Cost Accounting 2010 Updatex2

Compiled By Nut Khorn -Page 1

Table of Contents
1. Course Description: .......................................................................................... 6
Learning Objectives: ............................................................................................ 6
2. Course objectives .............................................................................................. 6
3. Course content ............................................................................................... 7
4. Learning Resources: ......................................................................................... 8
Additional Reading ......................................................................................... 8
5. Course requirement ......................................................................................... 8
6. Evaluation of the student performance .......................................................... 8
Internet Web for these Courses: ......................................................................... 10
7-HOME WORK AND ASSIGNMENT .......................................................... 10
Research the Manufacturing Companies in Pursat Province and prepare the
financial statements. ......................................................................................... 10
Course Outline for Fundamentals of Cost Accounting ................................ 11
Chapter 01: Cost Accounting: Information for Decision Making ................. 12
Learning Objectives ..................................................................................... 12
What Does Cost Accounting Mean? .................................................................. 13
Cost accounting .................................................................................................... 13
Classical cost elements are: ............................................................................... 13
Origins ................................................................................................................. 14
Elements of cost .................................................................................................. 14
Classification of costs ......................................................................................... 15
Value Chain ......................................................................................................... 15
The Value Chain Components .......................................................................... 15
Accounting Systems ............................................................................................ 16
Managerial Decisions ......................................................................................... 16
Trends in Cost Accounting ................................................................................ 16
Enterprise Resource Planning ........................................................................... 16
Ethical Issues for Accountants .......................................................................... 17
Sarbanes-Oxley Act of 2002 ............................................................................... 17
Institute of Management Accountants (IMA) Code of Ethics: Standards 18
Chapter Summary .............................................................................................. 18
Glossary ............................................................................................................... 19
Chapter 2: Cost Concepts and Behavior .......................................................... 23
In this chapter, the following learning objectives will be covered: .............. 24
Subtopics .............................................................................................................. 24
Objectives ............................................................................................................ 24
1.General cost classification ............................................................................... 25
Manufacturing costs ........................................................................................... 25
Nonmanufacturing cost ...................................................................................... 25
a. Marketing or selling costs. ............................................................................ 25
b .Administrative costs. ................................................................................. 26
2. Product cost versus period costs ............................................................... 26
2.1 Product costs .......................................................................................... 26
Period cost ........................................................................................................... 26
Cost Flow ............................................................................................................. 27
3. Cost classification on financial statements ................................................... 28
The balance sheet ................................................................................................ 28
The income statement ........................................................................................ 28
Schedule of Cost of Goods Manufactured ........................................................ 29
Cost classifications .............................................................................................. 31
For predicting cost behavior ......................................................................... 31
A. Variable cost ................................................................................................ 31
B. Fixed cost ........................................................................................................ 31
For assigning costs to cost objectives ................................................................. 32
A. Direct cost .............................................................................................. 32
B. Indirect cost .................................................................................................... 32
For decision making ........................................................................................... 32
A. Opportunity cost .......................................................................................... 32
B. Sunk cost ...................................................................................................... 32
Income Statement ................................................................................................ 33
1) Formula of Direct Materials .......................................................................... 33
Key Terms ............................................................................................................ 35
Problems ....................................................................................................... 37
Chapter 03: Fundamentals of Cost-Volume-Profit Analysis (CVP) .............. 46
GOALS ............................................................................................................ 46
DISCUSSION .................................................................................................. 46
COST BEHAVIOR ........................................................................................ 46
VARIABLE COSTS: ......................................................................................... 47
FIXED COSTS: .................................................................................................... 47
BUSINESS IMPLICATIONS OF THE FIXED COST STRUCTURE: ....... 48
ECONOMIES OF SCALE: .................................................................................. 49
RELEVANT RANGE: ......................................................................................... 49
DIALING IN YOUR BUSINESS MODEL: ........................................................ 50
COST BEHAVIOR ANALYSIS ....................................................................... 51
MIXED COSTS: .................................................................................................. 52
HIGH-LOW METHOD: ...................................................................................... 53
METHOD OF LEAST SQUARES: ..................................................................... 54
BREAK-EVEN AND TARGET INCOME ...................................................... 56
Assumptions ........................................................................................................ 57
CONTRIBUTION MARGIN: ........................................................................... 57
CONTRIBUTION MARGIN: ........................................................................... 58
Aggregated, per unit, or ratio? .............................................................................. 58
GRAPHIC PRESENTATION:............................................................................. 59
BREAK-EVEN CALCULATIONS: ................................................................. 59
TARGET INCOME CALCULATIONS: ......................................................... 60
CRITICAL THINKING ABOUT CVP: .......................................................... 61
The Margin of Safety ......................................................................................... 62
Operating Leverage ............................................................................................ 63
Summary Formulas of CVP .............................................................................. 64
Key Terms ........................................................................................................... 65
Solved Problems ........................................................................................... 66
Chapter 4 Cost Estimation ......................................................................... 71
Learning Objectives ......................................................................................... 71
Mixed Costs ......................................................................................................... 72
Mixed Costs Example ......................................................................................... 72
Analysis of Mixed Costs ..................................................................................... 72
Use a scatter graph plot to diagnose cost behavior. ........................................ 73
Analyze a mixed cost using the high-low method. ........................................... 74
Least-Squares Regression Method .................................................................... 76
Chapter Summary .............................................................................................. 80
Glossary ............................................................................................................... 81
Solved Problems ................................................................................................. 82

SYLLABUS FOR
Cost Accounting

By Nut Khorn
(Course Facilitator)
For BBA students
1. Course Description:
The course provides an introduction to cost accounting, a field of business
which develops the financial and non-financial information necessary to
effectively manage the firm or organization. Managerial Accounting is a
companys internal language, and is used for decision making, production
management, product design and pricing, performance evaluation, and
motivating employees. The central focus of this course is on how cost accounting
helps managers make better decisions. Understanding managerial accounting is
essential for developing a thorough understanding of a companys internal
operations. What you learn in this course will help you understand your future
employer and enable you to be more successful at your job. Upon completion of
the course students should be able to:

Learning Objectives:

1. Identify and evaluate ethical issues faced by management accountants.
2. Explain and analyze cost behavior.
3. Explain cost-volume-profit relationships, perform breakeven analysis and
interpret results.
4. Identify relevant costs and demonstrate their use in the decision making
process.
5. Explain the importance of cost allocations, and demonstrate their impact
on product costing, transfer pricing, and performance measurement
6. Explain the concept of standard costs and perform variance analysis.
7. Prepare master budget and flexible budgets.
8. Be able to calculate product cost, prime cost, conversion cost, the cost of
goods sold and income of a manufacturing, service, or merchandising
firm.
9. Use measures including ROI, residual income, and economic value
added to evaluate performance.
10. Build basic Excel models.
2. Course objectives
Cost accounting is concerned with the internal generation,
communication and interpretation of information for both operational and
strategic decision-making purposes. Note that this definition and this course both
focus on information internal to the firm. We will not be directly concerned here
with published or external financial statements or the impact of accounting
information in the broader market place. Note also that information is relevant
for two types of internal decision-making: operational decision-making, which
can include all aspects of planning and controlling an organizations day-to-day
operations; and strategic decision-making, which relates information to the
planning and control of an organizations strategy.

The objective of ACCT 6205 is to develop your ability to create and use
accounting information and tools to facilitate and influence decision-making. The
course will explore, at an introductory level, theories that underpin the discipline
of managerial accounting.
By the end of this course you should be able to:
Distinguish between product costs and period costs in preparing financial
statements.
Understand how product costs flow through the inventory accounts of a
manufacturing firm and are reported in the financial statements.
Use both one-stage and two-stage allocation methods to allocate indirect
costs to cost objects.
Distinguish between variable and fixed costs, and use cost-volume-profit
analysis to determine the impact of changes in prices, costs, and volumes
on profits.
Identify relevant costs in short-term and long-term settings and apply
relevant cost analysis to managerial decisions.

Unless you understand managerial accounting, you cannot have a thorough
understanding of a companys internal operations. What you learn in this course
will help you understand the operations of your future employer, and help you
understand other companies you encounter in your role as competitor, consultant,
auditor or investor.

3. Course content

Introduction and Overview
Chapter 1 Cost Accounting: Information for Decision Making
Chapter 2 Cost Concepts and Behavior
Cost Analysis and Estimation
Chapter 3 Fundamentals of Cost-Volume-Profit Analysis
Chapter 4 Fundamentals of Cost Analysis for Decision Making
Chapter 5 Cost Estimation
Cost Management Systems
Chapter 6 Fundamentals of Product and Service Costing
Chapter 7 Job Costing
Chapter 8 Process Costing
Chapter 9 Activity-Based Costing
Chapter 10 Fundamentals of Cost Management
Chapter 11 Service Department and Joint Cost Allocation


Management Control Systems
Chapter 12 Fundamentals of Management Control Systems
Chapter 13 Planning and Budgeting
Chapter 14 Business Unit Performance Measurement
Chapter 15 Transfer Pricing
Chapter 16 Fundamentals of Variance Analysis
Chapter 17 Additional Topics in Variance Analysis
Chapter 18 Nonfinancial and Multiple Measures of Performance
Appendix Capital Investment Decisions: An Overview

4. Learning Resources:
Required textbook
Lanen, Anderson, and Maher Fundamentals of Cost Accounting, 2
nd
edition is
available at the SMU book store.

Charles T. Horngren, Srikant M.Datar, George Foster. 2003. Cost
Accounting. 11. s.l. : Prentice Hall , 2003. 0-13-099619-x.

Ray H. Garrison. , Eric W. Noreen, and Peter C. Brewer (2005) Introduction
to Managerial Accounting, 2
nd
international Edition, McGraw. Hill (USA)

Additional Reading
Instructors can choose any of the following textbooks to accompany this
course:
Hilton, Ronald W. Managerial Accounting: Creating Value in a Dynamic
Business Environment, 6th edition, McGraw-Hill/Irwin, 2005, ISBN:
978-0-07-250287-9.
Garrison, Ray H., Eric W. Noreen, and Peter C. Brewer. Managerial
Accounting, 11th edition, McGraw-Hill/Irwin, 2006, ISBN: 978-0-07-
283494-9.
Hilton, Ronald W. Managerial Accounting: Creating Value in a Dynamic
Business Environment, 7th edition, McGraw-Hill/Irwin, 2008, ISBN:
978-0-07-302285-7.
Garrison, Ray H., Eric W. Noreen, and Peter C. Brewer. Managerial
Accounting, 12th edition, McGraw-Hill/Irwin, 2008, ISBN: 978-0-07-
352670-6.
5. Course requirement
Student should have basic knowledge of Business mathematics, financial
accounting, Merchandising Company and manufacturing company and so on.
6. Evaluation of the student performance
Course assessment:
Attendance and participation...10%
Quizzes, Homework Problems, Assignments 50%
Mid-term Exam 20%
Final Examination .. 20%

Total: .. 100%
Suggested Course Evaluation Criteria
Grade Points Point Range % Interpretation
A 4.0 93-100 Excellent
A- 3.7 90-92
B+ 3.3 87-89
B 3.0 83-86 Above Average
B- 2.7 80-82
C+ 2.3 77-79
C 2.0 73-76 Average
C- 1.7 70-72
D+ 1.3 66-69
D 1.0 60-65 Below average
F 0.0 59 & below Failure
I 0.0 Incomplete

Work Requirement for a Cost Accounting Major under Mr. Nut Khorn
I will apply the international standard when I teach all managerial
accounting courses I will require that you do all the assigned work
before class:

Read your textbook (slide presentation is not complete)
Read the power point materials
Do the assignments
Prepare for all examinations.
Internet research work.
To perform well in my courses, you need to spend about a minimum of 15
hours per week for this class. If you do not want to make this
commitment, then do not take my courses.

You should be present in all my classes. If you do not show up for my
lectures, I will consider you as absent (no need to give excuses).

If you fail any of my courses (I hope you wont), you must retake a new
written examination plus an oral examination to prove that you know the
subjects.

Internet Web for these Courses:

www.mhhe.com/lanen3e

When you search the web you will get power point presentation (Slide), quizzes,
multiple choices, excel template, and so on.
Other webs to supporting of your course.
www.mhhe.com (General subjects)
www.mhhe.com/williams_basis14e (Financial & Managerial Accounting)
www.mhhe.com/garrison12e (Managerial Accounting)

www.wiley.com (General Subjects)
www.wiley.com/college/weygandt (Accounting Principles, Financial
Accounting, Hospital Accounting, and Managerial Accounting)
General Research: www.en.wikipedia.org
www.mhhe.com/wild
www.mhhe.com/hm
www.nutkhorn.wordpress.com

Note: When you research the entire web above you should
enter the STUDENT CENTER OR STUDENT COMPONION.

7-HOME WORK AND ASSIGNMENT

Students MUST COMPLY STRICTLY with the following instructions in
writing their Home Work, Individual Assignments, Group Case-study and Group
Case-Study Presentation.
1. The student(s) is expected to do his/her own research in order to write up
individual assignments and home work.
2. All Individual Assignments/Home work and Group Case-Study MUST be
type written on A-4 sized paper with adequate margins. You should include a
TITLE PAGE and a LIST OF CONTENTS.
3. Use headings and sub-headings to organize your report, including supporting
material(s) as attachments.
4. All reference books/published materials you refer to should be properly
referenced (arrange in this order: name of author(s), year, and title of the book,
publisher, and the country the book was published) and this must be included in
a bibliography at the end of the assignment.
5. Use text referencing when you cite somebody elses work from your
references. Citation may mean direct quoting, or paraphrasing, or
summarizing, or simply to make a statement of that author's view of finding.
An example of text referencing: Beamer and Varner (2001), suggested that
culture is not something we are born with, but rather it is learned.
6. Number all pages sequentially and securely staple and/or bind all sheets
together.
Date Chapter Topic
Class Preparation and Home
work Assignments
16.Aug.
2010
Ch01
Research the Manufacturing Companies in Pursat
Province and prepare the financial statements.
Accounting data depend on your requirements.
Group Assignments
17.Aug.
2010
Ch02 P2-2; P2-10, P2-11 Home Work
20.Aug.
2010
Ch03 P3-4; P3-133TB Home Work
26Aug.
2010
Ch04 P4-1; Home Work

Course Outline for Fundamentals of Cost Accounting
Teaching
Weeks
Chapters Topics Due Dates Time Allowed
Week 1 Ch 01
Cost Accounting:
Information for Decision
Making
16 Aug.2010 3 Hrs
Week 2
Ch 02
Cost Concepts and
Behavior
17 Aug.2010 10 Hrs
Mid-Term Exam
Week 3 Ch03
Fundamentals of Cost-
Volume-Profit Analysis
(CVP)
20 Aug.2010 10 Hrs
Week 4 Ch04 Cost Estimation 25 Aug.2010 10 Hrs
Week 5 Ch 05 Job-Order Costing 30 Aug.2010 15 Hrs
Final Exam

Chapter 01: Cost Accounting: Information for Decision Making

Learning Objectives
After reading this chapter, you should be able to:
Describe the way managers use accounting information to create value in
organizations.
Distinguish between the uses and users of cost accounting and financial
accounting information.
Explain how cost accounting information is used for decision making and
performance evaluation in organizations.
Identify current trends in cost accounting.
Understand ethical issues faced by accountants and ways to deal with
ethical problems that you face in your career.

We start the study of the Fundamentals of Cost Accounting with a review and
overview of information necessary for decision making.

What Does Cost Accounting Mean?

A type of accounting process that aims to capture a company's costs of
production by assessing the input costs of each step of production as well as fixed
costs such as depreciation of capital equipment. Cost accounting will first
measure and record these costs individually, then compare input results to output
or actual results to aid company management in measuring financial
performance.
While cost accounting is often used within a company to aid in decision making,
financial accounting is what the outside investor community typically
sees. Financial accounting is a different representation of costs and financial
performance that includes a company's assets and liabilities. Cost accounting can
be most beneficial as a tool for management in budgeting and in setting up cost
control programs, which can improve net margins for the company in the future.

Cost accounting
In management accounting, cost accounting establishes budget and actual cost of
operations, processes, departments or product and the analysis of variances,
profitability or social use of funds. Managers use cost accounting to support
decision-making to cut a company's costs and improve profitability. As a form of
management accounting, cost accounting need not to follow standards such as
GAAP, because its primary use is for internal managers, rather than outside
users, and what to compute is instead decided pragmatically.
Costs are measured in units of nominal currency by convention. Cost accounting
can be viewed as translating the supply chain (the series of events in the
production process that, in concert, result in a product) into financial values.
There are various managerial accounting approaches:
standardized or standard cost accounting
lean accounting
activity-based costing
resource consumption accounting
throughput accounting
marginal costing/cost-volume-profit analysis
Classical cost elements are:
1. raw materials
2. labor
3. indirect expenses/overhead
Origins
Cost accounting has long been used to help managers understand the costs of
running a business. Modern cost accounting originated during the industrial
revolution, when the complexities of running a large scale business led to the
development of systems for recording and tracking costs to help business owners
and managers make decisions.
In the early industrial age, most of the costs incurred by a business were what
modern accountants call "variable costs" because they varied directly with the
amount of production. Money was spent on labor, raw materials, power to run a
factory, etc. in direct proportion to production. Managers could simply total the
variable costs for a product and use this as a rough guide for decision-making
processes.
Some costs tend to remain the same even during busy periods, unlike variable
costs, which rise and fall with volume of work. Over time, the importance of
these "fixed costs" has become more important to managers. Examples of fixed
costs include the depreciation of plant and equipment, and the cost of
departments such as maintenance, tooling, production control, purchasing,
quality control, storage and handling, plant supervision and engineering. In the
early twentieth century, these costs were of little importance to most businesses.
However, in the twenty-first century, these costs are often more important than
the variable cost of a product, and allocating them to a broad range of products
can lead to bad decision making. Managers must understand fixed costs in order
to make decisions about products and pricing.
For example: A company produced railway coaches and had only one product.
To make each coach, the company needed to purchase $60 of raw materials and
components, and pay 6 laborers $40 each. Therefore, total variable cost for each
coach was $300. Knowing that making a coach required spending $300,
managers knew they couldn't sell below that price without losing money on each
coach. Any price above $300 became a contribution to the fixed costs of the
company. If the fixed costs were, say, $1000 per month for rent, insurance and
owner's salary, the company could therefore sell 5 coaches per month for a total
of $3000 (priced at $600 each), or 10 coaches for a total of $4500 (priced at $450
each), and make a profit of $500 in both cases.
Elements of cost
1. Material(Material is a very important part of business)
o A. Direct material
o B. Indirect material
2. Labor
o A. Direct labor
o B. Indirect labor
3. Overhead
o A. Indirect material
o B. Indirect labor
(In some companies, machine cost is segregated form overhead and reported as a
separate element)

They are grouped further based on their functions as,
1. Production or works overheads
2. Administration overheads
3. Selling overheads
4. Distribution overheads
Classification of costs
Classification of cost means, the grouping of costs according to their common
characteristics. The important ways of classification of costs are:
By nature or element: materials, labor, expenses
By functions: production, selling, distribution, administration, R&D,
development,
As direct and indirect
By variability: fixed, variable, semi-variable
By controllability: controllable, uncontrollable
By normality: normal, abnormal
Value Chain
The value chain describes the set of activities that increase the value of an
organizations products or services. Value-added activities are activities that
customers perceive as valuable because the activity adds utility to the goods or
services they purchase. In other words, customers define value.
The Value Chain describes a set of activities that transforms raw materials
and resources into the goods and services end users purchase and
consume.
Value added activities
Non value added activities

The Value Chain Components

All products start with research and development. Is research and development
(creating and developing ideas related to a new product) value-added or
nonvalue-added?
Once we have the idea for a new product, the product must be developed and
engineered. Does this add value?
The purchasing department is responsible for acquiring all of the necessary
components and supplies in order to produce the product. Does this add value?
We must produce the product or deliver the service in order for the product or
service to have value to a customer.
We need to inform potential customers about the attributes of our product or
service.
Delivering the product or service to the customer adds value. If the customer
does not have the product or service, it has no value.
Finally, chances are you have experienced the value of customer service. Have
you ever called the technical support line for a software application you installed
on your computer? If so, I hope the support added value to your product.

Research and
Development
Design Purchasing

Production

Marketing Distribution
Customer
Services
Accounting Systems
Financial accounting information is designed for decision makers who are not
directly involved in the daily management of the firm.
Cost accounting information is designed for managers.

Managerial Decisions
The key question is: What adds value to the firm? Lets look at how cost
information adds value to the organization. Cost information adds value to the
organization if that information improves managers decisions.
Individuals make decisions.
Decisions determine the performance of the organization
Managers use information from the accounting system to make decisions.
Owners evaluate organizational and managerial performance with
accounting information.
Trends in Cost Accounting
Cost accounting continues to experience dramatic changes. Developments in
information technology (IT) have nearly eliminated manual bookkeeping.
Emphasis on cost control is increasing in all types of organizations.
Enterprise Resource Planning
Enterprise resource planning (ERP) uses information technology to link the
various processes of the enterprise into a single comprehensive information
system. Because all the companys processes are integrated, ERP has significant
potential for providing information on the cost of products and services.
However, implementation problems are keeping many companies from realizing
this potential
Financial
Accounting
Financial Position and
Income
Cost Accounting
Information about
Costs
Reports
Reports

Ethical Issues for Accountants
The design of the cost accounting system has the potential to be misused
to defraud customers, employees, or shareholders.
Accountants report information that can have a substantial impact on the
careers of managers who are generally held accountable for achieving
financial performance targets. Failure to achieve a target can have serious
negative consequences for a manager. Therefore, accountants may find
themselves under pressure by management to make accounting choices
that improve performance reports rather than accurately reflect
performance. As a professional accountant, manager, or business owner,
you will face ethical situations on an everyday basis.

Sarbanes-Oxley Act of 2002
When there is a public perception of widespread ethical problems, the result is
often legislation making certain conduct is not only unethical, but also illegal.
Congress passed the Sarbanes-Oxley Act of 2002 to address some of the more
serious problems of corporate governance that surfaced in the late 1990s and
early 2000s.

Technology
Purchasing
Human
Resources
Marketing
Production
Finance

Institute of Management Accountants (IMA) Code of Ethics: Standards
1. Competence
2. Confidentiality
3. Integrity
4. Credibility

Chapter Summary

This chapter discusses the use of cost accounting in its two primary managerial
uses: decision making and performance evaluation. The following summarizes
key ideas tied to the chapter's learning objectives. For example, L.O. 1 refers to
the first learning objective in the chapter.
L.O. 1. Describe the way managers use accounting information to create value in
organizations. Managers make decisions to increase the value of the organization
using information from the accounting system. Cost information helps identify
value-increasing alternatives and activities that do not add value to the product or
service.
L.O. 2. Distinguish between the uses and users of cost accounting and financial
accounting information. Financial accounting information provides information
to users (decision makers) who are not involved in the operations and strategy of
the firm. These users are often external to the firm. While cost accounting
information is often used in the financial accounting system, its primary role is to
aid managers inside the firm in making operational and strategic decisions.
L.O. 3. Explain how cost accounting information is used for decision making and
performance evaluation in organizations. Cost accounting information can be
used for decision making by assessing differential costs associated with
alternative courses of action. Accounting information also can be used to
evaluate performance by comparing budget amounts to actual results.
L.O. 4. Identify current trends in cost accounting. Cost accounting changes with
changes in information technology and the adoption of new operational
techniques.
L.O. 5. Understand ethical issues faced by accountants and ways to deal with
ethical problems that you face in your career. Ethical standards exist for
management accountants. These standards are related to competence,
confidentiality, integrity, and objectivity.
What is the intent?
Address problem of
corporate
governance
Accounting firms
and Corporations
Who is impacted?
How are
corporations
impacted?
Corporate
Responsibility
Compiled By Nut Khorn
Glossary

activity-based costing
(ABC)

benchmarking

budget

cost accounting

cost-benefit analysis

cost driver

cost of quality (COQ)

customer relationship
management (CRM)

differential costs

differential revenues

distribution chain

enterprise resource
planning (ERP)

financial accounting

generally accepted
accounting principles
(GAAP)

just-in-time (JIT)
method

nonvalue-added
activities

outsourcing

based costing Use of activity analysis to make decisions and
manage costs.
Continuous process of measuring products, services,
or activities against competitors' performance.
Financial plan of the resources needed to carry out
activities and meet financial goals.
Field of accounting that measures, records, and
reports information about costs.
benefit analysis Process of comparing benefits (often measured in
savings or increased profits) with costs associated
with a proposed change within an organization.
Factor that causes, or "drives," costs.
of quality (COQ) System that identifies the costs of producing low
quality items, including rework, returns, and lost
sales.
customer relationship
management (CRM)
System that allows firms to target profitable
customers by assessing customer revenues and costs.
With two or more alternatives, costs that differ
among or between alternatives.
differential revenues Revenues that change in response to a particular
course of action.
Set of firms and individuals that buys and distributes
goods and services from the firm.
Information technology that links the various systems
of the enterprise into a single comprehensive
information system.
financial accounting Field of accounting that reports financial position and
income according to accounting rules.
accounting principles
Rules, standards, and conventions that guide the
preparation of financial accounting statements for
shareholders.
In production or purchasing, each unit is purchased or
produced just in time for its use.
Activities that do not add value to the good or
service.
Having one or more of the firm's activities performed
by another firm or individual in the supply or
distribution chain.
Use of activity analysis to make decisions and
Continuous process of measuring products, services,
against competitors' performance.
Financial plan of the resources needed to carry out
Field of accounting that measures, records, and
Process of comparing benefits (often measured in
savings or increased profits) with costs associated
with a proposed change within an organization.
System that identifies the costs of producing low
quality items, including rework, returns, and lost
System that allows firms to target profitable
revenues and costs.
With two or more alternatives, costs that differ
Revenues that change in response to a particular
Set of firms and individuals that buys and distributes
Information technology that links the various systems
of the enterprise into a single comprehensive
Field of accounting that reports financial position and

Rules, standards, and conventions that guide the
of financial accounting statements for
In production or purchasing, each unit is purchased or
the good or
Having one or more of the firm's activities performed
by another firm or individual in the supply or
performance measure

responsibility center

supply chain

total quality management
(TQM)

value-added activities

value chain

Budget
Business process
Chief Financial
Officer (CFO)
Constraint
Control
Controller
Controlling

Corporate
governance
Decentralization
Directing and
motivating
performance measure Metric that indicates how well an individual, business
unit, product, firm, and so on, is working.
responsibility center Specific unit of an organization assigned to a
manager who is held accountable for its operations
and resources.
Linked set of firms that exchange goods
combination to provide a final product or service to
the consumer.
total quality management Management method by which the organization seeks
to excel on all dimensions, with the customer
ultimately defining quality.
added activities Those activities that customers perceive as adding
utility to the goods or services they purchase.
Linked set of activities that increases the usefulness
(or value) of the goods or services of an
A detailed plan for the future, usually expressed in formal
quantitative terms.
A series of steps that are followed to carry out some task in
a business.
The member of the top management team who is
responsible for providing timely and relevant data to
support planning and control activities and for preparing
financial statements for external users.
Anything that prevents an organization or individual from
getting more of what it wants.
The process of instituting procedures and then obtaining
feedback to ensure that all parts of the organization are
functioning effectively and moving toward overall
company goals.
The member of the top management team who is
responsible for providing relevant and timely data to
managers and for preparing financial statements for
external users. The controller reports to the CFO.
Ensuring that the plan is actually carried out and is
appropriately modified as circumstances change.
The system by which a company is directed and controlled.
If properly implemented it should provide incentives for
top management to pursue objectives that are in the
interests of the company and it should effectively monitor
performance.
The delegation of decision-making authority throughout an
organization by providing managers with the authority to
make decisions relating to their area of responsibility.
Mobilizing people to carry out plans and run routine
operations.
Metric that indicates how well an individual, business
unit, product, firm, and so on, is working.
Specific unit of an organization assigned to a
manager who is held accountable for its operations
Linked set of firms that exchange goods or services in
combination to provide a final product or service to
Management method by which the organization seeks
to excel on all dimensions, with the customer
Those activities that customers perceive as adding
utility to the goods or services they purchase.
Linked set of activities that increases the usefulness
(or value) of the goods or services of an organization.
A detailed plan for the future, usually expressed in formal
A series of steps that are followed to carry out some task in
management team who is
responsible for providing timely and relevant data to
support planning and control activities and for preparing
Anything that prevents an organization or individual from
The process of instituting procedures and then obtaining
feedback to ensure that all parts of the organization are
functioning effectively and moving toward overall
ment team who is
responsible for providing relevant and timely data to
managers and for preparing financial statements for
external users. The controller reports to the CFO.
Ensuring that the plan is actually carried out and is
modified as circumstances change.
The system by which a company is directed and controlled.
If properly implemented it should provide incentives for
top management to pursue objectives that are in the
and it should effectively monitor
making authority throughout an
organization by providing managers with the authority to
make decisions relating to their area of responsibility.
Mobilizing people to carry out plans and run routine
Enterprise system A software system that integrates data from across an
organization into a single centralized database that enables
all employees to access a common set of data.
Enterprise risk
management
A process used by a company to help identify the risks that
it faces and to develop responses to those risks that enable
the company to be reasonably assured of meeting its goals.
Feedback Accounting and other reports that help managers monitor
performance and focus on problems and/or opportunities
that might otherwise go unnoticed.
Financial
accounting
The phase of accounting concerned with providing
information to stockholders, creditors, and others outside
the organization.
Finished goods Units of product that have been completed but have not yet
been sold to customers.
Just-in-time (JIT) A production and inventory control system in which
materials are purchased and units are produced only as
needed to meet actual customer demand.
Lean thinking
model
A five-step management approach that organizes resources
around the flow of business processes and that pulls units
through these processes in response to customer orders.
Line A position in an organization that is directly related to the
achievement of the organization's basic objectives.
Managerial
accounting
The phase of accounting concerned with providing
information to managers for use inside the organization.
Non-value-added
activities
An activity that consumes resources but that does not add
value for which customers are willing to pay.
Organization chart A diagram of a company's organizational structure that
depicts formal lines of reporting, communication, and
responsibility between managers.
Performance
report
A detailed report comparing budgeted data to actual data.
Planning Selecting a course of action and specifying how the action
will be implemented.
Planning and
control cycle
The flow of management activities through planning,
directing and motivating, and controlling, and then back to
planning again.
Raw materials Materials that are used to make a product.
Sarbanes-Oxley Act
of 2002
Legislation enacted to protect the interests of stockholders
who invest in publicly traded companies by improving the
reliability and accuracy of the disclosures provided to them.
Segment Any part of an organization that can be evaluated
independently of other parts and about which the manager
seeks financial data. Examples include a product line, a
sales territory, a division, or a department.
Six Sigma A method that relies on customer feedback and objective
data gathering and analysis techniques to drive process
improvement.
Staff A position in an organization that is only indirectly related
to the achievement of the organization's basic objectives.
Such positions provide service or assistance to line
positions or to other staff positions.
Strategy A "game plan" that enables a company to attract customers
by distinguishing itself from competitors.
Supply chain
management
A management approach that coordinates business
processes across companies to better serve end consumers.
Theory of
Constraints (TOC)
A management approach that emphasizes the importance of
managing constraints.
Value chain The major business functions that add value to a company's
products and services such as research and development,
product design, manufacturing, marketing, distribution, and
customer service.
Work in process Units of product that are only partially complete and will require
further work before they are ready for sale to a customer.

End of Chapter 01

Chapter 2: Cost Concepts and Behavior
In this chapter, we have looked at some of the ways in which managers classify
costs. How the costs will be usedfor preparing external reports, predicting cost
behavior, assigning costs to cost objects, or decision makingwill dictate how
the costs are classified.
For purposes of valuing inventories and determining expenses for the balance
sheet and income statement, costs are classified as either product costs or period
costs. Product costs are assigned to inventories and are considered assets until the
products are sold. At the point of sale, product costs become cost of goods sold
on the income statement. In contrast, period costs are taken directly to the income
statement as expenses in the period in which they are incurred.
In a merchandising company, product cost is whatever the company paid for its
merchandise. For external financial reports in a manufacturing company, product
costs consist of all manufacturing costs. In both kinds of companies, selling and
administrative costs are considered to be period costs and are expensed as
incurred.
For purposes of predicting how costs will react to changes in activity, costs are
classified into two categoriesvariable and fixed. Variable costs, in total, are
strictly proportional to activity. The variable cost per unit is constant. Fixed costs,
in total, remain at the same level for changes in activity that occur within the
relevant range. The average fixed cost per unit decreases as the number of units
increases.
For purposes of assigning costs to cost objects such as products or departments,
costs are classified as direct or indirect. Direct costs can be conveniently traced to
cost objects. Indirect costs cannot be conveniently traced to cost objects.
For purposes of making decisions, the concepts of differential cost and revenue,
opportunity cost and sunk cost are vitally important. Differential costs and
revenues are the costs and revenues that differ between alternatives. Opportunity
cost is the benefit that is forgone when one alternative is selected over another.
Sunk cost is a cost that occurred in the past and cannot be altered. Differential
costs and opportunity costs should be carefully considered in decisions. Sunk
costs are always irrelevant in decisions and should be ignored.
These various cost classifications are different ways of looking at costs. A
particular cost, such as the cost of cheese in a taco served at Taco Bell, could be a
manufacturing cost, a product cost, a variable cost, a direct cost, and a differential
costall at the same time. Taco Bell is a manufacturer of fast food. The cost of
the cheese in a taco is a manufacturing cost and, as such, it would be a product
cost as well. In addition, the cost of cheese is variable with respect to the number
of tacos served and it is a direct cost of serving tacos. Finally, the cost of the
cheese in a taco is a differential cost of making and serving the taco.
In this chapter, the following learning objectives will be covered:

Identify and give examples of each of the three basic manufacturing cost
categories.

Distinguish between product costs and period costs and give examples of each.

Prepare an income statement including calculation of the cost of goods sold.

Prepare a schedule of cost of goods manufactured.

Understand the differences between variable costs and fixed costs.

Understand the differences between direct and indirect costs.

Define and give examples of cost classifications used in making decisions:
differential costs, opportunity costs, and sunk costs.

(Appendix 2A) Properly account for labor costs associated with idle time,
overtime, and fringe benefits.

(Appendix 2B) Identify the four types of quality costs and explain how they
interact.

(Appendix 2B) Prepare and interpret a quality cost report.
Subtopics
Cost Concepts: An Overview
General Cost Classifications
Cost Classifications on Financial Statements
Cost Classifications for Different Purposes
Objectives
Define cost and distinguish between product costs and period costs.
Analyze the fundamental manufacturing cost categories and diagram the
flow of product costs in a manufacturing operation.
Analyze the cost components on financial statements and prepare an
income statement and a schedule of cost of goods manufactured for a
manufacturer.
Compare direct and indirect costs and distinguish between variable and
fixed costs.

1.General cost classification
Costs are associated with all types of organizations business, nonbusiness,
manufacturing, retail, and service. Generally, the kind of costs that are incurred
and the way in which these costs are classified depend on the type of
organization involved.

Manufacturing costs

Most manufacturing companies divide manufacturing costs into three broad
categories: direct materials, direct labor, and manufacturing overhead
a- Direct materials

The materials that go into the final product are called raw materials.
Actually, raw materials refer to any materials that are used in final
product; and the finished product of one company can be the raw
materials of another company.

Direct materials are those materials that become an integral part of the
finished product and that can be physically and conveniently traced to it.

b- Direct labor

The term direct labor is served for those labor costs that can be easily
traced to individual unit of product. Direct labor is sometimes called
touch labor, since direct labor workers typically touch the product while
it is being made.

c- Manufacturing overhead

Manufacturing overhead, the third element of manufacturing cost,
included all cost of manufacturing except direct materials and direct
labor. Manufacturing overhead includes items such as indirect materials;
indirect labor; maintenance and repair production equipment; property
taxes; depreciation, and insurance on manufacturing facilities...

Various names are used for manufacturing overhead, such as indirect
manufacturing cost, factory overhead, and factory burden. all these terms
are synonymous of manufacturing overhead.

Nonmanufacturing cost

Generally, nonmanufacturing costs are subclassified into two categories:

a. Marketing or selling costs.

Include all costs necessary to secure customer orders and get the finished
product or service into the hands of customer. These costs are often called
order-getting and order-filling costs. Example of marketing costs include
advertising, shipping, sales travel, sales commission, sales salaries, and
cost of finished goods warehouses.
b .Administrative costs.

Include all executive, organizational, and clerical costs associated with
the general management of an organization rather than with
manufacturing, marketing or selling. Examples of administrative costs
include general accounting, secretarial, public relation...
2. Product cost versus period costs

In addition to the distinction between manufacturing and nonmanufacturing
costs, there are two other ways to look at costs. For instant, they can also be
classified as either product costs or period costs.
2.1 Product costs
For financial accounting purpose, product costs include all the costs there are
involved in acquiring or making a product
Period cost
Period cost is all cost that is not included in product costs. These cost are
expense on the income statement in the period in which they are incurred.

A suggested above, all selling and administrative expenses are considered to be
period cost.

Exhibit 2 1 Summary of cost terms

Manufacturing costs or product costs

Direct materials
Prime cost
Direct labor
Conversion cost
Manufacturing overhead

Nonmanufacturing costs or period costs

Marketing or selling costs

Administrative costs


Cost Flow

3. Cost classification on financial statements

The financial statements prepared by manufacturing company are more complex
than the statements are prepared by a merchandising company.
The balance sheet
The balance sheet or statement of financial position, of a manufacturing company
is similar to that of a merchandising company has only one class of inventory
goods purchased from suppliers that are awaiting resale to customer. By contrast,
manufacturing companies have three classes of inventories raw materials, work
in process, and finished goods.

Graham Manufacturing Company
Inventory Account

Beginning Ending
Balance balance

$ $
Raw materials................ 60,000 50,000
Work in process............... 90,000 60,000
Finished goods................125,000 175,000

In contrast, the inventory account at Reston Bookstore consist entirely of the cost
of books the company has purchased from publisher for resale to the public

Reston Bookstore
Inventory account
Beg. Bal Ending Bal
$ $
Merchandise inventory........ 100,000 150,000

The income statement

Exhibit 2 2 compares the income statements of Reston Bookstore and Graham
Manufacturing. For purpose of illustration, these statements contain more detail
about cost of goods sold than you will generally find and published financial
statements.
Exhibit 2 2 Comparative income statements:
Merchandise and manufacturing companies:

Merchandise Company
Reston Bookstore
____________________________

$ $
Sales.................................................. 1,000,000
Cost of goods sold:
Beginning merchandise inventory.... 100,000

Add: purchases................................ 650,000
Goods available for sale.................... 750,000
Deduct: ending merch. Inventory....... 150,000 600,000

Gross margin...................................... 400,000
Less: operating expenses:
Selling expense.................................. 100,000
Administrative expense...................... 200,000 300,000
Net income.......................................... 100,000

Manufacturing Company
Graham Manufacturing
___________________________

$
$
Sales................................................. 1,500,000
Cost of goods sold:
Beginning finished goods inventory.. 125,000
Add: cost of goods manufactured...... 850,000
Goods available for sale.................... 975,000
Deduct: ending finis. Goods inventory..... 175,000 800,000
Gross margin..................................... 700,000
Less: operating expenses:
Selling expense................................ 125,000
Administrative expense.................... 300,000 550,000
Net income........................................ 150,000

To determine the cost of goods sold in merchandising company like Reston
Bookstore, we only need to know the opening and closing balance in the
Merchandise Inventory account and purchases.

To determine the cost of goods sold in manufacturing company like Graham
Manufacturing, we need to know the cost of goods manufactured and the opening
and closing balance of Finished Goods Inventory account. The cost of goods
manufactured consists of the manufacturing costs associated with goods that
were finished during the period.

Schedule of Cost of Goods Manufactured
The cost of goods manufactured contains the three elements of product costs that
we discussed earlier direct materials, direct labor, and manufacturing overhead.

Exhibit 2 3 Schedule of cost of goods manufactured

Direct materials:
Opening raw materials inventory................. $ 60,000
Add: purchases of raw materials.................. 400,000
Raw materials available for use.................... 460,000
Deduct: closing raw materials inventory....... 50,000
Raw materials used in production................ 410,000

Direct labor.......................................................... 60,000

Manufacturing overhead:
Insurance factory........................................ 6,000
Indirect labor.............................................. 100,000
Machine rental............................................ 50,000
Utilities, factory........................................... 75,000
Supplies...................................................... 21,000
Depreciation, factory................................... 90,000
Property taxes, factory................................ 8,000
Total overhead cost............................ 350,000

Total manufacturing costs.... 820,000
Add: opening work in process inventory............ 90,000
910,000
Deduct: closing work in process inventory........ 60,000
Cost of goods manufactured................................ $850,000


Cost classifications
For predicting cost behavior
Cost behavior means how a cost will react or respond to changes in the level of
business activity. As the activity level rises and falls, a particular cost may rise
and fall as well.
A. Variable cost
A variable cost is a cost that
level of activity. The activity can be expressed in many ways, such as units
produced, units sold, miles driven, hours worked. The cost of direct materials
used during a period will varies, in total,
units that are produced.

It is importance to note that when we speak of a cost as being variable, we mean
the total cost rises and falls as the activity level rises and falls.
B. Fixed cost
A fixed cost is a cost that
level of activity. Fixed costs are not affected by changes in the activity.
Consequence, as the activity level rises and falls


predicting cost behavior
means how a cost will react or respond to changes in the level of
is a cost that varies, in total, in direct proportion to change in the
used during a period will varies, in total, in direct proportion to the number of
units that are produced.
the total cost rises and falls as the activity level rises and falls.
is a cost that remains constant, in total, regardless of changes in the
Consequence, as the activity level rises and falls.
means how a cost will react or respond to changes in the level of
varies, in total, in direct proportion to change in the
in direct proportion to the number of
remains constant, in total, regardless of changes in the

Units Total
Costs Total
Cost Unit =

For assigning costs to cost objectives

Costs are assigned to objectives for a variety of purpose including pricing,
profitability studies, and control of spending. A cost objective is anything for
which cost data are desired including products, customer, jobs, and
organization.
A. Direct cost
A direct cost is a cost that can be easily and conveniently traced to the particular
cost object under consideration. Direct Materials and Direct labor.
B. Indirect cost
An indirect cost is a cost that can not be easily and conveniently traced to the
particular cost object under consideration.
For decision making
A. Opportunity cost
Opportunity cost is the potential benefit that is given up when one alternative is
selected over another.
B. Sunk cost
A sunk cost is a cost that has already been incurred and that can not be changed
by any decision made now or in the future.

Income Statement
. /
arg /
Loss income Net
Expense Operating
in m profit Gross
COGS
Sales Net
=

s income/Los Net
Expenses Admin and Selling -
Margin
=
=
Gross
COGS
Sales Net

1) Formula of Direct Materials
production in used Materials Raw
Materials Raw Ending -
use for available Materials Raw
Materials Raw of Purchases
Materials Beg.Raw
=
=
+

2)
Costs ing Manufactur Total
(MOH) Overhead ing Manufactur
(DL) Labor Direct
(DM) Materials Direct
=
+
+

3)

ed Manufactur Goods of Cost
WIP Ending -
WIP of Cost Total
(WIP) process in Beg.Work
Costs ing Manufactur Total
=
=
+

4)
(COGS) Sold Goods of Cost
Goods Finished Ending -
Sale for Available Goods
ed Manufactur Goods of Cost
Goods Finished Beg.
=
=
+

Key Terms
Administrative
costs
All executive, organizational, and clerical costs associated
with the general
with manufacturing or selling.
Common cost A cost that is incurred to support a number of cost objects
but that cannot be traced to them individually. For example,
the wage cost of the pilot of a 747 airliner is
of all of the passengers on the aircraft. Without the pilot,
there would be no flight and no passengers. But no part of
the pilot's wage is caused by any one passenger taking the
flight.
Conversion cost Direct labor cost plus manufacturin
Cost behavior The way in which a cost reacts to changes in the level of
activity.
Cost object Anything for which cost data are desired. Examples of cost
objects are products, customers, jobs, and parts of the
organization such as dep
Cost of goods
manufactured
The manufacturing costs associated with the goods that were
finished during the period.
Differential cost A difference in cost between two alternatives. Also see
Incremental cost
Differential
revenue
The difference in revenue between two alternatives.
Direct cost A cost that can be easily and conveniently traced to a
specified cost object.
Direct labor Factory labor costs that can be easily traced to individual
units of product. Also called
Direct materials Materials that become an integral part of a finished product
and whose costs can be conveniently traced to it.
Finished goods Units of product that have been completed but not yet sold to
customers.
Fixed cost A cost
in the level of activity within the relevant range. If a fixed
cost is expressed on a per unit basis, it varies inversely with
the level of activity.
Incremental cost An increase in cost between two
Differential cost
Indirect cost A cost that cannot be easily and conveniently traced to a
Indirect labor The labor costs of janitors, supervisors, materials handlers,
and other factory workers that cann
to particular products.

Indirect
materials
Small items of material such as glue and nails that may be an
integral part of a finished product, but whose costs cannot be
easily or conveniently traced to it.
Inventoriable
costs
Synonym for

Manufacturing All manufacturing costs except direct materials and direct
with the general management of an organization rather than
with manufacturing or selling.
A cost that is incurred to support a number of cost objects
the wage cost of the pilot of a 747 airliner is a common cost
flight.
Direct labor cost plus manufacturing overhead cost.
The way in which a cost reacts to changes in the level of
activity.
Anything for which cost data are desired. Examples of cost
organization such as departments or divisions.
finished during the period.
A difference in cost between two alternatives. Also see
Incremental cost.
A cost that can be easily and conveniently traced to a
Factory labor costs that can be easily traced to individual
units of product. Also called touch labor.
Materials that become an integral part of a finished product
Units of product that have been completed but not yet sold to
customers.
A cost that remains constant, in total, regardless of changes
the level of activity.
An increase in cost between two alternatives. Also see
Differential cost.
A cost that cannot be easily and conveniently traced to a
The labor costs of janitors, supervisors, materials handlers,
and other factory workers that cannot be conveniently traced
to particular products.
easily or conveniently traced to it.
Synonym for product costs.
All manufacturing costs except direct materials and direct
management of an organization rather than
A cost that is incurred to support a number of cost objects
a common cost
g overhead cost.
The way in which a cost reacts to changes in the level of
Anything for which cost data are desired. Examples of cost
artments or divisions.
A difference in cost between two alternatives. Also see
A cost that can be easily and conveniently traced to a
Factory labor costs that can be easily traced to individual
Materials that become an integral part of a finished product
Units of product that have been completed but not yet sold to
that remains constant, in total, regardless of changes
alternatives. Also see
A cost that cannot be easily and conveniently traced to a
The labor costs of janitors, supervisors, materials handlers,
ot be conveniently traced
All manufacturing costs except direct materials and direct
overhead labor.
Opportunity cost The potential benefit that is given up when one alternative is
selected over another.
Period costs Costs that are taken directly to the income statement as
expenses in the period in which they are incurred or accrued.
Prime cost Direct materials cost plus direct labor cost.
Product costs All costs that are involved in acquiring or making a product.
In the case of manufactured goods, these costs consist of
direct materials, direct labor, and manufacturing overhead.
Also see Inventoriable costs.
Raw materials Any materials that go into the final product.
Relevant range The range of activity within which assumptions about
variable and fixed cost behavior are valid.
Schedule of cost of
goods
manufactured
A schedule showing the direct materials, direct labor, and
manufacturing overhead costs incurred during a period and
the portion of those costs that are assigned to Work in
Process and Finished Goods.
Selling costs All costs that are incurred to secure customer orders and get
the finished product or service into the hands of the
customer.
Sunk cost A cost that has already been incurred and that cannot be
changed by any decision made now or in the future.
Variable cost A cost that varies, in total, in direct proportion to changes in
the level of activity. A variable cost is constant per unit.
Work in process Units of product that are only partially complete.

Problems
P2-1)
The following data (in thousands of dollars) have been taken from the accounting
records of Kovach Corporation for the just completed year.

Raw materials inventory, beginning $ 80
Raw materials inventory, ending 140
Work in process inventory, beginning 140
Work in process inventory, ending 100
Finished goods inventory, beginning 240
Finished goods inventory, ending 320
Administrative expenses 300
Direct labor 400
Manufacturing overhead 460
Purchases of raw materials 240
Sales 1,980
Selling expenses 280

Part (a) what was the cost of the raw materials used in production during the year
(in thousands of dollars)?

Part (b) what was the cost of goods manufactured (finished) for the year (in
thousands of dollars)?

Part (c) What was the cost of goods sold for the year (in thousands of dollars)?

Part (d) what was the net income for the year (in thousands of dollars)?
P2-2
The following information is taken from the December 31, 2005, adjusted
trial balance and other records of OTW Company before the calendar
year-end closing entries are recorded:
Advertising expense $ 14,000 Direct labor 700,000
Depreciation expense Office equipment 5,100 Income taxes expense 212,000
Depreciation expense Selling equipment 8,560 Indirect labor 75,070
Depreciation expense Factory equipmen 32,420 Miscellaneous production costs 16,125
Factory supervision 98,100 Office salaries expense 57,000
Factory supplies used 18,400 Raw materials purchases 805,000
Factory utilities 25,000 Rent expense Office space 11,000
Inventories Rent expense Selling space 31,800
Raw materials, December 31, 2004 112,350 Rent expense Factory building 46,790
Raw materials, December 31, 2005 212,000 Maintenance Factory equipment 34,500
Goods in process, December 31, 2004 13,300 Sales 4,579,000
Goods in process, December 31, 2005 17,080 Sales discounts 42,500
Finished goods, December 31, 2004 122,500 Sales salaries expense 382,160
Finished goods, December 31, 2005 156,000

Required

1. Prepare the 2005 schedule of cost of goods manufactured for the company.

2. Prepare the 2005 income statement for the company that reports separate categories for: (a) selling expenses, (b) general and
administrative expenses, and, (3) income tax expense.

P2-3
Tommi Corporation incurred the following costs while manufacturing its product

Work-in-process inventory was $10,000 at January 1 and $14,000 at December
31. Finished goods inventory was $60,500 at January 1 and $50,600 at December
31.
Instructions
(a) Compute cost of goods manufactured.
(b) Compute cost of goods sold.
P2-4)
Data are provided below

Required:

Supply the missing data in the following cases.

Direct materials ................................
Direct labor ................................
Manufacturing overhead ............................
Total manufacturing costs
Beginning work in process inventory
Ending work in process inventory
Cost of goods manufactured

Income Statement
Sales ................................
Beginning finished goods inventory
Cost of goods manufactured
Goods available for sale ............................
Ending finished goods inventory
Cost of goods sold ................................
Gross margin ................................
Selling and administrative expenses
Net operating income ................................
inventory was $10,000 at January 1 and $14,000 at December
goods inventory was $60,500 at January 1 and $50,600 at December
Instructions
(a) Compute cost of goods manufactured.
(b) Compute cost of goods sold.
Data are provided below for four cases. Each case is independent of the others.
Supply the missing data in the following cases.
Case
1 2 3
......................................... $ 7,200 $ 4,500 $ 8,000
................................................ ? 3,900 7,000
............................ 5,500 4,000 ?
Total manufacturing costs ......................... 18,700 ? 19,500
Beginning work in process inventory ........ 1,000 ? 2,500
Ending work in process inventory ............. ? 1,000 3,000
Cost of goods manufactured ...................... $17,700 $13,400 $ ?

.......................................................... $35,000 $40,000 $15,000
Beginning finished goods inventory .......... 2,500 3,000 ?
Cost of goods manufactured ...................... ? ? ?
............................ ? ? ?
Ending finished goods inventory ............... ? 1,200 12,000
..................................... 17,200 ? 10,000
............................................. 17,800 ? 5,000
Selling and administrative expenses .......... ? 9,200 ?
................................ $15,800 $ ? $ 3,000
inventory was $10,000 at January 1 and $14,000 at December
goods inventory was $60,500 at January 1 and $50,600 at December
for four cases. Each case is independent of the others.
4

$7,500
6,000
4,900
?
?
2,000
$ ?

$38,000
4,000
19,300
?
2,000
?
?
?
$11,100
P2-5
Selected account balances for the year ended December 31 are provided below
for Rolling Company:

Selling and administrative salaries .......... $150,000

Insurance, factory .................................... $7,500

Utilities, factory ...................................... $30,000

Purchases of raw materials ...................... $165,000

Indirect labor ........................................... $45,000

Direct labor ............................................. ?

Advertising expense ................................ $76,000

Cleaning supplies, factory ....................... $4,900

Sales commissions .................................. $54,000

Rent, factory building ............................. $110,000

Maintenance, factory ............................... $22,500

Inventory balances at the beginning and end of the year were as follows:

Beginning of End of

the Year the Year

Raw materials............ $35,000 $20,000

Work in process ........ ? $27,500

Finished goods .......... $45,000 ?

The total manufacturing costs for the year were $479,000; the goods available for
sale totaled $520,000; and the cost of goods sold totaled $500,000.

Required:

1. Prepare a schedule of cost of goods manufactured and the cost of goods sold section of the
companys income statement for the year.
2. The company produced the equivalent of 10,000 units during the year. Compute the average
cost per unit for direct materials used and the average cost per unit for rent on the factory
building.
3. In the following year the company expects to produce 20,000 units. What average cost per
unit and total cost would you expect to be incurred for direct materials? For rent on the
factory building? (Assume that direct materials is a variable cost and that rent is a fixed cost.)
4. Explain to the president the reason for any difference in the average cost per unit between (2)
and (3) above.
[CHECK FIGURE (1) Cost of goods manufactured: $475,000]
P2-6)
Various cost and sales data for Jaskot Company for the just completed year
follow:

Finished goods inventory, beginning ........ $22,000

Finished goods inventory, ending ............. $18,000

Depreciation, factory ................................. $24,000

Administrative expenses ........................... $36,000

Utilities, factory ........................................ $15,000

Maintenance, factory ................................. $12,000

Supplies, factory ....................................... $6,000

Insurance, factory ...................................... $5,000

Purchases of raw materials ........................ $102,500

Raw materials inventory, beginning ......... $8,000

Raw materials inventory, ending ............... $10,000

Direct labor ............................................... $60,000

Indirect labor ............................................. $18,000

Work in process inventory, beginning ...... $10,000

Work in process inventory, ending ........... $12,000

Sales .......................................................... $400,000

Selling expenses ........................................ $63,000

Required:

1. Prepare a schedule of cost of goods manufactured.
2. Prepare an income statement.
3. The company produced the equivalent of 10,000 units of product during the year just
completed. What was the average cost per unit for direct materials? What was the average
cost per unit for factory depreciation?
4. The company expects to produce 12,000 units of product during the coming year. What
average cost per unit and what total cost would you expect the company to incur for direct
materials at this level of activity? For factory depreciation? (In preparing your answer,
assume that direct materials is a variable cost and that depreciation is a fixed cost that is
computed on a straight-line basis.)
5. Explain to the president any difference in the average cost per unit between (3) and (4)
above.
[CHECK FIGURE (1) Cost of goods manufactured: $238,500]
P2-7
CHECK FIGURE
(1) Cost of goods manufactured: $512,270

Madlinx Company was organized on April 1 of the current year. After five months of start-up
losses, management had expected to earn a profit during September, the most recent month.
Management was disappointed, however, when the income statement for September also showed
a loss. Septembers income statement follows:

Madlinx Company
Income Statement
For the Month Ended September 30

Sales .................................................... $725,000

Less operating expenses:

Indirect labor cost ............................ $ 22,000

Utilities ............................................ 23,000

Direct labor cost .............................. 115,000

Depreciation, factory equipment ..... 32,000

Raw materials purchased ................. 275,000

Depreciation, sales equipment ......... 28,000

Insurance ......................................... 6,800

Rent on facilities .............................. 85,000

Selling and administrative salaries .. 51,000

Advertising ...................................... 100,000 737,800

Net operating loss ............................... $(12,800)

After seeing the $12,800 loss for September, Madlinxs president stated,
I was sure wed be profitable within six months, but our six months are up and
this loss for September is even worse than Augusts. I think its time to start
looking for someone to buy out the companys assetsif we dont, within a few
months there wont be any assets to sell. By the way, I dont see any reason to
look for a new controller. Well just limp along with Harry for the time being.
The companys controller resigned a month ago. Harry, a new
inexperienced assistant in the controllers office, prepared the income statement
above. Additional information about the company follows:
a. Some 75% of the utilities cost and 65% of the insurance apply to factory operations. The
remaining amounts apply to selling and administrative activities.
b. Inventory balances at the beginning and end of September were:

September 1 September 30

Raw materials .......... $12,000 $17,900

Work in process ....... 31,000 38,000

Finished goods ......... 35,000 59,000

c. Only 70% of the rent on facilities applies to factory operations; the remainder applies to
selling and administrative activities.

The president has asked you to check over the income statement and
make a recommendation as to whether the company should look for a buyer for
its assets.
Required:

1. As one step in gathering data for a recommendation to the president, prepare a schedule of
cost of goods manufactured for September.
2. As a second step, prepare a new income statement for September.
3. Based on your statements prepared in (1) and (2) above, would you recommend that the
company look for a buyer?
P2-8
Selected account balances for the year ended December 31 are provided below
for Rolling Company:

Selling and administrative salaries $55,000
Insurance, factory. $6,000
Utilities, factory.. $10,000
Purchases of raw materials.. $76,000
Indirect labor. $3,000
Direct labor ?
Advertising expense. $26,000
Cleaning supplies, factory.. $4,000
Sales commissions.. $33,000
Rent, factory building $49,000
Maintenance, factory $15,000

Inventory balances at the beginning and end of the year were as follows:

Beginning of the year End of the year

Raw materials..$3,000 $9,000
Work in process.? 13,000
Finished goods.25,000 ?

The total manufacturing costs for the year were $242,000; the goods available for
sale totaled $269,000; and the cost of goods sold totaled $229,000.
Required:
1. Prepare a schedule of cost of goods manufacturing in good form and
the cost of goods sold section of the companys income statement for the year.
2. The company produced the equivalent of 7,000 units during the year.
Compute the average cost per unit for direct materials used and the average per
unit for rent on the factory building.
P2-9
The cost of goods manufactured schedule shows each of the
cost elements. Complete the following schedule for Lanier
Manufacturing Company:

LANIER MANUFACTURING COMPANY
Cost of Goods Manufactured Schedule
For the Year Ended December 31, 2010
Work in process (1/1).$200,000
Direct materials
Raw materials inventory (1/1)$?
Add: raw material purchases158,000
Less: raw material purchases 6,500
Direct material used $190,000
Direct labor?
Manufacturing overhead
Indirect labor .$18,000
Factory depreciation.36,000
Factory utilities .68,000
Total overhead .. 122,000
Total manufacturing costs ?
Total cost work in process..$ ?
Less: work in process (12/31)87,000
Cost of goods manufactured $560,000
P2-10
Hawkinson Company is manufacturer of toys. Its controller, Al
Duryea, resigned on August 2010. An inexperience assistant
accountant has prepared the following income statement for the
month of August 2010.
HAWKINSOM COMAPANY
Income Statement
For the Month Ended August31, 2010
Sales (net) $670,000
Less: Operating expenses
Raw materials purchased
Direct labor cost
Advertising expense
Selling and administrating salaries
Rent on factory facilities
Depreciation on sales equipment
Depreciation on factory equipment
Indirect labor cost
Factory utilities
Factory insurance
Net loss

Prior to August 2010 the company has been profitable every
month. The companys president is concerned about the
accuracy of the income statement above. As a friend of the
president, you have been asked to review the income statement
and make necessary cor
manufacturing cost data, you have required additional
information as follows:
1. Inventory balance at the beginning and end of August
were:
Raw materials ..$18,000
Work in proce
Finished goods ..40,000
2. Only 70% of the utilities expense and 80% of the
insurance expense apply to factory operations; the
remaining amounts should be charged to selling and
administrative activities.
Instructions:
(a) Prepare a cost of goods manufactured
schedule for August 2010.
(b) Prepare a correct income statement for August
2010.
P2-11)
Manufacturing cost data for Natasha Company are presented below

Raw materials purchased $200,000
Direct labor cost $150,000
Advertising expense $80,000
Selling and administrating salaries $70,000
Rent on factory facilities $60,000
Depreciation on sales equipment $55,000
Depreciation on factory equipment $40,000
Indirect labor cost $20,000
Factory utilities $10,000
Factory insurance $5,000

and make necessary corrections. After examining other
information as follows:
Inventory balance at the beginning and end of August

August 1
Raw materials ..$18,000
Work in process 25,000
Finished goods ..40,000
Only 70% of the utilities expense and 80% of the
administrative activities.
Prepare a cost of goods manufactured
schedule for August 2010.
Prepare a correct income statement for August
2010.
Manufacturing cost data for Natasha Company are presented below

$690,000
$(20,000)

rections. After examining other
Inventory balance at the beginning and end of August
August 31
$33,000
21,000
62,000
Only 70% of the utilities expense and 80% of the
Prepare a cost of goods manufactured
Prepare a correct income statement for August
Manufacturing cost data for Natasha Company are presented below.
Instructions
Indicate the missing amount for each letter (a)

P2-12)
Incomplete manufacturing cost data for Heintz Company for 2011 are presented
as follows for four different situations.

Instructions
(a) Indicate the missing amount for each letter.
(b) Prepare a condensed cost of goods
situation (1) for the
P2-13
Tart Corporation has the following cost records for June 2011.

Instructions
(a) Prepare a cost of goods manufactured schedule for June 2011.
(b) Prepare an income
assuming net sales

Indicate the missing amount for each letter (a) through (i).
as follows for four different situations.
(a) Indicate the missing amount for each letter.
(b) Prepare a condensed cost of goods manufactured schedule for
situation (1) for the year ended December 31, 2011.
Tart Corporation has the following cost records for June 2011.
a) Prepare a cost of goods manufactured schedule for June 2011.
(b) Prepare an income statement through gross profit for June 2011
assuming net sales are $85,100.
The End of Chapter 02
edule for
a) Prepare a cost of goods manufactured schedule for June 2011.
statement through gross profit for June 2011
Chapter 03: Fundamentals of Cost-Volume-Profit Analysis (CVP)

GOALS
Your goals for this "cost-volume-profit analysis" chapter are to learn about:
Cost behavior patterns and implications for managing business growth.
Methods of cost behavior analysis.
Break-even and target income analysis
Cost and profit sensitivity analysis.
Cost-volume-profit analysis for multiproduct scenarios.
Critical assumptions of cost-volume-profit modeling.
DISCUSSION
COST BEHAVIOR
"Profitability is just around the corner." This is a common expression in the
business world; you may have heard or said this yourself. But, the reality is that
many businesses don't make it! Business is tough, profits are illusive, and
competition has a habit of moving into areas where profits are available. And,
sometimes, business owners become frustrated because revenue growth only
seems to bring on waves of additional expenses, even to the point of going
backwards.
How does one realistically assess the viability of a business? This is perhaps the
most critical business assessment a manager must make. Most of us are taught
from an early age to do our best and not give up, even in the face of adversity.
And, there are countless stories of businesses that struggled to survive their
infancy, but went on to become highly successful firms. But, it is equally
important to note that some business models will not work. You likely have
heard the tongue-in-cheek story about the car dealer who said he loses money on
every sale but makes it up on volume. Of course, the math just won't work.
A good manager must learn to use information to make informed decisions about
which business prospects to pursue. Managerial accounting methods provide
techniques for evaluating the viability and ability to grow or "scale" a business.
These techniques are called cost-volume-profit analysis (CVP).
THE NATURE OF COSTS: Before one can begin to understand how a business
is going to perform over time and with shifts in volume, it is imperative to first
consider the cost structure of the business. This requires drilling down into the
specific types of costs that are to be incurred and trying to understand their
unique attributes.


VARIABLE COSTS:
Variable costs will vary in direct proportion to changes in the level of an
activity. For example, direct material, direct labor, sales commissions, fuel cost
for a trucking company, and so on, may be expected to increase with each
additional unit of output.
Assume that GoSound produces portable digital music players. Each unit
produced requires a printed circuit board (PCB) that costs $11. At right is a
spreadsheet that reveals rising PCB costs with increases in unit production. For
example, $1,650,000 is spent when 150,000 units are produced (150,000 X $11 =
$1,650,000). The data are plotted on the graphs. The top graph reveals that total
variable cost increases in a linear fashion as total production rises. The slope of
the line is constant. Of course, when plotted on a "per unit" basis (the bottom
graph), the variable cost is constant at $11 per unit. Increases in volume do not
change the per unit cost. In summary, every additional unit produced brings
another incremental unit of variable cost.
The activity base is the item or event that causes the incurrence of a variable
cost. It is easy to think of the activity base in terms of units produced, but it can
be more than that. Activity can relate to labor hours worked, units sold,
customers processed, or other such "cost drivers." For instance, a dentist will
uses a new pair of disposable gloves for each patient seen, no matter how many
teeth are being filled. Therefore, disposable gloves are variable and key on
patient count. But, the material used for fillings is a variable that is tied to the
number of decayed teeth that are repaired. Some patients have none, some have
one, and others have many. So, each variable cost must be considered
independently and with careful attention to what activity drives the cost.
FIXED COSTS:
The opposite of variable costs are fixed costs. Fixed costs do not fluctuate with
changes in the level of activity. Assume that GoSound leases the manufacturing
facility where the portable digital music players are assembled. Assume that rent
is $1,200,000 no matter the level of production. The rent is said to be a "fixed"
cost, because total rent will not change as output rises and falls. The following
spreadsheet reveals the factory rent incurred at different levels of production and
the resulting "per unit" rent amount. Observe that the fixed cost per unit will
decline with increases in production. This attribute of fixed costs is important to
consider in assessing the scalability of a business proposition. There are
numerous types of fixed costs. Examples include administrative salaries, rents,
property taxes, security, networking infrastructure support, and so forth.

BUSINESS IMPLICATIONS OF THE FIXED COST STRUCTURE:
The nature of a specific business will have a lot to do with defining its inherent
fixed cost structure. Airlines have historically been burdened with high fixed
costs related to gates, maintenance, contractual labor agreements, computer
reservation systems, aircraft, and the like. As you are aware, airlines have
struggled during lean years because they are unable to cover fixed costs. During
boom years, these same companies have been extremely profitable, because costs
do not rise (much) with increases in volume. Basically, there is not much cost
difference in flying a plane empty or full! Software companies have a big
investment in product development, but very little cost in reproducing multiple
electronic copies of the finished product. Their variable costs are low.
Other businesses have attempted to avoid fixed costs so that they can maintain a
more stable stream of income relative to sales. For example, a computer
company might outsource its tech support. Rather than having a fixed staff that
is either idle or overloaded at any point in time, they pay an independent support
company a per-call fee. The effect is to transform the organization's fixed costs
to variable, and better insulate the bottom line from fluctuations brought about by
the related ability to cover or not cover the fixed costs of operations.
Every business is unique, and a savvy business
person will be careful to understand their cost
structure. For a long time, the trend for many
businesses was toward increased fixed costs.
Some of this was the result of increased investment
in robotics and technology. However, those
components have become more affordable. And,
we are now seeing more outsourcing, elimination
of health insurance, conversion of pension plans,
and so forth. These activities suggest attempts to
structure businesses with a definitive margin
(revenues minus variable costs) that scales up and down with changes in the level
of business activity. No matter the specific example, a manager must understand
their cost structure.
ECONOMIES OF SCALE:
Economists speak of the concept of economies of scale. This means that certain
efficiencies are achieved as production levels rise. This can take many forms.
For starters, fixed costs can be spread over larger production runs, and this causes
a decrease in the per unit fixed cost. In addition, enhanced buying power results
(e.g., quantity discounts) as volume goes up, and this can reduce the per unit
variable cost. These are valid considerations. The accountant is not blind to
these issues and must take them into consideration in any business evaluation.
However, care must also be exercised to limit one's analysis to a "relevant range"
of activity.
RELEVANT RANGE:
At right is an excerpt from an online catalog (Digi-Key Corporation). This is a
pricing table for surface mount Zener Diodes. Notice that they are $0.44 each, or
$3.00 for ten units, or $20.80 for 100 units, or $92.00 per thousand. The bottom
line here is that they range from $0.44 down to $0.092 each, depending on the
quantity purchased. This is quite a remarkable spread.
Despite the wild spread in pricing, if your business needed about 150 of these
diodes in your production process, you would study the above table and
determine that the best quantity for you to order would be priced at $20.80 per
hundred. As a result, your per unit variable cost would be $0.208. The "relevant
range" is the anticipated activity level at which you will perform. Any pricing
data outside of this range is irrelevant and need not be considered. This enhanced
concept of variable cost is portrayed in the following graphic:

The relevant range comes into play when considering fixed costs as well. Many
fixed costs are only fixed for a certain level of production. For example, a
machine or manufacturing plant can reach capacity. To increase production
beyond a certain level, additional machinery (or a new plant, additional
supervisors, etc.) must be deployed. This will cause a major step upward in the
fixed cost. Fixed costs that behave in this fashion are also called step costs.
These costs are illustrated by the following diagram. The key conceptual point is
to note that fixed costs are only fixed over some particular range of activity, and
moving outside that range can significantly alter the cost structure.

DIALING IN YOUR BUSINESS MODEL:
After grasping the concepts of variable and fixed costs, it is important to
understand their full implications in managing a business. Let's first give added
thought to fixed cost concepts. In an ideal setting, you would try to produce at
the right-most edge of a fixed-cost step. This squeezes maximum productive
output from a given level of expenditure. For a machine, it is as simple as
running at full capacity. However, for a business with many fixed costs, it is
more challenging to orchestrate operations so that each component is fully
utilized.
Some fixed costs are committed fixed costs arising from an organization's
commitment to engage in operations. These elements include such items as
depreciation, rent, insurance, property taxes, and the like. These costs are not
easily adjusted with changes in business activity. On the other hand,
discretionary fixed costs originate from top management's yearly spending
decisions; proper planning can result in avoidance of these costs if cutbacks
become necessary or desirable. Examples of discretionary fixed costs include
advertising, employee training, and so forth. Committed fixed costs relate to the
desired long-run positioning of the firm; whereas, discretionary fixed costs have
a short-term orientation. Committed fixed costs are important because they
cannot be avoided in lean times; discretionary fixed costs can be altered with
proper planning. Of course, a company should be careful to avoid incurring
excessive committed fixed costs.
Variable costs are also subject to adjustment. In the Digi-Key Corporation
example, it was illustrated how such costs can vary based on quantities ordered.
Perhaps it occurred to you that one might order and store large quantities of the
diodes for use in future periods (after all, 1200 units at $.208 each > 3000 units at
$0.08 each). In a subsequent chapter, you will learn how to calculate economic
order quantities that take into account carrying and ordering costs in balancing
these important considerations. Even direct labor cost can be subject to
adjustment for overtime premiums, based on whether or not overtime is worked.
It may or may not make sense to meet customer demand by ramping up
production when overtime premiums kick in. Later in this book, you will learn
how to perform incremental analysis for such decision tasks.
The interplay between all of the different costs emphasizes the importance of
good planning. The trick is to synchronize operations so that the benefits of each
fixed cost are maximized, and variable cost patterns are established in the most
economic position. All of this must be weighed against revenue opportunities;
you must be able to sell what you produce. Some advanced managerial
accounting courses present sophisticated linear programming models that take
into account constraints and opportunities and project the ideal firm positioning.
Those models are beyond the scope of an introductory class, but a number of
simpler tools are available, and will be covered next.
COST BEHAVIOR ANALYSIS
Good managers must not only be able to understand the conceptual
underpinnings of cost behavior, but they must also be able to apply those
concepts to real world data that do not always behave in the expected manner.
Cost data are impacted by complex interactions. Consider for instance the costs
of operating a vehicle. Conceptually, fuel usage is a variable cost that is driven
by miles. But, the efficiency of fuel usage can fluctuate based on highway miles
versus city miles. Beyond that, tires wear faster at higher speeds; brakes suffer
more from city driving, and on and on. Vehicle insurance is seen as a fixed cost;
but some portions are required (liability coverage) and some portions are not
(collision coverage). Furthermore, if you have a wreck or get a ticket, your cost
of coverage can rise. Now, the point is that assessing the actual character of cost
behavior can be more daunting than you might first suspect. Nevertheless,
management must understand cost behavior, and this sometimes takes a bit of
forensic accounting work. Let's begin by considering the case of "mixed costs."
MIXED COSTS:
Many costs contain both variable and fixed components. These costs are called
mixed or semi-variable. If you have a cell phone, you probably know more
than you wish about such items. Cell phone agreements usually provide for a
monthly fee plus usage charges for excess minutes, text messages, and so forth.
With a mixed cost, there is some fixed amount plus a variable component tied to
an activity. Mixed costs are harder to evaluate, because they change in response
to fluctuations in volume. But, the fixed cost element means the overall change
is not directly proportional to the change in activity.
To illustrate, assume that Butler's Car Wash has a contract for its water supply
that provides for a flat monthly meter charge of $1,000, plus $3 per thousand
gallons of usage. This is a classic example of a mixed cost. Below is a graphic
portraying Butler's potential water bill, keyed to gallons used:

Look closely at the data in the spreadsheet, and notice that the "variable" portion
of the water cost is $3 per thousand gallons. For example, spreadsheet cell B12
is $2,100 (700 thousand gallons at $3 per thousand); observe the formula for cell
B12 in the upper bar of the spreadsheet (= (A12/1000)*3). In addition, the
"fixed" cost is $1,000, regardless of the gallons used. The total in column D is
the summation of columns B and C. The cost components are mapped in the
diagram at the right.
Hopefully, the preceding illustration is clear enough. But, what if you were not
given the "formula" by which the water bill is calculated? Instead, all you had
was the information from a handful of past water bills. How hard would it be to
to sort it out? Could you estimate how much the water bill should be for a
particular level of usage? This type of problem is frequently encountered in
business, as many expenses (individually and by category) contain both fixed and
variable components.

HIGH-LOW METHOD:
One approach to sorting out mixed costs is the high-low method. It is perhaps
the simplest technique for separating a mixed cost into fixed and variable
portions. However, beware that it can return an imprecise answer if the data set
under analysis has a number of rogue data points. But, it will work fine in other
cases, as with the water bills for Butler's Car Wash. Information from Butler's
actual water bills is shown at left. Butler is curious to know how much the
August water bill will be if 650,000 gallons are used. Assume that the only data
available are from the aforementioned four water bills.
With the high-low technique, the highest and lowest levels of activity are
identified for a period of time. The highest water bill is $3,550, and the lowest is
$2,020. The difference in cost between the highest and lowest level of activity
represents the variable cost ($3,550 - $2,020 = $1,530) associated with the
change in activity (850,000 gallons on the high end and 340,000 gallons on the
low end yields a 510,000 gallon difference). The cost difference is divided by
the activity difference to determine the variable cost for each additional unit of
activity ($1,530/510 thousand gallons = $3 per thousand). The fixed cost can be
calculated by subtracting variable cost (per-unit variable cost multiplied by the
activity level) from total cost. The table at right reveals the application of the
high-low method.
An electronic spreadsheet can be used to simplify the high-low calculations.
Click this link to open a separate browser window revealing an illustrative
spreadsheet for Butler.
METHOD OF LEAST SQUARES:
As cautioned, the high-low method can be quite misleading. The reason is that
cost data are rarely as linear as presented in the preceding illustration, and
inferences are based on only two observations (either of which could be a
statistical anomaly or "outlier"). For most cases, a more precise analysis tool
should be used. If you have studied statistical methods, recall "regression
analysis" or the "method of least squares." This tool is ideally suited to cost
behavior analysis. This method appears to be imposingly complex, but it is not
nearly so complex as it seems. Let's start by considering the objective of this
calculation.
The goal of least squares is to define a line so that it fits through a set of points on
a graph, where the cumulative sum of the squared distances between the points
and the line is minimized (hence, the name "least squares"). Simply, if you were
laying out a straight train track between a lot of cities, least squares would define
a straight-line route between all of the cities, so that the cumulative distances
(squared) from each city to the track is minimized.
Let's dissect this method, beginning with the definition of a line. A line on a
graph can be defined by its intercept with the vertical (Y) axis and the slope
along the horizontal (X) axis. In the following diagram, observe a red line
starting on the Y axis (at the value of "2"), and rising gently upward as it moves
out along the X axis. The rate of rise is called the slope of the line; in this case,
the slope is 0.8, because the line "rises" 8 units on the Y axis for every 10 units of
"run" along the X axis.

In general, a straight line can be defined by this formula:
Y = a + bX
Where:
a = the intercept on the Y axis
b = the slope of the line
X = the position on the X axis
For the line drawn above, the formula would be:
Y = 2 + 0.8 X
And, if you wished to know the value of Y, when X is 5 (see the red circle on the
line), you perform the following calculation:
Y = 2 + (0.8 * 5) = 6
Now, lets move on to fitting a line through a set of points. Below is a table of
data showing monthly unit production and the associated cost (sorted from low to
high). These data are plotted on the graph to the right. Through the middle of
the data points is drawn a line and the line has a formula of:
Y = $138,533 + $10.34X
This formula suggests that fixed costs are $138,533, and variable costs are $10.34
per unit. For example, how much would it cost to produce about 110,000 units?
The answer is about $1,275,000 ($138,533 + ($10.34 * 110,000)).
How was the formula derived? One approach would be to simply "eyeball the
points" and draw a line through them. You would then estimate the slope of the
line and the Y intercept. This approach is known as the scatter graph method,
but it would not be precise. A more accurate approach, and the one used to
derive the above formula, would be the least squares technique. With least
squares, the vertical distance between each point and resulting line (e.g., as
illustrated by an arrow at the $1,500,000 point) is squared, and all of the squared
values are summed. Importantly, the defined line is the one that minimizes the
summed squared values! This line is deemed to be the best fit line, hopefully
giving the clearest indication of the fixed portion (the intercept) and the variable
portion (the slope) of the observed data.
One can always fit a line to data, but how reliable or accurate is that resulting
line? The R-Square value is a statistical calculation that characterizes how well a
particular line fits a set of data. For the illustration, note (in cell B21) an R
2
of
.798; meaning that almost 80% of the variation in cost can be explained by
volume fluctuations. As a general rule, the closer R
2
is to 1.00 the better; as this
would represent a perfect fit where every point fell exactly on the resulting line.

The R-Square method is good in theory. But, how does one go about finding the
line that results in a minimization of the cumulative squared distances from the
points to the line? One way is to utilize built-in tools in spreadsheet programs, as
illustrated above. Notice that the formula for cell B21 (as noted at the top of
spreadsheet) contains the function RSQ(C5:C16,B5:B16). This tells the
spreadsheet to calculate the R
2
value for the data in the indicated ranges.
Likewise, cell B20 is based on the function SLOPE(C5:C16,B5:B16). Cell B19
is INTERCEPT(C5:C16,B5:B16). Most spreadsheets provide intuitive pop-up
windows with prompts for setting up these statistical functions.
Spreadsheets have not always been available. You may be curious to know the
underlying mechanics for the least squares method. If so, you can check out this
link.
RECAP: Before moving on, let's review a few key points. A good manager
must understand an organization's cost structure. This requires careful
consideration of variable and fixed cost components. However, it is sometimes
difficult to discern the exact cost structure. As a result, various methods can be
employed to analyze cost behavior. Once an organization's cost structure is
understood, it then becomes possible to perform important diagnostic
calculations which are the subject of the next sections of this chapter.
BREAK-EVEN AND TARGET INCOME
COST-VOLUME-PROFIT (CVP): CVP analysis is imperative for
management. It is used to build an understanding of the relationship between
costs, business volume, and profitability. The analysis focuses on the interplay of
pricing, volume, variable and fixed costs, and product mix. This analysis will
drive decisions about what products to offer, how to price them, and how to
manage an organization's cost structure. CVP is at the heart of techniques that
are useful for calculating the break-even point, volume levels necessary to
achieve targeted income levels, and similar computations. The starting point for
these calculations is to consider the contribution margin.
Cost-Volume-profit (CVP), in managerial economics is a form of cost
accounting. It is a simplified model, useful for elementary instruction and
for short-run decisions.
Cost-volume-profit (CVP) analysis expands the use of information provided by
breakeven analysis. A critical part of CVP analysis is the point where total
revenues equal total costs (both fixed and variable costs). At this breakeven point
(BEP), a company will experience no income or loss. This BEP can be an initial
examination that precedes more detailed CVP analysis. Cost-volume-profit
analysis employs the same basic assumptions as in breakeven analysis. The
assumptions underlying CVP analysis are:
The behavior of both costs and revenues is linear throughout the relevant range of
activity. (This assumption precludes the concept of volume discounts on either
purchased materials or sales.) Costs can be classified accurately as either fixed or
variable. Changes in activity are the only factors that affect costs. All units
produced are sold (there is no ending finished goods inventory). When a
company sells more than one type of product, the sales mix (the ratio of each
product to total sales) will remain constant.
The components of Cost-Volume-Profit Analysis are:
Level or volume of activity
Unit Selling Prices
Variable cost per unit
Total fixed costs
Sales mix
Assumptions
CVP assumes the following:
Constant sales price;
Constant variable cost per unit;
Constant total fixed cost;
Constant sales mix;
Units sold equal units produced.
These are simplifying, largely linearizing assumptions, which are often implicitly
assumed in elementary discussions of costs and profits. In more advanced
treatments and practice, costs and revenue are nonlinear and the analysis is
more complicated, but the intuition afforded by linear CVP remains basic and
useful.
CONTRIBUTION MARGIN:
The contribution margin is revenues minus variable expenses. Do not confuse
the contribution margin with gross profit as discussed in the previous chapter
(revenues minus cost of sales). Gross profit would be calculated after deducting
all manufacturing costs associated with sold units, whether fixed or variable.
Instead, the contribution margin is a conceptual number reflecting the amount
available from each sale, after deducting all variable costs associated with the
units sold. Some of these variable costs are product costs, and some are selling
and administrative in nature. The contribution margin is generally a number
calculated for internal use and analysis; it does not ordinarily become a part of
the externally reported data set.
CONTRIBUTION MARGIN:
Aggregated, per unit, or ratio?
When speaking of the contribution margin, one might be referring to aggregated
data, per unit data, or ratios. This point is illustrated below for Leyland Sports, a
manufacturer of score board signs. The production cost is $500 per sign, and
Leyland pays its sales representatives $300 per sign sold. Thus, variable costs
are $800 per sign. Each signs sells for $2,000. Leyland's contribution margin is
$1,200 ($2,000 - ($500 + $300)) per sign. In addition, assume that Leyland
incurs $1,200,000 of fixed costs, regardless of the level of activity. Below is a
schedule with contribution margin information, assuming 1,000 units are
produced and sold:

What would happen if Leyland sold 2,000 units?

What would happen if Leyland sold only 500 units?

Notice that changes in volume only impact certain amounts within the "total
column." Volume changes did not impact fixed costs, or change the per unit or
ratio calculations. By reviewing the above data, also note that 1,000 units
achieved breakeven net income. At 2,000 units, Leyland managed to achieve a
$1,200,000 net income. Conversely, 500 units resulted in a $600,000 loss.
GRAPHIC PRESENTATION:
Leyland's management would find the following chart handy. Dollars are
represented on the vertical axis and units on the horizontal:

Be sure to examine this chart, taking note of the following items:
The total sales line starts at "0" and raises $2,000 for each additional unit.
The total cost line starts at $1,200,000 (reflecting the fixed cost), and rises
$800 for each additional unit (reflecting the addition of variable cost).
"Break-even" results where sales equal total costs.
At any given point, the width of the loss area (in red) or profit area (in
green) is the difference between sales and total costs.
BREAK-EVEN CALCULATIONS:
As they say, a picture is worth a thousand words, and that is certainly true for the
CVP graphic just presented. However, everyone is not an artist, and you may
find it more precise to do a little algebra to calculate the break-even point.
Consider that:
Break-even results when:
Sales = Total Variable Costs + Total Fixed Costs
For Leyland, the math turns out this way:
(Units X $2,000) = (Units X $800) + $1,200,000
Solving:
Step
a:
(Units X
$2,000)
= (Units X $800) + $1,200,000
Step
b:
(Units X
$1,200)
= $1,200,000
Step
c:
Units = 1,000
Now, it is possible to "jump to step b" above by dividing the fixed costs by the
contribution margin per unit. Thus, a break-even short cut is:
Break-Even Point in Units = Total Fixed Costs / Contribution Margin per Unit
1,000 Units = $1,200,000 / $1,200
Sometimes, you may want to know the break-even point in dollars of sales
(rather than units). This approach is especially useful for companies with more
than one product, where those products all have a similar contribution margin
ratio:
Break-Even Point in Sales = Total Fixed Costs / Contribution Margin Ratio
$2,000,000 = $1,200,000 / 0.60
TARGET INCOME CALCULATIONS:
Breaking even is not a bad thing, but hardly a satisfactory outcome for most
businesses. Instead, a manager may be more interested in learning the necessary
sales level to achieve a targeted profit. The approach to solving this problem is
to treat the "target income" like an added increment of fixed costs. In other
words, the margin must cover the fixed costs and the desired profit:
Target Income results when:
Sales = Total Variable Costs + Total Fixed Costs + Target Income
Assume Leyland wants to know the level of sales to reach a $600,000 income:
(Units X $2,000) = (Units X $800) + $1,200,000 + $600,000
Solving:
Step
a:
(Units X
$2,000)
= (Units X $800) + $1,200,000 + $600,000
Step
b:
(Units X
$1,200)
= $1,800,000
Step
c:
Units = 1,500
Again, it is possible to "jump to step b" by dividing the fixed costs and target
income by the per unit contribution margin:
Units to Achieve a Target Income = (Total Fixed Costs + Target Income) /
Contribution Margin per Unit
1,500 Units = $1,800,000 / $1,200
If you want to know the dollar level of sales to achieve a target net income:
Sales to Achieve a Target Income = (Total Fixed Costs + Target Income) /
Contribution Margin Ratio
$3,000,000 = $1,800,000 / 0.60
CRITICAL THINKING ABOUT CVP:
CVP is more than just a mathematical tool to calculate values like the break-even
point. It can be used for critical evaluations about business viability.
For instance, a manager should be aware of the "margin of safety." The margin
of safety is the degree to which sales exceed the break-even point. For Leyland,
the degree to which sales exceed $2,000,000 (its break-even point) is the margin
of safety. This will give a manager valuable information as they plan for
inevitable business cycles.
A manager should also understand the scalability of the business. This refers to
the ability to grow profits with increases in volume. Compare the income
analysis for Leaping Lemming Corporation and Leaping Leopard Corporation:

Both companies "broke even" in 20X1. Which company would you rather own?
If you knew that each company was growing rapidly and expected to double sales
each year (without any change in cost structure), which company would you
prefer? With the added information, you would expect the following outcomes
for 20X2:

This analysis reveals that Leopard has a more scalable business model. Its
contribution margin is high and once it clears its fixed cost hurdle, it will turn
very profitable. Lemming is fighting a never ending battle; sales increases are
met with significant increases in variable costs. Be aware that scalability can be
a double-edged sword. Pull backs in volume can be devastating to companies
like Leopard because the fixed cost burden can be consuming. Whatever the
situation, managers need to be fully cognizant of the effects of changes in scale
on the bottom-line performance.
The Margin of Safety

The margin of safety is the excess of budgeted (or actual) sales over the break-
even volume of sales.

The margin of safety helps management assess how far above or below the
break-even point the company is currently operating. To calculate the margin of
safety, we take total current sales and subtract break-even sales.

Margin of safety = Total sales - Break-even sales

Lets calculate the margin of safety for RBC.
If we assume that Racing Bicycle Company has actual sales of $250,000, given
that we have already determined the break-even sales to be $200,000, the margin
of safety is $50,000 as shown.

We can express the margin of safety as a percent of sales.
Break-even
sales
400 units
Actual sales
500 units
Sales 200,000 $ 250,000 $
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income - $ 20,000 $
Break-even
sales
400 units
Actual sales
500 units
Sales 200,000 $ 250,000 $
Less: variable expenses 120,000 150,000
Less: fixed expenses 80,000 80,000
Net operating income - $ 20,000 $

sales actual) (or budgeted Total
dollars in safety of Margin
percentage safety of Margin =

In the case of RBC, the margin of safety is 20% ($50,000 divided by $250,000).
The margin of safety can be expressed in terms of the number of units sold. The
margin of safety at Racing is $50,000, and each bike sells for $500.
bikes 100
$500
$50,000
units in safety of Margin = =

Operating Leverage
A measure of how sensitive net operating income is to percentage changes in
sales.
The degree of operating leverage is a measure, at any given level of sales, of how
a percentage change in sales volume will affect profits. It is computed by
dividing contribution margin by net operating income.

income operating Net
Margin on Contributi
leverage operating of Degree =
Lets look at Racing Bicycle.
At Racing, the degree of operating leverage is 5.

5
000 , 20 $
0000 , 100 $
=

With an operating leverage of 5, if Racing increases its sales by 10%, net
operating income would increase by 50%.
If Racing is able to increase sales by 10%, net income will increase by 50%. We
multiply the percentage increase in sales by the degree of operating leverage.
Lets verify the 50% increase in profit.

Actual sales
500 Bikes
Sales 250,000 $
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000
Net income 20,000 $
Actual sales
500 Bikes
Sales 250,000 $
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000
Net income 20,000 $
Percent increase in sales 10%
Degree of operating leverage 5
Percent increase in profits 50%
A 10% increase in sales would increase bike sales from the current level of 500
to 550. Look at the contribution margin income statement and notice that income
increased from $20,000 to $30,000. That $10,000 increase in net income is a 50%
increase.

So it is true that a 10% increase in sales results in a 50% in net income. This is
powerful information for a manager to have.

Summary Formulas of CVP

Total Revenue (TR) = Price (P) x Units of output produced and sold (X)
TR = PX

Total cost (TC) = [variable cost per unit (V) x Units of output(X)] + Fixed Cost
(FC)
TC = VCX +FC

= TR-TC = PX (VCX+F) = (P-VC) X +FC
Contribution Margin
The difference between price and variable cost. It is what is leftover to cover
fixed costs and then add to operating profit.
Contribution Margin per Unit:
Price per unit Variable cost per unit = CM per unit
CM
unit =
P
unit
VC
unit

price selling Unit
margin
Sales
margin
) 1
on contributi Unit
ratio CM
on Contributi
ratio CM
=
=

Break-even:
The point at which profits equal zero. At break-even, all fixed costs are covered,
but the firm is not producing any operating profit.
Equation:
=TR TC
TR = TC +
PX = VCX + FC +
PX VCX = FC +
Actual sales
(500)
Increased
sales (550)
Sales 250,000 $ 275,000 $
Less variable expenses 150,000 165,000
Less fixed expenses 80,000 80,000
Net operating income 20,000 $ 30,000 $
X (P-VC) = F
VC P
FC
X
+
=

Break-even point in Units
VC P
FC
X
=

Break-even point in Dollars
ratio CM
FC
=

Target Profit Analysis

Volume Target ) 2
Volume( Target ) 1

Key Terms

Break-even point The level of sales at which profit is zero. The break
point can also be defined as the point where total sales
equals total expenses or as the point where total contribution
margin equals total fixed expenses.

Contribution
margin method
A method of computing the break
fixed expenses are divided by the contribution margin per
unit.

Contribution
margin ratio (CM
ratio)
A ratio computed by dividing contribution margin by dollar
sales.

Cost-volume-profit
(CVP) graph
A graphical representation of the relationships between an
organization's revenues, costs, and profits on the one hand
and its sales volume on the other hand.

Degree of
operating
leverage
A measure, at a given
change in sales will affect profits. The degree of operating
leverage is computed by dividing contribution margin by net
operating income.

= FC +
VC
Break even is where =0

even point in Units
unit CM
FC
VC
=
even point in Dollars
ratio

Target Profit Analysis
ratio CM
FC
Dollars) (sales Volume
CM Unit
FC
units) Volume(
+
=
+
=

The level of sales at which profit is zero. The break
margin equals total fixed expenses.
A method of computing the break-even point in which the
unit.
sales.
and its sales volume on the other hand.
A measure, at a given level of sales, of how a percentage
operating income.
The level of sales at which profit is zero. The break-even
even point in which the
level of sales, of how a percentage
Equation method A method of computing the break
the equation Sales = Variable expenses + Fixed expenses +
Profits.

Incremental
analysis
An analytical approach that focuses only on those costs and
revenues that change as a result of a decision.

Margin of safety The
break

Operating
leverage
A measure of how sensitive net operating income is to a
given percentage change in dollar sales.

Sales mix The relative proportions in
sold. Sales mix is computed by expressing the sales of each
product as a percentage of total sales.

Variable expense
ratio
A ratio computed by dividing variable expenses by dollar
sales.

P3-1Q). Which one of the following is the format of a CVP income statement?
A. Sales Variable costs = Fixed costs + Net income.
B. Sales Fixed costs
C. Sales Cost of goods sold
D. Sales Variable costs
P3-3Q.) Which one of the following describes the break
A. It is the point where sales total equals total variable plus total fixed costs.
B. It is the point where the contribution marg
C. It is the point where total variable costs equal total fixed costs.
D. It is the point where sales total equals total fixed costs.
P3-4Q) . The following information is available for Chap Company.
Sales. $350,000
Cost of good sold $120,000
Total fixed expenses $60,000
Total variable expenses $100,000
Which amount would you find on Chap's CVP income statement?
A. Contribution margin of $250,000.
B. Contribution margin of $190,000.
C. Gross profit of $230,000.
D. Gross profit of $190,000.
P3-5Q. Gabriel Corporation has fixed costs of $180,000 and variable costs of $8.50
per unit. It has a target income $268,000. How many units must it sell at $12 per unit
to achieve its target net income?
A. 51,429 units.
B. 128,000 units.
C. 76,571 units.
D. 21,176 units.
P3-1

ST ) . The format of a CVP Income statement is Sales
Operating expenses = Net Income.
A. True
B. False
P3-2ST) . Contribution margin ratio is contribution margin divided by sales.
A method of computing the break-even point that
Profits.
The excess of budgeted (or actual) dollar sales over the
break-even dollar sales.
given percentage change in dollar sales.
The relative proportions in which a company's products are
product as a percentage of total sales.
sales.
Solved Problems
Which one of the following is the format of a CVP income statement?
Variable costs = Fixed costs + Net income.
Fixed costs Variable costs Operating expenses = Net income.
Cost of goods sold Operating expenses =Net income.
Variable costs Fixed costs = Net income.
Which one of the following describes the break-even point?
It is the point where sales total equals total variable plus total fixed costs.
It is the point where the contribution margin equals zero.
It is the point where total variable costs equal total fixed costs.
It is the point where sales total equals total fixed costs.
The following information is available for Chap Company.
Sales. $350,000
good sold $120,000
Total fixed expenses $60,000
Total variable expenses $100,000
Which amount would you find on Chap's CVP income statement?
Contribution margin of $250,000.
Contribution margin of $190,000.
Gross profit of $230,000.
Gross profit of $190,000.
Gabriel Corporation has fixed costs of $180,000 and variable costs of $8.50
to achieve its target net income?
51,429 units.
8,000 units.
76,571 units.
21,176 units.
The format of a CVP Income statement is Sales Cost of goods sold
Operating expenses = Net Income.
Contribution margin ratio is contribution margin divided by sales.
even point that relies on
excess of budgeted (or actual) dollar sales over the
which a company's products are
Which one of the following is the format of a CVP income statement?
Operating expenses = Net income.
ome.
even point?
It is the point where sales total equals total variable plus total fixed costs.
It is the point where total variable costs equal total fixed costs.

Gabriel Corporation has fixed costs of $180,000 and variable costs of $8.50
Cost of goods sold
Contribution margin ratio is contribution margin divided by sales.
A. True
B. False
P3-11ST). ______ is the amount of revenue that remains after deducting variable
costs in a CVP income statement.
A. Net income.
B. Contribution margin.
C. Fixed income.
D. Gross income.
P3-12ST) . Given the following information, what is the contribution margin ratio?
Sales.. $900,000
Variable expenses... 400,000
Fixed Expenses.. 300,000
Net Income. 200,000
A. 44%
B. 22%
C. 33%
D. 56%
P3-1)
Cambridge, Inc. is considering the introduction of a new calculator with the
following price and cost characteristics:
Sales price . . . . . . . . . . . . . . $ 18 each
Variable costs . . . . . . . . . . . ..10 each
Fixed costs . . . . . . . . . . . . . . 20,000 per month
Required
a. What number must Cambridge sell per month to break even?
b. What number must Cambridge sell to make an operating profit t of $16,000 for
the month?
P3-2)
Balance, Inc. is considering the introduction of a new energy snack with the
following price and cost characteristics:
Sales price . . . . . . . . . . . $ 1.00 per unit
Variable costs . . . . . . . . . 0.20 per unit
Fixed costs . . . . . . . . . . . 400,000 per month
Required
a. What number must Balance sell per month to break even?
b. What number must Balance sell per month to make an operating profit of
$100,000?
P3-1Brew)
Bird Shelters, Inc. distributes a high-quality wooden birdhouse that sells for
$15.00 per unit. Variable costs are $4.50 per unit, and fixed costs total $135,000
per year.

Required:

Answer the following independent questions:
1. What is the products CM ratio?
2. Use the CM ratio to determine the break-even point in sales dollars.
3. Due to an increase in demand, the company estimates that sales will increase
by $56,250 during the next year. By how much should net operating income
increase (or net operating loss decrease), assuming that fixed costs do not
change?
P3- Solu-Gari)
Voltar Company manufactured and sells a telephone answering machine. The
companys contribution format income statement for the most recent year is
given below:
Total Per Unit Percent of Sales
Sales (20,000 units . 1,200,000 $ 60 $ 100%
Less variable expenses.. 900,000 45 ?
Contribution margin. 300,000 15 $ ? %
Less fixed expenses 240,000
Net operating income.. 60,000 $

Management is anxious to improve the companys profit performance and
has asked for an analysis of a number of items.
Required:
1- Compute the companys CM ratio and variable expense ratio.
2- Compute the companys break-even point in both units and sales dollars. Use
the equation method.
3- Assume that sales increase by $400,000 next year. If cost behavior patterns
remain unchanged, by how much will be companys net operating income
increase? Use the CM ratio to determine your answer.
4- Refer to the original data. Assume that next year management wants the
company to earn a minimum profit of $90,000. How many units will have to
be sold to meet this target profit figure?
5- Refer to the original data. Compute the companys margin of safety in both
dollar and percentage form.
6- a. Compute the companys degree of operating leverage at the present level
of sales.
b.Assume that through a more intense effort by the sales of staff the
companys sales increase by 8% next year. By what percentage would you
expect next operating income to increase? Use the operating leverage
concept to obtain your answer.
c.Verify your answer to (b) by preparing a new income statement showing an
8% increase in sales.
7- In an effort to increase sales and profits, management is considering the use
of a higher quality speaker. The higher quality speaker would increase
variable costs by $3 per unit, but management could eliminate one quality
inspector who is paid a salary of $30,000 per year. The sale manager
estimates that the higher quality speaker would increase annual sales by at
least 20%.
a) Assume that changes are made as described above; prepare a projected
income statement for next year. Show data on a total per unit, and percentage
basis.
b) Compute the companys new break-even point in both units and dollars of
sales. Use the contribution margin method.
c) Would you recommend that the changes be made?
P3-3)
Chen & Chen Furniture Inc. sells a small hand-crafted table for $30 per unit. The
variable costs related to the table, including product and shipping costs, are $18
per unit. Total fixed costs for the company are $60,000. Prepare a CVP graph to
approximate the break-even point in dollars and units.
P3-4)
Barnard Ltd. sells a single product. The product has a selling price of $100
per unit, variable expenses of 80% of sales, and its fixed expenses total
$150,000 per year.
Part (a) What is the companys contribution margin ratio?
Part (b) What is its break-even point? (Give answer in dollars and in units.)
Part (c) Draw the CVP graph and show the graph.
P3-5)
Dahlia Manufacturing Company reported $4,000,000 of sales during the month
and incurred variable expenses totaling $2,800,000 and fixed expenses of
$720,000. A total of 80,000 units were produced and sold last month. The
company has no beginning or ending inventories.
Part (a) what is the companys total contribution margin and contribution
margin per unit?
Part (b) how many units would the company have to sell to achieve a
desired target profit of $600,000?
Part (c) What is the companys break-even point in sales dollars?
Part (d) What is the companys margin of safety?
Part (e) What is the company's degree of operating leverage?

P3-132TB)
1

. Delphi Company has developed a new product that will be marketed for the first
time during the next fiscal year. Although the Marketing Department estimates
that 35,000 units could be sold at $36 per unit, Delphi's management has
allocated only enough manufacturing capacity to produce a maximum of 25,000
units of the new product annually. The fixed expenses associated with the new
product are budgeted at $450,000 for the year. The variable expenses of the new
product are $16 per unit.
Required:
a. How many units of the new product must Delphi sell during the next fiscal
year in order to break even on the product?
b. What is the profit Delphi would earn on the new product if all of the
manufacturing capacity allocated by management is used and the product is sold
for $36 per unit?
c. What is the degree of operating leverage for the new product if 25,000 units
are sold for $36 per unit?
d. The Marketing Department would like more manufacturing capacity to be
devoted to the new product. What would be the percentage increase in net
operating income for the new product if its unit sales could be expanded by 10%
without any increase in fixed expenses and without any change in the unit selling
price and unit variable expense?
e. Delphi's management has stipulated that the new product must earn a profit of
at least $125,000 in the next fiscal year. What unit selling price would achieve
this target profit if all of the manufacturing capacity allocated by management is
used and all of the output can be sold at that selling price?
P3-133TB).

1
Managerial Accounting _Edition_12_Garrison_Noreen_Brewer_Test _Bank
Parkins Company produces and sells a single product. The company's income
statement for the most recent month is given below:
Sales (6,000 units at $40 per unit) ............. . $240,000
Less manufacturing costs:
Direct materials...................................... $48,000
Direct labor (variable) ............................ 60,000
Variable factory overhead ...................... 12,000
Fixed factory overhead ........................... 30,000.. 150,000
Gross margin................................................................. 90,000
Less selling and other expenses:
Variable selling and other expenses ....... 24,000
Fixed selling and other expenses ............ 42,000.. 66,000
Net operating income ................................ ..$ 24,000
There are no beginning or ending inventories.
Required:
a. Compute the company's monthly break-even point in units of product.
b. What would the company's monthly net operating income be if sales increased
by 25% and there is no change in total fixed expenses?
c. What dollar sales must the company achieve in order to earn a net operating
income of $50,000 per month?

End of chapter 03

Chapter 4 Cost Estimation

Learning Objectives

Managers who understand how costs behave are better able to predict costs and
make decisions under various circumstances. This chapter explores the meaning
of variable, fixed, and mixed costs (the relative proportions of which define an
organizations cost structure). It also introduces a new income statement called
the contribution approach.

Understand how fixed and variable costs behave and how to use them to
predict costs
We discussed this table in an earlier chapter. Lets concentrate on variable costs
in total. Recall that total variable cost is proportional to the activity level within
the relevant range. As activity increases, total variable cost increases, and as
activity decreases, total variable cost decreases.
Types of Cost Behavior Patterns

After reading this chapter, you should be able to:
Understand the reasons for estimating fixed and variable costs.
Estimate costs using engineering estimates.
Estimate costs using account analysis.
Estimate costs using statistical analysis.
Interpret the results of regression output.
Identify potential problems with regression data.
Evaluate the advantages and disadvantages of alternative cost
estimation methods.
(Appendix A) Use Microsoft Excel to perform a regression analysis.
(Appendix B) Understand the mathematical relationship describing
the learning phenomenon.
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit
Variable Total variable cost is Variable cost per unit remains
proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.
Mixed Costs
A mixed cost has both a fixed and variable element.
If you pay your utility bill, you know that a portion of your total bill is fixed.
This is the standard monthly utility charge. The variable portion of your utility
costs depends upon the number of kilowatt hours you consume. In other words,
your total utility bill has both a fixed and variable element.
The graph demonstrates the nature of a normal utility bill.

The total mixed cost line can be expressed
as an equation: Y= aX +b or Y = a +bX
Where: Y = the total mixed cost
b = the total fixed cost (the
vertical intercept of the line)
a = the variable cost per unit of
activity (the slope of the line)
X = the level of activity

The mixed cost line can be expressed with the equation Y = A + B*X. This
equation should look familiar, from your algebra and statistics classes.
In the equation, Y is the total mixed cost; A is the total fixed cost (or the vertical
intercept of the line); B is the variable cost per unit of activity (or the slope of the
line), and X is the actual level of activity.
In our utility example, Y is the total mixed cost; A is the total fixed monthly
utility charge; B is the cost per kilowatt hour consumed, and X is the number of
kilowatt hours consumed.

Mixed Costs 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 = aX +b = $0.03*2,000 +$40 =$100.

Analysis of Mixed Costs

We can analyze mixed costs by looking at each account and classifying the cost
as variable, fixed or mixed based on the cost beha
A more sophisticated way to analyze the nature of a cost is to ask our engineers
to evaluate each cost in terms of production methods, material requirements,
labor usage and overhead.
Account Analysis and the Engineering Approach
Each account is classified as either
analysts knowledge of how the account behaves.
Cost estimates are based on an evaluation of production methods, and
material, labor and overhead requirements.

Use a scatter graph plot to diagnose
A scatter graph plot is a quick and easy way to isolate the fixed and variable
components of a mixed cost.

The first step is to identify the cost, which is referred to as the
variable, and plot it on the
variable, is plotted on the
If the plotted dots do not appear to be linear, do not analyze the data any further.
If there does appear to be a linear relationship between the level of activity and
cost, we will continue our analysis.
Next, we draw a straight line where, roughly speaking, an equal number of points
reside above and below the line. Make sure that the straight line goes through at
least one data point on the scattergraph.
Draw a line through the data points with about an
and below the line.

as variable, fixed or mixed based on the cost behavior over time.
labor usage and overhead.
Account Analysis and the Engineering Approach
nt is classified as either variable or fixed based on the
knowledge of how the account behaves.
material, labor and overhead requirements.
Use a scatter graph plot to diagnose cost behavior.
graph plot is a quick and easy way to isolate the fixed and variable
components of a mixed cost.
The first step is to identify the cost, which is referred to as the dependent
, and plot it on the Y axis. The activity, referred to as the independent
, is plotted on the X axis.
ost, we will continue our analysis.

least one data point on the scattergraph.
h the data points with about an equal numbers of points above
r fixed based on the
graph plot is a quick and easy way to isolate the fixed and variable
dependent
independent

equal numbers of points above
Part I
Where the straight line crosses the Y axis determines the estimate of total fixed
costs. In this case, the fixed costs are $10,000.
Part II
Next, select one data point to estimate the variable cost per patient day. In our
example, we used the first data point that was on the straight line. From this
point, we estimate the total number of patient days and the total maintenance
cost.

Part III
Our estimate of the total number of patient days at this data point is 800, and the
estimate of the total maintenance cost is $11,000. We will use this information to
estimate the variable cost per patient day.
Make a quick estimate of variable cost per unit and determine the cost equation.

Variable cost per unit = $1,000/ 800= $1.25/ patient day
Y = $10,000 +$1.25X
Where Y = Total maintenance cost
X= Number of patient days

Analyze a mixed cost using the high-low method.

The high-low method can be used to analyze mixed costs, if a scattergraph plot
reveals an approximately linear relationship between the X and Y variables. We
will use the data shown in the Excel spreadsheet to determine the fixed and
variable portions of maintenance costs. We have collected data about the number
of hours of maintenance and total cost incurred.
Lets see how the high-low method works.
Assume the following hours of maintenance work and the total maintenance costs
for six months.
Month Hours of maintenance Total maintenance cost
Jan 625 $7,950
Feb 500 $7,400
Mar 700 $8,275
Apr 550 $7,625
May 775 $9,100
Jun 800 $9,800

Part I
The first step in the process is to identify the high level of activity and its related
total cost and the low level of activity with its related total cost. You can see that
the high level of activity is 800 hours with a cost of $9,800 dollars. The low level
of activity is 500 hours with a related total cost of $7,400.
Part II
Total maintenance at 800 patients 11,000 $
Less: Fixed cost 10,000
Estimated total variable cost for 800 patients 1,000 $
Total maintenance at 800 patients 11,000 $
Less: Fixed cost 10,000
Estimated total variable cost for 800 patients 1,000 $
Now, we subtract the low level of activity from the high level and do the same
for the costs we have identified. In our case, the change in level of activity and
cost is 300 hours and $2,400, respectively.
The variable cost per unit of activity is determined by dividing the change in total
cost by the change in activity. For our maintenance example, we divide $2,400
by 300 and determine that the variable cost per hour of maintenance is $8.00.
Month Hours of maintenance Total maintenance cost
Jan 625 $7,950
Feb 500 $7,400
Mar 700 $8,275
Apr 550 $7,625
May 775 $9,100
Jun 800 $9,800
High 800 $9,800
Low 500 $7,400
Change 300 $2,400

The variable cost per hour of maintenance is equal to the change in cost divided
by the change in hours.
hour / 00 . 8 $
300
$2,400
hour per cost variable = =
Total Fixed Cost = Total Cost Total Variable Cost
Total Fixed Cost = $9,800 ($8/hour 800 hours)
Total Fixed Cost = $9,800 $6,400 = $3,400

The Cost Equation for Maintenance
Y = $3,400 + $8.00X

Quick Check
Sales salaries and commissions are $10,000 when 80,000 units are sold,
and $14,000 when 120,000 units are sold. Using the high-low method, what is
the variable portion of sales salaries and commission?
a. $0.08 per unit
b. $0.10 per unit
c. $0.12 per unit
d. $0.125 per unit
Sales salaries and commissions are $10,000 when 80,000 units are sold, and
$14,000 when 120,000 units are sold. Using the high-low method, what is the
fixed portion of sales salaries and commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000

Least-Squares Regression Method
The least-squares regression method is a more sophisticated approach to isolating
the fixed and variable portion of a mixed cost. This method uses all of the data
points to estimate the fixed and variable cost components of a mixed cost. This
method is superior to the scattergraph plot method that relies upon only one data
point and the high-low method that uses only two data points to estimate the
fixed and variable cost components of a mixed cost. 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.
The formulas that are used for least-squares regression are complex. Fortunately,
computer software can perform the calculations, quickly. The observed values of
the X and Y variables are entered into the computer program and all necessary
calculations are made. In the appendix to this chapter, we show you how to use
Microsoft Excel to complete a least-squares regression analysis.
Output from the regression analysis can be used to create the equation that
enables us to estimate total costs at any activity level. The key statistic to
examine when evaluating regression results is called R squared, which is a
measure of the goodness of fit.
bX a Y b aX Y + = + = ;
The Best Regression Line --: : :- u - -:u :- c
. b ax y + = :..

( )

=
x
x
n
y x xy n
a
2
2

( )

=
x
x
x
n
xy x y
b
2
2
2
( )

= x a y
n
b
1

:-- :- :: :-u :-:a (r)

( ) ( )

=
y y x
x
n n
y x xy n
r
2 2 2
2

.:. r ..:[[. ... . 1 1 r

625 $7,950 $4,968,750 390,625 63,202,500
500 $7,400 $3,700,000 250,000 54,760,000
700 $8,275 $5,792,500 490,000 68,475,625
550 $7,625 $4,193,750 302,500 58,140,625
775 $9,100 $7,052,500 600,625 82,810,000
800 $9,800 $7,840,000 640,000 96,040,000
3950 50,150 $ $33,547,500 2,673,750 423,428,750
15,602,500 2,515,022,500
a 7.26 $
b 3,581.68 $
r 0.95

Y = $3,581.68+ 7.26X

Fortunately, computers are adept at carrying out the computations required by the
least-squares regression formulas.
Use Microsoft Excel 2003 or 2007.

Find a : = slope(known_ys, known_xs)
Find b : = intercept(known_ys, known_xs)
Find r : =rsq(known_ys, known_xs)

Step 1:

Step 2:


Step 3

Note: Use the regression method in Microsoft Excel 2003 or 2007

Data > Data Analysis

Data > Data Analysis > Regression > ok


Chapter Summary

Accurate cost estimation is important to most organizations for decision-
making purposes. Although no estimation method is completely accurate,
some are better than others. The usefulness of a cost estimation method
depends highly on the user's knowledge of the business and the costs being
analyzed.
The following summarizes the key ideas tied to the chapter's learning
objectives.
L.O. 1. Understand the reasons for estimating fixed and variable costs. The
behavior of costs, not the accounting classification, is the important
distinction for decision making. Cost estimation focuses on identifying
(estimating) the fixed and variable components of costs.
L.O. 2. Estimate costs using engineering estimates. Cost estimates can be
developed by identifying all activities and resources required to make a
product or provide a service. An engineering cost estimate applies unit costs
to the estimate of the physical resources required to accomplish a task.
L.O. 3. Estimate costs using account analysis. Reviewing historical
accounting data to determine the behavior of costs requires analyzing the
accounts. Because these estimates are based on actual results, they include
factors such as downtime for maintenance and absenteeism that could be
missed by an engineering estimate.
L.O. 4. Estimate costs using statistical analysis. Statistical analysis of data
allows estimates of costs to be based on many periods of operation.
Statistical estimates average out fluctuations in the relation between costs
and activities. Scattergraphs provide a visual representation of the relation
and are useful to see how closely costs and activities are related. High-low
analysis uses two observations to estimate the slope of the line (an estimate
of the unit variable cost) and the intercept (an estimate of the fixed costs).
Regression analysis uses all data and can be accomplished easily with a
spreadsheet program. Using regression analysis avoids the problem of
selecting observations in the high-low method that might not be
representative.
L.O. 5. Interpret the results of regression output. Using regression analysis
requires care because the estimates depend on certain assumptions. At a
minimum, you should look at a scattergraph to determine whether the
relation appears to be representative for your data. You should also check the
coefficient of determination (R
2
) to determine how closely the estimates fit
the observed data.
L.O. 6. Identify potential problems with regression data. Regression methods rely
on certain assumptions. The relation between cost and activity is assumed to be
Glossary

account analysis Cost estimation method that calls for a review of each
account making up the total cost being analyzed.

adjusted R-
squared (R
2
)
Correlation coefficient squared and adjusted for the number
of independent variables used to make the estimate.

coefficient of
determination
Square of the correlation coefficient, interpreted as the
proportion of the variation in the dependent variable
explained by the independent variable(s).

correlation
coefficient
Measure of the linear relation between two or more
variables, such as cost and some measure of activity.

dependent
variable
Y term or the left-hand side of a regression equation.

engineering
estimate
Cost estimate based on measurement and pricing of the work
involved in a task.

high-low cost
estimation
Method to estimate costs based on two cost observations,
usually at the highest and lowest activity levels.

independent
variable
X term, or predictor, on the righthand side of a regression
equation.

learning
phenomenon
Systematic relationship between the amount of experience in
performing a task and the time required to perform it.

regression Statistical procedure to determine the relation between
variables.

relevant range Activity levels within which a cost estimate is valid; in
particular the range within which a given fixed or unit
variable cost will be unchanged even though volume
changes.

linear, but this might not be the case, especially outside the relevant range. In
using data from actual operations, it is important to ensure that each observation
is representative and that there have been no special circumstances (strikes,
weather disasters, etc.) for the period. Also, it is important to guard against
spurious relations that are masked by a good statistical fit.
L.O. 7. Evaluate the advantages and disadvantages of alternative cost
estimation methods. Each method has its advantages and disadvantages.
Using two, three, or four of the methods together can indicate whether you
should be confident of the estimates (if all the methods give similar results)
or invest in more analysis.
L.O. 8. (Appendix A) Use Microsoft Excel to perform a regression analysis.
Microsoft Excel or many other statistical software programs can be used to
perform a regression analysis.
L.O. 9. (Appendix B) Understand the mathematical relationship describing
the learning phenomenon.
scattergraph Graph that plots costs against activity levels.

t-statistic t is the value of estimated coefficient, b, divided by its
standard error.

Solved Problems

Brief Exercise 4-1: Fixed and Variable Cost Behavior (LO1)
Coffee Express operations a number of espresso coffee stands in busy suburban
mails. The fixed weekly expense of a coffee stand is $1,100 and the variable cost
per cup of coffee served is $0.26.

Required:
1- Fill in the following table with your estimates total costs and cost per
cup of coffee at the indicated levels of activity for a coffee stand. Round
off the cost of a cup of coffee to the nearest tenth of a cent.
Cups of Coffee Served in a Week
1,800 1,900 2,000
Fixed cost ? ? ?
Variable cost ? ? ?
Total cost. ? ? ?
Cost per cup of coffee served... ? ? ?

2- Does the cost per cup of coffee served increase, decrease, or remain the
same as the number of cups of coffee served in a week increases?
Explain.

Brief Exercise 4-2: Scattergraph Analysis (LO2)
The data below have been taken from the cost records of the Atlanta Processing
Company. The data relate to the cost of operating one of the companys
processing facilities at various levels of activities:
Month Units Processed Total Cost
January.. 8,000 $14,000
February 4,500 $10,000
March 7,000 $12,500
April.. 9,000 $15,500
May 3,750 $10,000
June 6,000 $12,500
July 3,000 $8,500
August 5,000 $11,500

Required:
1- Prepare a scattegraph by plotting the above data on a graph. Plot cost on
the vertical axis and activity on the horizontal axis. Fit a line to your
plotted points using a ruler.
2- Using the quick-and-dirty method, what is the approximate monthly
fixed cost? The approximate variable cost per unit processes? Show
your computations.

Brief Exercise 4-3: High-Low Method (LO3)
The Edelweiss Hotel in Vail, Colorado, has accumulated records of the total
electrical costs of the hotel and the number of occupancy-days over the last year.
An occupancy-day represents a room rented out for one day. The hotels business
is highly seasonal, with peaks occurring during the ski season and in the summer.
Month Occupancy-Day Electrical Costs
January.. 2,604 $6,257
February 2,856 $6,550
March 3,534 $7,986
April.. 1,440 $4,022
May 540 $2,289
June 1,116 $3,591
July 3,162 $7,264
August 3,608 $8,111
September.. 1,260 $3,707
October.. 186 $1,712
November.. 1,080 $3,321
December.. 2,046 $5,196

Required:
1- Using the high-low estimate the fixed cost of electricity per month and
the variable cost of electricity per occupancy-day. Round off the fixed
cost to the nearest whole dollar and the variable cost to the nearest
whole cent.
2- What other factors other than occupancy-days are likely to a affect the
variation in electrical costs from month to month?

Brief Exercise 4-4: Contribution Income Statement (LO4)
Haaki Shop, Inc., is a large retailer or water sports equipment. An income
statement for the companys surfboard department for a recent quarter is
presented below:
Sales.. 800,000 $
Less cost of goods sold. 300,000
Gross margin. 500,000
Less operating expenses:
Selling expense 250,000 $
Administrative expenses. 160,000 410000
Net operating income 90,000 $
THE HAAKI SHOP, INC.
Income Statement-Surfboard Department
For the Quarter Ended May 31

The surfboards sell, on the average, for $400 each. The departments
variable selling expenses are $50 per surfboard sold. The remaining selling
expenses are fixed. The administrative expenses are 25% variable and 75% fixed.
The company purchases its surfboards from a supplier at a cost of $150 per
surfboard.
Required:
1- Prepare an income statement for the quarter using the contribution
approach.
2- What was the contribution toward fixed expenses and profits from each
surfboard sold during the quarter? (State this as a dollar amount per
surfboard).

Brief Exercise 4-5: High-Low Method; Predicting Cost (LO1, LO3)
The number of X-rays taken and X-ray cost over the last nine months in Beverly
Hospital are given below:
Month X-Rays Taken X-Ray Costs
January 6,250 28,000 $
February 7,000 29,000 $
March 5,000 23,000 $
April 4,250 20,000 $
May 45,000 22,000 $
June 3,000 17,000 $
July 3,750 18,000 $
August 5,500 24,000 $
September 5,750 26,000 $

Required:
1- Using the high-low method, estimate the cost formula for X-ray costs.
2- Using the cost formula you derived above, what X-ray costs would you
expect to be incurred during a month in which 4,600 X-rays are taken?

Brief Exercise 4-6: Scattergraph Analysis; High-Low Method (LO2, LO3)
Refer to the data in Exercise 4-5

Required:
1- Prepare a scattergraph using the data from Exercise 4-5. Plot cost on the
vertical axis and activity on the horizontal axis. Using a ruler fit a line to
your plotted points.
2- Using the quick-and-dirty method, what is the approximate monthly
fixed cost for X-rays? The approximate variable cost per X-ray taken?
3- scattergraph cost formula in this situation.

P4_111TB
.Rapid Delivery, Inc., operates a parcel delivery service across the nation. The
company keeps detailed records relating to operating costs of trucks, and has
found that if a truck is driven 150,000 miles per year the average operating cost is
10 cents per mile. This cost increases to 11 cents per mile if a truck is driven only
100,000 miles per year.
Assume that all of the activity levels mentioned in this problem are within the
relevant range.
Required:
a. Using the high-low method, derive the cost formula for truck operating costs.
b. Using the cost formula you derived above, what total cost would you expect
the company to incur in connection with the truck if it is driven 130,000 miles in
a year?
P4-112TB)
. Butler Sales Company is a distributor that has an exclusive franchise to sell a
particular product made by another company. Butler Sales Company's income
statements for the last two years are given below:
This Year Last Year
Units sold ................................................... 200,000 .160, 000
Sales revenue ............................................. $1,000,000. $800,000
Less cost of goods sold .............................. 700,000.. 560,000
Gross margin ............................................. 300,000. 240,000
Less operating expenses ............................ 210,000.198, 000
Net operating income................................ $ 90,000$ 42,000
Operating expenses are a mixture of fixed costs and variable and mixed costs that
vary with respect to the number of units sold.
Required:
a. Estimate the company's variable operating expenses per unit, and its total fixed
operating expenses per year.
b. Compute the company's contribution margin for this year.
P4-113TB)
. SomethingNew is a small one-person company that provides elaborate and
imaginative wedding cakes to order for very large wedding receptions. The
owner of the company would like to understand the cost structure of the company
and has compiled the following records of activity and costs incurred. The owner
believes that the number of weddings catered is the best measure of activity.
Month Weddings Costs Incurred
January 3 $3,800
February 2 $3,600
March 6 $4,000
April 9 $4,300
May 12 $4,500
June 20 $5,200
Required:
a. Using the high-low method, estimate the variable cost per wedding and the
total fixed cost per month. (Round off the variable cost per wedding to the
nearest cent and the total fixed cost to the nearest dollar.)
b. Using the least-squares regression method, estimate the variable cost per
wedding and the total fixed cost per month. (Round off the variable cost per
wedding to the nearest cent and the total fixed cost to the nearest dollar.)
P4-1)
CHECK FIGURE
(1) $1,200 per month plus $24.00 per scan

Northern Province Hospital of British Columbia has just hired a new chief
administrator who is anxious to employ sound management and planning
techniques in the business affairs of the hospital. Accordingly, she has directed
her assistant to summarize the cost structure of the various departments so that
data will be available for planning purposes.
The assistant is unsure how to classify the utilities costs in the Radiology
Department since these costs do not exhibit either strictly variable or fixed cost
behavior. Utilities costs are very high in the department due to a CAT scanner
that draws a large amount of power and that is kept running at all times. The
scanner cant be turned off due to the long warm-up period required for its use.
When the scanner is used to scan a patient, it consumes an additional burst of
power. The assistant has accumulated the following data on utilities costs and use
of the scanner since the first of the year.

Month
Number of
Scans
Utilities
Cost
January ... 60 $2,640
February . 70 $3,120
March ..... 90 $3,480
April ....... 120 $3,960
May ......... 100 $3,600
June ......... 130 $4,320
July ......... 150 $4,800
August .... 140 $4,320
September 110 $3,720
October ................................ 80 $3,000

The chief administrator has informed her assistant that the utilities cost is
probably a mixed cost that will have to be broken down into its variable and fixed
cost elements by use of a scattergraph. The assistant feels, however, that if an
analysis of this type is necessary, then the high-low method should be used, since
it is easier and quicker. The controller has suggested that there may be a better
approach.

Required:

1. using the high-low method, estimate a cost formula for utilities. Express the
formula in the form Y = a + bX. (The variable rate should be stated in terms
of cost per scan.)
2. Prepare a scattergraph by using the data above. (The number of scans should
be placed on the horizontal axis, and utilities cost should be placed on the
vertical axis.) Fit a straight line to the plotted points using a ruler and estimate
a cost formula for utilities using the quick-and-dirty method.
3. using the regression method, estimate a cost formula for utilities.
P4-3A3Horngren)
Martina Fernandez, the president of Fernandez Tool Co., has asked for
information about the cost behavior of manufacturing support costs. Specially,
she wants to know how much support cost is fixed and how much is variable.
The following data are the only records available:
Month Machine Hours Support Costs
May 850 9,000 $
June 1400 12,500 $
July 1000 7,900 $
August 1250 11,000 $
September 1750 13,500 $

Required:
1. Find monthly fixed support cost and the variable support cost per
machine hour by the high-low method.
2. A least-squares regression analysis gave the following output:
Regression equation: Y = $2,728 +$6.77X
What recommendation would you give the president based on these
analyses?

End of Chapter 04

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