Chapter 2| Managerial Accounting & Cost Concepts

Learning Objectives:
1. Understand the types of cost classifications.
2. Explain assigning costs to cost objects; direct and indirect costs.
3. Identify each of the three basic manufacturing cost categories.
4. Distinguish between product costs and period costs and give examples of each.
5. Differentiate between variable costs, fixed costs and mixed costs.
6. Analyze a mixed cost using the high‐low method.
7. Define and give examples of cost classifications used in making decisions: differential
costs, opportunity costs, and sunk costs.
8. Identify the four types of quality costs and explain how they interact
- Appendix 2B
Types of Cost Classifications – Based on purpose

1. Assigning Costs to 2. Manufacturing

Cost Objects Companies

4. Predicting Cost
3. Financial Reporting
Behavior

5. Making Business
Decisions
 Cost object refers to
anything for which cost
1. For Assigning Costs to Cost Objects data is desired; products,
customers, jobs, SBUs, etc.
i. Direct Costs
To be TRACED,
CAN be easily and conveniently traced to a unit of product
(cost object). the cost must
be CAUSED BY
Materiality of THE cost
ii. Indirect Costs cost is imp. object.
CANNOT be easily and conveniently traced to a unit of product
(cost object).

Common Costs
• Incurred for a number of cost objects.
• Cannot be traced to any individual cost object.
Q. A company makes chairs and tables. Which of the following items would be treated as an common cost?
a) Wood used to make a chair
b) Fabric to cover the seat of a chair
c) The salary of the sales director of the company
Q. Classify the following costs incurred by Stylish furniture, in its factory into direct and indirect costs:
1. Salaries for assembly line inspectors. Indirect Cost

2. Insurance on factory machines. Indirect Cost

Cost object ??
3. Property taxes on the factory building. Indirect Cost
4. Factory repairs. Indirect Cost

5. Upholstery used in manufacturing furniture. Direct Cost

6. Wages paid to assembly line workers. Direct Cost
7. Factory machinery depreciation. Indirect Cost
8. Glue, nails, paint, and other small parts used in production. Indirect Cost
9. Factory supervisors’ salaries. Indirect Cost
10. Wood used in manufacturing furniture. Direct Cost
2. Manufacturing Companies can be direct or
indirect costs

i. Manufacturing Costs ii. Non-Manufacturing Costs

1. Direct Material SG&A Costs
1. Selling Costs
- Material cost that becomes integral part of
finished product Order-getting and Order Filling costs
2. Direct Labor 2. Administrative Costs
- Labor cost that can be easily traceable to unit
of product
Costs associated with the general
management of an organization
3. Mfg. Overhead • Indirect Material
• Indirect Labor
- All mfg. costs other
than DM & DL • Repair & Maintenance
• Depreciation
• Insurance, etc.
Q. Direct materials and direct labor of a company total $8,000,000. If
manufacturing overhead is $4,000,000, what is direct labor cost?

a. $4,000,000
b. $8,000,000
c. $0
d. Cannot be determined from the information provided
Q. Following costs relate to Crescent Hospital that are incurred in producing a
patient’s X-ray. Classify these costs into DM, DL, and Service Overheads.

Mfg. Cost Non-Mfg. Cost

Sr. # Types of Costs
DM DL Service OH Selling Cost G&A Cost
1 Salaries for the X-ray machine technicians
2 Wages for the hospital janitorial personnel
3 Film costs for the X-ray machines
4 Property taxes on the hospital building
5 Salary of the X-ray technicians’ supervisor
6 Electricity costs for the X-ray department
7 Maintenance and repairs on the X-ray machines
8 X-ray department supplies
9 Depreciation on the X-ray department equipment
10 Depreciation on the hospital building
 2. Manufacturing Companies

Manufacturing costs are often classified as:

Prime Cost = Direct Material + Direct Labor

Conversion Cost = Direct Labor + Indirect Material +

Indirect Labor + Indirect Expense
 Q. Which of the following costs is classified as a prime cost?

Direct materials Indirect materials

a) Yes Yes
b) Yes No
c) No No
d) No Yes

Q. During the month of April, direct labor cost totaled $27,000 and direct labor cost was 30% of prime
cost. If total manufacturing costs during April were $125,000, calculate the manufacturing overhead.

Direct labor cost = $27,000

Direct labor cost = 0.30 x Prime cost Total Mfg. Cost = Prime cost + Mfg. OH cost
Prime cost = $27,000 /0.3 = $90,000 $125,000 = $90,000 + Mfg. OH cost
Mfg. OH Cost = $35,000
 3. For Preparing Financial Statements | on basis of attributability
PRODUCT COSTS PERIOD COSTS
All MANUFACTURING costs required All NON-MANUFACTURING costs
to MAKE a product; the costs directly not included in product costs;
tied to production process associated with passage of time
PRODUCT COSTS Balance Sheet Income Statement
Inventories Expenses
Direct Material Raw Materials
INVENTORIABLE
(Material Purchased)
COSTS
Direct Labor Work in Process
Manufacturing OHs
Sales
Finished Goods Cost of Goods Sold

PERIOD COSTS
Selling & Administrative Selling &
Administrative
Q. All of the following would be classified as
product costs except:
a) property taxes on production premises.
b) insurance on factory machinery.
c) salaries of the marketing staff.
d) wages of machine operators Q. A partial listing of costs incurred during July at Denim
Corporation appears below:
Mfg., Direct labor, Product
Factory supplies $7,000
Administrative wages and salaries $82,000
Direct labor $82,000
Sales staff salaries $39,000
Factory depreciation $52,000
Corporate HQ building rent $45,000
Direct materials $176,000
Indirect labor $29,000
Marketing $126,000

Calculate the period cost.

Total Period Cost for July: $ 292,000

 Cost behavior refers to how
4. For Predicting Cost Behavior a cost will react to changes
in the level of activity.

i. Variable Costs ii. Fixed Costs iii. Mixed Costs

• Varies in direct proportion • Remains constant in total, • Contain both
to the changes in level of regardless of changes in the variable and fixed
activity level of activity elements

• Variable cost per unit is • Average fixed cost per unit

constant varies inversely with
changes in activity
Activity Base /
Cost Driver
A measure of what Manufacturing
Machine hours
causes the Overheads can be
Labor hours
incurrence of a Miles driven
variable cost
fixed or variable
Units produced
Room occupancy etc.
4. For Predicting Cost Behavior
Types of Fixed Costs

Discretionary Controllable
Committed costs

• Results from multi-year Investment/ • Can be altered in the short-

obligation already made term by managerial decisions
• Long-term, cannot be significantly • Period-specific cost, optional
reduced in the short term.
• Act as investments in the
• Capacity costs / contractual future.

Examples Examples
• Depreciation on NCA • Advertising Exp.
• Maintenance costs • R&D Exp.
• Mortgage payments • PR expenses
 • Variable cost is directly proportional
to level of activity – units produced
$10
$10 • Variable cost per unit remains constant
$10
$10 WORK THIS OUT
$5,000 • Avg. fixed cost per unit is inversely
$5,000 related to level of activity.
$5,000
$5,000

Which of the above best describes the

behavior of Costs A and B? Rent on a HO building
would be classified as a
A) Cost A is fixed, Cost B is variable.
PRODUCT OR PERIOD cost
B) Cost A is variable, Cost B is fixed.
and as a FIXED OR
C) Both Cost A and Cost B are variable.
D) Both Cost A and Cost B are fixed. VARIABLE cost.
4. For Predicting Cost Behavior | Fixed Costs and Relevant Range

Assume office space is

available at a rental
Fixed costs would increase in a step fashion at a rate
rate of $30,000 per
of $30,000 for each additional 1,000 square feet.
year in increments of
1,000 square feet.

Step-Variable Cost
90
Rent Cost ($ ‘000)

The relevant range for a

Relevant fixed cost is the range of LINERARITY
60 ASSUMPTION
Range activity over which the
cost is flat. Costs are
30 strictly linear
within relevant
range
0
0 1,000 2,000 3,000
Rented Area (Square Feet)
Q. At a volume of 8,000 units, ABC Ltd. incurred $42,000 in factory (mfg.) overhead costs, including
$18,000 in fixed costs. If volume increases to 9,500 units and both 8,000 units and 9,500 units are
within the relevant range, then the company would expect to incur total factory overhead costs of:

A) $38,500 B) $46,500
C) $42,000 D) $48,500

Total OH cost = Fixed OH cost + Variable OH cost

$42,000 = $18,000 + Variable OH cost
Variable OH cost = $24,000

Variable OH cost / unit = $24,000 ÷ 8,000 units

= $3.0 per unit

Total OH cost = Fixed OH cost + Variable OH cost

= $18,000 + ($3 per unit × 9,500 units)
= $18,000 + $28,500
= $46,500
 4. For Predicting Cost Behavior
iii. Mixed Costs contain both variable and fixed elements
Y
Total mixed cost The total mixed cost line can be expressed
160 as an equation: Y = a + bX
Landline Cost ($)

120 Where: Y = The total mixed cost.

Variable Cost a = The total fixed cost (the
80 vertical intercept of the line).
$0.5 x 250 = $125
b = The variable cost per unit of
40 activity (the slope of the line).
Fixed Monthly Line Rent
X = The level of activity.
X
250
Activity (no. of calls)

Y = a + bX
Q. If your fixed monthly landline rent is $40, your
= $40 + ($0.5 × 250)
variable cost is $0.5 per call, and you made a total calls
of 250, what is the amount of your telephone bill? $165
Total variable cost is
expected to remain
unchanged as activity
changes within the
relevant range. Q. Unique Wreath Corporation manufactures
crowns according to customer specifications and
TRUE / FALSE ships them to customers using Leopard Courier
Service. Which two terms below describe the cost
of shipping these crowns?

a) variable cost and product cost

b) fixed cost and product cost
c) variable cost and period cost
d) fixed cost and period cost
Q. At an activity level of 4,500 machine-hours in a month, Finland Corporation’s total
variable production engineering cost is $174,200 and its total fixed production engineering
cost is $125,550. What would be the total production engineering cost per unit, both fixed
and variable, at an activity level of 4,850 machine-hours in a month? Assume that this level of
activity is within the relevant range.
Also, comment on the behavior of fixed cost /unit at 4,850 machine hrs. as compared to
4,500 hours.
VC /unit = $174,200 ÷ 4,500 units = $38.71 / unit
A) $62.71 FC / unit at 4,850 units = $125,550 ÷ 4,850 units =
B) $64.60 $25.89 / unit
C) $60.94
D) $55.11 Total Cost /unit = VC + FC
= $38.71 /unit + $25.89/ unit
= $64.60 / unit

FC / unit at 4,500 machine hrs. = $128,550 / 4,500 = $28.57

FC / unit in inversely related to activity level.
Analyzing Mixed Costs
estimates the fixed and variable elements of a mixed
High-Low Method cost by analyzing past records of cost and activity data.

Calculate the change in cost and change in activity.

[Highest Total Cost – Lowest Total Cost]

[Highest activity level – Lowest activity level]

Calculate the variable cost / unit.

[Change in Total Cost / Change in Unit ]

Calculate the fixed cost element using the variable cost / unit calculated
at either at the highest or the lowest level of activity.

Total Fixed Cost = Total Cost – Total Variable Cost

 Analyzing Mixed Costs High-Low Method
Following data of ABC Ltd. pertains to Step 1: Calculate the change in cost and change in activity.
hours of maintenance work and the total
Change in Total cost = $9,800 - $7,400 = $2,400
maintenance costs for six months.
Change in activity = 850 - 450 = 400

Step 2: Calculate the variable cost / unit.

Change in Total Cost / Change in Units

= $2,400 / 400 = $6.0 /hr.

Step 3: Calculate the fixed cost element using the VC /

unit calculated at either at the highest or the lowest level
of activity.

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($6.0 x 850)
Calculate the fixed and variable components.
= $9,800 - $5,100 = $4,700
Q. FINTech Corporation has provided the following production and average cost data for two levels
of monthly production volume. The company produces a single product.
Production volume 4,000 units 5,000 units
Direct materials $85.80 / unit $85.80 / unit
Direct labor $56.10 / unit $56.10 / unit Required: Calculate the total cost to
Mfg. OH Fixed + Variable $73.60 / unit $62.10 / unit manufacture 4,300 units.

WORKOUT TOTAL COST AT HIGHEST & LOWEST ACTIVITY LEVEL

Total Variable Mfg. Cost / Unit
Total Mfg. OH at 5,000 units = 5,000 units × $62.10 per unit = $310,500
Total Mfg. OH at 4,000 units = 4,000 units × $73.60 per unit = $294,400 Total Var. Mfg. Cost / unit = DM + DL + Var. Mfg. OH
= $85.80 + $56.10 + $16.10
Variable Mfg. OH per unit = Change in cost ÷ Change in activity = $158.0 / unit

Var. Mfg. OH / unit = ($310,500 – $294,400) ÷ (5,000 – 4,000 units) Total Mfg. Cost for 4,300 units
= $16,100 ÷ 1,000 units = $16.10 / unit
Total Mfg. Cost = Total Var. Mfg. Cost/ Unit ×
Separate the Fixed Mfg. Cost from Total Mfg. Cost Units Manufactured + Total Fixed Mfg. Cost
= ($158.0 / unit × 4,300 units) + $230,000
Fixed Cost Element Of Mfg. OH = Total cost – Variable cost element = $909,400
= $310,500 – (5,000 units × $16.10 per unit)
Fixed Mfg. OH Cost = $230,000
 Decision making
5. For Decision Making involves
choosing
between
alternatives
a) Sunk Cost

 Sunk costs have already been incurred and cannot be changed now or in the future.

 These costs should be ignored when making decisions – Irrelevant to decision

b) Differential Cost & Differential Revenue For Planning &

Decision Making
 Cost and benefits that differ among alternatives. purpose, mixed costs
should be separated
 Consider only COSTS & BENEFITS that are RELEVANT to the decision.
into their variable and
fixed components
c) Opportunity Cost

 The potential benefit that is given up when one alternative is selected over another.

 Not entered in accounting records but explicitly considered while making a decision.