ACC406 Chapters 2 and 3

CHAPTER 2: Basic Managerial Accounting Concepts

Cost and Cost Assignment

Definition of Cost:

• Cost refers to the quantifiable amount of cash or cash equivalent that is sacrificed in exchange for goods or services.

• It encompasses not only the price paid to acquire goods or services but also associated costs like delivery, installation, and maintenance.

• Costs are typically incurred with the expectation of generating future benefits, primarily revenues in profit-oriented businesses.

Cost and Profit

Cost Expiration:

• Costs utilized in production are referred to as expired costs, transforming into expenses on the income statement.

• For a firm to maintain a healthy financial position, it is imperative that revenues consistently exceed total expenses.

Income Statement

Function:

• The income statement serves as a critical financial document that displays the relationship between revenues and expenses, ultimately determining net income (profit or loss) for a specified period.

Profit vs. Loss

Profit and Loss Conditions:

• Profitable Condition: When revenues exceed costs, a profit is realized.

• Break-even Condition: When revenues equate to costs, the situation results in zero profits, also termed break-even.

• Loss Condition: When revenues fall short of costs, the business incurs a loss.

Cost and Price

Illustration:

• Consider a furniture manufacturer that expends $10,000 on lumber. Here, the $10,000 represents the cost incurred. In contrast, the price is the amount the manufacturer charges customers for the finished product. Understanding this distinction is crucial for pricing strategies and overall profitability.

Cost Accumulation

Example:

• The Telephone Expense account, which records specific costs related to telecommunications, presents a relevant example. For instance, upon receiving a telephone bill for $950, there is a need for proper accounting and allocation of this expense to relevant departments.

Accumulating Costs

Management Needs:

• Managers require detailed visibility into which departments are responsible for incurred expenses, enabling effective budgeting and financial control.

Cost Objects

Definition:

• Cost objects are defined as items such as products, customers, departments, or regions, for which costs are systematically measured and assigned. Identification of cost objects is critical for accurate cost allocation.

Cost Assignment

Purpose:

• The purpose of cost assignment lies in linking incurred costs to specific cost objects. This process clarifies the reasoning behind expenditures, such as the telephone expenses incurred by different departments like Sales and Manufacturing.

Assigning Costs Examples

• Sales Department: $350

• Manufacturing Department: $600

• Total Telephone Expense: $950 (accurately recorded).

Cost Assignment Methods

Variability:

• Costs can be assigned through various methods, which range in their accuracy and complexity. These methods help in achieving better insights into cost behavior and management.

Cost Classification

Decision-Making Needs:

• Costs are classified based on management’s requirements for decision-making. This classification might involve distinguishing between direct and indirect costs, fixed and variable costs, and product costs versus period expenses.

Cost Classification Categories:

• In Relation To Cost Objects:

  • Direct Costs: Easily traceable to a specific cost object; they possess a clear observable relationship.

  • Indirect Costs: Not easily traceable to a single cost object; often require allocation across multiple cost objects.

• In Relation To Activity Levels:

  • Fixed Costs: These costs remain constant in total regardless of the level of activity within the business.

  • Variable Costs: These costs fluctuate in total according to the level of activity, increasing or decreasing as output changes.

• In Relation To Financial Statements:

  • Product Costs: Associated with the manufacturing process, these costs are inventoriable until the point of sale.

  • Period Expenses: Non-inventoriable costs that are recognized in the income statement within the period they are incurred, such as administrative or selling expenses.

Direct and Indirect Costs

Direct Costs:

• Direct costs can be easily tracked and attributed to a specific cost object, providing clarity and precision in financial reporting.

Indirect Costs:

• Indirect costs cannot be directly traced to a single object; thus, they require allocation methods to spread the cost appropriately among various cost objects.

Other Categories of Cost

Variable Costs:

• Variable costs are characterized by their direct correlation to production levels; they add to the total cost as output increases or decreases.

Fixed Costs:

• In contrast, fixed costs remain stable in total despite fluctuations in production levels, thus impacting profitability differently at varying output levels.

Mixed Costs:

• Mixed costs comprise both fixed and variable components, making them essential for a comprehensive understanding of total cost elements in production.

Output Types

Key Cost Objects:

• Products: Commonly linked with manufacturing activities where raw materials are transformed into final goods.

• Services: Primarily associated with service-oriented organizations providing intangible offerings to customers.

Product Costs

Definition:

• Product costs encompass all costs that are directly connected to the production or service provision. This includes direct materials, direct labor, and manufacturing overhead costs.

Non-Production Costs

Categories:

• Administrative Costs: Relate to the overall management and administration of the organization.

• Selling Costs: Include expenses incurred in marketing and distributing products or services to customers.

Total Product Cost Calculation

Formula:

• Total Product Cost: Total Product Cost = Direct Materials + Direct Labor + Manufacturing Overhead.

• To determine the unit product cost, utilize the formula: Unit Product Cost = Total Product Cost / Number of Units Produced.

Calculation Example (BlueDenim Company):

• Total Product Cost Calculation:

  • Direct Materials: $48,000

  • Direct Labor: $30,000

  • Overhead: $72,000

  • Total: $150,000.

• Cost Per Unit: $5 per pair of jeans produced for a total of 30,000 units.

Prime Costs and Conversion Costs

Prime Costs:

• Definition: Prime Costs consist of direct materials and direct labor. In this example, per unit is calculated to be $2.60.

Conversion Costs:

• Definition: Conversion Costs are calculated as the sum of direct labor and manufacturing overhead, resulting in a per unit cost of $3.40.

Period Costs

Definition:

• Period costs represent expenses for production that are not included in inventory; these costs are recognized in the income statement when incurred, falling into administrative and selling categories.

Types of Business Operations

Categories:

• Merchandising Operations: Involve the resale of finished goods.

• Service Operations: Focus on providing services rather than products.

• Manufacturing Operations: Encompass the entire production process from raw materials through to finished goods.

Income Statement for Manufacturing Operations

Components:

• The income statement for manufacturing operations incorporates direct materials, direct labor, and manufacturing overhead into the cost of the finished products, providing a comprehensive view of the profitability of manufacturing activities.

Inventory Reporting

Merchandising Operations:

• Products are categorized within current assets, such as cash and merchandise inventory.

Manufacturing Operations:

• Financial reporting includes various categories of inventory: finished goods, work-in-progress, and raw materials, each playing a critical role in the organization’s operational value.

Cost of Goods Manufactured (COGM)

Description:

• COGM represents the total cost of products available for sale during a specific period and is crucial for understanding product profitability.

Calculation through a Statement of COGM:

• Detailed calculations allow businesses to comprehensively assess their manufacturing costs and operational efficiency.

Income Statement for Manufacturing Business

Structure:

• The income statement for a manufacturing business presents sales revenues, deducts cost of goods sold (COGS), includes operating expenses, and culminates with net income, showcasing the financial outcome of the operations.

Steps for COGM Calculation

Detailed Steps:

1. Determine the cost of direct materials used in production.

2. Calculate total manufacturing costs incurred during the period.

3. Compute the COGM, which directly affects the financial standing of manufacturing operations.

Example: Direct Materials Used

Formula:

• Direct Materials = Beginning Materials Inventory + Purchases - Ending Materials Inventory.

COGM Calculation Example:

• Total Manufacturing Costs = Direct Materials + Direct Labor + Overhead.

COGS Calculations

Sales Dynamics:

• COGS is influenced by both beginning and ending inventory levels, alongside adjustments for COGM, which are critical for accurate financial reporting.

Creating an Income Statement for a Service Organization

Income Statement Structure:

• In service organizations, the income statement comprises sales revenues, operating expenses (inclusive of direct costs), and operating income, reflecting the organization’s performance within its service domain.

Mastering these intricate concepts lays a crucial groundwork for foundational knowledge in managerial accounting, cost analysis, and essential financial decision-making practices.

CHAPTER 3: Cost Behaviour

Cost Behaviour is is the general term to describe whether a cost changes when the

level of activity changes.

A fixed cost is a cost that does not change in total as activity changes; however, the fixed cost per unit will vary inversely with the level of activity.

On the other hand, a variable cost increases in total with an increase in activity and decreases in total with a decrease in activity.

Cost Behaviour – Measures of Output – Cost Driver

A cost driver is a key determinant of cost behaviour.

• A cost driver is a causal measurement that causes costs to change. This cost driver is some output measure.

• A cost is fixed or variable with respect to some output measure or cost driver.

• First we determine the underlying business activity and ask ourselves, “What causes the cost of this particular activity to go up or down?”

Unit Costs

The relevant range is the range of output over which an assumed cost relationship is

valid for the normal operations of a firm.

• The relevant range limits the cost relationship to the range of operations that the firm normally expects to occur.

• Avoids extremely high levels of activity

• Avoids extremely low levels of activity

Fixed Cost Example

Fixed costs in total are constant within the relevant range as the level of output increases or decreases but unit fixed cost decreases as output increases.

Discretionary vs. Committed Fixed Costs

Discretionary Fixed Costs:

• Fixed costs that can be changed relatively easily at management discretion

• Advertising is a discretionary fixed cost.

• Advertising cost depends on the decision by management to purchase print, radio, or video advertising.

Committed Fixed Costs:

• Fixed costs that cannot be easily changed; these often involve a long-term contract (e.g., leasing of machinery or warehouse space)

Variable costs in total vary in direct proportion to changes in output within the relevant range, while the unit variable cost remains fixed for each level of output

Cost Behaviour Mixed and Step Costs

• Mixed costs contain both fixed and variable components, making them more complex to analyze.

• Step costs remain fixed over a range of activity but will increase in steps once a certain threshold is reached.

  • Displays a constant cost for a range of output

  • Then jumps to a new cost level for a different

    range

Total Cost = Total Fixed Cost + Total Variable Cost

Separate Mixed Costs into Their Fixed and Variable Components

• Accounting records typically show only total cost and associated amount of activity of a mixed cost item

• Therefore, it is necessary to separate the total cost into its fixed and variable components.

• There are three methods to separate mixed costs into their fixed and variable components:

  • High-Low Method,

  • Scattergraph Method,

  • Method of Least Squares

Creating and Using a Cost Formula

• Cost-Volume-Profit Analysis: A crucial tool for understanding the relationship between cost, volume, and profit in decision-making.

1. Define the cost formula

2. Identify the dependent variable

3. Identify the independent variable

• The dependent variable is a variable whose value depends on the value of another variable.

• The independent variable is a variable that measures output and explains changes in the cost.

• In the context of cost analysis, the dependent variable typically represents the total cost incurred, while the independent variable could be the level of production or sales volume.

Intersect and Slope

Intersect: The independent variable is a variable that measures

output and explains changes in the cost.

Slope: Corresponds to variable rate (variable cost

per unit of output)

Variable Rate: is also called the slope of the cost line

• represents how much the total cost will change with each additional unit produced. This relationship is essential for understanding how production levels impact overall expenses.

• Fixed Costs: Costs that do not change with the level of output, remaining constant regardless of production volume.

• Total Cost: The sum of fixed and variable costs, which provides a complete picture of the expenses incurred in production.

• Variable Costs: Costs that vary directly with the level of output, increasing as production rises and decreasing when production falls.

Recall linear formula y = mx + b

y = dependent variable

x = independent variable

m = slope of the line, variable rate, representing the rate of change of the variable cost with respect to the level of output

b = total fixed cost, which remain constant regardless of the production level

High-Low Method: This method is used to estimate variable and fixed costs by analyzing the highest and lowest levels of activity within a given period.

Scattergraph Method

• This method involves plotting data points on a graph to visually assess the relationship between costs and activity levels, allowing for a more intuitive understanding of cost behavior.

Method of Least Squares

• This statistical method calculates the line of best fit for the given data points, minimizing the sum of the squares of the vertical distances of the points from the line, thereby providing an accurate estimation of fixed and variable costs.

• The best fitting line is one in which the data points are closer to the line than to any other line.

Steps:

1. Measure distance from points to line

2. Then square the differences

3. Add up all the squared differences

Regression Method

This process allows us to minimize the residuals and find the best-fitting line through the data points.

• This technique is essential for understanding how well our model predicts the dependent variable based on the independent variables.

Managerial Judgment

• Instead of the methods previously discussed, many managers use their experience and past observation of cost relationships to determine fixed and variable costs.

• Statistical techniques are highly accurate in depicting the past, but they cannot foresee the future.