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Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Costs Terms, Concepts and
Classifications
Chapter Two
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-2
Learning Objective 1
Identify and give examples Identify and give examples
of each of the three basic of each of the three basic
manufacturing cost manufacturing cost
categories.categories.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-3
The ProductThe Product
Direct
Materials
Direct
Labor
Manufacturing
Manufacturing
Overhead
Manufacturing Costs
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-4
Direct Materials
Raw 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 Example: A radio installed in an automobile
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-5
Direct Labor
Those labor costs that can be easily traced to individual units of product.
Example: Wages paid to automobile assembly workers Example: Wages paid to automobile assembly workers
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-6
Manufacturing costs that cannot be traced directly to specific units produced.
Manufacturing Overhead
Examples: Indirect labor and indirect materials 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.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-7
Non-manufacturing Costs
Selling
Costs
Costs necessary to get
the order and deliver
the product.
Administrative
Costs
All executive,
organizational, and
clerical costs.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-8
Learning Objective 2
Distinguish between Distinguish between
product costs and period product costs and period
costs and give examples costs and give examples
of each.of each.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-9
Product Costs Versus Period Costs
Product costs include
direct materials, direct
labor, and
manufacturing
overhead.
Period costs include all
selling costs and
administrative costs.
Inventory Cost of Good Sold
Balance
Sheet
Income
Statement
Sale
Expense
Income
Statement
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-10
Quick Check
Which of the following costs would be considered a
period rather than a product cost in a manufacturing
company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-11
Quick Check
Which of the following costs would be considered a
period rather than a product cost in a manufacturing
company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-12
Classifications of Costs
Direct
Direct
Material
Direct Direct
Labor
Manufacturing Manufacturing
Overhead
Prime
Cost
Conversion
Cost
Manufacturing costs are often
classified as follows:
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-13 Comparing Merchandising and
Manufacturing Activities
Merchandisers . . .
Buy finished goods.
Sell finished goods.
Manufacturers . . .
Buy raw materials.
Produce and sell
finished goods.
MegaLoMart
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-14
Balance Sheet
Merchandiser
Current assets
Cash
Receivables
Prepaid Expenses
Merchandise Inventory
Manufacturer
Current Assets
Cash
Receivables
Prepaid Expenses
Inventories
• Raw Materials
• Work in Process
• Finished Goods
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-15
Merchandiser
Current assets
Cash
Receivables
Prepaid Expenses
Merchandise Inventory
Manufacturer
Current Assets
Cash
Receivables
Prepaid Expenses
Inventories
• Raw Materials
• Work in Process
• Finished Goods
Balance Sheet
Partially complete products – some material, labor, or
overhead has been added.
Completed products awaiting sale.
Materials waiting to be processed.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-16
Learning Objective 3
Prepare an income Prepare an income
statement including statement including
calculation of the cost of calculation of the cost of
goods sold.goods sold.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-17
The Income Statement
Cost of goods sold for manufacturers differs only
slightly from cost of goods sold for merchandisers.
Manufacturing Company
Cost of goods sold:
Beg. finished
goods inv. 14,200$
+ Cost of goods
manufactured 234,150
Goods available
for sale 248,350$
- Ending
finished goods
inventory (12,100)
= Cost of goods
sold 236,250$
Merchandising Company
Cost of goods sold:
Beg. merchandise
inventory 14,200$
+ Purchases 234,150
Goods available
for sale 248,350$
- Ending
merchandise
inventory (12,100)
= Cost of goods
sold 236,250$
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-18
Basic Equation for Inventory Accounts
Beginning
balance to inventory
Additions
to inventory + + = = Ending
balance
Withdrawals Withdrawals
from
inventory + +
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-19
Quick Check
If your inventory balance at the beginning of the
month was $1,000, you bought $100 during the
month, and sold $300 during the month, what would
be the balance at the end of the month?
A. $1,000.
B. $ 800.
C. $1,200.
D. $ 200.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-20
Quick Check
If your inventory balance at the beginning of the
month was $1,000, you bought $100 during the
month, and sold $300 during the month, what would
be the balance at the end of the month?
A. $1,000.
B. $ 800.
C. $1,200.
D. $ 200.
$1,000 + $100 = $1,100
$1,100 - $300 = $800
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-21
Learning Objective 4
Prepare a schedule of cost Prepare a schedule of cost
of goods manufactured.of goods manufactured.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-22
Schedule of Cost of Goods Manufactured
Calculates the cost of raw
material, direct labor and
manufacturing overhead
used in production.
Calculates the manufacturing
costs associated with goods
that were finished during the
period.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-23
Manufacturing Work
Raw Materials Costs In Process
Beginning raw Direct materials
materials inventory
+ Raw materials
purchased
= Raw materials
available for use
in production
– Ending raw materials
inventory
= Raw materials used
in production
As items are removed from raw
materials inventory and placed into
As items are removed from raw
materials inventory and placed into
the production process, they are
called direct materials.
Product Cost Flows
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-24
Manufacturing Work
Raw Materials Costs In Process
Beginning raw Direct materials
materials inventory + Direct labor
+ Raw materials + Mfg. overhead
purchased = Total manufacturing
= Raw materials costs
available for use
in production
– Ending raw materials
inventory
= Raw materials used
in production
Conversion
costs are costs
direct material
into a finished
Conversion
costs are costs
incurred to
convert the
direct material
into a finished
product.
Product Cost Flows
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-25
Manufacturing Work
Raw Materials Costs In Process
Beginning raw Direct materials Beginning work in
materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials
inventory
= Raw materials used
in production
Product Cost Flows
All manufacturing costs incurred All manufacturing costs incurred
during the period are added to the
beginning balance of work in
process.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-26
Manufacturing Work
Raw Materials Costs In Process
Beginning raw Direct materials Beginning work in
materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials – Ending work in
inventory process inventory
= Raw materials used = Cost of goods
in production manufactured
Product Cost Flows
Costs associated with the goods that Costs associated with the goods that
are completed during the period are
transferred to finished goods
inventory.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-27
Work
In Process Finished Goods
Beginning work in Beginning finished
process inventory goods inventory
+ Manufacturing costs + Cost of goods
for the period manufactured
= Total work in process = Cost of goods
for the period available for sale
– Ending work in - Ending finished
process inventory goods inventory
= Cost of goods Cost of goods
manufactured sold
Product Cost Flows
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-28
Manufacturing Cost Flows
Finished
Goods
Cost of
Goods
Sold
Selling and
Administrative
Period Costs Selling and
Administrative
Manufacturing
Overhead
Work in
Process
Direct Labor
Balance Sheet
Costs Inventories
Income
Statement
Expenses Material Purchases Raw Materials
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-29
Quick Check
Beginning raw materials inventory was $32,000.
During the month, $276,000 of raw material was
purchased. A count at the end of the month
revealed that $28,000 of raw material was still
present. What is the cost of direct material used?
A. $276,000
B. $272,000
C. $280,000
D. $ 2,000
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-30
Quick Check
Beginning raw materials inventory was $32,000.
During the month, $276,000 of raw material was
purchased. A count at the end of the month
revealed that $28,000 of raw material was still
present. What is the cost of direct material used?
A. $276,000
B. $272,000
C. $280,000
D. $ 2,000
Beg. raw materials 32,000$
+ Raw materials
purchased 276,000
= Raw materials available
for use in production 308,000$
– Ending raw materials
inventory 28,000
= Raw materials used
in production 280,000$
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-31
Quick Check
Direct materials used in production totaled $280,000. Direct labor was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month?
A. $555,000
B. $835,000
C. $655,000
D. Cannot be determined.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-32
Direct materials used in production totaled $280,000. Direct labor was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month?
A. $555,000
B. $835,000
C. $655,000
D. Cannot be determined.
Direct Materials 280,000$
+ Direct Labor 375,000
+ Mfg. Overhead 180,000
= Mfg. Costs Incurred
for the Month 835,000$
Quick Check
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2-33
Quick Check
Beginning work in process was $125,000. Manufacturing costs incurred for the month were $835,000. There were $200,000 of partially finished goods remaining in work in process inventory at the end of the month. What was the cost of goods manufactured during the month?
A. $1,160,000 B. $ 910,000 C. $ 760,000 D. Cannot be determined.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-34
Beginning work in process was $125,000. Manufacturing costs incurred for the month were $835,000. There were $200,000 of partially finished goods remaining in work in process inventory at the end of the month. What was the cost of goods manufactured during the month?
A. $1,160,000 B. $ 910,000 C. $ 760,000 D. Cannot be determined.
Quick Check
Beginning work in
process inventory 125,000$
+ Mfg. costs incurred
for the period 835,000
= Total work in process
during the period 960,000$
– Ending work in
process inventory 200,000
= Cost of goods
manufactured 760,000$
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-35
Quick Check
Beginning finished goods inventory was $130,000. The cost of goods manufactured for the month was $760,000. And the ending finished goods inventory was $150,000. What was the cost of goods sold for the month?
A. $ 20,000.
B. $740,000.
C. $780,000.
D. $760,000.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-36
Quick Check
Beginning finished goods inventory was $130,000. The cost of goods manufactured for the month was $760,000. And the ending finished goods inventory was $150,000. What was the cost of goods sold for the month?
A. $ 20,000.
B. $740,000.
C. $780,000.
D. $760,000.
$130,000 + $760,000 = $890,000
$890,000 - $150,000 = $740,000
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-37
Learning Objective 5
Understand the Understand the
differences between differences between
variable costs and fixed variable costs and fixed
costs.costs.
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2-38 Cost Classifications for Predicting Cost
Behavior
How a cost will react to changes in the level of
How a cost will react to changes in the level of
activity within the relevant range.
Total variable costs change when activity changes.
Total fixed costs remain unchanged when activity changes.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-39
Variable Cost
Your total long distance telephone bill is based
on how many minutes you talk.
Minutes Talked
To
tal L
on
g D
ista
nce
Tele
ph
one
Bill
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-40
Variable Cost Per Unit
Minutes Talked
Pe
r M
inu
te
Tele
ph
one
Charg
e
The cost per long distance minute talked is
constant. For example, 10 cents per minute.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-41
Fixed Cost
Your monthly basic telephone bill probably
does not change when you make more local
calls.
Number of Local Calls
Mo
nth
ly B
asic
Tele
ph
one
Bill
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-42
Fixed Cost Per Unit
Number of Local Calls
Month
ly B
asic
Tele
ph
one
Bill
per
Lo
ca
l C
all
The average fixed cost per local call decreases
as more local calls are made.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-43 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 Average fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-44
Quick Check
Which of the following costs would be variable with
respect to the number of cones sold at a Baskins &
Robbins shop? (There may be more than one
correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-45
Quick Check
Which of the following costs would be variable with
respect to the number of cones sold at a Baskins &
Robbins shop? (There may be more than one
correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-46
Learning Objective 6
Understand the Understand the
differences between direct differences between direct
and indirect costs.and indirect costs.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-47
Assigning Costs to Cost Objects
Direct costs
• Costs that can be easily and conveniently traced to a unit of product or other cost object.
• Examples: direct material and direct labor
Indirect costs
• Costs that cannot be easily and conveniently traced to a unit of product or other cost object.
• Example: manufacturing overhead
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-48
Learning Objective 7
Define and give examples Define and give examples
of cost classifications used of cost classifications used
in making decisions: in making decisions:
differential costs, differential costs,
opportunity costs, and opportunity costs, and
sunk costs.sunk costs.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-49
• 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 can and should be
ignored.
Cost Classifications for Decision Making
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-50
Differential Cost and Revenue
Costs and revenues that differ among Costs and revenues that differ among
alternatives. 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.
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
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-51
Opportunity Cost
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.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-52
Sunk Costs
Sunk costs have already been incurred and cannot be changed now or in the future. They 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.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-53
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.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-54
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.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-55
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 annual cost of
licensing your car relevant in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-56
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 annual cost of
licensing your car relevant in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-57
Quick Check
Suppose that your car could be sold now for
$5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-58
Quick Check
Suppose that your car could be sold now for
$5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-59 Summary of the Types of Cost
Classifications
• Financial reporting
• Predicting cost behavior
• Assigning costs to cost objects
• Decision making
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Further Classification of Labor
Costs
Appendix 2A
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2-61
Learning Objective 8
(Appendix 2A)(Appendix 2A)
Properly account for labor Properly account for labor
costs associated with idle costs associated with idle
time, overtime, and fringe time, overtime, and fringe
benefits.benefits.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-62
Idle Time
The labor costs incurred
during idle time are ordinarily
treated as manufacturing
overhead.
Machine
Breakdowns
Material
Shortages
Power
Failures
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2-63
Overtime
The overtime premiums for all factory
workers are usually considered to be part
of manufacturing overhead.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-64
Labor Fringe Benefits
Fringe benefits include employer paid
costs for insurance programs, retirement
plans, supplemental unemployment
programs, Social Security, Medicare,
workers’ compensation and
unemployment taxes.
Some companies
include all of these
costs in
manufacturing
overhead.
Other companies treat
fringe benefit
expenses of direct
laborers as additional
direct labor costs.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-65
Learning Objective 1
Understand how fixed and Understand how fixed and
variable costs behave and variable costs behave and
how to use them to predict how to use them to predict
costs.costs.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-66
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit
Variable Total variable cost is Variable cost per unit remains
proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.
Recall the summary of our cost behavior Recall the summary of our cost behavior
discussion from an earlier chapter.discussion from an earlier chapter.
Types of Cost Behavior Patterns
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-67
The Activity Base
A measure of what A measure of what
causes the
incurrence of a
variable cost
Units
d
Units
produce
d
Miles Miles
driven
Labor Labor
hours
Machine Machine
hours
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-68
Minutes Talked
To
tal L
on
g D
ista
nce
Tele
ph
one
Bill
True Variable Cost Example
A variable cost is a cost whose total dollar amount
varies in direct proportion to changes in the activity
level. Your total long distance telephone bill is
based on how many minutes you talk.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-69
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit
Variable Total variable cost is Variable cost per unit remains
proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.
Recall the summary of our cost behavior Recall the summary of our cost behavior
discussion from an earlier chapter.discussion from an earlier chapter.
Types of Cost Behavior Patterns
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-70
Minutes Talked
Pe
r M
inu
te
Tele
ph
one
Charg
e
Variable Cost Per Unit Example
A variable cost remains constant if expressed on
a per unit basis. The cost per minute talked is
constant. For example, 10 cents per minute.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-71
Extent of Variable Costs
The proportion of variable costs differs across
organizations. For example . . .
A public utility withA public utility with A public utility withA public utility with
large investments inlarge investments in
equipment will tendequipment will tend
to have to have fewerfewer
variable costs.variable costs.
A manufacturing companyA manufacturing company A manufacturing companyA manufacturing company
will often have will often have manymany
variable costs.variable costs.
A merchandising companyA merchandising company
proportionproportion of variable costs,of variable costs,
A merchandising companyA merchandising company
usually will have a usually will have a highhigh
proportionproportion of variable costs,of variable costs,
like cost of sales.like cost of sales. proportionproportion of variable costs.of variable costs.
A service companyA service company
will normally have a will normally have a highhigh
proportionproportion of variable costs.of variable costs.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-72
Examples of Variable Costs
1. Merchandising companies – cost of goods sold.
2.
3.
commissions, shipping costs, and clerical costs,
4.
1. Merchandising companies – cost of goods sold.
2. Manufacturing companies – direct materials,
direct labor, and variable overhead.
3. Merchandising and manufacturing companies –
commissions, shipping costs, and clerical costs,
such as invoicing.
4. Service companies – supplies, travel, and
clerical.
Copyright © 2008, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
2-73
Volume
Cost
True Variable Cost
Direct materials is a true or proportionately variable
cost because the amount used during a period will
vary in direct proportion to the level of production
activity.
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Step-Variable Costs
A resource that is obtainable only in large chunks (such
as maintenance workers) and whose costs increase or
decrease only in response to fairly wide changes in
activity is known as a stepstep--variable costvariable cost.
Volume
Cost
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Step-Variable Costs
Small changes in the level of production are not Small changes in the level of production are not
likely to have any effect on the number of
maintenance workers employed.
Volume
Cost
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Step-Variable Costs
Only fairly wide changes in the activity level will Only fairly wide changes in the activity level will
cause a change in the number of maintenance
workers employed
Volume
Cost
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Relevant
Range
A straight line
approximates a
relevant range.
A straight line
closely
approximates a
curvilinear
variable cost
line within the
relevant range.
Activity
To
tal C
ost
Economist’s
Curvilinear Cost
Function
The Linearity Assumption and the Relevant Range
Accountant’s Straight-Line
Approximation (constant
unit variable cost)
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Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit
Variable Total variable cost is Variable cost per unit remains
proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.
Let’s look at fixed cost behavior on the next Let’s look at fixed cost behavior on the next
screens.screens.
Types of Cost Behavior Patterns
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Number of Local Calls
Mo
nth
ly B
asic
Tele
ph
one
Bill
Total Fixed Cost Example
A fixed cost is a cost whose total dollar amount remains
constant as the activity level changes. Your monthly
basic telephone bill is probably fixed and does not
change when you make more local calls.
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Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit
Variable Total variable cost is Variable cost per unit remains
proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.
Recall the summary of our cost behavior Recall the summary of our cost behavior
discussion from an earlier chapter.discussion from an earlier chapter.
Types of Cost Behavior Patterns
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Number of Local Calls
Month
ly B
asic
Tele
ph
one
Bill
per
Lo
ca
l C
all
Fixed Cost Per Unit Example
Average fixed costs per unit decrease as the activity
level increases. The fixed cost per local call
decreases as more local calls are made.
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Examples Examples
Advertising and Research and Development
Examples
Examples
Depreciation on Equipment and
Real Estate Taxes
Types of Fixed Costs
Discretionary
May be altered in the short-term by current managerial decisions
Discretionary
May be altered in the short-term by current managerial decisions
Committed
Long-term, cannot be significantly reduced in
the short term.
Committed
Long-term, cannot be significantly reduced in
the short term.
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The Trend Toward Fixed Costs
The trend in many industries is toward
greater fixed costs relative to variable costs.
As machines take overAs machines take over
As machines take overAs machines take over
many mundane tasksmany mundane tasks
previously performedpreviously performed
by humans, by humans,
““knowledge workersknowledge workers””
are demanded forare demanded for
their minds rathertheir minds rather
than their muscles.than their muscles.
Knowledge workersKnowledge workers
difficult to replace. Thedifficult to replace. The
these valued employeesthese valued employees
Knowledge workersKnowledge workers
tend to be salaried,tend to be salaried,
highlyhighly--trained andtrained and
difficult to replace. Thedifficult to replace. The
cost to compensatecost to compensate
these valued employeesthese valued employees
is is relatively fixedrelatively fixed
rather than variable.rather than variable.
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Is Labor a Variable or a Fixed Cost?
The behavior of wage and salary costs can
differ across countries, depending on labor
regulations, labor contracts, and custom.
In France, Germany, China, and Japan, management has In France, Germany, China, and Japan, management has
little flexibility in adjusting the size of the labor force.
Labor costs are more fixed in nature.
In the management
has greater latitude. Labor costs are more variable in nature.
In the United States and the United Kingdom, management
has greater latitude. Labor costs are more variable in nature.
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Rent C
ost
in T
housands
of D
olla
rs
0 1,000 2,000 3,000
Rented Area (Square Feet)
0
30
60
Fixed Costs and Relevant Range
90
Relevant
Range
Total cost doesn’t
range of activity, and
then jumps to a new
next higher range of
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.
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Fixed Costs and Relevant Range
Example:Example: Office space is Office space is
increments of 1,000 square increments of 1,000 square
feet. As the business grows, feet. As the business grows,
Example:Example: Office space is Office space is
available at a rental rate of available at a rental rate of
$30,000 per year in $30,000 per year in
increments of 1,000 square increments of 1,000 square
feet. As the business grows, feet. As the business grows,
more space is rented, more space is rented,
increasing the total cost.increasing the total cost.
The relevant range of activity for a fixed cost
is the range of activity over which the graph
of the cost is flat.
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How does this type How does this type
of fixed cost differ of fixed cost differ
from a stepfrom a step--variable variable
cost?cost?
Step-variable costs can be adjusted more
quickly and . . .
The width of the activity steps is much
wider for the fixed cost.
Fixed Costs and Relevant Range
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Quick Check
Which of the following statements about cost Which of the following statements about cost
behavior are true?
1. Fixed costs per unit vary with the level of
activity.
2. Variable costs per unit are constant within the
relevant range.
3. Total fixed costs are constant within the
relevant range.
4. Total variable costs are constant within the
relevant range.
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2-89
Quick Check
Which of the following statements about cost Which of the following statements about cost
behavior are true?
1. Fixed costs per unit vary with the level of
activity.
2. Variable costs per unit are constant within the
relevant range.
3. Total fixed costs are constant within the
relevant range.
4. Total variable costs are constant within the
relevant range.
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2-90
Fixed Monthly
Utility Charge
Variable
Cost per KW
Activity (Kilowatt Hours)
To
tal U
tilit
y C
ost
X
Y
A mixed cost has both fixed and variable
components. Consider the example of utility cost.
A mixed cost has both fixed and variable
components. Consider the example of utility cost.
Mixed Costs
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Fixed Monthly
Utility Charge
Variable
Cost per KW
Activity (Kilowatt Hours)
To
tal U
tilit
y 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
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Mixed Costs Example
If your fixed monthly utility charge is $40, your If your fixed monthly utility charge is $40, your
variable cost is $0.03 per kilowatt hour, and your variable cost is $0.03 per kilowatt hour, and your
If your fixed monthly utility charge is $40, your If your fixed monthly utility charge is $40, your
variable cost is $0.03 per kilowatt hour, and your variable cost is $0.03 per kilowatt hour, and your
monthly activity level is 2,000 kilowatt hours, monthly activity level is 2,000 kilowatt hours,
what is the amount of your utility bill?what is the amount of your utility bill?
Y = a + bX
Y = $40 + ($0.03 × 2,000)
Y = $100 $100
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Analysis of Mixed Costs
Each account is classified as eitherEach account is classified as either
variable or fixed based on the analyst’svariable or fixed based on the analyst’s
knowledge of how the account behaves.knowledge of how the account behaves.
Cost estimates are based on an Cost estimates are based on an Cost estimates are based on an Cost estimates are based on an
evaluation of production methods, and evaluation of production methods, and
material, labor and overhead material, labor and overhead
requirements.requirements.
Account Analysis and the Engineering ApproachAccount Analysis and the Engineering Approach
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Learning Objective 2
Use a scattergraph plot to Use a scattergraph plot to
diagnose cost behavior.diagnose cost behavior.
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Plot the data points on a graph Plot the data points on a graph Plot the data points on a graph Plot the data points on a graph
(total cost vs. activity).(total cost vs. activity).
0 1 2 3 4
*
Main
tena
nce C
ost
1,0
00
’s o
f D
olla
rs
10
20
0
* * *
* *
* *
*
*
Patient-days in 1,000’s
X
Y
The Scattergraph Method
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The Scattergraph Method
Draw a line through the data points with about anDraw a line through the data points with about an Draw a line through the data points with about anDraw a line through the data points with about an
equal numbers of points above and below the line. equal numbers of points above and below the line.
0 1 2 3 4
*
Main
tena
nce C
ost
1,0
00
’s o
f D
olla
rs
10
20
0
* * *
* *
* *
*
*
Patient-days in 1,000’s
X
Y
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The Scattergraph Method
Use one data point to estimate the total level of activity Use one data point to estimate the total level of activity Use one data point to estimate the total level of activity Use one data point to estimate the total level of activity
and the total cost. and the total cost.
Intercept = Fixed cost: $10,000
0 1 2 3 4
*
Main
tena
nce C
ost
1,0
00
’s o
f D
olla
rs
10
20
0
* * *
* *
* *
*
*
Patient-days in 1,000’s
X
Y
Patient days = 800Patient days = 800
Total maintenance cost = $11,000Total maintenance cost = $11,000
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The Scattergraph Method
Make a quick estimate of variable cost per unit and Make a quick estimate of variable cost per unit and Make a quick estimate of variable cost per unit and Make a quick estimate of variable cost per unit and
determine the cost equation. determine the cost equation.
Variable cost per unit = $1,000
800 = $1.25/patient$1.25/patient--dayday
Y = $10,000 + $1.25XY = $10,000 + $1.25X Y = $10,000 + $1.25XY = $10,000 + $1.25X
Total maintenance at 800 patients 11,000$
Less: Fixed cost 10,000
Estimated total variable cost for 800 patients 1,000$
Total maintenance costTotal maintenance cost Total maintenance costTotal maintenance cost Number of patient daysNumber of patient days Number of patient daysNumber of patient days
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Learning Objective 3
Analyze a mixed cost Analyze a mixed cost
using the highusing the high--low low
method.method.
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The High-Low Method
Assume the following hours of maintenance work and the total maintenance costs for six months.
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The High-Low Method
The The variable cost variable cost
equal to the change equal to the change
the change in hours.the change in hours.
The The variable cost variable cost
per hourper hour of of
maintenance is maintenance is
equal to the change equal to the change
in cost divided by in cost divided by
the change in hours.the change in hours.
= $8.00/hour$8.00/hour $2,400
300
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The High-Low Method
Total Fixed Cost = Total Cost Total Fixed Cost = Total Cost –– Total Variable CostTotal Variable Cost
Total Fixed Cost = $9,800 Total Fixed Cost = $9,800 –– ($8/hour ($8/hour ×× 800 hours)800 hours)
Total Fixed Cost = $9,800 Total Fixed Cost = $9,800 –– $6,400$6,400
Total Fixed Cost = Total Fixed Cost = $3,400$3,400
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The High-Low Method
Y = $3,400 + $8.00Y = $3,400 + $8.00XX
The Cost Equation for Maintenance
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Quick Check
Sales salaries and commissions are $10,000 when
Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is
the variable portion of sales salaries and
commission?
a. $0.08 per unit
b. $0.10 per unit
c. $0.12 per unit
d. $0.125 per unit
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Quick Check
Sales salaries and commissions are $10,000 when
Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is
the variable portion of sales salaries and
commission?
a. $0.08 per unit
b. $0.10 per unit
c. $0.12 per unit
d. $0.125 per unit $4,000 ÷ 40,000 units
= $0.10 per unit
Units Cost
High level 120,000 14,000$
Low level 80,000 10,000
Change 40,000 4,000$
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Quick Check
Sales salaries and commissions are $10,000 when
Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is
the fixed portion of sales salaries and commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000
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2-107
Quick Check
Sales salaries and commissions are $10,000 when
Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is
the fixed portion of sales salaries and commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000
Total cost = Total fixed cost +
Total variable cost
$14,000 = Total fixed cost +
($0.10 × 120,000 units)
Total fixed cost = $14,000 - $12,000
Total fixed cost = $2,000
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Least-Squares Regression Method
A method used to analyze mixed costs if a
scattergraph plot reveals an approximately linear
relationship between the X and Y variables.
This method uses This method uses of theof the This method uses This method uses allall of theof the
data points to estimatedata points to estimate
the fixed and variablethe fixed and variable
cost components of acost components of a
mixed cost.mixed cost.
sum of the squared errorssum of the squared errors..
The goal of this method isThe goal of this method is
to fit a straight line to theto fit a straight line to the
data that data that minimizes theminimizes the
sum of the squared errorssum of the squared errors..
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Least-Squares Regression Method
• 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 also provides a statistic, called Least-squares regression also provides a statistic, called
the R2, which is a measure of the goodness
of fit of the regression line to the data points.
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0 1 2 3 4
Tota
l C
ost
10
20
0
Activity
*
* * *
* *
* * * *
Least-Squares Regression Method
2R2 is the percentage of the variation in total cost
explained by the activity.
R2 varies from 0% to 100%, and
the higher the percentage the better.
X
Y
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Comparing Results From the Three Methods
The three methods just discussed provide The three methods just discussed provide
accurate estimate because it uses all the data accurate estimate because it uses all the data
The three methods just discussed provide The three methods just discussed provide
slightly different estimates of the fixed and slightly different estimates of the fixed and
variable cost components of the mixed cost.variable cost components of the mixed cost.
This is to be expected because each method This is to be expected because each method
uses differing amounts of the data points to uses differing amounts of the data points to
provide estimates.provide estimates.
LeastLeast--squares regression provides the most squares regression provides the most
accurate estimate because it uses all the data accurate estimate because it uses all the data
points.points.
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Learning Objective 4
Prepare an income Prepare an income
statement using the statement using the
contribution format.contribution format.
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Let’s put our
knowledge of cost
behavior to work by
preparing a
contribution format
income statement.
The Contribution Format