High-low or least squares regression analysis should only be done if

Chapter 2 Managerial Accounting and Cost Concepts

LEARNING OBJECTIVES

After studying Chapter 2 , you should be able to:

· LO1 Identify and give examples of each of the three basic manufacturing cost categories.

· LO2 Distinguish between product costs and period costs and give examples of each.

· LO3 Understand cost behavior patterns including variable costs, fixed costs, and mixed costs.

· LO4 Analyze a mixed cost using a scattergraph plot and the high-low method.

· LO5 Prepare income statements for a merchandising company using the traditional and contribution formats.

· LO6 Understand the differences between direct and indirect costs.

· LO7 Understand cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs.

· LO8 ( Appendix 2A ) Analyze a mixed cost using a scattergraph plot and the least-squares regression method.

· LO9 ( Appendix 2B ) Identify the four types of quality costs and explain how they interact.

· LO10 ( Appendix 2B ) Prepare and interpret a quality cost report.

BUSINESS FOCUS: Understanding Costs Aids the Growth of a Billion Dollar Company

In 1986, Women's World of Fitness went bankrupt despite having 14 locations and 50,000 members. The company's owner, Gary Heavin, says the fitness centers contained too many costly amenities such as swimming pools, tanning beds, cardio machines, kid's programs, juice bars, personal trainers, and aerobics classes. As costs escalated, he attempted to increase revenues by offering memberships to men, which alienated his female members. What did Heavin learn from his experience?

In 1992, Heavin founded a new brand of women's fitness centers called Curves. Rather than investing in every conceivable piece of fitness equipment and amenity, Heavin focused on simplicity. He created a simple fitness circuit that uses minimal equipment and is quick and easy for members to complete. Instead of operating almost 24 hours a day, he decided to close his gyms early. Even showers were deemed unnecessary. In short, Heavin eliminated numerous costs that did not provide benefits in the eyes of his customers. With dramatically lower costs, he has been able to maintain his “women only” approach while building a billion dollar company with nearly 10,000 locations worldwide. ▪

Source: Alison Stein Wellner, “Gary Heavin Is on a Mission from God,” Inc. magazine, October 2006, pp. 116–123.

This chapter explains that in managerial accounting the term cost is used in many different ways. The reason is that there are many types of costs, and these costs are classified differently according to the immediate needs of management. For example, managers may want cost data to prepare external financial reports, to prepare planning budgets, or to make decisions. Each different 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, whereas decision making may require predictions about future costs. This notion of different costs for different purposes is a critically important aspect of managerial accounting.

General Cost Classifications

We will start our discussion of cost concepts by focusing on manufacturing companies, because they are involved in most of the activities found in other types of organizations. Manufacturing companies such as Texas Instruments, Ford, and DuPont are involved in acquiring raw materials, producing finished goods, marketing, distributing, billing, and almost every other business activity. Therefore, an understanding of costs in a manufacturing company can be very helpful in understanding costs in other types of organizations.

Manufacturing Costs

Most manufacturing companies separate manufacturing costs into three broad categories: direct materials, direct labor, and manufacturing overhead. A discussion of each of these categories follows.

LEARNING OBJECTIVE 1

Identify and give examples of each of the three basic manufacturing cost categories.

Direct Materials

The materials that go into the final product are called raw materials . This term is somewhat misleading because it seems to imply unprocessed natural resources like wood pulp or iron ore. Actually, raw materials refer to any materials that are used in the final product; and the finished product of one company can become the raw materials of another company. For example, the plastics produced by Du Pont are a raw material used by Hewlett-Packard in its personal computers.

Raw materials may include both direct and indirect materials. Direct materials are those materials that become an integral part of the finished product and whose costs can be conveniently traced to the finished product. This would include, for example, the seats that Airbus purchases from subcontractors to install in its commercial aircraft and the tiny electric motor Panasonic uses in its DVD players.

Sometimes it isn't worth the effort to trace the costs of relatively insignificant materials to end products. Such minor items would include the solder used to make electrical connections in a SonyTV or the glue used to assemble an Ethan Allen chair. Materials such as solder and glue are called indirect materials and are included as part of manufacturing overhead, which is discussed later in this section.

Direct Labor

Direct labor consists of labor costs that can be easily (i.e., physically and conveniently) traced to individual units of product. Direct labor is sometimes called touch labor because direct labor workers typically touch the product while it is being made. Examples of direct labor include assembly-line workers at Toyota, carpenters at the home builder KB Home, and electricians who install equipment on aircraft at Bombardier Learjet.

Labor costs that cannot be physically traced to particular products, or that can be traced only at great cost and inconvenience, are termed indirect labor . Just like indirect materials, indirect labor is treated as part of manufacturing overhead. Indirect 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 impractical or impossible to accurately trace their costs to specific units of product. Hence, such labor costs are treated as indirect labor.

IN BUSINESS: IS SENDING JOBS OVERSEAS ALWAYS A GOOD IDEA?

Many companies send jobs from high labor-cost countries such as the United States to lower labor-cost countries such as India and China. But is chasing labor cost savings always the right thing to do? In manufacturing, the answer is no. Typically, total direct labor costs are around 7% to 15% of cost of goods sold. Because direct labor is such a small part of overall costs, the labor savings realized by “offshoring” jobs can easily be overshadowed by a decline in efficiency that occurs simply because production facilities are located farther from the ultimate customers. The increase in inventory carrying costs and obsolescence costs coupled with slower response to customer orders, not to mention foreign currency exchange risks, can more than offset the benefits of employing geographically dispersed low-cost labor.

One manufacturer of casual wear in Los Angeles, California, understands the value of keeping jobs close to home in order to improve performance. The company can fill orders for as many as 160,000 units in 24 hours. In fact, the company carries less than 30 days’ inventory and is considering fabricating clothing only after orders are received from customers rather than attempting to forecast what items will sell and making them in advance. How would they do this? The company's entire manufacturing process—including weaving, dyeing, and sewing—is located in downtown Los Angeles, eliminating shipping delays.

Source: Robert Sternfels and Ronald Ritter, “When Offshoring Doesn't Make Sense,” The Wall Street Journal, October 19, 2004, p. B8.

Manufacturing Overhead

Manufacturing overhead , the third element of manufacturing cost, includes all manufacturing costs except direct materials and direct labor. Manufacturing overhead includes items such as indirect materials; indirect labor; maintenance and repairs on production equipment; and heat and light, property taxes, depreciation, 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 manufacturing overhead.

Various names are used for manufacturing overhead, such as indirect manufacturing cost, factory overhead, and factory burden. All of these terms are synonyms for manufacturing overhead.

Nonmanufacturing Costs

Nonmanufacturing costs are often divided into two categories: (1) selling costs and (2)administrative costs. Selling costs include all costs that are incurred to secure customer orders and get the finished product to the customer. These costs are sometimes called order-getting and order-filling costs. Examples of selling costs include advertising, shipping, sales travel, sales commissions, sales salaries, and costs of finished goods warehouses.

Administrative costs include all costs associated with the general management of an organization rather than with manufacturing or selling. Examples of administrative costs include executive compensation, general accounting, secretarial, public relations, and similar costs involved in the overall, general administration of the organization as a whole.

Nonmanufacturing costs are also often called selling, general, and administrative (SG&A) costs or just selling and administrative costs.

Product Costs versus Period Costs

LEARNING OBJECTIVE 2

Distinguish between product costs and period costs and give examples of each.

In addition to classifying costs as manufacturing or nonmanufacturing costs, there are other ways to look at costs. For instance, they can also be classified as either product costs or period costs. To understand the difference between product costs and period costs, we must first discuss the matching principle from financial accounting.

Generally, costs are 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 year in which the payment is made. Instead, one-half of the cost would be recognized as an expense each year. The reason is that both years—not just the first year—benefit from the insurance 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 generate 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 occurs. Such costs are called product costs.

Product Costs

For financial accounting purposes, product costs include all costs involved in acquiring or 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 initially assigned to an inventory account on the balance sheet. When the goods are sold, the costs are released from inventory as expenses (typically called cost of goods sold) and matched against sales revenue. Because product costs are initially assigned to inventories, they are also known as inventoriable costs .

We want to emphasize that product costs are not necessarily treated as expenses in the period in which they are incurred. Rather, as explained above, they are treated 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. All selling and administrative expenses are treated as period costs. For example, sales commissions, advertising, executive 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 manufactured goods; instead, period costs are expensed on the income statement in the period in which they are 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 earlier, the costs of liability insurance are spread across the periods that benefit from the insurance—regardless of the period in which the insurance premium is paid.

Prime Cost and Conversion Cost

Two more cost categories are often used in discussions of manufacturing costs—prime cost andconversion 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 are incurred to convert materials into the finished product.

Exhibit 2–1 contains a summary of the cost terms that we have introduced so far.

EXHIBIT 2–1 Summary of Cost Terms

IN BUSINESS: THE CHALLENGES OF MANAGING CHARITABLE ORGANIZATIONS

Charitable organizations, such as Harlem Children's Zone, Sports4Kids, and Citizen Schools, are facing a difficult situation. Many donors—aware of stories involving charities that spent excessively on themselves while losing sight of their mission—have started prohibiting their charity of choice from using donated funds to pay for administrative costs. However, even the most efficient charitable organizations find it difficult to expand without making additions to their infrastructure. For example, Sports4Kids’ nationwide expansion of its sports programs drove up administrative costs from 5.6% to 14.7% of its total budget. The organization claims that this cost increase was necessary to build a more experienced management team to oversee the dramatically increased scale of operations.

Many charitable organizations are starting to seek gifts explicitly to fund administrative expenses. Their argument is simple—they cannot do good deeds for other people without incurring such costs.

Source: Rachel Emma Silverman and Sally Beatty, “Save the Children (But Pay the Bills, Too),” The Wall Street Journal, December 26, 2006, pp. D1–D2.

Cost Classifications for Predicting Cost Behavior

LEARNING OBJECTIVE 3

Understand cost behavior patterns including variable costs, fixed costs, and mixed costs.

It is often necessary to predict how a certain cost will behave in response to a change in activity. For example, a manager at Qwest, a telephone company, may want to estimate the impact a 5 percent increase in long-distance calls by customers would have on Qwest's total electric bill. 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 can be expected to change, the manager must be able to estimate how much it will change. To help make such distinctions, costs are often categorized as variable, fixed, or mixed. The relative proportion of each type of cost 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, it might have many variable costs but few fixed or mixed costs.

Variable Cost

A variable cost varies, in total, in direct proportion to changes in the level of activity. Common examples of variable costs include cost of goods sold for a merchandising company, direct materials, direct labor, variable elements of manufacturing overhead, such as indirect materials, supplies, and power, and variable elements of selling and administrative expenses, such as commissions and shipping costs. 1

For a cost to be variable, it must be variable with respect to something. That “something” is itsactivity 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 occupied in a hospital. While there are many activity bases within organizations, throughout this textbook, unless stated otherwise, you should assume that the activity base under consideration is the total volume of goods and services provided by the organization. We will specify the activity base only when it is something other than total output.

IN BUSINESS: COST DRIVERS IN THE ELECTRONICS INDUSTRY

Accenture Ltd. estimates that the U.S. electronics industry spends $13.8 billion annually to rebox, restock, and resell returned products. Conventional wisdom is that customers only return products when they are defective, but the data shows that this explanation only accounts for 5% of customer returns. The biggest cost drivers that cause product returns are that customers often inadvertently buy the wrong products and that they cannot understand how to use the products that they have purchased. Television manufacturer Vizio Inc. has started including more information on its packaging to help customers avoid buying the wrong product. Seagate Technologies is replacing thick instruction manuals with simpler guides that make it easier for customers to begin using their products.

Source: Christopher Lawton, “The War on Returns,” The Wall Street Journal, May 8, 2008, pp. D1 and D6.

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 Cascade Mountains. The company provides all of the necessary equipment and experienced guides, and it serves gourmet meals to its guests. The meals are purchased 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 of Guests

Cost of Meals per Guest

Total Cost of Meals

  250

$30

$7,500

  500

$30

$15,000

   750

$30

$22,500

1,000

$30

$30,000

While total variable costs change as the activity level changes, it is 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 of the meals increases and decreases with activity. The graph on the left-hand side of Exhibit 2–2 illustrates that the total variable cost rises and falls as the 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 meal cost rises to $30,000.

EXHIBIT 2–2 Variable and Fixed Cost Behavior

1

Direct labor costs often can be fixed instead of variable for a variety of reasons. For example, in some countries, such as France, Germany, and Japan, labor regulations and cultural norms may limit management's ability to adjust the labor force in response to changes in activity. In this textbook, always assume that direct labor is a variable cost unless you are explicitly told otherwise.

Fixed Cost

A fixed cost is a 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 fixed costs remain constant unless influenced by some outside 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 .

IN BUSINESS: FOOD COSTS AT A LUXURY HOTEL

The Sporthotel Theresa ( http://www.theresa.at/ ), owned and operated by the Egger family, is a four star hotel located in Zell im Zillertal, Austria. The hotel features access to hiking, skiing, biking, and other activities in the Ziller alps as well as its own fitness facility and spa.

Three full meals a day are included in the hotel room charge. Breakfast and lunch are served buffet-style while dinner is a more formal affair with as many as six courses. The chef, Stefan Egger, believes that food costs are roughly proportional to the number of guests staying at the hotel; that is, they are a variable cost. He must order food from suppliers two or three days in advance, but he adjusts his purchases to the number of guests who are currently staying at the hotel and their consumption patterns. In addition, guests make their selections from the dinner menu early in the day, which helps Stefan plan which foodstuffs will be required for dinner. Consequently, he is able to prepare just enough food so that all guests are satisfied and yet waste is held to a minimum.

Source: Conversation with Stefan Egger, chef at the Sporthotel Theresa.

Because total fixed costs remain constant for large variations in the level of activity, the average fixed cost per unit becomes progressively smaller as the level of activity increases. If Nooksack Expeditions has only 250 guests in a month, the $500 fixed rental cost would 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 this aspect of the behavior of fixed costs. Note that as the number of guests increase, the average fixed cost per guest drops.

Monthly Rental Cost

Number of Guests

Average Cost per Guest

$500

 250

$2.00

$500

 500

$1.00

$500

 750

$0.67

$500

1,000

$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 total fixed costs actually change as the level of activity changes.

For planning purposes, fixed costs can be viewed as either committed or discretionary. Committed fixed costs represent organizational investments with a multiyear planning horizon that can't be significantly reduced even for short periods of time without making fundamental changes. Examples include investments in facilities and equipment, as well as real estate taxes, insurance expenses, and salaries of top management. Even if operations are interrupted or cut back, committed fixed costs remain largely unchanged in the short term because the costs of restoring them later are likely to be far greater than any short-run savings that might be realized. Discretionary fixed costs (often referred to as managed fixed costs) usually arise from annualdecisions by management to spend on certain fixed cost items. Examples of discretionary fixed costs include advertising, research, public relations, management development programs, and internships for students. Discretionary fixed costs can be cut for short periods of time with minimal damage to the long-run goals of the organization.

The Linearity Assumption and the Relevant Range

Management accountants ordinarily assume that costs are strictly linear; that is, the relation between cost on the one hand and activity on the other can be represented by a straight line. Economists point out that many costs are actually curvilinear; that is, the relation between cost and activity is a curve. Nevertheless, even if a cost is not strictly linear, it can be approximated within a narrow band of activity known as the relevant range by a straight line as illustrated in Exhibit 2–3 . The relevant range is the range of activity within which the assumption that cost behavior is strictly linear is 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 behavior may be invalid if activity falls outside of the relevant range.

EXHIBIT 2–3 Curvilinear Costs and 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 $20,00