1. Weygandt-Kimmel-Kieso-Aly2

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

3. 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.
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4. 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
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5. 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
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6. 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
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7. 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
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8. 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
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9. 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.
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10. Prime Costs and Conversion Costs
Direct Material Costs
Direct Labour Costs
Conversion Costs
Manufacturing Overhead Costs
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11. 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
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12. 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
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13. Product versus Period Costs
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14. 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
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15. 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
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16. 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
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17. 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
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18. 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
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19. 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
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20. 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)
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21. Cost Behaviour Analysis Variable Costs - Example Continued
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22. 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
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23. 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)
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24. Cost Behaviour Analysis Fixed Costs - Example Continued
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25. 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.
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26. 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
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27. Cost Behaviour Analysis Relevant Range: Continued
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28. 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
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29. 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
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30. 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
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31. 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
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32. 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 km
Low Level of Activity: January , ,000 km
Difference $33, ,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 ,000 $30,000 March 70,000 $49,000
February , ,000 April 100, ,000
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33. 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.
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34. 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
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35. 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
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36. 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
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37. Manufacturing Costs in Financial Statements
Cost of Goods Sold Components
Merchandiser versus Manufacturer
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38. Manufacturing Costs in Financial Statements
Cost of Goods Sold Section of the Income Statement
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39. 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
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40. Cost of Goods Manufactured Schedule
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41. 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
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42. 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
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43. 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
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44. Copyright John Wiley & Sons Canada, Ltd.
Balance Sheet
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45. 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)
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46. 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)
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47. Copyright John Wiley & Sons Canada, Ltd.
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