Chapter 1 Notes: Managerial Accounting and Cost Concepts
Distinction Between Financial and Managerial Accounting
Financial accounting focuses on reporting financial information to external parties (stockholders, creditors, regulators).
Managerial accounting focuses on providing information to employees within the organization to help them plan, control operations, and make decisions.
Purposes of Cost Classification
Assigning costs to cost objects.
Accounting for costs in manufacturing companies.
Preparing financial statements.
Predicting cost behavior in response to changes in activity.
Making decisions.
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 materials, direct labor.
Indirect costs: costs that cannot be easily traced to a unit of product or other cost object.
Example: manufacturing overhead.
Common costs: indirect costs incurred to support a number of cost objects; cannot be traced to any single cost object.
Classifications of Manufacturing Costs
Direct Materials
Direct Labor
Manufacturing Overhead (MOH)
Direct Materials
Direct materials are raw materials that become an integral part of the product and can be conveniently traced to it.
Example: a seat installed in an aircraft.
Direct Labor
Direct labor costs are those labor costs that can be easily traced to individual units of product.
Example: wages paid to automobile assembly workers.
Manufacturing Overhead
Manufacturing overhead includes all manufacturing costs except direct materials and direct labor.
These costs cannot be readily traced to finished products.
Includes indirect materials that cannot be easily traced to specific units of product.
Includes indirect labor costs that cannot be easily traced to specific units of product.
Manufacturing Overhead – Examples
Depreciation of manufacturing equipment.
Utility costs.
Property taxes.
Insurance premiums for operating a manufacturing facility.
Only indirect costs associated with operating the factory are included in MOH.
Prime Costs and Conversion Costs
Prime costs are the direct material and direct labor costs.
Conversion costs are the costs necessary to convert raw materials into finished goods, i.e., direct labor and manufacturing overhead.
Formulas:
\text{Prime Costs} = \text{Direct Materials} + \text{Direct Labor}
\text{Conversion Costs} = \text{Direct Labor} + \text{Manufacturing Overhead}
Nonmanufacturing Costs
Selling Costs: costs necessary to secure the order and deliver the product; can be direct or indirect.
Administrative Costs: executive, organizational, and clerical costs; can be direct or indirect.
Product Costs
Product costs include all costs involved in acquiring or making a product.
These costs attach to a unit of product as it is purchased or manufactured and remain attached to each unit while it remains in inventory awaiting sale.
Manufacturing Product Costs and Inventory Flow
A manufacturer’s product costs flow through three inventory accounts:
Raw Materials: materials that go into the final product.
Work in Process (WIP): units that are partially complete and require further work.
Finished Goods: completed units not yet sold.
The Flow of Manufacturing Costs
Raw Materials → Work in Process → Finished Goods → Cost of Goods Sold (COGS)
When direct materials are used in production, their costs transfer from Raw Materials to Work in Process.
Direct labor and MOH are added to Work in Process to convert direct materials into finished goods.
Once units are completed, their costs transfer from Work in Process to Finished Goods.
When finished goods are sold, costs transfer from Finished Goods to Cost of Goods Sold.
Cost Classifications for Preparing Financial Statements
Product costs include direct materials, direct labor, and manufacturing overhead.
Period costs include all selling costs and administrative costs.
Quick Check 1 (Cost Classification in Manufacturing)
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.
Answer: B and E (period costs).
Cost Behavior and Relevant Range
Cost behavior refers to how a cost will react to changes in the level of activity.
Common classifications: Variable costs, Fixed costs, Mixed costs.
Variable Cost
A cost that varies in total in direct proportion to changes in the level of activity.
A variable cost per unit is constant.
Activity Base (Cost Driver)
A measure of what causes the incurrence of a variable cost.
Examples: units produced, units sold, machine hours, labor hours.
Fixed Cost
A cost that remains constant in total, regardless of changes in the level of activity.
If expressed on a per-unit basis, the average fixed cost per unit varies inversely with changes in activity.
Types of Fixed Costs
Committed: Multiyear planning horizon; cannot be easily adjusted in the short term.
Discretionary: Arise from annual decisions; easily reduced in the short term.
The Linearity Assumption and the Relevant Range
Total Cost vs Activity is approximated by a straight line within the relevant range.
Relevant range: the range of activity over which the graph of total cost is flat for fixed costs and proportional for variable costs.
Economists describe a curvilinear cost function; accountants approximate with a straight line with constant variable cost per unit within the relevant range.
Fixed Costs and the Relevant Range (Example)
Fixed costs can change in a step fashion within the relevant range (e.g., rent increasing in steps as space increases).
Relevant Range: Graphic Concept
The relevant range is the range of activity over which fixed cost behavior is constant (graph shown in course materials).
Comparison of Cost Classifications for Predicting Cost Behavior
Variable costs: total variable cost increases/decreases in proportion to changes in activity; variable cost per unit remains constant.
Fixed costs: total fixed cost remains unchanged within the relevant range; fixed cost per unit decreases as activity increases.
Quick Check 2 (Variable Costs in a Baskin & Robbins Shop)
Which costs are variable with respect to the number of ice cream cones sold? (More than one may be correct.)
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.
Likely answers: C and D (ice cream and napkins scale with sales). Lighting may be fixed or variable depending on context; manager wages are usually fixed.
Mixed Costs – Part 1 and Part 2
A mixed cost contains both variable and fixed elements.
Example: utility cost (some base charge plus usage-based cost).
The total mixed cost can be expressed as an equation: Y = a + bX
Y = total mixed cost
a = total fixed cost (vertical intercept)
b = variable cost per unit of activity (slope)
X = level of activity
Example: If fixed monthly utility charge is a = 40, variable cost per unit is b = 0.03 per kWh, and monthly activity level is X = 2000 kWh, then
Y = a + bX = 40 + 0.03\times 2000 = 40 + 60 = 100
Cost Classifications for Decision Making
Decision making involves choosing between alternatives.
Key concepts: differential costs and revenues, opportunity costs, and sunk costs.
Differential Cost and Revenue
Differential (incremental) costs are the difference in cost between two alternatives.
Differential revenues are the difference in revenue between two alternatives.
Both are always relevant to decisions.
Differential costs can be either fixed or variable.
Opportunity Cost
Opportunity cost is the potential benefit given up when one alternative is chosen over another.
Not usually recorded in accounting records, but are relevant costs in decision making.
Example prompt for students: What is the opportunity cost of attending class?
Sunk Cost
A sunk cost has already been incurred and cannot be changed by current or future decisions.
Sunk costs are not differential costs and are irrelevant to decisions.
Quick Check 3
Scenario: Decide whether to drive or take the train to a concert; you have ample cash for either. Is the cost of the train ticket relevant?
Answer: Yes, the train ticket cost is relevant (it is a differential cost between the two options).
Quick Check 4
Scenario: Is the annual cost of licensing your car relevant in the drive vs train decision?
Answer: No, licensing is a fixed cost not affected by the choice between driving or taking the train (irrelevant to the decision).
Quick Check 5
Scenario: If your car could be sold now for 5{,}000, is this a sunk cost?
Answer: Yes (it represents a past decision’s potential benefit that cannot be recovered by current choice).
Learning Objective 6: Income Statements — Traditional vs Contribution Formats
The Traditional Income Statement (external reporting focus):
Sales: 100{,}000
Cost of Goods Sold (COGS): 70{,}000
Gross Margin: 30{,}000
Selling & Administrative Expenses: 20{,}000
Net Operating Income: 10{,}000
The Contribution Format Income Statement (management planning tool):
Sales: 100{,}000
Variable Expenses: 60{,}000
Contribution Margin: 40{,}000
Fixed Expenses: 30{,}000
Net Operating Income: 10{,}000
Differences:
Traditional focuses on cost of goods sold and gross margin.
Contribution format separates variable and fixed costs to highlight contribution margin for decision making.
Uses of the Contribution Format
Internal planning and decision making; a tool for:
Cost-volume-profit (CVP) analysis (Chapter 6).
Segmented reporting of profit data (Chapter 7).
Budgeting (Chapter 8).
Special decisions (pricing, make-or-buy, etc., Chapter 11).
Exercise 1-11 (Overview)
1) Complete the above schedule.
2) Assume the company produces and sells 45{,}000 units during the year at a selling price of 16 per unit. Prepare a contribution format income statement for the year.