Chapter 2
Cost Terms, Concepts,
and Classifications
Comparing Merchandising
and Manufacturing Activities
Merchandisers . . .


Buy finished
goods.
Sell finished goods.
Manufacturers . . .


Buy raw materials.
Produce and sell
finished goods.
MegaLoMart
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Manufacturing Costs
Direct
Materials
Direct
Labor
Manufacturing
Overhead
The Product
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Direct Materials
Those materials that become an integral part
of the product and that can be conveniently
traced directly to it.
Example: A radio installed in an automobile
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Direct Labor
Those labor costs that can be easily traced to
individual units of product.
Example: Wages paid to automobile assembly workers
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I do not like getting my temperature taken by the vet!
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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.
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Materials used to support
the production process.
Examples: lubricants and
cleaning supplies used in the
automobile assembly plant.
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Classifications of Costs
Manufacturing costs are often
classified as follows:
Direct
Material
Direct
Labor
Prime
Cost
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Manufacturing
Overhead
Conversion
Cost
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Nonmanufacturing Costs
Marketing and
Selling Cost
Administrative
Cost
Costs necessary to get the
order and deliver the
product.
All executive,
organizational, and
clerical costs.
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Quick Check 
Which of the following costs would be
considered manufacturing overhead at Boeing?
(More than one answer may be correct.)
A. Depreciation on factory forklift trucks.
B. Sales commissions.
C. The cost of a flight recorder in a Boeing 767.
D. The wages of a production shift supervisor.
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Quick Check 
Which of the following costs would be
considered manufacturing overhead at Boeing?
(More than one answer may be correct.)
A. Depreciation on factory forklift trucks.
B. Sales commissions.
C. The cost of a flight recorder in a Boeing 767.
D. The wages of a production shift supervisor.
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Product Costs Versus Period
Costs
Product costs include
direct materials, direct
labor, and
manufacturing
overhead.
Cost of Good Sold
Inventory
Period costs are not
included in product
costs. They are
expensed on the
income statement.
Expense
Sale
Balance
Sheet
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Income
Statement
Income
Statement
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For Your Consideration …
Take a look at
Review Problems 1 & 2
on pages 48 and 49.
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Cost Classifications for
Predicting Cost Behavior
How a cost will react to
changes in the level of
business activity.
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
Total variable costs
change when activity
changes.

Total fixed costs
remain unchanged
when activity changes.
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Total Variable Cost
Total Long Distance
Telephone Bill
Your total long distance telephone bill
is based on how many minutes you talk.
Minutes Talked
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Variable Cost Per Unit
Per Minute
Telephone Charge
The cost per long distance minute talked is
constant. For example, 10 cents per minute.
Minutes Talked
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Total Fixed Cost
Monthly Basic
Telephone Bill
Your monthly basic telephone bill probably
does not change when you make more local
calls.
Number of Local Calls
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Fixed Cost Per Unit
Monthly Basic Telephone
Bill per Local Call
The average cost per local call decreases as
more local calls are made.
Number of Local Calls
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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.
Fixed cost per unit goes
down as activity level goes up.
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Cost Behavior
Examples of normally variable costs
Merchandisers
Service Organizations
Cost of Goods Sold
Supplies and travel
Manufacturers
Merchandisers and
Manufacturers
Direct Material, Direct
Labor, and Variable
Manufacturing Overhead
Sales commissions and
shipping costs
Examples of normally fixed costs
Merchandisers, manufacturers, and
service organizations
Real estate taxes, Insurance, Sales salaries
Depreciation, Advertising
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Types of Fixed Costs
Committed
Discretionary
Long-term, cannot be
reduced in the short
term.
May be altered in the
short-term by current
managerial decisions
Examples
Examples
Depreciation on
Buildings and
Equipment
Advertising and
Research and
Development
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Fixed Costs and Relevant
Range
Example: Office space is
available at a rental rate
of $30,000 per year in
increments of 1,000
square feet. As the
business grows more
space is rented,
increasing the total cost.
Continue
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Rent Cost in
Thousands of Dollars
Fixed Costs and Relevant
Range
Exh.
5-6
90
Relevant
60
Range
30
0
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0
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.
1,000
2,000
3,000
Rented Area (Square Feet)
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Fixed Costs and Relevant
Range
How does this type
of fixed cost differ
from a step-variable
cost?
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Step-variable costs
can be adjusted more
quickly and . . .
The width of the
activity steps is much
wider for the fixed
cost.
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Mixed Costs
A mixed cost has both fixed and variable
components. Consider the example of utility cost.
Total Utility Cost
Y
Variable
Cost per KW
X
Activity (Kilowatt
Hours)
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Fixed Monthly
Utility Charge
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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
X
Activity (Kilowatt
Hours)
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Fixed Monthly
Utility Charge
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The Analysis of Mixed Costs
Account Analysis
Engineering Approach
Scattergraph Plot
High-Low Method
Least-Square Regression Method
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Account Analysis &
Engineering Estimates
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.
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The Scattergraph Method
Plot the data points on a
graph (total cost vs. activity).
Total Cost in
1,000’s of Dollars
Y
20
*
10
0
*
*
*
* **
**
*
X
0
1
2
3
4
Activity, 1,000’s of Units Produced
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Quick-and-Dirty Method
Draw a line through the data points with about an
equal numbers of points above and below the line.
Total Cost in
1,000’s of Dollars
Y
20
*
10
0
*
*
*
* **
**
*
Intercept is the estimated
fixed cost = $10,000
X
0
1
2
3
4
Activity, 1,000’s of Units Produced
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Quick-and-Dirty Method
The slope is the estimated variable cost per unit.
Slope = Change in cost ÷ Change in units
Total Cost in
1,000’s of Dollars
Y
20
*
10
0
*
*
Horizontal
*
distance is
the change in
activity.
* **
**
*
Vertical distance is
the change in cost.
X
0
1
2
3
4
Activity, 1,000’s of Units Produced
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The High-Low Method
WiseCo recorded the following production activity and
maintenance costs for two months:
High activity level
Low activity level
Change
Units
8,000
5,000
3,000
Cost
$ 9,800
7,400
$ 2,400
Using these two levels of activity, compute:
• the variable cost per unit;
• the fixed cost; and then
• express the costs in equation form Y = a + bX.
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The High-Low Method
High activity level
Low activity level
Change
Units
8,000
5,000
3,000
Cost
$ 9,800
7,400
$ 2,400
in cost in units
 Variable cost per unit = ChangeChange
in cost ÷ change
Change in units
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The High-Low Method
High activity level
Low activity level
Change
Units
8,000
5,000
3,000
Cost
$ 9,800
7,400
$ 2,400
 Variable cost per unit = $2,400 ÷ 3,000 units
= $0.80 per unit
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The High-Low Method
High activity level
Low activity level
Change
Units
8,000
5,000
3,000
Cost
$ 9,800
7,400
$ 2,400
 Variable cost = $2,400 ÷ 3,000 units = $0.80 per unit
 Fixed cost = Total cost – Total variable cost
Fixed cost = $9,800 – ($0.80 per unit × 8,000 units)
Fixed cost = $9,800 – $6,400 = $3,400
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The High-Low Method
High activity level
Low activity level
Change
Units
8,000
5,000
3,000
Cost
$ 9,800
7,400
$ 2,400
 Variable cost = $2,400 ÷ 3,000 units = $0.80 per unit
 Fixed cost = Total cost – Total variable cost
Fixed cost = $9,800 – ($0.80 per unit × 8,000 units)
Fixed cost = $9,800 – $6,400 = $3,400
 Total cost = Fixed cost + Variable cost (Y = a + bX)
Y = $3,400 + $0.80X
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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, that is a measure of the goodness
of fit of the regression line to the data points.
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Least-Squares Regression
Method
R2 is the percentage of the variation in total cost
explained by the activity.
Y
Total Cost
20
*
10
*
*
* **
**
*
*R2 for this relationship is near
100% since the data points are
very close to the regression line.
0
0
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1
2
Activity
3
4
X
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Cost Estimation Methods
Regression Analysis
A statistical method used to create an equation
relating independent (or X) variables to dependent
(or Y) variables.
Past data is used to estimate relationships
between costs and activities.
Independent variables
are the cost drivers that
are correlated with the
dependent variables.
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Dependent variables are
caused by the
independent variables.
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Hey, Ed !
Remember who received a
mid-semester deficiency
in statistics in 1972 and 1973!
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Cost Estimation Methods
Regression Analysis
The simple cost model is actually a
regression model:
TC = F + VX
This model will only
be useful within a
relevant range of
activity.
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Caution: Before doing
the analysis, take time
to determine if a
logical relationship
between the variables
exists.
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Direct Costs and Indirect
Costs
Direct costs
Costs that can be
easily and conveniently
traced to a unit of
product or other cost
objective.
Examples: direct
material and direct labor
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Indirect costs
Costs cannot be easily
and conveniently traced
to a unit of product or
other cost object.
Example:
manufacturing
overhead
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Differential Costs and
Revenues
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
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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 pizza you ate last night relevant
in this decision? In other words, should the cost
of the pizza affect the decision of whether you
drive or take the train to Portland?
A. Yes, the cost of the pizza is relevant.
B. No, the cost of the pizza is not relevant.
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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 pizza you ate last night relevant
in this decision? In other words, should the cost
of the pizza affect the decision of whether you
drive or take the train to Portland?
A. Yes, the cost of the pizza is relevant.
B. No, the cost of the pizza is not relevant.
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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.
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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.
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Opportunity Costs
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.
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Sunk Costs
Sunk costs cannot be changed by any decision.
They are not differential costs and 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.
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Further Classification of Labor
Costs
Idle Time
Treated as
manufacturing
overhead cost
Overtime
Premium of
Factory Workers
Treated as
manufacturing
overhead cost
Labor Fringe
Benefits
Treated as indirect
labor or direct labor
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Further Classification of Labor
Costs
Idle Time
Treated as
manufacturing
overhead cost
Overtime
Premium of
Factory Workers
Treated as
manufacturing
overhead cost
Labor Fringe
Treated as indirect
labor or direct labor
BenefitsDiscovery Channel :: Video :: "Best Of"
Moments
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The Contribution Format
Sales Revenue
Less: Variable costs
Contribution margin
Less: Fixed costs
Net operating income
Total
$ 100,000
60,000
$ 40,000
30,000
$ 10,000
Unit
$ 50
30
$ 20
The contribution margin format emphasizes cost
behavior. Contribution margin covers fixed costs
and provides for income.
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The Contribution Format
Sales Revenue
Less: Variable costs
Contribution margin
Less: Fixed costs
Net operating income
Total
$ 100,000
60,000
$ 40,000
30,000
$ 10,000
Unit
$ 50
30
$ 20
The contribution margin format emphasizes cost
behavior. Contribution margin covers fixed costs
and provides for income.
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End of Chapter 2
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