Managerial Accounting and Cost

Concepts
Chapter 2

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 2-2

Learning Objective 1

Understand cost
classifications used for
assigning costs to cost
objects: direct costs and
indirect costs.
 2-3

Cost object
• Costs are assigned to cost objects for a variety
of purposes including pricing and profitability
studies.
• A cost object is anything for which cost data are
desired; including products, customers, jobs,
and divisions.
• For purposes of assigning costs to cost objects,
costs are classified as either direct or indirect.
 2-4

Assigning Costs to Cost Objects

Direct costs
• Costs that can be
easily and conveniently
traced to a unit of product
or other cost object.
• Examples: direct
material and direct labor
Indirect costs
• Costs that cannot be
easily and conveniently
traced to a unit of product
or other cost object.
• Example: manufacturing
overhead

Common costs
Indirect costs incurred to support a number
of cost objects. These costs cannot be
traced to any individual cost object.
 2-5

Manufacturing overhead
• Refers to indirect factory-related costs that are
incurred when a product is manufacturing.
• Examples:
- Depreciation on equipment used in the
production process
- Property taxes and insurance on the production
facility
- Rent on the factory building
- Salaries of manufacturing managers
- Salaries of maintenance personnel
 2-6

A particular cost may be direct

or indirect, depending on the
cost object.
 2-7

Learning Objective 2

Identify and give

examples of each of the
three basic
manufacturing cost
categories.
 2-8

Classifications of Manufacturing Costs

Direct
Direct Direct
Direct Manufacturing
Manufacturing
Materials
Materials Labor
Labor Overhead
Overhead

The Product
 2-9

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

Example:
Example: Steel
Steel used
used to
to manufacture
manufacture an
an
automobile
automobile
 2-10

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
 2-11

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
 2-12

Nonmanufacturing Costs

Administrative
Costs

All executive, organizational,

and clerical costs.
Administrative costs can be
either direct or indirect costs.
Examples: rental costs of
administrative offices,
secretary salary
 2-13

Selling and administrative costs

• Selling costs
Include all costs that are incurred to secure
customers orders and get the finished product to
customers. Examples include advertising,
shipping, and sales commissions.
• Administrative costs
Include all costs associated with the general
management of an organization rather than with
manufacturing or selling. Examples include
executive compensation, general accounting
and public relations.
 2-14

Learning Objective 3

Understand cost
classifications used to
prepare financial
statements: product
costs and period costs.
 2-15

Product costs
• For financial accounting purposes, product costs
include all costs involved in acquiring or making
a product.
• In the case of manufacturing goods, these costs
consist of direct materials, direct labor, and
manufacturing overhead.
• Product costs “attach” to units of products as
the goods are purchased or manufactured, and
they remain attached as the goods go into
inventory awaiting sale.
 2-16

Product costs
• Product costs are initially assigned to an
inventory account on the balance sheet. When
the goods are sold, the costs are released from
inventory as expenses (called costs of goods
sold) and matched against sales revenues.

• Product costs are treated as expenses in the

period in which the related products are sold.
 2-17

Period costs
• Period costs are all the costs that are not
product costs. All selling and administrative
expenses are treated as period costs.
• Period costs are not included as part of the cost
of either purchased or manufactured goods;
instead, period costs are expensed on the
income statement in the period in which they are
incurred using the usual rules of accrual
accounting.
 2-18

Cost Classifications for Preparing

Financial Statements
Product costs include Period costs include all
direct materials, direct selling costs and
labor, and administrative costs.
manufacturing
overhead.

Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
 2-19

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.
 2-20

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.
 2-21

Prime Costs and Conversion Costs

Manufacturing costs are often
classified as follows:
Direct Direct Manufacturing
Material Labor Overhead

Prime Conversion
Cost Cost
 2-22

Learning Objective 4

Understand cost
classifications used to
predict cost behavior:
variable costs, fixed
costs, and mixed costs.
 2-23

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.
 2-24

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

 2-25

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

 2-26

The Activity Base (Cost Driver)

Units Machine
produced hours

A measure of what
causes the
incurrence of a
variable cost

Miles Labor
driven hours
 2-27

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
 2-28

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
 2-29

Types of Fixed Costs

Committed
Committed Discretionary
Discretionary
Represent
Represent organizational
organizational Arise
Arise from
from annual
annual decisions
decisions
investments
investments with
with aa multiyear
multiyear by
by management
management to to spend
spend on
on
planning
planning horizon
horizon (long-term)
(long-term) certain
certain fixed
fixed costs
costs

Can not be significantly May be cut in the short

reduced for short periods term by current
of time, without making managerial decisions
fundamental changes
 2-30

Types of Fixed Costs

Committed Discretionary
Examples Examples
Depreciation on Buildings Advertising, Research
and Equipment and Real and public relations
Estate Taxes
 2-31

The Linearity Assumption and the

Relevant Range
• Management accountants assume that
costs are strictly linear; that is the relation
between cost and activity can be
represented by a straight line.

• Economists points out that many costs are

actually curvilinear; that is, the relation
between cost and activity is a curve.
 2-32

The Linearity Assumption and the

Relevant Range
• Nevertheless, even if a cost is not strictly linear, it
can be approximated within a narrow range of
activity known as the Relevant Range, by a
straight line as will be illustrated.
• The relevant Range is the range of activity within
which the assumption that the cost behavior is
strictly linear is reasonably valid.
• Managers should always keep in mind that the
assumptions made about cost behavior may be
invalid if activity falls outside of the relevant range.
 2-33

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
 2-34

Fixed Costs and the Relevant Range

The concept of the relevant range is important in
understanding fixed costs.
For example, suppose a facility rents a machine for
$20,000 per month. Furthermore, suppose that the
maximum capacity of the machine is 3,000 units per
month.
The assumption that the rent for the machine is
$20,000 per month is only valid within a relevant
range of 0 to 3,000 units per month.
The rental expense increase in discrete steps or
increments of 3,000 units.
 2-35

Fixed Costs and the Relevant Range

60
Rent Cost in Thousands

The
The relevant
relevant range
range
Relevant of
of activity
activity for
for aa fixed
fixed
40
of Dollars

cost
cost is
is the
the range
range of of
Range activity
activity over
over which
which
the
the graph
graph ofof the
the
cost
cost is
is flat.
flat.
20

0
0 3,000 6,000 9,000
number of units produced

Cost Classifications for Predicting Cost
Behavior
Behavior of Cost (within the relevant range)
Cost In Total
Variable Total variable cost Increase
and decrease in proportion
to changes in the activity level.
Fixed Total fixed cost is not affected
by changes in the activity
level within the relevant range.
2-36
Per Unit
Variable cost per unit
remains constant.
Fixed cost per unit decreases
as the activity level rises and
increases as the activity level falls.
 2-37

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.
 2-38

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.
 2-39

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

o st
d c
xe
al mi
t
To Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
 2-40

Mixed Costs

Y
Total Utility Cost

ost
d c
ixe
al m
t
To Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
 2-41

Mixed Costs – An Example

IfIf your
your fixed
fixed monthly
monthly utility
utility charge
charge is is $40,
$40, your
your
variable
variable cost
cost is
is $0.03
$0.03 per
per kilowatt
kilowatt hour,
hour, and
and your
your
monthly
monthly activity
activity level
level is
is 2,000
2,000 kilowatt
kilowatt hours,
hours, what
what is
is
the
the amount
amount of of your
your utility
utility bill?
bill?
 2-43

Learning Objective 5

Analyze a mixed cost

using a scattergraph plot
and the high-low
method.
 2-44

Scattergraph Plots – An Example

Assume the following hours of maintenance work and the total maintenance costs for six months.
 2-45

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
Total Maintenance Cost

Hours of Maintenance
 2-46

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
 2-47

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
 2-48

The High-Low Method – An Example

The Cost Equation for Maintenance

Y = $4,700 + $6.00X
 2-49

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
 2-50

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
 2-51

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
 2-52

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
 2-53

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.
 2-54

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 R22, which is a measure of the goodness
of fit of the regression line to the data points.
 2-55

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.
 2-56

Learning Objective 6

Prepare income
statements for a
merchandising company
using the traditional and
contribution formats.
 2-57

The Traditional and Contribution

Formats

Used primarily for

external reporting.
 2-58

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).
 2-59

End of Chapter 2