a eS CHAPTER 2 Managerial Accounting and Cost Concepts Lowering Healthcare Costs and Improving Patient Care LEARNING OBJECTIVES After studying Chapter 2, you should be cy & able to: Ka LO2-1 Understand cost casstcatons used for Zz assering costs to cost objets: drect I costs and indirect costs, i «« a 02-2. dentty and give examples of each of a the thre basic manufacturing cost 9 categories. c LOZ-3 Understand cost clasiatons used to PA prepare financial statements: produ costs and period costs L028 understand cost assiatons used to pred cost behavior: arable costs, ‘ee costs, and ite costs Providence Regional Medical Center's (PRMC) ‘single stay’ 102-5 \ward is lowering heaincae costs and increasing patent satisfaction, Rather than transporting postsurgical patents to stationary equoment throughout the hospital, a “single stay" ward brings all required equipment to stationary patients. For example, “after heart surgery, cardiac patients remain in one ‘oom throughout ther recovery, only the gear and stat are in mation. AS Doayan ames cost using 2 seater: ‘rap plot ad th ighow metro, 102-5 Prepare income statements for 8 merchandising company sing the ‘wavonl and conrbutn formas the patient's condition stabizes, the beeging machines of intensive care are 102-7 Understae cost eassifeations use removed and physical therapy equipment is added.” The results of this shift in making decisions: citerental cost, in evientaton have been impressive. Patient stistaction scores have skyrock: opportunity cost, and sunk cost, feted andthe average length ofa patient's stayin the hospital has declined by L028 pend 24) Araze a mixed cost more than aay. i sing a scattrgraph pt andthe least squares regression method. 102-9 pent 26) Wenty the four pes of qualty costs and expla how they interact. L02-10 penx 221 Prepare and interpret @ ualty cost report, Scarce Caro fet, Rasen! Sgn” Bloomber Buanac seek, nu 18, 2010, 2728 Chapter 2 his chapter explains that in managerial accounting the tem cost i used in many different ways. The reason is that there are many types of costs, and these costs ae classified differently according tothe immediate needs of management, For example, managers may want cost data to prepare external, ‘avancal reports, to prepare planning budgets, or to make decisions, Each diferent use of cost data demands a different classification and definition of costs. For example, the preparation of external financial reports requires the use of historical cost data, wheseas decision making may requie predictions about future cost. Ths notion of different costs {for different purposes is a tically important aspect of managerial accounting ‘Exhibit 2-1 summarizes the cost classifications that will be defined inthis chapter, namely cost classifications (1) for assigning coss to cost objects, (2) for manufacturing ‘companies, (3) for preparing financial statements, (1) for predicting cost behavior, and (5) for making decisions. As we begin defining the cost terminology related to cach of these cost classifications, please refer back to ths exhibit to help improve your under standing of the overall organization of the chapter. | Cost Classifications for As: Costs ate assigned to cost objects for a variety of purposes including pricing, prepar- ing profitability studies, and controlling spending. A cost object is anything for which ‘cost data are desired—including products, customers, jobs, and organizational subunits. For purposes of assigning costs to cost objects, costs are classified as either direct oF ning Costs to Cost Objects Lo2-1 Understand cost classifications used for assigning costs to cost objects: direct costs and indirect costs. indirect. Direct Cost A direct cost is a cost that can be easily and conveniently traced to a specified cost object. For example, if Reebok is assigning costs to its vasious regional and national sales offices, then the salay of the sales manager in its Tokyo office would be a dzect EXHIBIT 2-1 Summary of Cost Classifications Purpose of Cost Classification Cost Classifications Assigning costs to cost objects + Direct cost (ean be easily raced) * Indirect cost (cannot be easily traced) Accounting for costs in manufacturing + Manufacturing costs ‘companies + Direct materials + Direct bor * Manufacturing overhead + Nonmanufacturing costs + Seling costs + Administrative costs Preparing financial statements + Product costs (inventoriable) * Period costs (expensed) Predicting cost behavior in response + Variable cost (proportional to activity) to changes in actvity + Fixed cost (constant in total) + Mixed cost (has variable and fixed elements) Making decisions + Differential cost (differs between alternatives) + Sunk cost (should be ignored) * Opportunity cost (foregone benefit)Managerial Accounting and Cost Concepts cost of that office. If a printing company made 10,000 brochures for a specific customer, then the cost of the paper used to make the brochures would be a dizect cost of that customer, Indirect Cost An indirect cost is a cost that cannot be easily and conveniently traced to a specified cost object. For example, a Campbell Soup factory may produce dozens of varieties of canned soups. The factory manager's salary would be an indirect cost of a particular variety such as chicken noodle soup. The reason is that the factory manager's salary is incurred as a consequence of running the entire factory—it is not incurred to produce any one soup variety. To be traced toa cost object such as a particular product, the cost must be caused by the cost object, The factory manager's salary is called a common cost of producing the various products of the factory. A common cost is a cost that is incurred to support a ‘number of cost objects but cannot be traced to them individually. A common costs a type of indirect cost A particular cost may be direct or indirect, depending on the cost abject. While the Campbell Soup factory manager's salary is an indirect cost of manufacturing chicken noodle soup, it is a direct cost of the manufacturing division. In the first case, the cost lobject is chicken noodle soup. In the second case, the cost object is the entire manufactur ing division, 29 [a Cost Classifications for Manufacturing Companies | ‘Manufacturing companies such as Texas Instruments, Ford, and DuPont separate theit costs into owo broad categories—manufacturing and nonmanufacturing costs, Manufacturing Costs ‘Most manufacturing companies further separate their manufacturing cost into twa direct cost categories, direct materials an direct labor, and one indrest cost calegory, manlae- turing overhead, A discussion of cach ofthese categories follows Direct Materials the materials that go into the final product are called raw materials, This tema is somewhat misleading because it seems to imply unprocessed at- ual resources like wood pulp of iron ore. Actually, raw materials refer to any matezals that are used in the final product; andthe finished product of one company can become the raw materials of another company. For example, the plastics produced by Du Pont ae a raw material used by Hewlett-Packard in ts personal comptes. Raw materials may include both direct and indirect materials, Direct materials are those materials that become an integral part ofthe finished product and whoxe costs can be conveniently traced to the finished product. This would includ, for example, the seats that Airbus purchases from subcontractors to insall in its commercial aieraft and the electronic components that Apple uses in ts iPhones. Sometimes it isn't worth the effort to trace the costs of relatively insignificant materi als to end products, Such minor items would include the solder used to make electrical connections in a Sony HDTV or the glue used to assemble an Ethan Allen cbait, Mate- nals such as solder and glue are called indirect materials and ate included as pat of manufacturing ovethead, which is discussed shorty Direct Labor Direct abor consists of labor costs that can be easly (Le, physically and conveniently) traced to individual units of product. Dect labor is sometimes called touch labor because direct labor workers typically touch the product while itis being made, Examples of direct labor include assembly-line workers at Toyota, carpenters Lo2-2 Identity and give examples ‘of each of the tree basic rmansfacturing cost categories.30 Chapter 2 FOOD PRICES HIT RECORD HIGHS FOR RESTAURANTS Direct material costs are crtically important to restaurants and fastfood chain. n recent years, some food costs have spiked to record highs. For example, unexpected freezing temperatures in the southwestern portion of the Unted States caused the cost of lettuce to increase 290%, Similarly, te costs of green peppers, tomatoes, and cucumbers jumped 145%, 85%, and 20%, respectively. large chain such as Subway can withstand these price increases better than smaller ‘competitors because ofits buying power and longterm contacts. ‘Source: Anne Vanderey, Food For Thought Fortine, May 8, 2011, p12. at the home builder KB Home, and electricians who install equipment on aircraft at Bombardier Learjet. Labor costs that cannot be physically taced to particular products, or that can be traced only at great cost and inconvenience, are termed indirect labor. Just like indi- rect materials, inditect labor is weated as part of manufacturing overhead, Indicect labor includes the labor costs of janitors, supervisors, materials handlers, and night security ‘guards, Although the efforts of these workers are essential, it would be either impracti- cal or impossible to accurately trace their costs to specific nits of product, Hence, such labor costs are treated as indirect labor. Manufacturing Overhead Manufacturing overhead, the third manufacturing cost category, includes all manufacturing costs except direct materials and direct labor. ‘Manufacturing overhead includes items such as indirect materials; indirect labor; main- tenance and repaits on production equipment; and heat and light, property taxes, depre- ‘ciation, and insurance on manufacturing facilities. A company also incurs costs for heat and light, property taxes, insurance, depreciation, and so forth, associated with its selling and administrative functions, but these costs are not included as part of manufacturing overhead, Only those costs associated with operating the factory are included in manu facturing overhead. Various names are used for manufacturing overhead, such as indirect manufacturing ‘cost, factory overhead, and factory burden. All ofthese terms are synonyms for mantfac- turing overhead Nonmanufacturing Costs Nonmanufacturing costs are often divided into two categories: (1) selling costs and Q) administrative costs, Selling costs include all costs that are incurred to secure cus- tomer orders and get the finished product to the customer, These costs are sometimes called order-geting and ordering costs. Examples of selling costs include advertis- ing, shipping, sales ave, sales commissions, sales salaries, and costs of finished goods warehouses. Selling costs ean be either direct or indirect costs, For example, the cost of san advertising campaign dedicated to one specific product isa direct cost of that product, whereas the salary of a marketing manager who oversees numerous products is an indi- rect cost with respect to individual products Administrative costs include all costs associated with the general management of an organization rather than with manufacturing or selling. Examples of admin- istrative costs include executive compensation, general accounting, secretarial, pub- lic relations, and similar costs involved in the overall, general administration of the organization az a whole, Administrative costs can be either ditect or indirect costs. For example, the salary of an accounting manager in charge of accounts receivable collections in the East region is a dicect cost of that region, whereas the salary of aManagerial Accounting and Cost Concepts al chief financial officer who oversees all of a company's regions is an indirect cost with espect to individual segions. Nonmanufacturing costs are also often called selling, general, and administrative (SG&A) costs o just selling and administrative costs. | ____ Cost Classifications for Preparing Financial Statements | When preparing a balance sheet and an income statement, companies need to classify their costs as product costs or period costs. To understand the difference between prod= uct costs and period costs, we must first discuss the matching principle from financial accounting, Generally, costs ate recognized as expenses on the income statement in the period that benefits from the cost. For example, if a company pays for liability insurance in advance for two years, the entire amount is not considered an expense of the yeat in which the payment is made. Instead, one-half of the cost would be recognized as an expense teach year. The reason is that both years—not just the frst year—benefit from the insur- {ance payment. The unexpensed portion of the insurance payment is carried on the balance sheet as an asset called prepaid insurance ‘The matching principle is based on the accrual concept that costs incurred to gener- ate a particular revenue should be recognized as expenses in the same period that the revenue is recognized. This means that if a cost is incurred to acquire or make something that will eventually be sold, then the cost should be recognized as an expense only when the sale takes place—that is, when the benefit oceurs, Such costs are called product costs Lo2-3 Understand cost classifications sed to prepare financial statements: product costs ‘and period costs, Product Costs For financial accounting purposes, product costs include all costs involved in acquiring for making a product. In the case of manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead.' Product costs “attach” to units of product as the goods are purchased or manufactured, and they remain attached as the goods go into inventory awaiting sale, Product costs are intially assigned to an inventory Account on the balance sheet. When the goods are sold, the costs are released from inven tory as expenses (typically called cost of goods sold) and matched against sales revenue fn the income statement, Because product costs are initially assigned ta inventories, they are also known as inventoriable costs. ‘We want to emphasize that product costs are not necessarily recorded as expenses the income statement in the period in which they are incurred. Rather, as explained above, they are recorded as expenses in the period in which the related products are sold. Period Costs Period costs are all the costs that are not product costs. Al! selling and administrative expenses are treated as period costs. For example, sales commissions, advertising, exec~ utive salaries, public relations, and the rental costs of administrative offices are all period costs. Period costs are not included as part of the cost of either purchased or manufac tured goods; instead, period costs are expensed on the income statement in the period in which they arc incurred using the usual rules of accrual accounting. Keep in mind that the period in which a cost is incurred is not necessarily the period in which cash changes ‘hands. For example, as discussed eatlier, the costs of lability insurance are spread across the periods that benefit from the insurance—regardless of the period in hich the insus- ance premium is paid. For incernal management purposes, product costs may exclude some manufacturing costs, For exam ple, see Appendix 3A and te discussion in Chapter 5,32 Chapter 2 Prime Cost and Conversion Cost ‘Two more cost categories are often used in discussions of manufacturing costs—prime ‘cost and conversion cost, Prime cost is the sum of direct materials cost and direct labor ‘cost, Conversion cost is the sum of direct labor cost and manufacturing overhead cost ‘The term conversion cost is used to describe direct labor and manufacturing overhead because these costs ae incurred to convert materials into the finished product “To improve your understanding of these definitions, consider the following scenati: A company has reported the following costs and expenses forthe most recent month: Direct materials $68,000 Direct labor entree na 695000) Manufacturing overhead .............. $14,000 Seling expenses ......0-..-..s..-... $28,000 Aciministrative expenses $50,000 ‘These costs and expenses can be categorized in a number of ways, including product ‘costs, period costs, conversion costs, and prime costs Direct materials + Direct labor + Manufacturing overhead {$69,000 + $35,000 + $14,000 = $118,000 Period cost ~ Selling expenses + Administrative expenses $529,000 + $50,000 $79,000 Direct labor + Manufacturing overhead '$35,000 + $14,000 $49,000 Direct materials + Direct labor {$69,000 + $35,000, 104,000 Conversion cost WALMART LOOKS TO REDUCE ITS SHIPPING COSTS Walarthopes ta lower its shiping costs, thereby enabling it to reduce its “everyday low prices. In years past, suppliers would ship their merchandise to Walmart's distribution centers, and then Walmart would use its own fleet of trucks to ship goods from its distribution centers to its reall store locations. However, now Walmart wants to assume control of transporting merchandise from its suppliers’ manufacturing faclties to its distribution centers. Walmart believes it can lower these shipping costs by carrying more merchandise per tuck and by taking advantage of volume purchase price discounts for ful. n exchange for assuming these shipping responsibik ties, Walmart is seeking price reductions from suppliers that it can pass along, at least in part, tots customers ‘Source: Chis Burt, Carl Wal, and Mathew Boye, “Why WetNart Wants to Take the Druer's Seat” Bloom berg Businessweek, May 31-lune 6, 2010, 9p.17-18,Managerial Accounting and Cost Concepts 33 ii Cost Classifications for Predicting Cost Behavior | Itis often necessary to predict how a certain cost will behave in response toa change in activ ity, For example, a manager at Under Armour may want to estimate the impact a5 percent increase in sales would have on the company's tolal ditect materials cost. Cost behavior refers to how a cost reacts to changes in the level of activity. As the activity level rises and falls, a particular cost may rise and fall as well—or it may remain constant, For planning ‘Purposes, a manager must be able to anticipate which of these will happen; and if a cost tan be expected to change, the manager must be able (o estimate how much it will change, ‘To help make such distinctions, costs ae often categorized as variable, fixed, or mixed. The relative proportion of each type of cast in an organization is known as its cost structure For example, an organization might have many fixed costs but few variable or mixed costs, Alternatively, st might have many variable costs but few fixed or mixed costs. Variable Cost A variable cost vaties, in total, in ditect proportion to changes in the level of activity Common examples of variable costs include cost of goods sold for a merchandising com- pany, direct materials, diect labor, variable elements of manufacturing overhead, such as indirect materials, supplies, and power, and variabl live expenses, such as commissions and shipping costs.? For a cost to be variable, it must be variable with respect fo something. That “some- hing” is its activity Base. An activity base is a measure of whatever causes the incurrence of a variable cost, An activity base is sometimes referred to as a cost driver: Some of the most common activity bases are direct labor-hours, machine-hours, units produced, and units sold, Other examples of activity bases (cost drivers) include the number of miles driven by salespersons, the number of pounds of laundry cleaned by a hotel, the number of calls handled by technical support staff at a software company, and the number of beds jccupied in a hospital. While there are many activity bases within organizations, through ut this textbook, unless stated otherwise, you should ascume thatthe activity bace under consideration isthe total volume of goods and services provided by the organization. We will specify the activity base only when itis something other than total output To provide an example of a variable cost, consider Nooksack Expeditions, a small company that provides daylong whitewater rafting excursions on rivers in the North sments of selling and administra: COST DRIVERS IN THE ELECTRONICS INDUSTRY ‘Accenture Ltd estimates thatthe US. electronics industry spends $13.8 bilion annually to rebox, restock, and resell retuned products. Conventional wisdom is that customers only return products when they are defective, but the data show that this explanation only accounts for 5% of customer returns. The biggest cost drivers that cause product returns are that customers often inadvertently by the wrong products and that they cannot understand how to use the products that they have purenased. Television manufacturer Vizio hc. has started including more information on its packag. ing to help customers avoid buying the wrong product. Seagate Technologies is replacing tick instruction manuals with simpler guides that make t easier for customers to begin using their products. Source Christopher Lawton, "The War on Reta £ The Wall Steet Journal May 8, 2008, pp. D1 and 06 F Dizet labor cot often can be xed instead of variable fora variety ofreatons, For example, in vome couatries, suchas France, Germany and Japan, abor regulations and cltral norms tay limit manage rents ability o adjust the labor force in esponse to changes inactivity In this textbook, alway assume that dzet labor is 2 variable cos unless you are explicitly told otherwise Lo2-4 Understand cast classfcations used to predict cost behavior vatiable costs, fixed costs, and mixed costs34 Chapter 2 FOOD COSTS AT A LUXURY HOTEL ‘The Sporthote! Theresa thtp://imww.theresa.at), ned and operated by the Egger family i a four star hotel located in Zell iy Zilrtal, Austria, The tel features access to hiking, sking, biking, and ‘other actities in the Zier alps as wel as ts own fitness facility and spa. Three full meals a day are included inthe hotel room charge. Breakfast and lunch are served bulfetstyle while dimers a more formal affair with as many as six courses. The chet, Stefan Egger, believes that food costs are roughly proportional othe number of guests staying at the hotel; that is, they are a variable cost, He ust order food from supaliers two or thee days in advance, but he adjusts his putchases to the number of guests who are cutrently staying atthe hotel and ther consumption pattems. In additon, guests make their selectons from the dinner menu early nthe day, which helps Stefan plan which focdstutfs willbe required for nner. Consequenty, he is able to prepare just encugh fead so that all guests ae satisfied and yet waste is held to a minimum Source: Conversation with Steen Egger, chef atthe Sporthoel Theresa ‘Cascade Mountains. The company provides all of the necessary equipment and experi- ‘enced guides. and it serves gourmet meals to its guests. The meals are puschased from a caterer for $30 a person for a daylong excursion. The behavior of this variable cost, on both a per unit and a total basis, is shown below: Number Gostof Meals Total Cost of Guests per Guest of Meals 250 $30 $7,500 500. $30 $18,000 WO $80 $22,500 4,000 $20 $30,000 ‘While total variable costs change as the activity level changes, itis important to note that a variable cost is constant if expressed on a per unit basis, For example, the per unit ‘cost of the meals remains constant at $30 even though the total cost ofthe meals inereases and decreases with activity. The graph on the left-hand side of Exhibit 2-2 illustrates that the total variable cost rises and falls asthe activity level rises and falls. At an activity level, ‘of 250 guests, the total meal cost is $7,500, At an activity level of 1,000 guests, the total real cost rises to $30,000, Fixed Cost A fixed cost isa cost that remains constant, in total, regardless of changes in the level of activity. Examples of fixed costs include straight-line depreciation, insurance, property taxes, rent, supervisory salaries, administrative salaries, and advertising. Unlike variable costs, fixed costs are not affected by changes in activity. Consequently, as the activity level rises and falls, total xed costs remain constant unless influenced by some oul- side force, such as a landlord increasing your monthly rental expense. To continue the ‘Nooksack Expeditions example, assume the company rents a building for $500 per ‘month to store its equipment, The total amount of rent paid is the same regardless of the number of guests the company takes on its expeditions during any given month. The ‘concept of a fixed cost is shown graphically on the right-hand side of Exhibit 2-2. ‘Because total fixed costs remain constant for large variations in the level of activ- ity, the average fixed cost per unit becomes progressively smaller as the level of activ- ity increases. If Nooksack Expeditions has only 250 guests in a month, the $500 fixed rental cost ould amount to an average of $2 per guest. If there are 1,000 guests, the fixed rental cost would average only 50 cents per guest. The table below illustratesManageral Accounting and Cost Concepts 35 EXHIBIT 2-2 Varabe and Fee Cost Behavior Total Cost of Meals Total Cost of Renting the Building $20,000 A varable cost increase $25,000 Fixed cote remain in total, in proportion ied coe ras 2 » ‘amount through 3 $20,000 \ re esreatsl Sethayh Cost ot & 15,000 Salking } $500 A rental 3 s10,000 ‘$5,000 $0 $0 0 250 500 750 1,000 0 750-500 ~—750~—«+1,000 Number of uests Number of quests this aspect of the behavior of fixed costs, Note that as the number of guests increase, the average fixed cost per guest drops. Monthly Number Average Cost Rental Cost of Guests per Guest $500. 250 $2.00 $500. 500, $1.00 $500 750 $087 $500 4,000 $0.50 As a general rule, we caution against expressing fixed costs on an average per unit basis in internal reports because it creates the false impression that fixed costs are like variable costs and that toral fixed costs actually change as the level of activity changes: For planning purposes, fixed costs can be viewed as either committed of discretion- ary: Committed fixed costs represent organizational investments with a multiyear plan- ning horizon that can’t be significantly reduced even for short periods of time without ‘making fundamental changes. Examples include investments in facilites and equipment, as well a real estate taxes, insurance expenses, and salaries of top management. Even if ‘operations are interrupted ot cut back, committed fixed costs remain largely unchanged inthe short term because any short-run savings that might be realized. Discretionary fixed costs (often referred to as managed fixed costs) usually atise from annual decisions by management to spend fon certain fixed cost items. Examples of discretionary fixed costs include advertising rescarch, public relations, management development programs, and internships for stu dents. Discretionary fixed costs can be cut for short periods of time with minimal damage to the long-run goals of the organization, 1¢ costs of restoring them later are likely to be far greater than The Linearity Assumption and the Relevant Range ‘Management accountants ordinarily assume that costs ate strictly linea; tht is, the ela tion between cost onthe one hand and activity on the other can be represented by a Straightline. Economists point out that many costs are actualy curvilinear; that is, the felation between cost and activity isa curve. Nevertheless, even if a cost isnot stictly36 Chapter 2 EXHIBIT 2-3 Fxed Costs and the Relevant Renge $60,000 J s10.000 20.000 0 3000 6.000 8.000 ‘Number o Tests linear, it can be approximated within a narrow band of activity known as the relevant range by a sttaight line. The relevant range is the range of activity within which the assumption that cost behavior is strictly linearis reasonably valid. Outside of the relevant range, a fixed cost may no longer be strictly fixed or a variable cost may not be strictly variable. Managers should always keep in mind that assumptions made about cost behav- jor may be invalid if activity falls outside of the relevant range. ‘The concept of the relevant range is important in understanding fixed costs. For ‘example, suppose the Mayo Clinic rents a machine for $20,000 per month that tests blood samples for the presence of leukemia cells. Furthermore, suppose that the capac ity of the leukemia diagnostic machine is 3,000 tests per month. The assumption that the rent for the diagnostic machine is $20,000 per month is only valid within the rel- ‘evant range of 0 to 3,000 tests per month. If the Mayo Clinic needed to test 5,000 blood samples per month, then it would need to rent another machine for an additional $20,000 per month. It would be difficult to zent half of a diagnostic machine; thesefore, the step pattern depicted in Exhibit 2-3 is typical for such costs. This exhibit shows that the fixed rental expense is $20,000 for a relevant range of 0 to 3,000 tests. The fixed rental ‘expense increases to $40,000 wathin the relevant range of 3,001 to 6,000 tests. The rental ‘expense increases in discrete steps or increments of 3,000 tests, rather than increasing in a linear fashion per test This step-oriented cost behavior pattern can also be used to describe other costs, such as some labor costs, For example, salaried employee expenses can be characterized using a step pattern, Salaried employees are paid a fixed amount, such as $40,000 per ‘year, for providing the capacity to work a prespecified amount of time, such as 40 hours per week for 50 weeks a year (~ 2,000 houts per year). In this example, the total salaried ‘employee expense 1s $40,000 within a relevant range of 0 to 2.000 hours of work. The total salaried employee expense increases to $80,000 (ar two employees) ifthe organiza tion’s work requirements expand toa relevant range of 2,001 to 4,000 houts of work. Cost behavior patterns such as salaried employees are often called step-variable costs. Step- variable costs can often he adjusted quickly as conditions change. Furthermore, the width of the steps for step-variable costs is generally so narrow that these costs can be treated ‘essentially as variable costs for most purposes. The width of the steps for fixed costs, on the other hand, isso wide that these costs should be treated as entirely fixed within the relevant range. Exhibit 2-4 summarizes four key concepts related to variable and fixed costs. Study it carefully before reading further.Managerial Accounting and Cost Concepts a7 Behavior of the Cost (within the relevant range) Cost In Total Per Unit Variable cost Total variable cost increases Variable cost per unit and decreases in proportion remains constant. to.changes in the activity level Fixed cost Total fixed costis not affected Fixed cost per unit by changes in the activity decreases as the activity level within the relevant range. level rises and increases. as the activity level falls. EXHIBIT 2-4 Summary of Variable and Fed ‘ost Behavior HOW MANY GUIDES? Majestic Ocean Kayaking, of Ucluelet, British Columbia, is owned and operated by Tracy Mer- beneftink. The company offers @ number of guided kayaking excursions ranging from three. hour tours of the Ucluelet harbor to sixday kayaking and camping trips in Clayoquot Sound, (ne of the company's excursions is a four-day kayaking and camaing trip to The Broken Group Islands in the Pacific Rim National Perk, Special regulations apaly to trps inthe park—nclud ing a requirement that one certified guide must be assigned for every five guests or fraction thereof. For example, a trip with 12 guests must have at least three certified guides. Guides are not salaried and are paid on a per-day basis. Therefore, the cost to the company of the guides for atrip is 2 step-variable cost rather than a fixed cast or a strict variable cost. One guide is needed for 1 to 5 guests, two gudes for 6 to 10 guests, three guides for 11 to 15 guests, and so on Sources: Tracy Morbenfeftk, owner, Mlestc Ocean Kayeking. For more formation abou the company, se ‘nw. oceankayakng.com. Mixed Costs A mixed cost contains both variable and fixed cost elements. Mixedl costs are also known, as semivariable costs, To continue the Nooksack Expeditions example, the company incurs « mixed cost called fees paid to the state, It includes a license fee of $25,000 per year plus $3 per rafting party paid tothe state's Department of Natural Resources. Ifthe Company runs 1,000 rafting parties this year, then the otal fees paid to the state would be $28,000, made up of $25,000 in fixed cost plus $3,000 in variable cost. Exhibit 2-5 depicts the behavior ofthis mixed cost. Even if Nooksack fails to attract any customers, the company will still have to pay the license fee of $25,000. This is why the cost line in Exhibit 2-5 intersects the vertical cost axis at the $25,000 point. For each rafting party the company orga nizes, the total cost of the state fees wall increase by $3, Therefore, the total cost line slopes upward as the variable cost of $3 per party is added to the fixed cost of $25,000 per year Because the mixed cost in Exhibit 2-5 is represented by a straight line, the following equation fora straight line can be used (o express the relationship between a mixed cost and the level of activity ES38 Chapter 2 EXHIBIT 2-5 $30,000 Mixed Cost Behavor Sen E soncoo S9P#= Var cost pr unt of zivy 5 Variable 2 cost clement Fixed Intercept = Total fixed cost cost clement ° 500 1,000 Numbor of rafting patos Yoa+bx In this equation, = The total mixed cost a = The total fixed cost (the vertical intercept ofthe line) b = The variable cost per unit of activity (the slope of the line) X= The level of activity Because the variable cost per unit equals the slope of the straight line, the steeper the slope, the higher the variable cost per unit. In the case of the state fees paid by Nooksack Expeditions, the equation is written as follows ¥ = $25,000 + $3.00X, tet ft ‘Total Total Variable Activity mixed fixed cost per level cost cost unit of activity ‘This equation makes it easy to calculate the total mixed cost for any level of activity within the relevant range. For example, suppose that the company expects (0 orga- nize 800 rafting parties in the next year. The total state fees would be calculated as follows: ¥ = $25,000 + ($3.00 per rafting party X 800 rafting parties) = 327,400 | The Ani ned Costs ‘Mixed costs are very common. For example, the overall cost of providing X-ray services to patients at the Harvard Medical School Hospital is a mixed cost. The costs of equip- ‘ment depreciation and radiologists’ and technicians’ salaies are fixed, but the costs of Xray film, power, and supplies are variable. At Southwest Airlines, maintenance costsManagerial Accounting and Cost Concepts are a mixed cost. The company incurs fixed costs for renting maintenance facilities and {for keeping skilled mechanics on the payroll, bt the costs of replacement pasts, lubticat- ing oils, tires, and so forth, are variable with respect to how often and how far the com- ppany's aircraft are Flown, “The fixed portion of a mixed cost represents the minimum cost of having a service ready and available for use, The variable portion represents the cost incurred for actual consumption of the service, thus it varies in proportion to the amount of service actually consumed. Managers can use a variety of methods to estimate the fixed and variable compo- nents of a mixed cost such as account analysis, the engineering approach, the high-Iow method, and least-squares regression analysis, In account analysis, an account is classi- fied as either variable or fixed based on the analyst’s prior knowledge of how the cost in the account behaves. For example, dizect materials would be classified as variable and a building lease cost would be classified as fixed because of the nature of those costs. The engineering approach to cost analysis involves a detailed analysis of what cost behavior should be, based on an industrial engineet's evaluation of the production methods to be used, the materials specifications, labor requirements, equipment usage, production effi ciency, power consumption, and so on ‘The high-low and least-squares regression methods estimate the fixed and variable elements of a mixed cost by analyzing past records of cost and activity data, We will use an example from Brenlline Hospital to illustrate the high-low method calculations and to compare the resulting high-low method cost estimates to those obtained using least- squares regression, Appendix 2A demonstrates how (o use Microsoft Excel to perform least-squares regression computations. Diagnosing Cost Behavior with a Scattergraph Plot Assume that Brentline Hospital is interested in predicting future monthly maintenance costs for budgeting purposes, The senior management team believes that maintenance cost is a mixed cost and that the variable portion of this cost is driven by the number of patient-days. Each day a patient is in the hospital counts as one patient-day. The hospital's chief financial officer gathered the following data for the most recent seven- ‘month period: Activity Level: Maintenance Month Patient-Days Cost Incurred January 5,600 $7,800 February...... 7,100 $8,500 March ees. 5,000 $7,400 April 6,500 $8,200 Mayes 7,300 $9,100, une 8,000 $8,800, uly 6,200 $7,800 ‘The frst step in applying the high-low method or the least-squares regression method is to diagnose cost behavior with a scattergraph plot. The scattergraph plot of mainte nance costs versus patient-days at Brentline Hospital is shown in Exhibit 2-6, Two things should be noted about this scattergraph: 1. The total maintenance cost, ¥: is plotted on the vertical axis. Cost is known as the dependent variable because the amount of cost incurted during a period depends on the level of activity for the period. (That is, asthe level of activity increases, cotal cost will also ordinasily increase.) Lo2-5 Analyze a mixed cost using a scattergraph plot and the high- low method. 3940 Chapter 2 EXHIBIT 2-6 Y Plotting the Data Scattergraph Method of Cost $12,000 Analysis $10,000 0 Em ° 2000 4000 6,000 Patone-days x 000 10,000 2. The activity, X (patient-days in this case), is plotted on the horizontal axis. Activity is known as the independent variable because it causes variations in the cost From the scattergraph plot, its evident that maintenance costs do increase with the num- ber of patient-days in an approximately linear fashion, In other words, the points lie ‘more or less along a straight line that slopes upward and fo the right. Cost behavior is ‘considered linear whenever a straight linc isa reasonable approximation forthe relation between cost and activity Plotting the data on a scattergraph is an essential diagnostic step that should be per- formed before performing the high-low method or least-squares regression calculations If the seattergeaph plot reveals linear cost behavior, then it makes sense to perform the high-low or least-squares regression calculations to separate the mixed cost into its vari- able and fixed components. Ifthe seattergraph plot does not depict linear cost behavior, then it makes no sense to proceed any further in analyzing the data The High-Low Method Assuming that the scattergraph plot indicates a linear relation between cost and activity, the fixed and variable cost elements of a mixed cost can be estimated using the high-low ‘method or the least-squares regression method. Te high-low method is based on the rise-over-run formula for the slope of a straight line. As previously discussed, ifthe xela- lion between cost and activity can be represented by a straight line, then the slope of the straight line is equal to the variable cost per unit of activity. Consequently, the following formula can be used to estimate the variable cost: se_ io Variable cost = Slope of the line = Rise Run =X ‘To analyze mixed costs with the high-low method, begin by identifying the period with the lowest level of activity and the period with the highest level of activity. The period with the lowest activity is selected as the first point in the above formula andManagerial Accounting and Cost Concepts the period with the highest activity is selected as the second point. Consequently, the formula becomes: Variable cost = 22721. _Costat the high activity level ~ Cost tthe low activity level fariable cost = High activity Tevel — Low activity level Change in cost Variable cost = Thange in acuvity ‘Therefore, when the high-low method is used, the variable cost is estimated by dividing the difference in cost between the high and low levels of activity by the change in activity between those two points To return to the Brentline Hospital example, using the high-low method, we first Jdentify the periods with the highest and lowest activity—in this case, June and March We then use the activity and east data from these (wo periods to estimate the variable cost component as follows: Maintenance Patient-Days Cost Incurred High activity level (lune)... 8,000 $9,800 Low activity level (March) 5,000 7,400 Change «+. 3,000 $2,400 Change in cost 2,400 Change in scuvity — 3,000 patient-days Variable cost = $0.80 per patient-day Having determined that the vatiable maintenance cost is 80 cents per patient-day, we can now determine the amount of fixed cost. This is done by taking the total cost at cither the high of the low activity level and deducting the variable cost element. In the computation below, total cost at the high activity level is used in computing the fixed cost element Fixed cost element = Total cost — Variable cost element = $9,800 — ($0.80 per patientday X 8,000 patientdays) = $3,400 Both the variable and fixed cost elements have now been isolated. The cost of main- tenance can be expressed as $3,400 per month plus 80 cents per patient-day of as Y= $3,400 + $0.80x t t Total Total maintenance patient-days “The data used in this illustration are shown graphically in Exhibit 2-7. Notice that a straight line has been drawn through the points corresponding to the low and high levels, of activity. In essence, that is what the high-low method does—it draws a straight line Uhrough those two points Sometimes the high and low levels of activity don't coincide with the high and low amounts of cost, For example, the period that has the highest level of activity may not a42 Chapter 2 EXHIBIT 2-7 HighLow Method of Cost Analysis ‘Activity Patient- Maintenance Level Days Cost High 8,000 $9,800 Low 5,000 $7,400 y $12,000 | | | | Slope Variabie cost $0.80 por patontcay $10,000 8 Mahtnance cot a g 8 a) Fixed cost: $3,400 Bm x 2000" 4000 6.000 8,000" 10,000 Patontdays Ihave the highest amount of cost, Nevertheless, the costs atthe highest and lowest levels of activity are always used to analyze a mixed cost under the high-low method, The rea- som is that the analyst would like (0 use data that reflect the greatest possible variation in activity, ‘The high-low method is very simple to apply, but it suffers from a major (and sometimes critical) defect—it utilizes only two data points. Generally, two data points are not enough to produce accurate resulls. Additionally, the periods with the highest and lowest activity tend to be unusual. A cost formula that is estimated solely using data from these unusual periods may misrepresent the true cost behavior during normal periods. Such a distortion is evident in Exhibit 2-7. The straight line should probably be shifted down somewhat so that itis closer (© more of the data points, For these reasons, least-squares regression will generally be more accurate than the high- low method The Least-Squares Regression Method ‘The least-squares regression method, unlike the high-low method, uses all of the data to separate a mixed cost into its fixed and variable components. A regression line of the form Y= a + BX is fitted to the data, where a represents the total fixed cost and ‘b represents the variable cost per unit of activity. The basic idea underlying the least- squares regression method is illustrated in Exhibit 2-8 using hypothetical data points [Notice from the exhibit that the deviations from the plotted points to the regression line are measured vertically on the graph. These vertical deviations are called the regression ‘errors. There is nothing mysterious about the least-squares regression method. Tt simply ‘computes the regression line that minimizes the sum of these squared errors, The formu~ las that accomplish this are fairly complex and involve numerous calculations, but the principle is simple.Managerial Accounting and Cost Concepts 43 petal Y= E enimated = Regression ie +bX Level of activity EXHIBIT 2-8 ‘The Concept of Least Squares Regression Fortunately, computers are adept at carrying out the computations required by the least-squares regression formulas. The data—the observed values of X and ¥—are entered into the computer, and software does the rest. In the case of the Brentline Hos- pital maintenance cost data, a statistical software package on a personal computer can calculate the following least-squares regression estimates of the (otal fixed cost (a) and the variable cost per unit of activity (b): a= 83431 b= s0.759 ‘Therefore, using the least-squares regression method, the fixed element of the main- tenance cost is $3,431 per month and the variable portion is 75.9 cents per patientday. In terms of the linear equation ¥ = a ~ AX, the cost formula can be written as Y= $3431 + $0,759X where activity (X) is expressed in patient-days. Appendix 2A discusses how to use Microsoft Excel to perform least-squates regres- sion calculations. For now, you only need to understand that least-squares regression anal- ysis generally provides more accurate cost estimates than the high-low method because, rather than relying on just two data points, i uses all of the data points to fit a line that ‘minimizes the sum of the squared errors, The table below compares Brentline Hospital's cost estimates using the high-low method and the least-squares regression method: Least-Squares High-Low Regression Method Method Variable cost estimate per pationt-day . $0.800 $0,758 Fixed cost estimate per month $3,400 $3,431 When Brentline uses the least-squares regression method to create @ straight line that minimizes the sum of the squared errors, it resulls in estimated fixed costs that are $31 higher than the amount derived using the high-low method. It also decreases the slope of the straight line resulting in a lower variable cost estimate of 0.759 per paticat-day zather than $0.80 per patient-day as derived using the high-low method“4 Chapter 2 ‘THE ZIPCAR COMES TO COLLEGE CAMPUSES ‘Ziocar isa car sharing service based in Cambridge, Massachusetts. The company serves 13 cities and 120 university campuses, Members pay a $50 annual fe plus $7 an hour to rent a car, They ‘can use their Phones to rent a car, locate iin the nearest Zpcar parking lt, unlock it sing an access code, and dive tof the lot This mixed cost arrangement is attractive to customers who need a car infrequently and wish to avoid the large cash outlay that comes with buying of leasing a vehicle ‘Source: Jeferson Graham, “An (Phone Gets Zpcar Drivers on Ther Way" USA Today, September 20, 2008, . 38 | Traditional and Contribution Format Income Statements Lo2-6 Prepare income statements for a merchandising company using the trational and contribution formats In this section of the chapter, we discuss how to prepare traditional and contribution for mat income statements for 4 merchandising company.’ Merchandising companies do not manufacture the products that they sell to customers. For example, Lowe's and Home Depot are merchandising companies because they buy finished products from ‘manufacturers and then resell them to end consumers The Traditional Format Income Statement ‘Traditional income statements are prepared primarily for external reporting purposes ‘The left-hand side of Exhibit 2-9 shows a uaditional income statement format for ‘merchandising companies. This type of income statement organizes costs into two ‘categories —cost of goods sold and selling and administrative expenses, Sales minus cost of goods sold equals the gross margin. The gross margin minus selling and administrative ‘expenses equals net operating income, The cost of goods sold reparts the product costs attached to the merchandise sold during the period. The selling and administrative expenses report all period costs that have been expensed as incurred, The cost of goods sold for a merchandising company EXHIBIT 2-9 Fo CCompareg Traditional and Contioution Format Income Statements for Merchandising Companies (ll numbers are given) ‘Traditional Format Sales $12,000 Sales $12,000 Cost of goods sold™ 100 Variable expenses: Gross margin eee eeeee eves 6000 Cost of goods sold ....... $6,000 Selling and administrative expenses: Variable seling .......... 600 Selling $3,100 Variable administrative 400 _7,000 Administrative... 800 __§,000 Contribution margin... ,000 [Net operating income . $1,000 Fixed expenses: Fixed selling ............. 2,800 Fixed administrative .....1 1/800 ‘manufacturing company, the cost of goods sold would include some variable costs, such as direct materials, direct labor, and variable overhead, and some fixed costs, such as fxed manufacturing overhead. Income state- _ment formats for manufacturing companies will be explored in greater detail in a subsequent chapter. Contribution Format Net operating income ....... © Subsequent chapters compare the income statement formats for manutactsManagerial Accounting and Cost Concepts can be computed directly by multiplying the number of units sold by their unit cost or inditectly using the equation below’ Beginning Ending pode = merchandise + Pareases ~ merchandise eg) inventory For example, let's assume that the company depicted in Exhibit 2-9 purchased $3,000 of merchandise inventory during the period and had beginning and ending merchandise inventory balances of $7,000 and $4,000, respectively, The equation above could be used to.compute the cost of goods sold as follows: Besining sndng Contor gouts__ Be oF Bs shane Ftcass ~ methane ‘entry ‘oeny $1000 + 83000 ~ $4000 $6.00 Although the traditional income statement is useful for external reporting pur. ‘poses, it has serious limitations when used for internal purposes. It does not distinguish between fixed and variable costs. For example, under the heading “Selling and adminis- trative expenses,” both variable administrative costs ($400) and fixed administrative costs, (1,500) are lumped together ($1,900). Internally, managers need cost data organized by cost behavior to aid in planning, controlling, and decision making. The contribution for- _mat income statement nas been developed in response to these needs. The Contribution Format Income Statement ‘The crucial distinction between fixed and variable costs is atthe heast of the contribution approach to constructing income statements. The unique thing about the contribution approach is that it provides managers with an income statement that clearly distinguishes between fixed and variable costs and therefore aids planning, controlling, and decision making. The right-hand side of Exhibit 2-9 shows a contribution format income state- ‘ment for merchandising companies ‘The contribution approach separates costs into fixed and variable categories, first deducting variable expenses from sales to obtain the contribution margin. For a mer- chandising company, cost of goods sold is a variable cost that gets included in the “Vari- able expenses” portion of the contribution format income statement. The contribution ‘margin is the amount remaining from sales revenues after variable expenses have been deducted. This amount contribures toward covering fixed expenses and then toward ‘profits for the period ‘The contribution format income statement is used as an internal planning and deci- sion-making tool Is emphasis on cost behavior aids cost-volume-profit analysis (such as we shall be doing in a subsequent chapter), management performance appraisals, and budgeting. Moreover, the contribution approach helps managers organize data pertinent o numerous decisions such as product-ine analysis, pricing, use of scarce resources, end make or buy analysis. All of these topics are covered in later chapters, 45 ki Cost Classifications for Decision Making | Costs are an important feature of many business decisions. In making decisions, itis essen- Ua to have a firm grasp of the concepts differential cost, opportunity cost, and sunk cost Differential Cost and Revenue Decisions involve choosing between alternatives. Th business decisions, ech aeratve wll have costs and benefits tat must be compared to the costs and benelts ofthe other tvailabe alleruntves. A diference in costs between any two allemaives is known a5 a Lo2-7 Understand cost classtcations used in making decisions: diferential costs, opportunity costs, and sunk costs.46 Chapter 2 differential cost. A difference in revenues (usually just sales) between any two altema- lives is known as differential revenue. A differential cost is also known as an ineremental cost, although technically an incremental cost should refer only to an increase in cost from one alternative to another; decreases in cost should be teferted to as decremental costs. Differential cost isa broader term, encompassing both cost increases (incremental costs) and cost decreases (decre- mental costs) hetween alternatives, The accountant’s differential cast concept can be compared to the economist’s mar ginal cost concept. In speaking of changes in cost and revenue, the economist uses the terms marginal cost and marginal revenue. The revenue that can be obtained from selling fone more unit of product is called marginal revenue, and the cost involved in producing fone more uni of product i called marginal cost. The economist’s marginal concept is basi- cally the same as the accountants differential concept applied to a single unit of output Differential costs can be either fixed or variable. To illustrate, assume that Natural Cosmetics, Inc. is thinking about changing its marketing method from distribution through retailers to distibution by a network of neighborhood sales representatives. Present costs and revenues are compared to projected costs and revenues in the following table: Retailer Sales Differential Distribution Representatives Costs and. (present) (proposed) Revenues Sales (Variable) ........ +. $700,000 $800,000 $100,000 Cost of goods sold (Variable)... 350,000, ‘400,000 50,000 Advertising (Fixed) «eee. 2. 80,000 45,000 (88,000) Commissions (Variable) - 0 40,000 40,000 Warehouse depreciation (Fixed)... $0,000 80,000 30,000 Other expenses (Fixed) se. 60,000 60,000 0 ‘Total expenses Net operating income: 625,000 85,000 $175,000 $15,000 According to the above analysis, the differential revenue is $100,000 and the diferent costs total $85,000, leaving a positive differential net operating income of $15,000 in favor of using sales representatives. In general, only the differences between alternatives are relevant in decisions. Those items that are the same under all alternatives and that are not alfected by the decision ‘can be ignored. For example, in the Natural Cosmetics, Inc., example above, the “Other expenses” category, which is $60,000 under both alternatives, can be ignored because it hhas no effect on the decision. If it were removed from the calculations, the sales repre- sentatives would still be preferred by $15,000. This is an extremely important principle in management accounting that we will revisit in later chapters, Opportunity Cost and Sunk Cost Opportunity cost is the potential benefit that is given up when one alternative is selected over another. For example, assume that you have a part-time job while attending college that pays $200 per week. If you spend one week at the beach during spring break without pay, then the $200 in lost wages would be an opportunity cost of taking the week off to bbe al the beach, Opportunity costs are not usually found in accounting records, but they are costs that must be explicitly considered in every decision a manager makes. Virtually ‘every allernative involves an opportunity cost ‘Assunk cost is a cost thar has already been incurred and that cannot be changed by any decision made now or in the future, Because sunk costs cannot be changed by any decision, they are not differential costs. And because only differential costs are relevant in a decision, sunk costs should always be ignored.