Managerial Accounting: Tools For Business Decision-Making

Managerial Accounting
Tools for Business Decision-Making

Sixth Canadian Edition
Weygandt Kimmel Aly
Chapter 2
Managerial Cost Concepts and Cost
Behaviour Analysis
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Copyright ©2021 John Wiley & Sons Canada, Ltd.

Learning Objectives
1. Define the three classes of manufacturing costs and
differentiate between product costs and period costs.
2. Explain variable, fixed, and mixed costs and the relevant
range.
3. Apply the high-low method to determine the components
of mixed costs.
4. Demonstrate how to calculate the cost of goods
manufactured and prepare financial statements for a
manufacturer.
5. Apply regression analysis to determine the components of
mixed costs (Appendix 2A)
Copyright ©2021 John Wiley & Sons Canada, Ltd. 3
Managerial Cost Concepts
• To effectively plan, direct and control operations, managers
need reliable cost information
• Questions such as:
1. What costs are involved in making a product (or service)?
2. If volume changes, how will costs change?
3. Will automation impact costs?
4. How to best control costs and maintain quality?
5. Should a product/service be discontinued; or should a new
product/service be added?

Product Costs and Period Costs (1 of 2)
Cost Object: Anything for which we

want to accumulate costs
Examples:
• A hamburger made by a restaurant
• Providing a haircut
• Preparing a tax return
• Making a car

Product Costs and Period Costs (2 of 2)
Product costs
• Incurred only because the company manufactures their cost object
• as opposed to purchasing a completed product unit
Period costs
• Expenses incurred because the company is in business
• e.g. administrative, selling, marketing
Manufacturing Costs
Manufacturing consists of activities that convert raw (direct)
materials into finished goods.
Typical Classification of Manufacturing Costs
• In contrast, a merchandising firm sells goods in the form

in which they are purchased.

Manufacturing Costs – Direct Materials
Raw materials are basic materials Raw materials that can be

and parts used in manufacturing. physically, directly and easily
associated with the finished
product
= direct materials
e.g. steel used in making cars, milk used to make ice cream
Manufacturing Costs – Direct Labour
• Work completed by employees that can be physically,
directly and easily associated with converting raw
materials into finished goods
à direct labour
e.g. chefs at a food truck, legal staff at a law firm

Manufacturing Costs – Manufacturing
Overhead
• Costs incurred in the manufacture of a finished good that
cannot be practically traced to a specific unit
• i.e. all manufacturing costs that cannot be classified as direct
material or direct labour
e.g. indirect materials; indirect labour, depreciation on machinery, electricity in factory

Manufacturing Overhead – Indirect Materials
• Indirect materials
• Raw materials that cannot be easily associated with the cost
object
• Considered part of manufacturing overhead
• May not physically become part of the finished product
• Or may represent too small a part of the finished product in terms of
cost
Examples: lubricants, glue, cleaning supplies

Manufacturing Overhead – Indirect Labour
• Work completed by employees that has no direct
physical association with the finished product
• Or it is impractical to trace to the goods produced
• Time, accuracy, amount
Examples include maintenance workers, janitors, and security guards

Prime Costs
Prime costs: sum of all direct materials and direct labour costs.
• i.e. all direct manufacturing costs.
e.g. sushi restaurant – ingredients, chef wages

Conversion Costs
Conversion costs: the cost of converting raw materials into a

final product
• Sum of direct labour and manufacturing overhead costs.
e.g. cleaning supplies, supervisor salary
Prime Costs and Conversion Costs
Prime costs and conversion costs

Direct labour is a component of both Prime and Conversion costs

Let’s Review 1
Which of the following is not an element of
manufacturing overhead?
a. Sales manager’s salary
b. Plant manager’s salary
c. Factory repairman’s wages
d. Product inspector’s salary

Let’s Review 2
The following labour costs have been incurred by T.H. Makers
Ltd. Of this amount, how much would be considered a
product cost?
Description Amount
Direct labour: Plant $310,000
a. $310,000
Indirect labour: Plant 75,000 b. $385,000
Supervisor salary: Plant 95,000 c. $480,000
Sales commissions 140,000
d. $820,000
Sales salaries 200,000
$820,000

Product versus Period Costs
Product Costs (1 of 2)
• Consist of:
• direct material cost,
• direct labour cost,
• manufacturing overhead cost
• A necessary and integral part of producing the product
• Recorded as inventory when incurred
o Product costs also referred to as inventoriable costs

Product Costs (2 of 2)
• Become an expense to the business when the finished
good is sold
o Inventory (Balance Sheet) is reduced
o Cost of Goods Sold (Income Statement) is increased
DR COGS
CR Inventory

Period Costs
• Matched with revenue earned within a specific time
period and charged to expense as incurred
• Non-manufacturing costs
• Deducted from revenues in period incurred to
determine net income
• Include all
o Selling and marketing expenses
o General and Administrative expenses

Product versus period costs

Let’s Review 3
The following costs have been incurred by T.H. Makers Ltd. Of
this amount, how much would be considered period cost?
Description Amount
Direct materials $ 60 a. $52
Direct manufacturing labour 10
b. $20
Manufacturing overhead 50
Sales commissions 4 c. $16
Administrative salaries 16 d. $4
$140

Cost Behaviour Analysis (1 of 3)
• The study of how specific costs respond to changes in
the level of business activity
o As activity levels change, some costs change (e.g. car
service)
o Other costs will remain unchanged (e.g. limited capacity
barre studio)
• Helps management to plan operations and make
decisions
• Cost behaviour analysis begins by identifying and
measuring key business activities

• Activity levels may be expressed in terms of

o Sales dollars (in a retail company)
o Kilometres driven (in a trucking company)
o Room occupancy (in a hotel)
o Dance classes taught (by a dance studio)

• The activity level selected is called the activity (or

volume) index
o Identifies the activity that causes changes in the
behaviour of costs
o Allows costs to be classified according to their response
to changes in activity:
Variable Cost
Fixed Cost
Mixed Cost

Cost Behaviour Analysis: Variable Costs
(1 of 3)
Variable Costs
• Costs that vary in total directly and proportionately with
changes in the activity level
o Variable costs remain the same per unit regardless of
activity level
e.g. Direct material and direct labour, Sales commissions, gas

(2 of 3)
Example:
• Damon Company manufactures tablets that contain a $10
camera
• Activity index = number of tablets produced
• For each tablet produced, total cost of cameras increases by $10
o If 2,000 tablets are made:
o Total cost of the cameras is $20,000 (2,000 X $10)
o If 10,000 tablets are made:
o Total cost of the cameras is $100,000 (10,000 X $10)

(3 of 3)
Example (continued)
Behaviour of total and unit fixed costs

Cost Behaviour Analysis: Fixed Costs
(1 of 3)
• Costs that remain the same in total within the relevant
range regardless of changes in the activity level.
• Per unit cost varies inversely with activity:
o As volume increases, unit cost declines, and vice versa
Examples: Property taxes, Insurance, Rent

(2 of 3)
Example:
• Damon Company leases its productive facilities for
$10,000 per month
• Total fixed costs of the facilities are constant at $10,000 per
month (for all levels of activity)
• On a per unit basis, the cost of rent decreases as activity
increases and vice versa
o At 2,000 tablets, unit cost: $5 ($10,000 FC ÷ 2,000 units)
o At 10,000 tablets, unit cost: $1 ($10,000 FC ÷ 10,000 units)

(3 of 3)
Example (continued)
Behaviour of total and unit fixed costs

Variable vs. Fixed Costs
Variable costs Fixed costs
• Vary in total directly and • Remain the same in total

proportionately with within the relevant range
changes in activity level regardless of changes in
• Remain the same per the activity level
unit at every level of • FC per unit varies
activity inversely with activity
• As volume unit costs
and vice versa.

Cost Behaviour Analysis: Relevant Range
(1 of 3)
• Throughout range of all possible levels of activity:
• A straight-line relationship usually does not exist for
either variable costs or fixed costs
o The relationship between variable costs and changes
in activity level is often curvilinear
o For fixed costs, the relationship is nonlinear
o Some FC will not change over the entire range of activities
o Some may change at different levels of activity

(2 of 3)
Not efficient at
high activity
e.g. exponential labour
costs (overtime or hiring
new workers).
Same for certain

activity range
e.g. renting out
classrooms
Not cost efficient at

low activity
e.g. no bulk
discounts, lots of
training
Nonlinear behaviour of total and unit fixed costs

(3 of 3)
Defined as the range of activity over which a company expects
to operate during a year
Within this range, a straight-line relationship usually exists for
both variable and fixed costs
Linear behaviour
within relevant
range

Cost Behaviour Analysis: Mixed Costs
Costs that have both a

variable and a fixed cost
component
• Sometimes called semi
variable cost
Change in total but not
proportionately with
changes in activity level
e.g. electricity bill – FC = flat fee. VC = usage charge.
e.g. operating a car – FC = insurance , monthly parking pass. VC = gas
Variable, Fixed and Mixed Costs (1 of 2)
Product Costs
Fixed product Variable Mixed product

costs product costs costs
• factory rent • direct • factory utility
• factory materials costs
equipment • direct labour
depreciation
• plant
supervisor
salary

Variable, Fixed and Mixed Costs (2 of 2)
Period Costs
Fixed period Variable Mixed period

costs period costs costs
• President’s • sales • head office
salary commission utility costs
• Head office cost
equipment
depreciation

Cost Behaviour Analysis: High-Low
Method (1 of 3)
• Mixed costs must be classified into their fixed and
variable elements
• One approach to separate the costs is the high-low
method
o Uses the total costs incurred at both high and low
levels of activity
o The difference in costs between these levels = VC
o Since only variable costs change as activity levels change

Method (2 of 3)
Step 1: Determine variable cost per unit using the
following formula:
Step 2: Determine FC
FC = Total cost (@ H or L level) – Total VC (@ same level)

Method (3 of 3)
Step 1: Determine variable cost per unit using the
following formula:

Method Example (1 of 5)
Data for Metro Transit Company for the last 4-month
period

Step 1: Using the formula to find the variable cost
component:
($63,000 - $30,000) / (100,000km – 40,000km)

Example (continued):
Step 2: Subtract total variable costs at either the high or
low activity level from the total cost at that same level
i.e. TC (H or L level) – TVC (H or L level) = TFC

Example (continued):
After our calcs, we now have the formula to find TC.

• TC can be estimated at any activity level using the
high-low cost equation
Maintenance Cost = $8,000 + ($0.55 x km)
FC VC # units

EXAMPLE:
If the activity level is 45,000 km, the estimated
maintenance costs would be:
Total cost = $8,000 + ($0.55 x km)

Total cost = $8,000 + ($0.55 X 45,000 km)
Total cost = $32,750

Let’s Review 4
Variable costs are costs that:
a. Vary in total directly and proportionately with
changes in the activity level
b. Remain the same per unit at every activity level in the
relevant range
c. Neither of the above
d. Both (a) and (b) above

Let’s Review 5 (1 of 2)
The following cost and activity information has been provided
you. Based on this information what would total cost be if the
activity level was 4,250?
Activity Cost a. $200,750

3,000 $169,500
b. $198,950
3,500 184,000
4,000 190,500 c. $106,250
4,500 207,400 d. $94,500
5,000 219,500

Manufacturing Costs in Financial
Statements
• Manufacturing entities prepare the same financial
statements as merchandising or service firms
• Some of the components within a manufacturing firm’s FS will
be different to reflect the manufacturing aspect
o Balance Sheet
o Current assets
o Manufacturing firm will carry at least 3 different inventories
o Other industries will normally report one inventory
o Income Statement
o COGS (cost of goods sold) section reflects manufactured cost of goods

Balance Sheet: Inventories
Manufacturing companies may have 3 Merchandising companies have only one

inventory accounts: category of inventory:
1. Raw (Direct) materials inventory Merchandise inventory
– cost of raw materials on hand
2. Work in process inventory
– costs applicable to units on which production
has started (partially complete)
3. Finished goods inventory
– cost of completed goods on hand

Balance Sheet: Flow of Product Costs
• Product costs move through the Inventory accounts as
the product moves the manufacturing process
• Product costs remain on the Balance Sheet until the unit
is sold

Flow of Product Costs

Balance Sheet
Current assets sections of merchandising and manufacturing balance sheets

Statements (1 of 3)
Income Statement
• The income statement for a manufacturer is similar to
that of a merchandiser except for the cost of goods
sold section

Statements (2 of 3)
Cost of Goods Sold Components
Merchandiser versus Manufacturer
Costs of goods sold components

Statements (3 of 3)
Cost of Goods Sold Section of the Income Statement

Determining the Cost of Goods
Manufactured
• Work in Process – partially completed units
• Total Manufacturing Costs – sum of direct material costs, direct
labour costs, and manufacturing overhead incurred during the
current year
Cost of goods manufactured formula

Let’s Review 6
What amount is given by the sum of direct materials,
direct labour, and manufacturing overhead incurred?
a. Total cost of work in process
b. Cost of goods available for sale
c. Total manufacturing costs
d. Cost of goods manufactured

Let’s Review 7
In a manufacturer’s balance sheet, three inventories may be
reported: (1) raw (direct) materials, (2) work in process, and (3)
finished goods. In what sequence do theses inventories generally
appear on a balance sheet?
a. (1), (2), (3)
b. (2), (3), (1)
c. (3), (1), (2)
d. (3), (2), (1)

Let’s Review 8 - Challenge
For the current period, prime costs incurred by ABC Ltd.
were $195, conversion costs were $140 and total product
costs were $270.
What were the direct labour, direct material and

manufacturing overhead costs, respectively for the
period?

Appendix 2A Regression Analysis
• High-low method is easy to use, but a weakness is that it

uses only two data points and ignores the rest.
o If those two data points are representative of the entire
data set, then the high-low method provides reasonable
results
• Regression analysis uses all data points providing a more
reliable result

High-Low Method
Maintenance costs and mileage data
Assume that Hanson Trucking Company has 12 months of
maintenance cost data, as shown.
• The high and low activities are 65,000 km in December and

15,000 km in July.
• The maintenance costs at these two levels are $63,000 and
$39,000, respectively.
VC per unit
STEP 1
(63,000 – 39,000) / (65,000 – 15,000)

= 24,000/50,000
= 0.48

High-Low Method
Computation of variable and fixed costs
Total variable cost = number of km × cost per km.

• At the low activity of 15,000 km, TVC is $7,200 (15,000 × $0.48).
Fixed costs = TC (L) – TVC (L)
• Fixed costs = $39,000 − ($0.48 × 15,000) = $31,800

Regression Analysis
More precise estimates of the cost equation
• Statistical approach that estimates the cost equation
by employing information from all data points
• Not just the highest and lowest ones
• Finds a cost equation line that minimizes the sum of
the (squared) distances from the line to the data
points

Regression Analysis
Excel spreadsheet for Hanson Trucking Company
Illustration 2A.4, uses the Intercept and Slope functions
in Excel to estimate the regression equation for the
Hanson Trucking Company data.

Regression Analysis
Comparison to high-low cost equation
The resulting cost equation is:
Compare this to the high-low cost equation we

calculated previously:

Regression Analysis
Scatter plot and cost equation lines
Illustration 2A.5 shows, the intercept and slope differ
significantly between the regression equation (green) and
the high-low equation (red).

Regression Analysis: Limitations
• The regression approach applied assumes a linear
relationship between the variables
• If the actual relationship differs significantly from linearity,
then linear regression can provide misleading results
• Regression estimates can be severely influenced by
“outliers”
• Regression estimation is most accurate when it is based
on a large number of data points

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Managerial Accounting

Tools for Business Decision-Making

Copyright ©2021 John Wiley & Sons Canada, Ltd.

Copyright ©2021 John Wiley & Sons Canada, Ltd. 4

Cost Object: Anything for which we

Copyright ©2021 John Wiley & Sons Canada, Ltd. 5

• In contrast, a merchandising firm sells goods in the form

Copyright ©2021 John Wiley & Sons Canada, Ltd. 7

Raw materials are basic materials Raw materials that can be

e.g. chefs at a food truck, legal staff at a law firm

Copyright ©2021 John Wiley & Sons Canada, Ltd. 9

e.g. indirect materials; indirect labour, depreciation on machinery, electricity in factory

Copyright ©2021 John Wiley & Sons Canada, Ltd. 10

Examples: lubricants, glue, cleaning supplies

Copyright ©2021 John Wiley & Sons Canada, Ltd. 11

Examples include maintenance workers, janitors, and security guards

Copyright ©2021 John Wiley & Sons Canada, Ltd. 12

e.g. sushi restaurant – ingredients, chef wages

Copyright ©2021 John Wiley & Sons Canada, Ltd. 13

Conversion costs: the cost of converting raw materials into a

Prime costs and conversion costs

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Product versus period costs

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• Activity levels may be expressed in terms of

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• The activity level selected is called the activity (or

Copyright ©2021 John Wiley & Sons Canada, Ltd. 29

e.g. Direct material and direct labour, Sales commissions, gas

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Behaviour of total and unit fixed costs

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Examples: Property taxes, Insurance, Rent

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Behaviour of total and unit fixed costs

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Variable costs Fixed costs

• Vary in total directly and • Remain the same in total

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Same for certain

Not cost efficient at

Nonlinear behaviour of total and unit fixed costs

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Costs that have both a

Fixed product Variable Mixed product

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Fixed period Variable Mixed period