Chapter 1

Cost accounting Concepts

Prof. Dr. Farid Moharam
 Cost Terminology
 Costs as an economic resource s to achieve a specific
objective. A cost (such as Direct materials, Labor or
advertising) is usually measured as the monetary
amount that must be paid to acquire goods or
services.
 Actual cost is the historical amount, or cost incurred
 Budgeted cost, which is the predicted or forecasted
(future) amount of cost.
 Cost object is anything for which a measurement of
costs is desired. For example, this can be a product, an
assembly line, a product line, or a department.
The Types of Cost Classifications

1. General Classifications
(manufacturing and nonmanufacturing costs)

2. Assigning Costs to 3. Prepare Financial

Cost Objects Reporting

4. Predicting Cost 5.Making Business

Behavior Decisions
1. General Classifications (manufacturing and
nonmanufacturing costs)
Classifications of Manufacturing Costs

Manufacturing
Manufacturing
Materials
Materials Labor
Labor Overhead
Overhead

The Product
(Cost Object)
 Raw Materials
Raw materials that become an integral
part of the product and that can be
conveniently traced directly to it.

Example:
Example: AA radio
radio installed
installed in
in an
an automobile
automobile
 Factory Labor

Those labor costs that can be easily

traced to individual units of product.

Example:
Example: Wages
Wages paid
paid to
to automobile
automobile assembly
assembly workers
workers
 Manufacturing Overhead
Manufacturing costs that cannot be easily
traced directly to specific units produced.

Examples:
Examples: Indirect
Indirect materials
materials and
and indirect
indirect labor
labor

Materials used to support the Wages paid to employees who

production process.
Examples: lubricants and cleaning
supplies used in the automobile
assembly plant.
are not directly involved in
production work.
Examples: maintenance workers,
janitors, and security guards.
 Nonmanufacturing Costs

Selling Administrative
Costs Costs

Costs necessary to secure the order

All executive, organizational, and
and deliver the product. Selling
clerical costs. Administrative costs
costs can be either direct or indirect
can be either direct or indirect costs.
costs.
EXERCISE (1)
The PC Works assembles custom computers from components supplied by
various manufacturers. The company is very small and its assembly shop
and retail sales store are housed in a single facility in a Redmond,
Washington, industrial park. Listed below are some of the costs that are
incurred at the company.
Required:
For each cost, indicate whether it would most likely be classified as direct
labor, direct materials, manufacturing overhead, selling, or an
administrative cost.
1. The cost of a hard drive installed in a computer.
2. The cost of advertising in the Puget Sound Computer User newspaper.
3. The wages of employees who assemble computers from components.
4. Sales commissions paid to the company’s salespeople.
5. The wages of the assembly shop’s supervisor.
6. The wages of the company’s accountant.
7. Depreciation on equipment used to test assembled computers
before release to customers.
8. Rent on the facility in the industrial park.
 Answer
1.The cost of a hard drive installed in a computer: direct materials.
2.The cost of advertising in the Puget Sound Computer User
newspaper: selling.
3.The wages of employees who assemble computers from
components: direct labor.
4.Sales commissions paid to the company’s salespeople: selling.
5.The wages of the assembly shop’s supervisor: manufacturing
overhead.
6.The wages of the company’s accountant: administrative.
7. Depreciation on equipment used to test assembled computers
before release to customers: manufacturing overhead.
8. Rent on the facility in the industrial park: a combination of
manufacturing overhead, selling, and administrative. The rent
would most likely be prorated on the basis of the amount of
space occupied by manufacturing, selling, and administrative
operations.
2. Assigning Costs to Cost Objects
 Cost classifications for assigning costs to cost objects

Cost object  Anything for which cost data are desired including
products, customers, jobs, organizational subunits, etc. For purposes of
assigning costs to cost objects costs are classified two ways:

Direct costs Indirect costs

• Costs that can be
easily and conveniently traced to
a unit of product or other cost
object.
• Examples: direct material and
direct labor and direct expense.
• Costs that cannot be easily
and conveniently 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.
EXERCISE 2 (Identifying Direct and Indirect Costs)
Northwest Hospital is a full-service hospital that provides
everything from major surgery and emergency room care to
outpatient clinics.
Required:
For each cost incurred at Northwest Hospital, indicate whether
it would most likely be a direct cost or an indirect cost of the
specified cost object by placing an X in the appropriate column.
 Cost Cost Object Direct Indirect
Cost Cost
The wages of pediatric The pediatric X  
nurses department
Prescription drugs A particular patient X  
Heating the hospital The pediatric   X
department
The salary of the head of The pediatric X  
pediatrics department
The salary of the head of A particular pediatric   X
pediatrics patient
Hospital chaplain’s salary A particular patient   X
Lab tests by outside A particular patient X  
contractor
Lab tests by outside A particular X  
contractor department
Product costs and Period costs.
Cost Classifications for Preparing Financial
Statements

Product costs include direct Period costs include all selling

materials, direct labor, and costs and administrative
manufacturing overhead. costs.

Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
Cost Classifications for Preparing Financial Statements
• Product costs in a manufacturing • Period costs in a
company include all manufacturing manufacturing company
costs: direct materials, direct labor, include all non-
and manufacturing overhead.  manufacturing costs:
• Product costs are assigned first to an selling costs and
inventory account (direct materials administrative costs.
inventory, work-in-process inventory, • Period costs are treated
or finished goods inventory). That is, as expenses immediately
product costs are treated at first as an in the period they are
asset and appear in the balance sheet. incurred and appear in
When goods (the inventory) is sold the income statement.
product costs become an expense (cost
of goods sold) and appear in the
income statement.
• Product costs are also cold
inventoriable costs because they are
assigned first to inventory accounts.
Prime Costs and Conversion Costs
Manufacturing costs are often
classified as follows:
Direct Direct Manufacturing
Material Labor Overhead

Prime Conversion
Cost Cost
EXERCISE 4 Classification of Costs as Period or Product Cost
Suppose that you have been given a summer job as an intern at Issac Aircams, a company that
manufactures sophisticated spy cameras for remote-controlled military reconnaissance aircraft.
The company, which is privately owned, has approached a bank for a loan to help it finance its
growth. The bank requires financial statements before approving such a loan. You have been
asked to help prepare the financial statements and were given the following list of costs:
1. Depreciation on salespersons’ cars.
2. Rent on equipment used in the factory.
3. Lubricants used for machine maintenance.
4. Salaries of personnel who work in the finished goods warehouse.
5. Soap and paper towels used by factory workers at the end of a shift.
6. Factory supervisors’ salaries.
7. Heat, water, and power consumed in the factory.
8. Materials used for boxing products for shipment overseas. (Units are not normally boxed.)
9. Advertising costs.
10. Workers’ compensation insurance for factory employees.
11. Depreciation on chairs and tables in the factory lunchroom.
12. The wages of the receptionist in the administrative offices.
13. Cost of leasing the corporate jet used by the company’s executives.
14. The cost of renting rooms at a Florida resort for the annual sales conference.
15. The cost of packaging the company’s product.
Required:
Classify the above costs as either product costs or period costs for the purpose of preparing the
financial statements for the bank.
    
Product Period
Cost Cost
1. Depreciation on salespersons’ cars   X
2. Rent on equipment used in the factory X  
3. Lubricants used for machine maintenance X  
4. Salaries of personnel who work in the finished goods warehouse
X
5. Soap and paper towels used by factory workers at the end of a shift
X  
6. Factory supervisors’ salaries X  
7. Heat, water, and power consumed in the factory X  
8. Materials used for boxing products for shipment overseas (units are not
normally boxed)
  X
9. Advertising costs   X
10. Workers’ compensation insurance for factory employees
X  
11. Depreciation on chairs and tables in the factory lunchroom
X  
12. The wages of the receptionist in the administrative offices
  X
13. Cost of leasing the corporate jet used by the company's executives
  X
14. The cost of renting rooms at a Florida resort for the annual sales
conference
  X
15. The cost of packaging the company’s product X  
EXERCISE 5 (Cost Terminology for manufacturing)
Arden Company reported the following costs and expenses for
the most recent month:
Direct Material $ 80,000.00
Direct Labor $ 42,000.00
MOH $ 19,000.00
Selling expenses $ 22,000.00
Admin expenses $ 35,000.00
Required:
1. What is the total amount of product costs.
2. What is the total amount of period costs.
3. What is the total amount of conversion costs.
4. What is the total amount of prime costs.
1.Product costs:
Direct materials $ 80,000
Direct labor 42,000
Manufacturing overhead 19,000
Total product costs $141,000

2.Period costs:
Selling expenses $22,000
Administrative expenses 35,000
Total period costs $57,000

3.Conversion costs:
Direct labor $42,000
Manufacturing overhead 19,000
Total conversion costs $61,000

4.Prime costs:
Direct materials $ 80,000
Direct labor 42,000
Total prime costs $122,000
The Income Statement:
 Schedule of Cost of Goods Manufactured
Direct Materials:    
Beginning raw materials inventory $60,000  
+ Purchases of raw materials 400,000  
= Raw materials available for use 460,000  
- Ending raw materials inventory 50,000  
= Direct materials used in production $410,000
Direct labor   60,000
Manufacturing overhead:  
Indirect materials (supplies) 21,000  
Indirect labor 100,000  
Insurance, factory 6,000  
Machine rental 50,000  
Utilities, factory 75,000  
Depreciation, factory 90,000  
Property taxes, factory 8,000  
Total manufacturing overhead   350,000
Total manufacturing costs   820,000
+ Beginning work in process inventory   90,000
- Ending work in process inventory   (60,000)
= Cost of goods manufactured   $850,000
EXERCISE 6
Exercise 7
 Schedule of Cost of Goods Manufactured
For the Year Ended December 31
Direct materials:    
Raw materials inventory, January 1 $ 60,000.00  
Add: Purchases of raw materials $ 690,000.00  
Raw materials available for use   $ 750,000.00
Deduct: Raw materials inventory, December 31
  $ 45,000.00
60,000
Raw materials used in production   $ 615,000.00
Direct labor   $ 135,000.00
Manufacturing overhead   $ 370,000.00
Total manufacturing cost   $ 1,120,000.00
Add: Work in process inventory, January 1   $ 120,000.00
Deduct: Work in process inventory, December 31   $ 130,000.00
Cost of goods manufactured   $ 1,110,000.00
Part (2)
 Learning Objective 4
Understand cost classifications used to
predict cost behavior
variable costs, fixed costs, and mixed costs.
Cost Classifications for Predicting Cost
Behavior
Cost behavior refers
to how a cost will
react to changes in
the level of activity.
The most common
classifications are:
– Variable costs.
– Fixed costs.
– Mixed costs.
 Variable Cost
A cost that varies, in total, in direct proportion to
changes in the level of activity. Your total texting bill
may be based on how many texts you send.
Total Texting Bill

Number of Texts Sent

 Variable Cost Per Unit

However, variable cost per unit is constant. The cost per text
sent may be constant at 5 cents per text message.

Cost Per Text Sent

Number of Texts Sent

 Examples for Variable Cost
 There are many examples of costs that are variable with
respect to the products and services provided by a company.
A. In a manufacturing company, variable costs include items
such as direct materials, shipping costs, and sales
commissions and some elements of manufacturing overhead
such as lubricants. We will also usually assume that direct
labor is a variable cost, although direct labor may act more
like a fixed cost in some situations .
B. In a merchandising company, the variable costs of carrying
and selling products include items such as cost of goods sold,
sales commissions, and billing costs.
C. In a hospital, the variable costs of providing health care
services to patients would include the costs of the supplies,
drugs, meals, and perhaps nursing services.
 The Activity Base ABC
(Cost Driver)
Units Machine
produced hours

A measure of what
causes the incurrence
of a variable cost

Miles Labor
driven hours
 Fixed Cost
A cost that remains constant, in total, regardless of changes in
the level of the activity. Your monthly contract fee for your cell
phone may be fixed for the number of monthly minutes in
your contract.
Monthly Cell Phone
Contract Fee

Number of Minutes Used

Within Monthly Plan
 Fixed Cost Per Unit
However, if expressed on a per unit basis, the average fixed cost per unit varies
inversely with changes in activity. The average fixed cost per cell phone call
made decreases as more calls are made.

Monthly Cell Phone Contract

Fee

Number of Minutes Used

Within Monthly Plan
 Examples for Fixed Cost
 Examples of fixed costs include straight-line depreciation,
insurance, property taxes, rent, supervisory salaries,
administrative salaries, and advertising.
 Very few costs are completely fixed. Most will change if
activity changes enough. For example, suppose that the
capacity of the leukemia diagnostic machine at the Mayo
Clinic is 2,000 tests per month. If the clinic wishes to perform
more than 2,000 tests in a month, it would be necessary to
rent an additional machine, which would cause a jump in the
fixed costs. When we say a cost is fixed, we mean it is fixed
within some relevant range.
 Types of Fixed Costs

Committed Discretionary
Long-term, cannot be May be altered in the
significantly reduced in the short term by current
short term. managerial decisions

Examples Examples
Depreciation on Buildings Advertising and Research
and Equipment and Real and Development
Estate Taxes
The Linearity Assumption and the Relevant
Range
Economist’s AA straight
straight line
line
closely
closely
Curvilinear Cost approximates
approximates aa
Function curvilinear
curvilinear
variable
variable cost
cost line
line
within
within the
the
Relevant
relevant
relevant range.
range.
Range
Total Cost

Accountant’s Straight-Line
Approximation (constant unit
variable cost)

Activity
Fixed Costs and the Relevant Range
The relevant range of activity pertains to fixed cost as well as
variable costs. For example, assume office space is available at
a rental rate of $30,000 per year in increments of 1,000 square
feet.

Fixed costs would increase

in a step fashion at a rate of
$30,000 for each additional
1,000 square feet.
Fixed Costs and the Relevant Range

90
Rent Cost in Thousands of

The
The relevant
relevant range
range of of
Relevant activity
activity for
for aa fixed
fixed cost
cost
60 is
is the
the range
range ofof activity
activity
Dollars

Range over
over which
which the
the graph
graph
of
of the
the cost
cost isis flat.
flat.
30

0
0 1,000 2,000 3,000
Rented Area (Square Feet)
 Cost Classifications for Predicting Cost
Behavior

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost Increase Variable cost per unit

and decrease in proportion
to changes in the activity level.
Fixed Total fixed cost is not affected
by changes in the activity
level within the relevant range.
remains constant.
Fixed cost per unit decreases
as the activity level rises and
increases as the activity level falls.
EXERCISE 1: Below are costs and measures of activity in a variety of organizations.
Required: Classify each cost as variable or fixed with respect to the indicated measure of activity by
placing an X in the appropriate column.
    Cost Behavior
   Variable Fixed
1. X-ray film used in the radiology lab at Virginia X  
Mason Hospital in Seattle
2. The costs of advertising a Madonna rock concert in   X
New York City
3. Rental cost of a McDonald’s restaurant building in   X
Hong Kong
4. The electrical costs of running a roller coaster at X  
Magic Mountain
5. Property taxes on your local cinema   X

6. Commissions paid to salespersons at Nordstrom X  

7. Property insurance on a Coca-Cola bottling plant   X
8. The costs of synthetic materials used to make Nike X  
running shoes
9. The costs of shipping Panasonic televisions to retail X  
stores
10. The cost of leasing an ultra-scan diagnostic   X
machine at the American Hospital in Paris
EXERCISE 2: Below are listed various costs that are found in organizations.
1. Hamburger buns in a Wendy’s outlet.
2. Advertising by a dental office.
3. Apples processed and canned by Del Monte.
4. Shipping canned apples from a Del Monte plant to customers.
5. Insurance on a Bausch & Lomb factory producing contact lenses.
6. Insurance on IBM’s corporate headquarters.
7. Salary of a supervisor overseeing production of printers at Hewlett-Packard.
8. Commissions paid to Encyclopedia Britannica salespersons.
9. Depreciation of factory lunchroom facilities at a General Electric plant.
10. Steering wheels installed in BMWs.
Required:
Classify each cost as being either variable or fixed with respect to the number of
units produced and sold. Also classify each cost as either a selling and
administrative cost or a product cost. Prepare your answer sheet as shown below.
Place an X in the appropriate columns to show the proper classification of each
cost.
          Selling and    
   Cost Behavior   Administrative   Product
  Cost Item Variable Fixed   Cost   Cost
1.Hamburger buns at a Wendy’s
outlet X         X
2.Advertising by a dental office
  X   X    
3.Apples processed and canned
by Del Monte X         X
4.Shipping canned apples from
a Del Monte plant to
customers X     X    
5.Insurance on a Bausch &
Lomb factory producing
contact lenses   X       X
6.Insurance on IBM’s corporate
headquarters   X   X    
7.Salary of a supervisor
overseeing production of
printers at Hewlett-Packard
  X       X
8.Commissions paid to
Encyclopedia Britannica
salespersons X     X    
9.Depreciation of factory
lunchroom facilities at a
General Electric plant   X       X
10.Steering wheels installed in
BMWs X         X
EXERCISE 3
Espresso Express operates a number of espresso coffee stands in
busy suburban malls. The fixed weekly expenses of a coffee stand id
$1200 and the variable cost per cup of coffee served is $0.22
Required:
Fill in the following table:

Cups of Coffee served in a Week

2000 2100 2200
Fixed Costs ? ? ?
Variable Costs ? ? ?
Total Costs ? ? ?
Average Cost per cup of ? ? ?
coffee
1.   Cups of Coffee Served
in a Week
    2,000 2,100 2,200
  Fixed cost $1,200 $1,200 $1,200
  Variable cost     440     462     484
  Total cost $1,640 $1,662 $1,684
  Average cost per cup served * $0.820 $0.791 $0.765

* Total cost ÷ cups of coffee served in a week

2. The average cost of a cup of coffee declines as the
number of cups of coffee served increases because the
fixed cost is spread over more cups of coffee.
EXERCISE 4
 Learning Objective 5
Analyze a mixed cost using a scattergraph
plot and the high-low method.
 Mixed Costs
AA mixed
mixed cost
cost contains
contains both
both variable
variable and
and fixed
fixed elements.
elements.
Consider
Consider the
the example
example of
of utility
utility cost.
cost.
Y
Total Utility Cost

cost
xe d
m i
ta l
To Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
 Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX

Where: Y = The total mixed cost.

a = The total fixed cost (the
vertical intercept of the line).
Y b = The variable cost per unit of
activity (the slope of the line).
X = The level of activity.
Total Utility Cost

cost
xe d
i
talm
To Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
 Mixed Costs – An Example
If your fixed monthly utility charge is $40, your variable
cost is $0.03 per kilowatt hour, and your monthly activity
level is 2,000 kilowatt hours, what is the amount of your
utility bill?

Y = a + bX
Y = $40 + ($0.03 × 2,000)
Y = $100
 Analysis of Mixed Costs
Account Analysis and the Engineering Approach

In
In account
account analysis,
analysis, each
each account
account isis
classified
classified as
as either
either variable
variable or
or fixed
fixed based
based
on
on the
the analyst’s
analyst’s knowledge
knowledge of of how
how
the
the account
account behaves.
behaves.

The
The engineering
engineering approach
approach classifies
classifies costs
costs
based
based upon
upon an
an industrial
industrial engineer’s
engineer’s
evaluation
evaluation of
of production
production methods,
methods, andand
material,
material, labor,
labor, and
and overhead
overhead requirements.
requirements.
The High-Low Method – An Example

The variable cost per

hour of maintenance
is equal to the change
in cost divided by the
change in hours.

$2,400
= $6.00/hour
400
 The High-Low Method – An Example

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($6/hour × 850 hours)
Total Fixed Cost = $9,800 – $5,100
Total Fixed Cost = $4,700
The High-Low Method – An Example

The Cost Equation for Maintenance

Y = $4,700 + $6.00X
EXERCISE 5
 Learning Objective 6
Prepare income statements using the
traditional and contribution formats.
 The Traditional and Contribution Formats
(Merchandising Companies)

Comparison of the Contribution Income Statement

with the Traditional Income Statement

Traditional Format Contribution Format

Sales $ 100,000 Sales $ 100,000

Cost of goods sold 70,000 Variable expenses 60,000
Gross margin $ 30,000 Contribution margin $ 40,000
Selling & admin. expenses 20,000 Fixed expenses 30,000
Net operating income $ 10,000 Net operating income $ 10,000

Used primarily for Used primarily by

external reporting. management.
 The Traditional and Contribution Formats
(Manufacturing Companies)

Used primarily for

external reporting.

Used primarily by
management.
 Uses of the Contribution Format
The
The contribution
contribution income
income statement
statement format
format is
is used
used
as
as an
an internal
internal planning
planning andand decision-making
decision-making tool.
tool.
We
We will
will use
use this
this approach
approach for:
for:
1.Cost-volume-profit
1.Cost-volume-profit analysis
analysis
2.Budgeting
2.Budgeting
3.Segmented
3.Segmented reporting
reporting of
of profit
profit data
data ..
4.Special
4.Special decisions
decisions such
such as
as pricing
pricing and
and make-or-
make-or-
buy
buy analysis
analysis
Exercise:1
1
THE ALPINE HOUSE, INC.
Income Statement—Ski Department
For the Quarter  Ended March 31

Sales   $150,000
Less variable expenses:    
Cost of goods sold (200 pairs* × $450 per pair)
$90,000  
Selling expenses (200 pairs × $50 per pair) 10,000  
Administrative expenses (20% × $10,000)    2,000  102,000
Contribution margin   48,000
Less fixed expenses:    
Selling expenses
[$30,000 – (200 pairs × $50 per pair)] 20,000  
Administrative expenses (80% × $10,000)    8,000    28,000
Net operating income   $ 20,000

*$150,000 ÷ $750 per pair = 200 pairs.

2. Since 200 pairs of skis were sold and the contribution margin totaled
$48,000 for the quarter, the contribution of each pair of skis toward
covering fixed costs and toward earning of profits was $240 ($48,000 ÷ 200
pairs = $240 per pair). Another way to compute the $240 is:

 
Selling price per pair   $750
 
Less variable expenses:    
 
Cost per pair $450  
 
Selling expenses 50  
 
Administrative expenses
($2,000 ÷ 200 pairs)    10  510
 
Contribution margin per pair   $240
Exercise:2
 MARWICK’S PIANOS, INC.
1 Income Statement
.  For the Month of August
 Sales (40 pianos × $3,125 per piano)   $125,000
Less cost of goods sold
  (40 pianos × $2,450 per piano)      98,000
 Gross margin   27,000
 Less operating expenses:    
  Selling expenses:    
  Advertising $    700  
Sales salaries and commissions
  [$950 + (8% × $125,000)] 10,950  
Delivery of pianos
  (40 pianos × $30 per piano) 1,200  
  Utilities 350  
  Depreciation of sales facilities      800  
  Total selling expenses  14,000  
  Administrative expenses:    
  Executive salaries 2,500  
Insurance
  400  
Clerical
  [$1,000 + (40 pianos × $20 per piano)] 1,800  
  Depreciation of office equipment      300  
  Total administrative expenses   5,000  
 Total operating expenses      19,000
 Net operating income   $  8,000
 MARWICK’S PIANOS, INC.
2 Income Statement
.  For the Month of August
Per
   Total Piano
 Sales (40 pianos × $3,125 per piano) $125,000 $3,125
 Less variable expenses:    
Cost of goods sold
  (40 pianos × $2,450 per piano) 98,000 2,450
  Sales commissions (8% × $125,000) 10,000 250
  Delivery of pianos (40 pianos × $30 per piano) 1,200 30
  Clerical (40 pianos × $20 per piano)        800       20
 Total variable expenses  110,000   2,750
 Contribution margin    15,000 $  375
 Less fixed expenses:    
  Advertising 700  
  Sales salaries 950  
  Utilities 350  
  Depreciation of sales facilities 800  
  Executive salaries 2,500  
  Insurance 400  
  Clerical 1,000  
  Depreciation of office equipment        300  
 Total fixed expenses      7,000  
 Net operating income $ 8,000  
3. Fixed costs remain constant in total but vary on a per unit
basis inversely with changes in the activity level. As the
activity level increases, for example, the fixed costs will
decrease on a per unit basis. Showing fixed costs on a per
unit basis on the income statement might mislead
management into thinking that the fixed costs behave in the
same way as the variable costs. That is, management might
be misled into thinking that the per unit fixed costs would
be the same regardless of how many pianos were sold
during the month. For this reason, fixed costs generally are
shown only in totals on a contribution format income
statement.
Exercise:3
 1. Cost of goods sold Variable
  Advertising expense Fixed
  Shipping expense Mixed
  Salaries and commissions Mixed
  Insurance expense Fixed
  Depreciation expense Fixed
2. Analysis of the mixed expenses:
  Salaries and
  Shipping Commission
Units Expense Expense
High level of activity 5,000 A$38,000 A$90,000
Low level of activity 4,000   34,000   78,000
Change 1,000 A$ 4,000 A$12,000

Variable cost element:

Change in cost
Variable rate=
Change in activity

A$4,000
Shipping expense: =A$4 per unit.
1,000 units
A$12,000
Salaries and Commission Expense: =A$12 per unit.
1,000 units
Fixed cost element:
Salaries and Commission
  Shipping Expense Expense
Cost at high level of activity A$38,000 A$90,000
Less variable cost element:    
5,000 units × A$4 per unit   20,000  
5,000 units × A$12 per unit                  60,000
Fixed cost element A$18,000 A$30,000

The cost formulas are:

 Shipping expense: A$18,000 per month plus A$4 per unit or
Y = A$18,000 + A$4 X.
 Salaries and Comm. expense: A$30,000 per month plus A$12
per unit or
Y = A$30,000 + A$12 X.
 3
  Morrisey & Brown, Ltd.
  Income Statement
    For the Month Ended September 30
Sales revenue
  (5,000 units × A$100 per unit)   A$500,000
  Less variable expenses:    
Cost of goods sold
  (5,000 units × A$60 per unit) A$300,000  
Shipping expense
  (5,000 units × A$4 per unit) 20,000  
Salaries and commissions expense
  (5,000 units × A$12 per unit)      60,000    380,000
  Contribution margin   120,000
  Less fixed expenses:    
  Advertising expense 21,000  
  Shipping expense 18,000  
  Salaries and commissions expense 30,000  
  Insurance expense 6,000  
  Depreciation expense      15,000      90,000
  Net operating income   A$ 30,000
 Learning Objective 7
Understand cost classifications used in
making decisions: differential costs,
opportunity costs, and sunk costs.
 Cost Classifications for Decision Making

• Every decision involves a choice between at least

two alternatives.
Only those costs and benefits that differ between
alternatives are relevant in a decision. All other
costs and benefits can and should be ignored as
irrelevant.
 1. Differential Cost and Revenue

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: Differential cost is:

$2,000 – $1,500 = $500 $300
Differential costs can be either fixed or variable. To illustrate, assume that Nature
Way Cosmetics, Inc., is thinking about changing its marketing method from
distribution through retailers to distribution by a network of neighborhood sales
representatives. Present costs and revenues are compared to projected costs and
revenues in the following table:
 2. Opportunity Cost
The potential benefit that is given up when one alternative is
selected over another.
These
These costs
costs are
are not
not usually
usually entered
entered into
into the
the accounting
accounting records
records
of
of an
an organization,
organization, but
but must
must bebe explicitly
explicitly considered
considered in in all
all
decisions.
decisions.
What
What are
are the
the opportunity
opportunity costs
costs you
you incur
incur to
to attend
attend this
this class?
class?
 3. Sunk Costs
Sunk costs have already been incurred and
cannot be changed now or in the future. These
costs should be ignored when making decisions.
Example: Suppose you had purchased gold for
$1,100 an ounce, but now it is selling for $950 an
ounce. Should you wait for the gold to reach $1,100
an ounce before selling it? You may say, “Yes” even
though the $1,100 purchase is a sunk costs.
 Period
      Product Cost (Selling    
Manu- and Oppor-
Variable Fixed Direct Direct facturing Admin) tunity Sunk
Name of the Cost Cost Cost Materials Labor Overhead Cost Cost Cost
Rental revenue forgone, $30,000 per
year             X  
Direct materials cost, $80 per unit X   X          
Rental cost of warehouse, $500 per
month   X       X    
Rental cost of equipment, $4,000 per
month   X     X      
Direct labor cost, $60 per unit X     X        
Depreciation of the annex space, $8,000
per year   X     X     X
Advertising cost, $50,000 per year   X       X    
Supervisor's salary, $1,500 per month
  X     X      
Electricity for machines, $1.20 per unit
X       X      
Shipping cost, $9 per unit X         X    
Return earned on investments, $3,000
per year             X