Managerial Accounting and Cost
Concepts
Chapter Two
2-2
Learning Objective 1
Understand cost
classifications used for
assigning costs to cost
objects: Direct Costs and
Indirect Costs
2-3
Cost Classifications for assigning costs to cost objects
• Cost Object: Anything for which cost data are
desired-including products, customers, jobs and
organizational subunits.
• Direct Cost: A cost that can be easily and
conveniently traced to a specific cost object.
• Indirect Cost: A cost that cannot be easily and
conveniently traced to a specific cost object.
2-4
Learning Objective 2
Identify and give examples
of each of the three basic
manufacturing cost
categories.
2-5
Manufacturing Costs
Direct
Materials
Direct
Labor
The Product
Manufacturing
Overhead
2-6
Direct Materials
Raw materials that become an integral part of the
finished product and that can be conveniently
traced directly to it.
Example: A radio installed in an automobile
2-7
Direct Labor
Those labor costs that can be easily traced to
individual units of product.
Example: Wages paid to automobile assembly workers
2-8
Manufacturing Overhead
Manufacturing costs that cannot be traced directly to
specific units produced.
Examples: Indirect labor and indirect materials
Wages paid to employees
who are not directly
involved in production
work.
Examples: maintenance
workers, janitors and
security guards.
Materials used to support
the production process.
Examples: lubricants and
cleaning supplies used in
the automobile assembly
plant.
2-9
Non-manufacturing Costs
Selling
Costs
Administrative
Costs
Costs necessary to
secure the customer
order and deliver the
product to customer.
All costs associated
with the general
management of an
organization.
2-10
Learning Objective 3
Understand cost
classification used to
prepare financial
statements: product
costs and period costs.
2-11
Product Costs Versus Period Costs
Product costs include
all costs involved in
acquiring or making a
product, consists of
direct materials, direct
labor, and
manufacturing
overhead.
Inventory
Cost of Good Sold
Period costs are all the
costs that are not
product costs. All
selling and
administrative
expenses are treated
as period costs.
Expense
Sale
Balance
Sheet
Income
Statement
Income
Statement
2-12
Quick Check 
Which of the following costs would be considered a
period rather than a product cost in a manufacturing
company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.
2-13
Quick Check 
Which of the following costs would be considered a
period rather than a product cost in a manufacturing
company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.
2-14
Classifications of Costs
Manufacturing costs are often
classified as follows:
Direct
Material
Direct
Labor
Prime
Cost
Manufacturing
Overhead
Conversion
Cost
2-15
Learning Objective 4
Understand cost
classifications used to
predict cost behavior:
variable cost, fixed cost
& mixed cost.
2-16
Cost Classifications for Predicting Cost Behavior
How a cost will react to
changes in the level of
activity within the relevant
range. As the activity level
rises or falls, a particular
cost may rise or fall as wellor it may remain constant.
 Total variable costs
change when activity
changes.
 Total fixed costs remain
unchanged when activity
changes.
2-17
Variable Cost
Total Long Distance
Telephone Bill
A variable cost is a cost whose total dollar amount varies in
direct proportion to changes in the activity level. Your
total long distance telephone bill is based on how many
minutes you talk.
Ex- Direct materials, Direct labor, variable elements of
manufacturing overhead and variable elements of selling
and administrative expenses
Minutes Talked
2-18
Variable Cost
Total Long Distance
Telephone Bill
Your total long distance telephone bill is based on how many
minutes you talk.
Minutes Talked
2-19
Variable Cost Per Unit
Per Minute
Telephone Charge
A variable cost is constant if expressed on a per unit
basis. The cost per long distance minute talked is
constant. For example, 10 cents per minute.
Minutes Talked
2-20
Fixed Cost
Monthly Basic
Telephone Bill
Fixed cost is a cost that remains constant in total, regardless
of the changes in the level of activity. Your monthly basic
telephone bill probably does not change when you make
more local calls.
Ex: straight-line depreciation, insurance, property taxes, rent,
supervisor’s salaries, administrative salaries, and advertising.
Number of Local Calls
2-21
Fixed Cost Per Unit
Monthly Basic Telephone
Bill per Local Call
The average fixed cost per unit becomes progressively smaller
as the level of activity increases.
The average fixed cost per local call decreases as more local
calls are made.
Number of Local Calls
2-22
Cost Classifications for Predicting Cost Behavior
Behavior of Cost (within the relevant range)
Cost
In Total
Per Unit
Variable
Total variable cost changes
as activity level changes.
Variable cost per unit remains
the same over wide ranges
of activity.
Fixed
Total fixed cost remains
the same even when the
activity level changes.
Average fixed cost per unit goes
down as activity level goes up.
2-23
Quick Check 
Which of the following costs would be variable with
respect to the number of cones sold at a Baskins &
Robbins shop? (There may be more than one correct
answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
2-24
Quick Check 
Which of the following costs would be variable with
respect to the number of cones sold at a Baskins &
Robbins shop? (There may be more than one correct
answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
2-25
Types of Fixed Costs
Committed Fixed Costs
Organizational
investment with multiyear planning horizon,
cannot be significantly
reduced in the short
term.
Discretionary Fixed
Costs
Usually arise from
annual decisions by
management to spend
on certain fixed cost.
Examples
Examples
Depreciation on
Equipment and
Real Estate Taxes
Advertising and
Research and
Development
2-26
The Linearity Assumption and the Relevant
Range
Economist’s
Curvilinear Cost
Function
Total Cost
Relevant
Range
A straight line
closely
approximates a
curvilinear
variable cost
line within the
relevant range.
Accountant’s Straight-Line
Approximation (constant unit
variable cost)
Activity
2-27
Fixed Costs and Relevant Range
Rent Cost in Thousands of
Dollars
90
Relevant
60
Range
30
Total cost doesn’t
change for a wide
range of activity,
and then jumps to
a new higher cost
for the next higher
range of activity.
0
0
1,000
2,000
3,000
Rented Area (Square Feet)
2-28
Mixed Costs
A mixed cost contains both fixed and variable
components. Mixed costs are also known as semivariable costs. Consider the example of utility cost.
Total Utility Cost
Y
Variable
Cost per KW
Activity (Kilowatt Hours)
X
Fixed Monthly
Utility Charge
2-29
Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX
Where:
Total Utility Cost
Y
Y = the total mixed cost
a = the total fixed cost (the
vertical intercept of the line)
b = the variable cost per unit of
activity (the slope of the line)
X = the level of activity
Variable
Cost per KW
Activity (Kilowatt Hours)
X
Fixed Monthly
Utility Charge
2-30
Mixed Costs 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
2-31
The Analysis of Mixed Costs
Account Analysis and the Engineering Approach
Each account is classified as either
variable or fixed based on the analyst’s
knowledge of how the account behaves.
Cost estimates are based on an
evaluation of production methods, and
material, labor and overhead
requirements.
2-32
Learning Objective 5
Analyze a mixed cost using
scatter graph plot and the
high-low method.
2-33
The Scattergraph Method
Plot the data points on a graph
(total cost vs. activity).
Maintenance Cost
1,000’s of Dollars
Y
20
* *
* *
10
0
0
1
2
* ** *
**
3
4
Patient-days in 1,000’s
X
2-34
The Scattergraph Method
Draw a line through the data points with about an
equal numbers of points above and below the line.
Maintenance Cost
1,000’s of Dollars
Y
20
* *
* *
10
0
0
1
* ** *
**
2
3
4
Patient-days in 1,000’s
X
2-35
The Scattergraph Method
Maintenance Cost
1,000’s of Dollars
Use one data point to estimate the total level of activity
and the total cost.
Y Total maintenance cost = $11,000
20
* *
* *
10
* ** *
**
Intercept = Fixed cost: $10,000
0
0
1
2
3
4
Patient-days in 1,000’s
Patient days = 800
X
2-36
The Scattergraph Method
Make a quick estimate of variable cost per unit and
determine the cost equation.
Total maintenance at 800 patients
Less: Fixed cost
Estimated total variable cost for 800 patients
Variable cost per unit =
$1,000
800
$ 11,000
10,000
$ 1,000
= $1.25/patient-day
Y = $10,000 + $1.25X
Total maintenance cost
Number of patient days
2-37
The High-Low Method
The variable cost
per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.
$2,400/
= $8.00/hour
300
2-38
The High-Low Method
Total Fixed Cost = Total Cost – Total Variable Cost
Total Fixed Cost = $9,800 – ($8/hour × 800 hours)
Total Fixed Cost = $9,800 – $6,400
Total Fixed Cost = $3,400
2-39
The High-Low Method
The Cost Equation for Maintenance
Y = $3,400 + $8.00X
2-40
Quick Check

Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is the
variable portion of sales salaries and commission?
a. $0.08 per unit
b. $0.10 per unit
c. $0.12 per unit
d. $0.125 per unit
2-41
Quick Check

Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is the
variable portion of sales salaries and commission?
a. $0.08 per unit
b. $0.10 per unit
Units
Cost
c. $0.12 per unit High level
120,000
$ 14,000
d. $0.125 per unit Low level
80,000
10,000
Change
40,000
$
4,000
$4,000 ÷ 40,000 units
= $0.10 per unit
2-42
Quick Check

Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is the
fixed portion of sales salaries and commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000
2-43
Quick Check

Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is the
fixed portion of sales salaries and commissions?
Total cost = Total fixed cost +
a. $ 2,000
Total variable cost
b. $ 4,000
$14,000 = Total fixed cost +
c. $10,000
($0.10 × 120,000 units)
d. $12,000
Total fixed cost
= $14,000 - $12,000
Total fixed cost
= $2,000
2-44
Least-Squares Regression Method
A method used to analyze mixed costs if a scattergraph
plot reveals an approximately linear relationship between
the X and Y variables.
This method uses all of the
data points to estimate
the fixed and variable
cost components of a
mixed cost.
The goal of this method is
to fit a straight line to the
data that minimizes the
sum of the squared errors.
2-45
Least-Squares Regression Method
• Software can be used to fit
a regression line through
the data points.
• The cost analysis objective
is the same: Y = a + bX
Least-squares regression also provides a statistic, called
the R2, which is a measure of the goodness
of fit of the regression line to the data points.
2-46
Least-Squares Regression Method
R2 is the percentage of the variation in total cost
explained by the activity.
Y
Total Cost
20
* *
* *2
10
* ** *
**
R varies from 0% to 100%, and
the higher the percentage the better.
0
0
1
2
3
Activity
4
X
2-47
Comparing Results From the Three
Methods
The three methods just discussed provide
slightly different estimates of the fixed and
variable cost components of the mixed cost.
This is to be expected because each method
uses differing amounts of the data points to
provide estimates.
Least-squares regression provides the most
accurate estimate because it uses all the data
points.
2-48
Learning Objective 6
Prepare income
statements for a
merchandise company
using the traditional and
contribution formats
2-49
The Contribution Format
Let’s put our
knowledge of
cost behavior to
work by
preparing a
contribution
format income
statement.
2-50
The Contribution Format
Sales Revenue
Less: Variable costs
Contribution margin
Total
$ 100,000
60,000
$ 40,000
Less: Fixed costs
Net operating income
30,000
$ 10,000
Unit
$ 50
30
$ 20
The contribution margin format emphasizes
cost behavior. Contribution margin covers fixed
costs and provides for income.
2-51
The Contribution Format
Used primarily for
external reporting.
Used primarily by
management.
2-52
Learning Objective 7
Understand cost
classifications used in
making decisions:
differential costs,
opportunity costs, and
sunk costs.
2-53
Cost Classifications for Decision Making
• Every decision involves a choice between at least two alternatives.
• Differential Cost: A difference in cost between any two
alternatives is known as differential cost.
• Differential Revenue: A difference in revenues between any two
alternatives is known as differential revenue.
• Only those costs and benefits that differ between alternatives are
relevant in a decision. All other costs and benefits can and should
be ignored.
2-54
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:
$2,000 – $1,500 = $500
Differential cost is:
$300
2-55
Opportunity Cost
The potential benefit that is
given up when one
alternative is selected over
another.
Example: If you were
not attending college,
you could be earning
$15,000 per year.
Your opportunity cost
of attending college for one year
is $15,000.
2-56
Sunk Costs
Sunk costs have already been incurred and cannot be
changed now or in the future. They should be ignored
when making decisions.
Example: You bought an automobile that cost $10,000
two years ago. The $10,000 cost is sunk because
whether you drive it, park it, trade it, or sell it, you
cannot change the $10,000 cost.
2-57
Quick Check 
Suppose you are trying to decide whether to drive or
take the train to Portland to attend a concert. You have
ample cash to do either, but you don’t want to waste
money needlessly. Is the cost of the train ticket relevant
in this decision? In other words, should the cost of the
train ticket affect the decision of whether you drive or
take the train to Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant.
2-58
Quick Check 
Suppose you are trying to decide whether to drive or take
the train to Portland to attend a concert. You have ample
cash to do either, but you don’t want to waste money
needlessly. Is the cost of the train ticket relevant in this
decision? In other words, should the cost of the train ticket
affect the decision of whether you drive or take the train to
Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant.
2-59
Quick Check 
Suppose you are trying to decide whether to drive or take
the train to Portland to attend a concert. You have ample
cash to do either, but you don’t want to waste money
needlessly. Is the annual cost of licensing your car relevant
in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.
2-60
Quick Check 
Suppose you are trying to decide whether to drive or take
the train to Portland to attend a concert. You have ample
cash to do either, but you don’t want to waste money
needlessly. Is the annual cost of licensing your car relevant
in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.
2-61
Quick Check 
Suppose that your car could be sold now for $5,000. Is
this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.
2-62
Quick Check 
Suppose that your car could be sold now for $5,000. Is this
a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.
2-63
End of Chapter 2