Chapter 1: Managerial Accounting and Cost Concepts

Period Costs

"Operating Expenses"; aka "Non-manufacturing Costs" or "Selling and Administrative Costs" 1. Selling Costs 2. Administrative Costs 3. Includes selling, general & administrative expenses such as rent, insurance, depreciation, property taxes, etc. on selling and administrative facilities.

Activity Base

(also called a cost driver); is a measure of what causes variable costs to change (such as units produced, units sold, labor hours, number of customers, etc.) Machine Hours

Sunk Cost

-A cost that has already been incurred and cannot be changed by future decisions. -Not relevant to the decision!

3 Broad Categories of Product Cost for Manufacturing Companies (aka Manufacturing Costs):

-Direct Material -Direct Labor -Manufacturing Overhead

Characteristics of a Variable Cost:

-IN TOTAL: varies in direct proportion to activity -PER UNIT- remains constant

The Contribution Margin Approach

-Separates costs into fixed and variable categories and computes a contribution margin. -Emphasizes cost behavior-> important to managers. -The contribution approach is used as an internal planning and decision-making tool (aids cost-volume-profit analysis, performance evaluation and budgeting as we will see...)

The Traditional Approach

-Separates product costs from selling and administrative expenses as required for external reporting purposes. -Required to be used for external reporting purposes. -PROBLEM: This method does not distinguish between variable and fixed costs.

Differential Cost and Revenue

-The difference in cost or even between two alternatives. -Only differential costs and revenues are relevant to making future decisions.

Opportunity Cost

-The potential benefit that is given up by choosing one alternative. -Not found in the accounting records, but must be considered when choosing among alternatives.

The Least-Squares/Regression Method

-Use a mathematical model to minimize deviations to determine the variable and fixed component of a cost. -Most accurate method -You are not responsible for the calculations in this class.

Characteristics of a Fixed Cost:

-the Total Fixed Cost remains constant as activity changes -the fixed cost per unit varies inversely with changes in activity

4 Methods for Analyzing Cost Behavior

1. Account Analysis 2. Scattergraph Method 3. High-Low Method 4. Least-Squares/Regression Method

Cost Classifications for Predicting Cost Behavior

1. Cost Structure 2. Cost Behavior 3. Activity Base 4. Relevant Range

Additional Terms Used Related to Product Costs:

1. Prime Costs: DM + DL 2. Conversion Costs: DL + OH

Three Major Types of Business:

1. Service Companies- provide services; do not carry inventory. 2. Merchandise Companies- buy and resell inventory to customers. 3. Manufacturing Companies- buy raw material which they convert to a finished product and offer for sale to customers.

Mixed Cost

A cost that contains both variable and fixed element. Also called "Semi-variable Costs".

Fixed Cost

A cost that remains constant, in total, regardless of changes in the level of the activity.

Variable Cost (VC)

A cost that varies, in total, directly and proportionally to changes in the level of activity; the variable cost per unit is constant. Ex: DM

Cost Classifications For Decision making

A. Differential Cost and Revenue B. Opportunity Cost C. Sunk Cost

Methods for Analyzing Cost Behavior

Accountants usually assume that costs are strictly linear; however, economists point out that many costs are actually curvilinear. BUT within a narrow range of activity known as the relevant range, a cost can be approximated by a straight line.

Cost Object

Anything for which cost data are desired including products, customers, jobs, organizational subunits, etc. Example: The snack foods division of PepsiCo; the purchasing department for hospital.

Treatment of Product Costs

Assign to inventory as incurred; expense through COGS when inventory is sold (i.e., in accordance with the matching principle)

Direct Cost

Costs that can be easily and conveniently traced to a specified cost object. Example: Sales commission paid; direct material used.

Indirect Cost

Costs that cannot be easily and conveniently traced to a specified cost object. Example: HR costs; rent for space that houses 4 production.

Factory Labor includes:

Direct Labor and Indirect Labor

Costs are classified two ways:

Direct or Indirect

Account Analysis

Each account under consideration is classified as variable or fixed based on the analyst's prior knowledge about how costs behave- limited in value.

Treatment of Period Costs

Expensed in the period incurred (or allocated among periods benefitted for costs such as prepaid rent, supplies or depreciation).

Indirect Labor

Factory labor that is difficult to trace each unit so it is included as part of manufacturing overhead. Example: For a t-shirt manufacturer: -salary for factory supervisor -wages for factory janitorial staff

Manufacturing Overhead

Included all manufacturing costs except direct materials and direct labor. These costs cannot be easily traced to specific units produced (also called indirect manufacturing cost, factory overhead, and factory burden). Includes indirect materials used in production. Includes indirect labor.

Selling Costs

Includes all costs necessary to secure customer orders and get the finished product into the hands of the customer. Example: Sales salaries and commissions, travel expenses, delivery expense (to customer), marketing expense.

Product Cost

Includes all costs required to purchase or manufacture inventories. For a Retailer: includes cost of purchasing inventory. For a Manufacturer: includes all costs required to manufacture inventories.

Administrative Costs

Includes all executive, organizational, and clerical costs associated with the general management of an organization. Example: Administrative salaries, clerical wages, R&D expenses, etc.

Common Costs

Indirect costs incurred to support a number of cost objects. These costs cannot be traced to an individual cost object.

Relevant Range

Is the operating range over which a firm finds it practical to operate in the short-run. -It is the range of activity within which the assumptions made about cost behavior are valid. For example, outside the relevant range total fixed cost may NOT remain constant. -The relevant range of activity pertains to fixed cost as well as variable costs.

Direct Labor

Labor costs that can be easily traced to individual units of product (aka "Touch Labor"). Example: Sewing machine operator for a t-shirt manufacturer.

Other Examples of Manufacturing OH:

Maintenance and repairs on production equipment, heat and light, property taxes, depreciation, insurance, etc. on manufacturing facilities. (i.e., facilities costs that are related to operating the factory).

Indirect Materials

Materials that are relatively insignificant to the product; not worth tracing to each unit so are treated as part of manufacturing overhead. Example: For a t-shirt manufacturer: -Thread, oil for sewing machines -Scissors (i.e. small tools)

Scattergraph Method

Plot historical observations for cost and activity; then fit a line to the points so as to minimize deviations.

The four main purposes for different cost classifications:

Preparing external financial reports, predicting cost behavior, assigning costs to cost objects, and decision making.

Direct Material

Raw material that becomes an integral part of the finished product and whose costs can be conveniently traced to it. -Can be natural resources or parts purchased from another company. Ex: wood for table, wax for a candle, fabric for a t-shirt manufacturer.

Raw Material

Refers to any materials that go into the final product and includes both DIRECT and INDIRECT materials.

Cost Behavior

Refers to how a cost will react to changes in the level of activity. Understanding cost behavior facilitates planning and controlling.

Cost Structure

Refers to the relative proportion of each type of cost in an organization (Variable Cost vs Fixed Cost).

Committed Fixed Costs

Represent investment with a multi-year planning horizon that cannot be easily adjusted in the short term. Ex: Facilities cost; presidents salary

Traditional Format

Sales Less: COGS Gross Margin Less: Selling & Administrative Expenses Net Operating Income

What is the equation for a cost line?

Total Cost= (VC/Unit of Activity x activity) + Total FC

Basis for (Cost Behavior) Analysis

Total Cost= Total VC + Total FC

High-Low Method

Uses the following formulas and historical or projected information to calculate the variable and fixed components of a cost. 1st Calculate the VC per Unit of Activity= High Cost-Low Cost/High Activity-Low Activity 2nd Use total cost equation to determine total FC Total Cost= (VC/Unit x # Units) + Total FC

Discretionary Fixed Costs

Usually arise from annual decisions by management and they can be easily reduced in the short term. Ex: R+D, training programs, advertising.

3 Commonly Used Classifications of Cost Behavior:

Variable Costs, Fixed Costs, and Mixed Costs

Does the identity of the cost object have an impact on the classification of a cost as direct or indirect?

Yes -> MUST identify the cost object!

Rule of Thumb:

to be a direct cost it must be CAUSED by the cost object.