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Managerial Accounting and Cost

Concepts
Chapter 2

Chapter 2: 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.
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Manufacturing vs.
Nonmanufacturing costs
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Classifications of Manufacturing Costs

Direct Direct Manufacturing

Materials Labor Overhead

The Product

Manufacturing costs are usually grouped into three main categories: direct
materials, direct labor, and manufacturing overhead. These costs are incurred to
make a product.
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Direct Materials
Materials that become an integral part
of the product and that can be
conveniently traced directly to it.

Example: A radio installed in an automobile

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.
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Direct Labor

Those labor costs that can be easily

traced to individual units of product.

Example: Wages paid to automobile assembly workers

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.
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Manufacturing Overhead
• Also called indirect manufacturing costs,
factory overhead, and factory burden.

• It is manufacturing costs that cannot be

easily traced directly to specific units
produced. It includes all manufacturing costs
except direct materials and direct labor.
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Manufacturing Overhead
Examples: Indirect materials and indirect labor

Materials used to support Wages paid to employees

the production process. who are not directly involved
in production work.
E.g. lubricants and cleaning
supplies used in the
automobile assembly plant. E.g. production supervisors,
material handlers, maintenance
workers, and security guards.

Also includes: Maintenance on production equipment,

manufacturing property taxes, heat and light for the
manufacturing facility, depreciation and insurance on
manufacturing facility.
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Nonmanufacturing Costs
Called selling, general and administrative costs (SG&A).

1.Selling costs: also called order getting and order filling

costs. It includes all costs incurred to secure the
customer order and deliver the finished product. E.g.
advertising, shipping, sales commissions, cost of
warehousing.

2. Administrative costs: all costs associated with the

general management of an organization rather than
manufacturing or selling. E.g. executive compensations,
general accounting, public relations, and other general
costs associated with the organization as a whole.

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.
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Matching Principle of Financial Accounting

Costs incurred to generate a particular

revenue should be recognized as
expenses in the same period that the
revenue is recognized. (costs are
recognized as expenses on the income
statement in the period that benefits from
the cost)
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Product Costs Versus Period Costs

Product costs include Period costs include all

direct materials, direct selling costs and
labor, and administrative costs.
manufacturing
overhead.

Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement

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.
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Product Costs
• Product costs are attached to inventory accounts in the
balance sheet (Assets). The costs are released from the
account as expenses to the income statement in the
period the goods are sold.

• Product costs are also called inventoriable costs.

• So, product costs are not treated as expenses in the

period in which they are incurred (they remain as
assets), and then become expenses in the period the
products are sold.
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Manufacturing costs are often

classified as follows:
Direct Direct Manufacturing
Material Labor Overhead

Prime Conversion
Cost Cost

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.
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Cost Classification for Cost

Allocating
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Assigning Costs to Cost Objects

Direct costs Indirect costs
• Costs that can be • Costs that cannot
easily and be easily and
conveniently traced conveniently traced
to a unit of product to a unit of product
or other cost object. or other cost object.
• Examples: direct • Example:
material and direct manufacturing
labor overhead

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:

1. 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.

2. 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.
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Cost Classification for predicting

Cost behavior
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Cost Classifications for Predicting Cost

Behavior

Cost behavior refers to how a cost will react to

changes in the level of activity. The most
common classifications are:
▫ Variable costs.
▫ Fixed costs
▫ Mixed costs.

The relative proportion of each type of cost in an

organization is known as its cost structure.

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.
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Variable Cost varies in total in direct proportion to

the level of activity. (Variable cost is constant if
expressed on a per unit basis)

E.g. direct materials, direct labor, variable elements of

manufacturing overheads (indirect material, supplies,
and power), variable elements of selling and
administration expenses (commissions, shipping costs).

Activity base or cost driver is a measure of whatever

causes the occurrence of a variable cost. (e.g. direct
labor hours, machine hours, units produced, units sold,
# of miles driven by sales persons…etc)
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Fixed Cost is a cost that remains constant,

in total, regardless of changes in the level
of activity, over a relevant range.

E.g. straight line depreciation, insurance,

property taxes, rents, administrative
salaries, advertising..

The average fixed cost per unit becomes

progressively smaller as the level of
activity increases.
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Fixed Costs and the Relevant Range

Rent Cost in Thousands 90

The relevant range
Relevant of activity for a fixed
of Dollars

60 cost is the range of

Range activity over which
the graph of the
cost is flat.
30

0
0 1,000 2,000 3,000
Rented Area (Square Feet)
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Types of Fixed Costs

Committed Discretionary
Long-term (multiyear), (managed fixed costs)
cannot be significantly May be altered in the
reduced in the short short-term(annually) by
term. current managerial
decisions

Examples Examples
Depreciation on Buildings Advertising and
and Equipment and Real Research and
Estate Taxes Development

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.
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Cost Classifications for Predicting Cost

Behavior

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost Increase Variable cost per unit

and decrease in proportion remains constant.
to changes in the activity level.
Fixed Total fixed cost is not affected Fixed cost per unit decreases
by changes in the activity as the activity level rises and
level within the relevant range. increases as the activity level falls.
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Mixed Costs
(also called semivariable costs)
A mixed cost contains both variable and fixed
elements.
Y
Total Utility Cost

Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours) Utility rent

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.
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Mixed Costs
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
Y
b = The variable cost per unit of
Total Utility Cost

activity (the slope of the line).

X = The level of activity.

Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours) Utility rent

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.
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An Example
XXX hospital wants to predict future monthly maintenance
costs. Management believes that it is a mixed cost and
the cost driver is the number of patient days.

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.
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Diagnosing the behavior with a scatter

graph plot
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If the management is interested in the relation between the hospital

telephone costs and patient days.
Patients are billed directly for their use of telephone, so those costs do
not appear on the hospital’s costs records.
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If the management is
interested in the
relation between
total nursing wages
and patient days.
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High-low Method

This method can be used to analyze mixed costs if a scattergraph plot reveals an
approximately linear relationship between the X and Y variables.
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Least Squares Regression Method

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
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.
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Comparing Results From

the Two Methods
The two methods provide different estimates of
the fixed and variable cost components 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 more
accurate estimate because it uses all the data
points.
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The Traditional and Contribution Formats

Used primarily for Used primarily by

external reporting. management.

The contribution format allocates costs based on cost behavior. The contribution approach
differs from the traditional approach

The traditional approach organizes costs in a functional format. Costs relating to

manufacturing are grouped alone, while administration, and sales are grouped together
without regard to their cost behavior. The traditional approach is used primarily for external
reporting purposes.
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Cost Classifications for Decision Making

• 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 should be ignored
(irrelevant)

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.
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Differential Cost and differential Revenue

Costs and revenues that differ

among alternatives.
Example: 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 transportation
cost to the city is $300 per month.

Differential revenue is: Differential (incremental)

$2,000 – $1,500 = $500 cost is:
$300

Differential costs (or incremental costs) is the 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.
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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

These costs should be considered in

decision making.
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Sunk Costs

Sunk costs have already been incurred

and cannot be changed now or in the
future.

These costs should be ignored when

making 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.