Weygandt-Kimmel-Kieso-Aly 2

2 Managerial Cost Concepts and Cost Behaviour Analysis 2 Study Objectives Define the three classes of manufacturing costs and differentiate between product costs and period costs. Explain how costs are affected by changes in the levels of business activity. Explain the difference between a merchandising income statement and a manufacturing income statement. Explain the difference between a merchandising balance sheet and a manufacturing balance sheet. 2

Managerial Cost Concepts Manufacturing Costs Manufacturing consists of activities to convert raw materials into finished goods. Typical Classification of Manufacturing Costs In contrast, a merchandising firm sells goods in the form in which they were bought. Copyright John Wiley & Sons Canada, Ltd. 2

Managerial Cost Concepts Manufacturing Costs – Direct Materials Raw materials are basic materials and parts used in manufacturing. Raw materials that can be physically and directly associated with the finished product are called direct materials. Examples include: Flour in the baking of bread Syrup in the bottling of soft drinks Steel used in making automobiles Copyright John Wiley & Sons Canada, Ltd. 2

Managerial Cost Concepts Manufacturing Costs – Direct Labour Work of factory employees that can be physically and directly associated with converting raw materials into finished goods is direct labour Examples include Bottlers at Coca-Cola Bakers at Sara Lee Typesetters at a newspaper Copyright John Wiley & Sons Canada, Ltd. 2

Managerial Cost Concepts Manufacturing Costs – Manufacturing Overhead Costs that are indirectly associated with manufacturing of finished goods All manufacturing costs that cannot be classified as direct material and direct labour Examples include: Indirect materials Indirect labour Amortization on factory buildings, Insurance, taxes, maintenance on factory facilities Copyright John Wiley & Sons Canada, Ltd. 2

Managerial Cost Concepts Manufacturing Overhead – Indirect Materials Raw materials that cannot be easily associated with the finished product are called indirect materials Indirect materials do not physically become part of the finished product or represent too small a part of the finished product in terms of cost Considered part of manufacturing overhead Examples include: lubricants cleaning supplies Polishing compounds Copyright John Wiley & Sons Canada, Ltd. 2

Managerial Cost Concepts Manufacturing Overhead – Indirect Labour Work of factory workers that have no physical association with the finished product, or for which it is impractical to trace to the goods produced, is indirect labour Examples include: Wages of maintenance workers, janitors, and security guards Supervisors Time-Keepers Copyright John Wiley & Sons Canada, Ltd. 2

Prime Costs and Conversion Costs Prime costs are the sum of all direct materials costs and direct labour costs. These are all direct manufacturing costs. Conversion costs are the sum of all direct labour costs and manufacturing overhead costs, which together are the costs of converting raw materials into a final product. Copyright John Wiley & Sons Canada, Ltd. 2

Prime Costs and Conversion Costs Direct Material Costs Direct Labour Costs Conversion Costs Manufacturing Overhead Costs Copyright John Wiley & Sons Canada, Ltd. 2

Product versus Period Costs Product Costs Consist of the direct material cost, the direct labour cost, and the manufacturing overhead cost A necessary and integral part of producing the product Recorded as inventory when incurred Do not become expenses until the finished goods inventory is sold Copyright John Wiley & Sons Canada, Ltd. 2

Product versus Period Costs Period Costs Matched with revenue of 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 Selling expenses General and Administrative expenses Copyright John Wiley & Sons Canada, Ltd. 2

Product versus Period Costs Copyright John Wiley & Sons Canada, Ltd. 2

Copyright John Wiley & Sons Canada, Ltd. Let’s Review Which of the following is not an element of manufacturing overhead? Sales manager’s salary Plant manager’s salary Factory repairman’s wages Product inspector’s salary Copyright John Wiley & Sons Canada, Ltd. 2

Let’s Review: Solution Which of the following is not an element of manufacturing overhead? Sales manager’s salary Plant manager’s salary Factory repairman’s wages Product inspector’s salary Copyright John Wiley & Sons Canada, Ltd. 2

Cost Behaviour Analysis Definition: The study of how specific costs respond to changes in the level of business activity Some costs change; others remain the same Helps management plan operations and make decisions Applies to all types of businesses and entities Copyright John Wiley & Sons Canada, Ltd. 2

Cost Behaviour Analysis Continued Starting point is measuring key business activities Activity levels may be expressed in terms of Sales dollars (in a retail company) Kilometers driven (in a trucking company) Room occupancy (in a hotel) Dance classes taught (by a dance studio) For an activity level to be useful, changes in the level or volume of activity should be correlated with changes in cost Copyright John Wiley & Sons Canada, Ltd. 2

Cost Behaviour Analysis Continued The activity level selected is called the activity (or volume) index Identifies the activity that causes changes in the behaviour of costs Allows costs to be classified according to their response to changes in activity as: Variable Cost Fixed Cost Mixed Cost Copyright John Wiley & Sons Canada, Ltd. 2

Cost Behaviour Analysis Variable Costs Costs that vary in total directly and proportionately with changes in the activity level If the activity level increases 10%, total variable costs increase 10%; If the activity level decreases by 25%, total variable costs will decrease by 25% Variable costs also remain constant per unit at every level of activity Examples of variable costs include: Direct material and direct labour for a manufacturer Sales commissions for a merchandiser Gasoline in airlines and trucking companies Copyright John Wiley & Sons Canada, Ltd. 2

Cost Behaviour Analysis Variable Costs - Example Damon Company manufactures radios that contain a $10 clock Activity index is the number of radios produced For each radio produced, the total cost of the clocks increases by $10 If 2,000 radios are made, the total cost of the clocks is $20,000 (2,000 X $10) If 10,000 radios are made, the total cost of the clocks is $100,000 (10,000 X $10) Copyright John Wiley & Sons Canada, Ltd. 2

Cost Behaviour Analysis Variable Costs - Example Continued Copyright John Wiley & Sons Canada, Ltd. 2

Cost Behaviour Analysis Fixed Costs Costs that remain the same in total regardless of changes in the activity level. Per unit cost varies inversely with activity: As volume increases, unit cost decline, and vice versa Examples include: Property taxes Insurance Rent Amortization on buildings and equipment Copyright John Wiley & Sons Canada, Ltd. 2

Cost Behaviour Analysis Fixed Costs - Example Damon Company leases its productive facilities for $10,000 per month Total fixed costs of the facilities remain constant at all levels of activity - $10,000 per month On a per unit basis, the cost of rent decreases as activity increases and vice versa At 2,000 radios, the unit cost is $5 ($10,000 ÷ 2,000 units) At 10,000 radios, the unit cost is $1 ($10,000 ÷ 10,000 units) Copyright John Wiley & Sons Canada, Ltd. 2

Cost Behaviour Analysis Fixed Costs - Example Continued Copyright John Wiley & Sons Canada, Ltd. 2

Distinguish Between Variable and Fixed Costs Variable costs are costs that vary in total directly and proportionately with changes in the activity level. These costs remain the same per unit at every level of activity. Fixed costs are costs that remain the same in total within the relevant range regardless of changes in the activity level. Fixed costs per unit vary inversely with activity—in other words as volume increases, unit costs decrease and vice versa. Copyright John Wiley & Sons Canada, Ltd. 2

Cost Behaviour Analysis Relevant Range Throughout the range of possible levels of activity, a straight-line relationship usually does not exist for either variable costs or fixed costs The relationship between variable costs and changes in activity level is often curvilinear For fixed costs, the relationship is nonlinear – some fixed costs will not change over the entire range of activities, others may change at different levels of activity Copyright John Wiley & Sons Canada, Ltd. 2

Cost Behaviour Analysis Relevant Range: Continued Copyright John Wiley & Sons Canada, Ltd. 2

Cost Behaviour Analysis Relevant Range: Continued 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 Copyright John Wiley & Sons Canada, Ltd. 2

Cost Behaviour Analysis Mixed Costs Costs that have both a variable cost element and a fixed cost element Sometimes called semi variable cost Change in total but not proportionately with changes in activity level Copyright John Wiley & Sons Canada, Ltd. 2

Cost Behaviour Analysis Mixed Costs – High-Low Method Mixed costs must be classified into their fixed and variable elements One approach to separate the costs is called the high-low method Uses the total costs incurred at both the high and the low levels of activity to classify mixed costs The difference in costs between the high and low levels represents variable costs, since only variable costs change as activity levels change Copyright John Wiley & Sons Canada, Ltd. 2

Cost Behaviour Analysis Mixed Costs – High-Low Method: Steps in Method Step 1: Determine variable cost per unit using the following formula: Step 2: Determine the fixed cost by subtracting the total variable cost at either the high or the low activity level from the total cost at that level ÷ = Change in Total Costs Change in Activity Level Variable Cost per Unit Copyright John Wiley & Sons Canada, Ltd. 2

Cost Behaviour Analysis Mixed Costs – High-Low Method: Example Data for Metro Transit Company for the last 4-month period: High Level of Activity: April $63,000 100,000 km Low Level of Activity: January 30,000 40,000 km Difference $33,000 60,000 km Step 1: Using the formula, variable costs per unit are $33,000  60,000 = $.55 variable cost per km Month Kilometres Total Cost Month Kilometres Total Driven Driven Cost January 40,000 $30,000 March 70,000 $49,000 February 80,000 48,000 April 100,000 63,000 Copyright John Wiley & Sons Canada, Ltd. 2

Copyright John Wiley & Sons Canada, Ltd. Cost Behaviour Analysis Mixed Costs – High-Low Method: Example: Continued Step 2: Subtract total variable costs at either the high or low activity level from the total cost at that same level Activity Level High Low Total Cost $63,000 $30,000 Less: Variable costs (100,000 x $.55) 55,000 (40,000 x $.55) 22,000 Total fixed costs $ 8,000 EXAMPLE: If the activity level is 45,000 km, the estimated maintenance costs would be $8,000 fixed and $24,750 variable ($.55 X 45,000 km) for a total of $32,750. Copyright John Wiley & Sons Canada, Ltd. 2

Copyright John Wiley & Sons Canada, Ltd. Let’s Review Variable costs are costs that: Vary in total directly and proportionately with changes in the activity level Remain the same per unit at every activity level Neither of the above Both (a) and (b) above Copyright John Wiley & Sons Canada, Ltd. 2

Let’s Review: Solution Variable costs are costs that: Vary in total directly and proportionately with changes in the activity level Remain the same per unit at every activity level Neither of the above Both (a) and (b) above Copyright John Wiley & Sons Canada, Ltd. 2

Manufacturing Costs in Financial Statements Income Statement The income statement for a manufacturer is similar to that of a merchandiser except for the cost of goods sold section Copyright John Wiley & Sons Canada, Ltd. 2

Manufacturing Costs in Financial Statements Cost of Goods Sold Components Merchandiser versus Manufacturer Copyright John Wiley & Sons Canada, Ltd. 2

Manufacturing Costs in Financial Statements Cost of Goods Sold Section of the Income Statement Copyright John Wiley & Sons Canada, Ltd. 2

Determining the Cost of Goods Manufactured Work in Process – partially completed units of a product Total Manufacturing Costs – sum of direct material costs, direct labour costs, and manufacturing overhead, all incurred during the current year Copyright John Wiley & Sons Canada, Ltd. 2

Cost of Goods Manufactured Schedule Copyright John Wiley & Sons Canada, Ltd. 2

Copyright John Wiley & Sons Canada, Ltd. Let’s Review What amount is given by the sum of direct materials, direct labour, and manufacturing overhead incurred? Total cost of work in process Cost of goods available for sale Total manufacturing costs Cost of goods manufactured Copyright John Wiley & Sons Canada, Ltd. 2

Let’s Review: Solution What amount is given by the sum of direct materials, direct labour, and manufacturing overhead incurred? Total cost of work in process Cost of goods available for sale Total manufacturing costs Cost of goods manufactured Copyright John Wiley & Sons Canada, Ltd. 2

Balance Sheet Inventories Manufacturing companies may have three inventory accounts: Raw materials inventory – shows the cost of raw materials on hand Work in process inventory – shows the cost applicable to units on which production has started but is only partially complete Finished goods inventory – shows the cost of completed goods on hand Merchandising companies have only one category of inventory: Merchandise inventory Copyright John Wiley & Sons Canada, Ltd. 2

Copyright John Wiley & Sons Canada, Ltd. Balance Sheet Copyright John Wiley & Sons Canada, Ltd. 2

Copyright John Wiley & Sons Canada, Ltd. Let’s Review In a manufacturer’s balance sheet, three inventories may be reported: (1) raw materials, (2) work in process, and (3) finished goods. In what sequence do theses inventories generally appear on a balance sheet? (1), (2), (3) (2), (3), (1) (3), (1), (2) (3), (2), (1) Copyright John Wiley & Sons Canada, Ltd. 2

Let’s Review: Solution In a manufacturer’s balance sheet, three inventories may be reported: (1) raw materials, (2) work in process, and (3) finished goods. In what sequence do theses inventories generally appear on a balance sheet? (1), (2), (3) (2), (3), (1) (3), (1), (2) (3), (2), (1) Copyright John Wiley & Sons Canada, Ltd. 2

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