MA W1

24

B

U S

I N

E S

S F

O C

U S

2

After studying Chapter 2, you

should be able to:

LO1 Identify and give examples of each of the three basic

manufacturing cost categories.

LO2 Distinguish between product costs and period costs and give

examples of each.

LO3 Understand cost behavior patterns including variable costs,

fixed costs, and mixed costs.

LO4 Analyze a mixed cost using a scattergraph plot and the high-

low method.

LO5 Prepare income statements for a merchandising company

using the traditional and

contribution formats.

LO6 Understand the differences between direct and indirect costs.

LO7 Understand cost classifications used in making decisions:

differential costs, opportunity

costs, and sunk costs.

LO8 (Appendix 2A) Analyze a mixed cost using a scattergraph

plot and the least-squares

regression method.

LO9 (Appendix 2B) Identify the four types of quality costs and

explain how they interact.

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

Managerial Accounting and Cost Concepts

C h

a p

t e

r

LEARNING OBJECTIVES

Understanding Costs Aids the Growth of a Billion Dollar Company

In 1986, Women’s World of Fitness went bank-

rupt despite having 14 locations and 50,000

members. The company’s owner, Gary Heavin,

says the fitness centers contained too many

costly amenities such as swimming pools, tan-

ning beds, cardio machines, kid’s programs,

juice bars, personal trainers, and aerobics

classes. As costs escalated, he attempted to

increase revenues by offering memberships

to men, which alienated his female members.

What did Heavin learn from his experience?

In 1992, Heavin founded a new brand

of women’s fitness centers called Curves . Rather than investing in every conceivable

piece of fitness equipment and amenity, Heavin focused on simplicity. He created a

simple fitness circuit that uses minimal equipment and is quick and easy for members

to complete. Instead of operating almost 24 hours a day, he decided to close his gyms

early. Even showers were deemed unnecessary. In short, Heavin eliminated numerous

costs that did not provide benefits in the eyes of his customers. With dramatically

lower costs, he has been able to maintain his “women only” approach while building a

billion dollar company with nearly 10,000 locations worldwide. ■

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

pp. 116–123.

Managerial Accounting and Cost Concepts 25

T his chapter explains that in managerial accounting the term cost is used in many different ways. The reason is that there are many types of costs, and these costs are classified differently according to the immediate needs of management. For example, managers may want cost data to prepare external

financial reports, to prepare planning budgets, or to make decisions. Each different use of cost data demands a different classification and definition of costs. For example, the preparation of external financial reports requires the use of historical cost data, whereas decision making may require predictions about future costs. This notion of different costs for different purposes is a critically important aspect of managerial accounting.

General Cost Classifications

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

Manufacturing Costs

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

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

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

Sometimes it isn’t worth the effort to trace the costs of relatively insignificant materi- als to end products. Such minor items would include the solder used to make electrical connections in a Sony TV 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 manu- facturing overhead, which is discussed later in this section.

Direct Labor Direct labor consists of labor costs that can be easily (i.e., physi- cally 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 , carpen- ters at the home builder KB Home, and electricians who install equipment on aircraft at Bombardier Learjet .

Labor costs that cannot be physically traced to particular products, or that can be traced only at great cost and inconvenience, are termed indirect labor . Just like indi- rect 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

LEARNING OBJECTIVE 1

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

26 Chapter 2

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 element of manu- facturing cost, includes all manufacturing costs except direct materials and direct labor. Manufacturing overhead includes items such as indirect materials; indirect labor; main- tenance and repairs on production equipment; and heat and light, property taxes, depre- ciation, 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 manu- facturing 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 manufac- turing 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 cus- tomer orders and get the finished product to the customer. These costs are sometimes called order-getting and order-filling costs. Examples of selling costs include advertis- ing, shipping, sales travel, sales commissions, sales salaries, and costs of finished goods warehouses.

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

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

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

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

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

Managerial Accounting and Cost Concepts 27

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

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

The matching principle is based on the accrual concept that costs incurred to gener- ate a particular revenue should be recognized as expenses in the same period that the

revenue is recognized. This means that if a cost is incurred to acquire or make something that will eventually be sold, then the cost should be recognized as an expense only when the sale takes place—that is, when the benefit occurs. Such costs are called product costs.

Product Costs

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

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

Period Costs

Period costs are all the costs that are not product costs. All selling and administrative expenses are treated as period costs. For example, sales commissions, advertising, exec- utive 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 manufac- tured 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 insur- ance premium is paid.

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.

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

Product Costs versus Period Costs

LEARNING OBJECTIVE 2

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

28 Chapter 2

E X H I B I T 2 – 1

Summary of Cost Terms

Administrative CostsSelling Costs

Prime Cost Conversion Cost

Nonmanufacturing Costs (Also called Period Costs

or Selling and Administrative Costs)

All costs necessary to secure customer orders and get the finished product or service to the customer (such as sales commissions, advertising, and depreciation of delivery equipment and finished goods warehouses).

All costs associated with the gen- eral management of the company as a whole (such as executive compensation, executive travel costs, secretarial salaries, and depreciation of office buildings and equipment).

Manufacturing OverheadDirect LaborDirect Materials

Materials that can be conveniently traced to a product (such as wood in a table).

Labor cost that can be physically and conveniently traced to a product (such as assembly-line workers in a plant). Direct labor is sometimes called touch labor.

All costs of manufacturing a product other than direct materials and direct labor (such as indirect materials, indirect labor, factory utilities, and depreciation of factory buildings and equipment).

Manufacturing Costs (Also called Product Costs

for financial accounting purposes)

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

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

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

Managerial Accounting and Cost Concepts 29

LEARNING OBJECTIVE 3

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

Cost Classifications for Predicting Cost Behavior

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

Variable Cost

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

For a cost to be variable, it must be variable with respect to something. That “some- thing” 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, through- out 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.

1 Direct labor costs often can be fixed instead of variable for a variety of reasons. For example, in some

countries, such as France, Germany, and Japan, labor regulations and cultural norms may limit manage-

ment’s ability to adjust the labor force in response to changes in activity. In this textbook, always assume

that direct labor is a variable cost unless you are explicitly told otherwise.

I N B U S I N E S S COST DRIVERS IN THE ELECTRONICS INDUSTRY Accenture Ltd. estimates that the U.S. electronics industry spends $13.8 billion annually to rebox, restock, and resell returned products. Conventional wisdom is that customers only return products when they are defective, but the data shows that this explanation only accounts for 5% of customer returns. The biggest cost drivers that cause product returns are that customers often inadvertently buy the wrong products and that they cannot understand how to use the products that they have pur- chased. 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 instruc- tion manuals with simpler guides that make it easier for customers to begin using their products.

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

To provide an example of a variable cost, consider Nooksack Expeditions, a small company that provides daylong whitewater rafting excursions on rivers in the North Cas- cade Mountains. The company provides all of the necessary equipment and experienced

30 Chapter 2

guides, and it serves gourmet meals to its guests. The meals are purchased from a caterer for $30 a person for a daylong excursion. The behavior of this variable cost, on both a per unit and a total basis, is shown below:

Number Cost of Meals Total Cost of Guests per Guest of Meals

250 . . . . . . . . . $30 $7,500 500 . . . . . . . . . $30 $15,000 750 . . . . . . . . . $30 $22,500 1,000 . . . . . . . . . $30 $30,000

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

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, prop- erty 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 .

E X H I B I T 2 – 2

Variable and Fixed Cost Behavior

$30,000

$25,000

$20,000

$15,000

$10,000

$5,000

$0

T o

ta l c o

s t

o f

m e

a ls

0 250 500 750 1,000

Number of guests

Total Cost of Meals

A variable cost increases, in total, in proportion to activity.

Cost of building rental

$500

$0 0 250 500 750 1,000 1,250

Number of guests

Total Cost of Renting the Building

Fixed costs remain constant in total dollar amount through

wide ranges of activity.

Managerial Accounting and Cost Concepts 31

As a general rule, we caution against expressing fixed costs on an average per unit basis in internal reports because it creates the false impression that fixed costs are like

variable costs and that total fixed costs actually change as the level of activity changes. For planning purposes, fixed costs can be viewed as either committed or discretion-

ary. 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, manage- ment 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 rela- tion 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

Monthly Rental Cost Number of Guests Average Cost per

Guest

$500 250 $2.00 $500 500 $1.00 $500 750 $0.67 $500 1,000 $0.50

Because total fixed costs remain constant for large variations in the level of activ- ity, the average fixed cost per unit becomes progressively smaller as the level of activ- ity 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.

I N B U S I N E S S 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.

32 Chapter 2

relation between cost and activity is a curve. Nevertheless, even if a cost is not strictly lin- ear, it can be approximated within a narrow band of activity known as the relevant range by a straight line as illustrated in Exhibit 2–3 . The relevant range is the range of activ- ity 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.

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 2–4 is typical for such costs. This exhibit shows that the fixed rental expense

E X H I B I T 2 – 3

Curvilinear Costs and the Relevant Range

E X H I B I T 2 – 4

Fixed Costs and the Relevant Range

Relevant range

C o s t

Volume

Economist’s curvilinear cost function

Accountant’s straight-line approximation

Number of Tests

C o s t

$20,000

$40,000

$60,000

0 3,000 6,000 9,000

Managerial Accounting and Cost Concepts 33

Behavior of the Cost (within the relevant range)

Cost In Total Per Unit

Variable cost Total variable cost increases Variable cost per unit remains and decreases in proportion to constant. changes in the activity level. Fixed cost Total xed cost is not affected Fixed cost per unit decreases by changes in the activity level as the activity level rises and within the relevant range. increases as the activity level falls.

E X H I B I T 2 – 5

Summary of Variable and Fixed Cost Behavior

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.

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 essen- tially 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 rel- evant range.

Exhibit 2–5 summarizes four key concepts related to variable and fixed costs. Study it carefully before reading further.

I N B U S I N E S S 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 com- pany’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

34 Chapter 2

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 2–6 depicts the behavior of this mixed cost.

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 2–6 intersects 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 2–6 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:

Y = a + bX

In this equation,

Y   =  The total mixed cost

a   =  The total fixed cost (the vertical intercept of the line)

b  =  The variable cost per unit of activity (the slope of the line)

X   =  The level of activity

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:

E X H I B I T 2 – 6

Mixed Cost Behavior $30,000

$29,000

$28,000

$27,000

$26,000

$25,000

$0 0 1,000500

Number of rafting parties

C o s t o f s ta te l ic e n s e f e e s

Variable

cost

element

Fixed

cost

element

Intercept = Total fixed cost

Slope = Variable cost per unit of activity

Y = $25,000 + $3.00X

Total Total Variable Activity mixed fixed cost per level cost cost unit of activity

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:

Y = $25,000 + ($3.00 per rafting party × 800 rafting parties)

= $27,400

Managerial Accounting and Cost Concepts 35

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.

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 compo- nents of a mixed cost such as account analysis, the engineering approach, the high-low method, and least-squares regression analysis. In account analysis , an account is classi- fied 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 effi- ciency, 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

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:

LEARNING OBJECTIVE 4

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

Activity Level: Maintenance Month Patient-Days Cost Incurred

January . . . . . . . . 5,600 $7,900 February . . . . . . 7,100 $8,500 March . . . . . . . . . 5,000 $7,400 April . . . . . . . . . . . 6,500 $8,200 May . . . . . . . . . . 7,300 $9,100 June . . . . . . . . . . 8,000 $9,800 July . . . . . . . . . . 6,200 $7,800

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 mainte- nance costs versus patient-days at Brentline Hospital is shown in Exhibit 2–7 . Two things should be noted about this scattergraph:

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

36 Chapter 2

the level of activity for the period. (That is, as the level of activity increases, total cost will also ordinarily increase.)

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 num- ber 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 per- formed 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 vari- able 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.

For example, suppose that Brentline Hospital’s management is interested in the rela- tion between the hospital’s telephone costs and patient-days. Patients are billed directly for their use of telephones, so those costs do not appear on the hospital’s cost records. Rather, management is concerned about the charges for the staff’s use of telephones. The data for this cost are plotted in Exhibit 2–8 . It is evident from the nonlinear data pattern that while the telephone costs do vary from month to month, they are not related to patient-days. Something other than patient-days is driving the telephone bills. Therefore, it would not make sense to analyze this cost any further by attempting to estimate a variable cost per patient-day for telephone costs. Plotting the data helps diagnose such situations.

Plotting the data on a scattergraph can also reveal nonlinear cost behavior patterns that warrant further data analysis. For example, assume that Brentline Hospital’s managers were interested in the relation between total nursing wages and the number of patient-days at the hospital. The permanent, full-time nursing staff can handle up to 7,000 patient-days in a month. Beyond that level of activity, part-time nurses must be called in to help out. The cost and activity data for nurses are plotted on the scattergraph in Exhibit 2–9 (see page 38). Looking at that scattergraph, it is evident that two straight lines would do a much better job of fitting the data than a single straight line. Up to 7,000 patient-days, total nurs- ing wages are essentially a fixed cost. Above 7,000 patient-days, total nursing wages are a

E X H I B I T 2 – 7

Scattergraph Method of Cost Analysis

$12,000 Plotting the Data

$10,000

$8,000

$6,000

$4,000

$2,000

$0

M a in te n a n c e c o s t

0 2,000 4,000 6,000 8,000 10,000

Patient-days

Y

X

Managerial Accounting and Cost Concepts 37

E X H I B I T 2 – 8

A Diagnostic Scattergraph Plot $16,000

$14,000

$12,000

$10,000

$8,000

$6,000

$4,000

$2,000

$0

T e le p h o n e c o s ts

0 2,000 4,000 6,000 8,000 10,000

Patient-days

Y

X

mixed cost. This happens because, as previously mentioned, the permanent, full-time nurs- ing staff can handle up to 7,000 patient-days in a month. Above that level, part-time nurses are called in to help, which adds to the cost. Consequently, two straight lines (and two equations) would be used to represent total nursing wages—one for the relevant range of 5,600 to 7,000 patient-days and one for the relevant range of 7,000 to 8,000 patient-days.

I N B U S I N E S S OPERATIONS DRIVE COSTS White Grizzly Adventures is a snowcat skiing and snowboarding company in Meadow Creek, British Columbia, that is owned and operated by Brad and Carole Karafil. The company shuttles 12 guests to the top of the company’s steep and tree-covered terrain in a modified snowcat. Guests stay as a group at the company’s lodge for a fixed number of days and are provided healthy gourmet meals.

Brad and Carole must decide each year when snowcat operations will begin in December and when they will end in early spring, and how many nonoperating days to schedule between groups of guests for maintenance and rest. These decisions affect a variety of costs. Examples of costs that are fixed and variable with respect to the number of days of operation at White Grizzly include:

Source: Brad and Carole Karafil, owners and operators of White Grizzly Adventures, www.whitegrizzly.com.

Cost Behavior—Fixed or Variable with Respect to Cost Days of Operation

Property taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fixed Summer road maintenance and tree clearing . . . . . . . . Fixed Lodge depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fixed Snowcat operator and guides . . . . . . . . . . . . . . . . . . . . Variable Cooks and lodge help . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable Snowcat depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . Variable Snowcat fuel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable Food* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable

*The costs of food served to guests theoretically depend on the number of guests in residence. However, the lodge is almost always lled to its capacity of 12 persons when the snowcat operation is running, so food costs can be consid- ered to be driven by the days of operation.

38 Chapter 2

The examples in Exhibits 2–8 and 2–9 illustrate why preparing a scattergraph plot is an essential diagnostic step that should not be overlooked.

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 rela- tion between cost and activity can be represented by a straight line, then the slope of the

$180,000

$160,000

$140,000

$120,000

$100,000

$80,000

$60,000

$40,000

$20,000

$0

T o ta l n u rs in g w a g e s

0 2,000 4,000 6,000 8,000 10,000

Patient-days

Relevant range Relevant range

Y

X

$180,000

$160,000

$140,000

$120,000

$100,000

$80,000

$60,000

$40,000

$20,000

$0

T o ta l n u rs in g w a g e s

0 2,000 4,000 6,000 8,000 10,000

Patient-days

Y

X

E X H I B I T 2 – 9

More than One Relevant Range

Managerial Accounting and Cost Concepts 39

straight line is equal to the variable cost per unit of activity. Consequently, the following formula can be used to estimate the variable cost:

Variable cost = Slope of the line = Rise ____ Run

= Y 2 − Y 1 _______ X 2 − X 1

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:

Variable cost = Y 2 − Y 1

_______ X 2 − X 1

= Cost at the high activity level − Cost at the low activity level

_________________________________________________ High activity level − Low activity level

or

Variable cost = Change in cost

_______________ Change in activity

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:

Variable cost = Change in cost

_______________ Change in activity

= $2,400 _______________

3,000 patient-days = $0.80 per patient-day

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 computa- tion below, total cost at the high activity level is used in computing the fixed cost element:

Fixed cost element = Total cost − Variable cost element

= $9,800 − ($0.80 per patient-day × 8,000 patient-days)

= $3,400

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

Y = $3,400 + $0.80X

Total Total maintenance patient-days cost

The data used in this illustration are shown graphically in Exhibit 2–10 . Notice that a straight line has been drawn through the points corresponding to the low and high levels

Maintenance Patient-Days Cost Incurred

High activity level (June) . . . . . . . . 8,000 $9,800 Low activity level (March) . . . . . . . 5,000 7,400

Change . . . . . . . . . . . . . . . . . . . . . . 3,000 $2,400

40 Chapter 2

of activity. In essence, that is what the high-low method does—it draws a straight line through those two points.

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.

The high-low method is very simple to apply, but it suffers from a major (and some- times 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 2–10 . 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 2–11 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 formu- las that accomplish this are fairly complex and involve numerous calculations, but the principle is simple.

E X H I B I T 2 – 1 0

High-Low Method of Cost Analysis

$12,000

$10,000

$8,000

$6,000

$4,000

$2,000

$0

M a in te n a n c e c o s t

0 2,000 4,000 6,000 8,000 10,000

Patient-days

Y

X

Slope = Variable cost: $0.80 per patient-day

Intercept = Fixed cost: $3,400

Point relating to the high activity level

Point relating to the low activity level

Activity Level

High Low

Patient- Days

8,000 5,000

Maintenance Cost

$9,800 $7,400

Managerial Accounting and Cost Concepts 41

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 Hos- pital 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 ):

a = $3,431

b = $0.759

Therefore, using the least-squares regression method, the fixed element of the main- tenance 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

Y = $3,431 + $0.759X

where activity ( X ) is expressed in patient-days. Appendix 2A discusses how to use Microsoft Excel to perform least-squares regres-

sion calculations. For now, you only need to understand that least-squares regression anal- ysis 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:

E X H I B I T 2 – 1 1

The Concept of Least-Squares Regression

Error Regression line Y = a + bX

Y

X

Level of activity

Actual Y

Estimated Y

C o s t

High-Low Method

Least-Squares Regression

Method

Variable cost estimate per patient-day . . . . . . . . . $0.800 $0.759 Fixed cost estimate per month . . . . . . . . . . . . . . . $3,400 $3,431

When the least-squares regression method is used to create a straight line that mini- mizes the sum of the squared errors, it results in a Y -intercept that is $31 higher than the Y -intercept 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.

42 Chapter 2

Traditional and Contribution Format Income Statements

I N B U S I N E S S 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.

In this section of the chapter, we discuss how to prepare traditional and contribution for- mat income statements for a merchandising company. 2 Merchandising companies do not manufacture the products that they sell to customers. For example, Walmart is a merchan- dising company because it buys finished products from manufacturers and then resells 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 2–12 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.

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

LEARNING OBJECTIVE 5

Prepare income statements for a merchandising company

using the traditional and contribution formats.

2 Subsequent chapters discuss the cost classifications used on the financial statements of manufacturing

companies.

E X H I B I T 2 – 1 2

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

Contribution Format

Sales . . . . . . . . . . . . . . . . . . . . $12,000 Variable expenses:

Cost of goods sold . . . . . . . . . $6,000 Variable selling . . . . . . . . . . . . 600 Variable administrative . . . . . . 400 7,000

Contribution margin . . . . . . . . . . 5,000

Fixed expenses: Fixed selling . . . . . . . . . . . . . . 2,500 Fixed administrative . . . . . . . . 1,500 4,000

Net operating income . . . . . . . . . $ 1,000

Traditional Format

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,000 Cost of goods sold* . . . . . . . . . . . . . . . 6,000

Gross margin . . . . . . . . . . . . . . . . . . 6,000 Selling and administrative expenses: Selling . . . . . . . . . . . . . . . . . . . . . . . . $3,100

Administrative . . . . . . . . . . . . . . . . . 1,900 5,000

Net operating income . . . . . . . . . . . . . $ 1,000

* For a manufacturing company, the cost of goods sold would include some variable costs, such as direct materials, direct labor, and variable overhead, and some xed costs, such as xed manufacturing overhead. Income state- ment formats for manufacturing companies will be explored in greater detail in a subsequent chapter.

Managerial Accounting and Cost Concepts 43

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:

Cost of goods sold

= Beginning

merchandise

inventory

+ Purchases − Ending

merchandise

inventory

For example, let’s assume that the company depicted in Exhibit 2–12 purchased $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:

Cost of goods

sold

= Beginning

merchandise

inventory

+ Purchases − Ending

merchandise

inventory

= $7,000 + $3,000 − $4,000

= $6,000

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 2–12 shows a contribution format income state- ment for merchandising companies.

The contribution approach separates costs into fixed and variable categories, first deducting variable expenses from sales to obtain the contribution margin. For a merchan- dising 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 apprais- als, 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 Assigning Costs to Cost Objects

Costs are assigned to cost objects for a variety of purposes including pricing, prepar- ing 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.

LEARNING OBJECTIVE 6

Understand the differences between direct and indirect costs.

44 Chapter 2

Direct Cost

A direct cost is a cost that can be easily and conveniently traced to a specified cost object. The concept of direct cost extends beyond just direct materials and direct labor. For exam- ple, 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.

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. A common 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 manufactur- ing division.

Cost Classifications for Decision Making

Costs are an important feature of many business decisions. In making decisions, it is essen- tial 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 between any two alternatives is known as differential revenue .

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 as decremental costs. Differential cost is a broader term, encompassing both cost increases (incremental costs) and cost decreases (decre- mental costs) between alternatives.

The accountant’s differential cost concept can be compared to the economist’s mar- ginal 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 basi- cally 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 Nature Way Cosmetics, Inc. , is thinking about changing its marketing method from distribution

LEARNING OBJECTIVE 7

Understand cost classifications used in making decisions:

differential costs, opportunity costs, and sunk costs.

Managerial Accounting and Cost Concepts 45

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 under the proposed marketing plan.

The decision of whether Nature Way Cosmetics should stay with the present retail distribution or switch to sales representatives could be made on the basis of the net oper- ating incomes of the two alternatives. As we see in the above analysis, the net operating income under the present distribution method is $160,000, whereas the net operating income with sales representatives is estimated to be $175,000. Therefore, using sales rep- resentatives is preferred because it would result in $15,000 higher net operating income. Note that we would have arrived at exactly the same conclusion by simply focusing on the differential revenues, differential costs, and differential net operating income, which also show a $15,000 advantage for 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 Nature Way Cosmetics 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 repre- sentatives 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

Opportunity cost is the potential benefit that is given up when one alternative is selected over another. To illustrate this important concept, consider the following examples:

Example 1 Vicki has a part-time job that pays $200 per week while attending college. She

would like to spend a week at the beach during spring break, and her employer has agreed to

give her the time off, but without pay. The $200 in lost wages would be an opportunity cost of

taking the week off to be at the beach.

Example 2 Suppose that Neiman Marcus is considering investing a large sum of money

in land that may be a site for a future store. Rather than invest the funds in land, the com-

pany could invest the funds in high-grade securities. The opportunity cost of buying the

land is the investment income that could have been realized by purchasing the securities

instead.

Retailer Sales Differential Distribution Representatives Costs and (present) (proposed) Revenues

Revenues (Variable) . . . . . . . . . . . . . . . . $700,000 $800,000 $100,000

Cost of goods sold (Variable) . . . . . . . . 350,000 400,000 50,000 Advertising (Fixed) . . . . . . . . . . . . . . . . 80,000 45,000 (35,000) Commissions (Variable) . . . . . . . . . . . . 0 40,000 40,000 Warehouse depreciation (Fixed) . . . . . . 50,000 80,000 30,000 Other expenses (Fixed) . . . . . . . . . . . . . 60,000 60,000 0

Total expenses . . . . . . . . . . . . . . . . . . . 540,000 625,000 85,000

Net operating income . . . . . . . . . . . . . . $160,000 $175,000 $ 15,000

through retailers to distribution by a network of neighborhood sales representatives. Present costs and revenues are compared to projected costs and revenues in the follow- ing table:

46 Chapter 2

Example 3 Steve is employed by a company that pays him a salary of $38,000 per year. He

is thinking about leaving the company and returning to school. Because returning to school

would require that he give up his $38,000 salary, the forgone salary would be an opportunity

cost of seeking further education.

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 alterna- tive involves an opportunity cost.

Sunk 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 deci- sion, they are not differential costs. And because only differential costs are relevant in a decision, sunk costs should always be ignored.

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 obso- lete 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.

Exhibit 2–13 summarizes the types of cost classifications that we discussed in this chapter. Refer to this exhibit to keep the big picture in mind, which is that different costs for different purposes is a critically important concept in management accounting. This chapter discussed four main cost classifications that managers can use for different pur- poses within organizations.

Purpose of Cost Classification

Preparing external nancial statements

Predicting cost behavior in response to changes in activity

Assigning costs to cost objects (e.g., departments or products)

Making decisions

Cost Classifications

• Product costs (inventoriable) • Direct materials • Direct labor • Manufacturing overhead

• Period costs (expensed) • Nonmanufacturing costs • Selling costs • Administrative costs

• Variable cost (proportional to activity) • Fixed cost (constant in total) • Mixed cost (has variable and xed elements)

• Direct cost (can be easily traced) • Indirect cost (cannot be easily traced)

• Differential cost (differs between alternatives) • Sunk cost (past cost not affected by a decision)

• Opportunity cost (forgone bene t)

E X H I B I T 2 – 1 3

Summary of Cost Classifications

Managerial Accounting and Cost Concepts 47

Review Problem 1: Cost Terms

Many new cost terms have been introduced in this chapter. It will take you some time to learn what each term means and how to properly classify costs in an organization. Consider the following example: Porter Company manufactures furniture, including tables. Selected costs are given below: 1. The tables are made of wood that costs $100 per table. 2. The tables are assembled by workers, at a wage cost of $40 per table. 3. Workers assembling the tables are supervised by a factory supervisor who is paid $38,000

per year. 4. Electrical costs are $2 per machine-hour. Four machine-hours are required to produce a table. 5. The depreciation on the machines used to make the tables totals $10,000 per year. The

machines have no resale value and do not wear out through use. 6. The salary of the president of the company is $100,000 per year. 7. The company spends $250,000 per year to advertise its products. 8. Salespersons are paid a commission of $30 for each table sold. 9. Instead of producing the tables, the company could rent its factory space for $50,000 per year.

Required:

Classify these costs according to the various cost terms used in the chapter. Carefully study the classification of each cost. If you don’t understand why a particular cost is classified the way it is,

Summary

In this chapter, we have discussed ways in which managers classify costs. How the costs will be used—for preparing external reports, predicting cost behavior, assigning costs to cost objects, or decision making—will dictate how the costs are classified.

For external reporting purposes, costs are classified as either product costs or period costs. Product costs are assigned to inventories and are considered assets until the products are sold. At the point of sale, product costs become cost of goods sold on the income statement. In con- trast, period costs are taken directly to the income statement as expenses in the period in which they are incurred.

For purposes of predicting how costs will react to changes in activity, costs are classified into three categories—variable, fixed, and mixed. Variable costs, in total, are strictly proportional to activity. The variable cost per unit is constant. Fixed costs, in total, remain the same as the activity level changes within the relevant range. The average fixed cost per unit decreases as the activity level increases. Mixed costs consist of variable and fixed elements and can be expressed in equa- tion form as Y   =   a   +   bX, where X is the activity, Y is the cost, a is the fixed cost element, and b is the variable cost per unit of activity.

If the relation between cost and activity appears to be linear based on a scattergraph plot, then the variable and fixed components of a mixed cost can be estimated using the high-low method, which implicitly draws a straight line through the points of lowest activity and highest activity, or the least-squares regression method, which uses all of the data points to compute a regression line that minimizes the sum of the squares errors.

The traditional income statement format is used primarily for external reporting purposes. It organizes costs using product and period cost classifications. The contribution format income state- ment aids decision making because it organizes costs using variable and fixed cost classifications.

For purposes of assigning costs to cost objects such as products or departments, costs are clas- sified as direct or indirect. Direct costs can be conveniently traced to cost objects. Indirect costs cannot be conveniently traced to cost objects.

For purposes of making decisions, the concepts of differential cost and revenue, opportunity cost, and sunk cost are vitally important. Differential costs and revenues are the costs and revenues that differ between alternatives. Opportunity cost is the benefit that is forgone when one alternative is selected over another. Sunk cost is a cost that occurred in the past and cannot be altered. Dif- ferential costs and opportunity costs should be carefully considered in decisions. Sunk costs are always irrelevant in decisions and should be ignored.

48 Chapter 2

reread the section of the chapter discussing the particular cost term. The terms variable cost and fixed cost refer to how costs behave with respect to the number of tables produced in a year.

Solution to Review Problem 1

Period

(Selling and

Variable Fixed Administrative) Direct Direct Manufacturing Sunk Opportunity

Cost Cost Cost Materials Labor Overhead Cost Cost

1. Wood used in a table

($100 per table) . . . . . . . . . . X X

2. Labor cost to assemble

a table ($40 per table) . . . . . X X

3. Salary of the factory

supervisor ($38,000 per

year) . . . . . . . . . . . . . . . . . . . . X X

4. Cost of electricity to

produce tables ($2 per

machine-hour) . . . . . . . . . . . X X

5. Depreciation of machines

used to produce tables

($10,000 per year) . . . . . . . . X X X*

6. Salary of the company

president ($100,000 per

year) . . . . . . . . . . . . . . . . . . . . X X

7. Advertising expense

($250,000 per

year) . . . . . . . . . . . . . . . . . . X X

8. Commissions paid

to salespersons

($30 per table sold) . . . . . . . X X

9. Rental income forgone on

factory space . . . . . . . . . . . . X†

*This is a sunk cost because the outlay for the equipment was made in a previous period. †This is an opportunity cost because it represents the potential benefit that is lost or sacrificed as a result of using the factory space to produce tables. Opportunity cost is a special category of cost that is not ordinarily recorded in an organization’s accounting records. To avoid possible confusion with other costs, we will not attempt to classify this cost in any other way except as an opportunity cost.

Product Cost

Review Problem 2: High-Low Method

The administrator of Azalea Hills Hospital would like a cost formula linking the administrative costs involved in admitting patients to the number of patients admitted during a month. The Admit- ting Department’s costs and the number of patients admitted during the immediately preceding eight months are given in the following table:

Number of Admitting

Month Patients Admitted Department Costs

May . . . . . . . . . . . . . . . 1,800 $14,700

June . . . . . . . . . . . . . . 1,900 $15,200

July . . . . . . . . . . . . . . 1,700 $13,700

August . . . . . . . . . . . . 1,600 $14,000

September . . . . . . . . . 1,500 $14,300

October . . . . . . . . . . . . 1,300 $13,100

November . . . . . . . . . . 1,100 $12,800

December . . . . . . . . . . 1,500 $14,600

Managerial Accounting and Cost Concepts 49

Required:

1. Use the high-low method to estimate the fixed and variable components of admitting costs. 2. Express the fixed and variable components of admitting costs as a cost formula in the form

Y   =   a   +   bX.

Solution to Review Problem 2 1. The first step in the high-low method is to identify the periods of the lowest and highest activ-

ity. Those periods are November (1,100 patients admitted) and June (1,900 patients admitted).

The second step is to compute the variable cost per unit using those two data points:

Number of Admitting

Month Patients Admitted Department Costs

High activity level (June) . . . . . . . . . . . 1,900 $15,200

Low activity level (November) . . . . . . . 1,100 12,800

Change . . . . . . . . . . . . . . . . . . . . . . . . 800 $ 2,400

Variable cost = Change in cost

_______________ Change in activity

= $2,400

__________________ 800 patients admitted

= $3 per patient admitted

The third step is to compute the fixed cost element by deducting the variable cost element from the total cost at either the high or low activity. In the computation below, the high point of activity is used:

Fixed cost element = Total cost − Variable cost element

= $15,200 − ($3 per patient admitted × 1,900 patients admitted)

= $9,500

2. The cost formula is Y   =  $9,500  +  $3 X.

Glossary

Account analysis A method for analyzing cost behavior in which an account is classified as either variable or fixed based on the analyst’s prior knowledge of how the cost in the account behaves. (p. 35)

Activity base A measure of whatever causes the incurrence of a variable cost. For example, the total cost of X-ray film in a hospital will increase as the number of X-rays taken increases. Therefore, the number of X-rays is the activity base that explains the total cost of X-ray film. (p. 29)

Administrative costs All executive, organizational, and clerical costs associated with the general management of an organization rather than with manufacturing or selling. (p. 26)

Committed fixed costs Investments in facilities, equipment, and basic organizational structure that can’t be significantly reduced even for short periods of time without making fundamental changes. (p. 31)

Common cost A cost that is incurred to support a number of cost objects but that cannot be traced to them individually. For example, the wage cost of the pilot of a 747 airliner is a common cost of all of the passengers on the aircraft. Without the pilot, there would be no flight and no passengers. But no part of the pilot’s wage is caused by any one passenger taking the flight. (p. 44)

50 Chapter 2

Contribution approach An income statement format that organizes costs by their behavior. Costs are separated into variable and fixed categories rather than being separated into product and period costs for external reporting purposes. (p. 43)

Contribution margin The amount remaining from sales revenues after all variable expenses have been deducted. (p. 43)

Conversion cost Direct labor cost plus manufacturing overhead cost. (p. 27) Cost behavior The way in which a cost reacts to changes in the level of activity. (p. 29) Cost object Anything for which cost data are desired. Examples of cost objects are products, cus-

tomers, jobs, and parts of the organization such as departments or divisions. (p. 43) Cost structure The relative proportion of fixed, variable, and mixed costs in an organization.

(p. 29) Dependent variable A variable that responds to some causal factor; total cost is the dependent

variable, as represented by the letter Y, in the equation Y   =   a   +   bX. (p. 35) Differential cost A difference in cost between two alternatives. Also see Incremental cost.

(p. 44) Differential revenue The difference in revenue between two alternatives. (p. 44) Direct cost A cost that can be easily and conveniently traced to a specified cost object. (p. 44) Direct labor Factory labor costs that can be easily traced to individual units of product. Also

called touch labor. (p. 25) Direct materials Materials that become an integral part of a finished product and whose costs can

be conveniently traced to it. (p. 25) Discretionary fixed costs Those fixed costs that arise from annual decisions by management to

spend on certain fixed cost items, such as advertising and research. (p. 31) Engineering approach A detailed analysis of cost behavior based on an industrial engineer’s

evaluation of the inputs that are required to carry out a particular activity and of the prices of those inputs. (p. 35)

Fixed cost A cost that remains constant, in total, regardless of changes in the level of activity within the relevant range. If a fixed cost is expressed on a per unit basis, it varies inversely with the level of activity. (p. 30)

High-low method A method of separating a mixed cost into its fixed and variable elements by analyzing the change in cost between the high and low activity levels. (p. 39)

Incremental cost An increase in cost between two alternatives. Also see Differential cost. (p. 44) Independent variable A variable that acts as a causal factor; activity is the independent variable,

as represented by the letter X, in the equation Y   =   a   +   bX. (p. 36) Indirect cost A cost that cannot be easily and conveniently traced to a specified cost object.

(p. 44) Indirect labor The labor costs of janitors, supervisors, materials handlers, and other factory

workers that cannot be conveniently traced to particular products. (p. 25) Indirect materials Small items of material such as glue and nails that may be an integral part of a

finished product, but whose costs cannot be easily or conveniently traced to it. (p. 25) Inventoriable costs Synonym for product costs. (p. 27) Least-squares regression method A method of separating a mixed cost into its fixed and variable

elements by fitting a regression line that minimizes the sum of the squared errors. (p. 40) Linear cost behavior Cost behavior is said to be linear whenever a straight line is a reasonable

approximation for the relation between cost and activity. (p. 36) Manufacturing overhead All manufacturing costs except direct materials and direct labor.

(p. 26) Mixed cost A cost that contains both variable and fixed cost elements. (p. 33) Opportunity cost The potential benefit that is given up when one alternative is selected over

another. (p. 45) Period costs Costs that are taken directly to the income statement as expenses in the period in

which they are incurred or accrued. (p. 27) Prime cost Direct materials cost plus direct labor cost. (p. 27) Product costs All costs that are involved in acquiring or making a product. In the case of manufac-

tured goods, these costs consist of direct materials, direct labor, and manufacturing overhead. Also see Inventoriable costs. (p. 27)

Managerial Accounting and Cost Concepts 51

2–1 What are the three major elements of product costs in a manufacturing company? 2–2 Define the following: (a) direct materials, (b) indirect materials, (c) direct labor,

(d) indirect labor, and (e) manufacturing overhead. 2–3 Explain the difference between a product cost and a period cost. 2–4 Distinguish between ( a ) a variable cost, ( b ) a fixed cost, and ( c ) a mixed cost. 2–5 What effect does an increase in volume have on—

a. Unit fixed costs? b. Unit variable costs? c. Total fixed costs? d. Total variable costs?

2–6 Define the following terms: ( a ) cost behavior and ( b ) relevant range. 2–7 What is meant by an activity base when dealing with variable costs? Give several exam-

ples of activity bases. 2–8 Managers often assume a strictly linear relationship between cost and volume. How can

this practice be defended in light of the fact that many costs are curvilinear? 2–9 Distinguish between discretionary fixed costs and committed fixed costs. 2–10 Does the concept of the relevant range apply to fixed costs? Explain. 2–11 What is the major disadvantage of the high-low method? 2–12 Give the general formula for a mixed cost. Which term represents the variable cost? The

fixed cost? 2–13 What is meant by the term least-squares regression? 2–14 What is the difference between a contribution format income statement and a traditional

format income statement? 2–15 What is the contribution margin? 2–16 Define the following terms: differential cost, opportunity cost, and sunk cost. 2–17 Only variable costs can be differential costs. Do you agree? Explain.

Multiple-choice questions are provided on the text website at www.mhhe.com/garrison14e .

Raw materials Any materials that go into the final product. (p. 25) Relevant range The range of activity within which assumptions about variable and fixed cost

behavior are valid. (p. 32) Selling costs All costs that are incurred to secure customer orders and get the finished product or

service into the hands of the customer. (p. 26) Sunk cost A cost that has already been incurred and that cannot be changed by any decision made

now or in the future. (p. 46) Variable cost A cost that varies, in total, in direct proportion to changes in the level of activity.

A variable cost is constant per unit. (p. 29)

Questions

Applying Excel

Available with McGraw-Hill’s Connect™ Accounting.

The Excel worksheet form that appears on the next page is to be used to recreate Exhibit 2–12 on page 42. Download the workbook containing this form from the Online Learning Center at www. mhhe.com/garrison14e. On the website you will also receive instructions about how to use this worksheet form.

LEARNING OBJECTIVE 5

52 Chapter 2

Required:

1. Check your worksheet by changing the variable selling cost in the Data area to $900, keeping all of the other data the same as in Exhibit 2–12. If your worksheet is operating properly, the net operating income under the traditional format income statement and under the contribu- tion format income statement should now be $700 and the contribution margin should now be $4,700. If you do not get these answers, find the errors in your worksheet and correct them. How much is the gross margin? Did it change? Why or why not?

2. Suppose that sales are 10% higher as shown below:

Enter this new data into your worksheet. Make sure that you change all of the data that are different—not just the sales. Print or copy the income statements from your worksheet. What happened to the variable costs and to the fixed costs when sales increased by 10%? Why? Did the contribution margin increase by 10%? Why or why not? Did the net operating income increase by 10%? Why or why not?

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,200

Variable costs:

Cost of goods sold . . . . . . . . . . . . . . . . . $6,600

Variable selling . . . . . . . . . . . . . . . . . . . . $990

Variable administrative . . . . . . . . . . . . . . $440

Fixed costs:

Fixed selling . . . . . . . . . . . . . . . . . . . . . . $2,500

Fixed administrative . . . . . . . . . . . . . . . . $1,500

Managerial Accounting and Cost Concepts 53

All applicable exercises are available with McGraw-Hill’s Connect™ Accounting .

EXERCISE 2–1 Classifying Manufacturing Costs [LO1] Your Boat, Inc., assembles custom sailboats from components supplied by various manufacturers. The company is very small and its assembly shop and retail sales store are housed in a Gig Harbor, Washington, boathouse. Below are listed some of the costs that are incurred at the company.

Required:

For each cost, indicate whether it would most likely be classified as direct labor, direct materials, manufacturing overhead, selling, or an administrative cost. 1. The wages of employees who build the sailboats. 2. The cost of advertising in the local newspapers. 3. The cost of an aluminum mast installed in a sailboat. 4. The wages of the assembly shop’s supervisor. 5. Rent on the boathouse. 6. The wages of the company’s bookkeeper. 7. Sales commissions paid to the company’s salespeople. 8. Depreciation on power tools.

EXERCISE 2–2 Classification of Costs as Period or Product Costs [LO2]

Suppose that you have been given a summer job at Fairwings Avionics, a company that manufac- tures sophisticated radar sets for commercial aircraft. The company, which is privately owned, has approached a bank for a loan to help finance its tremendous growth. The bank requires financial statements before approving such a loan.

Required:

Classify each cost listed below as either a product cost or a period cost for purposes of preparing the financial statements for the bank. 1. The cost of the memory chips used in a radar set. 2. Factory heating costs. 3. Factory equipment maintenance costs. 4. Training costs for new administrative employees. 5. The cost of the solder that is used in assembling the radar sets. 6. The travel costs of the company’s salespersons. 7. Wages and salaries of factory security personnel. 8. The cost of air-conditioning executive offices. 9. Wages and salaries in the department that handles billing customers. 10. Depreciation on the equipment in the fitness room used by factory workers. 11. Telephone expenses incurred by factory management. 12. The costs of shipping completed radar sets to customers. 13. The wages of the workers who assemble the radar sets. 14. The president’s salary. 15. Health insurance premiums for factory personnel.

EXERCISE 2–3 Fixed and Variable Cost Behavior [LO3] Koffee Express operates a number of espresso coffee stands in busy suburban malls. The fixed weekly expense of a coffee stand is $1,100 and the variable cost per cup of coffee served is $0.26.

Required:

1. Fill in the following table with your estimates of total costs and average cost per cup of coffee at the indicated levels of activity for a coffee stand. Round off the cost of a cup of coffee to the nearest tenth of a cent.

Cups of Coffee Served in a Week

1,800 1,900 2,000

Fixed cost . . . . . . . . . . . . . . . . . . . . . . . . . . ? ? ?

Variable cost . . . . . . . . . . . . . . . . . . . . . . . . ? ? ?

Total cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ? ? ?

Average cost per cup of coffee served . . . . ? ? ?

Exercises

54 Chapter 2

2. Does the average cost per cup of coffee served increase, decrease, or remain the same as the number of cups of coffee served in a week increases? Explain.

EXERCISE 2–4 High-Low Method [LO4]

The Edelweiss Hotel in Vail, Colorado, has accumulated records of the total electrical costs of the hotel and the number of occupancy-days over the last year. An occupancy-day represents a room rented out for one day. The hotel’s business is highly seasonal, with peaks occurring during the ski season and in the summer.

Month

Occupancy-

Days

Electrical

Costs

January . . . . . . . . . 2,604 $6,257

February . . . . . . . . 2,856 $6,550

March . . . . . . . . . . . 3,534 $7,986

April . . . . . . . . . . . 1,440 $4,022

May . . . . . . . . . . . . 540 $2,289

June . . . . . . . . . . . 1,116 $3,591

July . . . . . . . . . . . . . 3,162 $7,264

August . . . . . . . . . 3,608 $8,111

September . . . . . . 1,260 $3,707

October . . . . . . . . . 186 $1,712

November . . . . . . . 1,080 $3,321

December . . . . . . . 2,046 $5,196

Required:

1. Using the high-low method, estimate the fixed cost of electricity per month and the variable cost of electricity per occupancy-day. Round off the fixed cost to the nearest whole dollar and the variable cost to the nearest whole cent.

2. What other factors other than occupancy-days are likely to affect the variation in electrical costs from month to month?

EXERCISE 2–5 Traditional and Contribution Format Income Statements [LO5]

Redhawk, Inc., is a merchandiser that provided the following information:

Number of units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Selling price per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15

Variable selling expense per unit . . . . . . . . . . . . . . . . . . . $2

Variable administrative expense per unit . . . . . . . . . . . . . . $1

Total xed selling expense . . . . . . . . . . . . . . . . . . . . . . . . $20,000

Total xed administrative expense . . . . . . . . . . . . . . . . . . . $15,000

Merchandise inventory, beginning balance . . . . . . . . . . . . $12,000

Merchandise inventory, ending balance . . . . . . . . . . . . . . $22,000

Merchandise purchases . . . . . . . . . . . . . . . . . . . . . . . . . . $90,000

Required:

1. Prepare a traditional income statement. 2. Prepare a contribution format income statement.

EXERCISE 2–6 Identifying Direct and Indirect Costs [LO6]

The Empire Hotel is a four-star hotel located in downtown Seattle.

Required:

For each of the following costs incurred at the Empire Hotel, indicate whether it would most likely be a direct cost or an indirect cost of the specified cost object by placing an X in the appropriate column.

Managerial Accounting and Cost Concepts 55

EXERCISE 2–7 Differential, Opportunity, and Sunk Costs [LO7]

The Sorrento Hotel is a four-star hotel located in downtown Seattle. The hotel’s operations vice president would like to replace the hotel’s antiquated computer terminals at the registration desk with attractive state-of-the-art flat-panel displays. The new displays would take less space, would consume less power than the old computer terminals, and would provide additional security since they can only be viewed from a restrictive angle. The new computer displays would not require any new wiring. The hotel’s chef believes the funds would be better spent on a new bulk freezer for the kitchen.

Required:

For each of the items below, indicate by placing an X in the appropriate column whether it should be considered a differential cost, an opportunity cost, or a sunk cost in the decision to replace the old computer terminals with new flat-panel displays. If none of the categories apply for a particular item, leave all columns blank.

Cost Cost Object

Direct

Cost

Indirect

Cost

Ex. Room service beverages A particular hotel guest X

1. The salary of the head chef The hotel’s restaurant

2. The salary of the head chef A particular restaurant customer

3. Room cleaning supplies A particular hotel guest

4. Flowers for the reception desk A particular hotel guest

5. The wages of the doorman A particular hotel guest

6. Room cleaning supplies The housecleaning department

7. Fire insurance on the hotel building The hotel’s gym

8. Towels used in the gym The hotel’s gym

Item

Differential

Cost

Opportunity

Cost

Sunk

Cost

Ex. Cost of electricity to run the terminals . . . . . . . . . . . . . . . X

1. Cost of the new ! at-panel displays . . . . . . . . . . . . . . . . .

2. Cost of the old computer terminals . . . . . . . . . . . . . . . . .

3. Rent on the space occupied by the registration desk . . .

4. Wages of registration desk personnel . . . . . . . . . . . . . . .

5. Bene ts from a new freezer . . . . . . . . . . . . . . . . . . . . . . . .

6. Costs of maintaining the old computer terminals . . . . . . .

7. Cost of removing the old computer terminals . . . . . . . . .

8. Cost of existing registration desk wiring . . . . . . . . . . . . .

EXERCISE 2–8 Cost Behavior; Contribution Format Income Statement [LO3, LO5]

Parker Company manufactures and sells a single product. A partially completed schedule of the company’s total and per unit costs over a relevant range of 60,000 to 100,000 units produced and sold each year is given below:

Units Produced and Sold

60,000 80,000 100,000

Total costs:

Variable costs . . . . . . . . . $150,000 ? ?

Fixed costs . . . . . . . . . . . 360,000 ? ?

Total costs . . . . . . . . . . . . . $510,000 ? ?

Cost per unit:

Variable cost . . . . . . . . . . ? ? ?

Fixed cost . . . . . . . . . . . . ? ? ?

Total cost per unit . . . . . . . . ? ? ?

56 Chapter 2

Required:

1. Complete the schedule of the company’s total and unit costs. 2. Assume that the company produces and sells 90,000 units during the year at the selling price

of $7.50 per unit. Prepare a contribution format income statement for the year.

EXERCISE 2–9 Cost Classification [LO1, LO2, LO3, LO7]

Several years ago Medex Company purchased a small building adjacent to its manufacturing plant in order to have room for expansion when needed. Since the company had no immediate need for the extra space, the building was rented out to another company for rental revenue of $40,000 per year. The renter’s lease will expire next month, and rather than renewing the lease, Medex Com- pany has decided to use the building itself to manufacture a new product.

Direct materials cost for the new product will total $40 per unit. It will be necessary to hire a supervisor to oversee production. Her salary will be $2,500 per month. Workers will be hired to manufacture the new product, with direct labor cost amounting to $18 per unit. Manufacturing operations will occupy all of the building space, so it will be necessary to rent space in a warehouse nearby in order to store finished units of product. The rental cost will be $1,000 per month. In addi- tion, the company will need to rent equipment for use in producing the new product; the rental cost will be $3,000 per month. The company will continue to depreciate the building on a straight-line basis, as in past years. Depreciation on the building is $10,000 per year.

Advertising costs for the new product will total $50,000 per year. Costs of shipping the new product to customers will be $10 per unit. Electrical costs of operating machines will be $2 per unit.

To have funds to purchase materials, meet payrolls, and so forth, the company will have to liqui- date some temporary investments. These investments are presently yielding a return of $6,000 per year.

Required:

Prepare an answer sheet with the following column headings:

Product Cost

Direct Direct Manufacturing

Materials Labor Overhead

Name

of the

Cost

Variable

Cost

Fixed

Cost

Period (Selling and

Administrative) Cost

Opportunity

Cost

Sunk

Cost

List the different costs associated with the new product decision down the extreme left col- umn (under Name of the Cost). Then place an X under each heading that helps to describe the type of cost involved. There may be X’s under several column headings for a single cost. (For example, a cost may be a fixed cost, a period cost, and a sunk cost; you would place an X under each of these column headings opposite the cost.)

EXERCISE 2–10 High-Low Method; Scattergraph Analysis [LO4]

Zerbel Company, a wholesaler of large, custom-built air conditioning units for commercial buildings, has noticed considerable fluctuation in its shipping expense from month to month, as shown below:

Month

Units

Shipped

Total Shipping

Expense

January . . . . . . . . . . 4 $2,200

February . . . . . . . . . 7 $3,100

March . . . . . . . . . . . . 5 $2,600

April . . . . . . . . . . . . 2 $1,500

May . . . . . . . . . . . . . 3 $2,200

June . . . . . . . . . . . . . 6 $3,000

July . . . . . . . . . . . . . . 8 $3,600

Required:

1. Prepare a scattergraph using the data given above. Plot cost on the vertical axis and activity on the horizontal axis. Is there an approximately linear relationship between shipping expense and the number of units shipped?

Managerial Accounting and Cost Concepts 57

2. Using the high-low method, estimate the cost formula for shipping expense. Draw a straight line through the high and low data points shown in the scattergraph that you prepared in requirement 1. Make sure your line intersects the Y axis.

3. Comment on the accuracy of your high-low estimates assuming a least-squares regression analysis estimated the total fixed costs to be $1,010.71 per month and the variable cost to be $317.86 per unit. How would the straight line that you drew in requirement 2 differ from a straight line that minimizes the sum of the squared errors?

4. What factors, other than the number of units shipped, are likely to affect the company’s ship- ping expense? Explain.

EXERCISE 2–11 Traditional and Contribution Format Income Statements [LO5]

Haaki Shop, Inc., is a large retailer of surfboards. The company assembled the information shown below for the quarter ended May 31:

Amount

Total sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000

Selling price per surfboard . . . . . . . . . . . . . . . . . . . . . . . $400

Variable selling expense per surfboard . . . . . . . . . . . . $50

Variable administrative expense per surfboard . . . . . . $20

Total xed selling expense . . . . . . . . . . . . . . . . . . . . . . $150,000

Total xed administrative expense . . . . . . . . . . . . . . . . $120,000

Merchandise inventory, beginning balance . . . . . . . . . $80,000

Merchandise inventory, ending balance . . . . . . . . . . . . $100,000

Merchandise purchases . . . . . . . . . . . . . . . . . . . . . . . . $320,000

Required: 1. Prepare a traditional income statement for the quarter ended May 31. 2. Prepare a contribution format income statement for the quarter ended May 31. 3. What was the contribution toward fixed expenses and profits for each surfboard sold during

the quarter? (State this figure in a single dollar amount per surfboard.)

EXERCISE 2–12 Cost Behavior; High-Low Method [LO3, LO4]

Speedy Parcel Service operates a fleet of delivery trucks in a large metropolitan area. A careful study by the company’s cost analyst has determined that if a truck is driven 120,000 miles during a year, the average operating cost is 11.6 cents per mile. If a truck is driven only 80,000 miles during a year, the average operating cost increases to 13.6 cents per mile.

Required:

1. Using the high-low method, estimate the variable and fixed cost elements of the annual cost of truck operation.

2. Express the variable and fixed costs in the form Y   =   a   +   bX. 3. If a truck were driven 100,000 miles during a year, what total cost would you expect to be

incurred?

EXERCISE 2–13 High-Low Method; Predicting Cost [LO3, LO4]

The number of X-rays taken and X-ray costs over the last nine months in Beverly Hospital are given below:

Month X-Rays Taken X-Ray Costs

January . . . . . . . . . . . 6,250 $28,000

February . . . . . . . . . . . 7,000 $29,000

March . . . . . . . . . . . . . . 5,000 $23,000

April . . . . . . . . . . . . . . 4,250 $20,000

May . . . . . . . . . . . . . . . 4,500 $22,000

June . . . . . . . . . . . . . . 3,000 $17,000

July . . . . . . . . . . . . . . . . 3,750 $18,000

August . . . . . . . . . . . . 5,500 $24,000

September . . . . . . . . . 5,750 $26,000

58 Chapter 2

Required:

1. Using the high-low method, estimate the cost formula for X-ray costs. 2. Using the cost formula you derived above, what X-ray costs would you expect to be incurred

during a month in which 4,600 X-rays are taken? 3. Prepare a scattergraph using the data given above. Plot X-ray costs on the vertical axis and

the number of X-rays taken on the horizontal axis. Draw a straight line through the two data points that correspond to the high and low levels of activity. Make sure your line intersects the Y -axis.

4. Comment on the accuracy of your high-low estimates assuming a least-squares regression analysis estimated the total fixed costs to be $6,529.41 per month and the variable cost to be $3.29 per X-ray taken. How would the straight line that you drew in requirement 3 differ from a straight line that minimizes the sum of the squared errors?

5. Using the least-squares regression estimates given in requirement 4, what X-ray costs would you expect to be incurred during a month in which 4,600 X-rays are taken?

Problems

All applicable problems are available with McGraw-Hill’s Connect™ Accounting .

PROBLEM 2–14 Contribution Format versus Traditional Income Statement [LO5] House of Organs, Inc., purchases organs from a well-known manufacturer and sells them at the retail level. The organs sell, on the average, for $2,500 each. The average cost of an organ from the manufacturer is $1,500. The costs that the company incurs in a typical month are presented below:

Costs Cost Formula

Selling:

Advertising . . . . . . . . . . . . . . . . . . . . . . . $950 per month

Delivery of organs . . . . . . . . . . . . . . . $60 per organ sold

Sales salaries and commissions . . . . . . $4,800 per month, plus 4% of sales

Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . $650 per month

Depreciation of sales facilities . . . . . . . . $5,000 per month

Administrative:

Executive salaries . . . . . . . . . . . . . . . $13,500 per month

Depreciation of office equipment . . . . . . $900 per month

Clerical . . . . . . . . . . . . . . . . . . . . . . . . . . $2,500 per month, plus $40 per organ sold

Insurance . . . . . . . . . . . . . . . . . . . . . . . . $700 per month

During November, the company sold and delivered 60 organs.

Required:

1. Prepare a traditional income statement for November. 2. Prepare a contribution format income statement for November. Show costs and revenues on

both a total and a per unit basis down through contribution margin. 3. Refer to the income statement you prepared in (2) above. Why might it be misleading to show

the fixed costs on a per unit basis?

PROBLEM 2–15 Identifying Cost Behavior Patterns [LO3]

A number of graphs displaying cost behavior patterns are shown on the next page. The vertical axis on each graph represents total cost and the horizontal axis represents the level of activity (volume).

Required:

1. For each of the following situations, identify the graph that illustrates the cost behavior pat- tern involved. Any graph may be used more than once.

a. Electricity bill—a flat fixed charge, plus a variable cost after a certain number of kilowatt- hours are used.

Managerial Accounting and Cost Concepts 59

c. Depreciation of equipment, where the amount is computed by the straight-line method. When the depreciation rate was established, it was anticipated that the obsolescence fac- tor would be greater than the wear and tear factor.

d. Rent on a factory building donated by the city, where the agreement calls for a fixed fee payment unless 200,000 labor-hours or more are worked, in which case no rent need be paid.

e. Cost of raw materials, where the cost starts at $7.50 per unit and then decreases by 5 cents per unit for each of the first 100 units purchased, after which it remains constant at $2.50 per unit.

f. Salaries of maintenance workers, where one maintenance worker is needed for every 1,000 hours of machine-hours or less (that is, 0 to 1,000 hours requires one maintenance worker, 1,001 to 2,000 hours requires two maintenance workers, etc.).

g. Cost of raw material used. h. Rent on a factory building donated by the county, where the agreement calls for rent of

$100,000 less $1 for each direct labor-hour worked in excess of 200,000 hours, but a minimum rental payment of $20,000 must be paid.

i. Use of a machine under a lease, where a minimum charge of $1,000 is paid for up to 400 hours of machine time. After 400 hours of machine time, an additional charge of $2 per hour is paid up to a maximum charge of $2,000 per period.

1 2 3 4

9 10 11 12

5 6 7 8

First 1,000,000 gallons or less . . . . . . $1,000 at fee

Next 10,000 gallons . . . . . . . . . . . . . . $0.003 per gallon used

Next 10,000 gallons . . . . . . . . . . . . . . $0.006 per gallon used

Next 10,000 gallons . . . . . . . . . . . . . . $0.009 per gallon used

Etc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Etc.

b. City water bill, which is computed as follows:

60 Chapter 2

2. How would a knowledge of cost behavior patterns such as those above be of help to a manager in analyzing the cost structure of his or her company?

(CPA, adapted)

PROBLEM 2–16 Variable and Fixed Costs; Subtleties of Direct and Indirect Costs [LO3, LO6]

The Central Area Well-Baby Clinic provides a variety of health services to newborn babies and their parents. The clinic is organized into a number of departments, one of which is the Immuniza- tion Center. A number of costs of the clinic and the Immunization Center are listed below.

Example: The cost of polio immunization tablets a. The salary of the head nurse in the Immunization Center. b. Costs of incidental supplies consumed in the Immunization Center, such as paper towels. c. The cost of lighting and heating the Immunization Center. d. The cost of disposable syringes used in the Immunization Center. e. The salary of the Central Area Well-Baby Clinic’s information systems manager. f. The costs of mailing letters soliciting donations to the Central Area Well-Baby Clinic. g. The wages of nurses who work in the Immunization Center. h. The cost of medical malpractice insurance for the Central Area Well-Baby Clinic. i. Depreciation on the fixtures and equipment in the Immunization Center.

Required:

For each cost listed above, indicate whether it is a direct or indirect cost of the Immunization Center, whether it is a direct or indirect cost of immunizing particular patients, and whether it is variable or fixed with respect to the number of immunizations administered. Use the form shown below for your answer.

The factory overhead costs above consist of indirect materials, rent, and maintenance. The com- pany has analyzed these costs at the 60,000 machine-hours level of activity as follows:

Direct or

Indirect Cost of

the Immunization

Center

Direct or

Indirect Cost

of Particular

Patients

Variable or Fixed

with Respect

to the Number

of Immunizations

Administered

Item Description Direct Indirect Direct Indirect Variable Fixed

Example: The cost of polio

immunization

tablets . . . . . . . . . . . X X X

PROBLEM 2–17 High-Low Method; Predicting Cost [LO3, LO4]

Echeverria SA is an Argentinian manufacturing company whose total factory overhead costs fluc- tuate somewhat from year to year according to the number of machine-hours worked in its produc- tion facility. These costs (in Argentinian pesos) at high and low levels of activity over recent years are given below:

Level of Activity

Low High

Machine-hours . . . . . . . . . . . . . . . . 60,000 80,000

Total factory overhead costs . . . . . 274,000 pesos 312,000 pesos

Indirect materials (variable) . . . . . . . . . . . 90,000 pesos

Rent (! xed) . . . . . . . . . . . . . . . . . . . . . . . 130,000

Maintenance (mixed) . . . . . . . . . . . . . . . . 54,000

Total factory overhead costs . . . . . . . . . . . 274,000 pesos

Managerial Accounting and Cost Concepts 61

For planning purposes, the company wants to break down the maintenance cost into its variable and fixed cost elements.

Required:

1. Estimate how much of the factory overhead cost of 312,000 pesos at the high level of activity consists of maintenance cost. (Hint: To do this, it may be helpful to first determine how much of the 312,000 pesos cost consists of indirect materials and rent. Think about the behavior of variable and fixed costs.)

2. Using the high-low method, estimate a cost formula for maintenance. 3. What total overhead costs would you expect the company to incur at an operating level of

65,000 machine-hours?

PROBLEM 2–18 Cost Behavior; High-Low Method; Contribution Format Income Statement

[LO3, LO4, LO5]

Frankel Ltd. , a British merchandising company, is the exclusive distributor of a product that is gaining rapid market acceptance. The company’s revenues and expenses (in British pounds) for the last three months are given below:

Frankel Ltd.

Comparative Income Statements

For the Three Months Ended June 30

April May June

Sales in units . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 3,750 4,500

Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . £420,000 £525,000 £630,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . 168,000 210,000 252,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252,000 315,000 378,000

Selling and administrative expenses:

Shipping expense . . . . . . . . . . . . . . . . . . . . . . . 44,000 50,000 56,000

Advertising expense . . . . . . . . . . . . . . . . . . . . . 70,000 70,000 70,000

Salaries and commissions . . . . . . . . . . . . . . . . 107,000 125,000 143,000

Insurance expense . . . . . . . . . . . . . . . . . . . . . . 9,000 9,000 9,000

Depreciation expense . . . . . . . . . . . . . . . . . . . . 42,000 42,000 42,000

Total selling and administrative expenses . . . . . . 272,000 296,000 320,000

Net operating income (loss) . . . . . . . . . . . . . . . . . £ (20,000) £ 19,000 £ 58,000

(Note: Frankel Ltd.’s income statement has been recast in the functional format common in the United

States. The British currency is the pound, denoted by £.)

Required:

1. Identify each of the company’s expenses (including cost of goods sold) as either variable, fixed, or mixed.

2. Using the high-low method, separate each mixed expense into variable and fixed elements. State the cost formula for each mixed expense.

3. Redo the company’s income statement at the 4,500-unit level of activity using the contribution format.

PROBLEM 2–19 High-Low and Scattergraph Analysis [LO4]

Sebolt Wire Company heats copper ingots to very high temperatures by placing the ingots in a large heat coil. The heated ingots are then run through a shaping machine that shapes the soft ingot into wire. Due to the long heat-up time, the coil is never turned off. When an ingot is placed in the coil, the temperature is raised to an even higher level, and then the coil is allowed to drop to the “waiting” temperature between ingots. Management needs to know the variable cost of power

62 Chapter 2

involved in heating an ingot and the fixed cost of power during “waiting” periods. The following data on ingots processed and power costs are available:

Required:

1. Using the high-low method, estimate a cost formula for power cost. Express the formula in the form Y   =   a   +   bX.

2. Prepare a scattergraph by plotting ingots processed and power cost on a graph. Draw a straight line though the two data points that correspond to the high and low levels of activity. Make sure your line intersects the Y -axis.

3. Comment on the accuracy of your high-low estimates assuming a least-squares regression analysis estimated the total fixed costs to be $1,185.45 per month and the variable cost to be $37.82 per ingot. How would the straight line that you drew in requirement 2 differ from a straight line that minimizes the sum of the squared errors?

PROBLEM 2–20 Ethics and the Manager [LO2]

The top management of General Electronics, Inc., is well known for “managing by the numbers.” With an eye on the company’s desired growth in overall net profit, the company’s CEO (chief executive officer) sets target profits at the beginning of the year for each of the company’s divi- sions. The CEO has stated her policy as follows: “I won’t interfere with operations in the divisions. I am available for advice, but the division vice presidents are free to do anything they want so long as they hit the target profits for the year.”

In November, Stan Richart, the vice president in charge of the Cellular Telephone Tech- nologies Division, saw that making the current year’s target profit for his division was going to be very difficult. Among other actions, he directed that discretionary expenditures be delayed until the beginning of the new year. On December 30, he was angered to discover that a ware- house clerk had ordered $350,000 of cellular telephone parts earlier in December even though the parts weren’t really needed by the assembly department until January or February. Contrary to common accounting practice, the General Electronics, Inc., Accounting Policy Manual states that such parts are to be recorded as an expense when delivered. To avoid recording the expense, Mr. Richart asked that the order be canceled, but the purchasing department reported that the parts had already been delivered and the supplier would not accept returns. Because the bill had not yet been paid, Mr. Richart asked the accounting department to correct the clerk’s mistake by delaying recognition of the delivery until the bill is paid in January.

Required:

1. Are Mr. Richart’s actions ethical? Explain why they are or are not ethical. 2. Do the general management philosophy and accounting policies at General Electronics

encourage or discourage ethical behavior? Explain.

Managerial Accounting and Cost Concepts 63

PROBLEM 2–21 High-Low Method; Predicting Cost [LO3, LO4]

Golden Company’s total overhead cost at various levels of activity are presented below:

Month Machine-Hours Total Overhead Cost

March . . . . . . . . . . . . . . . . . . . . . 50,000 $194,000

April . . . . . . . . . . . . . . . . . . . . 40,000 $170,200

May . . . . . . . . . . . . . . . . . . . . . 60,000 $217,800

June . . . . . . . . . . . . . . . . . . . . . . . . . 70,000 $241,600

Assume that the overhead cost above consists of utilities, supervisory salaries, and maintenance. The breakdown of these costs at the 40,000 machine-hour level of activity is as follows:

Utilities (variable) . . . . . . . . . . . . . . . . . $ 52,000

Supervisory salaries (! xed) . . . . . . . . . 60,000

Maintenance (mixed) . . . . . . . . . . . . . . 58,200

Total overhead cost . . . . . . . . . . . . . . . $170,200

The company wants to break down the maintenance cost into its variable and fixed cost elements.

Required:

1. Estimate how much of the $241,600 of overhead cost in June was maintenance cost. (Hint: To do this, it may be helpful to first determine how much of the $241,600 consisted of utili- ties and supervisory salaries. Think about the behavior of variable and fixed costs within the relevant range.)

2. Using the high-low method, estimate a cost formula for maintenance. 3. Express the company’s total overhead cost in the form Y   =   a   +   bX. 4. What total overhead cost would you expect to be incurred at an activity level of 45,000

machine-hours?

PROBLEM 2–22 Cost Classification [LO2, LO3, LO6]

Listed below are costs found in various organizations. 1. Depreciation, executive jet. 2. Costs of shipping finished goods to customers. 3. Wood used in manufacturing furniture. 4. Sales manager’s salary. 5. Electricity used in manufacturing furniture. 6. Secretary to the company president. 7. Aerosol attachment placed on a spray can produced by the company. 8. Billing costs. 9. Packing supplies for shipping products overseas. 10. Sand used in manufacturing concrete. 11. Supervisor’s salary, factory. 12. Executive life insurance. 13. Sales commissions. 14. Fringe benefits, assembly-line workers. 15. Advertising costs. 16. Property taxes on finished goods warehouses. 17. Lubricants for production equipment.

64 Chapter 2

PROBLEM 2–23 High-Low Method; Contribution Format Income Statement [LO4, LO5]

Alden Company has decided to use a contribution format income statement for internal planning purposes. The company has analyzed its expenses and has developed the following cost formulas:

Manufacturing

(Product) Cost

Direct IndirectCost Item

Variable

or Fixed

Selling

Cost

Administrative

Cost

Direct labor . . . . . . . . . . . . . . . . V X

Executive salaries . . . . . . . . . . . F X

Factory rent . . . . . . . . . . . . . . . . . F X

Cost Cost Formula

Cost of goods sold . . . . . . . . . . . . . . . . $20 per unit sold

Advertising expense . . . . . . . . . . . . . . . $170,000 per quarter

Sales commissions . . . . . . . . . . . . . . . . 5% of sales

Administrative salaries . . . . . . . . . . . . . $80,000 per quarter

Shipping expense . . . . . . . . . . . . . . . . . ?

Depreciation expense . . . . . . . . . . . . . . $50,000 per quarter

Management has concluded that shipping expense is a mixed cost, containing both variable and fixed cost elements. Units sold and the related shipping expense over the last eight quarters are given below:

Quarter Units Sold Shipping Expense

Year 1:

First . . . . . . . . . . . . . . . . . 16,000 $160,000

Second . . . . . . . . . . . . . 18,000 $175,000

Third . . . . . . . . . . . . . . . 23,000 $217,000

Fourth . . . . . . . . . . . . . . 19,000 $180,000

Year 2:

First . . . . . . . . . . . . . . . . . 17,000 $170,000

Second . . . . . . . . . . . . . 20,000 $185,000

Third . . . . . . . . . . . . . . . 25,000 $232,000

Fourth . . . . . . . . . . . . . . 22,000 $208,000

Management would like a cost formula derived for shipping expense so that a budgeted con- tribution format income statement can be prepared for the next quarter.

Required:

1. Using the high-low method, estimate a cost formula for shipping expense. 2. In the first quarter of Year 3, the company plans to sell 21,000 units at a selling price of $50

per unit. Prepare a contribution format income statement for the quarter.

PROBLEM 2–24 Cost Classification and Cost Behavior [LO2, LO3, LO6]

Heritage Company manufactures a beautiful bookcase that enjoys widespread popularity. The company has a backlog of orders that is large enough to keep production going indefinitely at the plant’s full capacity of 4,000 bookcases per year. Annual cost data at full capacity follow:

Required:

Prepare an answer sheet with column headings as shown below. For each cost item, indicate whether it would be variable or fixed with respect to the number of units produced and sold; and then whether it would be a selling cost, an administrative cost, or a manufacturing cost. If it is a manufacturing cost, indicate whether it would typically be treated as a direct or indirect cost with respect to units of product. Three sample answers are provided for illustration.

Managerial Accounting and Cost Concepts 65

Required:

1. Prepare an answer sheet with the column headings shown below. Enter each cost item on your answer sheet, placing the dollar amount under the appropriate headings. As examples, this has been done already for the first two items in the list above. Note that each cost item is classified in two ways: first, as either variable or fixed with respect to the number of units produced and sold; and second, as either a selling and administrative cost or a product cost. (If the item is a product cost, it should also be classified as either direct or indirect as shown.)

Direct materials used (wood and glass) . . . . . . . . . . . $430,000

Administrative office salaries . . . . . . . . . . . . . . . . . . . $110,000

Factory supervision . . . . . . . . . . . . . . . . . . . . . . . . . . $70,000

Sales commissions . . . . . . . . . . . . . . . . . . . . . . . . . . $60,000

Depreciation, factory building . . . . . . . . . . . . . . . . . . . $105,000

Depreciation, administrative office equipment . . . . . . $2,000

Indirect materials, factory . . . . . . . . . . . . . . . . . . . . . . $18,000

Factory labor (cutting and assembly) . . . . . . . . . . . . . $90,000

Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000

Insurance, factory . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,000

Administrative office supplies (billing) . . . . . . . . . . . . $4,000

Property taxes, factory . . . . . . . . . . . . . . . . . . . . . . . . $20,000

Utilities, factory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $45,000

Cost Behavior Selling or

Administrative

Cost

Product Cost

Cost Item Variable Fixed Direct Indirect*

Materials used . . . . . . . . . $430,000 $430,000

Administrative office

salaries . . . . . . . . . . . . . $110,000 $110,000

*To units of product.

2. Total the dollar amounts in each of the columns in (1) above. Compute the average product cost per bookcase.

3. Due to a recession, assume that production drops to only 2,000 bookcases per year. Would you expect the average product cost per bookcase to increase, decrease, or remain unchanged? Explain. No computations are necessary.

4. Refer to the original data. The president’s next-door neighbor has considered making himself a bookcase and has priced the necessary materials at a building supply store. He has asked the president whether he could purchase a bookcase from the Heritage Company “at cost,” and the president has agreed to let him do so.

a. Would you expect any disagreement between the two men over the price the neighbor should pay? Explain. What price does the president probably have in mind? The neighbor?

b. Because the company is operating at full capacity, what cost term used in the chapter might be justification for the president to charge the full, regular price to the neighbor and still be selling “at cost”? Explain.

Cases

All applicable cases are available with McGraw-Hill’s Connect™ Accounting .

CASE 2–25 Scattergraph Analysis; Selection of an Activity Base [LO4]

Mapleleaf Sweepers of Toronto manufactures replacement rotary sweeper brooms for the large sweeper trucks that clear leaves and snow from city streets. The business is seasonal, with the largest demand during and just preceding the fall and winter months. Because there are so many different kinds of sweeper brooms used by its customers, Mapleleaf Sweepers makes all of its brooms to order.

66 Chapter 2

Number of Units

Produced

Number of

Janitorial

Workdays

Janitorial

Labor Cost

January . . . . . . . . . . . . . 115 21 $3,840

February . . . . . . . . . . . . 109 19 $3,648

March . . . . . . . . . . . . . . . 102 23 $4,128

April . . . . . . . . . . . . . . . . 76 20 $3,456

May . . . . . . . . . . . . . . . . 69 23 $4,320

June . . . . . . . . . . . . . . . 108 22 $4,032

July . . . . . . . . . . . . . . . . . 77 16 $2,784

August . . . . . . . . . . . . . . 71 14 $2,688

September . . . . . . . . . . . 127 21 $3,840

The number of workdays varies from month to month due to the number of weekdays, holi- days, days of vacation, and sick leave taken in the month. The number of units produced in a month varies depending on demand and the number of workdays in the month.

There are two janitors who each work an eight-hour shift each workday. They each can take up to 10 days of paid sick leave each year. Their wages on days they call in sick and their wages during paid vacations are charged to miscellaneous overhead rather than to the janitorial labor cost account.

Required:

1. Plot the janitorial labor cost and units produced on a scattergraph. (Place cost on the vertical axis and units produced on the horizontal axis.)

2. Plot the janitorial labor cost and number of workdays on a scattergraph. (Place cost on the vertical axis and the number of workdays on the horizontal axis.)

3. Which measure of activity—number of units produced or janitorial workdays—should be used as the activity base for explaining janitorial labor cost?

CASE 2–26 Mixed Cost Analysis and the Relevant Range [LO3, LO4]

The Ramon Company is a manufacturer that is interested in developing a cost formula to estimate the fixed and variable components of its monthly manufacturing overhead costs. The company wishes to use machine-hours as its measure of activity and has gathered the data below for this year and last year:

Last Year This Year

Month

Machine-

Hours

Overhead

Costs

Machine-

Hours

Overhead

Costs

January . . . . . . . . . . . . . . . . . . 21,000 $84,000 21,000 $86,000

February . . . . . . . . . . . . . . . . . 25,000 $99,000 24,000 $93,000

March . . . . . . . . . . . . . . . . . . . 22,000 $89,500 23,000 $93,000

April . . . . . . . . . . . . . . . . . . . . 23,000 $90,000 22,000 $87,000

May . . . . . . . . . . . . . . . . . . . . . 20,500 $81,500 20,000 $80,000

June . . . . . . . . . . . . . . . . . . . . 19,000 $75,500 18,000 $76,500

July . . . . . . . . . . . . . . . . . . . . . . 14,000 $70,500 12,000 $67,500

August . . . . . . . . . . . . . . . . . . 10,000 $64,500 13,000 $71,000

September . . . . . . . . . . . . . . . 12,000 $69,000 15,000 $73,500

October . . . . . . . . . . . . . . . . . . 17,000 $75,000 17,000 $72,500

November . . . . . . . . . . . . . . . . 16,000 $71,500 15,000 $71,000

December . . . . . . . . . . . . . . . . 19,000 $78,000 18,000 $75,000

The company has been analyzing its overhead accounts to determine fixed and variable com- ponents for planning purposes. Below are data for the company’s janitorial labor costs over the last nine months. (Cost data are in Canadian dollars.)

The company leases all of its manufacturing equipment. The lease arrangement calls for a flat monthly fee up to 19,500 machine-hours. If the machine-hours used exceeds 19,500, then the fee

Managerial Accounting and Cost Concepts 67

becomes strictly variable with respect to the total number of machine-hours consumed during the month. Lease expense is a major element of overhead cost.

Required:

1. Using the high-low method, estimate a manufacturing overhead cost formula. 2. Prepare a scattergraph using all of the data for the two-year period. Fit a straight line or lines

to the plotted points using a ruler. Describe the cost behavior pattern revealed by your scat- tergraph plot.

3. Assume a least-squares regression analysis using all of the given data points estimated the total fixed costs to be $40,102 and the variable costs to be $2.13 per machine-hour. Do you have any concerns about the accuracy of the high-low estimates that you have computed or the least-squares regression estimates that have been provided?

4. Assume that the company consumes 22,500 machine-hours during a month. Using the high- low method, estimate the total overhead cost that would be incurred at this level of activity. Be sure to consider only the data points contained in the relevant range of activity when perform- ing your computations.

5. Comment on the accuracy of your high-low estimates assuming a least-squares regression analysis using only the data points in the relevant range of activity estimated the total fixed costs to be $10,090 and the variable costs to be $3.53 per machine-hour.

Appendix 2A: Least-Squares Regression Computations

The least-squares regression method for estimating a linear relationship is based on the equation for a straight line:

Y = a + bX

As explained in the chapter, least-squares regression selects the values for the intercept a and the slope b that minimize the sum of the squared errors. The following formulas, which are derived in statistics and calculus texts, accomplish that objective:

b = n(ΣXY) − (ΣX)(ΣY)

______________ n( ΣX 2 ) − (ΣX) 2

a = (ΣY) − b(ΣX)

____________ n

where:

X   =  The level of activity (independent variable) Y   =  The total mixed cost (dependent variable) a   =  The total fixed cost (the vertical intercept of the line) b   =  The variable cost per unit of activity (the slope of the line) n   = Number of observations ∑   =  Sum across all n observations

Manually performing the calculations required by the formulas is tedious at best. Fortunately, statistical software packages are widely available that perform the calcula- tions automatically. Spreadsheet software, such as Microsoft ® Excel, can also be used to do least-squares regression—although it requires a little more work than using a special- ized statistical application.

In addition to estimates of the intercept (fixed cost) and slope (variable cost per unit), Excel also provides a statistic called the R 2 , which is a measure of “goodness of fit.” The R 2 tells us the percentage of the variation in the dependent variable (cost) that is explained by variation in the independent variable (activity). The R 2 varies from 0% to 100%, and the higher the percentage, the better. You should always plot the data in a scattergraph,

LEARNING OBJECTIVE 8

Analyze a mixed cost using a scattergraph plot and the least- squares regression method.

68 Chapter 2

but it is particularly important to check the data visually when the R 2 is low. A quick look at the scattergraph can reveal that there is little relation between the cost and the activity or that the relation is something other than a simple straight line. In such cases, additional analysis would be required.

To illustrate how Excel can be used to calculate the intercept a, the slope b, and the R 2 , we will use the Brentline Hospital data for maintenance costs on page 35. The work- sheet in Exhibit 2A–1 contains the data and the calculations.

As you can see, the X values (the independent variable) have been entered in cells B4 through B10. The Y values (the dependent variable) have been entered in cells C4 through C10. The slope, intercept, and R 2 are computed using the Excel functions INTERCEPT, SLOPE, and RSQ. You must specify the range of cells for the Y values and for the X values.

In Exhibit 2A–1 , cell B12 contains the formula  = INTERCEPT(C4:C10,B4:B10); cell B13 contains the formula  = SLOPE(C4:C10,B4:B10); and cell B14 contains the formula = RSQ(C4:C10,B4:B10).

According to the calculations carried out by Excel, the fixed maintenance cost (the intercept) is $3,431 per month and the variable cost (the slope) is $0.759 per patient-day. Therefore, the cost formula for maintenance cost is:

Y = a + bX

Y = $3,431 + $0.759X

Note that the R 2 (i.e., RSQ) is 0.90, which is quite good and indicates that 90% of the variation in maintenance costs is explained by the variation in patient-days.

Plotting the data is easy in Excel. Select the range of values that you would like to plot—in this case, cells B4:C10. Then select the Chart Wizard tool on the toolbar and make the appropriate choices in the various dialogue boxes that appear. When you are finished, you should have a scattergraph that looks like the plot in Exhibit 2A–2 . Note that the relation between cost and activity is approximately linear, so it is reason- able to fit a straight line to the data as we have implicitly done with the least-squares regression.

E X H I B I T   2 A – 1

The Least-Squares Regression Worksheet for Brentline Hospital

Managerial Accounting and Cost Concepts 69

R 2 A measure of goodness of fit in least-squares regression analysis. It is the percentage of the variation in the dependent variable that is explained by variation in the independent variable. (p. 67)

Glossary (Appendix 2A)

E X H I B I T   2 A – 2

A Scattergraph Plot of the Brentline Hospital Data

$12,000

$10,000

$8,000

$6,000

$4,000

$2,000

$0

M a in te n a n c e c o s t

0 2,000 4,000 6,000 8,000 10,000

Patient-days

Y

X

Appendix 2A Exercises and Problems

All applicable exercises and problems are available with McGraw-Hill’s Connect™ Accounting.

EXERCISE 2A–1 Least-Squares Regression [LO8]

EZ Rental Car offers rental cars in an off-airport location near a major tourist destination in Florida. Management would like to better understand the behavior of the company’s costs. One of those costs is the cost of washing cars. The company operates its own car wash facility in which each rental car that is returned is thoroughly cleaned before being released for rental to another customer. Management believes that the costs of operating the car wash should be related to the number of rental returns. Accordingly, the following data have been compiled:

Month Rental Returns Car Wash Costs

January . . . . . . . . . . . . . . . . . . . . 2,310 $10,113

February . . . . . . . . . . . . . . . . . . . 2,453 $12,691

March . . . . . . . . . . . . . . . . . . . . . . 2,641 $10,905

April . . . . . . . . . . . . . . . . . . . . . . 2,874 $12,949

May . . . . . . . . . . . . . . . . . . . . . . . 3,540 $15,334

June . . . . . . . . . . . . . . . . . . . . . . . . 4,861 $21,455

July . . . . . . . . . . . . . . . . . . . . . . . . 5,432 $21,270

August . . . . . . . . . . . . . . . . . . . . 5,268 $19,930

September . . . . . . . . . . . . . . . . . 4,628 $21,860

October . . . . . . . . . . . . . . . . . . . 3,720 $18,383

November . . . . . . . . . . . . . . . . . 2,106 $9,830

December . . . . . . . . . . . . . . . . . 2,495 $11,081

70 Chapter 2

Required:

Using least-squares regression, estimate the fixed cost and variable cost elements of monthly car wash costs. The fixed cost element should be estimated to the nearest dollar and the variable cost element to the nearest cent.

EXERCISE 2A–2 Least-Squares Regression [LO3, LO8]

One of Varic Company’s products goes through a glazing process. The company has observed glazing costs as follows over the last six weeks:

Week

Units

Produced

Total

Glazing Cost

1 . . . . . . . . . . 8 $270

2 . . . . . . . . . . 5 $200

3 . . . . . . . . . . 10 $310

4 . . . . . . . . . . 4 $190

5 . . . . . . . . . . 6 $240

6 . . . . . . . . . . 9 $290

For planning purposes, the company’s management wants to know the amount of variable glazing cost per unit and the total fixed glazing cost per week.

Required:

1. Using the least-squares regression method, estimate the variable and fixed elements of the glazing cost.

2. Express the cost data in (1) above in the form Y   =   a   +   bX. 3. If the company processes seven units next week, what would be the expected total glazing cost?

PROBLEM 2A–3 Scattergraph; Cost Behavior; Least-Squares Regression Method [LO3, LO8]

Amanda King has just been appointed director of recreation programs for Highland Park, a rap- idly growing community in Connecticut. In the past, the city has sponsored a number of softball leagues in the summer months. From the city’s cost records, Amanda has found the following total costs associated with the softball leagues over the last five years:

Each league requires its own paid supervisor and paid umpires as well as printed schedules and other copy work. Therefore, Amanda knows that some variable costs are associated with the leagues. She would like to know the amount of variable cost per league and the total fixed cost per year associated with the softball program. This information would help her for planning purposes.

Required:

1. Using the least-squares regression method, estimate the variable cost per league and the total fixed cost per year for the softball program.

2. Express the cost data derived in (1) above in the form Y   =   a   +   bX. 3. Assume that Amanda would like to expand the softball program during the coming year to

involve a total of seven leagues. Compute the expected total cost for the softball program.

Managerial Accounting and Cost Concepts 71

Can you see any problem with using the cost formula from (2) above to derive this total cost figure? Explain.

4. Prepare a scattergraph, and fit a line to the plotted points using the cost formula expressed in (2) above.

PROBLEM 2A–4 Least-Squares Regression; Scattergraph; Comparison of Activity Bases [LO3, LO8]

The Hard Rock Mining Company is developing cost formulas for management planning and decision-making purposes. The company’s cost analyst has concluded that utilities cost is a mixed cost, and he is attempting to find a base with which the cost might be closely correlated. The con- troller has suggested that tons mined might be a good base to use in developing a cost formula. The production superintendent disagrees; she thinks that direct labor-hours would be a better base. The cost analyst has decided to try both bases and has assembled the following information:

Quarter

Tons

Mined

Direct

Labor-Hours

Utilities

Cost

Year 1:

First . . . . . . . . . . . . . . . . . . . 15,000 5,000 $50,000

Second . . . . . . . . . . . . . . . . 11,000 3,000 $45,000

Third . . . . . . . . . . . . . . . . . 21,000 4,000 $60,000

Fourth . . . . . . . . . . . . . . . . . 12,000 6,000 $75,000

Year 2:

First . . . . . . . . . . . . . . . . . . . 18,000 10,000 $100,000

Second . . . . . . . . . . . . . . . . 25,000 9,000 $105,000

Third . . . . . . . . . . . . . . . . . 30,000 8,000 $85,000

Fourth . . . . . . . . . . . . . . . . 28,000 11,000 $120,000

Required:

1. Using tons mined as the independent ( X ) variable: a. Determine a cost formula for utilities cost using the least-squares regression method. b. Prepare a scattergraph and plot the tons mined and utilities cost. (Place cost on the verti-

cal axis and tons mined on the horizontal axis.) Fit a straight line to the plotted points using the cost formula determined in ( a ) above.

2. Using direct labor-hours as the independent ( X ) variable, repeat the computations in ( a ) and ( b ) above.

3. Would you recommend that the company use tons mined or direct labor-hours as a base for planning utilities cost?

CASE 2A–5 Analysis of Mixed Costs in a Pricing Decision [LO3, LO8]

Jasmine Lee owns a catering company that serves food and beverages at exclusive parties and busi- ness functions. Lee’s business is seasonal, with a heavy schedule during the summer months and holidays and a lighter schedule at other times.

One of the major events that Lee’s customers request is a cocktail party. She offers a standard cocktail party and has estimated the cost per guest for this party as follows:

Food and beverages . . . . . . . . . . . . . . . . . . . . . . . . . . . $17.00

Labor (0.5 hour @ $10.00 per hour) . . . . . . . . . . . . . . . 5.00

Overhead (0.5 hour @ $18.63 per hour) . . . . . . . . . . . . 9.32

Total cost per guest . . . . . . . . . . . . . . . . . . . . . . . . . . . . $31.32

This standard cocktail party lasts three hours and Lee hires one worker for every six guests, which is one-half hour of labor per guest. These workers are hired only as needed and are paid only for the hours they actually work.

Lee ordinarily charges $45 per guest. She is confident about her estimates of the costs of food and beverages and labor, but is not as comfortable with the estimate of overhead cost. The $18.63

72 Chapter 2

overhead cost per labor-hour was determined by dividing total overhead expenses for the last 12 months by total labor-hours for the same period. Monthly data concerning overhead costs and labor-hours appear below:

Month

Labor

Hours

Overhead

Expenses

January . . . . . . . . . . . . . . . . 1,500 $ 44,000

February . . . . . . . . . . . . . . . 1,680 47,200

March . . . . . . . . . . . . . . . . . 1,800 48,000

April . . . . . . . . . . . . . . . . . . . 2,520 51,200

May . . . . . . . . . . . . . . . . . . . 2,700 53,600

June . . . . . . . . . . . . . . . . . . 3,300 56,800

July . . . . . . . . . . . . . . . . . . 3,900 59,200

August . . . . . . . . . . . . . . . . . 4,500 61,600

September . . . . . . . . . . . . . 4,200 60,000

October . . . . . . . . . . . . . . . . 2,700 54,400

November . . . . . . . . . . . . . . 1,860 49,600

December . . . . . . . . . . . . . . 3,900 58,400

Total . . . . . . . . . . . . . . . . . . 34,560 $644,000

Lee has received a request to bid on a 120-guest fund-raising cocktail party to be given next month by an important local charity. (The party would last the usual three hours.) She would like to win this contract because the guest list for this charity event includes many prominent individuals that she would like to land as future clients. Lee is confident that these potential customers would be favorably impressed by her company’s services at the charity event.

Required:

1. Prepare a scattergraph plot that puts labor-hours on the X-axis and overhead expenses on the Y-axis. What insights are revealed by your scattergraph?

2. Use the least-squares regression method to estimate the fixed and variable components of over- head expenses.

3. Estimate the contribution to profit of a standard 120-guest cocktail party if Lee charges her usual price of $45 per guest. (In other words, by how much would her overall profit increase?)

4. How low could Lee bid for the charity event, in terms of a price per guest, and still not lose money on the event itself?

5. The individual who is organizing the charity’s fund-raising event has indicated that he has already received a bid under $42 from another catering company. Do you think Lee should bid below her normal $45 per guest price for the charity event? Why or why not?

(CMA, adapted)

Appendix 2B: Cost of Quality

A company may have a product with a high-quality design that uses high-quality com- ponents, but if the product is poorly assembled or has other defects, the company will have high warranty repair costs and dissatisfied customers. People who are dissatisfied with a product are unlikely to buy the product again. They often tell others about their bad experiences. This is the worst possible sort of advertising. To prevent such problems, companies expend a great deal of effort to reduce defects. The objective is to have high quality of conformance.

Quality of Conformance

A product that meets or exceeds its design specifications and is free of defects that mar its appearance or degrade its performance is said to have high quality of conformance . Note that if an economy car is free of defects, it can have a quality of conformance

Managerial Accounting and Cost Concepts 73

that is just as high as a defect-free luxury car. The purchasers of economy cars cannot expect their cars to be as opulently equipped as luxury cars, but they can and do expect them to be free of defects.

Preventing, detecting, and dealing with defects causes costs that are called quality costs or the cost of quality. The use of the term quality cost is confusing to some people. It does not refer to costs such as using a higher-grade leather to make a wallet or using 14K gold instead of gold-plating in jewelry. Instead, the term quality cost refers to all of the costs that are incurred to prevent defects or that result from defects in products.

Quality costs can be broken down into four broad groups. Two of these groups— known as prevention costs and appraisal costs —are incurred in an effort to keep defective products from falling into the hands of customers. The other two groups of costs—known as internal failure costs and external failure costs —are incurred because defects occur despite efforts to prevent them. Examples of specific costs involved in each of these four groups are given in Exhibit 2B–1 .

Several things should be noted about the quality costs shown in the exhibit. First, quality costs don’t relate to just manufacturing; rather, they relate to all the activities in a company from initial research and development (R&D) through customer service. Sec- ond, the number of costs associated with quality is very large; total quality cost can be very high unless management gives this area special attention. Finally, the costs in the four groupings are quite different. We will now look at each of these groupings more closely.

Prevention Costs

Generally, the most effective way to manage quality costs is to avoid having defects in the first place. It is much less costly to prevent a problem from ever happening than it is to find and correct the problem after it has occurred. Prevention costs support activities whose purpose is to reduce the number of defects.

Systems development Quality engineering Quality training Quality circles Statistical process control activities Supervision of prevention activities Quality data gathering, analysis, and reporting Quality improvement projects Technical support provided to suppliers Audits of the effectiveness of the quality system

Net cost of scrap Net cost of spoilage Rework labor and overhead Reinspection of reworked products Retesting of reworked products Downtime caused by quality problems Disposal of defective products Analysis of the cause of defects in production Re-entering data because of keying errors Debugging software errors

Prevention Costs Internal Failure Costs

Appraisal Costs External Failure Costs

Test and inspection of incoming materials Test and inspection of in-process goods Final product testing and inspection Supplies used in testing and inspection Supervision of testing and inspection activities Depreciation of test equipment Maintenance of test equipment Plant utilities in the inspection area Field testing and appraisal at customer site

Cost of ! eld servicing and handling complaints Warranty repairs and replacements Repairs and replacements beyond the warranty period Product recalls Liability arising from defective products Returns and allowances arising from quality problems Lost sales arising from a reputation for poor quality

E X H I B I T   2 B – 1

Typical Quality Costs

LEARNING OBJECTIVE 9

Identify the four types of quality costs and explain how they interact.

74 Chapter 2

Note from Exhibit 2B–1 that prevention costs include activities relating to quality circles and statistical process control. Quality circles consist of small groups of employ- ees that meet on a regular basis to discuss ways to improve quality. Both management and workers are included in these circles. Quality circles are widely used and can be found in manufacturing companies, utilities, health care organizations, banks, and many other organizations.

Statistical process control is a technique that is used to detect whether a process is in or out of control. An out-of-control process results in defective units and may be caused by a miscalibrated machine or some other factor. In statistical process control, workers use charts to monitor the quality of units that pass through their workstations. With these charts, workers can quickly spot processes that are out of control and that are creating defects. Problems can be immediately corrected and further defects prevented rather than waiting for an inspector to catch the defects later.

Note also from the list of prevention costs in Exhibit  2B–1 that some companies provide technical support to their suppliers as a way of preventing defects. Particularly in just-in-time (JIT) systems, such support to suppliers is vital. In a JIT system, parts are delivered from suppliers just in time and in just the correct quantity to fill customer orders. There are no parts stockpiles. If a defective part is received from a supplier, the part cannot be used and the order for the ultimate customer cannot be filled on time. Hence, every part received from a supplier must be free of defects. Consequently, com- panies that use JIT often require that their suppliers use sophisticated quality control programs such as statistical process control and that their suppliers certify that they will deliver parts and materials that are free of defects.

Appraisal Costs

Any defective parts and products should be caught as early as possible in the production process. Appraisal costs , which are sometimes called inspection costs, are incurred to identify defective products before the products are shipped to customers. Unfortunately, performing appraisal activities doesn’t keep defects from happening again, and most managers now realize that maintaining an army of inspectors is a costly (and ineffec- tive) approach to quality control. Therefore, employees are increasingly being asked to be responsible for their own quality control. This approach, along with designing products to be easy to manufacture properly, allows quality to be built into products rather than relying on inspection to get the defects out.

Internal Failure Costs

Failure costs are incurred when a product fails to conform to its design specifications. Failure costs can be either internal or external. Internal failure costs result from iden- tifying defects before they are shipped to customers. These costs include scrap, rejected products, reworking of defective units, and downtime caused by quality problems. In some companies, as little as 10% of the company’s products make it through the produc- tion process without rework of some kind. Of course, the more effective a company’s appraisal activities, the greater the chance of catching defects internally and the greater the level of internal failure costs. This is the price that is paid to avoid incurring external failure costs, which can be devastating.

External Failure Costs

External failure costs result when a defective product is delivered to a customer. As shown in Exhibit 2B–1 , external failure costs include warranty repairs and replacements, product recalls, liability arising from legal action against a company, and lost sales aris- ing from a reputation for poor quality. Such costs can decimate profits.

Managerial Accounting and Cost Concepts 75

In the past, some managers have taken the attitude, “Let’s go ahead and ship every- thing to customers, and we’ll take care of any problems under the warranty.” This attitude generally results in high external failure costs, customer ill will, and declining market share and profits.

Distribution of Quality Costs

Quality costs for some companies range between 10% and 20% of total sales, whereas experts say that these costs should be more in the 2% to 4% range. How does a company reduce its total quality cost? The answer lies in how the quality costs are distributed. Refer to the graph in Exhibit 2B–2 , which shows total quality costs as a function of the quality of conformance.

The graph shows that when the quality of conformance is low, total quality cost is high and that most of this cost consists of costs of internal and external failure. A low quality of conformance means that a high percentage of units are defective and hence the company has high failure costs. However, as a company spends more and more on prevention and appraisal, the percentage of defective units drops. This results in lower internal and external failure costs. Ordinarily, total quality cost drops rapidly as the qual- ity of conformance increases. Thus, a company can reduce its total quality cost by focus- ing its efforts on prevention and appraisal. The cost savings from reduced defects usually swamp the costs of the additional prevention and appraisal efforts.

The graph in Exhibit 2B–2 has been drawn so that the total quality cost is minimized when the quality of conformance is less than 100%. However, some experts contend that the total quality cost is not minimized until the quality of conformance is 100% and there are no defects. Indeed, many companies have found that the total quality costs seem to keep dropping even when the quality of conformance approaches 100% and defect rates get as low as 1 in a million units. Others argue that total quality cost eventually increases as the quality of conformance increases. However, in most companies this does not seem to happen until the quality of conformance is very close to 100% and defect rates are very close to zero.

E X H I B I T 2 B – 2

Effect of Quality Costs on Quality of Conformance

C o s ts

0 100

Costs of prevention and

appraisal

Quality of conformance (percent of output without defects)

Total quality cost

Costs of internal and

external failure

76 Chapter 2

As a company’s quality program becomes more refined and as its failure costs begin to fall, prevention activities usually become more effective than appraisal activities. Appraisal can only find defects, whereas prevention can eliminate them. The best way to prevent defects from happening is to design processes that reduce the likelihood of defects and to continually monitor processes using statistical process control methods.

Quality Cost Reports

LEARNING OBJECTIVE 10

Prepare and interpret a quality cost report.

As an initial step in quality improvement programs, companies often construct a quality cost report that provides an estimate of the financial consequences of the company’s cur- rent level of defects. A quality cost report details the prevention costs, appraisal costs, and costs of internal and external failures that arise from the company’s current quality control efforts. Managers are often shocked by the magnitude of these costs. A typical quality cost report is shown in Exhibit 2B–3 .

E X H I B I T 2 B – 3

Quality Cost Report

Ventura Company Quality Cost Report For Years 1 and 2

Year 1 Year 2

Amount Percent* Amount Percent* Prevention costs: Systems development . . . . . . . . . . . . . . . . . . . . . . . . . . $ 270,000 0.54% $ 400,000 0.80% Quality training . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,000 0.26% 210,000 0.42% Supervision of prevention activities . . . . . . . . . . . . . . . . . 40,000 0.08% 70,000 0.14% Quality improvement projects . . . . . . . . . . . . . . . . . . . . . 210,000 0.42% 320,000 0.64%

Total prevention cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 650,000 1.30% 1,000,000 2.00%

Appraisal costs: Inspection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 560,000 1.12% 600,000 1.20% Reliability testing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420,000 0.84% 580,000 1.16% Supervision of testing and inspection . . . . . . . . . . . . . . . 80,000 0.16% 120,000 0.24% Depreciation of test equipment . . . . . . . . . . . . . . . . . . . . 140,000 0.28% 200,000 0.40%

Total appraisal cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200,000 2.40% 1,500,000 3.00%

Internal failure costs: Net cost of scrap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750,000 1.50% 900,000 1.80% Rework labor and overhead . . . . . . . . . . . . . . . . . . . . . . 810,000 1.62% 1,430,000 2.86% Downtime due to defects in quality . . . . . . . . . . . . . . . . . 100,000 0.20% 170,000 0.34% Disposal of defective products . . . . . . . . . . . . . . . . . . . . 340,000 0.68% 500,000 1.00%

Total internal failure cost . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000,000 4.00% 3,000,000 6.00%

External failure costs: Warranty repairs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000 1.80% 400,000 0.80% Warranty replacements . . . . . . . . . . . . . . . . . . . . . . . . . 2,300,000 4.60% 870,000 1.74% Allowances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 630,000 1.26% 130,000 0.26% Cost of ! eld servicing . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320,000 2.64% 600,000 1.20%

Total external failure cost . . . . . . . . . . . . . . . . . . . . . . . . . . 5,150,000 10.30% 2,000,000 4.00%

Total quality cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,000,000 18.00% $7,500,000 15.00%

*As a percentage of total sales. In each year sales totaled $50,000,000.

Managerial Accounting and Cost Concepts 77

Several things should be noted from the data in the exhibit. First, Ventura Company’s quality costs are poorly distributed in both years, with most of the costs due to either internal failure or external failure. The external failure costs are particularly high in Year 1 in comparison to other costs.

Second, note that the company increased its spending on prevention and appraisal activities in Year 2. As a result, internal failure costs went up in that year (from $2 mil- lion in Year 1 to $3 million in Year 2), but external failure costs dropped sharply (from $5.15 million in Year 1 to only $2 million in Year 2). Because of the increase in appraisal activity in Year 2, more defects were caught inside the company before they were shipped to customers. This resulted in more cost for scrap, rework, and so forth, but saved huge amounts in warranty repairs, warranty replacements, and other external failure costs.

Third, note that as a result of greater emphasis on prevention and appraisal, total qual- ity cost decreased in Year 2. As continued emphasis is placed on prevention and appraisal in future years, total quality cost should continue to decrease. That is, future increases in prevention and appraisal costs should be more than offset by decreases in failure costs. Moreover, appraisal costs should also decrease as more effort is placed into prevention.

Quality Cost Reports in Graphic Form

As a supplement to the quality cost report shown in Exhibit 2B–3 , companies frequently prepare quality cost information in graphic form. Graphic presentations include pie charts, bar graphs, trend lines, and so forth. The data for Ventura Company from Exhibit 2B–3 are presented in bar graph form in Exhibit 2B–4 .

The first bar graph in Exhibit 2B–4 is scaled in terms of dollars of quality cost, and the second is scaled in terms of quality cost as a percentage of sales. In both graphs, the data are “stacked” upward. That is, appraisal costs are stacked on top of prevention costs, internal failure costs are stacked on top of the sum of prevention costs plus appraisal costs, and so forth. The percentage figures in the second graph show that total quality cost equals 18% of sales in Year 1 and 15% of sales in Year 2, the same as reported earlier in Exhibit 2B–3 .

E X H I B I T 2 B – 4

Quality Cost Reports in Graphic Form

$10

9

8

7

6

5

4

3

2

1

0

Q u a lit y c o s t (i n m ill io n s )

1 2 Year

20

18

16

14

12

10

8

6

4

2

0

Q u a lit y c o s t a s a p e rc e n ta g e o f s a le s

1 2 Year

External failure

Internal failure

Appraisal

Prevention

External failure

Internal failure

Appraisal

Prevention

External failure

Internal failure

Appraisal

Prevention

External failure

Internal failure

Appraisal

Prevention

78 Chapter 2

Data in graphic form help managers to see trends more clearly and to see the magni- tude of the various costs in relation to each other. Such graphs are easily prepared using computer graphics and spreadsheet applications.

Uses of Quality Cost Information

A quality cost report has several uses. First, quality cost information helps managers see the financial significance of defects. Managers usually are not aware of the magnitude of their quality costs because these costs cut across departmental lines and are not normally tracked and accumulated by the cost system. Thus, when first presented with a quality cost report, managers often are surprised by the amount of cost attributable to poor quality.

Second, quality cost information helps managers identify the relative importance of the quality problems faced by their companies. For example, the quality cost report may show that scrap is a major quality problem or that the company is incurring huge warranty costs. With this information, managers have a better idea of where to focus their efforts.

Third, quality cost information helps managers see whether their quality costs are poorly distributed. In general, quality costs should be distributed more toward prevention and appraisal activities and less toward failures.

Counterbalancing these uses, three limitations of quality cost information should be recognized. First, simply measuring and reporting quality costs does not solve qual- ity problems. Problems can be solved only by taking action. Second, results usually lag behind quality improvement programs. Initially, total quality cost may even increase as quality control systems are designed and installed. Decreases in quality costs may not begin to occur until the quality program has been in effect for some time. And third, the most important quality cost, lost sales arising from customer ill will, is usually omitted from the quality cost report because it is difficult to estimate.

Typically, during the initial years of a quality improvement program, the benefits of compiling a quality cost report outweigh the costs and limitations of the reports. As managers gain experience in balancing prevention and appraisal activities, the need for quality cost reports often diminishes.

International Aspects of Quality

Many of the tools used in quality management today were developed in Japan after World War II. In statistical process control, Japanese companies borrowed heavily from the work of W. Edwards Deming. However, Japanese companies are largely responsible for quality circles, JIT, the idea that quality is everyone’s responsibility, and the emphasis on prevention rather than on inspection.

In the 1980s, quality reemerged as a pivotal factor in the market. Many companies now find that it is impossible to effectively compete without a very strong quality program in place. This is particularly true of companies that wish to compete in the European market.

The ISO 9000 Standards

The International Organization for Standardization (ISO), based in Geneva, Switzerland, has established quality control guidelines known as the ISO 9000 standards . Many com- panies and organizations in Europe will buy only from ISO 9000-certified suppliers. This means that the suppliers must demonstrate to a certifying agency that:

1. A quality control system is in use, and the system clearly defines an expected level of quality.

2. The system is fully operational and is backed up with detailed documentation of quality control procedures.

3. The intended level of quality is being achieved on a sustained, consistent basis.

Managerial Accounting and Cost Concepts 79

Defects cause costs, which can be classified into prevention costs, appraisal costs, internal failure costs, and external failure costs. Prevention costs are incurred to keep defects from happening. Appraisal costs are incurred to ensure that defective products, once made, are not shipped to cus- tomers. Internal failure costs are incurred as a consequence of detecting defective products before they are shipped to customers. External failure costs are the consequences (in terms of repairs, ser- vicing, and lost future business) of delivering defective products to customers. Most experts agree that management effort should be focused on preventing defects. Small investments in prevention can lead to dramatic reductions in appraisal costs and costs of internal and external failure.

Quality costs are summarized on a quality cost report. This report shows the types of quality costs being incurred and their significance and trends. The report helps managers understand the importance of quality costs, spot problem areas, and assess the way in which the quality costs are distributed.

Summary (Appendix 2B)

The key to receiving certification under the ISO 9000 standards is documentation. It’s one thing for a company to say that it has a quality control system in operation, but it’s quite a different thing to be able to document the steps in that system. Under ISO 9000, this documentation must be so detailed and precise that if all the employees in a com- pany were suddenly replaced, the new employees could use the documentation to make the product exactly as it was made by the old employees. Even companies with good quality control systems find that it takes up to two years of painstaking work to develop this detailed documentation. But companies often find that compiling this documentation results in improvements in their quality systems.

The ISO 9000 standards have become an international measure of quality. Although the standards were developed to control the quality of goods sold in European countries, they have become widely accepted elsewhere as well. Companies in the United States that export to Europe often expect their own suppliers to comply with ISO 9000 standards because these exporters must document the quality of the materials going into their prod- ucts as part of their own ISO 9000 certification.

The ISO program for certification of quality management programs is not limited to manufacturing companies. The American Institute of Certified Public Accountants was the first professional membership organization in the United States to win recognition under an ISO certification program.

Glossary (Appendix 2B)

Appraisal costs Costs that are incurred to identify defective products before the products are shipped to customers. (p. 74)

External failure costs Costs that are incurred when a product or service that is defective is deliv- ered to a customer. (p. 74)

Internal failure costs Costs that are incurred as a result of identifying defective products before they are shipped to customers. (p. 74)

ISO 9000 standards Quality control requirements issued by the International Organization for Standardization that relate to products sold in European countries. (p. 78)

Prevention costs Costs that are incurred to keep defects from occurring. (p. 73) Quality circles Small groups of employees that meet on a regular basis to discuss ways of improv-

ing quality. (p. 74) Quality cost Costs that are incurred to prevent defective products from falling into the hands of

customers or that are incurred as a result of defective units. (p. 73) Quality cost report A report that details prevention costs, appraisal costs, and the costs of inter-

nal and external failures. (p. 76)

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Quality of conformance The degree to which a product or service meets or exceeds its design specifications and is free of defects or other problems that mar its appearance or degrade its performance. (p. 72)

Statistical process control A charting technique used to monitor the quality of work being done in a workstation for the purpose of immediately correcting any problems. (p. 74)

Appendix 2B Exercises and Problems

All applicable exercises and problems are available with McGraw-Hill’s Connect™ Accounting.

EXERCISE 2B–1 Using Quality Management Terms [LO9]

Listed below are terms relating to quality management.

Appraisal costs Quality circles Quality cost report Prevention costs Quality External failure costs Internal failure costs Quality of conformance

Choose the term or terms that most appropriately complete the following statements. The terms can be used more than once. (Note that a blank can hold more than one word.)

1. When a product or service does not conform to customer expectations in terms of features or performance, it is viewed as being poor in .

2. A product or service will have a low if it does not function the way its designers intended, or if it has many defects as a result of sloppy manufacture.

3. A company incurs and in an effort to keep poor quality of conformance from occurring.

4. A company incurs and because poor quality of conformance has occurred.

5. Of the four groups of costs associated with quality of conformance, are generally the most damaging to a company.

6. Inspection, testing, and other costs incurred to keep defective products from being shipped to customers are known as .

7. are incurred in an effort to eliminate poor product design, defective manufacturing practices, and the providing of substandard service.

8. The costs relating to defects, rejected products, and downtime caused by quality problems are known as .

9. When a product that is defective in some way is delivered to a customer, then are incurred.

10. Over time, a company’s total quality costs should decrease if it redistributes its quality costs by placing its greatest emphasis on and .

11. In many companies, small groups of employees, known as , meet on a regular basis to discuss ways to improve the quality of output.

12. The way to ensure that management is aware of the costs associated with quality is to sum- marize such costs on a .

EXERCISE 2B–2 Classification of Quality Costs [LO9]

A number of activities that are part of a company’s quality control system are listed below:

a. Repairs of goods still under warranty. b. Customer returns due to defects. c. Statistical process control. d. Disposal of spoiled goods. e. Maintaining testing equipment. f. Inspecting finished goods. g. Downtime caused by quality problems. h. Debugging errors in software.

i. Recalls of defective products. j. Training quality engineers. k. Re-entering data due to typing errors. l. Inspecting materials received from suppliers. m. Audits of the quality system. n. Supervision of testing personnel. o. Rework labor.

Required:

1. Classify the costs associated with each of these activities into one of the following categories: prevention cost, appraisal cost, internal failure cost, or external failure cost.

Managerial Accounting and Cost Concepts 81

2. Which of the four types of costs listed in (1) above are incurred to keep poor quality of con- formance from occurring? Which of the four types of costs are incurred because poor quality of conformance has occurred?

PROBLEM 2B–3 Quality Cost Report [LO9, LO10]

Yedder Enterprises was a pioneer in designing and producing precision surgical lasers. Yedder’s product was brilliantly designed, but the manufacturing process was neglected by management with a consequence that quality problems have been chronic. When customers complained about defective units, Yedder would simply send out a repairperson or replace the defective unit with a new one. Recently, several competitors came out with similar products without Yedder’s quality problems, and as a consequence Yedder’s sales have declined.

To rescue the situation, Yedder embarked on an intensive campaign to strengthen its quality control at the beginning of the current year. These efforts met with some success—the downward slide in sales was reversed, and sales grew from $95 million last year to $100 million this year. To help monitor the company’s progress, costs relating to quality and quality control were compiled for last year and for the first full year of the quality campaign this year. The costs, which do not include the lost sales due to a reputation for poor quality, appear below:

Costs (in thousands)

Last Year This Year

Product recalls . . . . . . . . . . . . . . . . . . . . . . . $3,500 $600

Systems development . . . . . . . . . . . . . . . . . $120 $680

Inspection . . . . . . . . . . . . . . . . . . . . . . . . . . $1,700 $2,770

Net cost of scrap . . . . . . . . . . . . . . . . . . . . . $800 $1,300

Supplies used in testing . . . . . . . . . . . . . . . . $30 $40

Warranty repairs . . . . . . . . . . . . . . . . . . . . . $3,300 $2,800

Rework labor . . . . . . . . . . . . . . . . . . . . . . . . $1,400 $1,600

Statistical process control . . . . . . . . . . . . . . $0 $270

Customer returns of defective goods . . . . . . $3,200 $200

Cost of testing equipment . . . . . . . . . . . . . . $270 $390

Quality engineering . . . . . . . . . . . . . . . . . . . $1,080 $1,650

Downtime due to quality problems . . . . . . . . $600 $1,100

Required:

1. Prepare a quality cost report for both this year and last year. Carry percentage computations to two decimal places.

2. Prepare a bar graph showing the distribution of the various quality costs by category. 3. Prepare a written evaluation to accompany the reports you have prepared in (1) and (2) above.

This evaluation should discuss the distribution of quality costs in the company, changes in the distribution over the last year, and any other information you believe would be useful to management.

PROBLEM 2B–4 Analyzing a Quality Cost Report [LO10]

Bergen, Inc. , produces telephone equipment at its Georgia plant. In recent years, the company’s market share has been eroded by stiff competition from Asian and European competitors. Price and product quality are the two key areas in which companies compete in this market.

Two years ago, Jerry Holman, Bergen’s president, decided to devote more resources to improving product quality after learning that his company’s products had been ranked fourth in quality in a survey of telephone equipment users. He believed that Bergen could no longer afford to ignore the importance of product quality. Holman set up a task force that he headed to imple- ment a formal quality improvement program. Included on this task force were representatives from engineering, sales, customer service, production, and accounting. This broad representation was needed because Holman believed that this was a companywide program, and that all employees should share the responsibility for its success.

After the first meeting of the task force, Sheila Haynes, manager of sales, asked Tony Reese, production manager, what he thought of the proposed program. Reese replied, “I have reservations. Quality is too abstract to be attaching costs to it and then to be holding you and me responsible for cost improvements. I like to work with goals that I can see and count! I’m nervous about having my annual bonus based on a decrease in quality costs; there are too many variables that we have no control over.”

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As they were reviewing the report, Haynes asked Reese what he now thought of the quality improvement program. “The work is really moving through the production department,” Reese replied. “We used to spend time helping the customer service department solve their problems, but they are leaving us alone these days. I have no complaints so far, and I’m relieved to see that the new quality improvement hasn’t adversely affected our bonuses. I’m anxious to see if it increases our bonuses in the future.”

Required:

1. By analyzing the company’s quality cost report, determine if Bergen, Inc. ’s quality improve- ment program has been successful. List specific evidence to support your answer. Show per- centage figures in two ways: first, as a percentage of total production cost; and second, as a percentage of total quality cost. Carry all computations to one decimal place.

2. Discuss why Tony Reese’s current reaction to the quality improvement program is more favor- able than his initial reaction.

3. Jerry Holman believed that the quality improvement program was essential and that Bergen, Inc. , could no longer afford to ignore the importance of product quality. Discuss how Bergen, Inc. , could measure the opportunity cost of not implementing the quality improvement program.

(CMA, adapted)

Bergen, Inc.

Quality Cost Report

(in thousands)

Year 1 Year 2

Prevention costs:

Machine maintenance . . . . . . . . . . . $ 215 $ 160

Training suppliers . . . . . . . . . . . . . . . 5 15

Design reviews . . . . . . . . . . . . . . . . . 20 95

Total prevention cost . . . . . . . . . . . . . . 240 270

Appraisal costs:

Incoming inspection . . . . . . . . . . . . . 45 22

Final testing . . . . . . . . . . . . . . . . . . . 160 94

Total appraisal cost . . . . . . . . . . . . . . . 205 116

Internal failure costs:

Rework . . . . . . . . . . . . . . . . . . . . . . . 120 62

Scrap . . . . . . . . . . . . . . . . . . . . . . . . 68 40

Total internal failure cost . . . . . . . . . . . 188 102

External failure costs:

Warranty repairs . . . . . . . . . . . . . . . . 69 23

Customer returns . . . . . . . . . . . . . . . 262 80

Total external failure cost . . . . . . . . . . . 331 103

Total quality cost . . . . . . . . . . . . . . . . . $ 964 $ 591

Total production cost . . . . . . . . . . . . . . $4,120 $4,510

Bergen’s quality improvement program has now been in operation for two years. The com- pany’s most recent quality cost report is shown below.