Chap 01 - Cost concepts

Chapter 1: Managerial Accounting And Cost Concepts. In This Chapter We Explain 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. Learning Objective Number 1 Is To Identify And Give Examples Of Each Of The Three Basic Manufacturing Cost Categories. Manufacturing Costs Are Usually Grouped Into Three Main Categories: Direct Materials, Direct Labor, And Manufacturing Overhead. These Costs Are Incurred To Make A Product. Direct Materials Are Raw Materials That Become An Integral Part Of The Finished Product And Whose Costs Can Be Conveniently Traced To It. Examples Include The Aircraft Engines On A Boeing 777, The Intel Processing Chip In A Personal Computer, The Blank Video Cassette In A Pre-Recorded Video, And A Radio In An Automobile. Direct Labor Consists Of That Portion Of Labor Cost That Can Be Easily Traced To A Product. Direct Labor Is Sometimes Referred To As "Touch Labor," Since It Consists Of The Costs Of Workers Who "Touch" The Product As It Is Being Made. 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). Manufacturing Overhead Includes Indirect Materials That Are Part Of The Finished Product, But That Cannot Be Easily Traced To It. 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. A Manufacturing Company Incurs Many Other Costs In Addition To Manufacturing Costs. For Financial Reporting Purposes, Most Of These Other Costs Are Typically Classified As Selling Costs And Administrative Costs. These Costs Are Also Called Selling, General, And Administrative Costs, Or SG&A. Selling And Administrative Costs Are Incurred In Both Manufacturing And Merchandising Firms. Selling Costs Include All Costs Necessary To Secure Customer Orders And Get The Finished Product Into The Hands Of The Customer. These Costs Are Also Referred To As 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. Administrative Costs Include All Executive, Organizational, And Clerical Costs Associated With The General Management Of An Organization. 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. Learning Objective Number 2 Is To Distinguish Between Product Costs And Period Costs And Give Examples Of Each. Costs Can Also Be Classified As Product Or Period Costs. Product Costs Include All The Costs That Are Involved In Acquiring Or Making A Product. More Specifically, It Includes Direct Materials, Direct Labor, And Manufacturing Overhead. Consistent With The Matching Principle, Product Costs Are Recognized As Expenses When The Products Are Sold. This Can Result In A Delay Of One Or More Periods Between The Time In Which The Cost Is Incurred And When It Appears As An Expense On The Income Statement. Product Costs Are Also Known As Inventoriable Costs. The Discussion In The Chapter Follows The Usual Interpretation Of GAAP In Which All Manufacturing Costs Are Treated As Product Costs. Period Costs Include All Selling Costs And Administrative Costs. These Costs Are Expensed On The Income Statement In The Period Incurred. All Selling And Administrative Costs Are Typically Considered To Be Period Costs. The Usual Rules Of Accrual Accounting Apply To Period Costs. For Example, Administrative Salary Costs Are "Incurred" When They Are Earned By The Employees And Not Necessarily When They Are Paid To Employees. Which Of The Following Costs Would Be Considered A Period Rather Than A Product Cost In A Manufacturing Company? Property Taxes On Corporate Headquarters And Sales Commissions Are Period Costs. All Of The Other Costs Listed Are Product Costs. Two More Cost Categories Are Often Used In Discussions Of Manufacturing Costs—Prime Cost And Conversion Cost. Prime Cost Is The Sum Of Direct Materials Cost And Direct Labor Cost. Conversion Cost Is The Sum Of Direct Labor Cost And Manufacturing Overhead Cost. The Term Conversion Cost Is Used To Describe Direct Labor And Manufacturing Overhead Because These Costs Are Incurred To Convert Materials Into The Finished Product. Learning Objective Number 3 Is To Understand Cost Behavior Patterns Including Variable Costs, Fixed Costs, And Mixed Costs. Quite Frequently, It Is Necessary To Predict How A Certain Cost Will Behave In Response To A Change In Activity. For Example, A Manager May Want To Estimate The Impact That A 5% Increase In Sales Would Have On The Company's Total Electric Bill. Cost Behavior Refers To How A Cost Will React To Changes In The Level Of Activity Within The Relevant Range. The Most Commonly Used Classifications Of Cost Behavior Are Variable And Fixed Costs. A Variable Cost Varies, In Total, In Direct Proportion To Changes In The Level Of Activity. For Example, If You Don't Have A Texting Plan On Your Cell Phone, Text Messaging Costs 5 Cents Per Text. Your Total Texting Bill Increases With The Number Of Texts You Send. Although Variable Costs Change In Total As The Activity Level Rises And Falls, Variable Cost Per Unit Is Constant. For Example, The Cost Per Text Message Sent Is Constant At 5 Cents Per Text. An Activity Base (Also Called A Cost Driver) Is A Measure Of What Causes The Incurrence Of Variable Costs. As The Level Of The Activity Base Increases, The Total Variable Cost Increases Proportionally. Units Produced (Or Sold) Is Not The Only Activity Base Within Companies. A Cost Can Be Considered Variable If It Varies With Activity Bases Such As Miles Driven, Machine-Hours, Or Labor-Hours. A Fixed Cost Is Constant Within The Relevant Range. In Other Words, Fixed Costs Do Not Change For Changes In Activity That Fall Within The "Relevant Range." For Example, Your Monthly Contract Fee For Your Cell Phone Is A Fixed Amount For A Certain Number Of Minutes. The Monthly Contract Fee Does Not Change Based On The Number Of Calls You Make. Of Course, If You Go Over Your Monthly Minutes Allotment, You Have Exceeded The Relevant Range For Your Monthly Contract And Will Be Charged Above And Beyond Your Monthly Contract Fee. However, When Expressed On A Per Unit Basis, A Fixed Cost Is Inversely Related To Activity—The Per Unit Cost Decreases When Activity Rises And Increases When Activity Falls. For Example, The Average Fixed Cost Per Cell Phone Call Made Decreases As More Calls Are Made In The Month. One Type Of Fixed Cost Is Known As Committed Fixed Costs. These Are Long-Term Fixed Costs That Cannot Be Significantly Reduced In The Short Term. Some Examples Include Depreciation On Buildings And Equipment And Real Estate Taxes On Factory Property. Another Type Of Fixed Cost Is Known As Discretionary Fixed Costs. These Fixed Costs May Be Altered In The Short-Term By Current Management Decisions. Some Examples Of Discretionary Fixed Costs Include Advertising And Research And Development Costs. A Cost May Be Discretionary Or Committed Depending Upon Management's Strategy. For Example, Some Construction Companies May Layoff Workers During Months With Minimal Customer Demand. However, Other Construction Companies May Opt To Retain Their Workers All Year. Economists Correctly Point Out That Many Costs Which Accountants Classify As Variable Costs Actually Behave In A Curvilinear Fashion. 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. 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 1,000 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. It Is Helpful To Think About Variable And Fixed Cost Behavior In A 2 By 2 Matrix, As Illustrated Here. Take A Few Minutes And Review This Summary Of Cost Behavior For Variable And Fixed Costs. Which Of The Following Costs Would Be Variable With Respect To The Number Of Cones Sold At A Baskins And Robbins Shop? (There May Be More Than One Correct Answer.) Right. The Cost Of Ice Cream And The Cost Of Napkins For Customers Would Be Variable Costs. As Baskins And Robbins Sells More Ice Cream Cones, We Would Expect The Total Cost Of Ice Cream And Napkins To Increase. Mixed Costs (Also Called Semivariable Costs) Contain Both Variable And Fixed Cost Elements. The Graph Depicts The Mixed Costs Of A Normal Utility Bill. As Illustrated In The Graph, A Utility Bill Contains A Fixed And A Variable Cost Component. The Fixed Portion Of The Utility Bill Is Constant Regardless Of Kilowatt Hours Consumed. This Cost Represents The Minimum Cost That Is Incurred To Have The Service Ready And Available For Use. The Variable Portion Of The Utility Bill Varies In Direct Proportion To The Consumption Of Kilowatt Hours. The Mixed Cost Line Can Be Expressed With The Equation Y = A + Bx. This Equation Should Look Familiar, From Your Algebra And Statistics Classes. In The Equation, Y Is The Total Mixed Cost; A Is The Total Fixed Cost (Or The Vertical Intercept Of The Line); B Is The Variable Cost Per Unit Of Activity (Or The Slope Of The Line), And X Is The Actual Level Of Activity. In Our Utility Example, Y Is The Total Mixed Cost; A Is The Total Fixed Monthly Utility Charge; B Is The Cost Per Kilowatt Hour Consumed, And X Is The Number Of Kilowatt Hours Consumed. Read Through This Short Question To See If You Can Calculate The Total Utility Bill For The Month. The Total Bill Is $100. How Did You Do? In Account Analysis, Each Account Under Consideration Is Classified As Variable And 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. The Engineering Approach Classifies Costs Based Upon An Industrial Engineer's Evaluation Of Production Methods, Materials 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. Learning Objective Number 4 Is To Analyze A Mixed Cost Using A Scattergraph Plot And The High-Low Method. The High-Low Method Can Be Used To Analyze Mixed Costs If A Scattergraph Plot Reveals A Linear Relationship Between The X And Y Variables. For Illustrative Purposes, Assume The Information Regarding Hours Of Maintenance Work And The Total Maintenance Costs For Six Months As Shown On This Slide. A Scattergraph Plot (Also Called The Quick-And-Dirty Method) Is A Quick And Easy Way To Isolate The Fixed And Variable Components Of A Mixed Cost. The First Step When Using This Method To Analyze A Mixed Cost Is To Plot The Data On The Scattergraph. The Cost, Which Is Known As The Dependent Variable, Is Plotted On The Y (Vertical) Axis. The Activity, Which Is Known As The Independent Variable, Is Plotted On The X (Horizontal) Axis. The Second Step Is To 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. If There Does Appear To Be A Linear Relationship Between The Level Of Activity And Cost, We Will Continue Our Analysis. The First Step Is To Choose The Data Points Pertaining To The Highest And Lowest Activity Levels. In This Case, The High Level Of Activity Was In June At 850 Hours Of Maintenance And The Low Level Of Activity Is In February With 450 Hours Of Maintenance. Notice That This Method Relies Upon Two Data Points To Estimate The Fixed And Variable Portions Of A Mixed Cost, As Opposed To One Data Point With The Scattergraph Method. The Second Step Is To Determine The Total Costs Associated With The Two Chosen Points. We Incurred Costs Of $9,800 At The High Level Of Activity And $7,400 At The Low Level Of Activity. The Third Step Is To Calculate The Change In Cost Between The Two Data Points. The Change In Maintenance Hours Was 400 Hours And The Change In Maintenance Dollars Was $2,400. Notice, This Method Relies Upon Two Data Points To Estimate The Fixed And Variable Portions Of A Mixed Cost, As Opposed To One Data Point With The Scattergraph Method. For This Example, We Divide $2,400 By 400 And Determine That The Variable Cost Per Hour Of Maintenance Is $6.00. The Fourth Step Is To Take The Total Cost At Either Activity Level (In This Case, $9,800). Deduct The Variable Cost Component ($6 Per Hour Times 850 Hours) For The Total Cost Of $5,100. The Difference Represents The Estimate Of Total Fixed Costs ($4,700). The Fifth Step Is To Construct An Equation That Can Be Used To Estimate The Total Cost At Any Activity Level (Y = $4,700 + $6.00X). The Basic Equation Of Y Is Equal To $4,700 (The Total Fixed Cost) Plus $6 Times The Actual Level Of Activity. You Can Verify The Equation By Calculating Total Maintenance Costs At 450 Hours, The Low Level Of Activity. It Will Be Worth Your Time To Make The Calculation. See If You Can Apply What We Have Just Discussed To Determine The Variable Portion Of Sales Salaries And Commissions For This Company. The Correct Answer Is Variable Sales Salaries And Commission Costs Of 10 Cents Per Unit. Using The Same Data, Calculate The Total Fixed Cost Portion Of Sales Salaries And Commissions. The Calculation Of The Answer Is A Bit More Complex, But We See That Total Fixed Cost Equals $2,000. This Method Can Be Used To Analyze Mixed Costs If A Scattergraph Plot Reveals An Approximately Linear Relationship Between The X And Y Variables. The Least-Squares Regression Method Is A More Sophisticated Approach To Isolating The Fixed And Variable Portion Of A Mixed Cost. 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 Scattergraph Plot Method That Relies Upon Only One Data Point And The High-Low Method That Uses Only Two Data Points To Estimate The Fixed And Variable Cost Components Of A Mixed Cost. 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. The Formulas That Are Used For Least-Squares Regression Are Complex. Fortunately, Computer Software Can Perform The Calculations Quickly. The Observed Values Of The X And Y Variables Are Entered Into The Computer Program And All Necessary Calculations Are Made. The Output From The Regression Analysis Can Be Used To Create An Equation That Enables You To Estimate Total Costs At Any Activity Level. The Key Statistic To Look At When Evaluating Regression Results Is Called R Squared, Which Is A Measure Of The "Goodness Of Fit." In The Appendix To This Chapter, We Show You How To Use Microsoft Excel To Complete A Least-Squares Regression Analysis. The Three Methods Just Discussed Provide Slightly Different Estimates Of The Fixed And Variable Portions Of A Mixed Cost. This Is To Be Expected Because Each Method Uses 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. Learning Objective Number 5 Is To Prepare Income Statements For A Merchandising Company Using The Traditional And Contribution Formats. The Contribution Format Allocates Costs Based On Cost Behavior. The Contribution Approach Differs From The Traditional Approach Illustrated In An Earlier Chapter. The Traditional Approach Organizes Costs In A Functional Format. Costs Relating To Production, Administration, And Sales Are Grouped Together Without Regard To Their Cost Behavior. The Traditional Approach Is Used Primarily For External Reporting Purposes. This Approach Is Used As An Internal Planning And Decision-Making Tool. For Example, This Approach Is Useful For And Discussed Further In Cost-Volume-Profit Analysis (Chapter 5), Budgeting (Chapter 7), Segmented Reporting Of Profit Data (Chapter 6), Special Decisions Such As Pricing And Make Or Buy Analysis (Chapter 10). Learning Objective Number 6 Is To Understand The Differences Between Direct And Indirect Costs. A Cost Object Is Anything For Which Cost Data Are Desired Including Products, Customers, Jobs, Organizational Subunits, Etc. For Purposes Of Assigning Costs To Cost Objects, Costs Are Classified Two Ways: Direct Costs Are Costs That Can Be Easily And Conveniently Traced To A Specified Cost Object. Examples Of Direct Costs Are Direct Material And Direct Labor. Indirect Costs Are Costs That Cannot Be Easily And Conveniently Traced To A Specified Cost Object. An Example Of An Indirect Cost Is Manufacturing Overhead. Common Costs Are Indirect Costs Incurred To Support A Number Of Cost Objects. These Costs Cannot Be Traced To Any Individual Cost Object. Learning Objective Number 7 Is To Understand Cost Classifications Used In Making Decisions: Differential Costs, Opportunity Costs, And Sunk Costs. 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. Costs And Benefits That Differ Between Alternatives Are Relevant In A Decision. All Other Costs And Benefits Are Irrelevant And Can And Should Be Ignored. To Make Decisions, It Is Essential To Have A Grasp On Three Concepts: Differential Costs, Opportunity Costs, And Sunk Costs. Differential Costs (Or Incremental Costs) Is A Difference In Cost Between Any Two Alternatives. Differential Costs Can Be Either Fixed Or Variable. A Difference In Revenue Between Two Alternatives Is Called Differential Revenue. For Example, Assume You Have A Job Paying $1,500 Per Month In Your Hometown. You Have A Job Offer In A Neighboring City That Pays $2,000 Per Month. The Commuting Cost To The City Is $300 Per Month. In This Example, The Differential Revenue Is $500 And The Differential Cost Is $300. Opportunity Cost Is 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. A Sunk Cost Is A Cost That Has Already Been Incurred And That Cannot Be Changed By Any Decision Made Now Or In The Future. Since Sunk Costs Cannot Be Changed And Therefore Cannot Be Differential Costs, They Should Be Ignored In Decision Making. While Students Usually Accept The Idea That Sunk Costs Should Be Ignored On An Abstract Level, Like Most People, They Often Have Difficulty Putting This Idea Into Practice. Take A Minute And Read The Information On This Slide. Should The Cost Of The Train Ticket Affect The Decision Of Whether You Drive Or Take The Train To Portland? Yes, It Should Because The Cost Of The Train Ticket Is Relevant. Take A Minute And Read The Information On This Slide. Is The Annual Cost Of Licensing Your Car Relevant In This Decision? No, It Is Not Because The Licensing Cost Is Not Relevant. Suppose That Your Car Could Be Sold Now For $5,000. Is This A Sunk Cost? No, It Is Not A Sunk Cost. We Have Looked At The Cost Classifications Used For Financial Reporting, Predicting Cost Behavior, Assigning Costs To Cost Objects, And Making Business Decisions. Now, Let's Look At How To Classify Idle Time, Overtime, And Fringe Benefits.