Lecture 2

(1)Costs Terms, Concepts and

Classifications
(2) Cost Behavior –
Analysis and Use
Costs Terms, Concepts and
Classifications
Purposes for cost classification

1. preparing external financial reports

2. predicting cost behavior

3. assigning costs to cost objects

4. making business decisions

 Manufacturing Costs

Direct Direct Manufacturing

Materials Labor 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: 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 workers

 Manufacturing Overhead

Manufacturing costs that cannot be traced

directly to specific units produced.
Examples: Indirect labor and indirect materials

Wages paid to employees Materials used to support

who are not directly the production process.
involved in production
work. Examples: lubricants and
Examples: maintenance cleaning supplies used in the
workers, janitors and automobile assembly plant.
security guards.
 Classifications of Costs
Manufacturing costs are often
classified as follows:
Direct Direct Manufacturing
Material Labor Overhead

Prime Conversion
Cost Cost
 Non-manufacturing Costs

Marketing or Administrative
Selling Cost Cost

Costs necessary to get All executive,

the order and deliver organizational, and
the product. clerical costs.
Product Costs Versus Period
Costs
Product costs include Period costs include
direct materials, direct all marketing or
labor, and selling costs and
manufacturing
administrative
overhead.
costs.
Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
 Quick Check ü
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.
 Comparing Merchandising and
Manufacturing Activities
Merchandisers . . . Manufacturers . . .
– Buy finished goods. – Buy raw materials.
– Sell finished goods. – Produce and sell
finished goods.

MegaLoMart
 Balance Sheet
Manufacturer
Merchandiser Current Assets
Current assets ! Cash
uCash ! Receivables

uReceivables ! Prepaid Expenses

! Inventories
uPrepaid Expenses
Raw Materials
uMerchandise Work in Process
Inventory Finished Goods
 The Income Statement
Cost of goods sold for manufacturers differs
only slightly from cost of goods sold for
merchandisers.

Merchandising Company Manufacturing Company

Cost of goods sold: Cost of goods sold:

Beg. merchandise Beg. finished
inventory $ 14,200 goods inv. $ 14,200
+ Purchases 234,150 + Cost of goods
Goods available manufactured 234,150
for sale $ 248,350 Goods available
- Ending for sale $248,350
merchandise - Ending
inventory (12,100) finished goods
= Cost of goods inventory (12,100)
sold $ 236,250 = Cost of goods
sold $236,250
 Inventory Flows
Beginning
Additions Available
balance + $$$ = $$$$$
$$

Available _ Withdrawals Ending

$$$$$ $$$ = balance
$$
 Quick Check ü

If your inventory balance at the beginning of

the month was $1,000, you bought $100
during the month, and sold $300 during the
month, what would be the balance at the end
of the month?
A. $1,000. $1,000 + $100 = $1,100
B. $ 800. $1,100 - $300 = $800
C. $1,200.
D. $ 200.
 Schedule of Cost of Goods
Manufactured
Calculates the cost of raw
material, direct labor and
manufacturing overhead
used in production.

Calculates the manufacturing

costs associated with goods
that were finished during the
period.
 Product Cost Flows
Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials

materials inventory
+ Raw materials
purchased
= Raw materials
available for use
in production
– Ending raw materials
inventory
= Raw materials used
As items are removed from raw
in production materials inventory and placed into
the production process, they are
called direct materials.
 Product Cost Flows
Manufacturing Work
Raw Materials Costs In Process
Conversion
Beginning raw Direct materials
materials inventory + Direct labor
costs are costs
+ Raw materials + Mfg. overhead incurred to
purchased = Total manufacturing convert the
= Raw materials costs
available for use
direct material
in production into a finished
– Ending raw materials product.
inventory
= Raw materials used
in production
 Product Cost Flows
Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials
inventory All manufacturing costs incurred
= Raw materials used during the period are added to the
in production
beginning balance of work in
process.
 Product Cost Flows
Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials – Ending work in
inventory
Costs associated with the goods that process inventory
= Raw materials used = Cost of goods
areincompleted
production
during the period are manufactured
transferred to finished goods
inventory.
 Product Cost Flows
Work
In Process Finished Goods

Beginning work in Beginning finished

process inventory goods inventory
+ Manufacturing costs + Cost of goods
for the period manufactured
= Total work in process = Cost of goods
for the period available for sale
– Ending work in - Ending finished
process inventory goods inventory
= Cost of goods Cost of goods
manufactured sold
Product Cost Flows
Work
In Process Finished Goods

Beginning work in Beginning finished

process inventory goods inventory
+ Manufacturing costs + Cost of goods
for the period manufactured
= Total work in process = Cost of goods
for the period available for sale
– Ending work in - Ending finished
process inventory goods inventory
= Cost of goods Cost of goods
manufactured sold
 Manufacturing Cost Flows
Balance Sheet Income
Costs Inventories Statement
Expenses
Material Purchases Raw Materials

Direct Labor Work in

Process
Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold

Selling and Period Costs Selling and

Administrative Administrative
 Quick Check ü
Beginning raw materials inventory was
$32,000. During the month, $276,000 of
raw material was purchased. A count at
the end of the month revealed that
$28,000 of raw material was still present.
What is the cost of direct material used?
A. $276,000 Beg. raw materials $ 32,000
+ Raw materials
B. $272,000 purchased 276,000
= Raw materials available
C. $280,000 for use in production $ 308,000
D. $ 2,000 – Ending raw materials
inventory 28,000
= Raw materials used
in production $ 280,000
 Quick Check ü
Direct materials used in production
totaled $280,000. Direct labor was
$375,000 and factory overhead was
$180,000. What were total
manufacturing costs incurred for the
month?
A. $555,000 Direct Materials $ 280,000
B. $835,000 + Direct Labor 375,000
C. $655,000 + Mfg. Overhead 180,000
D. Cannot be determined.
= Mfg. Costs Incurred
for the Month $ 835,000
 Quick Check ü
Beginning work in process was
$125,000. Manufacturing costs
incurred for the month were
$835,000. There were $200,000 of
partially finished goods remaining in
work in process inventory at the end
of the month. What was the cost of
goods manufactured duringBeginning
the work in
process inventory $ 125,000
month? + Mfg. costs incurred

A. $1,160,000 for the period

= Total work in process
835,000

B. $ 910,000 during the period

– Ending work in
$ 960,000

C. $ 760,000 process inventory 200,000

D. Cannot be determined.
= Cost of goods
manufactured $ 760,000
 Quick Check ü
Beginning finished goods inventory
was $130,000. The cost of goods
manufactured for the month was
$760,000. And the ending finished
goods inventory was $150,000. What
was the cost of goods sold for the
month?
A. $ 20,000. $130,000 + $760,000 = $890,000
B. $740,000. $890,000 - $150,000 = $740,000
C. $780,000.
D. $760,000.
 Cost Classifications for
Predicting Cost Behavior
How a cost will react
to changes in the
level of activity within
the relevant range.
– Total variable costs
change when activity
changes.
– Total fixed costs
remain unchanged
when activity changes.

29
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 traced to a unit of
product or other cost product or other cost
object. object.
• Examples: direct • Example:
material and direct manufacturing
labor overhead

30
 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.

31
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.

Differential revenue is:

$2,000 – $1,500 = $500

Differential cost is:

$300 32
 Opportunity Costs
The potential benefit that is
given up when one
alternative is selected over
another.
Example: If you were
not attending college,
you could be earning
$15,000 per year.
Your opportunity cost
of attending college for
one year is $15,000. 33
 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.

34
 Quick Check ü
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.
35
 Quick Check ü
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.
36
 Quick Check ü
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.

37
 Summary of the Types of Cost
Classifications
• Financial reporting

• Predicting cost behavior

• Assigning costs to cost objects

• Decision making
38
 Idle Time
Machine Material
Breakdowns Shortages

Power
Failures

The labor costs incurred

during idle time are ordinarily
treated as manufacturing
overhead. 39
 Overtime

The overtime premiums for all factory

workers are usually considered to be part
of manufacturing overhead.

40
 Labor Fringe Benefits
Fringe benefits include employer paid
costs for insurance programs, retirement
plans, supplemental unemployment
programs, Social Security, Medicare,
workers’ compensation and
unemployment taxes.

Some companies Other companies treat

include all of these fringe benefit
costs in expenses of direct
manufacturing laborers as additional
overhead. direct labor costs.
41
Cost Behavior –
Analysis and Use
 The Activity Base
Units
Machine
produce
hours
d
A measure of what
causes the
incurrence of a
variable cost

Miles Labor
driven hours
43
True Variable Cost Example
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.
Total Long Distance
Telephone Bill

Minutes Talked 44
Variable Cost Per Unit Example
A variable cost remains constant if
expressed on a per unit basis. The cost
per minute talked is constant. For
example, 10 cents per minute.

Telephone Charge
Per Minute

Minutes Talked 45
 Extent of Variable Costs
The proportion of variable costs differs across
organizations. For example . . .
A public utility with
large investments in A manufacturing company
equipment will tend will often have many
to have fewer variable costs.
variable costs.

A merchandising company
A service company
usually will have a high
will normally have a high
proportion of variable costs
proportion of variable costs.
like cost of sales.
46
 Examples of Variable Costs
1. Merchandising companies – cost of goods sold.
2. Manufacturing companies – direct materials,
direct labor, and variable overhead.
3. Merchandising and manufacturing companies –
commissions, shipping costs, and clerical costs
such as invoicing.
4. Service companies – supplies, travel, and
clerical.

47
 Step-Variable Costs
A resource that is obtainable only in large chunks (such
as maintenance workers) and whose costs increase or
decrease only in response to fairly wide changes in
activity is known as a step-variable cost.
Cost

Volume 48
 Step-Variable Costs

Small changes in the level of production are

not likely to have any effect on the number of
maintenance workers employed.
Cost

Volume 49
 Step-Variable Costs
Only fairly wide changes in the activity level will
cause a change in the number of maintenance
workers employed
Cost

Volume 50
 The Linearity Assumption and the
Relevant Range

Economist’s A straight line

closely
Curvilinear Cost approximates a
Function curvilinear
variable cost
line within the
Relevant
relevant range.
Total Cost

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

Activity 51
 Total Fixed Cost Example
A fixed cost is a cost whose total dollar amount
remains constant as the activity level changes. Your
monthly basic telephone bill is probably fixed and
does not change when you make more local calls.
Monthly Basic
Telephone Bill

52
Number of Local Calls
 Fixed Cost Per Unit Example
Average fixed costs per unit decrease as the
activity level increases. The fixed cost per local
call decreases as more local calls are made.

Monthly Basic Telephone

Bill per Local Call

Number of Local Calls 53

 Types of Fixed Costs

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

Examples Examples
Depreciation on Advertising and
Equipment and Research and
Real Estate Taxes Development
54
 Types of Cost Behavior
Patterns
Recall the summary of our cost behavior.

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity
level within the relevant range.
Total fixed cost remains the
same even when the activity
Fixed level changes within the
relevant range.
the same over wide ranges
of activity.
Fixed cost per unit goes
down as activity level goes up.

55
The Trend Toward Fixed Costs
The trend in many industries is toward
greater fixed costs relative to variable costs.
As machines take over Knowledge workers
many mundane tasks tend to be salaried,
previously performed highly-trained and
by humans, difficult to replace. The
“knowledge workers” cost to compensate
are demanded for these valued employees
their minds rather is relatively fixed
than their muscles rather than variable.
56
Is Labor a Variable or a Fixed
Cost?
The behavior of wage and salary costs can
differ across countries, depending on labor
regulations, labor contracts, and custom.

In France, Germany, China, and Japan management has

little flexibility in adjusting the size of the labor force.
Labor costs are more fixed in nature.

In the United States and the United Kingdom management

has greater latitude. Labor costs are more variable in nature.

57
 Fixed Costs and Relevant
Range
90
Thousands of Dollars

Total cost doesn’t

Rent Cost in

Relevant change for a wide

60 range of activity, and
Range
then jumps to a new
higher cost for the
30 next higher range of
activity.
0
0 1,000 2,000 3,000
Rented Area (Square Feet)
58
 Fixed Costs and Relevant
Range
The relevant range of activity for a fixed cost
is the range of activity over which the graph
of the cost is flat.
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.
59
 Quick Check ü

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.

60
 Mixed Costs
A mixed cost has both fixed and variable
components. Consider the example of utility
cost.
Y
Total Utility Cost

s t
d co
ixe
l m
t a
To Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
61
 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
Y vertical intercept of the line)
b = the variable cost per unit of
Total Utility Cost

activity (the slope of the line)

s t
d co X = the level of activity
ixe
l m
t a
To Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
62
 Analysis of Mixed Costs
Account Analysis and the Engineering Approach

Each account is classified as either

variable 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.
63
 The Scattergraph Method
Plot the data points on a graph
(total cost vs. activity).
Y
20
Maintenance Cost

* ** *
1,000’s of Dollars

* *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s
64
 The Scattergraph Method
Draw a line through the data points with about an
equal numbers of points above and below the line.
Y
20
Maintenance Cost

* ** *
1,000’s of Dollars

* *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s
65
 The Scattergraph Method
Use one data point to estimate the total level of activity
and the total cost.
Y Total maintenance cost = $11,000
20
Maintenance Cost

* ** *
1,000’s of Dollars

* *
**
10 * *
Intercept = Fixed cost: $10,000

0 X
0 1 2 3 4
Patient-days in 1,000’s
Patient days = 800 66
 The Scattergraph Method
Make a quick estimate of variable cost per unit and
determine the cost equation.

Total maintenance at 800 patients $ 11,000

Less: Fixed cost 10,000
Estimated total variable cost for 800 patients $ 1,000

$1,000
Variable cost per unit = = $1.25/patient-day
800

Y = $10,000 + $1.25X

Total maintenance cost Number of patient days

67
 The High-Low Method
Assume the following hours of maintenance work
and the total maintenance costs for six months.

68
The High-Low Method
The variable cost
per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.

$2,400
= $8.00/hour
300

69
 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 70
The High-Low Method

The Cost Equation for Maintenance

Y = $3,400 + $8.00X

71
 Quick Check ü
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
Units Cost
b. $0.10 per unit
High level 120,000 $ 14,000
c. $0.12 per unit Low level 80,000 10,000
d. $0.125 per unit Change 40,000 $ 4,000

$4,000 ÷ 40,000 units

= $0.10 per unit 72
 Quick Check ü
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. $ 2,000 Total cost = Total fixed cost +
b. $ 4,000 Total variable cost
$14,000 = Total fixed cost +
c. $10,000 ($0.10 × 120,000 units)
d. $12,000 Total fixed cost = $14,000 - $12,000
Total fixed cost = $2,000
73
 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.

74
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.

75
 Let’s put our
knowledge of cost
behavior to work
by preparing a
contribution
format income
statement.

76
 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.
77
Uses of the Contribution Format
The contribution income statement format is used
as an internal planning and decision making tool.
We will use this approach for:
1. Cost-volume-profit analysis.
2. Budgeting.
3. Segmented reporting of profit data.
4. Special decisions such as pricing and make-or-
buy analysis.
78
 The Contribution Format

Used primarily for Used primarily by

external reporting. management.
79