Chapter 1 Notes — Managerial Accounting and Cost Concepts

Needs of Management

Financial accounting vs managerial accounting
- Financial accounting is concerned with reporting financial information to external parties (stockholders, creditors, regulators).
- Managerial accounting provides information to employees within an organization to help them formulate plans, 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 and 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.
- These costs cannot be traced to any individual cost object.

Classifications of Manufacturing Costs

Direct Materials
Direct Labor
Manufacturing Overhead

Direct Materials

Direct materials are raw materials that become an integral part of the product and can be conveniently traced directly 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 material 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

Examples of manufacturing overhead:
- Depreciation of manufacturing equipment.
- Utility costs.
- Property taxes.
- Insurance premiums incurred to operate a manufacturing facility.
Only those indirect costs associated with operating the factory are included in manufacturing overhead.

Prime Costs and Conversion Costs

Manufacturing costs are often classified as follows:
- Prime costs = Direct Materials + Direct Labor
- Conversion costs = Direct Labor + Manufacturing Overhead

Nonmanufacturing Costs

Selling Costs: Costs necessary to secure the order and deliver the product. Selling costs can be either direct or indirect costs.
Administrative Costs: All executive, organizational, and clerical costs. Administrative costs can be either direct or indirect costs.

Product Costs

Product costs include all costs involved in acquiring or making a product.
Product 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

A manufacturer’s product costs flow through three inventory accounts on the balance sheet:
- Raw materials: include any materials that go into the final product.
- Work in process (WIP): units of product that are only partially complete and require further work before sale.
- Finished goods: completed units not yet sold to customers.

The Flow of Manufacturing Costs

Raw Materials → Work in Process → Finished Goods → Cost of Goods Sold (upon sale)

Transfer of Product Costs

When direct materials are used in production, their costs are transferred from Raw Materials to Work in Process.
Direct labor and manufacturing overhead costs are added to Work in Process to convert direct materials into finished goods.
Once units are completed, their costs are transferred from Work in Process to Finished Goods.
When finished goods are sold, costs are transferred 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 (Sample Question)

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 (conceptual): Period costs are selling and administrative costs. Therefore, B (Property taxes on corporate headquarters) and E (Sales commissions) are period costs; A, C, and D are product costs (A is overhead related to facilities used in production; C is direct materials; D is production facility electricity).

Cost Classifications for Predicting Cost Behavior

Cost behavior refers to how a cost will react to changes in the level of activity.
Most 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.

An Activity Base (Cost Driver)

A measure of what causes the incurrence of a variable cost.
Examples of drivers: Machine hours, Labor hours, Units produced, Units sold

Fixed Cost

A cost that remains constant, in total, regardless of changes in the level of the 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:
- Economist's view: Curvilinear cost function; a straight line closely approximates the curvilinear variable cost within the relevant range.
- Accountant's view: Straight-line approximation (constant unit variable cost).

Fixed Costs and the Relevant Range

The relevant range of activity applies to fixed costs as well as variable costs.
- Example: Office space rental at $30,000 per year in increments of 1,000 square feet; fixed costs increase in a step fashion at $30,000 per added 1,000 sq ft.

Relevant Range (Graphic Description)

The relevant range is the range of activity over which the cost graph is flat (for fixed costs) or behaves linearly (within that range).

Comparison of Cost Classifications for Predicting Cost Behavior

Behavior of cost within the relevant range:
- Variable costs: Total variable cost changes with activity; variable cost per unit remains constant.
- Fixed costs: Total fixed cost remains constant; fixed cost per unit decreases as activity rises and increases as activity falls.

Quick Check 2 (Sample Question)

Which of the following costs would be variable with respect to the number of ice cream cones sold at a Baskin & 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.
Answer (conceptual): Variable costs vary with sales; C (cost of ice cream) is clearly variable; D (napkins) is often variable with sales; A (lighting) could be variable depending on usage (but often treated as mixed or variable with hours); B (store manager wages) is typically fixed. There may be multiple correct depending on how cost behavior is defined for lighting.

Mixed Costs – Part 1

A mixed cost contains both variable and fixed elements.
Example: Utility cost can have a fixed monthly charge plus a variable charge depending on usage.

Mixed Costs – Part 2

The total mixed cost can be expressed as an equation: Y = a + bX
- Where: Y = total mixed cost
- a = total fixed cost (vertical intercept of the line)
- b = variable cost per unit of activity (slope of the line)
- x = level of activity

Mixed Costs – An Example

If very important that you identifyt per unit is b = 0.03 per kilowatt hour, and your monthly activity level is X = 2000 kilowatt hours, then the total utility bill is:
- Y = a + bX = 40 + 0.03(2000) = 40 + 60 = 100

Cost Classifications for Decision Making

Decisions involve choosing between alternatives. The goal is to identify costs that are relevant or irrelevant.
Key concepts:
- Differential costs and differential revenues
- Opportunity costs
- Sunk costs

Differential Cost and Revenue

Differential (incremental) costs are the difference in cost between any two alternatives.
Differential revenue is the difference in revenue between two alternatives.
Both are always relevant to decisions.
Differential costs can be either fixed or variable.

Opportunity Cost

The potential benefit forgone when one alternative is selected over another.
Not usually found in accounting records but is a relevant cost in every decision.
Example note: What is the opportunity cost of attending class?

Sunk Cost

A cost that has already been incurred and cannot be changed by any future decision.
Because sunk costs cannot be changed, they are not differential costs.
Since only differential costs are relevant to decisions, sunk costs are irrelevant and should be ignored.

Quick Check 3 (Sample Question)

Scenario: Drive vs train to Portland for a concert. You have ample cash; is the train ticket cost relevant?
Answer: Yes, the train ticket cost is a relevant differential cost when comparing driving vs taking the train, because it differs between options and affects the choice.

Quick Check 4 (Sample Question)

Scenario: Driving vs train; is the annual cost of licensing your car relevant?
Answer: No, it is not relevant in the trip decision because licensing is a fixed, unavoidable cost regardless of the travel choice.

Quick Check 5 (Sample Question)

Scenario: Your car could be sold now for 5{,}000. Is this a sunk cost?
Answer: No. The 5{,}000 salvage value is not a sunk cost; a sunk cost is a past cost already incurred. The salvage value is an opportunity cost or potential benefit of selling the asset.

Learning Objective 6

Prepare income statements for a merchandising company using the traditional and contribution formats.

The Traditional and Contribution Formats

Traditional income statement (external reporting):
- Sales: 100{,}000
- Cost of goods sold: 70{,}000
- Gross margin: 30{,}000
- Selling & administrative expenses: 20{,}000
- Net operating income: 10{,}000
Contribution format income statement (internal management use):
- Sales: 100{,}000
- Variable expenses: 60{,}000
- Contribution margin: 40{,}000
- Fixed expenses: 30{,}000
- Net operating income: 10{,}000
Key takeaway: Traditional format emphasizes gross margin; contribution format emphasizes contribution margin to cover fixed costs and evaluate profitability.

Uses of the Contribution Format

Used as an internal planning and decision-making tool for:
- Cost-volume-profit analysis (Chapter 6).
- Segmented reporting of profit data (Chapter 7).
- Budgeting (Chapter 8).
- Special decisions such as pricing and make-or-buy analysis (Chapter 11).

Exercise 1-11

1) Complete the above schedule.
2) If 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.