Cost Terms, Concepts, and Classifications

1. Chapter 2 Cost Terms, Concepts, and Classifications

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

3. DirectMaterials DirectLabor ManufacturingOverhead Manufacturing Costs The Product

4. 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. 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. 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. Manufacturing Overhead Manufacturing costs that cannot be traced directly to specific units produced. Examples:Indirect labor and indirect materials

8. PrimeCost ConversionCost Classifications of Costs Manufacturing costs are oftenclassified as follows: DirectMaterial DirectLabor ManufacturingOverhead

9. Marketing and Selling Cost Administrative Cost Costs necessary to get the order and deliver the product. All executive, organizational, and clerical costs. Nonmanufacturing 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  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 include direct materials, direct labor, and manufacturing overhead. Period costs are not included in product costs. They are expensed on the income statement. Inventory Expense Cost of Good Sold Sale BalanceSheet IncomeStatement IncomeStatement Product Costs Versus Period Costs

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 costschange when activity changes. • Total fixed costsremain unchanged when activity changes. Note excellent red tie !

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

16. Per MinuteTelephone Charge Minutes Talked Variable Cost Per Unit The cost per long distance minute talked is constant. For example, 10 cents per minute.

18. Monthly Basic Telephone Bill Number of Local Calls Total Fixed Cost Your monthly basic telephone bill probably does not change when you make more local calls.

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

21. Cost Classifications for Predicting Cost Behavior

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

25. 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 0 0 1,000 2,000 3,000 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. Y X Mixed Costs A mixed cost has both fixed and variablecomponents. Consider the example of utility cost. Total mixed cost Total Utility Cost Variable Cost per KW Fixed MonthlyUtility Charge Activity (Kilowatt Hours)

28. Y X Mixed Costs Total mixed cost Y = a + bX Total Utility Cost Variable Cost per KW Fixed MonthlyUtility 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 eithervariable 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. Y 20 * * * * * * * * Total Cost in1,000’s of Dollars * * 10 0 X 0 1 2 3 4 Activity, 1,000’s of Units Produced The Scattergraph Method Plot the data points on a graph (total cost vs. activity).

32. Quick-and-Dirty Method Draw a line through the data points with about anequal numbers of points above and below the line. Y 20 * * * * * * * * Total Cost in1,000’s of Dollars * * 10 Intercept is the estimated fixed cost = $10,000 0 X 0 1 2 3 4 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 in1,000’s of Dollars * * 10 Horizontal distance is the change in activity. Vertical distance is the change in cost. 0 X 0 1 2 3 4 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 costChange in units • Variable cost per unit = Change in cost ÷ change in units

36. 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. 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 Method Least-squares regression also provides a statistic, called the R2, that is a measure of the goodnessof 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 near100% since the data points arevery close to the regression line. 0 X 0 1 2 3 4 Activity

41. Independent variables are the cost drivers that are correlated with the dependent variables. Dependent variables are caused by the independent variables. Cost Estimation MethodsRegression 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.

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

43. Cost Estimation MethodsRegression 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 Costs that can beeasily 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 Direct Costs and Indirect Costs

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 werenot attending college,you could be earning$15,000 per year. Your opportunity costof attending college for one year is $15,000.