CHAPTER 2:

BASIC MANAGERIAL
ACCOUNTING CONCEPTS

Cornerstones of Managerial Accounting, 6e

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THE MEANING AND USES
OF COST
 Determine the cost of products, services, customers, and other items to
managers.
 Cost is the amount of cash or cash equivalent sacrificed for goods and/or
services that bring a current or future benefit to the organization.
 As costs are used up in the production of revenues do expire.
 Expired costs are called expenses.
 The revenue per unit is called price.
 Managerial accounting systems are structured to measure and assign
costs.
 A cost object is any item such as a product, customer, department,
project, geographic region, plant, and so on, for which costs are
measured and assigned.
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COST CLASSIFICATION
Relationship to
item measured:
Cost Behavior: Direct & Indirect Decision Analysis:
Fixed, Variable Relevant, Sunk &
& Mixed Opportunity

Recognition
Manufacturing:
timing: Product
- Direct labor COST & Period Cost
- Direct
Material
- Fact.
Overhead Functional areas:
Output: - Administrative
- Product
- R&D
- Services Input: - Marketing, etc
Prime & Conversion
Source: Oliver, 2000 (Modified)
 DETERMINING PRODUCT
COST
 Product (manufacturing) costs are costs, both direct and indirect, of
producing a product in a manufacturing firm or of acquiring a product in a
merchandising firm and preparing it for sale.
 Only costs in the production of the value chain are included in product costs.

 Direct materials are materials that
are a part of the final product and
can be directly traced to the goods
being produced.
 The materials cost can be directly
charged to products because
physical observation can be used
to measure the quantity used by
each product.
 Materials that become part of a
product usually are classified as
direct materials.
 Direct labor is the labor that can be directly
traced to the goods being produced.
 Physical observation can be used to measure
the amount of labor used to produce a
product.
 Those employees who convert direct
materials into a product are classified as direct
labor.
 A company also have indirect labor costs.
 Indirect labor is included in overhead and,
therefore, is an indirect cost rather than a
direct cost. LO-2
 MANUFACTURING
OVERHEAD
 All product costs  Costs are included as manufacturing
other than direct overhead if they cannot be traced to
materials and direct the cost object of interest (e.g., unit of
labor are considered product).
manufacturing
 Manufacturing overhead cost
overhead.
category includes a variety of items.
 Manufacturing
 Examples include depreciation on
overhead also is
plant buildings and equipment,
known as factory
janitorial and maintenance labor,
burden or indirect
plant supervision, materials
manufacturing
handling, power for plant utilities,
costs.
and plant property taxes.
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 PRIME AND CONVERSION
COSTS
 Product costs of DM, DL, and manufacturing overhead
can be grouped into prime cost and conversion cost:
 Prime cost is the sum of direct materials cost and
direct labor cost.
 Prime cost = Direct materials + Direct labor

 Conversion cost is the sum of direct labor cost and

manufacturing overhead cost.
Conversion cost = Direct labor + Manufacturing Overhead
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PERIOD COSTS

 Costs of production are assets that are carried in

inventories until the goods are sold.
 Other costs, such as period costs, are not carried in
inventory.
 Period costs are all costs that are not product costs (i.e., all
areas of the value chain except for production).
 Examples of period costs: Office supplies, research and
development activities, the CEO’s salary, and advertising.
 The level of period costs can be significant and controlling
them may bring greater cost savings than the same effort
exercised in controlling production costs.
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 SELLING COSTS

 Those costs necessary to market, distribute, and service

a product or service are selling costs.

EXAMPLES
Order-getting Sales personnel
Salaries &
Commissions
Advertising
EXAMPLES
Warehousing
Shipping
Customer
Service Order- Filling

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 ADMINISTRATIVE COSTS
 Administrative costs include research, development, and
general administration of the organization and cannot be
assigned to either selling or production.
 General administration ensures that the various activities
of the organization are integrated so that the overall
mission of the firm is realized.
 Examples of general administrative costs are: Executive
salaries, legal fees, printing the annual report, and
general accounting.
 Research and development costs include: Designing and
developing new products and must be expensed in the
period incurred. LO-2
p.48
PREPARING INCOME STATEMENTS:
COST OF GOODS MANUFACTURED
 The cost of goods manufactured represents the total product cost of
goods completed during the current period and transferred to
finished goods inventory.
 The cost of direct materials can be derived using formula:

 The direct materials used is then used to calculate the cost of goods
manufactured as follows: + Direct materials
+ Direct labor
+ Manufacturing overhead costs
+ Beginning WIP inventory
- Ending WIP inventory
= Cost of goods manufactured LO-3
 COST OF GOODS SOLD

To meet external  Cost of goods sold represents the cost of

reporting goods that were sold during the period
requirements, and then transferred from finished goods
costs must be inventory on the balance sheet to cost of
classified into goods sold on the income statement (i.e.,
three categories:
as an inventory expense). Cost of goods
 Production
sold is calculated as:
 Selling
 Administration + Beginning finished goods inventory
+ Cost of goods manufactured
- Ending finished goods inventory

LO-3 = Cost of goods sold

 INCOME STATEMENT:
MANUFACTURING FIRM
 All sales revenue and
expenses attached to a time
period are on the income
statement.
 The heading of the financial
statement tells us what type
of statement it is – Income
Statement; for what firm- the
name of the company; and for
what period.
 Sales revenue is calculated as:
Sales revenue = Price x Units
sold
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 Gross margin is the difference
between sales revenue and cost of
goods sold:
Sales Revenue
– Cost of Goods Sold
= Gross Margin
 It shows how much the firm is
making over and above the cost of
the units sold.
 Gross margin does not equal
operating income or profit as it is
computed without subtracting
selling and administrative
OPERATING INCOME

 Selling and administrative expenses for the period

are subtracted from gross margin to arrive at
operating income.
Gross Margin - Selling and Administrative
Expenses = Operating Income
 Operating income is the key figure from the
income statement
 It shows how much the owners are actually
earning (profit) from the company.
LO-3
CHAPTER 3:
COST
BEHAVIOR
Cornerstones of Managerial Accounting, 6e
Basics of Cost Behavior

Cost behavior is the foundation upon which managerial accounting

is built.
Describes whether a cost changes when the level of output changes.
Costs can be variable, fixed, or mixed.
A cost that does not change in total as output changes is a fixed
cost.
A variable cost increases in total with an increase in output and
decreases in total with a decrease in output.
Knowing how costs change as output changes is essential to
planning, controlling, and decision making.

LO-1
Measures of Output and the
Relevant Range
Fixed and variable costs have meaning only when related to an
output measure.
A cost driver measures the output of the activity that leads (or
causes) costs to change.
Identifying and managing drivers helps managers predict and
control costs.
For example, weather is a significant driver in the airline
industry.

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Relevant Range and Cost
Relationships
Relevant range is the range of output over which the assumed
cost relationship is valid for the normal operations of a firm.
Limits the cost relationship to the range of operations that the
firm normally expects to occur.
The following graph shows the relevant range which allows
managers to assume a linear cost relationship.

LO-1
Fixed Costs

The number of computers produced is called the output

measure, or driver.
Even though fixed costs may change, this does not make them
variable.
They are fixed at a new higher (or lower) rate.
A graph of Colley’s fixed supervision costs is shown below:

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Discretionary Fixed Costs and
Committed Fixed Costs
Two types of fixed costs: discretionary fixed costs and
committed fixed costs.
Discretionary fixed costs are fixed costs that can be changed or
avoided easily at management discretion.
 Advertising is a discretionary fixed cost, because it depends
on a management decision.
Committed fixed costs, on the other hand, are fixed costs that
cannot be easily changed.
 Lease cost is a committed fixed cost because it involves a
long-term contract.

LO-1
Variable Costs
Variable costs are costs that vary in direct proportion to
changes in output within the relevant range.
Variable costs can also be represented by a linear equation.
Total variable costs depend on the level of output.
This relationship can be described by the following equation or
graphs:
Total variable costs = Variable rate x Amount of output

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The Reasonableness of Straight-
Line Cost Relationships
Caution when applying cost behavior assumptions to output levels that fall
outside of the company’s relevant range of operations.
Straight-line cost relationships that are assumed within the relevant range may
actually be semi-variable costs.
Example: At extremely low levels of output, workers often use more materials
per unit or require more time per unit than they do at higher levels of output.
As the level of output increases, workers learn how to use materials and time
more efficiently so that the variable cost per unit decreases as more and more
output is produced.

LO-1
 Mixed costs are costs that have both a
Mixe fixed and a variable component.

d Example: Overhead for a company may

consist of a fixed supervisor salary plus
Costs the cost of supplies that vary with the
quantity of output produced.
The formula and graph depiction for a
mixed cost is as follows:

Total cost = Total fixed cost + Total variable cost

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Step Costs: Narrow/Wide
Steps
Some cost functions may be discontinuous.
Known as step costs (or semi-fixed).
Displays a constant level of cost for a
range of output and then jumps to a higher
level (or step) of cost at some point, where
it remains for a similar range of output.
If a step cost has narrow steps, it means that
the cost changes in response to small
changes in output and we can approximate it
as a variable cost (i.e., the red line).
Step cost with wide steps are more
characteristic of fixed costs.
Example: A company may have to
lease production machinery.
If the machine can only produce
1,000 units and the company
grows, they will have to lease
additional machines for each 1,000
units of production needed
Resulting in the wide steps shown
in the following graph.
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Methods for Separating Mixed Costs
into Fixed and Variable Components
Three methods of separating a mixed cost:
1. the high-low method
2. the scattergraph method
3. the method of least squares
Each method requires the assumption of a linear cost relationship.

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Methods for Separating Mixed Costs
into Fixed and Variable Components
Expression of cost as an
equation for a straight line is:
Total cost = Fixed cost +
(Variable rate x Output)
The dependent variable is a
variable whose value depends
on the value of another
variable.
In the previous equation, total
cost is the dependent variable;
it is the cost we are trying to
predict.
The independent variable
measures output and explains
changes in the cost or other
dependent variable.
 A good independent variable is one
that causes or is closely associated
with the dependent variable.
 Many managers refer to an
independent variable as a cost
driver.
The intercept corresponds to
fixed cost.
The slope of the cost line
corresponds to the variable rate.
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APPENDIX 3A:
Using the Regression Programs
Computing the regression formula manually is tedious, even with only
a few data points.
As the number of data points increases, manual computation becomes
impractical.
Fortunately, spreadsheet packages like Microsoft Excel have
regression routines that perform these computations.
Input the data and the spreadsheet regression program supplies more
than the estimates of the coefficients.
Also provides information that can be used to see how reliable the cost
equation is—a feature that is not available for the scattergraph and
high-low methods.

LO-4
Exercises
The relevant range is a relatively

a. wide span of production where total fixed costs are expected to remain the
same
b. wide range of sales where total variable costs remain the same
c. wide range of sales where all costs remain the same
d. narrow range of production where total variable costs remain the same

ABC Company has $50,000 in fixed cost per month. In April, 50,000 units
were produced. In May, 55,000 units were produced.
Which of the following statements is true?

a. Total fixed costs will change.

b. Fixed cost will increase on a per unit basis.
c. Fixed cost will decrease on a per unit basis.
d. There will be no change to the fixed cost per unit.
Exercises
Management is interested in utilizing the full capacity of production
facilities because it
a. spreads variable costs over a greater number of units, thereby reducing the
variable cost per unit
b. spreads fixed costs over a greater number of units, thereby reducing the fixed
cost per unit
c. reduces total variable costs
d. reduces total fixed costs

The following information was available about supplies cost for the first three months of the year:
Using the high-low method, an estimate of supplies cost at 20,000 units of production would be
Month Production Volume Supplies Cost
January 12,000 $ 80,000 
February 23,000 140,000
March 27,000 164,000
a. $96,000
b. $112,000
c. $124,800
d. $130,400