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1 Managerial Accounting and Cost Concepts

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Learning Objectives

After studying Chapter 1, you will be able to:

• Distinguish between financial accounting and managerial accounting.

• Recognize the primary roles and ethical responsibilities of the management accountant.

• Define, distinguish, and illustrate key cost concepts.

• Understand the differences in cost flows among service, merchandising, and manufacturing enterprises.

• Distinguish between the behavior of variable and fixed costs and formulate cost functions.

• Understand cost terms relating to planning and control.

• Introduce the concept of contribution margin and its variations.

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Chapter Outline

1.1 The Dual Roles of Accounting Information Financial Accounting Managerial Accounting Differences Between Managerial and Financial Accounting

1.2 Role of the Management Accountant Certified Management Accountant Ethical Conduct of Management Accountants Using Cost Information

1.3 The Nature of Cost

1.4 Comparing Service, Merchandising, and Manufacturing Organizations Service Organizations Merchandising Organizations Manufacturing Organizations Traditional Groupings of Product Costs

1.5 Cost Behavior Variable Costs Fixed Costs Expressing Variable and Fixed Costs—A Cost Function Relevant Range Semivariable and Semifixed Costs

1.6 Cost Concepts for Planning and Controlling Direct Costs Versus Indirect Costs Controllable Costs Versus Noncontrollable Costs

1.7 Contribution Margin and Its Many Variations Variable Contribution Margin—Per Unit, Ratio, and Total Dollars Controllable and Direct Contribution Margins Illustration of All Contribution Margin Concepts

The Controller’s Work Day: Where Did the Time Go?

It’s early October. Mary Rosen, Controller of Herschel Software Products, has just arrived at her office at about 7:30 a.m. She scans her email messages, checks her electronic calendar, and looks through her in-basket. She says, “Wow, another ‘normal’ day!” She wonders if she’ll make her tennis date with her husband at 6 p.m. Her calendar shows:

9:00 Meet with division head of Customer Support to discuss next year’s budget numbers. Review preliminary budget numbers before meeting.

10:00 Meet with accounting systems analysts to discuss status of a project to improve the firm’s monthly management “plan versus actual” reporting system.

11:30 Hold a quick session with Marketing Vice-President, Gary Martin, to discuss pricing negotiations with new customer.

12:15 Have working lunch with corporate attorney to discuss customer contract wording for a new product being introduced early next year.

2:00 With budget manager, review September’s actual results and budget comparisons and identify problem areas. Also, review third quarter results before her presentation to the President at Friday’s staff meeting.

4:00 Review a special cost-volume-profit study of Herschel Software Products, relative to the firm’s strategic plan’s profitability goals.

Mary also knows that she needs to:

• Respond to four email questions about product costs and operating expenses. • Talk to Steve Simcha, New Product Development Vice-President, about a serious

cost-overrun problem with a new product project. • Prepare a presentation on cash flows for the firm’s strategic planning meeting next

month. • Write a memo supporting the spending of $100,000 by the Marketing Vice-President

on media contracts.

Every meeting, discussion, and decision that Mary has today, and every day, uses accounting information. She must generate relevant data in the right form and at the right time. She and her fellow managers must understand cost behavior, cost/benefit analyses, plan versus actual comparisons, and how to use information to achieve Herschel Software Products’ long-term and short-term goals.

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Chapter Outline

1.1 The Dual Roles of Accounting Information Financial Accounting Managerial Accounting Differences Between Managerial and Financial Accounting

1.2 Role of the Management Accountant Certified Management Accountant Ethical Conduct of Management Accountants Using Cost Information

1.3 The Nature of Cost

1.4 Comparing Service, Merchandising, and Manufacturing Organizations Service Organizations Merchandising Organizations Manufacturing Organizations Traditional Groupings of Product Costs

1.5 Cost Behavior Variable Costs Fixed Costs Expressing Variable and Fixed Costs—A Cost Function Relevant Range Semivariable and Semifixed Costs

1.6 Cost Concepts for Planning and Controlling Direct Costs Versus Indirect Costs Controllable Costs Versus Noncontrollable Costs

The Controller’s Work Day: Where Did the Time Go?

9:00 Meet with division head of Customer Support to discuss next year’s budget numbers. Review preliminary budget numbers before meeting.

10:00 Meet with accounting systems analysts to discuss status of a project to improve the firm’s monthly management “plan versus actual” reporting system.

11:30 Hold a quick session with Marketing Vice-President, Gary Martin, to discuss pricing negotiations with new customer.

12:15 Have working lunch with corporate attorney to discuss customer contract wording for a new product being introduced early next year.

4:00 Review a special cost-volume-profit study of Herschel Software Products, relative to the firm’s strategic plan’s profitability goals.

Mary also knows that she needs to:

• Respond to four email questions about product costs and operating expenses. • Talk to Steve Simcha, New Product Development Vice-President, about a serious

cost-overrun problem with a new product project. • Prepare a presentation on cash flows for the firm’s strategic planning meeting next

month. • Write a memo supporting the spending of $100,000 by the Marketing Vice-President

on media contracts.

Managers make decisions. Managers select one or more alternatives from a set of choices. Making the best choice depends on the manager’s goals, the expected results from each alter- native, and the information available when the decision is made. Decision-making informa- tion is the focus of this text. Collecting, classifying, reporting, and analyzing relevant informa- tion are fundamental to every action that managers take. Management accountants prepare information for decision makers. In this chapter, the stage is set for discussing how manage- ment accountants are involved in decision making. First, we discuss the distinction between financial and managerial accounting.

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FINANCIAL ACCOUNTING

Interested Parties

Shareholders Investment analysts Creditors Labor unions Employees Managers Customers & vendors Government agencies Industry associations

Typical Reports

Income statements Balance sheets Cash-flow statements Tax returns Regulatory reports

MANAGERIAL ACCOUNTING

Interested Parties

Managers: Executive Middle Supervisory Other employees

Typical Reports

Budgets and plans Budget versus actual Product cost Cost control Decision analyses Segment performance Cash-flow forecasts Financial statements Internal audits

ACCOUNTING INFORMATION

RESPONSIBILITIES

Section 1.1 The Dual Roles of Accounting Information

Financial Accounting Financial accounting is the branch of accounting that organizes accounting information for presentation to interested parties both inside and outside of the organization. The primary financial accounting reports are the balance sheet (often called a statement of financial posi- tion), the income statement, and the statement of cash flows. The balance sheet is a summary of assets, liabilities, and shareholders’ equity at a specified point in time. The income state- ment reports revenues and expenses resulting from the company’s operations for a particu- lar time period. The statement of cash flows shows the sources and uses of cash over a time period for operating, investing, and financing activities.

Most businesses are complex, and guidelines (known as generally accepted accounting princi- ples or GAAP) are provided for financial reporting. The Financial Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC), and the Public Company Accounting Oversight Board (PCAOB) oversee the development of these principles, corporate financial

1.1 The Dual Roles of Accounting Information The accounting system generates the information that satisfies two reporting needs that coexist within an organization: financial accounting and managerial accounting. Figure 1.1 shows the primary interested parties and the typical reports generated to serve these two user groups.

Figure 1.1: Scope of financial and managerial accounting

FINANCIAL ACCOUNTING

Interested Parties

Shareholders Investment analysts Creditors Labor unions Employees Managers Customers & vendors Government agencies Industry associations

Typical Reports

Income statements Balance sheets Cash-flow statements Tax returns Regulatory reports

MANAGERIAL ACCOUNTING

Interested Parties

Managers: Executive Middle Supervisory Other employees

Typical Reports

Budgets and plans Budget versus actual Product cost Cost control Decision analyses Segment performance Cash-flow forecasts Financial statements Internal audits

ACCOUNTING INFORMATION

RESPONSIBILITIES

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Section 1.1 The Dual Roles of Accounting Information

reporting responsibilities, and internal control standards. Internationally, while some coun- tries have developed their own accounting principles, many countries have adopted stan- dards set by the International Accounting Standards Board (IASB).

Owners, Investors, and Creditors Shareholder-owned firms rely heavily on owners, investors, and creditors (providers of short-term credit and long-term loans) for sources of capital. Shareholders and investors use accounting reports to decide whether to buy, sell, or hold the firm’s stock. Also, creditors assess whether the firm is able to pay its debts on time.

Taxing Authorities The assessment of many taxes is based on accounting information submitted by the taxpayer. Examples of such taxes include income taxes, sales taxes, use taxes, franchise taxes, excise taxes, property taxes, and gift and estate taxes. In most cases, the dominant taxing authority is the federal government and its tax collection agency, the Internal Revenue Service.

Regulatory Agencies Local, state, and federal agencies regulate a substantial portion of business activity in the United States. Much regulation is implemented through or involves accounting reports.

Industry Associations Most industries have an association that gathers important statistics about the national and international industry. A large part of the information they provide comes from accounting reports provided by member firms. Examples include corporate annual reports, call reports for banks, and auto dealership sales reports.

Managers and Employees Managers typically have direct vested interests in their firms’ results. Performance bonuses, stock options, and incentive compensation programs are common. Thus, managers are not passive observers as to how certain transactions are recorded. Firm policies, performance evaluation methods, and compensation systems should encourage managers to act in the best interests of themselves and the firm as a whole.

The firm’s executives are responsible to the board of directors and shareholders for the firm’s financial results. Numerous examples of changes in high-level executive positions reaffirm the importance of achieving strong profits to remain in power and employed. Based in part on financial statement information, employees make decisions about continued employment, union wage demands and contract negotiations, adequacy of pension plans, and employee stock purchase or savings plans. Profit sharing may encourage employees to want the com- pany to be financially successful.

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Section 1.2 Role of the Management Accountant

Managerial Accounting Managerial accounting is the branch of accounting that meets managers’ information needs. Whereas financial accounting has a backwards focus, i.e., focusing on historical informa- tion, managerial accounting focuses more on the future. Because managerial accounting is designed to assist the firm’s managers in making business decisions, relatively few restrictions are imposed by regulatory bodies and generally accepted accounting principles. Therefore, a manager must define which data are relevant for a particular purpose and which are not.

Differences Between Managerial and Financial Accounting Several important differences distinguish managerial accounting from financial accounting. First, managerial accounting is not subject to the same rules and principles as is financial accounting. In many cases, “common sense” is the most important guide for decision makers.

A second difference is that financial accounting relies on accounting principles structured around the accounting equation. Management reports, on the other hand, are designed to meet managers’ needs. These reports often use estimates and forecasts, use different values for the same events, do not balance in a debit/credit sense, and are designed for particular decisions or analyses. The expression “different costs for different purposes” has long been used to describe relevance. Relevant information has an impact on the decision analysis. Irrel- evant data have no impact.

Another difference is that managerial accounting focuses on segments of the organization as well as on the whole organization. The primary interest of financial accounting is the com- pany as a whole. In managerial accounting, however, the segment is of major importance. Segments may be products, projects, divisions, plants, branches, regions, or any other subset of the business. Tracing or allocating costs, revenues, and assets to segments creates difficult issues for managerial accountants.

Two important similarities do exist. The same transaction and accounting information sys- tems are used to generate the data inputs for both financial statements and management reports. Therefore, when the system accumulates and classifies information, it should do so in formats that accommodate both types of accounting. The other similarity is the manner in which accountants measure costs, define assets, and specify accounting periods. Many con- cepts underlie accounting information, whether the data are later used for financial or mana- gerial reporting. Recording the results of events is often based on rationales that are common to both financial and managerial accounting. We must understand what is a common thread and what must be independently collected.

1.2 Role of the Management Accountant Although the top accounting-oriented people in an organization are the chief financial officer and the controller, the accounting and financial management functions contain a range of jobs. A variety of careers is available as shown in Figure 1.2; these careers can frequently be paths to executive management.

Figure 1.2: Management accounting job titles

Accounting systems analyst Bid cost estimator Budget performance analyst Capital investment analyst Cash disbursements manager Cash flow analyst Cash receipts manager Computer controls auditor Corporate tax planner Cost accountant Cost forecasting analyst Customer or sales analyst Efficiency cost analyst

Internal auditor International controller

Labor negotiations cost analyst Master budget coordinator Physical asset accountant

Plant controller Product cost/profit analyst

Project controller Quality cost analyst

Risk management analyst Statistical cost analyst

Strategic planner Transfer pricing analyst

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Internal auditor International controller

Labor negotiations cost analyst Master budget coordinator Physical asset accountant

Plant controller Product cost/profit analyst

Project controller Quality cost analyst

Risk management analyst Statistical cost analyst

Strategic planner Transfer pricing analyst

Section 1.2 Role of the Management Accountant

A management accountant maintains accounting records, prepares financial statements, generates managerial reports and analyses, and coordinates budgeting efforts. The manage- ment accountant is an advisor, an internal consultant, and an integral part of management. The controller is responsible for managing the entire accounting function. The controller influences management by answering questions like: What information should be reported? What format best displays the information? How can data be collected and processed? By the nature of the job, the management accountant applies management principles and often is a major player in decision making itself.

Certified Management Accountant The Certified Management Accounting program recognizes a person’s achievement of a spe- cific level of knowledge and professional skill. Becoming a Certified Management Accoun- tant (CMA) is considered an important professional step for anyone desiring to become a management accounting or financial executive. The CMA program was founded on the prin- ciple that a management accountant is a contributor to and a participant in management.

To qualify for the CMA designation, candidates must pass a comprehensive examination and meet specific educational and professional standards and experience requirements. To remain a CMA, a person must meet continuing educational requirements and adhere to the program’s “Statement of Ethical Professional Practices.” The Institute of Management Accoun- tants (IMA) is the professional organization of management accountants and sponsors the CMA designation.

Ethical Conduct of Management Accountants Earlier in the chapter, we discussed managers’ needs for accounting information. We assumed that whatever information the accounting system generates is presented and used in an ethi- cal manner. Ethical conduct is a necessary asset of a managerial accountant. The credibility of

Figure 1.2: Management accounting job titles

Internal auditor International controller

Labor negotiations cost analyst Master budget coordinator Physical asset accountant

Plant controller Product cost/profit analyst

Project controller Quality cost analyst

Risk management analyst Statistical cost analyst

Strategic planner Transfer pricing analyst

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Section 1.2 Role of the Management Accountant

the information provided, analyses done, and opinions offered depends heavily on the repu- tation of the responsible accountant. Independence, competence, lack of bias or favoritism, trust, and objectivity are key elements in establishing credibility.

While true for all managers, management accountants in particular must maintain integrity and ethical behavior and must make top management aware of unethical behavior on the part of others within the organization. This does not mean the management accountant is a police officer. Rather, the management accountant promotes and encourages ethical behavior in all aspects of business life.

Ethical standards of businesspersons have been given much more visibility and scrutiny in recent years. Issues that appear again and again in management careers test the ethical stan- dards of everyone. Among common ethical issues are:

• Business practices and policies. Practices that seem harmless on the surface may encourage or require employees or managers to be deceitful or dishonest.

• Objective reporting. Because situations exist where prejudiced reporting of cer- tain numbers may influence decisions, accountants are guided by goals of unbiased reporting and professional judgment.

• Colleague behavior. Even if we have high ethical standards, people around us may not be so disposed. Many policies and internal controls are in place in organizations to prevent wrongdoing and to encourage proper behavior. In addition, you should not compromise your personal integrity by condoning unethical behavior in others.

• Competitors. Winning is part of the business “game.” But to do so in a fair environ- ment is critical. Using true product and competitor data; following corporate poli- cies; and abhorring bribes, kickbacks, and other similar payments are easy exam- ples. Many firms provide behavior guidelines and policies to purchasing and sales personnel who are at particular risk in giving and receiving favors and improper inducements.

• Tax avoidance and evasion. Tax burdens can be significant. Proper planning and careful use of tax laws to minimize the organization’s tax liability are acceptable. Tax avoidance is legitimate. Inappropriate use of the same laws or use of deceit to hide income or overstate deductions is tax evasion, which is unethical as well as illegal.

• Confidentiality. Internal data are developed for managers’ use. Disclosures outside the firm often require review and approvals. Privacy of competitive, personnel, and negotiating data is critical. Negative examples of overheard conversations in eleva- tors, on golf courses, and at lunches that lead to lost business, embarrassment, and lawsuits are unfortunately common. Confidentiality also demands that “insider” information should not be used for anyone’s personal advantage.

• Appearance of independence. The accountant should be independent in situations where the resulting information is used for analysis and decision making. Indepen- dence applies to both actual independence and the appearance of independence. If it appears that the management accountant is biased because of that person’s conduct, associations, or vested interests (possible promotion, salary increases or bonuses, or investments), the information provided is tainted and open to doubt by other deci- sion makers.

• Corporate loyalty and personal advancement. Many situations exist in which, because of an unethical act, the reputation of the firm itself is in danger. Alternately, an unethical act may seem to ensure your personal enhancement in some manner.

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Section 1.2 Role of the Management Accountant

Sometimes reporting an unethical act will endanger the future of the person report- ing the act. These are all difficult dilemmas, pitting right against wrong, and not always in an obvious way.

While space and time do not allow us to develop approaches for resolving these problems here, it is clear that ethical issues underlie management accountants’ professional and day- to-day activities. Each person must develop a method of handling ethical problems. Of pri- mary importance is the ability to see an ethical dilemma when it faces us. Once identified, the situation may cause us to request advice. Numerous sources are available for guidance, including:

• Personal values. We would like to think that our own value system is “ethical” and provides enough guidance. Clearly, this is our main line of defense against “wrong.”

• Corporate policies and ethics statements. Many firms have statements on expected employee behavior or written policies and procedures on how a range of situations should be handled. These statements do set limits or barriers and may describe expected levels of behavior. Some companies also offer ethics seminars and classes to their employees.

• Laws. “If it’s legal, it must be okay” is often used a basis for defining ethical behavior. This is absolutely not true. Laws are developed in a political process, often without much serious consideration for the ethical conduct of any parties involved. It’s highly probable that if the behavior is illegal, it is also unethical.

• Professional standards. Most professions have developed a statement of ethical standards for their members. Figure 1.3 presents a statement developed for man- agement accountants. These statements are basic standards of behavior and give professional guidance in many areas.

• Supervisors, internal auditors, and other company officials. These are often per- sons with more experience and broader understanding of conflicting issues and of corporate attitudes. An ethical situation, however, may involve a supervisor or other corporate official, which may make the dilemma much more sensitive and severe. A few companies have created an ombudsperson position to assist employees in han- dling delicate situations.

• Counselors from outside of the organization. This is a last resort and gener- ally violates another ethical consideration—confidentiality. While close friends, a spouse, or a personal counselor may seem like logical sources of advice and sup- port, the nature of the dilemma may require confidentiality until all other avenues of resolution are exhausted. Merely consulting outsiders presents serious risks of unauthorized disclosure that may only further complicate an issue.

Even though all of these options may exist, we each need to develop a rational approach to identifying, analyzing, and deciding on ethical issues that confront us. Management accoun- tants must be aware of ethical dilemmas, perhaps more than the typical manager, because of their responsibility for decision-making information and their involvement in many decision- making processes.

The Institute of Management Accountants believes ethics is a cornerstone of its organization and recognizes the importance of providing ethical guidance. The IMA has developed Stan- dards of Ethical Professional Practice. That statement is presented in Figure 1.3. The Stan- dards are broken into four sections: competence, confidentiality, integrity, and credibility.

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Section 1.2 Role of the Management Accountant

Competence refers to the skills that the accountant brings to the job. Confidentiality is defined as protecting the access to and use of information. Integrity focuses primarily on the personal behavior and interactions of the management accountant. Credibility, as defined here, is pri- marily directed toward disclosure of unbiased information.

Using Cost Information Much of managerial accounting deals with cost information. Understanding cost behavior and knowing which costs to consider and which to ignore are critical to making decisions in business and in everyday life situations. Managers use cost information in many different ways. Cost data are especially important in these areas:

Figure 1.3: Institute of Management Accountants’ Standards of Ethical Professional Practice

IMA (Institute of Management Accountants). Reprinted with permission.

I. COMPETENCE 1. Maintain an appropriate level of professional leadership and expertise by enhancing knowledge and skills. 2. Perform professional duties in accordance with relevant laws, regulations, and technical standards. 3. Provide decision support information and recommendations that are accurate, clear, concise, and timely. Recognize and help manage risk.

II. CONFIDENTIALITY 1. Keep information confidential except when disclosure is authorized or legally required. 2. Inform all relevant parties regarding appropriate use of confindential information. Monitor to ensure compliance. 3. Refrain from using confidential information for unethical or illegal advantage.

III. INTEGRITY 1. Mitigate actual conflicts of interest. Regularly communicate with business associates to avoid apparent conflicts of interest. Advise all parties of any potential conflicts of interest. 2. Refrain from engaging in any conduct that would prejudice carrying out duties ethically. 3. Abstain from engaging in or supporing any activity that might discredit the profession. 4. Contribute to a positive ethical culture and place integrity of the profession above personal interests.

IV. CREDIBILITY 1. Communicate information fairly and objectively. 2. Disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, analyses, or recommendations. 3. Report any delays or deficiencies in information, timeliness, processing, or internal controls in conformance with organization policy and/or applicable law. 4. Communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity.

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Outputs

Cost Object

Inputs

Costs

Work

Cost Drivers

ProductsActivitiesResources

Section 1.3 The Nature of Cost

• Planning. Estimating future costs in preparing budgets and in projecting operating activities.

• Decision making. Considering costs relevant to a wide variety of decision-making processes.

• Cost control. Measuring costs incurred; comparing these costs with budgets, goals, targets, or standards; and evaluating differences or variances.

• Income measurement. Determining the costs of products and services sold to determine this time period’s profitability for the entire business or some segment of the business, such as a contract, a product, or a customer.

1.3 The Nature of Cost Cost, broadly defined, is the amount of resources given up to gain a specific objective or object. Generally, cost refers to the monetary measurement (exchange price) attached to acquiring goods and services consumed by some activity. A cost need only be incurred and not neces- sarily be paid for it to be considered a cost. Cash outlays are monetary measurements; occa- sionally, goods and services are also obtained by exchanging other assets, such as receivables or property, or by taking on debt. A cost object is defined as anything for which one accumu- lates costs. A cost object is the reason for making decisions, costing products, planning spend- ing levels, or evaluating actual performances. It is the “why” of cost analysis.

Business people undertake activities to achieve some output or result. Often these activi- ties incur costs—purchasing materials, hiring people, and renting space—and are known as cost drivers. Determining a product’s cost involves finding the cause-and-effect connection between inputs and outputs. A cost driver links activities that create outputs with the inputs that are used.

Figure 1.4 presents the fundamental relationship among resources, activities, and products. Activities are at the core of all we do in business. Activities drive the use of resources; from the activities, come products. This is the traditional input-to-output cycle, understanding that work is done in the middle box of Figure 1.4—meaning tasks are performed with labor, machines, or hired resources. Costs are incurred by cost drivers and are assigned to the prod- ucts. These linkages will be used over and over as we progress through our costing analyses to aid decision making, particularly in Chapter 9.

Figure 1.4: Activity-centered costing relationships

Outputs

Cost Object

Inputs

Costs

Work

Cost Drivers

ProductsActivitiesResources

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Section 1.4 Comparing Service, Merchandising, and Manufacturing Organizations

Cost, in many respects, is an elusive term. Cost has meaning only for a particular purpose and situation. Consequently, meaningful use of the term cost requires an adjective—such as incre- mental, average, or avoidable—to define its use. Each adjective indicates certain attributes, and those attributes dictate the relevance of each cost.

Since costs are resources given up to obtain a specific good or service, that good or service may be consumed or it may still be an asset at the end of an accounting period. In many mana- gerial analyses, the distinction among cost, expense, and asset is clouded. The words cost and expense are used interchangeably, as is done throughout this text. Yet for profit measurement, cost dollars imply assets, and expenses are subtracted from revenues.

1.4 Comparing Service, Merchandising, and Manufacturing Organizations

Many similarities exist when we compare service, merchandising, and manufacturing organi- zations. Providing a service to a client in a law firm or repairing a washing machine in a fix-it shop have strong similarities to manufacturing automobiles in spite of different physical and business settings. In service industries, resources are brought together to provide the service, just as they are brought together to create a product in a factory environment.

Differences in measuring profits are largely a function of inventoried costs. Service firms have only supplies inventories. Merchandising firms buy and sell products and hold merchandise inventories. Manufacturing firms buy materials and convert these inputs into saleable prod- ucts. Inventories here include materials, work in process inventory (partially complete prod- ucts), and finished goods inventory (completed and ready-to-sell products). Figure 1.5 com- pares income statements and selected balance sheet accounts for the three business types.

Service Organizations A service organization performs a business activity for a fee. Costs of performing the service may include salaries of professionals and support personnel, supplies, purchased services, and routine costs such as rent and utilities. In Figure 1.5, the expenses of Kalwerisky Con- sultants, a public relations firm, are reported as either direct client expenses or operating expenses. Some service organizations report all expenses as operating expenses.

Essentially, all operating costs incurred by the firm are period costs; they become expenses of the time period in which the costs are incurred. Receivables, payables, supplies, deprecia- tion, and perhaps costs not yet billed to clients would cause accrual net income to differ from operating cash flow. In a service organization, the problems of measuring performance, such as the profitability of specific contracts, and matching direct costs with specific revenues are surprisingly similar to manufacturing cost analyses.

Figure 1.5: Measuring income in service, merchandising, and manufacturing firms

Services Firms

Kalwerisky Consultants

$8,000,000

Income Statements for the Year

Merchandising Firms

Burchfield Supermarket

$8,000,000

Manufacturing Firms

Holbrook Products

$8,000,000Sales

Cost of goods sold

Cost of goods manufactured

Purchases of direct materials

+ Beginning direct materials inventory

– Ending direct materials inventory

Materials used

+ Direct labor

+ Manufacturing overhead

Total manufacturing costs

+ Beginning work in process

– Ending work in process

Cost of goods manufactured

Purchases of finished goods

+ Beginning finished goods inventory

– Ending finished goods inventory

Cost of goods sold

Direct client expenses

Gross margin

Operating expenses:

Selling expenses

Administrative expenses

Total operating expenses

Net operating income

Accounts receivable

Materials inventory

Work in process inventory

Finished goods inventory

Accounts payable

$ 2,300,000

360,000

(310,000)

$ 2,350,000

920,000

2,300,000

$ 5,570,000

320,000

(340,000)

$ 5,550,000

600,000

(620,000)

$ 5,530,000

$ 2,470,000

$ 980,000

1,030,000

$ 2,010,000

$ 460,000

$ 1,020,000

310,000

340,000

620,000

460,000

$ 7,000,000

510,000

(480,000)

$ 7,030,000

$ 970,000

$ 550,000

260,000

$ 810,000

$ 160,000

$ 80,000

480,000

110,000

5,800,000

$ 2,200,000

$ 610,000

1,270,000

$ 1,880,000

$ 320,000

$ 1,350,000

220,000

Selected Balance Sheet Information for Year-end

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Services Firms

Kalwerisky Consultants

$8,000,000

Income Statements for the Year

Merchandising Firms

Burchfield Supermarket

$8,000,000

Manufacturing Firms

Holbrook Products

$8,000,000Sales

Cost of goods sold

Cost of goods manufactured

Purchases of direct materials

+ Beginning direct materials inventory

– Ending direct materials inventory

Materials used

+ Direct labor

+ Manufacturing overhead

Total manufacturing costs

+ Beginning work in process

– Ending work in process

Cost of goods manufactured

Purchases of finished goods

+ Beginning finished goods inventory

– Ending finished goods inventory

Cost of goods sold

Direct client expenses

Gross margin

Operating expenses:

Selling expenses

Administrative expenses

Total operating expenses

Net operating income

Accounts receivable

Materials inventory

Work in process inventory

Finished goods inventory

Accounts payable

$ 2,300,000

360,000

(310,000)

$ 2,350,000

920,000

2,300,000

$ 5,570,000

320,000

(340,000)

$ 5,550,000

600,000

(620,000)

$ 5,530,000

$ 2,470,000

$ 980,000

1,030,000

$ 2,010,000

$ 460,000

$ 1,020,000

310,000

340,000

620,000

460,000

$ 7,000,000

510,000

(480,000)

$ 7,030,000

$ 970,000

$ 550,000

260,000

$ 810,000

$ 160,000

$ 80,000

480,000

110,000

5,800,000

$ 2,200,000

$ 610,000

1,270,000

$ 1,880,000

$ 320,000

$ 1,350,000

220,000

Selected Balance Sheet Information for Year-end

Section 1.4 Comparing Service, Merchandising, and Manufacturing Organizations

1.4 Comparing Service, Merchandising, and Manufacturing Organizations

Figure 1.5: Measuring income in service, merchandising, and manufacturing firms

Services Firms

Kalwerisky Consultants

$8,000,000

Income Statements for the Year

Merchandising Firms

Burchfield Supermarket

$8,000,000

Manufacturing Firms

Holbrook Products

$8,000,000Sales

Cost of goods sold

Cost of goods manufactured

Purchases of direct materials

+ Beginning direct materials inventory

– Ending direct materials inventory

Materials used

+ Direct labor

+ Manufacturing overhead

Total manufacturing costs

+ Beginning work in process

– Ending work in process

Cost of goods manufactured

Purchases of finished goods

+ Beginning finished goods inventory

– Ending finished goods inventory

Cost of goods sold

Direct client expenses

Gross margin

Operating expenses:

Selling expenses

Administrative expenses

Total operating expenses

Net operating income

Accounts receivable

Materials inventory

Work in process inventory

Finished goods inventory

Accounts payable

$ 2,300,000

360,000

(310,000)

$ 2,350,000

920,000

2,300,000

$ 5,570,000

320,000

(340,000)

$ 5,550,000

600,000

(620,000)

$ 5,530,000

$ 2,470,000

$ 980,000

1,030,000

$ 2,010,000

$ 460,000

$ 1,020,000

310,000

340,000

620,000

460,000

$ 7,000,000

510,000

(480,000)

$ 7,030,000

$ 970,000

$ 550,000

260,000

$ 810,000

$ 160,000

$ 80,000

480,000

110,000

5,800,000

$ 2,200,000

$ 610,000

1,270,000

$ 1,880,000

$ 320,000

$ 1,350,000

220,000

Selected Balance Sheet Information for Year-end

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Section 1.4 Comparing Service, Merchandising, and Manufacturing Organizations

Internally, financial reports for service firms often separate revenues and expenses by type of service or customer. For example, hospitals track revenues by procedure type and attempt to measure costs of those procedures. Professional firms, such as accountants, lawyers, and architects, measure the direct costs of performing services by client. Lawyers record time spent on each case, both for billing purposes and for tracing salary costs. In Figure 1.5, Kal- werisky Consultants apparently serves multiple clients and can identify professional time, service costs, and other traceable costs with specific client contracts.

Merchandising Organizations A merchandising business purchases products for resale. Generally, a merchandising firm is a link in the physical distribution chain, acting as a wholesaler or retailer. Figure 1.5 presents cost of goods sold on the income statement of Burchfield Supermarket, a retail grocery store. Again, comprising the reported totals are detailed revenues and costs of sales for various seg- ments, such as produce, hardware, meat, and grocery departments. Merchandise costs are inventoriable or product costs, meaning that they are an asset until sold, after which they become cost of goods sold. All other expenses in the supermarket operation are treated as period costs.

Manufacturing Organizations Manufacturing generally occurs in a factory, defined as a place where resources are brought together to produce a product. Examples include:

Soft-drink bottling company—mixing batches and filling bottles of root beer University cafeteria—preparing and serving food Print shop—printing a variety of items such as brochures, booklets, and business cards Breakfast cereal manufacturer—processing grains into cereal Automotive assembly plant—joining parts and subassemblies to create a minivan

But, you can see how many service firms really do “produce” the service using our definition of a factory.

Landscaping company—cutting lawns and planting Pharmacy—filling prescriptions Tax return preparation firm—preparing tax returns Hospital surgery department—performing heart bypass operations

As Figure 1.5 illustrates, manufacturing firms have more complexity in determining cost of goods sold. A new portion of the income statement, cost of goods manufactured, is intro- duced. It includes:

• The costs of inputs to the manufacturing process: direct materials, direct labor, and manufacturing overhead

• Direct materials inventory and work in process inventory needed for factory activities

sch84920_01_c01_001-046.indd 14 8/1/17 1:53 PM

PERIOD COSTS PRODUCT COSTS

Vice-President Production

Vice-President Personnel

Vice-President Treasurer

Vice-President Controller

Vice-President Marketing

Vice-President Manager

President

Materials Warehouse

Materials Inventory

THE FACTORY FLOOR Work in Process Inventory

(Assembly Line)

Finished Goods Warehouse

Finished Goods InventoryFactory Manager

Cost Accounting

Production Planning

THE OFFICE THE FACTORY

Receiving

Shipping

Section 1.4 Comparing Service, Merchandising, and Manufacturing Organizations

The sum of the product inputs, manufacturing costs for the period, is called total manufac- turing costs.

Figure 1.6 illustrates a simplified version of the Holbrook Products factory. Here resources are brought together for producing aircraft components. An assembly line in the factory is the focus of “manufacturing” activities.

Materials (primarily parts and components) are purchased for production, and factory employees work to convert parts into finished products. Many support services are used, and manufacturing overhead costs are incurred for materials handlers, equipment maintenance people, heat, power, employee benefits, factory accountants, supervisors, and depreciation on equipment and the building.

Figure 1.6: The Holbrook Products factory

PERIOD COSTS PRODUCT COSTS

Vice-President Production

Vice-President Personnel

Vice-President Treasurer

Vice-President Controller

Vice-President Marketing

Vice-President Manager

President

Materials Warehouse

Materials Inventory

THE FACTORY FLOOR Work in Process Inventory

(Assembly Line)

Finished Goods Warehouse

Finished Goods InventoryFactory Manager

Cost Accounting

Production Planning

THE OFFICE THE FACTORY

Receiving

Shipping

In Figure 1.6, the business is divided into office and factory areas. Obviously, this example is simplified and avoids many business complexities. But, it shows:

• Product and period costs. Any cost incurred in the manufacturing process is a manufacturing cost, an inventoriable cost, and a product cost. Any cost not involved in the manufacturing process is a nonmanufacturing cost, a noninventoriable cost, and a period cost. Whereas the product costs are treated as inventory until sold, the period costs are treated as expenses immediately or as noninventory assets such as office supplies.

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Work in Process

Inventory

Finished Goods

Inventory

Manufacturing

Overhead

Direct Labor

Costs of Goods Manufactured

Direct Materials Used

THE FACTORY

Section 1.4 Comparing Service, Merchandising, and Manufacturing Organizations

• Location of inventories. Manufacturing requires three production inventories: materials, work in process, and finished products. Materials purchases are received and stored in the materials warehouse, and their costs recorded in Materials Inventory. When materials are sent to the factory floor, direct materials costs are transferred to Work in Process Inventory, which is production that is started but not completed. Completed products are physically sent to the finished goods ware- house; their work in process costs are moved to Finished Goods Inventory, which are products that are ready for sale to customers. When a sale occurs and is shipped, finished goods product costs are moved to Cost of Goods Sold, an expense account.

• Flow of costs and products. Figure 1.6 assumes an assembly process, but many different production systems exist. Materials are added, workers process, and other activities support; a physical flow and a cost flow coexist.

Figure 1.7 compares a factory to a large bucket. When the whistle blows to start the produc- tion period, the bucket already has resources in it—beginning work in process inventory. During the period, more resources are poured into the bucket—total manufacturing costs (direct materials used, direct labor, and manufacturing overhead). Flowing out of the bucket are all products that are finished during the period and added to finished goods inventory. The cost transferred out is called cost of goods manufactured. When the whistle blows to end the period, ending work in process inventory remains in the bucket.

Figure 1.7: The factory as a “bucket” of costs

Work in Process

Inventory

Finished Goods

Inventory

Manufacturing

Overhead

Direct Labor

Costs of Goods Manufactured

Direct Materials Used

THE FACTORY

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Section 1.4 Comparing Service, Merchandising, and Manufacturing Organizations

To illustrate the determination of cost of goods manufactured, suppose work in process inventory of Metz Corporation changed from $21,000 to $23,500 during November. Costs incurred during November were $42,000 for direct materials used, $33,000 for direct labor, and $51,000 for manufacturing overhead. The cost of goods manufactured for November is determined as follows:

Direct materials used $42,000

Direct labor 33,000

Factory overhead 51,000

Total manufacturing costs $126,000

+ beginning work in process 21,000

– ending work in process (23,500)

Cost of goods manufactured $123,500

Note that cost of goods manufactured represents the cost of those goods that were finished during November. Since $21,000 of costs was incurred prior to November, it must be added to the $126,000 in costs that were incurred during November. Ending work in process of $23,500 must be deducted from the costs incurred during November because this amount represents costs for goods that have not yet been finished, and the cost of goods manufac- tured includes only costs pertaining to finished goods.

Traditional Groupings of Product Costs Figure 1.5 illustrates the income measurement for Holbrook Products. Product cost account- ing combines three groups of manufacturing costs: direct materials, direct labor, and manu- facturing overhead. While automated manufacturing and cost systems can utilize many more or fewer cost groups, these three have historically been used in nearly all manufacturing costing.

Direct materials costs are costs of physical components of the product. The range of materi- als includes natural resources, such as oil, grain, or lumber, and partially processed compo- nents (another company’s finished product). Often, a complete list of all materials used in a product is prepared and is called a bill of materials. A materials requisition form is used as authorization to transfer direct materials out of the materials storeroom and into the produc- tion area. Direct materials issued to production are direct materials used. To determine materials used, begin with materials purchases, add beginning materials inventory, and sub- tract ending materials inventory. Supplies like nails, glue, lubricants, and paints are usually not worth the effort of tracking as direct materials, so most companies refer to these items as indirect materials, and these are included as part of factory overhead costs. At McDonald’s,

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Section 1.4 Comparing Service, Merchandising, and Manufacturing Organizations

potatoes used to make French fries are direct materials, while the salt added to the fries is an indirect material.

Direct labor costs are wages paid to workers who directly process the product. In Figure 1.7, assembly line workers would be direct labor. At McDonald’s, the wages paid to the cooks are direct labor costs.

Factory overhead costs include all manufacturing costs that are not materials or direct labor. Manufacturing overhead, factory burden, and indirect manufacturing costs are other names for these costs. Obviously, a wide variety of costs fall into this category, such as maintenance staff wages, factory managers’ salaries, factory utilities costs, and factory equipment depre- ciation and repair costs. Hundreds of different cost accounts could be grouped under man- ufacturing overhead. Certain workers’ tasks could be overhead in one company and direct labor in another. For example, materials handlers and quality control personnel costs could be accounted for as either direct or indirect labor. Generally, if the worker has direct contact with the product or the production process, the cost is direct labor. Generally, support tasks are indirect labor—part of overhead. At McDonald’s, a particular restaurant manager’s salary is an indirect labor cost.

Historically, the three cost groups were assumed to be about equal portions of total prod- uct cost. Today, automation reduces direct labor and causes factory overhead to increase. As more production is generated from the same capacity, materials as a percentage of total cost may also increase. Thus, managers have paid more attention to direct materials and overhead costs because they have grown as a portion of total manufacturing costs.

Types of Product Costs Direct materials and direct labor costs are often viewed as direct product costs since they are easily identified with specific products and units of product. Factory overhead is usu- ally thought of as indirect product costs. Factory overhead is not easily traced to specific products or units. For example, the plant manager’s salary cannot be tied to specific product units in a multiproduct factory, since the manager is responsible for all activities in the fac- tory. An exception may exist for a few overhead costs that may be traced to specific products and be considered direct costs. Figure 1.8 illustrates these concepts and shows a dotted line between factory overhead and direct costs to indicate this possibility. At McDonald’s, the cost of hamburger buns is a direct product cost, while the restaurant’s electricity costs are indirect product costs.

Direct materials and direct labor are also known as the prime costs of a product. These costs are easily traceable to a specific product. Direct labor and factory overhead are called conver- sion costs. In the factory, materials are “converted” into finished product using labor and all of the factory’s supporting resources—overhead costs.

Figure 1.8: Product costs and product cost groups

Prime Costs

Conversion Costs

Direct Materials

Costs

Direct Labor

Costs

Factory Overhead

Costs

Direct Product

Costs

Indirect Product

Costs

Contemporary Practice 1.1: Survey on Indirect Costs

In a survey of 185 European companies in various industries, respondents ranked the importance of indirect cost categories (other than personnel costs) as follows:

Ranking Cost Category

1 Information Technology

2 Energy

3 Maintenance

4 Fleet Management

5 Marketing

6 Facility Management

7 Freight

8 Logistics

9 Telecommunications

10 Insurance

11 Travel Expenses

12 Tools/Supplies

Source: Wald, A., Schneider, C., Schulze, M. & Marfleet, F. (2013, November/December). A study on the status quo, current trends, and success factors in cost management. Cost Management, 28–38.

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Section 1.4 Comparing Service, Merchandising, and Manufacturing Organizations

potatoes used to make French fries are direct materials, while the salt added to the fries is an indirect material.

Figure 1.8: Product costs and product cost groups

Prime Costs

Conversion Costs

Direct Materials

Costs

Direct Labor

Costs

Factory Overhead

Costs

Direct Product

Costs

Indirect Product

Costs

Contemporary Practice 1.1: Survey on Indirect Costs

In a survey of 185 European companies in various industries, respondents ranked the importance of indirect cost categories (other than personnel costs) as follows:

Ranking Cost Category

1 Information Technology

2 Energy

3 Maintenance

4 Fleet Management

5 Marketing

6 Facility Management

7 Freight

8 Logistics

9 Telecommunications

10 Insurance

11 Travel Expenses

12 Tools/Supplies

Source: Wald, A., Schneider, C., Schulze, M. & Marfleet, F. (2013, November/December). A study on the status quo, current trends, and success factors in cost management. Cost Management, 28–38.

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Section 1.5 Cost Behavior

Calculating Unit Costs Product costing assigns costs to units of product. The approach is to divide the number of units produced into total manufacturing costs to obtain a cost per unit of product. For exam- ple, a highly automated factory produces a variety of tablet computers. The same produc- tion processes are used for all models with minimal costs to change over the production line. Three million tablet computers are manufactured every month. Different circuit boards dis- tinguish the models. March production data by product line are as follows:

Deluxe Super Deluxe Basic Total

Direct materials costs $3,600,000 $4,200,000 $1,500,000 $9,300,000

Indirect other costs 6,000,000

Total costs $15,300,000

Units produced 120,000 120,000 60,000 300,000

Direct materials costs per unit $30.00 $35.00 $25.00 $31.00

Indirect other costs per unit 20.00 20.00 20.00 20.00

Product cost per unit $50.00 $55.00 $45.00 $51.00

Note: The “Indirect other costs per unit” of $20.00 is obtained from dividing $6,000,000 of “Indirect other costs” by the 300,000 units produced.

The costing approach is to divide the total costs of $15,300,000 by 300,000 tablet comput- ers. However, the $51.00 average cost hides the different direct costs of each model of circuit board. A second approach identifies materials costs as direct to each model and averages all other costs over all units. This produces a high cost of $55.00 for Super Deluxe models and a low cost of $45.00 for Basic models. More complex costing is needed if different models use different amounts of resources. The goal is to obtain the most accurate unit cost, given man- agers’ decision-making needs.

1.5 Cost Behavior To say that a cost “behaves” in a certain way is somewhat misleading. Costs result from taking actions or from the mere passage of time. Something drives a cost—some activity, decision, or event. Selling one more hamburger involves a burger, a bun, a container, a napkin, and any condiments used. But selling one more hamburger has no impact on supervision, equipment rental, or advertising costs. Building lease expense will not change unless the lease includes a rental payment based on a percentage of sales. Cost behavior, then, is the impact that a cost driver has on a cost.

Which costs can be expected to remain constant when the amount of work activity increases or decreases? Also, which costs increase as more work is performed? If costs are to be esti- mated and controlled, we need to know whether or not costs will change if conditions change,

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Variable Costs Per Unit

Activity Level (Units)

C o st

P e r

U n it

Total Variable Costs

Activity Level (Units)

To ta

l C o st

Slope =

Change in $ Change in Units

Section 1.5 Cost Behavior

and, if so, by what amount. Cost behavior is often viewed as a dichotomous pattern—either variable or fixed. But in the real world, many behavior patterns exist since most costs are not strictly variable or fixed. Thus, the concepts of semivariable and semifixed costs add complex- ity to cost behavior studies. It may oversimplify the analysis, but a split between variable and fixed is common and is used frequently.

Variable Costs A variable cost changes in total in direct proportion to changes in business activity such as units produced or hours worked. A decrease in activity brings a proportional decrease in total variable cost, and vice versa. For example, direct materials costs are usually variable costs since each unit produced requires the same amount of materials. Thus, materials costs change in direct proportion to the number of units manufactured. At McDonald’s, the cost of raw hamburger meat is a variable cost.

A proportional relationship between activity and cost has these important characteristics:

Variable cost is a rate per unit of activity or output. A variable cost per unit remains constant across a reasonable range of activity. The slope of the total variable cost curve is the variable cost per unit—the added cost divided by the added units.

For example, if a product costs $4.00 per unit, the expression $4X yields the total variable cost at X level. Figure 1.9 shows the behavior of variable costs on a per unit basis and in total, and also highlights the variable cost line’s slope.

Figure 1.9: Behavior of variable costs

Variable Costs Per Unit

Activity Level (Units)

C o st

P e r

U n it

Total Variable Costs

Activity Level (Units)

To ta

l C o st

Slope =

Change in $ Change in Units

Fixed Costs A fixed cost is constant in total amount regardless of changes in business activity level. Costs such as the plant manager’s salary, depreciation, insurance, and rent usually remain the same in total regardless of whether the plant is above or below its expected level of operations. At

sch84920_01_c01_001-046.indd 21 8/1/17 1:53 PM

Fixed Costs Per Unit

Activity Level (Units)

C o st

P e r

U n it

Total Fixed Costs

Activity Level (Units)

To ta

l C o st

Section 1.5 Cost Behavior

McDonald’s, the cost of heating the restaurant is a fixed cost since the cost does not change with activity such as labor hours or amount of food prepared.

Important characteristics of a fixed cost are:

Fixed cost is a lump of costs that is not normally divisible and does not change as activity or volume changes. A fixed cost remains constant across a reason- able range of activity. The fixed cost per unit decreases as activity or volume increases and increases as activity or volume decreases.

For example, March’s rent is stated as a dollar amount for that month, not as an amount per unit of output or even per hour of use.

By definition, total fixed costs are constant, causing the fixed cost per unit to vary at different levels of activity. Figure 1.10 shows the behavior of fixed costs on a per unit basis and in total. When a company produces a greater number of units, the fixed cost per unit decreases. Con- versely, when fewer units are produced, the fixed cost per unit increases. This variability of fixed costs per unit creates problems in product costing. The cost per unit depends on the number of units produced or on level of activity.

Figure 1.10: Behavior of fixed costs

Fixed Costs Per Unit

Activity Level (Units)

C o st

P e r

U n it

Total Fixed Costs

Activity Level (Units)

To ta

l C o st

Certain fixed costs can be changed by management action. These are discretionary fixed costs. Discretionary fixed costs are expenditures that managers can elect to spend or not to spend. For example, a company might budget the cost of consultants at $20,000 per month for the coming year. But the contract states that the company can cancel the contract at any time. Management maintains discretionary control over the spending. On the other hand, if the contract guarantees the consultant a 12-month relationship and the contract has been signed, a committed fixed cost has been created. A committed fixed cost is one over which a manager has no control and must incur. Advertising cost for McDonald’s is a discretionary fixed cost. Depreciation on McDonald’s restaurant equipment is a committed fixed cost.

sch84920_01_c01_001-046.indd 22 8/1/17 1:53 PM

Section 1.5 Cost Behavior

An interesting observation is necessary here. Managers can, with time and intent, change the cost behavior of certain activities. For example, variable direct labor costs can be replaced by a fixed cost by guaranteeing full-time employment for some period, such as a three-year union contract. Or equipment could be leased on a short-term basis (day-to-day or even hourly) instead of purchased—replacing a fixed cost with a variable cost. Also, automated equipment with a fixed rent or depreciation could replace variable-cost manual labor. Thus, we recognize that managers can act to change certain cost behavior, particularly over time.

Contemporary Practice 1.2: Fixed Versus Variable Expenses

“You can get quality people to invent, develop and design products for you on a percentage of the products’ billing—in other words, on a variable expense basis. Many will want to work on upfront fees only, a fixed expense. Salesmanship on your part can get them to charge your way. If they’re sold on your company, you personally, or the product, they’re more likely to comply with your wishes. Sometimes a compromise is required where you pay a modest upfront fee and a modest percentage on sales of the product.” (Reiss, 2010, paragraphs 12 and 13)

Expressing Variable and Fixed Costs—A Cost Function Since a variable cost is a rate, it is a function of an independent variable—an activity or output level. Unit variable costs can be converted into total variable costs only by knowing the activ- ity or output level. Fixed costs are first expressed as a total, lump sum amount, a constant. Total fixed costs can be converted into a rate per unit only if the activity or output level is known. In the following example, the cost per unit of $7 and total costs of $700,000 can be found only if the output of 100,000 units is known.

Costs of 100,000 Units Costs of 120,000 Units

Cost per Unit Total Costs Cost per Unit Total Costs

Variable costs $4.00 ⟶ $400,000 $4.00 ⟶ $480,000

Fixed costs 3.00 ⟵ 300,000 2.50 ⟵ 300,000

Total $7.00 $700,000 $6.50 $780,000

If the production level increases to 120,000, both the cost per unit and total costs change. A decrease in the cost per unit from $7 to $6.50 results from spreading fixed costs of $300,000 over more units—120,000 instead of 100,000. The increase in total cost equals the variable costs for the additional 20,000 units. A decrease in volume has similar reverse impacts—the cost per unit increases, but total costs decline.

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Section 1.5 Cost Behavior

Three factors must generally be known to perform cost analyses:

1. The variable cost rate 2. The fixed cost amount 3. The level of activity or output

Notice that if we know the bold numbers in the example above and the activity level, we can calculate all other numbers. These factors can be brought together in a cost function—an expression that mathematically links costs, their behavior, and their cost driver. In the exam- ple, the expression is:

Total costs = $300,000 + $4(X), where X is the number of units produced.

This cost function can be symbolically shown as:

Total costs = a + b(X), where a is total fixed costs and b is variable cost per unit.

This is an important formula in managerial accounting. Understanding these relationships can give insight into cost behavior for planning, control, and decision making. By knowing the activity level and cost function, we can calculate either total costs or costs per unit.

Determining the Cost Function Using Total Costs and Activity Levels In this example, let’s assume we know the total costs ($700,000 and $780,000) at both activ- ity levels (100,000 and 120,000 units). How do we obtain the cost function? First, we calcu- late the variable cost per unit as follows:

Change in cost Change in activity level

= $780,000 – $700,000

120,000 – 100,000 =

$80,000 20,000

= $4 per unit

The $4 per unit amount is the variable cost per unit in the cost function. The change in cost from a change in activity yields the slope of the total variable cost line.

To obtain the fixed cost, which is a in the cost function, we take the total costs at either activity level and subtract the total variable costs at that level, as follows:

$780,000 – ($4 × 120,000 units) = $300,000

$700,000 – ($4 × 100,000 units) = $300,000

We now have both a and b. Total cost = $300,000 + $4 (X).

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To ta

l C o st

s (0

0 0 s)

Activity Level (000s) 100 120 100

Fixed Costs

Variable Costs

Total Costs

120

To ta

l C o st

s (0

0 0 s)

Activity Level (000s)

$ 300

$ 700 $ 780

Section 1.5 Cost Behavior

Obtaining the Cost Function Using Per Unit Costs and Activity Levels Using the same example, per unit costs were $7 at the 100,000 units activity level and $6.50 at 120,000 units. First, we calculate total costs at each level by multiplying the cost per unit by the activity level as follows:

$7 per unit × 100,000 = $700,000 and $6.50 per unit × 120,000 = $780,000

Second, we follow the same procedure as shown previously in converting total costs into the cost function. The same calculations could be applied separately to total variable costs for b and to total fixed costs for a. Calculations at both levels produce the same cost function.

One danger in converting total fixed costs into cost per unit is that the unit cost can be mis- interpreted. It might be assumed that $7 is the variable cost—forgetting that the $300,000 is a fixed cost. At different activity levels, the per unit cost will be different. Even in solving homework problems, students are in danger of missing the impact of volume changes on total costs and unit costs if only costs per unit or total costs are used.

Relevant Range In Figures 1.9 and 1.10, activity is assumed to start at zero and increase to very high levels. Realistically, the cost function holds only for a much narrower range of activity—a relevant range. A relevant range is the normal range of expected activity. Management does not expect activity to exceed a certain upper bound nor to fall below a lower bound. Production activity is expected to be within this range, and costs are budgeted for these levels. In cost analysis, costs are expected to behave as defined within the relevant range. The cost function is assumed to be valid for this range of activity. Usually, past experience establishes the relevant range.

Total fixed costs are fixed and total variable costs are variable within the relevant range. In the above example, the volume range was between 100,000 and 120,000 units. The cost function of $300,000 plus $4 per unit is valid between 100,000 and 120,000 units as shown in Figure 1.11. If planned production were 130,000 units, our cost function might not be valid or useful.

Figure 1.11: Cost patterns using a relevant range

To ta

l C o st

s (0

0 0 s)

Activity Level (000s) 100 120 100

Fixed Costs

Variable Costs

Total Costs

120

To ta

l C o st

s (0

0 0 s)

Activity Level (000s)

$ 300

$ 700 $ 780

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Example A (Mixed Cost)

Example B (Step-Fixed Cost)

Example C (Nonlinear Cost)

Example D (Piece-Wise Linear Cost)

X-axis is activity level; Y-axis is total costs.

Section 1.5 Cost Behavior

Semivariable and Semifixed Costs Figure 1.12 illustrates cost functions that are neither strictly variable nor fixed. In the real world, very few costs are truly variable or fixed. Semivariable costs change but not in direct proportion to the changes in output. Some semivariable costs, called mixed costs, may be broken down into fixed and variable components, thus making it easier to budget and control costs. Using the cost function techniques shown previously, fixed and variable parts can be identified. In Example A of Figure 1.12, telephone expenses may include a monthly basic con- nection fee (fixed) plus a per-minute charge for each call (variable).

Semifixed costs or step-fixed costs are typified by step increases in costs with changes in activity as shown in Example B. Activity can be increased somewhat without a cost increase. However, at some activity level, additional fixed cost must be incurred to expand capacity. An example is adding an additional full-time worker when sales increase beyond a certain level. If many narrow steps exist, a step-cost pattern may approximate a variable cost. Or with wide steps, one step may encompass the entire relevant range and the step cost appears as a fixed cost.

Figure 1.12: Examples of semivariable and semifixed cost patterns

Example A (Mixed Cost)

Example B (Step-Fixed Cost)

Example C (Nonlinear Cost)

Example D (Piece-Wise Linear Cost)

X-axis is activity level; Y-axis is total costs.

Example C shows a cost that increases but at a lower cost per unit as activity increases. An example is increased worker efficiency as activity increases, resulting in a lower per unit cost. This is a nonlinear cost. Example D shows a piece-wise linear cost. It is a constant variable rate until a certain activity level is reached, then the variable cost per unit increases. Perhaps an electric utility offers a low per kilowatt rate for the first 500 kilowatts and a higher rate beyond that level.

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Section 1.6 Cost Concepts for Planning and Controlling

1.6 Cost Concepts for Planning and Controlling This section introduces terminology relating to traceability and controllability of costs. These concepts are useful for planning and control purposes.

Direct Costs Versus Indirect Costs Costs are often defined as being direct or indirect with respect to a cost object—an activity, a department, or a product. If a cost can be specifically identified with a particular cost object, it is traced to the cost object and is considered to be a direct cost. A direct cost is also called a traceable cost. The cost of installing a sunroof on a particular car is a direct cost of that car because it is traceable to that particular car. If no clear link between a cost and the cost object is apparent, the cost is an indirect cost (also called a common cost). For example, the heat- ing cost for a physical therapy center is an indirect cost to each patient being served there.

The same cost can be direct for one purpose and indirect for another. For example, the sal- ary of the St. Louis office manager is a direct cost of that branch. But within the branch office where numerous products are sold, the manager’s salary is an indirect cost of specific prod- ucts. At McDonald’s, cleaning supplies are a direct cost for a particular restaurant, but corpo- rate legal expenses are an indirect cost for a particular restaurant.

Indirect costs not traceable to particular products or departments may need to be allocated to those cost objects. A cost object may use a resource, but the amount used may not be eas- ily measured. For example, a shoe department occupies 2,000 square feet of a 50,000 square foot store and accounts for 10% of sales and 6% of profits. If the rent for the entire store is $300,000 per year, how much should be allocated to the shoe department—$12,000 (space), $18,000 (profits), $30,000 (sales), or some other amount? No cost allocation is absolutely correct, and different viewpoints will argue for different allocations. The allocation process should attempt to link the cost, the use of the resource, and the activity or output.

Controllable Costs Versus Noncontrollable Costs Another important aspect of cost is the distinction between costs that can and cannot be controlled by a given manager. This cost classification, like the direct and indirect cost clas- sification, depends on a point of reference. If a manager is responsible for a cost, that cost is a controllable cost with respect to that manager. If that manager is not responsible for incur- ring a cost, it is a noncontrollable cost with respect to that manager. The entire cost control system rests on who can control each cost.

All costs are controllable at some level of management. Every cost in an organization is con- trollable by some manager in that organization. Costs should be planned or budgeted by the manager who has responsibility for that cost. For a McDonald’s restaurant manager, the cost of utilities usage is controllable, while property insurance costs are noncontrollable.

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Variable Contribution Margin:

Total sales – Total variable costs

Variable contribution margin or Contribution margin

Controllable Contribution Margin:

Total sales – Controllable costs

Controllable contribution margin

Direct (or Segment) Contribution Margin:

Total sales – Direct (or Segment) costs

Direct (or Segment) contribution margin

Sales price per unit – Variable cost per unit

Contribution margin per unit

Sales percentage – Variable cost percentage

Contribution margin percentage or Contribution margin ratio

Section 1.7 Contribution Margin and Its Many Variations

1.7 Contribution Margin and Its Many Variations Thus far, we have defined cost terms. But managerial responsibility for profit measurement is even more important. Revenue is added to the analysis. While net profit evaluates the entire firm, determining profitability of parts of a firm requires more precise profit measures. The term we use is contribution margin, which is the revenue minus certain costs, a margin. This margin contributes to covering all remaining costs and to earning a net profit. Figure 1.13 shows five variations used in different situations.

Figure 1.13: Variations of contribution margin

Variable Contribution Margin:

Total sales – Total variable costs

Variable contribution margin or Contribution margin

Controllable Contribution Margin:

Total sales – Controllable costs

Controllable contribution margin

Direct (or Segment) Contribution Margin:

Total sales – Direct (or Segment) costs

Direct (or Segment) contribution margin

Sales price per unit – Variable cost per unit

Contribution margin per unit

Sales percentage – Variable cost percentage

Contribution margin percentage or Contribution margin ratio

Variable Contribution Margin—Per Unit, Ratio, and Total Dollars The basic and most common definition of contribution margin is sales minus variable costs. Variable contribution margin is a more explicit term because only variable items (revenue and costs) are included in the calculation. This contribution margin contributes towards cov- ering fixed costs and provides for a net profit.

As an example, a salesperson is selling a product for $20 per unit. The firm buys the item for $12 per unit and pays the salesperson a 10% commission on sales. The firm expects to sell 10,000 units. Variable contribution margin can be shown as follows:

Variable Contribution Margin

Per Unit Ratio Total Dollars

Sales (10,000 units) $20 100% $200,000

Variable costs:

Costs of sales and commissions ($12 plus 10% of $20) 14 70 140,000

Variable contribution margin $6 30% $60,000

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Section 1.7 Contribution Margin and Its Many Variations

Thus, the contribution margin can be expressed as either $6 per unit, 30% of sales, or $60,000. Depending on the analysis needed, we may use one, two, or all three versions. From total vari- able contribution margin, we subtract fixed expenses—the remaining expenses—to arrive at net profit.

Controllable and Direct Contribution Margins The next contribution margin concept looks at managerial control and is used when a man- ager has revenue and cost responsibility. Costs controllable by the manager are typically vari- able costs and controllable fixed costs. These costs are subtracted from sales to yield con- trollable contribution margin or controllable margin. This represents the amount available to cover any noncontrollable expenses and includes any company net profit. Note that the definitions of controllable and noncontrollable developed previously are used for both reve- nue and costs. Controllable contribution margin is used to evaluate managerial performance. However, this is not the net profit that the manager generates for the company, since noncon- trollable costs must be covered before any net profit is earned.

Direct or segment contribution margin or segment margin is a segment’s revenue minus its direct costs. A segment might be a product, a region, or a division. Definitions of direct and indirect were discussed earlier and focus on traceability. As an example, the direct contribu- tion margin of a product line is sales less product-line cost of sales, product-line advertising costs, and any other costs traceable to that product line. The product line’s direct contribu- tion margin is the amount remaining to cover company common costs and to earn company profits.

Illustration of All Contribution Margin Concepts Pearl Engel owns three Burgers Plus locations. Figure 1.14 presents a summary income state- ment, expanded for the Grand Avenue location. Variable contribution margin is shown in total dollars for each store and also as a ratio for the Grand Avenue store. Direct controllable fixed expenses include assistant managers’ salaries, maintenance services, and other fixed costs that the store manager controls. The controllable contribution margin is the profit on which the Grand Avenue manager will be evaluated and rewarded (a bonus for meeting profit goals or profit improvement). Direct noncontrollable fixed expenses include rent on the building and the outlet manager’s salary, which are probably controlled by Engel.

This direct or store contribution margin is used to measure the profit performance of each store. Measuring store profitability stops at the direct contribution margin. Direct contribu- tion margin is the finest-tuned profit measure that is free of allocations. Common corporate expenses, which include Engel’s salary and other corporate expenses, cannot be traced to the three locations.

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Contribution Analysis by Store for the Month of September

Sales

Variable food expenses

Other variable expenses

Total variable expenses

Variable contribution margin

Direct controllable fixed expenses

Controllable contribution margin

Direct noncontrollable fixed expenses

Direct contribution margin

Common corporate expenses

Net profit

$ 120,000

$ 55,500

6,000

$ 61,500

$ 58,500

12,600

$ 45,900

24,400

$ 21,500

$ 96,000

$ 46,000

4,500

$ 50,500

$ 45,500

13,900

$ 31,600

21,300

$ 10,300

$ 185,000

$ 85,100

11,100

$ 96,200

$ 88,800

20,400

$ 68,400

38,900

$ 29,500

100%

47%

52%

48%

$ 401,000

$ 186,600

21,600

$ 208,200

$ 192,800

46,900

$ 145,900

84,600

$ 61,300

36,900

$ 24,400

River Road

Pine Street

Grand Avenue Totals

Section 1.7 Contribution Margin and Its Many Variations

Contribution margin per unit requires more detail. Engel has set target contribution margins for her three main burger products as follows:

Average for

Cheap Burger Double Burger Triple Burger

Selling price per unit $1.00 $2.00 $3.00

Variable product costs per unit 0.65 1.20 1.50

Variable contribution margin per unit $0.35 $0.80 $1.50

Variable contribution margin ratio 35% 40% 50%

Note that the other variable expenses (probably supplies and condiments) in Figure 1.14 can- not be traced accurately to each product. As shown in Figure 1.14, actual burger margins can be compared across all stores and to margin targets.

Ms. Engel has numerous versions of profitability for each location. She will use each to answer specific questions about her products, managers, and stores. Common use of the term contri- bution margin frequently means variable contribution margin. To avoid misunderstanding, define which contribution margin you are using.

Figure 1.14: Contribution margin analysis by store

Contribution Analysis by Store for the Month of September

Sales

Variable food expenses

Other variable expenses

Total variable expenses

Variable contribution margin

Direct controllable fixed expenses

Controllable contribution margin

Direct noncontrollable fixed expenses

Direct contribution margin

Common corporate expenses

Net profit

$ 120,000

$ 55,500

6,000

$ 61,500

$ 58,500

12,600

$ 45,900

24,400

$ 21,500

$ 96,000

$ 46,000

4,500

$ 50,500

$ 45,500

13,900

$ 31,600

21,300

$ 10,300

$ 185,000

$ 85,100

11,100

$ 96,200

$ 88,800

20,400

$ 68,400

38,900

$ 29,500

100%

47%

52%

48%

$ 401,000

$ 186,600

21,600

$ 208,200

$ 192,800

46,900

$ 145,900

84,600

$ 61,300

36,900

$ 24,400

River Road

Pine Street

Grand Avenue Totals

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Summary & Resources

Chapter Summary Accounting information is provided from a system that handles the requirements of two branches of accounting: financial accounting and managerial accounting. Financial account- ing presents accounting information to parties outside the organization. Managerial account- ing organizes accounting information for internal management. Internal reporting is gener- ally directed to the decision areas mentioned earlier.

The ethical conduct and integrity of the management accountant are critical to the success of the accountant’s mission. Ethical situations are common and often complex. Management accountants have a special responsibility to their management colleagues and to themselves to uphold high ethical standards.

Cost analysis and income measurement are equally important to service, merchandising, or manufacturing firms. Tracing cost flows is important to understanding the conversion of materials, direct labor, and overhead into a product or service. The cost driver is the link between resources used and outputs.

Different decisions need different costs. A “cost” must have an adjective attached to give it meaning. In general, costs have many attributes, but the three most important ones for using cost concepts are cost behavior, traceability, and controllability.

Variable and fixed costs behave differently when activity levels change. Variable costs are naturally expressed as a rate; fixed costs are naturally a lump of costs. Fixed and variable costs can be expressed as a cost function, such as a + b (X), where a is the fixed cost, b is the variable rate, and X is the level of activity.

Direct costs are traceable; indirect costs are nontraceable. Controllability refers to a specific manager’s authority to incur the cost and responsibility to use the resource generating the cost.

Contribution margin is revenue minus a subset of costs. Variable contribution margin can be expressed as an amount per unit, a ratio, or total dollars. Controllable contribution margin is used to evaluate the manager, and direct or segment contribution margin is used to evaluate the segment.

Key Terms bill of materials A complete list of all mate- rials used in a product.

Certified Management Accountant (CMA) A person who has passed a qualify- ing examination sponsored by the Institute of Management Accountants, has met an experience requirement, and participates in continuing education.

committed fixed cost A fixed cost over which a manager has no control and must incur.

common cost A cost that has no clear link to a specific cost object.

contribution margin Sales revenue less variable costs.

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Summary & Resources

controllable contribution margin Vari- able contribution margin less direct control- lable fixed expenses (represents the amount available to cover any noncontrollable expenses and includes any company net profit).

controllable cost A cost that a manager has the ability to influence.

controller The person responsible for man- aging the entire accounting function.

conversion costs Direct labor plus manu- facturing overhead (costs incurred to con- vert raw materials into finished products).

cost The amount of resource given up to gain a specific objective or object.

cost behavior How a cost changes with changes in business activity.

cost drivers Measures that link activities that create outputs to resources that are used.

cost function An expression that math- ematically links costs, their behavior, and their cost driver.

cost object Any purpose for accumulating costs.

cost of goods manufactured Total cost of goods completed during the period.

cost of goods sold The total of direct mate- rials, direct labor, and manufacturing over- head costs associated with the goods that have been sold during the period.

direct contribution margin Controllable contribution margin less direct noncontrol- lable fixed expenses (reflects the amount remaining to cover common costs and earn profits).

direct controllable fixed expenses Fixed expenses that are traceable and that a man- ager has the ability to influence.

direct cost A cost that is traceable to a cost object.

direct labor costs Wages paid to workers who work directly on the product.

direct materials costs Costs of the physical components of the product.

direct materials used Materials issued to production.

direct noncontrollable fixed expenses Fixed expenses that are traceable, but that a manager is not able to influence.

direct product costs Costs that can be traced to specific products.

discretionary fixed costs Expenditures that managers can elect to spend or not to spend.

factory overhead costs All manufacturing costs that are not direct materials or direct labor.

financial accounting The branch of accounting that organizes accounting infor- mation for presentation to interested parties outside of the organization.

finished goods inventory Products that have been completed and are ready for sale.

fixed cost A cost that remains constant, regardless of changes in a company’s activity.

indirect cost A cost that has no clear link to a specific cost object.

indirect product costs Manufacturing costs that cannot be traced to a specific product.

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Summary & Resources

management accountant An accountant who prepares information for a company’s decision makers.

managerial accounting The branch of accounting that meets managers’ informa- tion needs.

materials inventory Materials that are stored by the company.

mixed cost A cost that contains both vari- able and fixed elements.

noncontrollable cost A cost that a man- ager is not able to influence.

nonlinear costs A cost for which the cost function cannot be represented as a straight line.

period costs Operating costs that are expensed in the period in which they are incurred.

piece-wise linear cost A cost function consisting of connected straight lines with differing slopes.

prime costs Direct materials cost plus direct labor cost.

product costing The process of attaching costs to units of product.

product costs Costs that are treated as assets until the products are sold.

relevant range Normal range of expected activity.

segment contribution margin A segment’s revenues minus its direct costs.

semifixed costs Costs that are typified by step increases in costs with changes in activity.

semivariable cost A cost composed of a mixture of fixed and variable components.

step-fixed costs Costs that are typified by step increases in costs with changes in activity.

total manufacturing costs The sum of direct materials, direct labor, and factory overhead costs.

traceable cost A cost that can be directly linked to a cost object.

variable contribution margin Sales rev- enues less all variable expenses.

variable cost A cost that changes in pro- portion to a change in a company’s activity.

work in process inventory The cost of products that have been started in the manufacturing process but have not yet been completed.

Problem for Review Rabin Corporation operates sales, administrative, and printing activities from a facility in Augusta. It prints, prepares, and mails a wide variety of promotional materials. The following selected costs relate to the firm’s activities and particularly to the factory’s Mail Preparation Department.

a. Production paper used in Mail Preparation Department b. Hourly wages of production personnel in Mail Preparation Department c. Factory property taxes and insurance

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Summary & Resources

d. Supplies used, which changes with printing volume in Mail Preparation Department

e. Contract signed by Mail Preparation Department manager for an annual mainte- nance fee on postage application machinery

f. Equipment depreciation in Mail Preparation Department g. Building depreciation h. Sales commissions i. Advertising agency contract costs for a special program j. Annual computer staff; uses the same number of staff all year—half for opera-

tions, which includes the Mail Preparation Department, and half for administra- tive work

Questions:

Based on reasonable assumptions about Rabin Corporation, classify each cost as:

1. Variable or fixed cost 2. Controllable or noncontrollable by the supervisor of the Mail Preparation

Department 3. Direct or indirect product costs or period costs

Solution:

Cost Behavior Under Control of

Department Manager Product Cost

Cost Item

Variable Cost

Fixed Cost Yes No

Direct Cost

Indirect Cost

Period Cost

(a) X X X

(b) X X X

(d) X X X

(e) X X X

(f ) X X X

(g) X X X

(h) X X X

(i) X X X

(j) X X X* X*

* An allocation between the operations and administration is required.

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Summary & Resources

Questions for Review and Discussion

1. Briefly describe three ways in which financial accounting and managerial accounting are different. Name two ways in which they are the same or similar.

2. Briefly describe the management accountant’s responsibility for ethical behavior with respect to competence, confidentiality, integrity, and credibility.

3. What are sources of counsel and guidance on ethical dilemmas available to a manager?

4. What characteristics distinguish accounting for revenues and expenses for service, merchandising, and manufacturing organizations?

5. What does the mathematical expression $100,000 + $12X mean in terms of measur- ing product cost?

6. Distinguish among the following terms: cost of goods manufactured, cost of goods sold, and total manufacturing costs.

7. Name the three traditional cost elements in a manufactured product. How can these elements be attached to the product?

8. Identify at least two ways in which fixed costs pose difficulties for cost accountants and managers.

9. (a) In a recent speech, controller Judy Koch said, “I rarely see a real variable cost or a truly fixed cost.” What did she mean? (b) She also commented, “Some of my friends define semivariable costs, semifixed costs, step costs, and mixed costs differently. Other friends often use these terms interchangeably. And I like all of my friends.” Was she just trying to be funny, or is there truth in her quip? Explain.

10. How can an individual cost be both a direct and an indirect cost? A controllable and a noncontrollable cost? Give examples.

11. Sybil Goldstein supervises the Admissions Department at Tender Care Hospital. The hospital accountant includes Sybil’s salary among the direct expenses in her depart- mental expense report. Sybil claims she cannot control her own salary; therefore, it should not be in the Admissions Department’s expense report. Is Sybil correct? Explain.

12. We have 15 subsidiaries. All corporate costs are allocated to the subsidiaries. In evaluating the profitability of our French subsidiary, we find it generates a net loss. Why might this number not be a good indicator of the profit contribution that this subsidiary makes to the corporation as a whole?

Exercises

1-1. Ethical Dilemma. You are on your way to lunch and the elevator is packed. Two persons from a firm that competes with your employer happen to be talking about a business deal that involves one of your customers. Your computer-like mind lists your alternatives: Plug your ears, tell them that you are with a competitor, listen and then delete the information from your brain, immediately go back to the office and act on the new information, or call their supervisor and report the conversation you just overheard. What should you do?

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Summary & Resources

1-2. Ethical Conduct. Comment on the following frequently heard statements about ethical conduct: a. “You can’t teach ethics. If people don’t know right from wrong by now, they’ll

never learn.” b. “It’s legal. My attorney says so. Therefore, it’s okay.” c. “Are you trying to impose your values on me?” d. “I believe in situational ethics. What’s right or wrong depends on the situation.” e. “I can’t be ethical all the time. My competitors would eat me alive!” f. “Everyone does it.”

1-3. Cost Flows in Manufacturing. The following data are from the Westerman Com- pany for August production activities:

Inventories August 1 August 31

Direct materials $18,000 $10,000

Work in process 12,000 16,000

Finished goods 45,000 38,000

Month of August

Factory overhead $120,000

Cost of goods manufactured ?

Direct materials purchased 80,000

Direct labor 30,000

Questions:

1. What was the cost of direct materials used during August? 2. What was the cost of goods manufactured?

1-4. Cost of Goods Manufactured. The following data are available for Marcellino Enterprises:

March Balances

April Balances

May Balances

Beginning materials inventory $10,000 $ ? $15,000

Ending materials inventory 8,000 ? 11,000

Beginning work in process inventory 30,000 ? 18,000

Ending work in process inventory 24,000 ? 21,000

Direct labor 20,000

Factory overhead 40,000

Materials purchases 30,000

Question:

Determine the cost of goods manufactured for April.

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Summary & Resources

1-5. Classifying Cost Behavior. Jonah Roberts operates a pizza shop near Bronx Univer- sity. During critical periods like registration and final exams, he is open 24 hours a day. Half of his business is takeout. He has these expenses: a. Cost of supplies (e.g., napkins, toothpicks, and pizza boxes) b. Cost of dough used in pizzas c. Salary of the supervisor of the overnight shift when needed d. Wages of the delivery persons e. Straight-line depreciation on equipment f. Power costs to operate the ovens g. Monthly lease partially based on sales h. Cost of drinks served i. Insurance premiums covering his equipment j. Equipment maintenance costs

Question:

Classify each cost as variable, fixed, semivariable, or semifixed. Add any assumptions or com- ments you need to clarify your answers.

1-6. Searching for Unknowns in Manufacturing Cost Flows. Three Japanese firms— Kumamoto, Kawasaki, and Kanazawa—produce musical products. Operating results for a recent year follow (all numbers are in millions of yen):

Kumamoto Co. Kawasaki Co. Kanazawa Co.

Sales ¥ ? ¥90,000 ¥ ?

Materials used 15,000 ? 22,000

Direct labor 25,000 20,000 15,000

Factory overhead 60,000 25,000 ?

Total manufacturing costs ? ? ?

Beginning work in process 4,000 9,000 9,000

Ending work in process 12,000 4,000 6,000

Cost of goods manufactured ? 69,000 61,000

Beginning finished goods 6,000 ? 8,000

Ending finished goods 21,000 22,000 ?

Cost of goods sold ? ? 68,000

Gross margin ? 24,000 24,000

Operating expenses 25,000 ? 13,000

Net income 6,000 (6,000) ?

Question:

Determine the missing values. Helpful hint: Format a manufacturing cost of sales section, and insert the known amounts.

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Summary & Resources

1-7. Manufacturing Cost Flows. Analyze the following cases: A. In Jiao Company, costs incurred during November were $25,000 for materials

purchased, $50,000 for direct labor, and $60,000 for overhead. Materials inven- tory changed from $24,000 to $18,000.

Question:

If cost of goods manufactured in November was $129,000 and beginning work in process inventory was $16,000, determine the ending work in process inventory.

B. In Tong Company, the cost of goods sold for November was $186,000, finished goods inventory decreased from $30,000 to $21,000, and work in process inven- tory increased from $21,000 to $33,000.

Question:

Calculate the total manufacturing costs for November.

1-8. Variable Contribution Margin. Bob David’s Lab performs soil tests for toxic chemi- cals in its laboratory. Data from the third quarter of the past year include:

Selling price $15 per test

Variable lab costs $8 per test

Variable administrative and shipping expenses $3 per test

Total fixed lab costs $25,000 per quarter

Total fixed administrative expenses $15,000 per quarter

Tests performed 15,000 tests

Question:

Prepare an income statement showing variable contribution margin plus net income.

1-9. Direct and Controllable Costs. Gus Undheidt is manager of Allergy Relief Services in the Frankfurt, Germany office and has the authority to buy supplies, hire labor, and maintain equipment for the office. Costs in euros for January appearing in the Frankfurt office performance report are:

Home office general manager’s salary allocated to Frankfurt office €3,000

Home office operating expenses allocated to Frankfurt office 2,200

Home office marketing costs allocated to Frankfurt office 1,700

Equipment maintenance charges—Frankfurt office 2,600

Supplies used—Frankfurt office 1,400

Salary—Gus Undheidt 2,500

Labor costs—Frankfurt office 14,600

Home office depreciation allocated to Frankfurt office 1,000

Equipment depreciation—Frankfurt office 2,300

Total €31,300

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Summary & Resources

Questions:

1. Identify costs that can be controlled by Gus Undheidt. 2. Identify costs that can be traced directly to the Frankfurt office. 3. Identify costs allocated to the Frankfurt office from the home office. Suggest a cost

driver that might have been used to allocate these costs at the home office for each cost.

1-10. Ethics in Cost Control. Zoya Arbiser, regional manager of Gold Medal Sports Shops, is reviewing the results of 15 stores in her region. Store managers are moved annu- ally. Each store manager’s income is dependent on the direct contribution margin of that store. For the past year, Store 9 has been managed by a person who has oper- ated several other profitable stores in recent years and is about to be promoted to a larger store. Zoya notices several items that bother her.

1. Store 9 has almost no personnel training expenses relative to other stores. 2. Store 9 has stopped participating in numerous community events that gave the store

significant visibility but did incur substantial expenses. 3. Store 6, where this store manager worked the prior year, has had a severe drop in

profits due to higher operating expenses. 4. The advertising budget for Store 9 was spent almost entirely in the first four months

of the year, with almost nothing spent in the last several months.

Question:

Comment on a possible negative managerial scenario that the regional manager may be sens- ing. Might the manager of Store 9 be an exceptional manager? Explain.

1-11. Managing by Contribution Margin. We know the following about March’s results for Location 18 for Alan’s Fine Gold Jewelry, a franchise operation operating in Southern states:

Sales $480,000

Variable cost of jewelry 185,000

Other variable costs 55,000

Controllable fixed costs 100,000

Direct noncontrollable fixed costs 85,000

Home office allocated costs 50,000

Questions:

1. Based on what contribution margin number would you evaluate the Location 18 manager?

2. Based on what contribution margin number would you evaluate Location 18?

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Summary & Resources

1-12. Contribution Margin. As a recent marketing graduate of Big Time University, you landed a job with Food Mills, Inc. as product manager for Red Pop. Recent operating results are:

Sales of Red Pop $2,000,000

Variable costs of Red Pop 600,000

Direct noncontrollable fixed marketing expenses 500,000

Variable selling expenses 300,000

Direct controllable fixed marketing expenses 100,000

Allocated corporate marketing expenses (percentage of sales) 400,000

Allocated corporate office costs (per employee) 200,000

Questions:

1. Evaluate the profitability of Red Pop. 2. What data should be used to evaluate you as manager of Red Pop?

Problems 1-13. Determining Production Costs. Shirley Brickman knows the following about the

production process in her plant: Department 1:

Conversion costs are $200,000. Prime costs are $300,000. Materials purchases are $200,000. Increase in materials inventory is $20,000. Decrease in work in process inventory is $40,000.

Question:

Calculate factory overhead costs.

Department 2:

Direct product costs are materials and direct labor. Conversion costs are 300% of materials. Indirect product costs are 50% of conversion costs. Total manufacturing costs are $600,000.

Question:

Calculate materials costs.

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Summary & Resources

Department 3:

Conversion costs are 40% of total manufacturing costs. Direct labor is 25% of conversion costs. Factory overhead is $600,000.

Question:

Calculate total manufacturing costs.

1-14. Determining Unknowns. Determine the missing values in the following manufac- turing income statement:

2018 2019 2020

Sales $? $118,700 $?

Cost of goods sold:

Direct materials inventory 1/1 $8,000 $? $?

+ Direct materials purchased ? 20,000 30,000

Direct materials available $? $26,000 $?

– Less direct materials inventory 12/31 ? (9,000) (12,000)

Direct materials used $? $? $?

Direct labor 20,000 23,500 ?

Factory overhead 16,000 ? 24,000

Total manufacturing costs $53,000 $ ? $90,900

+ Work in process inventory 1/1 12,000 18,000 ?

– Work in process inventory 12/31 ? (16,300) (22,300)

Cost of goods manufactured $ ? $63,500 $84,900

+ Finished goods inventory 1/1 ? ? ?

Goods available for sale $62,000 $84,500 $103,200

– Finished goods inventory 12/31 (21,000) ? ?

Cost of goods sold $ ? $ ? $78,200

Gross profit $60,000 $? $46,800

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Summary & Resources

1-15. Determining Cost of Goods Sold. Asnien Outfitters makes Artic Hotsuits. The gen- eral manager has a special board on his office wall where he writes key statistics. For March, the board shows the following:

Production output 25,000 suits

Materials costs $50,000

Direct labor costs 2,000 hours at $10 per hour

Factory overhead $2 per outfit plus $40,000 per month

Selling expenses $1 per outfit sold plus $50,000 per month

He heard the sales manager brag about selling 22,000 suits this month.

Questions:

1. From the data, what was the cost of producing an Artic Hotsuit in March? 2. What was cost of goods sold in March? 3. What are the total product and period costs that will appear on Asnien Outfitters’

income statement for March?

1-16. Income Statement Preparation. A partial list of account balances for Ackerman Corporation follows:

Revenue and Expenses: January 1 Inventories:

Purchases of direct materials

$140,000 Direct materials $45,000

Direct labor 225,000 Work in process 30,000

Indirect labor 40,000 Finished goods 105,000

Rent – factory 84,000

Depreciation – machinery 35,000 December 31 Inventories:

Insurance – factory 18,000 Direct materials $40,000

Salespersons’ salaries 72,000 Work in process 35,000

Maintenance – machinery 12,000 Finished goods 110,000

Administrative salaries 50,000

Miscellaneous – factory 26,000

Miscellaneous – office 40,000

Sales 850,000

Question:

Prepare an income statement with a cost of goods manufactured section.

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Graph A Graph B Graph C Graph D

Graph E Graph F Graph G Graph H

Graph I Graph J Graph K Graph L

Summary & Resources

1-17. Identifying Cost Patterns. Match the graphs in Figure 1.15 with the numbered descriptions. Indicate any assumptions you are making. The x-axis is activity; the y-axis is total dollars of cost.

Figure 1.15: Summary of cost classifications

Graph A Graph B Graph C Graph D

Graph E Graph F Graph G Graph H

Graph I Graph J Graph K Graph L

1. _____ a + b (X), where “a” and “b” are not equal to zero. 2. _____ Straight-line depreciation expense (a classic fixed cost). 3. _____ Shift supervision salaries (shifts added as demand increases). 4. _____ Municipal utility costs where the rate increases as usage increases. Usage

increases with activity increases. 5. _____ Sales commissions paid to salespersons. 6. _____ Workers’ wages plus overtime premium. Overtime is needed after a certain

activity level is reached. Workers are less efficient when they work a lot of overtime.

7. _____ Water and waste water costs with a fixed-cost base charge plus a per-gallon rate beyond a certain level.

8. _____ Payroll taxes that are based on the first $30,000 of each employee’s wages. All employees earn more than this at high activity levels.

9. _____ Mixed costs within a relevant range.

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Summary & Resources

10. _____ Cost of hourly messenger service for a regional bank with a reduced rate after 2,000 hours of chargeable time.

11. _____ Wage costs as more hourly telephone callers are added in a telemarketing campaign.

12. _____ Materials costs where cost per pound decreases as larger quantities are purchased.

1-18. Cost Classification. Selected costs associated with a variety of business situations are shown below: a. Sales commissions of the marketing staff b. Salary of the plant manager c. Lubricating oils for machines d. Brass rods used in making plumbing products e. Property taxes on a building that includes both the factory and home office f. Labor in the repairs and maintenance section g. Salary of the supervisor in the grinding department h. Crude oil used in a refining process that results in numerous products i. Wages of artists preparing ads for a grocery chain, working for the grocery chain j. Depreciation on administrative office furniture k. Salaries of quality assurance personnel who test products during production l. Salaries of software engineers in a production plant using robots m. Wages of union auto assembly workers guaranteed 2,000 hours of work per year

Question:

Create columns to classify each item by cost behavior (variable, semivariable, or fixed) with respect to activity; as a product or period cost; and, if it is a product cost, as a direct or indirect product cost.

1-19. Cost Analysis Without Profit as a Bottom Line. Riverdale Transport, Inc. runs pas- senger and freight services between the Cleveland airport and other nearby towns and cities. The owner, Serena Bailey, is an operations-wise manager. She recently heard about a “segment contribution margin” approach at a university continuing education program. Her actual results for the first half of this year have just arrived.

Total revenue was $5.0 million, of which $3.5 million was freight traffic and $1.5 mil- lion was passenger traffic. Of the passenger revenue, 60% was generated by Route 1, 30% by Route 2, and 10% by Route 3.

Total direct controllable fixed costs were $600,000, of which $500,000 was spent on freight traffic. Of the remainder, $40,000 could not be traced to specific routes, although it was clearly applicable to passenger traffic in general. Routes 1, 2, and 3 incurred costs of $30,000, $18,000, and $12,000, respectively.

Total direct costs not controllable by segment managers were $500,000, of which 80% was traceable to freight traffic. Of the 20% traceable to passenger traffic, Routes 1, 2, and 3 should be charged $40,000, $20,000, and $15,000, respectively. The balance was not traceable to a specific route.

Total variable costs were $3.2 million, of which $2.0 million was freight traffic. Of the $1.2 million traceable to passenger traffic, $670,000, $400,000, and $130,000 were incurred by Routes 1, 2, and 3, respectively.

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Summary & Resources

The common fixed costs not clearly traceable to any part of the company amounted to $500,000. Serena has always allocated these costs using a percentage of sales basis.

Questions:

1. Serena asks you to prepare an earnings statement that shows the performance of each segment of the firm by various types of contribution margin.

2. Comment on what the results tell Serena.

Case: Bureau of Business and Economics Research

The Bureau of Business and Economics Research (BBER) at Western State University has contracted with the Fiscal Planning Office (FPO) of the state legislature to do economic analyses and forecasting. Most of the work involves computer operations using a large planning model and databases that the state Department of Commerce has assembled. The contract calls for payment of all direct costs of personnel with limits on the amount of chargeable time per quarter. An overhead rate is applied to personnel charges at 60% of direct personnel costs. This rate is developed by the university to cover common costs of operating the university plus personnel benefits of the persons working on the project.

Data processing costs are reimbursed on a cost basis and include additional equipment needed to perform the analyses, purchase of modeling software, computer time, and data storage.

An auditor from the state’s Auditor General’s Office has just finished a routine audit of this contract and has written a report critical of the BBER. Among the items noted are:

1. A large copy machine was leased by BBER to prepare reports for the FPO and charged to the contract. The BBER uses the machine for preparing many other reports for the university, including course materials.

2. Computer time is billed at the “average cost of computing time at priority level.” This rate is approximately eight times the rate faculty and students are charged for work done on the university’s server. The same rate is used for other outside customers of the computer center.

3. Personnel time was billed to the contract using a rate based on the contracting faculty person’s annual salary divided by 250 work days. But the auditor found that the work was actually done by a graduate student earning about 20% of the faculty person’s salary.

4. The software model purchased for FPO contract use has been adapted at low cost to perform analyses for several other BBER corporate clients. It is also used by two faculty members who are doing outside consulting on their own. Corporate clients are charged for the use of the model. The faculty use the model at nights and on weekends when the model is not otherwise used.

Questions:

1. Identify the parties that have an economic interest in these issues. 2. Does the BBER appear to be costing the contract with the FPO fairly? Evaluate each

issue, given the information available.

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