CHAPTER 2 MANAGERIAL ACCOUNTING AND COST CONCEPTS I Different costs for different purposes is a critically important aspect of managerial accounting GENERAL COST CLASSIFICATIONS a Manufacturing Costs i Direct Materials The materials that become an integral part of the finished product and whose costs can be conveniently traced to the finished product Prime Cost 1 Raw Materials Materials that go into final product ANY materials that are used in final product May include direct indirect materials Indirect Materials Materials where it isn t worth the effort to trace the costs of relatively insignificant materials to end products and are therefore included in manufacturing overhead ii Direct Labor Touch Labor Costs that can be easily traced to individual units of product Prime Cost Conversion Cost Indirect Labor The costs that cannot be physically traced to particular products or that can be traced only at great cost and inconvenience Treated as manufacturing overhead Cost of janitors supervisors security guards etc 2 1 iii Manufacturing Overhead Includes all manufacturing costs except direct materials and direct labor Only the costs associated with operating the factory are included Indirect materials indirect labor maintenance and repairs on production equipment heat and light property taxes depreciation and insurance on manufacturing facilities Conversion Cost b Nonmanufacturing Costs i Selling Costs All costs that are incurred to secure customer orders and get the finished product to the customer Advertising shipping sales travel sales commissions sales salaries and costs of finished goods warehouses ii Administrative costs All costs associated with the general management of an organization rather than with manufacturing or selling All costs involved in the overall administration of the organization as a whole Executive compensation general accounting secretarial PR COST CLASSIFICATIONS FOR PREDICTING COST BEHAVIOR II i Cost Behavior How a cost reacts to changes in the level of activity 1 As the activity level rises and falls a particular cost may rise and fall or may remain constant ii Cost Structure the relative proportion of each type of cost in an organization b Variable Cost Cost that varies in total in direct proportion to changes in the level of activity COGS Direct Materials Direct Labor Variable MOH Indirect Materials Supplies Power Variable S A Commissions and Shipping Costs i In Total Variable cost increases and decreases in proportion to changes in the activity level 1 Activity Base Measure of whatever causes the incurrence of a variable cost The cost driver Direct Labor Hours Machine Hours Units Produced and Units Sold 2 Textbook assumes unless stated otherwise that the activity base under consideration is the total output volume of goods and services provided by the organization ii Per Unit A variable cost is constant if expressed on a per unit basis c Fixed Cost Cost that remains constant in total regardless of changes in the level of activity Straight line depreciation insurance property taxes rent supervisory salaries administrative salaries advertising i In Total Not affected by changes in level of activity within the relevant range 1 Relevant Range the range of activity within which the assumption that cost behavior is strictly linear is reasonably valid 2 As activity level rises and falls total fixed costs remain constant unless 3 influenced by some outside force In total costs are actually curvilinear the relationship between cost and activity is a curve It can be approximated within a narrow band of activity known as the relevant range by a straight line ii Per Unit A fixed cost is constant for large variations in the level of activity its average cost per unit becomes progressively smaller as the level of activity increases 1 Committed Fixed Costs represent organizational investments with a multiyear planning horizon that cannot be significantly reduced even for short periods of time without making fundamental changes Real estate taxes insurance expenses salaries of top management 2 Discretionary Fixed Costs Managed Fixed Costs Arise from annual decisions by management to spend on certain fixed cost items Advertising research PR management development programs and internships d Mixed Cost Semi variable Costs Costs that contain both fixed and variable elements i Y a bX 1 Y Total Mixed Cost 2 a Total fixed cost Vertical Intercept in graph Ready and Available 3 b Variable Cost Unit of Activity Slope of line Actual Consumption 4 X Level of activity ii The steeper the slope the higher the variable cost unit III The Analysis of Mixed Costs a Managers can use a variety of methods to estimate the fixed and variable components of a mixed cost Account Analysis Engineering Approach High Low method Least Squares regression analysis i Account Analysis classifying accounts as either variable or fixed based on analyst s prior knowledge of how the cost in the account behaves b Diagnosing Cost Behavior with a Scatter graph Plot i First Step in applying the High Low Method or Least Squares regression method is to diagnose cost behavior with a scatter graph plot 1 Total Maintenance Cost Y is plotted on the vertical axis Dependent Variable because the amount of cost incurred during a period depends on the level of activity for the period 2 The Activity X is plotted on the horizontal axis Activity is known as the Independent Variable because it causes variations in the cost ii Cost behavior is considered linear whenever a straight line is a reasonable approximation for the relation between cost and activity c The High Low Method Based on the rise run formula for the slope of a s i If scatterplot indicates a linear relation between cost and activity the fixed and variable cost elements can be estimated using the high low method ii Variable Cost Slope of the Line Rise Run Y2 Y1 X2 X1 1 Identify the period with the lowest level of activity and the period with the highest level of activity 2 Variable Cost Cost at High Activity Cost at Low Activity High level activity Low Level Activity a Variable Cost Change in Cost Change in Activity iii Fixed Cost Take the total cost at either the high low activity level and deduct the variable cost element a Fixed Cost Total Cost Variable Cost Element iv Disadvantage of using high low method Utilizes only two data points 1 Not enough to produce accurate results 2 Highest and lowest activity tends to be unusual d The Least Squares Regression
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