Chapter 01 Lecture Notes
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Chapter 1
Lecture Notes
Chapter theme: This chapter explains how managers
need to rely on different cost classifications for different
I. Summary of the types of cost classifications
A. This slide summarizes the types of cost classifications
II. Cost classifications for assigning costs to cost objects
Learning Objective 1-1: Understand cost classifications
used for assigning costs to cost objects: direct costs and
indirect costs.
A. Cost object − Anything for which cost data are desired
including products, customers, jobs, organizational
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1. Common costs − Indirect costs incurred to
support a number of cost objects. These
costs cannot be traced to any individual cost
object.
III. Cost classifications for manufacturing companies
A. Classifications of manufacturing costs
i. Direct materials − Raw materials that
become an integral part of the finished
product and whose costs can be conveniently
traced to it.
ii. Direct labor − Labor costs that can be easily
iii. Manufacturing overhead − Includes all
manufacturing costs except direct materials
and direct labor. These costs cannot be easily
traced to specific units produced (also called
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2. Includes indirect labor costs that cannot be
conveniently traced to the creation of
B. Classifications of nonmanufacturing costs (also called
selling and administrative costs).
i. Selling costs – Includes all costs necessary to
secure customer orders and get the finished
Learning Objective 1-3: Understand cost classifications
used to prepare financial statements: product costs and
period costs.
C. Cost classifications for preparing financial
statements
i. Product costs – Includes all the costs that are
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1. Product costs are expensed in the income
statement when the products are sold.
ii. Period costs – Includes all selling and
Quick Check
−
product versus period costs
D. Prime costs and conversion costs
i. Prime cost − Direct materials cost plus direct
IV. Cost classifications for predicting cost behavior
Learning Objective 1-4: Understand cost classifications
used to predict cost behavior: variable costs, fixed
i. Variable cost − A cost that varies, in total, in
direct proportion to changes in the level of
activity. However, variable cost per unit is
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1. An activity base (also called a cost driver)
is a measure of what causes the incurrence
ii. Fixed cost − A cost that remains constant, in
total, regardless of changes in the level of the
1. Committed fixed costs represent
investments with a multi-year planning
horizon that cannot be easily adjusted in the
Helpful Hint: To illustrate fixed costs, ask students for
the cost of a large pizza. Then ask: What would be the
cost per student if two students buy a pizza? What if
four students buy a pizza? This makes it clear why
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iii. The linearity assumption and the relevant
range − Accountants usually assume that
costs are strictly linear; however, economists
1. The relevant range is that range of activity
within which the assumptions made about
cost behavior are valid.
iv. The relevant range of activity pertains to
fixed cost as well as variable costs.
1. For example, assume office space is
v. The relevant range for a fixed cost is the
range of activity over which the graph of the
cost is flat.
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vii. Mixed cost – A cost that contains both
variable and fixed elements.
1. For example, utility bills often contain fixed
and variable cost components.
a. The fixed portion of the utility bill is
ii. An equation can be used to express the relationship
between mixed costs and the level of the activity.
This equation can be used to calculate what the
total mixed cost would be for any level of activity.
1. The equation is Y = a + bX
a. Y = The total mixed cost.
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III. The analysis of mixed costs
a. Account analysis and the engineering approach
i. In account analysis, each account under
consideration is classified as variable or fixed
ii. The engineering approach classifies costs based
upon an industrial engineer’s evaluation of
production methods, material specifications, labor
Learning Objective 1-5: Analyze a mixed cost using a
scattergraph plot and the high-low method.
i. Before analyzing a mixed cost you should plot the
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1. The maintenance cost, which is known as
ii. After plotting the data, examine the dots on the
scattergraph to see if they are linear, such that a
straight line can be drawn that approximates the
relation between cost and activity.
1. If the dots are not linear, do not analyze the
c. The high-low method
i. This method can be used to analyze mixed costs if
a scattergraph plot reveals a linear relationship
between the X and Y variables. Let’s continue
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iii. The second step is to determine the total costs
iv. The third step is to calculate the change in cost
between the two data points ($2,400) and divide it
by the change in activity level between the two
v. The fourth step is to take the total cost at either
activity level (in this case, $9,800) and deduct the
variable cost component ($5,100). The residual
represents the estimate of total fixed costs
($4,700).
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d. The least-squares regression method
i. This method can be used to analyze mixed costs if
a scattergraph plot reveals an approximately linear
relationship between the X and Y variables.
ii. This method uses all of the data points to
iii. The basic goal of this method is to fit a straight
line to the data that minimizes the sum of the
squared errors. The regression errors are the
vertical deviations from the data points to the
regression line.
1. The output from the regression analysis can
be used to create an equation that enables
you to estimate total costs at any activity
level.
v. The high-low and least-squares regression
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IV. Traditional and contribution format income statements
Learning Objective 1-6: Prepare income statements for
a merchandising company using the traditional and
contribution formats.
a. The traditional and contribution formats differ as
follows:
i. The traditional approach separates product costs
as required for external reporting purposes from
iii. The contribution approach is used as an internal
planning and decision-making tool. For example,
this approach is useful for:
1. Cost-volume-profit analysis (Chapter 5).
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Helpful Hint: The income statement from the annual
report of a well-known local manufacturing firm can be
V. Cost classifications for decision making
Learning Objective 1-7: Understand cost classifications
used in making decisions: differential costs, opportunity
costs, and sunk costs.
A. It is important to realize that every decision involves a
choice between at least two alternatives. The goal of
i. Differential costs (or incremental costs) − A
difference in cost between any two
alternatives (a difference in revenue between
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ii. Opportunity cost − The potential benefit that
Helpful Hint: Ask students what opportunity costs they
incur by attending class. Their opportunity cost is the
value to them of the activity they would be doing
otherwise (e.g., working, sleeping, partying, studying,
etc.)
iii. Sunk cost − A cost that has already been
incurred and that cannot be changed now or in
the future.
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