Mangerial Accounting and Cost Concepts 3-1 Mangerial Accounting and Cost Concepts Chapter One Managers need to rely upon different classifications of costs 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 making business decisions. Our initial focus is on manufacturing companies since their basic activities include most of the activities found in other types of business organizations. Nonetheless, many of the concepts developed in this chapter apply to diverse organizations.

3-2 Learning Objective 1 Identify and give examples of each of the three basic manufacturing cost categories. Learning objective number 1 is to identify and give examples of each of the three basic manufacturing cost categories.

Manufacturing Overhead 3-3 Manufacturing Costs Direct Materials Direct Labor Manufacturing Overhead Manufacturing costs are usually grouped into three main categories: direct materials, direct labor, and manufacturing overhead. These costs are incurred to make a product. The Product

3-4 Learning Objective 2 Distinguish between product costs and period costs and give examples of each. Learning objective number 2 is to distinguish between product costs and period costs and give examples of each.

Product Costs Versus Period Costs 3-5 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 Costs can also be classified as period or product 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.

Non-manufacturing Costs 3-6 Non-manufacturing Costs Selling Costs Costs necessary to get the order and deliver the product. Administrative Costs All executive, organizational, and clerical costs. 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. Selling costs include all costs necessary to secure customer orders and get the finished product into the hands of the customer. These costs are also referred to as order-getting and order-filling costs. Examples of selling costs include advertising, shipping, sales travel, sales commissions, sales salaries, and costs of finished goods warehousing. Administrative costs include all executive, organizational, and clerical costs associated with the general management of an organization. Examples of administrative costs include executive compensation, general accounting, secretarial, public relations, and similar costs involved in the overall general administration of the organization as a whole.

3-7 Learning Objective 3 Prepare an income statement including calculation of the cost of goods sold. Learning objective number 3 is to prepare an income statement including calculation of the cost of goods sold.

3-8 The Income Statement Cost of goods sold for manufacturers differs only slightly from cost of goods sold for merchandisers. Merchandising companies calculate cost of goods sold as Beginning Merchandise Inventory plus Purchases minus Ending Merchandise Inventory. For manufacturing companies, the cost of goods sold for a period is not simply the manufacturing costs incurred during the period. Manufacturing companies calculate cost of goods sold as Beginning Finished Goods Inventory plus Cost of Goods Manufactured minus Ending Finished Goods Inventory. Some of the cost of goods sold may be for units completed in a previous period. And some of the units completed in the current period may not have been sold and will still be on the balance sheet as assets. The cost of goods sold is computed with the aid of a schedule of costs of goods manufactured, which takes into account changes in inventories. The schedule of cost of goods manufactured is not ordinarily included in external financial reports, but must be compiled by accountants within the company in order to arrive at the cost of goods sold. We will learn more about a schedule of costs of goods manufactured later in this chapter.

3-9 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. 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?

Quick Check  $1,000 + $100 = $1,100 $1,100 - $300 = $800 3-10 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 Right. $800. This is calculated as beginning inventory of $1,000 plus purchases of $100 minus ending inventory of $300.

Prepare a schedule of cost of goods manufactured. 3-11 Learning Objective 4 Prepare a schedule of cost of goods manufactured. Learning objective number 4 is to prepare a schedule of cost of goods manufactured.

Schedule of Cost of Goods Manufactured 3-12 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. The schedule of cost of goods manufactured contains the three elements of costs mentioned previously, namely direct materials, direct labor, and manufacturing overhead. It calculates the cost of raw material, direct labor and manufacturing overhead used in production. It also calculates the manufacturing costs associated with goods that were finished during the period.

3-13 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 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?

3-14 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 Right. $280,000. Take a minute and review the solution before proceeding.

3-15 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. 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?

3-16 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. Right. $835,000. Take a minute and review the solution before proceeding.

3-17 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. 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?

3-18 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. Right. $760,000. Take a minute and review the solution before proceeding.

3-19 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. 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?

3-20 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 Right. $740,000. Take a minute and review the solution before proceeding.

Understand the differences between variable costs and fixed costs. 3-21 Learning Objective 5 Understand the differences between variable costs and fixed costs. Learning objective number 5 is to understand the differences between variable costs and fixed costs.

Cost Classifications for Predicting Cost Behavior 3-22 Cost Classifications for Predicting Cost Behavior 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. 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. Cost behavior refers to how a cost will react to changed in the level of activity within the relevant range. The most commonly used classifications of cost behavior are variable and fixed costs.

Total Long Distance Telephone Bill 3-23 Variable Cost Your total long distance telephone bill is based on how many minutes you talk. Minutes Talked Total Long Distance Telephone Bill A variable cost varies in direct proportion to changes in the level of activity. For example, your long distance telephone bill may be based on how many minutes your talk—the total bill varies with the number of minutes used.

Per Minute Telephone Charge 3-24 Variable Cost Per Unit The cost per long distance minute talked is constant. For example, 10 cents per minute. Minutes Talked Per Minute Telephone Charge Although variable costs change in total as the activity level rises and falls, variable cost per unit is constant. For example, the cost per long distance minute may be ten cents a minute.

Monthly Basic Telephone Bill 3-25 Fixed Cost Your monthly basic telephone bill probably does not change when you make more local calls. Number of Local Calls Monthly Basic Telephone Bill A fixed cost is constant within the relevant range. In other words, fixed costs do not change for changes in activity that fall within the “relevant range.” For example, your monthly basic telephone bill probably is a set amount and does not change based on the number of calls you make.

Monthly Basic Telephone Bill per Local Call 3-26 Fixed Cost Per Unit The average fixed cost per local call decreases as more local calls are made. Number of Local Calls Monthly Basic Telephone Bill per Local Call However, when expressed on a per unit basis, a fixed cost is inversely related to activity—the per unit cost decreases when activity rises and increases when activity falls. For example, the average fixed cost per local call decreases as more local calls are made.

Cost Classifications for Predicting Cost Behavior 3-27 Cost Classifications for Predicting Cost Behavior It is helpful to think about variable and fixed cost behavior in a two by two matrix, as illustrated here. Take a few minutes and review this summary of cost behavior for variable and fixed costs.

3-28 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. Which of the following costs would be variable with respect to the number of cones sold at a Baskins and Robbins shop? (There may be more than one correct answer.)

3-29 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. Right. The cost of ice cream and the cost of napkins for customers would be variable costs. As Baskins and Robbins sells more ice cream cones, we would expect the total cost of ice cream and napkins to increase.

3-30 Learning Objective 7 Define and give examples of cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs. Learning objective number 7 is to define and give examples of cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs.

Cost Classifications for Decision Making 3-31 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 can and should be ignored. 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.

Differential Cost and Revenue 3-32 Differential Cost and 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 commuting cost to the city is $300 per month. Differential costs (or incremental costs) is a 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. For example, assume 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. In this example, the differential revenue is $500 and the differential cost is $300. Differential revenue is: $2,000 – $1,500 = $500 Differential cost is: $300

3-33 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. 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. While students usually accept the idea that sunk costs should be ignored on an abstract level, like most people, they often have difficulty putting this idea into practice.

3-34 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. Take a minute and read the information on this slide. Should the cost of the train ticket affect the decision of whether you drive or take the train to Portland?

3-35 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. Yes, it should because the cost of the train ticket is relevant.

3-36 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. Take a minute and read the information on this slide. Is the annual cost of licensing your car relevant in this decision?

3-37 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. No, it is not because the licensing cost is not relevant.

3-38 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. Suppose that your car could be sold now for $5,000. Is this a sunk cost?

3-39 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. No, it is not a sunk cost.