chapter 2 · mcgraw-hill/irwin © the mcgraw-hill companies, inc., 2003 direct materials those...

Cost Terms, Concepts,

and Classifications

Chapter 2

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Comparing Merchandising

and Manufacturing Activities

Merchandisers . . .

Buy finished

goods.

Sell finished goods.

Manufacturers . . .

Buy raw materials.

Produce and sell

finished goods.

MegaLoMart


The Product

Direct

Materials

Direct

Labor

Manufacturing

Overhead

Manufacturing Costs


Direct Materials

Those 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 Labor

Those labor costs that can be easily traced to individual units of product.

Example: Wages paid to automobile assembly workers


I do not like getting my temperature taken by the vet!


Manufacturing costs that cannot be traced directly to specific units produced.

Manufacturing Overhead

Examples: Indirect labor and indirect materials

Wages paid to employees who are not directly

involved in production work.

Examples: maintenance workers, janitors and

security guards.

Materials used to support the production process.

Examples: lubricants and

cleaning supplies used in the automobile assembly plant.


Classifications of Costs

Direct

Material

Direct

Labor

Manufacturing

Overhead

Prime

Cost

Conversion

Cost

Manufacturing costs are often classified as follows:


Nonmanufacturing Costs

Marketing and

Selling Cost

Costs necessary to get the

order and deliver the

product.

Administrative

Cost

All executive,

organizational, and

clerical costs.


Quick Check

Which of the following costs would be

considered manufacturing overhead at Boeing?

(More than one answer may be correct.)

A. Depreciation on factory forklift trucks.

B. Sales commissions.

C. The cost of a flight recorder in a Boeing 767.

D. The wages of a production shift supervisor.


Product Costs Versus Period

Costs

Product costs include

direct materials, direct

labor, and

manufacturing

overhead.

Period costs are not

included in product

costs. They are

expensed on the

income statement. Inventory Cost of Good Sold

Balance

Sheet

Income

Statement

Sale

Expense

Income

Statement


For Your Consideration …

Take a look at Review Problems 1 & 2

on pages 48 and 49.


Cost Classifications for

Predicting Cost Behavior

How a cost will react to changes in the level of

business activity.

Total variable costs change when activity changes.

Total fixed costs remain unchanged when activity changes.


Total Variable Cost

Your total long distance telephone bill

is based on how many minutes you talk.

Minutes Talked

Tota

l Long D

ista

nce

Tele

ph

one

Bill


Variable Cost Per Unit

Minutes Talked

Per

Min

ute

Tele

ph

one

Charg

e

The cost per long distance minute talked is

constant. For example, 10 cents per minute.


Total Fixed Cost

Your monthly basic telephone bill probably does not change when you make more local

calls.

Number of Local Calls

Month

ly B

asic

Tele

ph

one

Bill


Fixed Cost Per Unit

Number of Local Calls

Mo

nth

ly B

asic

Te

lep

ho

ne

Bill

per

Lo

ca

l C

all

The average cost per local call decreases as

more local calls are made.


Cost Classifications for

Predicting Cost Behavior

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remains

as activity level changes. the same over wide ranges

of activity.

Fixed Total fixed cost remains Fixed cost per unit goes

the same even when the down as activity level goes up.

activity level changes.


Cost Behavior

Merchandisers

Cost of Goods Sold

Manufacturers

Direct Material, Direct Labor, and Variable

Manufacturing Overhead

Merchandisers and Manufacturers

Sales commissions and shipping costs

Service Organizations

Supplies and travel

Examples of normally variable costs

Examples of normally fixed costs

Merchandisers, manufacturers, and service organizations

Real estate taxes, Insurance, Sales salaries Depreciation, Advertising


Examples

Advertising and Research and Development

Examples

Depreciation on Buildings and

Equipment

Types of Fixed Costs

Discretionary

May be altered in the short-term by current managerial decisions

Committed

Long-term, cannot be reduced in the short

term.


Example: Office space is

available at a rental rate

of $30,000 per year in

increments of 1,000

square feet. As the

business grows more

space is rented,

increasing the total cost.

Fixed Costs and Relevant

Range

Continue


Ren

t C

ost

in

Th

ou

san

ds o

f D

oll

ars

0 1,000 2,000 3,000

Rented Area (Square Feet)

0

30

60


Range

90

Relevant

Range

Total cost doesn’t

change for a wide

range of activity,

and then jumps to a

new higher cost for

the next higher

range of activity.

Exh.

5-6


How does this type

of fixed cost differ

from a step-variable

cost?

Step-variable costs can be adjusted more

quickly and . . .

The width of the activity steps is much

wider for the fixed cost.


Range


Fixed Monthly

Utility Charge

Variable

Cost per KW

Activity (Kilowatt

Hours)

To

tal U

tili

ty C

ost

X

Y

A mixed cost has both fixed and variable

components. Consider the example of utility cost.

Mixed Costs


Fixed Monthly

Utility Charge

Variable

Cost per KW

Activity (Kilowatt

Hours)

To

tal U

tili

ty C

ost

X

Y

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 (the

vertical intercept of the line)

b = the variable cost per unit of

activity (the slope of the line)

X = the level of activity


The Analysis of Mixed Costs

Engineering Approach

Account Analysis

High-Low Method

Least-Square Regression Method

Scattergraph Plot


Account Analysis &

Engineering Estimates

Each account is classified as either

variable or fixed based on the analyst’s

knowledge of how the account behaves.

Cost estimates are based on an

evaluation of production methods,

and material, labor and overhead

requirements.


Plot the data points on a

graph (total cost vs. activity).

0 1 2 3 4

*

To

tal C

os

t in

1,0

00’s

of

Do

llars

10

20

0

* * *

* *

* *

*

*

Activity, 1,000’s of Units Produced

X

Y

The Scattergraph Method


0 1 2 3 4

*

To

tal C

os

t in

1,0

00’s

of

Do

llars

10

20

0

* * *

* *

* *

*

*


X

Y

Quick-and-Dirty Method

Intercept is the estimated

fixed cost = $10,000

Draw a line through the data points with about an

equal numbers of points above and below the line.


0 1 2 3 4

*

To

tal C

os

t in

1,0

00’s

of

Do

llars

10

20

0

* * *

* *

* *

*

*


X

Y

Quick-and-Dirty Method The slope is the estimated variable cost per unit.

Slope = Change in cost ÷ Change in units

Vertical distance is

the change in cost.

Horizontal

distance is

the change in

activity.


WiseCo recorded the following production activity and maintenance costs for two months:

Using these two levels of activity, compute:

• the variable cost per unit; • the fixed cost; and then • express the costs in equation form Y = a + bX.

The High-Low Method

Units Cost

High activity level 8,000 9,800$

Low activity level 5,000 7,400

Change 3,000 2,400$


Changein cost

Change in units

The High-Low Method

Variable cost per unit = Change in cost ÷ change in units

Units Cost



Change 3,000 2,400$


The High-Low Method

Variable cost per unit = $2,400 ÷ 3,000 units

= $0.80 per unit

Units Cost



Change 3,000 2,400$


The High-Low Method

Variable cost = $2,400 ÷ 3,000 units = $0.80 per unit

Fixed cost = Total cost – Total variable cost

Fixed cost = $9,800 – ($0.80 per unit × 8,000 units)

Fixed cost = $9,800 – $6,400 = $3,400

Units Cost



Change 3,000 2,400$


Variable cost = $2,400 ÷ 3,000 units = $0.80 per unit

Fixed cost = Total cost – Total variable cost

Fixed cost = $9,800 – ($0.80 per unit × 8,000 units)

Fixed cost = $9,800 – $6,400 = $3,400

Total cost = Fixed cost + Variable cost (Y = a + bX)

Y = $3,400 + $0.80X

The High-Low Method

Units Cost



Change 3,000 2,400$


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

Method

Least-squares regression also provides a statistic,

called the R2, that is a measure of the goodness

of fit of the regression line to the data points.


0 1 2 3 4

To

tal C

ost

10

20

0

Activity

*

* * *

* *

* * * *

Least-Squares Regression

Method

R2 is the percentage of the variation in total cost

explained by the activity.

R2 for this relationship is near

100% since the data points are

very close to the regression line.

X

Y


Cost Estimation Methods

Regression Analysis

A statistical method used to create an equation

relating independent (or X) variables to dependent

(or Y) variables.

Past data is used to estimate relationships

between costs and activities.

Dependent variables are

caused by the

independent variables.

Independent variables

are the cost drivers that

are correlated with the

dependent variables.


Hey, Ed !

Remember who received a

mid-semester deficiency

in statistics in 1972 and 1973!


Caution: Before doing

the analysis, take time

to determine if a

logical relationship

between the variables

exists.

Cost Estimation Methods

Regression Analysis

The simple cost model is actually a

regression model:

TC = F + VX

This model will only

be useful within a

relevant range of

activity.


Direct Costs and Indirect

Costs

Direct costs

Costs that can be easily and conveniently traced to a unit of product or other cost objective.

Examples: direct material and direct labor

Indirect costs

Costs cannot be easily and conveniently traced to a unit of product or other cost object.

Example: manufacturing overhead


Differential Costs and

Revenues

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 commuting cost

to the city is $300 per month.

Differential revenue is:

$2,000 – $1,500 = $500

Differential cost is:

$300


Quick Check

Suppose you are trying to decide whether to

drive or take the train to Portland to attend a

concert. You have ample cash to do either, but

you don’t want to waste money needlessly. Is

the cost of the pizza you ate last night relevant

in this decision? In other words, should the cost

of the pizza affect the decision of whether you

drive or take the train to Portland?

A. Yes, the cost of the pizza is relevant.

B. No, the cost of the pizza is not relevant.


Quick Check

Suppose you are trying to decide whether to

drive or take the train to Portland to attend a

concert. You have ample cash to do either, but

you don’t want to waste money needlessly. Is

the cost of the train ticket relevant in this

decision? In other words, should the cost of the

train ticket affect the decision of whether you

drive or take the train to Portland?

A. Yes, the cost of the train ticket is relevant.

B. No, the cost of the train ticket is not relevant.


Opportunity Costs

The potential benefit that is

given up when one alternative

is selected over another.

Example: If you were

not attending college,

you could be earning

$15,000 per year.

Your opportunity cost

of attending college for

one year is $15,000.


Sunk Costs

Sunk costs cannot be changed by any decision. They are not differential costs and should be

ignored when making decisions.

Example: You bought an automobile that cost

$10,000 two years ago. The $10,000 cost is

sunk because whether you drive it, park it, trade

it, or sell it, you cannot change the $10,000 cost.


Further Classification of Labor

Costs

Idle Time

Treated as

manufacturing

overhead cost

Overtime

Premium of

Factory Workers

Treated as

manufacturing

overhead cost

Labor Fringe

Benefits

Treated as indirect

labor or direct labor


Further Classification of Labor

Costs

Idle Time

Treated as

manufacturing

overhead cost

Overtime

Premium of

Factory Workers

Treated as

manufacturing

overhead cost

Labor Fringe BenefitsDiscovery Channel :: Video :: "Best Of"

Moments

Treated as indirect

labor or direct labor

http://media.dsc.discovery.com/fansites/amchopper/videogalleries/bestof/bestof.html

http://media.dsc.discovery.com/fansites/amchopper/videogalleries/bestof/bestof.html


The Contribution Format

Total Unit

Sales Revenue 100,000$ 50$

Less: Variable costs 60,000 30

Contribution margin 40,000$ 20$

Less: Fixed costs 30,000

Net operating income 10,000$

The contribution margin format emphasizes cost

behavior. Contribution margin covers fixed costs

and provides for income.


End of Chapter 2

chapter 2 · mcgraw-hill/irwin © the mcgraw-hill companies, inc., 2003 direct materials those...

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