Chapter 2: Managerial Accounting and Cost Concepts

Indirect Cost

A cost that cannot be easily and conveniently traced to a specified cost object

Mixed Cost

A cost that contains both variable and fixed elements

Sunk Cost

A cost that has already been incurred and that cannot be changed by any decision made now or in the future

Common Cost

A cost that is incurred to support a number of cost objects but that cannot be traced to them individually; for example, the wage cost of a commercial pilot is a common cost of all of the passengers on the aircraft -without the pilot there would be no flight and no passengers, but no part of the pilot's wage is caused by any on passenger taking the flight

Fixed Cost

A cost that remains constant, in total, regardless of changes in the level of activity within the relevant range; if a fixed cost is expressed on a per unit basis, it varies inversely with the level of activity

Variable Cost

A cost that varies, in total, in direct proportion to changes in the level of activity; a variable cost is constant per unit

Independent Variable

A variable that acts as a causal factor; activity is the independent variable, as represented by X in the equation Y = a + bX

Dependent Variable

A variable that responds to some causal factors; total cost is the dependent variable, as represented by the letter Y in the equation Y = a + bX

Selling Costs

All costs that are incurred to secure customer orders and get the finished product or service into the hands of the customer

Product Costs

All costs that are involved in acquiring or making a product; in the case of manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead

Administrative Costs

All executive, organizational, and clerical costs associated with the general management of an organization rather than with manufacturing or selling

Manufacturing Overhead

All manufacturing costs except direct materials and direct labor

Committed Fixed Costs

Investments in facilities, equipment, and basic organizational structure that can't be significantly reduced even for short periods of time without making fundamental changes

Quality of Conformance

The degree to which a product or service meets or exceeds its design specifications and is free of defects or other problems that mar its appearance or degrade its performance

Differential Revenue

The difference in revenue between two alternatives

What is the major disadvantage of the high-low method?

The high-low method only uses two data points, which generally are not enough to produce accurate results; additionally, the periods with the highest and lowest activity tend to be unusual

Indirect Labor

The labor costs of janitors, supervisors, material handlers, and other factory workers that cannot be conveniently traced to particular products

Opportunity Cost

The potential benefit that is given up when one alternative is selected over another

Relevant Range

The range of activity within which assumptions about variable and fixed cost behavior are valid

Cost Structure

The relative proportion of fixed, variable, and mixed costs in an organization

Cost Behavior

The way in which a cost reacts to changes in the level of activity

Discretionary Fixed Costs

Those fixed costs that arise from annual decisions by management to spend on certain fixed cost items, such as advertising and research

Conversion Cost (formula)

= Direct Labor + Manufacturing Overhead

Prime Cost (formula)

= Direct Materials + Direct Labor

Contribution Margin (formula)

= Sales - Variable Expenses

Mixed Cost (formula)

= a + bX, where a is the total fixed cost (the vertical intercept of the line), b is the variable cost per unit of activity (the slope of the line), and X is the level of activity

Statistical Process Control

A charting technique used to monitor the quality of work being done in a workstation for the purpose of immediately correcting any problems

Direct Cost

A cost that can be easily and conveniently traced to a specified cost object

Engineering Approach

A detailed analysis of cost behavior based on an industrial engineer's evaluation of the inputs that are required to carry out a particular activity and of the prices of those inputs

Differential Cost

A difference in cost between two alternatives

R^2

A measure of goodness of fit in least-squares regression analysis; the percentage of variation in the dependent variable that is explained by variation in the dependent variable that is explained by variation in the independent variable

Activity Base

A measure of whatever causes the incurrence of a variable cost

Account Analysis

A method for analyzing cost behavior in which an account is classified as either variable or fixed based on the analyst's prior knowledge of how the cost in the account behaves

High-Low Method

A method of separating a mixed cost into its fixed and variable elements by analyzing the change in cost between the high and low activity levels

Least-Squares Regression Method

A method of separating a mixed cost into its fixed and variable elements by fitting a regression line that minimizes the sum of the squared errors

Quality Cost Report

A report that details prevention costs, appraisal costs, and the costs of internal and external failures

What is meant by an activity based when dealing with variable costs?

An activity base is a measure of whatever causes the incurrence of a variable cost, sometimes referred to as a "cost driver," such as direct labor-hours, machine-hours, units produced, and units sold

Contribution Approach

An income statement format that organizes costs by behavior; costs are separated into variable and fixed categories rather than being separated into product and period costs for external reporting purposes

Incremental Cost

An increase in cost between two alternatives

Raw Materials

Any materials that go into the final product

Cost Object

Anything for which cost data are desired; products, customers, jobs, and parts of the organization

What effect does an increase in volume have on total fixed costs?

As volume increases, total fixed costs remain constant

What effect does an increase in volume have on total variable costs?

As volume increases, total variable costs increase

What effect does an increase in volume have on unit fixed costs?

As volume increases, unit fixed costs decrease

What effect does an increase in volume have on unit variable costs?

As volume increases, unit variable costs remain constant

Linear Cost Behavior

Cost behavior is said to be linear whenever a straight line is a reasonable approximation for the relation between cost and activity

Internal Failure Costs

Costs that are incurred as a result of identifying defective products before they are shipped to customers

Appraisal Costs

Costs that are incurred to identify defective products before the products are shipped to customers

Prevention Costs

Costs that are incurred to keep defects from occurring

Quality Cost

Costs that are incurred to prevent defective products from falling into the hands of customers or that are incurred as a result of defective units

External Failure Costs

Costs that are incurred when a product or service that is defective is delivered to a customer

Period Costs

Costs that are taken directly to the income statement as expenses in the period in which they are incurred or accrued

Direct Labor

Factory labor costs that can be easily traced t individual units of product

What are the three major elements of product costs in a manufacturing company?

In a manufacturing company, the three major elements of product costs consist of direct materials, direct labor, and manufacturing overhead

Direct Materials

Materials that become an integral part of a finished product and whose costs can be conveniently traced to it

Can only variable costs be differential costs?

No; differential costs can either be fixed or variable

Explain the difference between a product cost and a period cost

Product costs include all costs involved in acquiring or making a product (direct materials, direct labor, and manufacturing overhead); product costs are initially assigned to an inventory account on the balance sheet, and once the goods are sold, are released from inventory as expenses and matched against sales revenue on the income statement Period costs are all the costs that are not product costs (including all selling and administrative costs); period costs are expenses on the income statement in the period in which they are incurred using the usual rules of accrual accounting

ISO 9000 Standards

Quality control requirements issued by the International Organization for Standardization that relate to products sold in European countries

Quality Circles

Small groups of employees that meet on a regular basis to discuss ways of improving quality

Indirect Materials

Small items of material such as glue and nails that may be an integral part of a finished product, but whose costs cannot be easily or conveniently traced to it

Contribution Margin

The amount remaining from sales revenues after all variable expenses have been deducted

What is the difference between a contribution format income statement and a traditional format income statement?

The contribution approach separates costs into fixed and variable categories, first deducting variable expenses from sales to obtain the contribution margin; this amount contributes toward covering fixed expenses and then toward profits for the period The traditional approach organizes costs into two categories - cost of goods sold and selling and administrative expenses; sales minus cost of goods sold equals the gross margin; the gross margin minus selling and administrative expenses equals net operating income

Does the concept of relevant range apply to fixed costs?

Yes; outside of the relevant range (the range of activity within which the assumption that cost behavior is strictly linear is reasonably valid), a fixed cost may no longer be strictly fixed; for example, the assumption that the rent for a diagnostic machine is $20,000 per month is only valid withing the relevant range of 0 to 3,000 tests per month - if the Mayo Clinic needed to test 5,000 samples per month, then it would need to rent another machine for an additional $20,000 per month