and security guards.
assembly plant.
Nonmanufacturing Costs

Selling Administrative
Costs Costs

Costs necessary to secure the order All executive, organizational,

and deliver the product. Selling and clerical costs.
costs can be either direct or indirect Administrative costs can be
costs. either direct or indirect costs.
Learning Objective 3

Understand cost
classifications used
to prepare financial
statements: product
costs and period
costs.
Cost Classifications for Preparing
Financial Statements
Product costs include direct Period costs include all selling
materials, direct labor, and costs and administrative
manufacturing overhead. costs.

Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
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.
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.
Prime Costs and Conversion Costs
Manufacturing costs are often
classified as follows:

Direct Direct Manufacturing

Material Labor Overhead

Prime Conversion
Cost Cost
Learning Objective 4

Understand cost
classifications used
to predict cost
behavior: variable
costs, fixed costs,
and mixed costs.
Cost Classifications for Predicting
Cost Behavior
Cost behavior refers to
how a cost will react to
changes in the level of
activity. The most
common classifications
are:
• Variable costs.
• Fixed costs.
• Mixed costs.
Variable Cost
A cost that varies, in total, in direct proportion to
changes in the level of activity. Your total texting bill
may be based on how many texts you send.

Total Texting Bill

Number of Texts Sent

Variable Cost Per Unit
However, variable cost per unit is constant. The cost per text
sent may be constant at 5 cents per text message.

Cost Per Text Sent

Number of Texts Sent
The Activity Base (Cost Driver)
Units Machine
produced hours

A measure of what
causes the incurrence
of a variable cost

Miles Labor
driven hours
Fixed Cost
A cost that remains constant, in total, regardless of changes in
the level of the activity. Your monthly contract fee for your cell
phone may be fixed for the number of monthly minutes in your
contract.
Monthly Cell Phone
Contract Fee

Number of Minutes Used

Within Monthly Plan
Fixed Cost Per Unit
However, if expressed on a per unit basis, the average fixed cost per unit varies
inversely with changes in activity. The average fixed cost per cell phone call
made decreases as more calls are made.

Monthly Cell Phone

Contract Fee
Number of Minutes Used
Within Monthly Plan
Types of Fixed Costs

Committed Discretionary
Long-term, cannot be May be altered in the
significantly reduced in the short term by current
short term. managerial decisions

Examples Examples
Depreciation on Buildings Advertising and Research
and Equipment and Real and Development
Estate Taxes
The Linearity Assumption and the
Relevant Range
Economist’s AA straight
straight line
line
closely
closely
Curvilinear Cost approximates
approximates aa
Function curvilinear
curvilinear
variable
variable cost
cost line
line
within
within the
the
Relevant
relevant
relevant range.
range.
Total Cost

Range
Accountant’s Straight-Line
Approximation (constant
unit variable cost)

Activity
Fixed Costs and the Relevant Range
The relevant range of activity pertains to fixed cost as well as
variable costs. For example, assume office space is available at
a rental rate of $30,000 per year in increments of 1,000 square
feet.

Fixed costs would increase in a

step fashion at a rate of $30,000
for each additional 1,000 square
feet.
Fixed Costs and the Relevant Range

90
Rent Cost in Thousands
The relevant range of
Relevant activity for a fixed cost
60
of Dollars
is the range of activity
Range over which the graph
of the cost is flat.

30

0
0 1,000 2,000 3,000
Rented Area (Square Feet)
Cost Classifications for Predicting
Cost Behavior
Behavior of Cost (within the relevant range)
Cost In Total Per Unit

Variable Total variable cost Increase Variable cost per unit

and decrease in proportion remains constant.
to changes in the activity level.
Fixed Total fixed cost is not affected Fixed cost per unit decreases
by changes in the activity as the activity level rises and
level within the relevant range. increases as the activity level falls.
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.
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.
Mixed Costs
A
A mixed
mixed cost
cost contains
contains both
both variable
variable and
and fixed
fixed
elements.
elements. Consider
Consider the
the example
example of
of utility
utility cost.
cost.
Y
Total Utility Cost

os t
d c
ixe
al m
Tot
Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
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).
Y b = The variable cost per unit of
activity (the slope of the line).
X = The level of activity.
Total Utility Cost

os t
d c
ixe
al m
Tot
Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
Mixed Costs – An 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
Analysis of Mixed Costs
Account Analysis and the Engineering Approach

In
In account
account analysis,
analysis, each
each account
account isis
classified
classified as
as either
either variable
variable or
or fixed
fixed based
based
on
on the
the analyst’s
analyst’s knowledge
knowledge of of how
how
the
the account
account behaves.
behaves.

The
The engineering
engineering approach
approach classifies
classifies costs
costs
based
based upon
upon an
an industrial
industrial engineer’s
engineer’s
evaluation
evaluation of
of production
production methods,
methods, and
and
material,
material, labor,
labor, and
and overhead
overhead requirements.
requirements.
Learning Objective 5

Analyze a mixed cost

using a scattergraph
plot and the high-
low method.
Scattergraph Plots – An Example
Assume the following hours of maintenance work and the total maintenance costs for six months.
The Scattergraph Method
Plot
Plot the
the data
data points
points on
on aa graph
graph (Total
(Total Cost
Cost YY “dependent
“dependent
variable”
variable” vs.
vs. Activity
Activity XX “independent
“independent variable”).
variable”).
Y Scattergraph Method
$10,000
Total Maintenance

$9,500

$9,000

$8,500
Cost

$8,000

$7,500

$7,000 X
400 500 600 700 800 900

Hours of
The High-Low Method – An Example

The variable cost per

hour of maintenance
is equal to the change
in cost divided by the
change in hours.

$2,400
= $6.00/hour
400
The High-Low Method – An Example

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($6/hour × 850 hours)
Total Fixed Cost = $9,800 – $5,100
Total Fixed Cost = $4,700
The High-Low Method – An Example

The Cost Equation for Maintenance

Y = $4,700 + $6.00X
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
Quick Check 
Sales
Sales salaries
salaries and
and commissions
commissions are are $10,000
$10,000 when
when
80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold.
sold. Using
Using the
the high-low
high-low method,
method, what
what is
is
the
the variable
variable portion
portion of
of sales
sales salaries
salaries and
and
commission?
commission?
a.
a. $0.08
$0.08 per
per unit
unit
b.
b. $0.10
$0.10 per
per unit
unit
c.
c. $0.12
$0.12 per
per unit
unit
d.
d. $0.125
$0.125 per
per unit
unit
 2-41

Quick Check 
Sales
Sales salaries
salaries and
and commissions
commissions are are $10,000
$10,000
when
when 80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when
120,000
120,000 units
units are
are sold.
sold. Using
Using the
the high-low
high-low
method,
method, what
what is
is the
the fixed
fixed portion
portion of
of sales
sales
salaries
salaries and
and commissions?
commissions?
a.
a. $$ 2,000
2,000
b.
b. $$ 4,000
4,000
c.
c. $10,000
$10,000
d.
d. $12,000
$12,000
 2-42

Quick Check 
Sales
Sales salaries
salaries and
and commissions
commissions are are $10,000
$10,000
when
when 80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 whenwhen
120,000
120,000 units
units are
are sold.
sold. Using
Using the
the high-low
high-low
method,
method, what
what is
is the
the fixed
fixed portion
portion of
of sales
sales
salaries
salaries and
and commissions?
commissions?
a.
a. $$ 2,000
2,000 Total cost = Total fixed cost +
b.
b. $$ 4,000
4,000 Total variable cost

c.
c. $10,000
$10,000 $14,000 = Total fixed cost +
($0.10 × 120,000 units)
d.
d. $12,000
$12,000
Total fixed cost = $14,000 - $12,000
Total fixed cost = $2,000
 2-43

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 the

data points to estimate
the fixed and variable
cost components of a
mixed cost. The goal of this method is
to fit a straight line to the
data that minimizes the
sum of the squared errors.
 2-44

Least-Squares Regression Method

• 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.
 2-45

Comparing Results From

the Two Methods
The
The two
two methods
methods just
just discussed
discussed provide
provide
different
different estimates
estimates of
of the
the fixed
fixed and
and variable
variable cost
cost
components
components of of aa mixed
mixed cost.
cost.
This
This is
is to
to be
be expected
expected because
because each
each method
method
uses
uses differing
differing amounts
amounts of
of the
the data
data points
points to
to
provide
provide estimates.
estimates.
Least-squares
Least-squares regression
regression provides
provides the
the most
most
accurate
accurate estimate
estimate because
because itit uses
uses all
all the
the data
data
points.
points.
 2-46

Learning Objective 6

Prepare income
statements for a
merchandising company
using the traditional and
contribution formats.
 2-47

The Traditional and Contribution Formats

Comparison of the Contribution Income Statement
with the Traditional Income Statement

Traditional Format Contribution Format

Sales $ 100,000 Sales $ 100,000

Cost of goods sold 70,000 Variable expenses 60,000
Gross margin $ 30,000 Contribution margin $ 40,000
Selling & admin. expenses 20,000 Fixed expenses 30,000
Net operating income $ 10,000 Net operating income $ 10,000

Used primarily for Used primarily by

external reporting. management.
 2-48

Uses of the Contribution Format

The
The contribution
contribution income
income statement
statement format
format is
is used
used
as
as an
an internal
internal planning
planning andand decision-making
decision-making tool.
tool.
We
We will
will use
use this
this approach
approach for:
for:
1.Cost-volume-profit
1.Cost-volume-profit analysis
analysis (Chapter
(Chapter 5).
5).
2.Budgeting
2.Budgeting (Chapter
(Chapter 8).
8).
3.Segmented
3.Segmented reporting
reporting of
of profit
profit data
data (Chapter
(Chapter 6).
6).
4.Special
4.Special decisions
decisions such
such as
as pricing
pricing and
and make-or-
make-or-
buy
buy analysis
analysis (Chapter
(Chapter 12).
12).
 2-49

Learning Objective 7

Understand cost
classifications used in
making decisions:
differential costs,
opportunity costs, and
sunk costs.
 2-50

Cost Classifications for Decision Making

• 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 as irrelevant.
 2-51

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.

Differential revenue is: Differential cost is:

$2,000 – $1,500 = $500 $300
 2-52

Opportunity Cost
The potential benefit that is
given up when one alternative
is selected over another.
These costs are not
usually entered into the
accounting records of an
organization, but must be
explicitly considered in all
decisions.
What are the
opportunity costs you
incur to attend this class?
 2-53

Sunk Costs

Sunk costs have already been incurred

and cannot be changed now or in the
future. These costs should be ignored
when making decisions.

Example: Suppose you had purchased gold for

$1,100 an ounce, but now it is selling for $950 an
ounce. Should you wait for the gold to reach $1,100
an ounce before selling it? You may say, “Yes” even
though the $1,100 purchase is a sunk costs.
 2-54

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.
 2-55

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.
 2-56

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.
 2-57

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 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.
 2-58

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

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.