Chapter 2 Homework The Total Mixed Cost The Total Fixed

Chapter 2

Lecture Notes

Chapter theme: This chapter explains how managers

need to rely on different cost classifications for different

purposes. The four main purposes emphasized in this

I. General cost classifications We’ll begin by looking at

manufacturing companies because their basic activities

include most of the activities found in other types of

business organizations.

Learning Objective 1: Identify and give examples of

each of the three basic manufacturing cost categories.

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.

3

2

4

1. Includes indirect materials that are part of

the finished product, but that cannot be

easily traced to it.

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

product into the hands of the customer.

C. Product costs versus period costs

i. Product costs – Includes all the costs that are

involved in acquiring or making a product.

9

1. Product costs are expensed in the income

statement when the products are sold.

Quick Check

−

product versus period costs

D. Prime costs and conversion costs

i. Prime cost − Direct materials cost plus direct

labor cost.

12

II. Cost classifications for predicting cost behavior

Learning Objective 3: Understand cost behavior

patterns including variable costs, fixed costs, and mixed

costs.

10–11

13

1. An activity base (also called a cost driver)

is a measure of what causes the incurrence

of variable costs. As the level of the activity

base increases, the total variable cost

increases proportionally.

1. Committed fixed costs represent

investments with a multi-year planning

horizon that cannot be easily adjusted in the

short term.

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

17

20

iii. The linearity assumption and the relevant

range − Accountants usually assume that

costs are strictly linear; however, economists

point out that many costs are actually

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.

v. The relevant range for a fixed cost is the

range of activity over which the graph of the

cost is flat.

23

vii. Mixed cost – A cost that contains both

variable and fixed elements.

b. The variable portion of the bill varies

in direct proportion to the

consumption of kilowatt hours.

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.

iii. For example, if your fixed monthly utility charge is

$40, your variable cost is $0.03 per kilowatt hour,

and your monthly activity level was 2,000 kilowatt

III. The analysis of mixed costs

a. Account analysis and the engineering approach

1. This approach is limited in value in the

sense that it glosses over the fact that some

accounts may have both fixed and variable

components.

b. Diagnosing cost behavior with a scattergraph plot

Learning Objective 4: Analyze a mixed cost using a

scattergraph plot and the high-low method.

30

31

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.

2. In this example, the dots are linear so we can

proceed to the high-low method.

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

with our data from the scattergraph plot.

33

iii. The second step is to determine the total costs

associated with the two chosen points (high =

$9,800; low = $7,400).

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

data points (400 units).

1. The quotient represents an estimate of

variable cost per unit of activity ($6.00 per

unit).

1. The variable cost component ($5,100) is

determined by multiplying the level of

activity (850 units) by the estimated variable

cost per unit of the activity ($6.00 per unit).

35

34

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.

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.

IV. The contribution approach income statement

Learning Objective 5 Prepare income statements for a

merchandising company using the traditional and

contribution formats.

a. The traditional and contribution formats differ as

follows:

ii. The contribution approach separates costs into

fixed and variable categories. Sales − variable

costs = contribution margin. The contribution

margin − fixed costs = net operating income.

46

44