11

Managerial Accounting Managerial Accounting & &

Costing Costing

ACC 122 Week 2 Lecture 2ACC 122 Week 2 Lecture 2

22

Learning GoalsLearning Goals

To be able to describe the To be able to describe the different types of cost behavior different types of cost behavior patterns.patterns.

To be able to analysis mixed To be able to analysis mixed costs.costs.

Cost EstimationCost Estimation

33

Cost BehaviorCost Behavior Cost Behavior: is how a cost will react – Cost Behavior: is how a cost will react –

change – as changes take place in the activity change – as changes take place in the activity base. base. As the activity level rises and falls, a As the activity level rises and falls, a particular cost may rise and fall as well – or it particular cost may rise and fall as well – or it may remain constant.may remain constant.

A cost behavior is a key tool in the hands of managers who are A cost behavior is a key tool in the hands of managers who are request to predict the costs that will be occurred under various request to predict the costs that will be occurred under various activity levels. activity levels.

In order to predict costs we use 3 cost behavior In order to predict costs we use 3 cost behavior patterns: Variable costspatterns: Variable costs

Fixed CostsFixed Costs Mixed (semi variable) CostsMixed (semi variable) Costs

Cost Structure is the percentage of each type of cost in Cost Structure is the percentage of each type of cost in an organization’s total cost of productionan organization’s total cost of production. .

44

Minutes Talked

To

tal L

on

g D

ista

nce

Tel

eph

on

e B

ill

Your total long distance telephone bill is increasing as the minutes you

talk are increasing.

Variable CostsVariable CostsAre those costs that vary-fluctuate directly as the Are those costs that vary-fluctuate directly as the company’s level of activity changes. They rise as company’s level of activity changes. They rise as production increases and fall as production decreases. production increases and fall as production decreases.

If activity level by 50% total variable cost by 50% If activity level by 50% total variable cost by 50% If activity level by 10% total variable cost by 10%If activity level by 10% total variable cost by 10%

55Minutes Talked

Per

Min

ute

Tel

eph

on

e C

har

ge

Variable CostsVariable Costs

The per minute cost of long distance calls

is constant, for example, 10¢ per

minute.

A variable cost remains constant if expressed on A variable cost remains constant if expressed on a a per unit basis.per unit basis.

So a variable cost is constant per unit but varies in total with the activity level.

66

Variable CostsVariable Costs

For a cost to be variable it must be For a cost to be variable it must be variable in respect to variable in respect to something,something, that is that is the activity base. the activity base. Activity baseActivity base or or cost cost driverdriver is whatever causes the rise and fall is whatever causes the rise and fall of a variable cost.of a variable cost.

For example the direct materials for the For example the direct materials for the production of a ford car is a variable costs. production of a ford car is a variable costs. As the output of ford increases, car As the output of ford increases, car increases, the direct materials needed increases, the direct materials needed increases.increases.

77

The Activity BaseThe Activity Base

A measure of what causes the

fluctuation of a variable cost.

A measure of what causes the

fluctuation of a variable cost.

UnitsUnitsproducedproduced

UnitsUnitsproducedproduced

Miles driven

Miles driven

Labor hours

Labor hours

Machine hours

Machine hours

88

VARIABLE COSTSVARIABLE COSTS

Extent of Variable Costs:Extent of Variable Costs: The proportion of variable costs in a firm differs across organizations. For example . .

A service company : audit, consulting, medical, A service company : audit, consulting, medical, architectural companies have very large fixed architectural companies have very large fixed costs (salaries etc)costs (salaries etc)

A manufacturing company or a restaurantA manufacturing company or a restaurantwill often have manywill often have manyvariable costs.variable costs.

99

True Variable CostsTrue Variable Costs. Direct materials is a . Direct materials is a true or true or proportionatelyproportionately variable cost because the amount used variable cost because the amount used during a period will vary in direct proportion to the level during a period will vary in direct proportion to the level of production activityof production activity,, moreover any amounts moreover any amounts purchased but not used can be stored and carried purchased but not used can be stored and carried forward to the next period as inventory.forward to the next period as inventory.

Step – Variable CostsStep – Variable Costs. A resource that is acquire in . A resource that is acquire in large amount and that increases or decreases only in large amount and that increases or decreases only in response to wide changes in activity is known as a step response to wide changes in activity is known as a step – variable cost. For example, the wages of skilled – variable cost. For example, the wages of skilled repair technicians are often considered to be a step – repair technicians are often considered to be a step – variable costs. variable costs. Small changes in the level of production are not likely to have any effect on the number of maintenance workers employed.

1010Volume

Co

st

Step-Variable CostsStep-Variable Costs

Co

st

Volume

True Variable Cost

1111

Volume

Co

st

Volume

Co

st

Small ChangesWide Changes

Step variable cost

1212

The Linearity Assumption and the Relevant The Linearity Assumption and the Relevant Range.Range.

– Except in the case of step – variable costs, we Except in the case of step – variable costs, we ordinarily assume a strictly linear relationship ordinarily assume a strictly linear relationship between cost and volume.between cost and volume.

– Economists correctly point out that many costs that Economists correctly point out that many costs that the accountant classifies as variable actually the accountant classifies as variable actually behave in a behave in a curvilinear fashion, curvilinear fashion, that is, the that is, the relation between cost and activity is a curve.relation between cost and activity is a curve.

– The relevant range The relevant range is that range of activity within is that range of activity within which the assumptions made about cost behaviour which the assumptions made about cost behaviour by the manager are valid.by the manager are valid.

1313

RelevantRange

A straight line closely

approximates a curvilinear

variable cost line within the

relevant range.

A straight line closely

approximates a curvilinear

variable cost line within the

relevant range.

Activity

To

tal

Co

st

Economist’sEconomist’sCurvilinear Cost Curvilinear Cost

FunctionFunction

The Linearity Assumption and The Linearity Assumption and the Relevant Rangethe Relevant Range

Accountant’s Straight-Line Accountant’s Straight-Line Approximation (constant Approximation (constant

unit variable cost)unit variable cost)

1414

FIXED COSTSFIXED COSTSAAre costs that tends to remain the same regardless of re costs that tends to remain the same regardless of

production volume. Such examples are rents, advertising, production volume. Such examples are rents, advertising,

insurance, office supplies e.t.cinsurance, office supplies e.t.c

Average fixed costs per unit decrease as the activity level Average fixed costs per unit decrease as the activity level

increases.increases.

1515

Number of customers

Total

Cost of Ren

t

Total Fixed Cost ExampleTotal Fixed Cost ExampleTotal Fixed Cost of Rent

Number of customers

Per Unit Cost of

Rent

Fixed Cost of Rent per customer

Fixed costs decreases on a per unit basis as the activity level – customers increases

1616

Number of Local Calls

Mo

nth

ly B

asic

Tel

eph

on

e B

ill p

er L

oca

l Cal

l

Fixed Cost Per Unit ExampleFixed Cost Per Unit Example

Average fixed costs per unit decreaseas the activity level increases.

The fixed cost per local call decreases as more local calls

are made.

1717

11. . Committed Fixed Costs. Committed Fixed Costs. Investments in Investments in facilities, equipment, and the basic organisation facilities, equipment, and the basic organisation structure. structure.

Examples: depreciation on buildings and Examples: depreciation on buildings and equipment, real estate taxes, insurance equipment, real estate taxes, insurance expenses, salaries of managers and operational expenses, salaries of managers and operational staff e.t.cstaff e.t.c

They have long-term nature and they can not be They have long-term nature and they can not be significantly reduced even for short periods of significantly reduced even for short periods of time without affecting seriously the goals and time without affecting seriously the goals and profitability of the company. E.g. if we discharge profitability of the company. E.g. if we discharge a manager because operation lowers the cost of a manager because operation lowers the cost of re-employment a new is greater than the short-re-employment a new is greater than the short-run saving realized.run saving realized.

As it is difficult to change committed costs As it is difficult to change committed costs management should make such engagements management should make such engagements only after careful thoughts. only after careful thoughts.

1818

2.Discretionary Fixed Costs2.Discretionary Fixed Costs. Discretionary . Discretionary Fixed Costs usually arise from annual decisions Fixed Costs usually arise from annual decisions by management to spend on certain fixed cost by management to spend on certain fixed cost items.items.

Examples: advertising, research, public relations, Examples: advertising, research, public relations, internship for students, training of employees etc.internship for students, training of employees etc.

Differences with committed fixed costs:Differences with committed fixed costs: 1. Are planning for the short run not for many 1. Are planning for the short run not for many yearsyears 2. They can be alter or cut-down without serious 2. They can be alter or cut-down without serious

impact on profitability and goals.impact on profitability and goals. 3. They are optional costs and not practically 3. They are optional costs and not practically

necessary for the operation of the firm. necessary for the operation of the firm.

1919

Is Labor a Variable or a Fixed Is Labor a Variable or a Fixed Cost?Cost?

The behavior of wage and salary costs can differ across countries, depending on labor regulations, labor contracts and custom.

In France, Germany, China, and Japan,management has little flexibility in adjustingthe size of the labor force.Labor costs are more fixed in nature. Most companies in the United States continueto view direct labor as a variable cost.

The demand for knowledge workers has grown extremely and most companies consider their employees as a valuable asset. As a result knowledge workers are relatively a fixed cost. On the other hand direct workers are a variable cost because managers prefer to recruit temporary or part-time workers when sales increases rather than keep them permanently at the company and keep payroll budget in a cost-effective level.

Labor costs a mixture of fixed and variable costs

2020

IN GENERAL FIXED COSTS CAN CHANGE BUT NOT WHEN SMALL CHANGES OCCUR.THEY ALTER IN LONG RUN WHEN LARGE CHANGES REALIZED IN ACTIVITY BASE.

2121

A mixed cost has both fixed and variableA mixed cost has both fixed and variablecomponents. Consider your utility costs.components. Consider your utility costs.

Example with expeditions company: €25,000 per year for license €3 per customerIf the company has 1000 customers this year € 25000+ € 3x1000= € 28000If the company has 0 customers this year € 25000+ € 3x0= € 25000

Mixed CostsMixed Costs

2222

Mixed CostsMixed Costs

2323

Fixed Yearly

license Charge

Variable

Cost per Customer

Customers

Co

st o

f st

ate

lice

nse

fee

s

X

Y

Total mixed cost

Mixed CostsMixed Costs

Example with expeditions company

Methods of MeasuringMethods of MeasuringCost FunctionsCost Functions

1. Engineering analysis1. Engineering analysis 2. Account analysis2. Account analysis 3. High-low analysis3. High-low analysis 4. Visual-fit analysis4. Visual-fit analysis

Cost estimation is the process of determining how a particular cost behaves

2424

2525

1.1. Account AnalysisAccount Analysis. Each account is classified . Each account is classified as either variable or fixed based on the as either variable or fixed based on the analyst’s prior knowledge of how the cost in analyst’s prior knowledge of how the cost in the account behaves.the account behaves.

2.2. The engineering ApproachThe engineering Approach Cost analysis Cost analysis involves a detailed analysis of what cost involves a detailed analysis of what cost behaviour should be, based on an industrial behaviour should be, based on an industrial engineer’s evaluation of the production engineer’s evaluation of the production methods to be used, the materials methods to be used, the materials requirements, labour requirements, equipment requirements, labour requirements, equipment usage and so on.usage and so on.

Account Analysis ExampleAccount Analysis Example

Supervisor’s salary and benefitsSupervisor’s salary and benefits $ 3,800 $ 3,800 $3,800$3,800

Hourly workers’ wages and benefitsHourly workers’ wages and benefits 14,674 14,674 $14,674$14,674

Equipment depreciation and rentalsEquipment depreciation and rentals 5,873 5,873 5,873 5,873

Equipment repairsEquipment repairs 5,6045,604 5,604 5,604

Cleaning suppliesCleaning supplies 7,4727,472 7,4727,472

Total maintenance costsTotal maintenance costs $37,42 $9,673 $27,750 $37,42 $9,673 $27,750

Monthly costMonthly cost AmountAmount FixedFixed VariableVariable

2626

Account Analysis ExampleAccount Analysis Example

Fixed cost per month = $9,673Fixed cost per month = $9,673

Variable cost per patient-dayVariable cost per patient-day= $27,750 ÷ 3,700= $27,750 ÷ 3,700

= $7.50 per patient-day= $7.50 per patient-day

3,700 patient-days3,700 patient-days

Y = $9,673 + ($7.50 × patient-days)Y = $9,673 + ($7.50 × patient-days)

2727

3. High-Low Method3. High-Low Method

The focus of this method is normally onThe focus of this method is normally onthe highest- and lowest-activity pointsthe highest- and lowest-activity points..

The first step is to plot the historicalThe first step is to plot the historicaldata points on a table.data points on a table.

2828

Difference between the costs corresponding Variable Model = to the highest and lowest activity levels

Difference between the highest and lowest activity levels

High-Low Method ExampleHigh-Low Method Example

High month: AprilHigh month: AprilMaintenance cost: $47,000Maintenance cost: $47,000

Number of patient-days: 4,900Number of patient-days: 4,900

Low month: SeptemberLow month: SeptemberMaintenance cost: $17,000Maintenance cost: $17,000

Number of patient-days: 1,200Number of patient-days: 1,200

What is the variable cost?What is the variable cost?

2929

High-Low Method ExampleHigh-Low Method Example

($47,000 – $17,000) ÷ (4,900 – 1,200)($47,000 – $17,000) ÷ (4,900 – 1,200)= $30,000 ÷ 3,700 = $8.1081= $30,000 ÷ 3,700 = $8.1081

What is the fixed cost?What is the fixed cost?Two ways to find thisTwo ways to find this

a)$47,000 = Fixed cost + ($8.1081× 4,900)a)$47,000 = Fixed cost + ($8.1081× 4,900)$47,000 – $39,730 = $7,270$47,000 – $39,730 = $7,270

b)$17,000 = Fixed cost + ($8.1081× 1,200)b)$17,000 = Fixed cost + ($8.1081× 1,200)$17,000 – $9,730 = $7,270$17,000 – $9,730 = $7,270

3030

The mixed cost line equation in this The mixed cost line equation in this case is:case is:

Y = 7270 + 8.1081*XY = 7270 + 8.1081*X

3131

4. Visual-Fit Method4. Visual-Fit Method

In the In the visual-fit method,visual-fit method, the cost analyst the cost analystvisually fits a straight line through a plotvisually fits a straight line through a plot

of all of the available data, not justof all of the available data, not justbetween the high point and thebetween the high point and the

low point, making it more reliablelow point, making it more reliablethan the high-low method.than the high-low method.

3232

When the cost has been classified as a semi When the cost has been classified as a semi variable or when the analyst has variable or when the analyst has no clear idea no clear idea about the behavior of a cost itemabout the behavior of a cost item it is helpful it is helpful to use the to use the visual fit method visual fit method to plot (design) to plot (design) recent observations of the cost at various activity recent observations of the cost at various activity levels. So first it makes a table and then a graph-a levels. So first it makes a table and then a graph-a diagram which displays the results. The resulting diagram which displays the results. The resulting diagram helps the analyst to diagram helps the analyst to visualize –see and visualize –see and understand-understand- the relationship between cost and the relationship between cost and the level of activity ( or the cost driver)the level of activity ( or the cost driver)

3333

Month Cost for month Dozen of bakery items sold per month (cost driver)

Jan 5100 75000

Feb 5300 78000

Then make a graph with these data

3434

e.g. $ 1500

The visual cost line cut off the vertical axis at $1500 so this give us the estimation of the fixed cost component in the semi variable cost approximation. To determine the variable cost per unit deduct the fixed cost from the total cost at any activity level.