Managerial Accounting and Cost Concepts

Needs of Management
• Financial accounting is concerned with reporting financial information to external parties, such as
stockholders, creditors, and regulators.
• Managerial accounting is concerned with providing information to managers within an organization so that
they can formulate plans, control operations, and make decisions.

Purposes of Cost Classification
1. Assigning costs to cost objects.
2. Accounting for costs in manufacturing companies.
3. Preparing financial statements.
4. Predicting cost behavior in response to changes in activity.
5. Making decisions.

Assigning Costs to Cost Objects

Direct costs
• Costs that can be easily and conveniently traced to a unit of
product or other cost object.
• Examples: direct materials and direct labor.
Indirect costs
• Costs that cannot be easily and conveniently traced to a
unit of product or other cost object.
• Example: manufacturing overhead.
Common costs
• Indirect costs incurred to support a number of cost objects.
These costs cannot be traced to any individual cost object.

Classifications of Manufacturing
Costs
• Direct materials.
• Direct labor.
• Manufacturing overhead.

Classifications of Manufacturing
Costs
• Direct materials.
• Direct labor.
• Manufacturing overhead.

Direct Materials
• Direct materials are raw materials that become an
integral part of the product and that can be
conveniently traced directly to it.
• Example: A radio installed in an automobile.

Direct Labor
• Direct labor consists of labor costs that can be easily
traced to individual units of product.
• Example: Wages paid to automobile assembly workers.

Manufacturing Overhead
Manufacturing overhead includes all manufacturing
costs except direct material and direct labor. These costs
cannot be readily traced to finished products.
• Includes indirect materials that cannot be easily or
conveniently traced to specific units of product.
• Includes indirect labor that cannot be easily or conveniently
traced to specific units of product.

Manufacturing Overhead –
Examples
Examples of manufacturing overhead:
• Depreciation of manufacturing equipment.
• Utility costs.
• Property taxes.
• Insurance premiums incurred to operate a manufacturing
facility.
Only those indirect costs associated with operating the
factory are included in manufacturing overhead.

Prime Costs and Conversion Costs
Manufacturing costs are often classified as
follows:
Prime cost
• Direct materials.
• Direct labor.
Conversion cost
• Direct labor.
• Manufacturing overhead.

Nonmanufacturing Costs
Selling costs
• The costs incurred to secure customer orders and get the
finished product to the customer. Selling costs can be either
direct or indirect costs.
Administrative costs
• The costs associated with the general management of an
organization rather than with manufacturing or selling.
Administrative costs can be either direct or indirect costs.

Product Costs
• Product costs include all the costs involved in acquiring
or making a product.
• Product costs “attach” to a unit of product as it is
purchased or manufactured and they stay attached to
each unit of product as long as it remains in inventory
awaiting sale.

Manufacturing Product Costs
For manufacturing companies, product costs include:
• Raw materials include any materials that go into the
final product.
• Work in process consists of units of product that are
only partially complete and will require further work
before they are ready for sale to the customer.
• Finished goods consist of completed units of product
that have not yet been sold to customers.

Transfer of Product Costs
• When direct materials are used in production, their costs
are transferred from Raw Materials to Work in Process.
• Direct labor and manufacturing overhead costs are added
to Work in Process to convert direct materials into finished
goods.
• Once units of product are completed, their costs are
transferred from Work in Process to Finished Goods.
• When a manufacturer sells its finished goods to customers,
the costs are transferred from Finished Goods to Cost of
Goods Sold.

Cost Classifications for Preparing
Financial Statements 1
Product costs include direct materials, direct labor, and
manufacturing overhead.

Cost Classifications for Preparing
Financial Statements 2
Period costs include all selling costs and administrative
costs.

Cost Classifications for Predicting
Cost Behavior
Cost behavior refers to how a cost will react to changes in
the level of activity.
The most common classifications are:
• Variable costs.
• Fixed costs.
• Mixed costs.

Variable Cost
• A variable cost varies, in total, in direct proportion to
changes in the level of activity.
• A variable cost per unit is constant.

An Activity Base (Cost Driver)
An activity base is a measure of what causes the
incurrence of a variable cost.
• Units produced.
• Machine hours.
• Miles driven.
• Labor hours.

Fixed Cost
• A fixed cost is a cost that remains constant, in total,
regardless of changes in the level of the activity.
• If expressed on a per unit basis, the average fixed cost
per unit varies inversely with changes in activity.

Types of Fixed Costs
Committed
• Long term, cannot be significantly reduced in the short
term.
Discretionary
• May be altered in the short term by current managerial
decisions.

The Linearity Assumption and the
Relevant Range
• The relevant range of activity pertains to fixed cost as
well as variable costs. For example, assume office
space is available at a rental rate of $30,000 per year in
increments of 1,000 square feet.
• Fixed costs would increase in a step fashion at a rate of
$30,000 for each additional 1,000 square feet.

Mixed Costs 1
A mixed cost contains both variable and fixed elements.  
Consider the example of utility cost.

Mixed Costs 2
The total mixed cost line can be expressed as an
equation: Y = a + bX
Where:
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

Mixed Costs – An Example
If your fixed monthly utility charge is $40, your variable
cost is $0.03 per kilowatt hour, and your monthly activity
level is 2,000 kilowatt hours, what is the amount of your
utility bill?
Y = a + bX
Y = $40 + ($0.03 × 2,000)
Y = $100

Cost Classifications for
Decision Making
• Decisions involve choosing between alternatives. The
goal of making decisions is to identify those costs that
are either relevant or irrelevant to the decision.
• It is important to understand the terms differential cost
and revenue, sunk cost, and opportunity cost.

Differential Costs
• Differential cost (or incremental cost) is the difference
in cost between any two alternatives.
• A difference in revenue between two alternatives is
called differential revenue.
• Both are always relevant to decisions.
• Differential costs can be either fixed or variable.

Sunk Costs
• Sunk costs have already been incurred and cannot be
changed by any decision made now or in the future.
• These costs should be ignored when making decisions.

Opportunity Cost
• Opportunity cost is the potential benefit that is given
up when one alternative is selected over another.
• These costs are not usually found in accounting records
but must be explicitly considered in every decision.
• For students: What is the opportunity cost you incur by
attending class?