2 page research paper - accounting

BUSINESS FOCUS

Lowering Healthcare Costs and Improving Patient Care

Source: Catherine Arnst, “Radical Surgery,” Bloomberg Businessweek, January 18, 2010, pp. 40–45.

Providence Regional Medical Center’s (PRMC) “single stay” ward is lowering healthcare costs and increasing patient satisfaction. Rather than transporting post-surgical patients to stationary equipment throughout the hospital, a “single stay” ward brings all required equipment to stationary patients. For example, “after heart surgery, cardiac patients remain in one room throughout their recovery, only the gear and staff are in motion. As the patient’s condition stabilizes, the beeping machines of intensive care are removed and physical therapy equipment is added.” The results of this shift in orientation have been impressive. Patient satisfaction scores have skyrocketed and the average length of a patient’s stay in the hospital has declined by more than a day. 

LEARNING OBJECTIVES After studying Chapter 2, you should be able to:
LO2–1	Understand cost classifications used for assigning costs to cost objects: direct costs and indirect costs.
LO2–2	Identify and give examples of each of the three basic manufacturing cost categories.
LO2–3	Understand cost classifications used to prepare financial statements: product costs and period costs.
LO2–4	Understand cost classifications used to predict cost behavior: variable costs, fixed costs, and mixed costs.
LO2–5	Analyze a mixed cost using a scatter-graph plot and the high-low method.
LO2–6	Prepare income statements for a merchandising company using the traditional and contribution formats.
LO2–7	Understand cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs.
LO2–8	(Appendix 2A) Analyze a mixed cost using a scattergraph plot and the least-squares regression method.
LO2–9	(Appendix 2B) Identify the four types of quality costs and explain how they interact.
LO2–10	(Appendix 2B) Prepare and interpret a quality cost report.

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

Exhibit 2–1 summarizes the cost classifications that will be defined in this chapter, namely cost classifications (1) for assigning costs to cost objects, (2) for manufacturing companies, (3) for preparing financial statements, (4) for predicting cost behavior, and (5) for making decisions. As we begin defining the cost terminology related to each of these cost classifications, please refer back to this exhibit to help improve your understanding of the overall organization of the chapter.

EXHIBIT 2–1 Summary of Cost Classifications

Cost Classifications for Assigning Costs to Cost Objects

LO2–1

Understand cost classifications used for assigning costs to cost objects: direct costs and indirect costs.

Costs are assigned to cost objects for a variety of purposes including pricing, preparing profitability studies, and controlling spending. A cost object is anything for which cost data are desired—including products, customers, jobs, and organizational subunits. For purposes of assigning costs to cost objects, costs are classified as either direct or indirect.

Direct Cost

A direct cost is a cost that can be easily and conveniently traced to a specified cost object. For example, if Reebok is assigning costs to its various regional and national sales offices, then the salary of the sales manager in its Tokyo office would be a direct cost of that office. If a printing company made 10,000 brochures for a specific customer, then the cost of the paper used to make the brochures would be a direct cost of that customer.

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Indirect Cost

An indirect cost is a cost that cannot be easily and conveniently traced to a specified cost object. For example, a Campbell Soup factory may produce dozens of varieties of canned soups. The factory manager’s salary would be an indirect cost of a particular variety such as chicken noodle soup. The reason is that the factory manager’s salary is incurred as a consequence of running the entire factory—it is not incurred to produce any one soup variety. To be traced to a cost object such as a particular product, the cost must be caused by the cost object. The factory manager’s salary is called a common cost of producing the various products of the factory. Acommon cost is a cost that is incurred to support a number of cost objects but cannot be traced to them individually. A common cost is a type of indirect cost.

A particular cost may be direct or indirect, depending on the cost object. While the Campbell Soup factory manager’s salary is an indirect cost of manufacturing chicken noodle soup, it is a direct cost of the manufacturing division. In the first case, the cost object is chicken noodle soup. In the second case, the cost object is the entire manufacturing division.

Cost Classifications for Manufacturing Companies

Manufacturing companies such as Texas Instruments, Ford, and DuPontseparate their costs into two broad categories—manufacturing and nonmanufacturing costs.

Manufacturing Costs

LO2–2

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

Most manufacturing companies further separate their manufacturing costs into two direct cost categories, direct materials and direct labor, and one indirect cost category, manufacturing overhead. A discussion of each of these categories follows.

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

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

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

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

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IN BUSINESS

FOOD PRICES HIT RECORD HIGHS FOR RESTAURANTS

Direct material costs are critically important to restaurants and fast-food chains. In recent years, some food costs have spiked to record highs. For example, unexpected freezing temperatures in the southwestern portion of the United States caused the cost of lettuce to increase 290%. Similarly, the costs of green peppers, tomatoes, and cucumbers jumped 145%, 85%, and 30%, respectively. A large chain such as Subwaycan withstand these price increases better than smaller competitors because of its buying power and long-term contracts.

Source: Anne VanderMey, “Food For Thought,” Fortune, May 9, 2011, p. 12.

Labor costs that cannot be physically traced to particular products, or that can be traced only at great cost and inconvenience, are termed indirect labor. Just like indirect materials, indirect labor is treated as part of manufacturing overhead. Indirect labor includes the labor costs of janitors, supervisors, materials handlers, and night security guards. Although the efforts of these workers are essential, it would be either impractical or impossible to accurately trace their costs to specific units of product. Hence, such labor costs are treated as indirect labor.

Manufacturing Overhead   Manufacturing overhead, the third manufacturing cost category, includes all manufacturing costs except direct materials and direct labor. Manufacturing overhead includes items such as indirect materials; indirect labor; maintenance and repairs on production equipment; and heat and light, property taxes, depreciation, and insurance on manufacturing facilities. A company also incurs costs for heat and light, property taxes, insurance, depreciation, and so forth, associated with its selling and administrative functions, but these costs are not included as part of manufacturing overhead. Only those costs associated with operating the factory are included in manufacturing overhead.

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

Nonmanufacturing Costs

Nonmanufacturing costs are often divided into two categories: (1) selling costs and (2) administrative costs. Selling costs include all costs that are incurred to secure customer orders and get the finished product to the customer. These costs are sometimes called order-getting and order-fillingcosts. Examples of selling costs include advertising, shipping, sales travel, sales commissions, sales salaries, and costs of finished goods warehouses. Selling costs can be either direct or indirect costs. For example, the cost of an advertising campaign dedicated to one specific product is a direct cost of that product, whereas the salary of a marketing manager who oversees numerous products is an indirect cost with respect to individual products.

Administrative costs include all costs associated with the general management of an organization rather than with manufacturing or selling. Examples of administrative costs include executive compensation, general accounting, secretarial, public relations, and similar costs involved in the overall, general administration of the organization as a whole.Administrative costs can be either direct or indirect costs. For example, the salary of an accounting manager in charge of accounts receivable collections in the East region is a direct cost of that region, whereas the salary of a chief financial officer who oversees all of a company’s regions is an indirect cost with respect to individual regions.

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

Cost Classifications for Preparing Financial Statements

LO2–3

Understand cost classifications used to prepare financial statements: product costs and period costs.

When preparing a balance sheet and an income statement, companies need to classify their costs as product costs or period costs. To understand the difference between product costs and period costs, we must first discuss the matching principle from financial accounting.

Generally, costs are recognized as expenses on the income statement in the period that benefits from the cost. For example, if a company pays for liability insurance in advance for two years, the entire amount is not considered an expense of the year in which the payment is made. Instead, one-half of the cost would be recognized as an expense each year. The reason is that both years—not just the first year—benefit from the insurance payment. The unexpensed portion of the insurance payment is carried on the balance sheet as an asset called prepaid insurance.

The matching principle is based on the accrual concept that costs incurred to generate a particular revenue should be recognized as expenses in the same period that the revenue is recognized. This means that if a cost is incurred to acquire or make something that will eventually be sold, then the cost should be recognized as an expense only when the sale takes place—that is, when the benefit occurs. Such costs are called product costs.

Product Costs

For financial accounting purposes, product costs include all costs involved in acquiring or making a product. In the case of manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead.1Product costs “attach” to units of product as the goods are purchased or manufactured, and they remain attached as the goods go into inventory awaiting sale. Product costs are initially assigned to an inventory account on the balance sheet. When the goods are sold, the costs are released from inventory as expenses (typically called cost of goods sold) and matched against sales revenue on the income statement. Because product costs are initially assigned to inventories, they are also known asinventoriable costs.

We want to emphasize that product costs are not necessarily recorded as expenses on the income statement in the period in which they are incurred. Rather, as explained above, they are recorded as expenses in the period in which the related products are sold.

Period Costs

Period costs are all the costs that are not product costs. All selling and administrative expenses are treated as period costs. For example, sales commissions, advertising, executive salaries, public relations, and the rental costs of administrative offices are all period costs. Period costs are not included as part of the cost of either purchased or manufactured goods; instead, period costs are expensed on the income statement in the period in which they are incurred using the usual rules of accrual accounting. Keep in mind that the period in which a cost is incurred is not necessarily the period in which cash changes hands. For example, as discussed earlier, the costs of liability insurance are spread across the periods that benefit from the insurance—regardless of the period in which the insurance premium is paid.

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Prime Cost and Conversion Cost

Two more cost categories are often used in discussions of manufacturing costs—prime cost and conversion cost. Prime cost is the sum of direct materials cost and direct labor cost. Conversion cost is the sum of direct labor cost and manufacturing overhead cost. The term conversion cost is used to describe direct labor and manufacturing overhead because these costs are incurred to convert materials into the finished product.

To improve your understanding of these definitions, consider the following scenario: A company has reported the following costs and expenses for the most recent month:

d 

These costs and expenses can be categorized in a number of ways, including product costs, period costs, conversion costs, and prime costs:

IN BUSINESS

WALMART LOOKS TO REDUCE ITS SHIPPING COSTS

Walmart hopes to lower its shipping costs, thereby enabling it to reduce its “everyday low prices.” In years past, suppliers would ship their merchandise to Walmart’s distribution centers, and then Walmart would use its own fleet of trucks to ship goods from its distribution centers to its retail store locations. However, now Walmart wants to assume control of transporting merchandise from its suppliers’ manufacturing facilities to its distribution centers. Walmart believes it can lower these shipping costs by carrying more merchandise per truck and by taking advantage of volume purchase price discounts for fuel. In exchange for assuming these shipping responsibilities, Walmart is seeking price reductions from suppliers that it can pass along, at least in part, to its customers.

Source: Chris Burritt, Carol Wolf, and Matthew Boyle, “Why Wal-Mart Wants to Take the Driver’s Seat,” Bloomberg Businessweek, May 31–June 6, 2010, pp. 17–18.

Cost Classifications for Predicting Cost Behavior

LO2–4

Understand cost classifications used to predict cost behavior: variable costs, fixed costs, and mixed costs.

It is often necessary to predict how a certain cost will behave in response to a change in activity. For example, a manager at Under Armour may want to estimate the impact a 5 percent increase in sales would have on the company’s total direct materials cost. Cost behavior refers to how a cost reacts to changes in the level of activity. As the activity level rises and falls, a particular cost may rise and fall as well—or it may remain constant. For planning purposes, a manager must be able to anticipate which of these will happen; and if a cost can be expected to change, the manager must be able to estimate how much it will change. To help make such distinctions, costs are often categorized as variable, fixed, or mixed. The relative proportion of each type of cost in an organization is known as its cost structure. For example, an organization might have many fixed costs but few variable or mixed costs. Alternatively, it might have many variable costs but few fixed or mixed costs.

Variable Cost

A variable cost varies, in total, in direct proportion to changes in the level of activity. Common examples of variable costs include cost of goods sold for a merchandising company, direct materials, direct labor, variable elements of manufacturing overhead, such as indirect materials, supplies, and power, and variable elements of selling and administrative expenses, such as commissions and shipping costs.2

For a cost to be variable, it must be variable with respect to something.That “something” is its activity base. An activity base is a measure of whatever causes the incurrence of a variable cost. An activity base is sometimes referred to as a cost driver. Some of the most common activity bases are direct labor-hours, machine-hours, units produced, and units sold. Other examples of activity bases (cost drivers) include the number of miles driven by salespersons, the number of pounds of laundry cleaned by a hotel, the number of calls handled by technical support staff at a software company, and the number of beds occupied in a hospital. While there are many activity bases within organizations, throughout this textbook, unless stated otherwise, you should assume that the activity base under consideration is the total volume of goods and services provided by the organization. We will specify the activity base only when it is something other than total output.

To provide an example of a variable cost, consider Nooksack Expeditions, a small company that provides daylong whitewater rafting excursions on rivers in the North Cascade Mountains. The company provides all of the necessary equipment and experienced guides, and it serves gourmet meals to its guests. The meals are purchased from a caterer for $30 a person for a daylong excursion. The behavior of this variable cost, on both a per unit and a total basis, is shown below:

d 

 

IN BUSINESS

COST DRIVERS IN THE ELECTRONICS INDUSTRY

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

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

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IN BUSINESS

FOOD COSTS AT A LUXURY HOTEL

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

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

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

While total variable costs change as the activity level changes, it is important to note that a variable cost is constant if expressed on a per unitbasis. For example, the per unit cost of the meals remains constant at $30 even though the total cost of the meals increases and decreases with activity. The graph on the left-hand side of Exhibit 2–2 illustrates that the total variable cost rises and falls as the activity level rises and falls. At an activity level of 250 guests, the total meal cost is $7,500. At an activity level of 1,000 guests, the total meal cost rises to $30,000.

 

EXHIBIT 2–2 Variable and Fixed Cost Behavior

Fixed Cost

A fixed cost is a cost that remains constant, in total, regardless of changes in the level of activity. Examples of fixed costs include straight-line depreciation, insurance, property taxes, rent, supervisory salaries, administrative salaries, and advertising. Unlike variable costs, fixed costs are not affected by changes in activity. Consequently, as the activity level rises and falls, total fixed costs remain constant unless influenced by some outside force, such as a landlord increasing your monthly rental expense. To continue the Nooksack Expeditions example, assume the company rents a building for $500 per month to store its equipment. The total amount of rent paid is the same regardless of the number of guests the company takes on its expeditions during any given month. The concept of a fixed cost is shown graphically on the right-hand side of Exhibit 2–2.

Because total fixed costs remain constant for large variations in the level of activity, the average fixed cost per unit becomes progressively smaller as the level of activity increases. If Nooksack Expeditions has only 250 guests in a month, the $500 fixed rental cost would amount to an average of $2 per guest. If there are 1,000 guests, the fixed rental cost would average only 50 cents per guest. The table below illustrates this aspect of the behavior of fixed costs. Note that as the number of guests increase, the average fixed cost per guest drops.

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d 

As a general rule, we caution against expressing fixed costs on an average per unit basis in internal reports because it creates the false impression that fixed costs are like variable costs and that total fixed costs actually change as the level of activity changes.

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

The Linearity Assumption and the Relevant Range

Management accountants ordinarily assume that costs are strictly linear; that is, the relation between cost on the one hand and activity on the other can be represented by a straight line. Economists point out that many costs are actually curvilinear; that is, the relation between cost and activity is a curve. Nevertheless, even if a cost is not strictly linear, it can be approximated within a narrow band of activity known as the relevant rangeby a straight line. The relevant range is the range of activity within which the assumption that cost behavior is strictly linear is reasonably valid. Outside of the relevant range, a fixed cost may no longer be strictly fixed or a variable cost may not be strictly variable. Managers should always keep in mind that assumptions made about cost behavior may be invalid if activity falls outside of the relevant range.

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The concept of the relevant range is important in understanding fixed costs. For example, suppose the Mayo Clinic rents a machine for $20,000 per month that tests blood samples for the presence of leukemia cells. Furthermore, suppose that the capacity of the leukemia diagnostic machine is 3,000 tests per month. The assumption that the rent for the diagnostic machine is $20,000 per month is only valid within the relevant range of 0 to 3,000 tests per month. If the Mayo Clinic needed to test 5,000 blood samples per month, then it would need to rent another machine for an additional $20,000 per month. It would be difficult to rent half of a diagnostic machine; therefore, the step pattern depicted in Exhibit 2–3 is typical for such costs. This exhibit shows that the fixed rental expense is $20,000 for a relevant range of 0 to 3,000 tests. The fixed rental expense increases to $40,000 within the relevant range of 3,001 to 6,000 tests. The rental expense increases in discrete steps or increments of 3,000 tests, rather than increasing in a linear fashion per test.

EXHIBIT 2–3 Fixed Costs and the Relevant Range

This step-oriented cost behavior pattern can also be used to describe other costs, such as some labor costs. For example, salaried employee expenses can be characterized using a step pattern. Salaried employees are paid a fixed amount, such as $40,000 per year, for providing the capacity to work a prespecified amount of time, such as 40 hours per week for 50 weeks a year (= 2,000 hours per year). In this example, the total salaried employee expense is $40,000 within a relevant range of 0 to 2,000 hours of work. The total salaried employee expense increases to $80,000 (or two employees) if the organization’s work requirements expand to a relevant range of 2,001 to 4,000 hours of work. Cost behavior patterns such as salaried employees are often called step-variable costs. Step-variable costs can often be adjusted quickly as conditions change. Furthermore, the width of the steps for step-variable costs is generally so narrow that these costs can be treated essentially as variable costs for most purposes. The width of the steps for fixed costs, on the other hand, is so wide that these costs should be treated as entirely fixed within the relevant range.

Exhibit 2–4 summarizes four key concepts related to variable and fixed costs. Study it carefully before reading further.

 

EXHIBIT 2–4 Summary of Variable and Fixed Cost Behavior

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IN BUSINESS

HOW MANY GUIDES?

Majestic Ocean Kayaking, of Ucluelet, British Columbia, is owned and operated by Tracy Morben-Eeftink. The company offers a number of guided kayaking excursions ranging from three-hour tours of the Ucluelet harbor to six-day kayaking and camping trips in Clayoquot Sound. One of the company’s excursions is a four-day kayaking and camping trip to The Broken Group Islands in the Pacific Rim National Park. Special regulations apply to trips in the park—including a requirement that one certified guide must be assigned for every five guests or fraction thereof. For example, a trip with 12 guests must have at least three certified guides. Guides are not salaried and are paid on a per-day basis. Therefore, the cost to the company of the guides for a trip is a step-variable cost rather than a fixed cost or a strictly variable cost. One guide is needed for 1 to 5 guests, two guides for 6 to 10 guests, three guides for 11 to 15 guests, and so on.

Sources: Tracy Morben-Eeftink, owner, Majestic Ocean Kayaking. For more information about the company, see www.oceankayaking.com.

Mixed Costs

A mixed cost contains both variable and fixed cost elements. Mixed costs are also known as semivariable costs. To continue the Nooksack Expeditions example, the company incurs a mixed cost called fees paid to the state. It includes a license fee of $25,000 per year plus $3 per rafting party paid to the state’s Department of Natural Resources. If the company runs 1,000 rafting parties this year, then the total fees paid to the state would be $28,000, made up of $25,000 in fixed cost plus $3,000 in variable cost. Exhibit 2–5 depicts the behavior of this mixed cost.

 

EXHIBIT 2–5 Mixed Cost Behavior

Even if Nooksack fails to attract any customers, the company will still have to pay the license fee of $25,000. This is why the cost line in Exhibit 2–5intersects the vertical cost axis at the $25,000 point. For each rafting party the company organizes, the total cost of the state fees will increase by $3. Therefore, the total cost line slopes upward as the variable cost of $3 per party is added to the fixed cost of $25,000 per year.

Because the mixed cost in Exhibit 2–5 is represented by a straight line, the following equation for a straight line can be used to express the relationship between a mixed cost and the level of activity:

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Because the variable cost per unit equals the slope of the straight line, the steeper the slope, the higher the variable cost per unit.

In the case of the state fees paid by Nooksack Expeditions, the equation is written as follows:

This equation makes it easy to calculate the total mixed cost for any level of activity within the relevant range. For example, suppose that the company expects to organize 800 rafting parties in the next year. The total state fees would be calculated as follows:

The Analysis of Mixed Costs

Mixed costs are very common. For example, the overall cost of providing X-ray services to patients at the Harvard Medical School Hospital is a mixed cost. The costs of equipment depreciation and radiologists’ and technicians’ salaries are fixed, but the costs of X-ray film, power, and supplies are variable. At Southwest Airlines, maintenance costs are a mixed cost. The company incurs fixed costs for renting maintenance facilities and for keeping skilled mechanics on the payroll, but the costs of replacement parts, lubricating oils, tires, and so forth, are variable with respect to how often and how far the company’s aircraft are flown.

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The fixed portion of a mixed cost represents the minimum cost of having a service ready and available for use. The variable portion represents the cost incurred for actual consumption of the service, thus it varies in proportion to the amount of service actually consumed.

Managers can use a variety of methods to estimate the fixed and variable components of a mixed cost such as account analysis, the engineering approach, the high-low method, and least-squares regression analysis. Inaccount analysis, an account is classified as either variable or fixed based on the analyst’s prior knowledge of how the cost in the account behaves. For example, direct materials would be classified as variable and a building lease cost would be classified as fixed because of the nature of those costs. The engineering approach to cost analysis involves a detailed analysis of what cost behavior should be, based on an industrial engineer’s evaluation of the production methods to be used, the materials specifications, labor requirements, equipment usage, production efficiency, power consumption, and so on.

The high-low and least-squares regression methods estimate the fixed and variable elements of a mixed cost by analyzing past records of cost and activity data. We will use an example from Brentline Hospital to illustrate the high-low method calculations and to compare the resulting high-low method cost estimates to those obtained using least-squares regression.Appendix 2A demonstrates how to use Microsoft Excel to perform least-squares regression computations.

Diagnosing Cost Behavior with a Scattergraph Plot

LO2–5

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

Assume that Brentline Hospital is interested in predicting future monthly maintenance costs for budgeting purposes. The senior management team believes that maintenance cost is a mixed cost and that the variable portion of this cost is driven by the number of patient-days. Each day a patient is in the hospital counts as one patient-day. The hospital’s chief financial officer gathered the following data for the most recent seven-month period:

d 

The first step in applying the high-low method or the least-squares regression method is to diagnose cost behavior with a scattergraph plot. The scattergraph plot of maintenance costs versus patient-days at Brentline Hospital is shown in Exhibit 2–6. Two things should be noted about this scattergraph:

EXHIBIT 2–6 Scattergraph Method of Cost Analysis

1. The total maintenance cost, Y, is plotted on the vertical axis. Cost is known as the dependent variable because the amount of cost incurred during a period depends on the level of activity for the period. (That is, as the level of activity increases, total cost will also ordinarily increase.)

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2. The activity, X (patient-days in this case), is plotted on the horizontal axis. Activity is known as the independent variable because it causes variations in the cost.

From the scattergraph plot, it is evident that maintenance costs do increase with the number of patient-days in an approximately linear fashion. In other words, the points lie more or less along a straight line that slopes upward and to the right. Cost behavior is considered linear whenever a straight line is a reasonable approximation for the relation between cost and activity.

Plotting the data on a scattergraph is an essential diagnostic step that should be performed before performing the high-low method or least-squares regression calculations. If the scattergraph plot reveals linear cost behavior, then it makes sense to perform the high-low or least-squares regression calculations to separate the mixed cost into its variable and fixed components. If the scattergraph plot does not depict linear cost behavior, then it makes no sense to proceed any further in analyzing the data.

The High-Low Method

Assuming that the scattergraph plot indicates a linear relation between cost and activity, the fixed and variable cost elements of a mixed cost can be estimated using the high-low method or the least-squares regression method. The high-low method is based on the rise-over-run formula for the slope of a straight line. As previously discussed, if the relation between cost and activity can be represented by a straight line, then the slope of the straight line is equal to the variable cost per unit of activity. Consequently, the following formula can be used to estimate the variable cost:

To analyze mixed costs with the high-low method, begin by identifying the period with the lowest level of activity and the period with the highest level of activity. The period with the lowest activity is selected as the first point in the above formula and the period with the highest activity is selected as the second point. Consequently, the formula becomes:

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or

Therefore, when the high-low method is used, the variable cost is estimated by dividing the difference in cost between the high and low levels of activity by the change in activity between those two points.

To return to the Brentline Hospital example, using the high-low method, we first identify the periods with the highest and lowest activity—in this case, June and March. We then use the activity and cost data from these two periods to estimate the variable cost component as follows:

d 

Having determined that the variable maintenance cost is 80 cents per patient-day, we can now determine the amount of fixed cost. This is done by taking the total cost at either the high or the low activity level and deducting the variable cost element. In the computation below, total cost at the high activity level is used in computing the fixed cost element:

Both the variable and fixed cost elements have now been isolated. The cost of maintenance can be expressed as $3,400 per month plus 80 cents per patient-day or as:

The data used in this illustration are shown graphically in Exhibit 2–7. Notice that a straight line has been drawn through the points corresponding to the low and high levels of activity. In essence, that is what the high-low method does—it draws a straight line through those two points.

 

EXHIBIT 2–7 High-Low Method of Cost Analysis

Sometimes the high and low levels of activity don’t coincide with the high and low amounts of cost. For example, the period that has the highest level of activity may not have the highest amount of cost. Nevertheless, the costs at the highest and lowest levels of activity are always used to analyze a mixed cost under the high-low method. The reason is that the analyst would like to use data that reflect the greatest possible variation in activity.

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The high-low method is very simple to apply, but it suffers from a major (and sometimes critical) defect—it utilizes only two data points. Generally, two data points are not enough to produce accurate results. Additionally, the periods with the highest and lowest activity tend to be unusual. A cost formula that is estimated solely using data from these unusual periods may misrepresent the true cost behavior during normal periods. Such a distortion is evident in Exhibit 2–7. The straight line should probably be shifted down somewhat so that it is closer to more of the data points. For these reasons, least-squares regression will generally be more accurate than the high-low method.

The Least-Squares Regression Method

The least-squares regression method, unlike the high-low method, uses all of the data to separate a mixed cost into its fixed and variable components. A regression line of the form Y = a + bX is fitted to the data, where a represents the total fixed cost and b represents the variable cost per unit of activity. The basic idea underlying the least-squares regression method is illustrated in Exhibit 2–8 using hypothetical data points. Notice from the exhibit that the deviations from the plotted points to the regression line are measured vertically on the graph. These vertical deviations are called the regression errors. There is nothing mysterious about the least-squares regression method. It simply computes the regression line that minimizes the sum of these squared errors. The formulas that accomplish this are fairly complex and involve numerous calculations, but the principle is simple.

 

EXHIBIT 2–8 The Concept of Least-Squares Regression

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Fortunately, computers are adept at carrying out the computations required by the least-squares regression formulas. The data—the observed values of X and Y—are entered into the computer, and software does the rest. In the case of the Brentline Hospital maintenance cost data, a statistical software package on a personal computer can calculate the following least-squares regression estimates of the total fixed cost (a) and the variable cost per unit of activity (b):

Therefore, using the least-squares regression method, the fixed element of the maintenance cost is $3,431 per month and the variable portion is 75.9 cents per patient-day.

In terms of the linear equation Y = a + bX, the cost formula can be written as

where activity (X) is expressed in patient-days.

Appendix 2A discusses how to use Microsoft Excel to perform least-squares regression calculations. For now, you only need to understand that least-squares regression analysis generally provides more accurate cost estimates than the high-low method because, rather than relying on just two data points, it uses all of the data points to fit a line that minimizes the sum of the squared errors. The table below compares Brentline Hospital’s cost estimates using the high-low method and the least-squares regression method:

d 

When Brentline uses the least-squares regression method to create a straight line that minimizes the sum of the squared errors, it results in estimated fixed costs that are $31 higher than the amount derived using the high-low method. It also decreases the slope of the straight line resulting in a lower variable cost estimate of $0.759 per patient-day rather than $0.80 per patient-day as derived using the high-low method.

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IN BUSINESS

THE ZIPCAR COMES TO COLLEGE CAMPUSES

Zipcar is a car sharing service based in Cambridge, Massachusetts. The company serves 13 cities and 120 university campuses. Members pay a $50 annual fee plus $7 an hour to rent a car. They can use their iPhones to rent a car, locate it in the nearest Zipcar parking lot, unlock it using an access code, and drive it off the lot. This mixed cost arrangement is attractive to customers who need a car infrequently and wish to avoid the large cash outlay that comes with buying or leasing a vehicle.

Source: Jefferson Graham, “An iPhone Gets Zipcar Drivers on Their Way,” USA Today, September 30, 2009, p. 3B.

Traditional and Contribution Format Income Statements

LO2–6

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

In this section of the chapter, we discuss how to prepare traditional and contribution format income statements for a merchandising company.3Merchandising companies do not manufacture the products that they sell to customers. For example, Lowe’s and Home Depot are merchandising companies because they buy finished products from manufacturers and then resell them to end consumers.

The Traditional Format Income Statement

Traditional income statements are prepared primarily for external reporting purposes. The left-hand side of Exhibit 2–9 shows a traditional income statement format for merchandising companies. This type of income statement organizes costs into two categories—cost of goods sold and selling and administrative expenses. Sales minus cost of goods sold equals the gross margin. The gross margin minus selling and administrative expenses equals net operating income.

EXHIBIT 2–9 Comparing Traditional and Contribution Format Income Statements for Merchandising Companies (all numbers are given)

The cost of goods sold reports the product costs attached to the merchandise sold during the period. The selling and administrative expenses report all period costs that have been expensed as incurred. The cost of goods sold for a merchandising company can be computed directly by multiplying the number of units sold by their unit cost or indirectly using the equation below:

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For example, let’s assume that the company depicted in Exhibit 2–9purchased $3,000 of merchandise inventory during the period and had beginning and ending merchandise inventory balances of $7,000 and $4,000, respectively. The equation above could be used to compute the cost of goods sold as follows:

Although the traditional income statement is useful for external reporting purposes, it has serious limitations when used for internal purposes. It does not distinguish between fixed and variable costs. For example, under the heading “Selling and administrative expenses,” both variable administrative costs ($400) and fixed administrative costs ($1,500) are lumped together ($1,900). Internally, managers need cost data organized by cost behavior to aid in planning, controlling, and decision making. The contribution format income statement has been developed in response to these needs.

The Contribution Format Income Statement

The crucial distinction between fixed and variable costs is at the heart of the contribution approach to constructing income statements. The unique thing about the contribution approach is that it provides managers with an income statement that clearly distinguishes between fixed and variable costs and therefore aids planning, controlling, and decision making. The right-hand side of Exhibit 2–9 shows a contribution format income statement for merchandising companies.

The contribution approach separates costs into fixed and variable categories, first deducting variable expenses from sales to obtain thecontribution margin. For a merchandising company, cost of goods sold is a variable cost that gets included in the “Variable expenses” portion of the contribution format income statement. The contribution margin is the amount remaining from sales revenues after variable expenses have been deducted. This amount contributes toward covering fixed expenses and then toward profits for the period.

The contribution format income statement is used as an internal planning and decision-making tool. Its emphasis on cost behavior aids cost-volume-profit analysis (such as we shall be doing in a subsequent chapter), management performance appraisals, and budgeting. Moreover, the contribution approach helps managers organize data pertinent to numerous decisions such as product-line analysis, pricing, use of scarce resources, and make or buy analysis. All of these topics are covered in later chapters.

Cost Classifications for Decision Making

LO2–7

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

Costs are an important feature of many business decisions. In making decisions, it is essential to have a firm grasp of the concepts differential cost, opportunity cost, and sunk cost.

Differential Cost and Revenue

Decisions involve choosing between alternatives. In business decisions, each alternative will have costs and benefits that must be compared to the costs and benefits of the other available alternatives. A difference in costs between any two alternatives is known as a differential cost. A difference in revenues (usually just sales) between any two alternatives is known asdifferential revenue.

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A differential cost is also known as an incremental cost, although technically an incremental cost should refer only to an increase in cost from one alternative to another; decreases in cost should be referred to asdecremental costs. Differential cost is a broader term, encompassing both cost increases (incremental costs) and cost decreases (decremental costs) between alternatives.

The accountant’s differential cost concept can be compared to the economist’s marginal cost concept. In speaking of changes in cost and revenue, the economist uses the terms marginal cost and marginal revenue. The revenue that can be obtained from selling one more unit of product is called marginal revenue, and the cost involved in producing one more unit of product is called marginal cost. The economist’s marginal concept is basically the same as the accountant’s differential concept applied to a single unit of output.

Differential costs can be either fixed or variable. To illustrate, assume that Natural Cosmetics, Inc., is thinking about changing its marketing method from distribution through retailers to distribution by a network of neighborhood sales representatives. Present costs and revenues are compared to projected costs and revenues in the following table:

d 

According to the above analysis, the differential revenue is $100,000 and the differential costs total $85,000, leaving a positive differential net operating income of $15,000 in favor of using sales representatives.

In general, only the differences between alternatives are relevant in decisions. Those items that are the same under all alternatives and that are not affected by the decision can be ignored. For example, in the Natural Cosmetics, Inc., example above, the “Other expenses” category, which is $60,000 under both alternatives, can be ignored because it has no effect on the decision. If it were removed from the calculations, the sales representatives would still be preferred by $15,000. This is an extremely important principle in management accounting that we will revisit in later chapters.

Opportunity Cost and Sunk Cost

Opportunity cost is the potential benefit that is given up when one alternative is selected over another. For example, assume that you have a part-time job while attending college that pays $200 per week. If you spend one week at the beach during spring break without pay, then the $200 in lost wages would be an opportunity cost of taking the week off to be at the beach. Opportunity costs are not usually found in accounting records, but they are costs that must be explicitly considered in every decision a manager makes. Virtually every alternative involves an opportunity cost.

A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Because sunk costs cannot be changed by any decision, they are not differential costs. And because only differential costs are relevant in a decision, sunk costs should always be ignored.

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To illustrate a sunk cost, assume that a company paid $50,000 several years ago for a special-purpose machine. The machine was used to make a product that is now obsolete and is no longer being sold. Even though in hindsight purchasing the machine may have been unwise, the $50,000 cost has already been incurred and cannot be undone. And it would be folly to continue making the obsolete product in a misguided attempt to “recover” the original cost of the machine. In short, the $50,000 originally paid for the machine is a sunk cost that should be ignored in current decisions.

IN BUSINESS

THE ECONOMICS OF DRIVING YOUR DREAM CAR

The costs of buying, insuring, repairing, and garaging ultra-luxury vehicles can be very expensive. For example, the purchase price alone for a new Lamborghini or Bentley can easily exceed $300,000. Thus, Gotham Dream Cars offers an alternative to customers who want to drive ultra-luxury cars while avoiding the exorbitant costs of ownership. It sells fractional shares in luxury cars—the minimum price starts at $9,000 for 20 driving-days. George Johnson is a Gotham Dream Cars customer who spent $30,000 for 90 driving-days in two types of ultra-luxury vehicles. He noted that “it’s not worth it to buy one of these cars when you have to fix them.” In essence, Johnson compared the costs of ownership with the rental costs and decided to rent.

Source: David Kiley, “My Lamborghini—Today, Anyway,” BusinessWeek, January 14, 2008, p. 17.