1. Managerial Accounting and Cost Concepts Chapter Two

2. 2-2 Learning Objective 1 Understand cost classifications used for assigning costs to cost objects: Direct Costs and Indirect Costs

3. 2-3 Cost Classifications for assigning costs to cost objects Cost Object Cost Object: Anything for which cost data are desired-including products, customers, jobs and organizational subunits. Direct Cost: A cost that can be easily and conveniently traced to a specific cost object. Indirect Cost: A cost that cannot be easily and conveniently traced to a specific cost object.

4. 2-4 Learning Objective 2 Identify and give examples of each of the three basic manufacturing cost categories.

5. 2-5 The Product Direct Materials Direct Labor Manufacturing Overhead Manufacturing Costs

6. 2-6 Direct Materials Raw materials that become an integral part of the finished product and that can be conveniently traced directly to it. Example: A radio installed in an automobile

7. 2-7 Direct Labor Those labor costs that can be easily traced to individual units of product. Example: Wages paid to automobile assembly workers

8. 2-8 Manufacturing costs that cannot be traced directly to specific units produced. Manufacturing Overhead Examples: Indirect labor and indirect materials Wages paid to employees who are not directly involved in production work. Examples: maintenance workers, janitors and security guards. Materials used to support the production process. Examples: lubricants and cleaning supplies used in the automobile assembly plant.

9. 2-9 Non-manufacturing Costs Selling Costs Costs necessary to secure the customer order and deliver the product to customer. Administrative Costs All costs associated with the general management of an organization.

10. 2-10 Learning Objective 3 Understand cost classification used to prepare financial statements: product costs and period costs.

11. 2-11 Product Costs Versus Period Costs Product costs Product costs include all costs involved in acquiring or making a product, consists of direct materials, direct labor, and manufacturing overhead. Period costs Period costs are all the costs that are not product costs. All selling and administrative expenses are treated as period costs. InventoryCost of Good Sold Balance Sheet Income Statement Sale Expense Income Statement

12. 2-12 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.

13. 2-13 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.

14. 2-14 Classifications of Costs Direct Material Direct Labor Manufacturing Overhead Prime Cost Conversion Cost Manufacturing costs are often classified as follows:

15. 2-15 Learning Objective 4 Understand cost classifications used to predict cost behavior: variable cost, fixed cost & mixed cost.

16. 2-16 Cost Classifications for Predicting Cost Behavior How a cost will react to changes in the level of activity within the relevant range. As the activity level rises or falls, a particular cost may rise or fall as well- or it may remain constant.  Total variable costs change when activity changes.  Total fixed costs remain unchanged when activity changes. How a cost will react to changes in the level of activity within the relevant range. As the activity level rises or falls, a particular cost may rise or fall as well- or it may remain constant.  Total variable costs change when activity changes.  Total fixed costs remain unchanged when activity changes.

17. 2-17 Minutes Talked Total Long Distance Telephone Bill Variable Cost total dollar amount varies 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. Ex- Direct materials, Direct labor, variable elements of manufacturing overhead and variable elements of selling and administrative expenses

18. 2-18 Variable Cost Your total long distance telephone bill is based on how many minutes you talk. Minutes Talked Total Long Distance Telephone Bill

19. 2-19 Variable Cost Per Unit Minutes Talked Per Minute Telephone Charge constanton a per unit A variable cost is constant if expressed on a per unit basis. The cost per long distance minute talked is constant. For example, 10 cents per minute.

20. 2-20 Fixed Cost constant in total Fixed cost is a cost that remains constant in total, regardless of the changes in the level of activity. Your monthly basic telephone bill probably does not change when you make more local calls. Ex: straight-line depreciation, insurance, property taxes, rent, supervisor’s salaries, administrative salaries, and advertising. Number of Local Calls Monthly Basic Telephone Bill

21. 2-21 Fixed Cost Per Unit Number of Local Calls Monthly Basic Telephone Bill per Local Call progressively smaller the level of activity increases The average fixed cost per unit becomes progressively smaller as the level of activity increases. The average fixed cost per local call decreases as more local calls are made.

22. 2-22 Cost Classifications for Predicting Cost Behavior

23. 2-23 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.

24. 2-24 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.

25. 2-25 Examples Advertising and Research and Development Examples Depreciation on Equipment and Real Estate Taxes Types of Fixed Costs Discretionary Fixed Costs Usually arise from annual decisions by management to spend on certain fixed cost. Committed Fixed Costs Organizational investment with multi- year planning horizon, cannot be significantly reduced in the short term.

26. 2-26 Relevant Range A straight line closely approximates a curvilinear variable cost line within the relevant range. Activity Total Cost Economist’s Curvilinear Cost Function The Linearity Assumption and the Relevant Range Accountant’s Straight-Line Approximation (constant unit variable cost)

27. 2-27 Rent Cost in Thousands of Dollars 0 1,000 2,000 3,000 Rented Area (Square Feet) 0 30 60 Fixed Costs and Relevant Range 90 Relevant Range wide Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity.

28. 2-28 Fixed Monthly Utility Charge Variable Cost per KW Activity (Kilowatt Hours) Total Utility Cost X Y A mixed cost contains both fixed and variable components. Mixed costs are also known as semi- variable costs. Consider the example of utility cost. Mixed Costs Total mixed cost

29. 2-29 Fixed Monthly Utility Charge Variable Cost per KW Activity (Kilowatt Hours) Total Utility Cost X Y Mixed Costs Total mixed cost

30. 2-30 Mixed Costs Example If your fixed monthly utility charge is $40, your variable cost is $0.03 per kilowatt hour, and your monthly activity level is 2,000 kilowatt hours, what is the amount of your utility bill? Y = a + bX Y = $40 + ($0.03 × 2,000) Y = $100

31. 2-31 The Analysis of Mixed Costs 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. Account Analysis and the Engineering Approach

32. 2-32 Learning Objective 5 Analyze a mixed cost using scatter graph plot and the high-low method.

33. 2-33 Plot the data points on a graph (total cost vs. activity). 0 1 2 3 4 * Maintenance Cost 1,000’s of Dollars 10 20 0 * * * * * * * * * Patient-days in 1,000’s X Y The Scattergraph Method

34. 2-34 The Scattergraph Method Draw a line through the data points with about an equal numbers of points above and below the line. 0 1 2 3 4 * Maintenance Cost 1,000’s of Dollars 10 20 0 * * * * * * * * * Patient-days in 1,000’s X Y

35. 2-35 The Scattergraph Method Use one data point to estimate the total level of activity and the total cost. Intercept = Fixed cost: $10,000 0 1 2 3 4 * Maintenance Cost 1,000’s of Dollars 10 20 0 * * * * * * * * * Patient-days in 1,000’s X Y Patient days = 800 Total maintenance cost = $11,000

36. 2-36 The Scattergraph Method Make a quick estimate of variable cost per unit and determine the cost equation. Variable cost per unit = $1,000 800 $1.25/patient-day = $1.25/patient-day Y = $10,000 + $1.25X Total maintenance cost Number of patient days

37. 2-37 The High-Low Method The variable cost per hour of maintenance is equal to the change in cost divided by the change in hours. = $8.00/hour $2,400/ 300

38. 2-38 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

39. 2-39 The High-Low Method Y = $3,400 + $8.00X The Cost Equation for Maintenance

40. 2-40 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

41. 2-41 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 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 $4,000 ÷ 40,000 units = $0.10 per unit

42. 2-42 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 fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000

43. 2-43 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 fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000

44. 2-44 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. The goal of this method is to fit a straight line to the data that minimizes the sum of the squared errors.

45. 2-45 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 R 2, which is a measure of the goodness of fit of the regression line to the data points.

46. 2-46 0 1 2 3 4 Total Cost 10 20 0 Activity * * * * * * * * * * Least-Squares Regression Method R 2 is the percentage of the variation in total cost explained by the activity. R 2 varies from 0% to 100%, and the higher the percentage the better. X Y

47. 2-47 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.

48. 2-48 Learning Objective 6 Prepare income statements for a merchandise company using the traditional and contribution formats

49. 2-49 Let’s put our knowledge of cost behavior to work by preparing a contribution format income statement. The Contribution Format

50. 2-50 The Contribution Format The contribution margin format emphasizes cost behavior. Contribution margin covers fixed costs and provides for income.

51. 2-51 The Contribution Format Used primarily for external reporting. Used primarily by management.

52. 2-52 Learning Objective 7 Understand cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs.

53. 2-53 Every decision involves a choice between at least two alternatives. Differential Cost Differential Cost: A difference in cost between any two alternatives is known as differential cost. Differential Revenue Differential Revenue: A difference in revenues between any two alternatives is known as differential revenue. Only those costs and benefits that differ between alternatives are relevant in a decision. All other costs and benefits can and should be ignored. Cost Classifications for Decision Making

54. 2-54 Differential Cost and Revenue 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

55. 2-55 Opportunity Cost 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.

56. 2-56 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.

57. 2-57 Quick Check 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.

58. 2-58 Quick Check 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.

59. 2-59 Quick Check 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.

60. 2-60 Quick Check 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.

61. 2-61 Quick Check 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.

62. 2-62 Quick Check 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.

63. 2-63 End of Chapter 2