Managerial Accounting: Cost Concepts

• Managerial accounting and cost concepts are the subject of Chapter 2.

Classifications of Manufacturing Costs

• Direct materials, direct labor, and manufacturing overhead are the three basic manufacturing cost categories.

Direct Materials

• Raw materials become an integral part of the product and are easily traced to it.
• An example of direct material is a radio installed in an automobile.

Direct Labor

• Labor costs are easily traced to individual units of product.
• Wages paid to automobile assembly workers are an example of direct labor.

Manufacturing Overhead

• Manufacturing costs cannot be easily traced to specific units produced.
• Indirect materials and indirect labor are examples of manufacturing overhead.
• Materials that support the production process, like lubricants, are example of indirect materials.
• Wages being paid to those not directly involved in production, such as maintenance, are examples of indirect labor.

Nonmanufacturing Costs

• Selling costs are necessary to secure the order and deliver the product.
• Administrative costs include all executive, organizational, and clerical costs.

Product Costs

• Product costs include direct materials, direct labor, and manufacturing overhead.
• Product costs are inventoried and expensed when sold as cost of goods sold; listed as "inventory" on the balance sheet, then when sold moved to the "income statement".

Period Costs

• Period costs include all selling and administrative costs.
• Period costs are expensed as incurred; they go directly to the "income statement".
• Product costs are considered a period cost rather than a product cost in a manufacturing company.

More Classifications of Costs

• Manufacturing costs are often classified.
• "Prime Cost" is the combination of Direct Material + Direct Labor
• "Conversion Cost" is the combination of Direct Labor + Manufacturing Overhead

Cost Behavior Patterns

• Cost classifications include variable costs, fixed costs, and mixed costs.
• Cost behavior is how a cost reacts to changes in the level of activity.

Variable Costs

• Variable costs change with the number of texts someone sends.
• Variable cost per unit, such as cost per text, remains constant, like 5 cents a text.
• Activity base (cost driver) is what causes the incurrence of a variable cost.
• Activity base can be measured in units produced, miles driven, machine hours, or labor hours.

Fixed Costs

• Spending does not change within the monthly contract allotment, regardless of the number of calls made.
• The average fixed cost per cell phone call decreases as more calls are made within the monthly contract allotment.
• There are committed and discretionary fixed costs.
• Committed costs are long-term and aren't reduced in the short term, such as depreciation on buildings.
• Discretionary fixed costs can be altered in the short-term by current managerial decisions.
• Advertising and research and development are examples of discretionary costs.
• A straight line closely approximates a curvilinear variable cost line within the relevant range (linearity assumption).
• Fixed costs increase in a step fashion at a rate of $30,000 for each additional 1,000 square feet.
• The relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is flat.

Costing Behavior

• The behavior of costs within the relevant range includes variable and fixed costs.
• The total variable cost increases and decreases in proportion to changes in the activity level, while the variable cost per unit remains constant.
• The total fixed cost isn't affected by changes in the activity level, but fixed cost per unit decreases as the activity level rises and increases as the activity level falls.

Mixed Costs

• Mixed costs are also called semivariable costs.
• A mixed cost contains both variable and fixed elements, such as utility cost.
• The total mixed cost line can be expressed as an equation: Y = a + bX where:
  • Y = The total mixed cost.
  • a = The total fixed cost (the vertical intercept of the line).
  • b = The variable cost per unit of activity (the slope of the line).
  • X = The level of activity.
• In account analysis, each account is classified as either variable or fixed based on the analyst's knowledge of how the account behaves.
• The engineering approach classifies costs based upon an industrial engineer's evaluation of production methods, and material, labor, and overhead requirements.

Analyze a Mixed Cost

• Analyze a mixed cost using a scattergraph plot and the high-low method.
• The total maintenance costs for six months are taken for analysis.
• Data points are plotted on a graph with total cost Y vs. Activity X.

High-Low Method

• The variable cost per hour of maintenance = change in cost / change in hours.
• Total Fixed Cost = Total Cost - Total Variable Cost
• The Cost Equation for Maintenance can be written as Y = Fixed Costs + Variable Cost.

Least-Squares Regression Method

• Used to analyze mixed costs if a scattergraph plot reveals an approximately linear relationship between variables.
• This method uses all the data points to estimate the fixed and variable cost components of a mixed cost.
• The goal of this method is to fit a straight line to the data that minimizes the sum of the squared errors.
• Software can be used to fit a regression line through the data points.
• The cost analysis objective is the same: Y = a + bX
• Least-squares regression also provides a statistic, called the R2, which is a measure of the goodness of fit of the regression line to the data points.
• Each method uses differing amounts of the data points to provide estimates.
• Least-squares regression provides the most accurate estimate because it uses all the data points.

Preparing Income Statements

• Traditional and contribution formats are used when preparing income statements for a merchandising company.

• A comparison of Traditional and Contribution Income Statements:

  • Traditional Format: Sales - Cost of goods sold = Gross margin - Selling & admin. expense = Net operating income
  • Contribution Format: Sales - Variable expenses = Contribution margin - Fixed expenses = Net operating income

• The traditional format is used primarily for external reporting.

• The contribution format is used primarily by management.

• Uses of the Contribution Format:

  • As an internal planning and decision-making tool.
  • Cost-volume-profit analysis (Chapter 5).
  • Budgeting (Chapter 8).
  • Segmented reporting of profit data (Chapter 6).
  • Special decisions such as pricing and make-or- buy analysis (Chapter 12).

Assigning Costs to Cost Objects

• Understand the differences between direct and indirect costs.
• Direct costs are easily and conveniently traced to a unit of product or other cost object.
  • Direct material and direct labor are examples of direct costs.
• Direct costs are can be directly and conveniently traced to a unit if it easily and cost effectively measures and applies it to the cost object.
• Indirect costs cannot be easily and conveniently traced to a unit of product or other cost object.
  • Manufacturing overhead is an example of an indirect costs.
• Indirect costs generally have to be allocated amount various products departments based on some activity.

Cost Classifications for Making Decisions

Understand cost classifications used in making decisions:

• Differential costs
• Opportunity costs
• Sunk costs

Decisions

• Every decision involves a choice between at least two alternatives.
• Only those costs and benefits that differ between alternatives are relevant in a decision.
• All other costs and benefits can and should be ignored as irrelevant.

Differential Cost Definition

Costs and revenues that differ among alternatives are differential cost and revenue

Opportunity Cost Definition

The potential benefit given up when one alternative is selected over another defines opportunity cost.

Sunk Cost Defined:

• Sunk costs have already been incurred and cannot be changed now or in the future.
• Costs that have already been incurred and cannot be changed now or in the future should be ignored when making decisions.

Cost Classification Summary

• Types of Classifications for:
• Financial Reporting
• Predicting Cost Behavior
• Assigning Costs to Cost Objects
• Making Business Decisions

Chapter 2 focuses on managerial accounting and cost concepts. The chapter discusses classifications of manufacturing costs, direct materials, direct labor, and manufacturing overhead. Nonmanufacturing costs are also discussed.