cost terms, concepts, and classifications

Cost Terms, Concepts, and Classifications

Chapter 2

© The McGraw-Hill Companies, Inc., 2003McGraw-Hill/Irwin

Comparing Merchandising and Manufacturing Activities

Merchandisers . . . Buy finished

goods. Sell finished goods.

Manufacturers . . . Buy raw materials. Produce and sell

finished goods.

MegaLoMart


The ProductThe Product

DirectMaterials

DirectMaterials

DirectLaborDirectLabor

ManufacturingOverhead


Manufacturing Costs


Direct Materials

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

traced directly to it.

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


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


I do not like getting my temperature taken by the vet!


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.


Classifications of Costs

DirectMaterialDirect

MaterialDirectLaborDirectLabor



PrimeCost

ConversionCost

Manufacturing costs are oftenclassified as follows:


Nonmanufacturing Costs

Marketing and Selling Cost

Costs necessary to get the order and deliver the

product.

Administrative Cost

All executive, organizational, and

clerical costs.


Quick Check

Which of the following costs would be considered manufacturing overhead at Boeing? (More than one answer may be correct.)

A. Depreciation on factory forklift trucks.

B. Sales commissions.

C. The cost of a flight recorder in a Boeing 767.

D. The wages of a production shift supervisor.


Quick Check

Which of the following costs would be Which of the following costs would be considered manufacturing overhead at Boeing? considered manufacturing overhead at Boeing? (More than one answer may be correct.)(More than one answer may be correct.)

A. Depreciation on factory forklift trucks.A. Depreciation on factory forklift trucks.

B. Sales commissions.B. Sales commissions.

C. The cost of a flight recorder in a Boeing 767.C. The cost of a flight recorder in a Boeing 767.

D. The wages of a production shift supervisor.D. The wages of a production shift supervisor.


Product Costs Versus Period Costs

Product costs include direct materials, direct

labor, and manufacturing

overhead.

Period costs are not included in product

costs. They are expensed on the

income statement.Inventory Cost of Good Sold

BalanceSheet

IncomeStatement

Sale

Expense

IncomeStatement


For Your Consideration …

Take a look at Review Problems 1 & 2

on pages 48 and 49.


Cost Classifications for Predicting Cost Behavior

How a cost will react to changes in the level of

business activity. 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

business activity. Total variable costs

change when activity changes.

Total fixed costs remain unchanged when activity changes.


Total Variable Cost

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

Minutes Talked

Tot

al L

ong

Dis

tanc

eT

elep

hone

Bill


Variable Cost Per Unit

Minutes Talked

Per

Min

ute

Tel

epho

ne C

harg

e

The cost per long distance minute talked is constant. For example, 10 cents per minute.


Total Fixed Cost

Your monthly basic telephone bill probably does not change when you make more local

calls.

Number of Local Calls

Mon

thly

Bas

ic

Tel

epho

ne B

ill


Fixed Cost Per Unit

Number of Local Calls

Mon

thly

Bas

ic T

elep

hone

B

ill p

er L

ocal

Cal

l

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


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 Fixed cost per unit goesthe same even when the down as activity level goes up. activity level changes.


Cost Behavior

MerchandisersCost of Goods Sold

MerchandisersCost of Goods Sold

ManufacturersDirect Material, Direct Labor, and Variable


ManufacturersDirect Material, Direct Labor, and Variable


Merchandisers and Manufacturers

Sales commissions and shipping costs

Merchandisers and Manufacturers

Sales commissions and shipping costs

Service Organizations Supplies and travel

Service Organizations Supplies and travel

Examples of normally variable costsExamples of normally variable costs

Examples of normally fixed costsExamples of normally fixed costs

Merchandisers, manufacturers, and service organizations

Real estate taxes, Insurance, Sales salariesDepreciation, Advertising

Merchandisers, manufacturers, and service organizations

Real estate taxes, Insurance, Sales salariesDepreciation, Advertising


Examples

Advertising and Research and Development

Examples

Advertising and Research and Development

Examples

Depreciation on Buildings and

Equipment

Examples

Depreciation on Buildings and

Equipment

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 reduced in the short

term.

Committed

Long-term, cannot be reduced in the short

term.


Example: Office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet. As the

business grows more space is rented,

increasing the total cost.

Fixed Costs and Relevant Range

Continue


Ren

t C

ost

in

T

ho

usa

nd

s o

f D

oll

ars

0 1,000 2,000 3,000 Rented Area (Square Feet)

0

30

60


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.

Exh.5-6


How does this type of fixed cost differ

from a step-variable cost?

Step-variable costs can be adjusted more

quickly and . . .

The width of the activity steps is much

wider for the fixed cost.



Fixed Monthly

Utility Charge

Variable

Cost per KW

Activity (Kilowatt Hours)

To

tal

Uti

lity

Co

st

X

Y

A mixed cost has both fixed and variablecomponents. Consider the example of utility cost.

A mixed cost has both fixed and variablecomponents. Consider the example of utility cost.

Mixed Costs

Total mixed cost


Fixed Monthly

Utility Charge

Variable

Cost per KW

Activity (Kilowatt Hours)

To

tal

Uti

lity

Co

st

X

Y

Mixed Costs

Total mixed cost Y

= a + bX


The Analysis of Mixed Costs

Engineering Approach

Account Analysis

High-Low Method

Least-Square Regression Method

Scattergraph Plot


Account Analysis & Engineering Estimates

Each account is classified as eithervariable or fixed based on the analyst’s

knowledge of how the account behaves.

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.

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

requirements.


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

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

0 1 2 3 4

*

To

tal

Co

st i

n1,

000’

s o

f D

oll

ars

10

20

0

***

**

**

*

*

Activity, 1,000’s of Units Produced

X

Y

The Scattergraph Method


0 1 2 3 4

*

To

tal

Co

st i

n1,

000’

s o

f D

oll

ars

10

20

0

***

**

**

*

*


X

Y

Quick-and-Dirty Method

Intercept is the estimated fixed cost = $10,000

Intercept is the estimated fixed cost = $10,000

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

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


0 1 2 3 4

*

To

tal

Co

st i

n1,

000’

s o

f D

oll

ars

10

20

0

***

**

**

*

*


X

Y

Quick-and-Dirty MethodThe slope is the estimated variable cost per unit.

Slope = Change in cost ÷ Change in units

The slope is the estimated variable cost per unit.

Slope = Change in cost ÷ Change in units

Vertical distance is the change in cost.

Vertical distance is the change in cost.

Horizontal distance is

the change in activity.

Horizontal distance is

the change in activity.


WiseCo recorded the following production activity and maintenance costs for two months:

Using these two levels of activity, compute:• the variable cost per unit; • the fixed cost; and then• express the costs in equation form Y = a + bX.

The High-Low Method


Changein costChange in units

The High-Low Method

Variable cost per unit = Change in cost ÷ change in units


The High-Low Method

Variable cost per unit = $2,400 ÷ 3,000 units

= $0.80 per unit


The High-Low Method

Variable cost = $2,400 ÷ 3,000 units = $0.80 per unit Fixed cost = Total cost – Total variable cost

Fixed cost = $9,800 – ($0.80 per unit × 8,000 units)

Fixed cost = $9,800 – $6,400 = $3,400


Variable cost = $2,400 ÷ 3,000 units = $0.80 per unit Fixed cost = Total cost – Total variable cost

Fixed cost = $9,800 – ($0.80 per unit × 8,000 units)

Fixed cost = $9,800 – $6,400 = $3,400 Total cost = Fixed cost + Variable cost (Y = a + bX)

Y = $3,400 + $0.80X

The High-Low 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 Method

Least-squares regression also provides a statistic,

called the R2, that is a measure of the goodness

of fit of the regression line to the data points.

Least-squares regression also provides a statistic,

called the R2, that is a measure of the goodness

of fit of the regression line to the data points.


0 1 2 3 4

To

tal

Co

st

10

20

0

Activity

**

***

**

***

Least-Squares Regression Method

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

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

R2 for this relationship is near100% since the data points are

very close to the regression line.

X

Y


Cost Estimation MethodsRegression Analysis

A statistical method used to create an equation relating independent (or X) variables to dependent

(or Y) variables.

Past data is used to estimate relationships between costs and activities.

A statistical method used to create an equation relating independent (or X) variables to dependent

(or Y) variables.

Past data is used to estimate relationships between costs and activities.

Dependent variables are caused by the

independent variables.

Dependent variables are caused by the

independent variables.

Independent variables are the cost drivers that are correlated with the dependent variables.

Independent variables are the cost drivers that are correlated with the dependent variables.


Hey, Ed !

Remember who received a mid-semester deficiency

in statistics in 1972 and 1973!


Caution: Before doing the analysis, take time

to determine if a logical relationship

between the variables exists.

Caution: Before doing the analysis, take time

to determine if a logical relationship

between the variables exists.

Cost Estimation MethodsRegression Analysis

The simple cost model is actually a regression model:

TC = F + VX

The simple cost model is actually a regression model:

TC = F + VX

This model will only be useful within a relevant range of

activity.

This model will only be useful within a relevant range of

activity.


Direct Costs and Indirect Costs

Direct costs

Costs that can beeasily and conveniently traced to a unit of product or other cost objective.

Examples: direct material and direct labor

Indirect costs

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

Example: manufacturing overhead


Differential Costs and Revenues

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


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 pizza you ate last night relevant in this decision? In other words, should the cost of the pizza affect the decision of whether you drive or take the train to Portland?

A. Yes, the cost of the pizza is relevant.

B. No, the cost of the pizza is not relevant.


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.


Opportunity Costs

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.


Sunk Costs

Sunk costs cannot be changed by any decision. They are not differential costs and 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.


Further Classification of Labor Costs

Idle TimeTreated as

manufacturing overhead cost

Overtime Premium of

Factory Workers

Treated as manufacturing overhead cost

Labor Fringe Benefits

Treated as indirect labor or direct labor


Further Classification of Labor Costs

Idle TimeTreated as

manufacturing overhead cost

Overtime Premium of

Factory Workers

Treated as manufacturing overhead cost

Labor Fringe Benefits

Discovery Channel :: Video :: "Best Of" Moments

Treated as indirect labor or direct labor


The Contribution Format

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.


End of Chapter 2

cost terms, concepts, and classifications

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