Accounting 211 Chapter 1 Notes
General Cost Classifications (p22)
1.) Manufacturing Costs: Direct Materials, Direct Labor, & Manufacturing Overhead. 2.) Non-manufacturing Costs (SG&A): Selling Costs & Administrative Costs.
Behavior of the Cost, within the relevant range (p30 exhibit 1-4)
Cost behavior patterns such as salaried employees are often called step-variable costs. The width of the steps for step-variable costs is generally so narrow that these costs can be treated essentially as variable costs for most purposes. The width of the steps for fixed costs, on the other hand, is so wide that these costs should be treated as entirely fixed within the relevant range. Variable Cost: a) Total Variable Cost increases and decreases in proportion to changes in the activity level. b) Variable Cost per Unit remains constant. Fixed Cost: a) Total Fixed Cost is not affected by the changes in the activity level within the relevant range. b) Fixed cost per unit decreases as the activity level rises and increases as the activity level falls.
The Analysis of Mixed Costs (p32)
Methods to estimate the fixed and variable components of a mixed cost are Account Analysis, the Engineering Approach, the High-low Method, and Least-Squares Regression Analysis.
Opportunity Cost (p41)
Opportunity cost is the potential benefit that is given up when one alternative is selected over another. Opportunity costs are not usually found in accounting records, but they are costs that must be explicitly considered in every decision a manager makes. Virtually every alternative involves an opportunity cost.
Traditional Format Income Statement (p38)
Traditional income statements are prepared primarily for external reporting purposes. This type of income statement 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.
Period Cost (p23)
All costs that are not product costs (SG&A). The are expensed in the period in which they occur.
Conversion Cost (p23)
The sum of Direct Labor cost and Manufacturing Overhead cost. The term conversion cost is used to describe direct labor and manufacturing overhead because these costs are incurred to convert materials into the finished product.
Mixed Costs including the calculation (p31)
A mixed cost contains both variable and fixed cost elements. Mixed costs are also known as semivariable costs. Calculating the total mixed cost of an activity within the relevant range: Y = a + bX Y = Total Mixed Cost a = Total Fixed Cost b = Variable Cost / Unit X = The Level of Activity (Quantity)
Linearity Assumption and the Relevant Range (p29)
The Relevant Range is the range of activity within which the assumption that cost behavior is strictly linear is reasonably valid. Outside of the relevant range, a fixed cost may no longer be strictly fixed or a variable cost may not be strictly variable. Managers should always keep in mind that assumptions made about cost behavior may be invalid if activity falls outside of the relevant range.
Prime Cost (p23)
The sum of Direct Materials cost and Direct Labor cost.
Differential Cost & Revenue (p40)
A difference in costs between any two alternatives is known as a differential cost. A difference in revenues between any two alternatives is known as differential revenue. A differential cost is also known as an incremental cost, although technically an incremental cost should refer only to an increase in cost from one alternative to another; decreases in cost should be referred to as decremental costs. Differential cost is a broader term, encompassing both cost increases (incremental costs) and cost decreases (decremental costs) between alternatives. In general, only the differences between alternatives are relevant in decisions. Those items that are the same under all alternatives and that are not affected by the decision can be ignored. Differential costs can be either fixed or variable.
Fixed Costs both Committed and Discresionary (p28)
A fixed cost is a cost that remains constant, in total, regardless of changes in the level of activity. For planning purposes, fixed costs can be viewed as either Committed or Discretionary. Committed Fixed Costs represent organizational investments with a multiyear planning horizon that can't be significantly reduced even for short periods of time without making fundamental changes. Discretionary Fixed Costs (often referred to as managed fixed costs) usually arise from annual decisions by management to spend on certain fixed cost items
Sunk Cost (p42)
A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Because sunk costs cannot be changed by any decision, they are not differential costs. And because only differential costs are relevant in a decision, sunk costs should always be ignored.
Variable Costs & their Activity Base(p26)
A variable cost varies, in total, in direct proportion to changes in the level of activity. For a cost to be variable, it must be variable with respect to something. That "something" is its Activity Base. An activity base is a measure of whatever causes the incurrence of a variable cost. An activity base is sometimes referred to as a Cost Driver.
Product Cost (p23)
AKA Inventoriable Costs. All costs involved in acquiring or making a product. Using the matching principle these costs are incurred as expenses in the period in which the product(s) is sold. In the case of manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead.
4 Methods of Mixed Cost Analysis, Account Analysis & Engineering Approach Defined (p32)
Account Analysis: an account is classified as either variable or fixed based on the analyst's prior knowledge of how the cost in the account behaves. Engineering Approach: involves a detailed analysis of what cost behavior should be, based on an industrial engineer's evaluation of the production methods to be used, the materials specifications, labor requirements, equipment usage, production efficiency, power consumption, and so on.
High-Low Method (p34)
Allows you to break out variable and fixed costs: Variable Cost = ((High Cost - Low Cost) / (High Activity - Low Activity)) * High Activity Level) Fixed Cost = High Total Cost - High Variable Cost. Note a drawback of High/Low is it only uses 2 data points. Also you can do the same calculation using all low points.
Cost Behavior & Cost Structure (p26)
Cost behavior refers to how a cost reacts to changes in the level of activity. As the activity level rises and falls, a particular cost may rise and fall as well—or it may remain constant. To help make such distinctions, costs are often categorized as variable, fixed, or mixed. The relative proportion of each type of cost in an organization is known as its Cost Structure.
Cost Classifications for Decision Making (p40)
Differential cost, Opportunity cost, and Sunk cost. See these in the Chapter 1 Definitions.
Contribution Format Income Statement (p39)
The crucial distinction between fixed and variable costs is at the heart of the contribution approach to constructing income statements. The unique thing about the contribution approach is that it provides managers with an income statement that clearly distinguishes between fixed and variable costs and therefore aids planning, controlling, and decision making. The contribution approach separates costs into fixed and variable categories, first deducting variable expenses from sales to obtain the contribution margin. For a merchandising company, cost of goods sold is a variable cost that gets included in the "Variable expenses" portion of the contribution format income statement. The contribution margin is the amount remaining from sales revenues after variable expenses have been deducted. This amount contributes toward covering fixed expenses and then toward profits for the period. The contribution format income statement is used as an internal planning and decision-making tool. Its emphasis on cost behavior aids cost-volume-profit analysis management performance appraisals, and budgeting. Moreover, the contribution approach helps managers organize data pertinent to numerous decisions such as product-line analysis, pricing, use of scarce resources, and make or buy analysis.
Scattergraph Plot (p33, exhibit 1-6)
The first step in applying the high-low method or the least-squares regression method is to diagnose cost behavior with a scattergraph plot. Cost, Y, is plotted on the vertical axis. Cost is known as the DEPENDENT VARIABLE because the amount of cost incurred during a period depends on the level of activity for the period. (That is, as the level of activity increases, total cost will also ordinarily increase.) Activity, X, is plotted on the horizontal axis. Activity is known as the INDEPENDENT VARIABLE because it causes variations in the cost. Cost behavior is considered linear whenever a straight line is a reasonable approximation for the relation between cost and activity. Plotting the data on a scattergraph is an essential diagnostic step that should be performed before performing the high-low method or least-squares regression calculations. If the scattergraph plot reveals linear cost behavior, then it makes sense to perform the high-low or least-squares regression calculations to separate the mixed cost into its variable and fixed components. If the scattergraph plot does not depict linear cost behavior, then it makes no sense to proceed any further in analyzing the data.
Least Squares Regression Method (p36)
The least-squares regression method, unlike the high-low method, uses all of the data to separate a mixed cost into its fixed and variable components. A regression line of the form Y = a + bX is fitted to the data, where a represents the total fixed cost and b represents the variable cost per unit of activity. Least-squares regression analysis generally provides more accurate cost estimates than the high-low method because, rather than relying on just two data points, it uses all of the data points to fit a line that minimizes the sum of the squared errors. NOTE: Due to the complexity of the formula a software package is usually needed.
