Managerial Accounting: Tools For Business Decision-Making

Managerial Accounting
Tools for Business Decision-Making

Sixth Canadian Edition
Weygandt Kimmel Aly
Chapter 2
Managerial Cost Concepts and Cost
Behaviour Analysis
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Copyright ©2021 John Wiley & Sons Canada, Ltd.

Learning Objectives
1. Define the three classes of manufacturing costs and
differentiate between product costs and period costs.
2. Explain variable, fixed, and mixed costs and the relevant
range.
3. Apply the high-low method to determine the components
of mixed costs.
4. Demonstrate how to calculate the cost of goods
manufactured and prepare financial statements for a
manufacturer.
Copyright ©2021 John Wiley & Sons Canada, Ltd. 2

Managerial Cost Concepts
• To effectively plan, direct and control operations managers
need reliable cost information
• Questions such as:
1. What costs are involved in making a product (or service)?
2. If volume changes, how will costs change?
3. Will automation impact costs?
4. How to best control costs and maintain quality?
5. Should a product/service be discontinued; or should a new
product/service be added?
• To answer these questions managers must be familiar with a
cost object is and the various types of costs

Product Costs and Period Costs (1 of 2)
Cost Object: Anything for which we

want to accumulate costs
Examples:
• A hamburger made by a restaurant
• Providing a haircut
• Preparing a tax return for a client
• Building a house

Product Costs and Period Costs (2 of 2)
Product costs are those costs incurred only because the company
manufacturers their cost object (as opposed to purchasing a completed
product unit).
Period costs are those costs (aka expenses) incurred because the
company is in business (e.g. administrative, selling, marketing)
Manufacturing Costs
Manufacturing consists of activities that convert raw (direct)

materials into finished goods.
Typical Classification of Manufacturing Costs
• In contrast, a merchandising firm sells goods in the form

in which they are purchased.

Manufacturing Costs – Direct Materials
• Raw materials are basic materials and parts used in

manufacturing.
• Raw materials that can be physically, directly and easily
associated with the finished product are called direct
materials.
• Examples include:
o Flour in the baking of bread
o Syrup in the bottling of soft drinks
o Steel used in making automobiles

Manufacturing Costs – Direct Labour
• Work completed by employees that can be physically,

directly and easily associated with converting raw
materials into finished goods is direct labour
o Legal staff at a law firm
o Mechanics at a vehicle service department
o Typesetters at a newspaper

Manufacturing Costs – Manufacturing Overhead
• Costs incurred in the manufacture of a finished good that

cannot be practically traced to a specific unit
• Includes all manufacturing costs that cannot be classified
as direct material or direct labour
o Indirect materials; indirect labour
o Depreciation on factory buildings
o Insurance, taxes, maintenance on factory facilities

Manufacturing Overhead – Indirect Materials
• Raw materials that cannot be easily associated with the

cost object are called indirect materials
o Considered part of manufacturing overhead
• Indirect materials may not physically become part of the
finished product or may represent too small a part of the
finished product in terms of cost
o Examples: lubricants, cleaning supplies, polishing
compounds

Manufacturing Overhead – Indirect Labour
• Work completed by employees that has no direct

physical association with the finished product, or for
which it is impractical to trace to the goods produced
o Wages of maintenance workers, janitors, and, factory
security guards
o Supervisors

Prime Costs
Prime costs: sum of all direct materials and direct labour

costs.
• Prime costs are all direct manufacturing costs.

Conversion Costs
Conversion costs: the cost of converting raw materials into a

final product
• Sum of direct labour and manufacturing overhead costs.

Prime Costs and Conversion Costs
Prime costs and conversion costs

Direct labour is a component of both Prime and Conversion costs

Let’s Review 1
Which of the following is not an element of
manufacturing overhead?
a. Sales manager’s salary
b. Plant manager’s salary
c. Factory repairman’s wages
d. Product inspector’s salary

Let’s Review 1: Solution
Which of the following is not an element of
manufacturing overhead?
a. Sales manager’s salary (correct answer)
b. Plant manager’s salary
c. Factory repairman’s wages
d. Product inspector’s salary

Let’s Review 2
The following labour costs have been incurred by T.H. Makers
Ltd. Of this amount, how much would be considered a
product cost?
Description Amount
Direct labour: Plant $310,000 a. $310,000
Indirect labour: Plant 75,000 b. $385,000
Supervisor salary: Plant 95,000
c. $480,000
Sales commissions 140,000
Sales salaries 200,000
d. $820,000
$820,000

The following labour costs have been incurred by T.H. Makers
Ltd. Of this amount, how much would be considered a
product cost?
Description Amount
Direct labour: Plant $310,000 a. $310,000
Indirect labour: Plant 75,000 b. $385,000
Supervisor salary: Plant 95,000
c. $480,000 (correct answer)
Sales commissions 140,000
Sales salaries 200,000
d. $820,000
$820,000

Product versus Period Costs
Product Costs (1 of 2)
• Consist of the direct material cost, direct labour cost,

and manufacturing overhead cost
• A necessary and integral part of producing the product
• Recorded as inventory when incurred
o Product costs also referred to as inventoriable costs

Product Costs (2 of 2)
• Become an expense to the business when the finished

good is sold
o Inventory (Balance Sheet) is reduced and Cost of Goods
Sold (Income Statement) is increased

Period Costs
• Matched with revenue earned within a specific time

period and charged to expense as incurred
• Non-manufacturing costs
• Deducted from revenues in period incurred to
determine net income
• Include all
o Selling and marketing expenses
o General and Administrative expenses

Product versus period costs

Let’s Review 3
The following costs have been incurred by T.H. Makers Ltd. Of
this amount, how much would be considered period cost?
Description Amount
Direct materials $ 60
a. $52
Direct manufacturing labour 10
Manufacturing overhead 50
b. $20
Sales commissions 4 c. $16
Administrative salaries 16 d. $4
$140

The following costs have been incurred by T.H. Makers Ltd. Of
this amount, how much would be considered period cost?
Description Amount
Direct materials $ 60
a. $52
Direct manufacturing labour 10
Manufacturing overhead 50
b. $20 (correct answer)
Sales commissions 4 c. $16
Administrative salaries 16 d. $4
$140

Cost Behaviour Analysis (1 of 3)
• The study of how specific costs respond to changes in
the level of business activity
o As activity levels change, some costs do change; others
will remain unchanged
o Applies to all types of businesses and entities
• Helps management to plan operations and make
decisions
• Cost behaviour analysis begins by identifying and
measuring key business activities

• Activity levels may be expressed in terms of

o Sales dollars (in a retail company)
o Kilometres driven (in a trucking company)
o Room occupancy (in a hotel)
o Dance classes taught (by a dance studio)
• For an activity level to be useful, changes in the level

or volume of activity should be correlated with
changes in cost

• The activity level selected is called the activity (or

volume) index
o Identifies the activity that causes changes in the
behaviour of costs
o Allows costs to be classified according to their
response to changes in activity as:
Variable Cost
Fixed Cost
Mixed Cost

Cost Behaviour Analysis: Variable Costs
(1 of 3)
• Costs that vary in total directly and proportionately with
changes in the activity level
o Variable costs remain the same per unit regardless of
activity level
• Examples of variable costs include:
o Direct material and direct labour for a manufacturer
o Sales commissions for a merchandiser
o Gasoline in airlines and trucking companies

(2 of 3)
Example:
• Damon Company manufactures tablets that contain a $10
camera
• Activity index is the number of tablets produced
• For each tablet produced, the total cost of the cameras
increases by $10
o If 2,000 tablets are made, the total cost of the cameras is
$20,000 (2,000 X $10)
o If 10,000 tablets are made, the total cost of the cameras is
$100,000 (10,000 X $10)
(3 of 3)
Example (continued)
Behaviour of total and unit fixed costs

Cost Behaviour Analysis: Fixed Costs
(1 of 3)
• Costs that remain the same in total within the relevant
range regardless of changes in the activity level.
• Per unit cost varies inversely with activity:
o As volume increases, unit cost decline, and vice versa
o Property taxes
o Insurance
o Rent
o Deprecation on buildings and equipment

(2 of 3)
Example:
• Damon Company leases its productive facilities for
$10,000 per month
• Total fixed costs of the facilities remain constant
$10,000 per month for all levels of activity
• On a per unit basis, the cost of rent decreases as activity
increases and vice versa
o At 2,000 tablets, unit cost is $5 ($10,000 ÷ 2,000 units)
o At 10,000 tablets, unit cost is $1 ($10,000 ÷ 10,000 units)

(3 of 3)
Example (continued)
Behaviour of total and unit fixed costs

Distinguish Between Variable and Fixed
Costs
• Variable costs are costs that vary in total directly and
proportionately with changes in the activity level.
These costs remain the same per unit at every level
of activity.
• Fixed costs are costs that remain the same in total
within the relevant range regardless of changes in
the activity level. Fixed costs per unit vary inversely
with activity—in other words as volume increases,
unit costs decrease and vice versa.

Cost Behaviour Analysis: Relevant Range
(1 of 3)
• Throughout the range of possible levels of activity, a
straight-line relationship usually does not exist for
either variable costs or fixed costs
o The relationship between variable costs and changes
in activity level is often curvilinear
o For fixed costs, the relationship is nonlinear – some
fixed costs will not change over the entire range of
activities, others may change at different levels of
activity

(2 of 3)
Nonlinear behaviour of total and unit fixed costs

(3 of 3)
Defined as the range of activity over which a company expects
to operate during a year
Within this range, a straight-line relationship usually exists for
both variable and fixed costs
Linear behaviour
within relevant
range

Cost Behaviour Analysis: Mixed Costs
Costs that have both a

variable and a fixed cost
component
Sometimes called semi
variable cost
Change in total but not
proportionately with
changes in activity level
Behaviour of mixed costs
Variable, Fixed and Mixed Costs (1 of 2)
• Product costs may be either fixed, variable or mixed.
o Fixed product costs: factory rent; factory equipment
depreciation; plant supervisor salary
o Variable product costs: direct materials; direct
labour
o Mixed product costs: factory utility costs

Variable, Fixed and Mixed Costs (2 of 2)
• Period costs may be either fixed, variable or mixed.
o Fixed period costs: President’s salary; Head office
equipment depreciation
o Variable period costs: sales commission cost
o Mixed period costs: head office utility costs

Cost Behaviour Analysis: High-Low
Method (1 of 3)
• Mixed costs must be classified into their fixed and
variable elements
• One approach to separate the costs is the high-low
method
o Uses the total costs incurred at both high and low
levels of activity
o The difference in costs between the high and low
levels represents variable costs, since only variable
costs change as activity levels change

Method (2 of 3)
Step 1: Determine variable cost per unit using the
following formula:
Step 2: Determine the fixed cost by subtracting the total

variable cost at either the high or the low activity level
from the total cost at that level

Method (3 of 3)
Step 1: Determine variable cost per unit using the
following formula:

Method Example (1 of 5)
Data for Metro Transit Company for the last 4-month
period

Step 1: Using the formula to find the variable cost
component:
Variable costs per unit = $33,000 ÷ 60,000 = $0.55 per km

Example (continued):
Step 2: Subtract total variable costs at either the high or
low activity level from the total cost at that same level

Example (continued):
Total cost can now be estimated at any activity level using
the following high-low cost equation
Maintenance Cost = $8,000 + ($0.55 x km)

EXAMPLE:
If the activity level is 45,000 km, the estimated
maintenance costs would be:
Total cost = $8,000 + ($0.55 x km)

Total cost = $8,000 + ($.55 X 45,000 km)
Total cost = $32,750

Let’s Review 4
Variable costs are costs that:
a. Vary in total directly and proportionately with changes
in the activity level
b. Remain the same per unit at every activity level
c. Neither of the above
d. Both (a) and (b) above

Variable costs are costs that:
a. Vary in total directly and proportionately with changes
in the activity level
b. Remain the same per unit at every activity level
c. Neither of the above
d. Both (a) and (b) above (correct answer)

Let’s Review 5 (1 of 2)
The following cost and activity information has been provided
you. Based on this information what would total cost be if the
activity level was 4,250?
Activity Cost
a. $200,750
3,000 $169,500
3,500 184,000 b. $198,950
4,000 190,500 c. $106,250
4,500 207,400
5,000 219,500 d. $94,500

Let’s Review 5 (2 of 2)
The following cost and activity information has been provided
you. Based on this information what would total cost be if the
activity level was 4,250?
Activity Cost
a. $200,750 (correct answer)
3,000 $169,500
3,500 184,000 b. $198,950
4,000 190,500 c. $106,250
4,500 207,400
5,000 219,500 d. $94,500

Manufacturing Costs in Financial
Statements
• Manufacturing entities prepare the same financial
statements as merchandising or service firms
• Some of the components within a manufacturing firms
financial statements will be different to reflect the
manufacturing aspect
o Current assets: manufacturing firm will carry at least three
(3) different inventories, other industries will normally
report one inventory
o Income Statement: cost of goods sold section reflects
manufactured cost of goods

Balance Sheet: Inventories
• Manufacturing companies may have three inventory
accounts:
1. Raw (Direct) materials inventory – shows the cost of raw
materials on hand
2. Work in process inventory – shows the costs applicable to
units on which production has started but is only partially
complete
3. Finished goods inventory – shows the cost of completed
goods on hand
• Merchandising companies have only one category of
inventory:
o Merchandise inventory
Balance Sheet: Flow of Product Costs
• Product costs move through the Inventory accounts as
the product moves the manufacturing process
• Product costs remain on the Balance Sheet until the
unit is sold
• How do these costs flow through the various
accounts?

Flow of Product Costs

Balance Sheet
Current assets sections of merchandising and manufacturing balance sheets

Statements (1 of 3)
Income Statement
• The income statement for a manufacturer is similar to
that of a merchandiser except for the cost of goods
sold section

Statements (2 of 3)
Cost of Goods Sold Components
Merchandiser versus Manufacturer
Costs of goods sold components

Statements (3 of 3)
Cost of Goods Sold Section of the Income Statement
Costs of goods sold sections of merchandising and manufacturing

income statements

Determining the Cost of Goods
Manufactured
• Work in Process – partially completed units
• Total Manufacturing Costs – sum of direct material costs, direct
labour costs, and manufacturing overhead incurred during the
current year
Cost of goods manufactured formula

Let’s Review 6
What amount is given by the sum of direct materials,
direct labour, and manufacturing overhead incurred?
a. Total cost of work in process
b. Cost of goods available for sale
c. Total manufacturing costs
d. Cost of goods manufactured

What amount is given by the sum of direct materials,
direct labour, and manufacturing overhead incurred?
a. Total cost of work in process
b. Cost of goods available for sale
c. Total manufacturing costs (correct answer)
d. Cost of goods manufactured

Let’s Review 7
Which of the following is the correct calculation for cost of goods
available for sale? Total cost of work in process
a. Beginning Finished Goods Inventory + Total Manufacturing
Costs – Ending Finished Goods Inventory
b. Beginning Work in Process Inventory + Cost of Goods
Manufactured – Ending Work in Process Inventory
c. Ending Finished Goods Inventory + Cost of Goods
Manufactured – Beginning Finished Goods Inventory
d. Beginning Finished Goods Inventory + Cost of Goods
Manufactured – Ending Finished Goods Inventory

Which of the following is the correct calculation for cost of goods
available for sale? Total cost of work in process
a. Beginning Finished Goods Inventory + Total Manufacturing
Costs – Ending Finished Goods Inventory
b. Beginning Work in Process Inventory + Cost of Goods
Manufactured – Ending Work in Process Inventory
c. Ending Finished Goods Inventory + Cost of Goods
Manufactured – Beginning Finished Goods Inventory
d. Beginning Finished Goods Inventory + Cost of Goods
Manufactured – Ending Finished Goods Inventory (correct
answer)

Let’s Review 8
In a manufacturer’s balance sheet, three inventories may be
reported: (1) raw (direct) materials, (2) work in process, and (3)
finished goods. In what sequence do theses inventories generally
appear on a balance sheet? Beginning Finished Goods Inventory +
Total Manufacturing Costs – Ending Finished Goods Inventory
a. (1), (2), (3)
b. (2), (3), (1)
c. (3), (1), (2)
d. (3), (2), (1)

In a manufacturer’s balance sheet, three inventories may be
reported: (1) raw (direct) materials, (2) work in process, and (3)
finished goods. In what sequence do theses inventories generally
appear on a balance sheet? Beginning Finished Goods Inventory +
Total Manufacturing Costs – Ending Finished Goods Inventory
a. (1), (2), (3)
b. (2), (3), (1)
c. (3), (1), (2)
d. (3), (2), (1) (correct answer)

Let’s Review Challenge
For the current period, prime costs incurred by ABC Ltd.
were $195, conversion costs were $140 and total product
costs were $270. What were the direct labour, direct
material and manufacturing overhead costs, respectively
for the period?

Let’s Review Challenge: Solution
For the current period, prime costs incurred by ABC Ltd. were $195,
conversion costs were $140 and total product costs were $270.
What were the direct labour, direct material and manufacturing
overhead costs, respectively for the period?
Total cost – Prime Cost = Overhead
=$270 – 195 = $75
Total cost – Conversion Cost = Direct materials
=$270 – 140 = $130
Prime cost – Direct materials = Direct labour
= $195 – 130 = $65

High-Low Method
Maintenance costs and mileage data
Assume that Hanson Trucking Company has 12 months of

maintenance cost data, as shown.
• The high and low activities are 65,000 km in December and

15,000 km in July.
• The maintenance costs at these two levels are $63,000 and
$39,000, respectively.
High-Low Method
Computation of variable and fixed costs
Total variable cost = number of km × cost per km.

At the low activity level of 15,000 km, total variable cost is $7,200
(15,000 × $0.48).
To determine fixed costs, subtract total variable costs at the low
activity level from the total cost at the low activity level.
Fixed costs = $39,000 − ($0.48 × 15,000) = $31,800
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Managerial Accounting

Tools for Business Decision-Making

Copyright ©2021 John Wiley & Sons Canada, Ltd.

Copyright ©2021 John Wiley & Sons Canada, Ltd. 2

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Cost Object: Anything for which we

Copyright ©2021 John Wiley & Sons Canada, Ltd. 4

Manufacturing consists of activities that convert raw (direct)

• In contrast, a merchandising firm sells goods in the form

Copyright ©2021 John Wiley & Sons Canada, Ltd. 6

• Raw materials are basic materials and parts used in

Copyright ©2021 John Wiley & Sons Canada, Ltd. 7

• Work completed by employees that can be physically,

Copyright ©2021 John Wiley & Sons Canada, Ltd. 8

• Costs incurred in the manufacture of a finished good that

Copyright ©2021 John Wiley & Sons Canada, Ltd. 9

• Raw materials that cannot be easily associated with the

Copyright ©2021 John Wiley & Sons Canada, Ltd. 10

• Work completed by employees that has no direct

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Prime costs: sum of all direct materials and direct labour

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Conversion costs: the cost of converting raw materials into a

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Prime costs and conversion costs

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• Consist of the direct material cost, direct labour cost,

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• Become an expense to the business when the finished

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• Matched with revenue earned within a specific time

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Product versus period costs

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• Activity levels may be expressed in terms of

• For an activity level to be useful, changes in the level

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• The activity level selected is called the activity (or

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Behaviour of total and unit fixed costs

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Behaviour of total and unit fixed costs

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Nonlinear behaviour of total and unit fixed costs

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Costs that have both a

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Step 2: Determine the fixed cost by subtracting the total