1. Cost Terms, Concepts, and Classifications
Chapter 2
Cost Terms, Concepts, and Classifications

2. Comparing Merchandising and Manufacturing Activities
Merchandisers . . .
Buy finished goods.
Sell finished goods.
Manufacturers . . .
Buy raw materials.
Produce and sell finished goods.
MegaLoMart

3. Manufacturing Overhead
Manufacturing Costs
Direct Materials
Direct Labor
Manufacturing Overhead
The Product

4. Example: A radio installed in an automobile
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

5. Example: Wages paid to automobile assembly workers
Direct Labor
Those labor costs that can be easily traced to individual units of product.
Example: Wages paid to automobile assembly workers

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

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

8. Classifications of Costs
Manufacturing costs are often classified as follows:
Direct Material
Direct Labor
Manufacturing Overhead
Prime Cost
Conversion Cost

9. Nonmanufacturing Costs
Marketing and Selling Cost
Costs necessary to get the order and deliver the product.
Administrative Cost
All executive, organizational, and clerical costs.

10. 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.

11. Quick Check  A. Depreciation on factory forklift trucks.
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.

12. 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

13. For Your Consideration …
Take a look at
Review Problems 1 & 2
on pages 48 and 49.

14. 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.
Note excellent red tie !

15. Total Long Distance Telephone Bill
Total Variable Cost
Your total long distance telephone bill is based on how many minutes you talk.
Minutes Talked
Total Long Distance Telephone Bill

16. Per Minute Telephone Charge
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

18. Monthly Basic Telephone Bill
Total 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

19. Monthly Basic Telephone Bill per Local Call
Fixed Cost Per Unit
The average cost per local call decreases as more local calls are made.
Number of Local Calls
Monthly Basic Telephone Bill per Local Call

21. Cost Classifications for Predicting Cost Behavior

22. Cost Behavior Examples of normally variable costs
Merchandisers
Cost of Goods Sold
Service Organizations
Supplies and travel
Manufacturers
Direct Material, Direct Labor, and Variable Manufacturing Overhead
Merchandisers and Manufacturers
Sales commissions and shipping costs
Examples of normally fixed costs
Merchandisers, manufacturers, and service organizations
Real estate taxes, Insurance, Sales salaries Depreciation, Advertising

23. Types of Fixed Costs Committed
Long-term, cannot be reduced in the short term.
Discretionary
May be altered in the short-term by current managerial decisions
Examples
Depreciation on Buildings and Equipment
Examples
Advertising and Research and Development

24. Fixed Costs and Relevant Range
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.
Continue

25. Fixed Costs and Relevant Range
Exh.
5-6
Fixed Costs and Relevant Range 90
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.
Relevant Range 60
Rent Cost in Thousands of Dollars 30
, , , Rented Area (Square Feet)

26. Fixed Costs and Relevant Range
Step-variable costs can be adjusted more quickly and . . .
The width of the activity steps is much wider for the fixed cost.
How does this type of fixed cost differ from a step-variable cost?

27. Fixed Monthly Utility Charge Activity (Kilowatt Hours)
Mixed Costs
A mixed cost has both fixed and variable components. Consider the example of utility cost. X Y
Total mixed cost
Total Utility Cost
Variable Cost per KW
Fixed Monthly Utility Charge
Activity (Kilowatt Hours)

28. Mixed Costs Y Total mixed cost Y = a + bX Total Utility Cost X
Variable Cost per KW
Fixed Monthly Utility Charge
Activity (Kilowatt Hours)

29. The Analysis of Mixed Costs
Account Analysis
Engineering Approach
Scattergraph Plot
High-Low Method
Least-Square Regression Method

30. 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.

31. The Scattergraph Method
Plot the data points on a graph (total cost vs. activity). *
Total Cost in 1,000’s of Dollars 10 20
Activity, 1,000’s of Units Produced X Y

32. Quick-and-Dirty Method
Draw a line through the data points with about an equal numbers of points above and below the line. Y 20 * * * * * * * *
Total Cost in 1,000’s of Dollars * * 10
Intercept is the estimated fixed cost = $10,000 X
Activity, 1,000’s of Units Produced

33. Quick-and-Dirty Method
The slope is the estimated variable cost per unit.
Slope = Change in cost ÷ Change in units Y 20 * * * * * * * *
Total Cost in 1,000’s of Dollars * * 10
Horizontal distance is the change in activity.
Vertical distance is the change in cost. X
Activity, 1,000’s of Units Produced

34. The High-Low Method
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.

35. The High-Low Method Changein cost Change in units
Variable cost per unit = Change in cost ÷ change in units
Changein cost Change in units

36. Variable cost per unit = $2,400 ÷ 3,000 units
The High-Low Method
Variable cost per unit = $2,400 ÷ 3,000 units
= $0.80 per unit

37. 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

38. 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
Total cost = Fixed cost + Variable cost (Y = a + bX) Y = $3,400 + $0.80X

39. 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 the R2, that is a measure of the goodness of fit of the regression line to the data points.

40. Least-Squares Regression Method
R2 is the percentage of the variation in total cost explained by the activity. Y 20 * * * * * * * * * *
Total Cost 10
R2 for this relationship is near 100% since the data points are very close to the regression line. X
Activity

41. 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.

42. Remember who received a mid-semester deficiency
Hey, Ed !
Remember who received a
mid-semester deficiency
in statistics in 1972 and 1973!

43. Cost Estimation Methods Regression Analysis
The simple cost model is actually a regression model:
TC = F + VX
Caution: Before doing the analysis, take time to determine if a logical relationship between the variables exists.
This model will only be useful within a relevant range of activity.

44. Direct Costs and Indirect 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

45. 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

46. 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.

47. 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.

48. 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.

49. 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.

50. 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.

51. 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.

52. 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

53. 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

54. The Contribution Format
The contribution margin format emphasizes cost behavior. Contribution margin covers fixed costs and provides for income.

55. The Contribution Format
The contribution margin format emphasizes cost behavior. Contribution margin covers fixed costs and provides for income.

56. End of Chapter 2