Chapter 2: Managerial Accounting and Cost Concepts

Conversion cost =

Direct labor + manufacturing overhead

Conversion cost

Direct labor cost plus manufacturing overhead cost.

Costs are classified as:

either direct or indirect

Methods to estimate the fixed and variable components of a mixed cost such as

1. Account analysis 2. Engineering approach 3. High-low method 4. Least-squares regression analysis

Preparing financial statements

1. Product costs (inventoriable) 2. Period costs (expensed)

Indirect cost

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

Common cost

A cost that is incurred to support a number of cost objects, but that cannot be traced to them individually. Type of indirect cost.

Selling costs

All costs that are incurred to secure customer orders and get the finished product or service into the hands of the customer. Also called order-getting and order-filling costs. Includes: advertising, shipping, sales travel, sales commissions, sales salaries, cost of finished goods warehouses.

Period cost =

Selling expenses + administrative expenses

Contribution margin

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

Differential revenue

The difference in revenue between two alternatives.

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.

To be traced to a cost object

the cost must be caused by the cost object

Incremental cost

An increase in cost between two alternatives. An increase in cost from one alternative to another.

Step-variable costs

Cost behavior patterns such as salaried employees.

Direct labor

Factory labor costs that can be easily traced to individual units of product. Also called touch labor.

Opportunity cost

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

Average fixed cost per unit

becomes progressively smaller as the level of activity increases

Cost of goods sold reports

products costs attached to the merchandise sold during the period

High-low and least-squares repression methods

Estimate the fixed and variable elements of a mixed cost by analyzing past records of cost and activity data.

Prime cost =

Direct materials + direct labor

Product cost =

Direct materials + direct labor + manufacturing overhead

Prime cost

Direct materials cost plus direct labor cost.

Purpose of Cost Classification

1. Assigning costs to cost objects 2. Accounting for costs in manufacturing companies 3. Preparing financial statements 4. Predicting cost behavior in response to changes in activity 5. Making decisions

3 types of costs

1. Variable 2. Fixed 3. Mixed

Predicting cost behavior in response to changes in activity

1. Variable cost (proportional to activity) 2. Fixed cost (constant in total) 3. Mixed cost (has variable and fixed elements)

Matching principle

Based on the accrual concept that costs incurred to generate a particular revenue should be recognized as expenses in the same period that the revenue is recognized.

To analyze mixed costs with the high-low method:

Begin by identifying the period with the lowest level of activity and the period with the highest level of activity. The period with the lowest activity is selected as the first point in the above formula and the period with the highest activity is selected as the second point.

Period costs

Costs that are taken directly to the income statement as expenses in the period in which they are incurred or accrued. Includes all selling and administrative expenses.

First step in applying the high-low method or the least-squares regression method

Diagnose cost behavior with a scattergraph plot. Cost is plotted on the vertical axis and the activity is plotted on the horizontal axis.

How to calculate gross margin in the traditional format income statement

Gross margin = Sales - cost of goods sold

Indirect materials

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

Cost behavior

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

Formula to estimate variable cost

Variable cost = Slope of the line = Rise/Run = (Y2-Y1)/(X2-X1) Variable cost = (Cost at the high activity level - cost at the low activity level) / (high activity level - low activity level) Variable cost = change in cost / change in activity

When is cost behavior considered linear

Whenever a straight line is a reasonable approximation for the relation between cost and activity

Equation to express the relationship between a mixed cost and the level of activity

Y = a + bX In this equation: Y=the total mixed cost a=the total fixed cost (vertical intercept of the graph) b=variable cost per unit of activity (slope of the line) X=the level of activity Steeper the slope, the higher the variable cost per unit.

Regression line for least-squares regression method

Y = a + bX, where a represents the total fixed cost and b represents the variable cost per unit of activity

The selling and administrative expenses report

all period costs that have been expensed as incurred

The fixed portion of a mixed cost represents

the minimum cost of having a service ready and available for use.

As the level of activity increases,

total cost will also ordinarily increase

Activity base typically used in this course

total volume of goods and services provided by the organization

Determining the fixed cost element

Fixed cost = Total cost - variable cost element

Contribution approach to constructing income statements

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

How to calculate contribution margin using the contribution format income statement

Contribution margin = Sales - (Cost of goods sold) - (variable selling) - (variable administrative)

Limitation of the traditional income statement

It does not distinguish between fixed and variable costs. It has limitations internally in that managers need cost data organized by cost behavior to aid in planning, controlling, and decision making.

Direct materials

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

Indirect labor

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

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. Examples: advertising, research, public relations, management development programs, and internships for students.

What type of cost is cost of goods sold

Variable cost that gets included in the variable expenses portion of the contribution format income statement

The variable portion of a mixed cost represents

the cost incurred for actual consumption of the service. It varies in proportion to the amount of service actually consumed.

2 categories of costs in the traditional format income statement

1. Cost of goods sold 2. Selling and administrative expenses

Making decisions

1. Differential cost (differs between alternatives) 2. Sunk cost (should be ignored) 3. Opportunity cost (foregone benefit)

Assigning costs to cost objects

1. Direct costs (can be easily traced) 2. Indirect costs (can't be easily traced)

Manufacturing costs

1. Direct materials (direct cost) 2. Direct labor (direct cost) 3. Manufacturing overhead (indirect cost)

Accounting for costs in manufacturing companies

1. Manufacturing costs (direct materials, direct labor, manufacturing overhead) 2. Non-manufacturing costs (selling costs, administrative costs)

Non-manufacturing costs

1. Selling costs 2. Administrative costs

Direct cost

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

Mixed cost (semivariable costs)

A cost that contains both variable and fixed cost elements.

Sunk cost

A cost that has already been incurred and that cannot be changed by any decision made now or in the future. Not relevant in a decision, and should always be ignored.

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. Examples: straight-line depreciation, insurance, property taxes, rent, supervisory salaries, administrative salaries, and advertising. Can be viewed as committed or discretionary.

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. Examples: cost of goods sold for a merchandising company, direct materials, direct labor, variable elements of manufacturing overhead, such as indirect materials, supplies and power, and variable elements of selling and administrative expenses, such as commissions and shipping costs.

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. Encompasses both cost increases and cost decreases. Can be either fixed or variable.

Activity base

A measure of whatever causes the incurrence of a variable cost. Sometimes referred to as a cost driver. Includes: direct labor-hours, machine-hours, units produced, and units sold.

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 oh 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. Based on the rise-over-run formula for the slope of a straight line. Slope of the line is equal to the variable cost per unit of activity.

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. Unlike the high-low method, uses all of the data to separate a mixed cost into its fixed and variable components.

Independent variable

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

Dependent variable

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

Product costs (inventoriable 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. Recorded as expenses in the period in which the related products are sold.

Administrative costs

All executive, organizational, and clerical costs associated with the general management of an organization rather than with manufacturing or selling. Includes: executive compensation, general accounting, secretarial, public relations, and similar costs involved in the overall, general administration of the organization as a whole.

Manufacturing overhead

All manufacturing costs besides direct materials and direct labor. Also called: indirect manufacturing cost, factory overhead, and factory burden. Only costs associated with operating the factory are included. Includes: indirect materials, indirect labor, maintenance and repairs on production equipment, heat & lighting, property taxes, depreciation, and insurance on manufacturing facilities.

Raw materials

Any materials that go into the final product. May include both direct and indirect materials.

Cost object

Anything for which cost data are desired. Examples of cost objects are products, customers, jobs, and parts of the organization such as departments or divisions.

What are used to analyze a mixed cost under the high-low method?

Highest and lowest levels of activity

When to perform and when to not perform the high-low method or the least-squares regression method

If the scattergraph reveals linear behavior, perform high-low or least-squares regression calculations to separate the mixed cost into its variable and fixed components. Do not proceed if the scattergraph does not depict linear cost behavior.

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. Examples: Investments in facilities and equipment, real estate taxes, insurance expenses, and salaries of top management.

Why use the contribution format income statement as an internal planning and decision-making tool?

Its emphasis on cost behavior aids cost-volume-profit analysis, management performance appraisals, and budgeting. Also, it helps managers organize data pertinent to numerous decisions, such as product-line analysis, pricing, use of scarce resources, and make or buy analysis.

Which provides more accurate cost estimates: the high-low method or the least-squares regression method? Why?

Least-squares regression 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.

How to calculate net operating income using the contribution format income statement

Net operating income = Contribution margin - Fixed expenses

How to calculate net operating income in the traditional format income statement

Net operating income = Gross margin - selling and administrative expenses

Determining cost of goods sold for a merchandising company

Number of units sold X unit cost