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Managerial Accounting and Cost Concepts
Chapter Two
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Learning Objective 1
Understand cost classifications used for assigning costs to cost
objects: Direct Costs and Indirect Costs
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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.
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Learning Objective 2
Identify and give examples of each of the three basic
manufacturing cost categories.
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The Product
DirectMaterials
DirectMaterials
DirectLaborDirectLabor
ManufacturingOverhead
ManufacturingOverhead
Manufacturing Costs
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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
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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.
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Learning Objective 3
Understand cost classification used to
prepare financial statements: product
costs and period costs.
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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
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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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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
ManufacturingOverhead
ManufacturingOverhead
PrimeCost
ConversionCost
Manufacturing costs are oftenclassified as follows:
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Learning Objective 4
Understand cost classifications used to predict cost behavior:
variable cost, fixed cost & mixed cost.
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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
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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
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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.
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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.
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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.
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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.
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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
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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
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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
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Learning Objective 5
Analyze a mixed cost using scatter graph plot and the
high-low method.
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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
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The Scattergraph Method
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
***
**
**
*
*
Patient-days in 1,000’s
X
Y
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The Scattergraph Method
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
***
**
**
*
*
Patient-days in 1,000’s
X
Y
Patient days = 800
Total maintenance cost = $11,000
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The Scattergraph Method
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
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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
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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
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The High-Low Method
Y = $3,400 + $8.00X
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 unitb. $0.10 per unit c. $0.12 per unitd. $0.125 per unit
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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 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$
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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 fixed portion of sales salaries and commissions?a. $ 2,000b. $ 4,000 c. $10,000d. $12,000
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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 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 = $2,000
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Least-Squares Regression Method
A method used to analyze mixed costs if a scattergraph plot reveals an approximately linear relationship between
the X and Y variables.
This method uses all of thedata points to estimatethe fixed and variablecost components of a
mixed cost.The goal of this method isto fit a straight line to thedata that minimizes the
sum of the squared errors.
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Least-Squares Regression Method
• Software can be used to fit a regression line through the data points.
• The cost analysis objective is the same: Y = a + bX
Least-squares regression also provides a statistic, called
the R2, which is a measure of the goodness
of fit of the regression line to the data points.
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0 1 2 3 4
Tota
l Cos
t
10
20
0
Activity
****
**
****
Least-Squares Regression Method
R2 is the percentage of the variation in total cost explained by the activity.
R2 varies from 0% to 100%, andthe higher the percentage the better.
X
Y
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Comparing Results From the Three Methods
The three methods just discussed provide slightly different estimates of the fixed and
variable cost components of the mixed cost.
This is to be expected because each method uses differing amounts of the data points to
provide estimates.
Least-squares regression provides the most accurate estimate because it uses all the data
points.
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Learning Objective 6
Prepare income statements for a
merchandise company using the traditional and
contribution formats
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Let’s put our knowledge of cost behavior to work by preparing a contribution format income statement.
The Contribution Format
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The Contribution Format
Total Unit
Sales Revenue 100,000$ 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.
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The Contribution Format
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.
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Learning Objective 7
Understand cost classifications used in
making decisions: differential costs,
opportunity costs, and sunk costs.
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• 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
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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End of Chapter 2