Managerial Accounting 252 Ch. 1

Differential Cost / Incremental Cost

A future cost that differs between any two alternatives. In business decisions, each alternative will have costs and benefits that must be compared to the costs and benefits of other available alternatives. Differential costs are always relevant costs. Future revenue that differs between any two alternatives is known as differential revenue.

Committed Fixed Costs

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. Examples include investments in facilities and equipment, as well as real estate taxes, insurance premiums, and salaries of top management. Even if Page operations are interrupted or cut back, committed fixed costs remain largely unchanged in the short term because the costs of restoring them later are likely to be far greater than any short-run savings that might be realized.

Contribution Income Statement

Contribution format income statements are prepared for internal management purposes. They use cost classifications for predicting costs behavior (variable and fixed costs) to better inform decisions affecting the future. The two different purposes served by these income statements highlight what is arguably the most important difference between financial accounting and managerial accounting—an emphasis on recording past performance versus an emphasis on making predictions and decisions that affect future performance. 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. it provides managers with an income statement that clearly distinguishes between fixed and variable costs and therefore aids planning, controlling, and decision making

Differential Revenue

Differential revenue is an example of a relevant benefit. Any future cost or benefit that does not differ between the alternatives is irrelevant and should be ignored.

Contribution Margin

Is the amount remaining from sales revenues after all variable expenses have been deducted. This amount contributes toward covering fixed expenses and then toward profits for the period. The contribution margin can also be stated on a per unit basis

Cost Structure

The relative proportion of each type of cost in an organization. For example, an organization might have many fixed costs but few variable or mixed costs. Alternatively, it might have many variable costs but few fixed or mixed costs.

Traditional Income Statement

Traditional income statements are prepared primarily for external reporting purposes. They rely on cost classifications for preparing financial statements (product and period costs) to depict the financial consequences of past transactions.

Period Costs

are all the costs that are not product costs. All selling and administrative expenses are treated as period costs. For example, sales commissions, advertising, executive salaries, public relations, and the rental costs of administrative offices are all period costs. Period costs are not included as part of the cost of either purchased or manufactured goods; instead, period costs are expensed on the income statement in the period in which they are incurred using the usual rules of accrual accounting. Keep in mind that the period in which a cost is incurred is not necessarily the period in which cash changes hands. For example, as discussed earlier, the cost of liability insurance is spread across the periods that benefit from the insurance—regardless of the period in which the insurance premium is paid.

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. This means that if a cost is incurred to acquire or make Page 29something that will eventually be sold, then the cost should be recognized as an expense only when the sale takes place—that is, when the benefit occurs. Such costs are called product costs.

Administrative Costs

include all costs associated with the general management of an organization rather than with manufacturing or selling. Examples of administrative costs include executive compensation, general accounting, secretarial, public relations, and similar costs involved in the overall, general administration of the organization as a whole. Administrative costs can be either direct or indirect costs. For example, the salary of an accounting manager in charge of accounts receivable collections in the East region is a direct cost of that region, whereas the salary of a chief financial officer who oversees all of a company's regions is an indirect cost with respect to individual regions.

Product Costs / Inventoriable Costs

include all costs involved in acquiring or making a product. Product costs "attach" to a unit of product as it is purchased or manufactured and they stay attached to each unit of product as long as it remains in inventory awaiting sale. When units of product are sold, their costs are released from inventory as expenses (typically called cost of goods sold) and matched against sales on the income statement. For manufacturing companies, product costs include direct materials, direct labor, and manufacturing overhead. A manufacturer's product costs flow through three inventory accounts on the balance sheet—Raw Materials, Work in Process, and Finished Goods—prior to being recorded in cost of goods sold on the income statement.

Indirect Cost

is a cost that cannot be easily and conveniently traced to a specified cost object. For example, a Campbell Soup factory may produce dozens of varieties of canned soups. The factory manager's salary would be an indirect cost of a particular variety such as chicken noodle soup. The reason is that the factory manager's salary is incurred as a consequence of running the entire factory—it is not incurred to produce any one soup variety. To be traced to a cost object such as a particular product, the cost must be caused by the cost object.

Common Cost

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

Non manufacturing Costs

often divided into two categories: (1) selling costs and (2) administrative costs. Non manufacturing costs are also often called selling, general, and administrative (SG&A) costs or just selling and administrative costs.

Raw Materials

raw materials refer to any materials that are used in the final product; and the finished product of one company can become the raw materials of another company.

Indirect Labor

refers to employees, such as janitors, supervisors, materials handlers, maintenance workers, and night security guards, that play an essential role in running a manufacturing facility; however, the cost of compensating these people cannot be easily or conveniently traced to specific units of product. Since indirect materials and indirect labor are difficult to trace to specific products, their costs are included in manufacturing overhead. Only those indirect costs associated with operating the factory are included in manufacturing overhead.

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. For planning purposes, a manager must be able to anticipate which of these will happen; and if a cost can be expected to change, the manager must be able to estimate how much it will change. To help make such distinctions, costs are often categorized as variable, fixed, or mixed.

Discretionary Fixed Costs / Managed Fixed Costs

usually arise from annual decisions by management to spend on certain fixed cost items. Examples of discretionary fixed costs include advertising, research, public relations, management development programs, and internships for students. Discretionary fixed costs can be cut for short periods of time with minimal damage to the long-run goals of the organization.

Variable Cost

varies, in total, in direct proportion to changes in the level of activity. Common examples of variable costs include 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. For a cost to be variable, it must be variable with respect to something. That "something" is its activity base.

Finished Goods

consist of completed units of product that have not yet been sold to customers.

Direct Labor

consists of labor costs that can be easily traced to individual units of product. Direct labor is sometimes called touch labor because direct labor workers typically touch the product while it is being made. Examples of direct labor include assembly-line workers at Toyota, carpenters at the home builder KB Home, and electricians who install equipment on aircraft at Bombardier Learjet.

Work in Process

consists of units of product that are only partially complete and will require further work before they are ready for sale to the customer.

Selling Costs

include all costs that are incurred to secure customer orders and get the finished product to the customer. These costs are sometimes called order-getting and order-filling costs. Examples of selling costs include advertising, shipping, sales travel, sales commissions, sales salaries, and costs of finished goods warehouses. Selling costs can be either direct or indirect costs. For example, the cost of an advertising campaign dedicated to one specific product is a direct cost of that product, whereas the salary of a marketing manager who oversees numerous products is an indirect cost with respect to individual products.

Manufacturing Overhead

includes all manufacturing costs except direct materials and direct labor. For example, manufacturing overhead includes a portion of raw materials know as indirect materials as well as indirect labor. Indirect materials are raw materials, such as the solder used to make electrical connections in a Samsung HDTV and the glue used to assemble an Ethan Allen chair, whose costs cannot be easily or conveniently traced to finished products.

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

Fixed Cost

is a cost that remains constant, in total, regardless of changes in the level of activity. Manufacturing overhead usually includes various fixed costs such as depreciation, insurance, property taxes, rent, and supervisory salaries. Similarly, selling and administrative costs often include fixed costs such as administrative salaries, advertising, and depreciation of non manufacturing assets. Unlike variable costs, fixed costs are not affected by changes in activity. Consequently, as the activity level rises and falls, total fixed costs remain constant unless influenced by some outside force, such as a landlord increasing your monthly rent. To continue the Nooksack Expeditions example, assume the company rents a building for $500 per month to store its equipment. The total amount of rent paid is the same regardless of the number of guests the company takes on its expeditions during any given month. Because total fixed costs remain constant for large variations in the level of activity, the average fixed cost per unit becomes progressively smaller as the level of activity increases. If Nooksack Expeditions has only 250 guests in a month, the $500 fixed rental cost would amount to an average of $2 per guest. If there are 1,000 guests, the fixed rental cost would average only 50 cents per guest. The table below illustrates this aspect of the behavior of fixed costs. Note that as the number of guests increase, the average fixed cost per guest drops.

Activity Base / Cost Driver

is a measure of whatever causes the incurrence of a variable cost. Some of the most common activity bases are direct labor-hours, machine-hours, units produced, and units sold. Other examples of activity bases (cost drivers) include the number of miles driven by salespersons, the number of pounds of laundry cleaned by a hotel, the number of calls handled by technical support staff at a software company, and the number of beds occupied in a hospital.

Cost Object

is anything for which cost data are desired—including products, customers, and organizational subunits. For purposes of assigning costs to cost objects, costs are classified as either direct or indirect.

Opportunity Cost

is the potential benefit that is given up when one alternative is selected over another. For example, assume that you have a part-time job while attending college that pays $200 per week. If you spend one week at the beach during spring break without pay, then the $200 in lost wages would be an opportunity cost of taking the week off to be at the beach. 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.

Relevant Range

is the range of activity within which the assumption that cost behavior is strictly linear is reasonably valid.

Prime Cost

is the sum of direct materials cost and direct labor cost.

Direct Materials

refers to raw materials that become an integral part of the finished product and whose costs can be conveniently traced to the finished product. This would include, for example, the seats that Airbus purchases from subcontractors to install in its commercial aircraft, the electronic components that Apple uses in its iPhones, and the doors that Whirlpool installs on its refrigerators.