CHAPTER 1
FPO
Managerial Accounting
and Cost Concepts
Curbing Administrative Expenses!
LEARNING OBJECTIVES
BUSINESS FOCUS
After studying Chapter 1, you should be able to:
LO"–" Understand cost classifications
used for assigning costs to cost
objects: direct costs and indirect
costs.
LO"–# Identify and give examples
of each of the three basic
manufacturing cost categories.
LO"–$ Understand cost classifications
used to prepare financial
© Raymond Boyd/Getty Images statements: product costs and
period costs.
When Eric Kaler was appointed as the University of Minnesota’s President LO"–% Understand cost classifications
he promised to cut administrative expenses. Over an 11-year period, the used to predict cost behavior:
university’s administrative headcount had climbed by 1,000 employees, or variable costs, fixed costs, and
37%. This growth rate practically doubled the faculty and student growth mixed costs.
rates during the same time period. Beyond the disparity in headcount LO"–& Understand cost classifications
growth rates, the executive administrators’ pay raises exceeded the pay used in making decisions:
raises given to faculty members, while at the same time the university’s differential costs, sunk costs, and
in-state tuition and fees more than doubled. opportunity costs.
Dr. Kaler’s cost cutting efforts included closing dozens of extension
school offices, freezing or reducing salaries, eliminating 14 car allowances, LO"–' Prepare income statements for a
restructuring healthcare and retirement benefits, and eliminating the merchandising company using the
Office of Academic Administration—a move that cut 5.5 full-time positions traditional and contribution formats.
including a senior vice-president who earned more than $300,000. ! LO"–( (Appendix !A) Identify the four
Source: Douglas Belkin and Scott Thurm, “Dean’s List: Hiring Spree Fattens College Bureaucracy—And Tuition,” types of quality costs and explain
The Wall Street Journal, December 29–30, 2012, pp. A1 and A10. how they interact.
LO"–) (Appendix !A) Prepare and
interpret a quality cost report.
24
Managerial Accounting and Cost Concepts 25
I
n accounting, costs can be classified differently! depending on
the needs of management. For example, the Prologue mentioned that financial
accounting is concerned with reporting financial information to external parties,
such as stockholders, creditors, and regulators. In this context, costs are classified
in accordance with externally imposed rules to enable the preparation of financial state-
ments. Conversely, managerial accounting is concerned with providing information to
managers within an organization so that they can formulate plans, control operations, and
make decisions. In these contexts, costs are classified in diverse ways that enable man-
agers to predict future costs, to compare actual costs to budgeted costs, to assign costs
to segments of the business (such as product lines, geographic regions, and distribution
channels), and to properly contrast the costs associated with competing alternatives.
The notion of different cost classifications for different purposes is the most impor-
tant unifying theme of this chapter and one of the key foundational concepts of the
entire textbook.! Exhibit 1–1 summarizes five types of cost classifications that will be
used throughout the textbook, namely cost classifications (1) for assigning costs to cost
objects, (2) for manufacturing companies, (3) for preparing financial statements, (4) for
predicting cost behavior, and (5) for making decisions. As we begin defining the cost ter-
minology related to each of these cost classifications, please refer back to this exhibit to
help improve your understanding of the overall organization of the chapter.
Cost Classifications for Assigning Costs to Cost Objects
Costs are assigned to cost objects for a variety of purposes including pricing, preparing
profitability studies, and controlling spending. A cost object is anything for which cost LO1!1
Understand cost classifications
data are desired—including products, customers, and organizational subunits. For pur- used for assigning costs to
poses of assigning costs to cost objects, costs are classified as either direct or indirect. cost objects: direct costs and
indirect costs.
EXHIBIT 1*1
Summary of Cost Classifications
Purpose of Cost Classification Cost Classifications
Assigning costs to cost objects • Direct cost (can be easily traced)
• Indirect cost (cannot be easily traced)
Accounting for costs in manufacturing • Manufacturing costs
companies • Direct materials
• Direct labor
• Manufacturing overhead
• Nonmanufacturing costs
• Selling costs
• Administrative costs
Preparing financial statements • Product costs (inventoriable)
• Period costs (expensed)
Predicting cost behavior in response • Variable cost (proportional to activity)
to changes in activity • Fixed cost (constant in total)
• Mixed cost (has variable and fixed elements)
Making decisions • Differential cost (differs between alternatives)
• Sunk cost (should be ignored)
• Opportunity cost (foregone benefit)
26 Chapter 1
Direct Cost
A direct cost is a cost that can be easily and conveniently traced to a specified cost
object. For example, if Adidas is assigning costs to its various regional and national
sales offices, then the salary of the sales manager in its Tokyo office would be a
direct cost of that office. If a printing company made 10,000 brochures for a specific
customer, then the cost of the paper used to make the brochures would be a direct cost
of that customer.
Indirect Cost
An indirect cost is a cost that cannot be easily and conveniently traced to a specified
cost object. For example, a Campbell Soup factory may produce dozens of varieties
of canned soups. The factory manager’s salary would be an indirect cost of a particular
variety such as chicken noodle soup. The reason is that the factory manager’s salary is
incurred as a consequence of running the entire factory—it is not incurred to produce
any one soup variety. To be traced to a cost object such as a particular product, the cost
must be caused by the cost object. The factory manager’s salary is called a common cost
of producing the various products of the factory. A common cost is a cost that is incurred
to support a number of cost objects but cannot be traced to them individually. A common
cost is a type of indirect cost.
A particular cost may be direct or indirect, depending on the cost object. While the
Campbell Soup factory manager’s salary is an indirect cost of manufacturing chicken
noodle soup, it is a direct cost of the manufacturing division. In the first case, the cost
object is chicken noodle soup. In the second case, the cost object is the entire manufactur-
ing division.
IN BUSINESS
THE HIGH PRICE OF SELLING ON MANHATTAN’S FIFTH AVENUE
The cost to buy retail real estate on Manhattan’s Fifth Avenue exceeds $15,000 per square foot.
Investors are willing to pay such a high price because they can turn around and rent their space
to high-end retailers (such as Dolce & Gabbana, Tommy Bahama, and Massimo Dutti) for as
much as $3,000 per square foot per year. Abercrombie & Fitch’s store at 720 Fifth Avenue is its
single most profitable store—bringing in $100 million in annual sales while incurring annual rent
of $12.5 million. When Abercrombie measures the profits earned at its Fifth Avenue location, the
rental expense of $12.5 million is a direct cost of operating that particular store.
Source: Kris Hudson and Dana Mattioli, “Fifth Avenue’s Eye-Popping Rents,” The Wall Street Journal, November 21, 2012,
pp. C1 and C10.
Cost Classifications for Manufacturing Companies
Manufacturing companies such as Texas Instruments, Ford, and DuPont separate their
LO1!2 costs into two broad categories—manufacturing and nonmanufacturing costs.
Identify and give examples
of each of the three basic
manufacturing cost categories.
Manufacturing Costs
Most manufacturing companies further separate their manufacturing costs into two direct
cost categories, direct materials and direct labor, and one indirect cost category, manufac-
turing overhead. A discussion of these three categories follows.
Managerial Accounting and Cost Concepts 27
Direct Materials The materials that go into the final product are called raw materials.
This term is somewhat misleading because it seems to imply unprocessed natural resources
like wood pulp or iron ore. Actually, raw materials refer to any materials that are used in
the final product; and the finished product of one company can become the raw materials
of another company. For example, the plastics produced by DuPont are a raw material
used by Hewlett-Packard in its personal computers.
Direct materials!refers to raw materials that become an integral part of the finished
product and whose costs can be conveniently traced to the finished product. This would
include, for example, the seats that Airbus purchases from subcontractors to install in its
commercial aircraft, the electronic components that Apple uses in its iPhones, and the
doors that Whirlpool!installs on its refrigerators.
IN BUSINESS
CHEAP PART COSTS GENERAL MOTORS A FORTUNE
A direct material component part, called a detent plunger, is used by General Motors (GM) in
the manufacture of its automobile ignition switches. The part, which can be installed by direct
laborers in a matter of minutes, costs GM between $2.00 and $5.00 per unit to manufacture.
However, when this seemingly trivial component part caused ignition system failures that killed
12 people, its legal and financial impacts on GM became front-page news.
GM’s troubles include a federal criminal probe that is investigating why the company
did not act sooner to redesign, recall, and replace the flawed detent plunger. It appears as
though GM learned of ignition switch failures in its Chevy Cobalt in 2004, but it did not rede-
sign the detent plunger to eliminate the problem until 2007. Furthermore, the company did © Monty Rakusen/Getty Images RF
not issue a recall for cars that contained the faulty ignition switches until 2014. Beyond its
legal matters, GM expects to spend $8 million replacing the ignition switches of 1.6 million
recalled vehicles.
Source: Jeff Bennett, “For GM, Cheap Part Now a Pricey Fix,” The Wall Street Journal, March 13, 2014, pp. B1–B2.
Direct Labor Direct labor consists of labor costs that can be easily traced to indi-
vidual units of product. Direct labor is sometimes called touch labor because direct labor
workers typically touch the product while it is being made. Examples of direct labor
include assembly-line workers at Toyota, carpenters at the home builder KB Home, and
electricians who install equipment on aircraft at Bombardier Learjet.
Managers occasionally refer to their two direct manufacturing cost categories as
prime costs.!Prime cost is the sum of direct materials cost and direct labor cost.
Manufacturing Overhead Manufacturing overhead, the third manufacturing cost
category, includes all manufacturing costs except direct materials and direct labor. For
example, manufacturing overhead includes a portion of raw materials know as indirect
materials as well as indirect labor. Indirect materials are raw materials, such as the
solder used to make electrical connections in a Samsung!HDTV and the glue used to
assemble an Ethan Allen! chair, whose costs cannot be easily or conveniently traced
to finished products. Indirect labor refers to employees, such as janitors, supervisors,
materials handlers, maintenance workers, and night security guards, that play an essential
role in running a manufacturing facility; however, the cost of compensating these people
cannot be easily or conveniently traced to specific units of product. Since indirect materi-
als and indirect labor are difficult to trace to specific products, their costs are included in
manufacturing overhead.
Manufacturing overhead also includes other indirect costs that cannot be readily
traced to finished products such as depreciation of manufacturing equipment and the
28 Chapter 1
utility costs, property taxes, and insurance premiums incurred to operate a manufacturing
facility. Although companies also incur depreciation, utility costs, property taxes, and
insurance premiums to sustain their nonmanufacturing operations, these costs are not
included as part of manufacturing overhead. Only those indirect costs associated with
operating the factory are included in manufacturing overhead. !
In practice, managers use various names for manufacturing overhead, such as indi-
rect manufacturing cost, factory overhead, and factory burden. All of these terms are
synonyms for manufacturing overhead. Another term that managers frequently use in
practice is conversion cost.!Conversion cost refers to the sum of direct labor and manu-
facturing overhead. The term conversion cost is used to describe direct labor and man-
ufacturing overhead because these costs are incurred to convert direct materials into
finished products.
Nonmanufacturing Costs
Nonmanufacturing costs are often divided into two categories: (1) selling costs and
(2) administrative costs. Selling costs include all costs that are incurred to secure cus-
tomer orders and get the finished product to the customer. These costs are sometimes
called order-getting and order-filling costs. Examples of selling costs include advertising,
shipping, sales travel, sales commissions, sales salaries, and costs of finished goods ware-
houses. Selling costs can be either direct or indirect costs. For example, the cost of an
advertising campaign dedicated to one specific product is a direct cost of that product,
whereas the salary of a marketing manager who oversees numerous products is an indirect
cost with respect to individual products.
Administrative costs include all costs associated with the general management of
an organization rather than with manufacturing or selling. Examples of administrative
costs include executive compensation, general accounting, secretarial, public relations,
and similar costs involved in the overall, general administration of the organization as
a whole. Administrative costs can be either direct or indirect costs. For example, the
salary of an accounting manager in charge of accounts receivable collections in the
East region is a direct cost of that region, whereas the salary of a chief financial officer
who oversees all of a company’s regions is an indirect cost with respect to individual
regions.
Nonmanufacturing costs are also often called selling, general, and administrative
(SG&A) costs or just selling and administrative costs.
Cost Classifications for Preparing Financial Statements
When preparing a balance sheet and an income statement, companies need to classify
LO1!3 their costs as product costs or period costs. To understand the difference between prod-
Understand cost classifications
used to prepare financial
uct costs and period costs, we must first discuss the matching principle from financial
statements: product costs and accounting.
period costs. Generally, costs are recognized as expenses on the income statement in the period
that benefits from the cost. For example, if a company pays for liability insurance in
advance for two years, the entire amount is not considered an expense of the year in
which the payment is made. Instead, one-half of the cost would be recognized as an
expense each year. The reason is that both years—not just the first year—benefit from the
insurance payment. The unexpensed portion of the insurance payment is carried on the
balance sheet as an asset called prepaid insurance.
The matching principle is based on the accrual concept that costs incurred to gen-
erate a particular revenue should be recognized as expenses in the same period that
the revenue is recognized. This means that if a cost is incurred to acquire or make
Managerial Accounting and Cost Concepts 29
something that will eventually be sold, then the cost should be recognized as an expense
only when the sale takes place—that is, when the benefit occurs. Such costs are called
product costs.
Product Costs
For financial accounting purposes, product costs include all costs involved in acquir-
ing or making a product. Product costs “attach” to a unit of product as it is purchased
or manufactured and they stay attached to each unit of product as long as it remains in
inventory awaiting sale. When units of product are sold, their costs are released from
inventory as expenses (typically called cost of goods sold) and matched against sales on
the income statement. Because product costs are initially assigned to inventories, they are
also known as inventoriable costs.
For manufacturing companies, product costs include direct materials, direct labor,
and manufacturing overhead.1!A manufacturer’s product costs flow through three inven-
tory accounts on the balance sheet—Raw Materials, Work in Process, and Finished
Goods—prior to being recorded in cost of goods sold on the income statement. Raw
materials include any materials that go into the final product. Work in process consists
of units of product that are only partially complete and will require further work before
they are ready for sale to the customer. Finished goods consist of completed units of
product that have not yet been sold to customers.
When direct materials are used in production, their costs are transferred from Raw
Materials to Work in Process. Direct labor and manufacturing overhead costs are added to
Work in Process to convert direct materials into finished goods. Once units of product are
completed, their costs are transferred from Work in Process to Finished Goods. When a
manufacturer sells its finished goods to customers, the costs are transferred from Finished
Goods to Cost of Goods Sold.
We want to emphasize that product costs are not necessarily recorded as expenses
on the income statement in the period in which they are incurred. Rather, as explained
above, they are recorded as expenses in the period in which the related products are sold.
Period Costs
Period costs are all the costs that are not product costs. All selling and administrative
expenses are treated as period costs. For example, sales commissions, advertising, exec-
utive salaries, public relations, and the rental costs of administrative offices are all period
costs. Period costs are not included as part of the cost of either purchased or manufac-
tured goods; instead, period costs are expensed on the income statement in the period in
which they are incurred using the usual rules of accrual accounting. Keep in mind that
the period in which a cost is incurred is not necessarily the period in which cash changes
hands. For example, as discussed earlier, the cost of liability insurance is spread across
the periods that benefit from the insurance—regardless of the period in which the insur-
ance premium is paid.
Exhibit 1–2 summarizes the product and period cost flows for manufacturers that
were just discussed. Notice that product costs flow through three inventory accounts on
the balance sheet prior to being recognized as part of cost of goods sold in the income
statement. Conversely, period costs do not flow through the inventory accounts on the
balance sheet and they are not included in cost of goods sold in the income statement.
Instead, they are recorded as selling and administrative expenses in the income statement
during the period incurred.
1
For internal management purposes, product costs may exclude some manufacturing costs. For example,
see Appendix 2B and the discussion in Chapter 6.
30 Chapter 1
EXHIBIT 1*2
Cost Flows and Classifications in a Manufacturing Company
Costs
Balance Sheet
Raw materials Raw Materials inventory
purchases
Product costs
Direct materials
used in production
Direct labor
Work in Process inventory
Manufacturing Goods completed
overhead Income Statement
Finished Goods inventory Cost of Goods Sold
Goods
sold
Selling and
Period
Selling and
costs
Administrative
administrative Expenses
Cost Classifications for Predicting Cost Behavior
It is often necessary to predict how a certain cost will behave in response to a change in
LO1!4 activity. For example, a manager at Under Armour may want to estimate the impact a
Understand cost
5 percent increase in sales would have on the company’s total direct materials cost. Cost
classifications used to predict
cost behavior: variable costs,
behavior refers to how a cost reacts to changes in the level of activity. As the activity
fixed costs, and mixed costs. level rises and falls, a particular cost may rise and fall as well—or it may remain constant.
For planning purposes, a manager must be able to anticipate which of these will happen;
and if a cost can be expected to change, the manager must be able to estimate how much
it will change. To help make such distinctions, costs are often categorized as variable,
fixed, or mixed. The relative proportion of each type of cost in an organization is known
as its cost structure. For example, an organization might have many fixed costs but few
variable or mixed costs. Alternatively, it might have many variable costs but few fixed or
mixed costs.
Variable Cost
A variable cost varies, in total, in direct proportion to changes in the level of activity.
Common examples of variable costs include cost of goods sold for a merchandising com-
pany, direct materials, direct labor, variable elements of manufacturing overhead, such as
indirect materials, supplies, and power, and variable elements of selling and administra-
tive expenses, such as commissions and shipping costs.2
2
Direct labor costs often can be fixed instead of variable for a variety of reasons. For example, in some
countries, such as France, Germany, and Japan, labor regulations and cultural norms may limit manage-
ment’s ability to adjust the labor force in response to changes in activity. In this textbook, always assume
that direct labor is a variable cost unless you are explicitly told otherwise.
Managerial Accounting and Cost Concepts 31
For a cost to be variable, it must be variable with respect to something. That “something”
is its activity base. An activity base is a measure of whatever causes the incurrence of a
variable cost. An activity base is sometimes referred to as a cost driver. Some of the most
common activity bases are direct labor-hours, machine-hours, units produced, and units
sold. Other examples of activity bases (cost drivers) include the number of miles driven
by salespersons, the number of pounds of laundry cleaned by a hotel, the number of calls
handled by technical support staff at a software company, and the number of beds occupied
in a hospital. While there are many activity bases within organizations, throughout
this textbook, unless stated otherwise, you should assume that the activity base under
consideration is the total volume of goods and services provided by the organization. We
will specify the activity base only when it is something other than total output.
To provide an example of a variable cost, consider Nooksack Expeditions, a small
company that provides daylong whitewater rafting excursions on rivers in the North
Cascade Mountains. The company provides all of the necessary equipment and experi-
enced guides, and it serves gourmet meals to its guests. The meals are purchased from a
caterer for $30 a person for a daylong excursion. The behavior of this variable cost, on
both a per unit and a total basis, is shown below:
Number Cost of Meals Total Cost of
of Guests per Guest Meals
"#$ . . . . . . . . . . . . . . . . . $%$ $&,#$$
#$$ . . . . . . . . . . . . . . . . . $%$ $'#,$$$
&#$ . . . . . . . . . . . . . . . . . $%$ $"",#$$
',$$$. . . . . . . . . . . . . . . . . $%$ $%$,$$$
While total variable costs change as the activity level changes, it is important to note
that a variable cost is constant if expressed on a per unit basis. For example, the per unit
cost of the meals remains constant at $30 even though the total cost of the meals increases
and decreases with activity. The graph on the left-hand side of Exhibit 1–3!illustrates that
the total variable cost rises and falls as the activity level rises and falls. At an activity
level of 250 guests, the total meal cost is $7,500. At an activity level of 1,000 guests, the
total meal cost rises to $30,000.
EXHIBIT 1*3
Variable and Fixed Cost Behavior
Total Cost of Meals Total Cost of Renting the Building
$30,000
A variable cost increases,
$25,000 Fixed costs remain
in total, in proportion
constant in total dollar
to activity.
amount through
Total cost of meals
$20,000 wide ranges of activity.
Cost of
$15,000 building $500
rental
$10,000
$5,000
$0 $0
0 250 500 750 1,000 0 250 500 750 1,000
Number of guests Number of guests