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Lecture Notes
Chapter theme : This chapter explains how managers need to rely on different cost classifications for different purposes. The four main purposes emphasized in this chapter include preparing external financial reports, predicting cost behavior, assigning costs to cost objects, and decision making.
I. General cost classifications We’ll begin by looking at manufacturing companies because their basic activities include most of the activities found in other types of business organizations.
Learning Objective 1: Identify and give examples of each of the three basic manufacturing cost categories.
A. Classifications of manufacturing costs
i. Direct materials − Raw materials that become an integral part of the finished product and whose costs can be conveniently traced to it.
ii. Direct labor − Labor costs that can be easily traced to individual units of product (also called touch labor).
iii. Manufacturing overhead − Includes 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 that are part of the finished product, but that cannot be easily traced to it.
- Includes indirect labor costs that cannot be conveniently traced to the creation of products.
- Other examples of manufacturing overhead include: maintenance and repairs on production equipment, heat and light, property taxes, depreciation and insurance on manufacturing facilities, etc.
B. Classifications of nonmanufacturing costs (also called selling and administrative costs).
i. Selling costs – Includes all costs necessary to secure customer orders and get the finished product into the hands of the customer.
ii. Administrative costs – Includes all costs associated with the general management of an organization.
Learning Objective 2: Distinguish between product costs and period costs and give examples of each.
C. Product costs versus period costs
i. Product costs – Includes all the costs that are involved in acquiring or making a product. More specifically, it includes direct materials, direct labor, and manufacturing overhead. Product costs are expensed in the income statement when the products are sold.
- base increases, the total variable cost increases proportionally.
ii. Fixed cost − A cost that remains constant, in total, regardless of changes in the level of the activity. However, if expressed on a per unit basis, the average fixed cost per unit varies inversely with changes in activity.
- Committed fixed costs represent investments with a multi-year planning horizon that cannot be easily adjusted in the short term.
- Discretionary fixed costs usually arise from annual decisions by management and they can be easily reduced in the short term.
Helpful Hint: To illustrate fixed costs, ask students for the cost of a large pizza. Then ask: What would be the cost per student if two students buy a pizza? What if four students buy a pizza? This makes it clear why average fixed costs change on a per unit basis. To illustrate variable costs, add that a beverage costs $ and each student eating the pizza has one beverage. So, if two people were eating the pizza, the total beverage bill would come to $2; if four people, $4. The cost per beverage remains the same, but the total cost depends on the number of people ordering a beverage.
iii. The linearity assumption and the relevant range − Accountants usually assume that costs are strictly linear; however, economists point out that many costs are actually curvilinear. Nonetheless, within a narrow band of activity known as the relevant range, a curvilinear cost can be satisfactorily approximated by a straight line.
- The relevant range is that range of activity within which the assumptions made about cost behavior are valid.
iv. The relevant range of activity pertains to fixed cost as well as variable costs.
- For example, assume office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet.
- Fixed costs would increase in a step fashion at a rate of $30,000 for each additional 1, square feet.
v. The relevant range for a fixed cost is the range of activity over which the graph of the cost is flat.
vi. It is helpful to think about variable and fixed cost behavior in a 2x2 matrix.
Quick Check – variable vs. fixed costs
III. The analysis of mixed costs
a. Account analysis and the engineering approach
i. In account analysis , each account under consideration is classified as variable or fixed based on the analyst’s prior knowledge about how costs behave.
- This approach is limited in value in the sense that it glosses over the fact that some accounts may have both fixed and variable components.
ii. The engineering approach classifies costs based upon an industrial engineer’s evaluation of production methods, material specifications, labor requirements, equipment usage, power consumption, and so on.
- This approach is particularly useful when no past experience is available concerning activity and costs.
b. Diagnosing cost behavior with a scattergraph plot
Learning Objective 4: Analyze a mixed cost using a scattergraph plot and the high-low method.
i. Before analyzing a mixed cost you should plot the data on a scattergraph. For illustrative purposes, assume the following information, which would be plotted as follows:
- The maintenance cost, which is known as the dependent variable, is plotted on the Y (vertical) axis.
- The activity (hours of maintenance), which is known as the independent variable, is plotted on the X (horizontal) axis.
ii. After plotting the data, examine the dots on the scattergraph to see if they are linear, such that a straight line can be drawn that approximates the relation between cost and activity.
- If the dots are not linear, do not analyze the data any further. Instead, search for another independent variable that bears a stronger linear relationship with the dependent variable.
- In this example, the dots are linear so we can proceed to the high-low method.
c. The high-low method
i. This method can be used to analyze mixed costs if a scattergraph plot reveals a linear relationship between the X and Y variables. Let’s continue with our data from the scattergraph plot.
ii. The first step is to choose the data points pertaining to the highest and lowest activity levels (high = 850 units; low = 450 units).
- Notice, this method relies on two data points to estimate the fixed and variable portions of a mixed cost.
d. The least-squares regression method
i. This method can be used to analyze mixed costs if a scattergraph plot reveals an approximately linear relationship between the X and Y variables.
ii. This method uses all of the data points to estimate the fixed and variable cost components of a mixed cost. This method is superior to the high-low method that uses only two data points to estimate the fixed and variable cost components of a mixed cost.
iii. The basic goal of this method is to fit a straight line to the data that minimizes the sum of the squared errors. The regression errors are the vertical deviations from the data points to the regression line.
iv. The formulas that are used for least-squares regression are complex. Fortunately, computers can perform the calculations quickly. The observed values of the X and Y variables are entered into the computer and the software does the rest.
- The output from the regression analysis can be used to create an equation that enables you to estimate total costs at any activity level.
v. The high-low and least-squares regression methods provide different estimates of the fixed and variable cost components of a mixed cost. This is to be expected because each method uses
vi. differing amounts of the data points to provide estimates. Least-squares regression provides the most accurate estimates because it uses all of the data points.
IV. The contribution approach income statement
Learning Objective 5 Prepare income statements for a merchandising company using the traditional and contribution formats.
a. The traditional and contribution formats differ as follows:
i. The traditional approach separates product costs as required for external reporting purposes from selling and administrative expenses. It does not focus on cost behavior. ii. The contribution approach separates costs into fixed and variable categories. Sales − variable costs = contribution margin. The contribution margin − fixed costs = net operating income.
iii. The contribution approach is used as an internal planning and decision-making tool. For example, this approach is useful for:
- 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).
VI. Cost classifications for decision making
Learning Objective 7: Understand cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs.
A. It is important to realize that every decision involves a choice between at least two alternatives. The goal of making decisions is to identify those costs that are either relevant or irrelevant to the decision. To make decisions, it is essential to have a grasp on three concepts:
i. Differential costs (or incremental costs ) − A difference in cost between any two alternatives (a difference in revenue between two alternatives is called differential revenue ).
- Differential costs can be either fixed or variable.
ii. Opportunity cost − The potential benefit that is given up when one alternative is selected over another.
- These costs are not usually entered into the accounting records of an organization, but must be explicitly considered in all decisions.
Helpful Hint: Ask students what opportunity costs they incur by attending class. Their opportunity cost is the value to them of the activity they would be doing
otherwise (e.g., working, sleeping, partying, studying, etc.)
iii. Sunk cost − A cost that has already been incurred and that cannot be changed now or in the future.
Helpful Hint: Ask students: “Suppose you had purchased gold for $400 an ounce, but now it is selling for $250 an ounce. Should you wait for the gold to reach $400 an ounce before selling it?” Many students will say “yes” even though the $400 purchase is a sunk cost.
Quick Check − relevant costs
VII. Summary of the types of cost classifications
A. We have looked at the cost classifications used for financial reporting, predicting cost behavior, assigning costs to cost objects, and making business decisions.
