COB 242 1st Edition Lecture 7 Outline of Current Lecture 1. Chapter 2 a. Cost classifications for:i. Assigning costs to cost objectsii. Manufacturing companiesiii. Preparing financial statements1. Traditional and Contribution formatsiv. Predicting cost behavior1. Analysis of mixed costsv. Decision MakingCurrent Lecture1. Cost classifications for:a. Assigning costs to cost objects1. Cost object- anything for which cost data are desiredii. Direct cost- can be easily and conveniently traced to a specified cost object 1. Cost must be caused by cost objectiii. Indirect cost- cannot be easily and conveniently traced to a specified cost object1. Common cost- is incurred to support a number of cost objects but cannot be traced to them individually iv. Cost objects determine whether a particular costs is direct or indirectb. Manufacturing companiesi. Manufacturing costs1. Direct materials- become an integral part of the finished product and whose costs can be conveniently traced to the finished products a. Raw materials- go into the finished product (either direct or indirect materials)2. Direct Labor (“touch labor”)- labor costs that can be easily traced to individual units of product 3. Manufacturing overhead- all manufacturing costs associated with operating the factory except direct materials and laborThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.a. Indirect materials- small items that may be an integral part of a finished product, but whose costs cannot be easily traced to itb. Indirect labor- labor costs that cannot be physically traced to particular products easily or conveniently ii. Nonmanufacturing costs- (selling and administrative costs)1. Selling costs- incurred to secure customer orders and get the finished product to the customer2. Administrative costs- associated with the general management of an organization rather than the manufacturing or selling3. Both costs can be direct or indirect costsc. Preparing financial statements1. Matching principle- cost incurred to generate a particular revenue should be recognized as expenses during the period the revenue isrecognizedii. Product costs- involved in acquiring or making a product1. Direct materials + direct labor + manufacturing overhead = product costsiii. Period costs- every other cost (not product costs) like selling and administrative expenses1. Selling expenses + administrative expenses = period costsiv. Prime cost- the sum of direct materials and direct labor costs1. Direct materials + direct labor = prime costv. Conversion cost- the sum of direct labor and manufacturing overhead costs1. Direct labor + manufacturing overhead = conversion costd. Predicting cost behaviori. Cost behavior- how a cost reacts to changes in the level of activityii. Cost structure- relative proportion of fixed, variable, and mixed costs in an organizationiii. Variable cost- varies, in total, in direct proportion to changes in the level of activity1. Activity base (cost driver)- a measure of whatever causes the incurrence of a variable costa. Example: direct labor hours, machine hours, units produced, and units soldiv. Fixed cost- remains constant, in total, regardless of changes in the level of activity 1. Example: straight-line depreciation, insurance, property tax, rent, and salaries2. Committed fixed costs- organizational investments with a multiyear planning horizon that can’t be significantly reduced even for short periods of time without making fundamental changes a. Example: facilities and equipment3. Discretionary fixed costs- arise from annual decisions by management to spend on curtained fixed cost itemsa. Example: advertising, research, internships, and developmentv. The linearity assumption and the relevant range1. Relevant range- the range of activity within which the assumption that cost behavior is strictly linear is reasonably validvi. Mixed costs- contains both variable and fixed cost elements1. Y = a + bXa. Y = total mixed costb. A = total fixed cost (vertical intersect)c. B = variable cost per unit of activity (slope of line)i. Steeper slope means higher variable cost per unitd. X = level of activityvii. Analysis of mixed costs1. Fixed portion- minimum cost of having a service ready and available for use2. Variable portion- cost incurred for actual consumption of the service3. Account analysis- account is classified as fixed or variable based onthe analyst’s prior knowledge of how the cost in the account behaves4. Engineering approach- analysis of what cost behavior should be, based on an industrial engineer’s evaluation of the production methods to be used5. High-low and Least-squares regression methods estimate the fixedand variable elements by analyzing past recordsviii. Diagnosing Cost Behavior with a Scatter-graph Plot1. This is first step in applying the high-low or least-squares methods2. Dependent variable = cost; plotted on Y-axis3. Independent variable = activity; plotted on X-axis4. Cost behavior= linear whenever a straight line is a reasonable approximation for the relation between cost and activity ix. The High-Low Method (if linear)1. Variable cost = slope of line = rise/run = y2-y1/x2-x1 = change in cost / change in activity2. Fixed element = total cost – variable cost element3. Downfall: this method only uses 2 data points so it is not always the most accuratex. The Least-squares regression method (uses all data points)1. Computers generally compute this linee. Traditional and Contribution Format Income Statementsi. Tradition format income statement is used for external purposesii. Contribution format income statement is used for internal purposes1. Contribution approach organizes based on cost category 2. Contribution margin = sales – variable expenses f. Decision Makingi. Differential cost and Revenue- (fixed + variable)1. Differential cost- a difference in costs between any to alternativesa. Incremental cost- an increase in cost from one alternative to anotherb. Decremental cost- a decrease in cost from one alternative to another2. Differential revenue- a difference in revenues (usually sales) between any two alternativesii. Opportunity Cost and Sunk Cost1. Opportunity cost- the potential benefit that is given up when one alternative is selected over another2. Sunk Cost- has already been incurred and cannot be changed by any decision made now or in the future (generally should