Managerial Accounting and Cost Concept cost and activity can be represented by a

straight line, then the slope of the straight line

Continuation
is equal to the variable cost per unit of activity.
Lesson Proper:
To analyze mixed costs with the high-low
THE ANALYSIS OF MIXED COSTS method, begin by identifying the period with the
lowest level of activity and the period with the
Mixed costs are very common. For example, highest level of activity. The period with the
the overall cost of providing X-ray services to lowest activity is selected as the first point in
patients at the Harvard Medical School the above formula and the period with the
Hospital is a mixed cost. The costs of highest activity is selected as the second point.
equipment depreciation and radiologists’ and Consequently, this formula can be used:
technicians’ salaries are fixed, but the costs of
X-ray film, power, and supplies are variable. At
Southwest Airlines, maintenance costs are a Variable Cost = Cost of High Level activity – Cost
mixed cost. The company incurs fixed costs for of Low level activity
renting maintenance facilities and for keeping High activity level – Low activity level
skilled mechanics on the payroll, but the costs
Or
of replacement parts, lubricating oils, tires, and
so forth, are variable with respect to how often
Variable Cost = Change in cost
and how far the company’s aircraft are flown.
Change in activity
The fixed portion of a mixed cost represents
the minimum cost of having a service ready
and available for use. The variable portion
represents the cost incurred for actual Therefore, when the high-low method is used,
consumption of the service, thus it varies in the variable cost is estimated by dividing the
proportion to the amount of service actually difference in cost between the high and low
consumed. levels of activity by the change in activity
Managers can use a variety of methods to between those two points.
estimate the fixed and variable components of To illustrate, we use the Brentline Hospital
a mixed cost such as account analysis, the example, using the high-low method, we first
engineering approach, the high-low method, identify the periods with the highest and lowest
and Ieast-squares regression analysis. In activity-in this case, June and March.
account analysis, an account is classified as
Month Activity level: Maintenance Cost
either variable or fixed based on the analyst’s
Patient-Days Incurred
prior knowledge of how the cost in the account January 5600 $7,900
behaves. For example, direct materials would February 7,100 $8,500
be classified as variable and a building lease March 5,000 $7,400
cost would be classified as fixed because of April 6,500 $8,200
the nature of those costs. The engineering May 7,300 $9,100
approach to cost analysis involves a detailed June 8,000 $9,800
analysis of what cost behavior should be, July 6,200 $7,800
based on an industrial engineer’s evaluation of
the production methods to be used, the We then use the activity and cost data from
materials specifications, labor requirements, these two periods to estimate the variable cost
equipment usage, production efficiency, power component as follows:
consumption, and so on.
Month Patient- Maintenance Cost
For purposes of our discussion, we will just Days Incurred
focus on the high-low method. High activity level (June) 8000 $ 9800
The High-Low Method Low activity level (March) 5000 7400
Change 3000 $ 2400
The high-low method is based on the rise-over-
run formula: for the slope of a straight line. As
previously discussed, if the relation between
 Exhibit 1-7 High-Low Method of Cost Analysis
Variable Cost = Change in cost
                          Change in activity

= $ 2,400
3000 patient-days
= $0.80 per patient-day

Having determined that the variable

maintenance cost is 80 cents per patient-day,
we can now determine the amount of fixed
cost. This is done by taking the total cost at
either the high or the low activity level and
deducting the variable cost element. In the
computation below, total cost at the high Sometimes the high and low levels of activity
activity level is used in computing the fixed don’t coincide with the high and low amounts
cost element: of cost. For example, the period that has the
highest level of activity may not have the
highest amount of cost. Nevertheless, the
Fixed cost element =  Total cost  - Variable costs at the highest and lowest levels of
cost element activity are always used to analyze a mixed
= 9,800−(0.80 per cost under the high-low method. The reason is
that the analyst would like to use data that
patient-day X 8,000
reflect the greatest possible variation in
patient-days)
activity.
= $3,400
The high-low method is very simple to apply,
but it suffers from a major (and sometimes
critical) defect-it utilizes only two data points.
Generally, two data points are not enough to
Both the variable and fixed cost elements have produce accurate results. Additionally, the
now been isolated. The cost of maintenance periods with the highest and lowest activity
can be expressed as $3,400 per month plus 80 tend to be unusual. A cost formula that is
cents per patient-day, or as estimated solely using data from these unusual
Y = 3,400+0.80X periods may misrepresent the true cost
behavior during normal periods. Such a
The data used in this illustration are shown distortion is evident in Exhibit 1-7.The straight
graphically in Exhibit 1-7. Notice that a straight line should probably be shifted down
line has been drawn through the points somewhat so that it is closer to more of the
corresponding to the low and high levels of data points. For these reasons, least-squares
activity. In essence, that is what the high-low regression will generally be more accurate
method does-it draws a straight line through than the high-low method.
those two points.
TRADITIONAL AND CONTRIBUTION
FORMAT INCOME STATEMENTS
In this section, we discuss how to prepare
traditional and contribution format income
statements for a merchandising company.
Merchandising companies do not manufacture
the products that they sell to customers. For
example, Lowe’s and Home Depot are
merchandising companies because they buy
finished products from manufacturers and then
resell them to end consumers.
  The Traditional Format Income Statement The cost of goods sold reports the product
costs attached to the merchandise sold during
the period. The selling and administrative
Cost
Beginning expenses report all period costs that have
of Ending
merchandis Purchases been expensed as incurred. The cost of goods
Good merchandis
e inventory - sold for a merchandising company can be
s Sold e inventory
+ computed directly by multiplying the number of
=
units sold by their unit cost or indirectly using
the equation below:
Traditional income statements are prepared
primarily for external reporting purposes. The
For example, let’s assume that the company
left-hand side of Exhibit 1-9 shows a traditional
income statement format for merchandising depicted in Exhibit 1-9 purchased 3,000 of
companies. This type of income statement merchandise inventory during the period
organizes costs into two categories cost of and had beginning and ending merchandise
goods sold and selling and administrative inventory balances of 7,000 and $4,000,
expenses. Sales minus cost of goods sold respectively. The equation above could be
equals the gross margin. The gross margin used to compute the cost of goods sold as
minus selling and administrative expenses follows:
equals net Operating income.
Cost Beginning Purchases- Ending
Exhibit 1-9 Comparing Traditional and
of merchandise merchandise
Contribution Format Income Statement for
Goods inventory + inventory
Merchandising Companies
Sold =
Traditional Format = $7000 + $3000 - $4000
Sales $12,000 = $6000
Cost of Goods 6,000
Sold
Gross Margin 6,000 Although the traditional income statement is
Selling and useful for external reporting purposes, it has
Administrative serious limitations when used for internal
Expenses: purposes. It does not distinguish between fixed
Selling $3,100 and variable costs. For example, under the
Administrative 1,900 5,000 heading “Selling and administrative expenses,”
Net Operating $ 1,000 both variable administrative costs ( 400) and
Income fixed administrative costs (1,500) are lumped
together ($1,900). Internally, managers need
cost data organized by cost behavior to aid in
Contribution Format planning, controlling, and decision making. The
Sales $12,000 contribution format income statement has been
Variable Expenses: developed in response to these needs.
Cost of goods $6,000
sold The Contribution Format Income Statement
Variable Selling 600 The crucial distinction between fixed
Variable 400 7,000 and variable costs is at the heart of the
Administrative contribution approach to constructing income
Contribution Margin 5,000 statements. The unique thing about the
Fixed Expenses: contribution approach is that it provides
Fixed Selling $2,500 managers with an income statement that
Fixed 1,500 4,000 clearly distinguishes between fixed and
Administrative variable costs and therefore aids planning,
Net Operating $1,000 controlling, and decision making. The right-
Income hand side of Exhibit 1-9 shows a contribution
format income statement for merchandising
companies.
The contribution approach separates costs into The accountant’s differential cost concept can
fixed and variable categories, first deducting be compared to the economist’s marginal cost
variable expenses from sales to obtain the concept. In speaking of changes in cost and
contribution margin. For a merchandising revenue, the economist uses the terms
company, cost of goods sold is a variable cost marginal cost and marginal revenue. The
that gets included in the “Variable expenses” revenue that can be obtained from selling one
portion of the contribution format income more unit of product is called marginal
statement. The contribution margin is the revenue, and the cost involved in producing
amount remaining from sales revenues after one more unit of product is called marginal
variable expenses have been deducted. This cost. The economist’s marginal concept is
amount contributes toward covering fixed basically the same as the accountant’s
expenses and then toward profits for the differential concept applied to a single unit of
period. output.
The contribution format income statement is Differential costs can be either fixed or
used as an internal planning and decision variable. To illustrate, assume that Natural
making tool. Its emphasis on cost behavior Cosmetics, Inc., is thinking about changing its
aids cost-volume-profit analysis (such as we marketing method from distribution through
shall be doing in a subsequent chapter), retailers to distribution by a network of
management performance appraisals, and neighbourhood sales representatives. Present
budgeting. Moreover, the contribution costs and revenues are compared to projected
approach helps managers organize data costs and revenues in the following table:
pertinent to numerous decisions such as
product-line analysis, pricing, use of scarce
resources, and make or buy analysis. All of Retailer Sales Differential
these topics are covered in later chapters. Distribution Representatives Costs and
(present) (present) Revenues
COST CLASSIFICATIONS FOR DECISION Sales $700,000 $800,000 $100,000
MAKING (variables)
Cost of 350,000 400,000 50,000
Costs are an important feature of many goods sold
business decisions. In making decisions, it is (variable)
essential to have a firm grasp of the concepts Advertising 80,000 45,000 (35,000)
differential cost, opportunity cost, and sunk (fixed)
cost. Commission 0 40,000 40,000
s (variable)
Differential Cost and Revenue Warehouse 50,000 80,000 30,000
Depreciation
Decisions involve choosing between (fixed)
alternatives. In business decisions, each Other 60,000 60,000 0
alternative will have costs and benefits that Expenses
must be compared to the costs and benefits of (fixed)
the other available alternatives. A difference in Total 540,000 652,000 85,000
costs between any two alternatives is known Expenses
as a differential cost. A difference in revenues Net $ 160,000 $ 175,000 $ 15,000
Operating
(usually just sales) between any two
Income
alternatives is known as differential revenue.
According to theabove analysis, the
A differential cost is also known as an
incremental cost, although technically an differential is 100,000 and the
revenue
incremental cost should refer only to an differential costs total 85, 000, leaving a
increase in cost from one alternative to positive differential net operating income of
another; decreases in cost should be referred $15,000 in favor of using sales
to as decremental costs. Differential cost is a representatives.
broader term, encompassing both cost
In general, only the differences between
increases (incremental costs) and cost
alternatives are relevant in decisions. Those
decreases (decremental costs) between
items that are the same under all alternatives
alternatives.
and that are not affected by the decision can
be ignored. For example, in the Natural
Cosmetics, Inc., example above, the “Other
expenses” category, which is 60,000 under
both alternatives can be ignored because it
has no effect on the decision If it were
removed from the calculations the sales
representatives would still be preferred by
15, 000. This is an extremely important
principle in management accounting that we
will revisit in later chapters.
 
Opportunity Cost and Sunk Cost
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.
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. 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.
To illustrate a sunk cost, assume that a
company paid 50,000 several years ago for a
special purpose machine. The machine was
used to make a product that is now obsolete
and is no longer being sold. Even though in
hind sight purchasing the machine may have
been unwise the 50,000 cost has already
been incurred and cannot be undone. And it
would be folly to continue making the obsolete
product in a misguided attempt to “recover” the
original cost of the machine. In short, the
$50,000 originally paid for the machine is a
sunk cost that should be ignored in current
decisions.