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Revised Fall 2012

CHAPTER 1
MANAGERIAL ACCOUNTING AND COST
CONCEPTS
Key Terms and Concepts to Know
Major Management Activities
Planning- formulating long and short-term plans
Directing and Motivating- implementing plans
Controlling- measuring performance; comparing actual to planned performance
Manufacturing or Product Costs
Direct Costs can be easily and conveniently traced to the finished product:
o Direct Materials includes material costs which are an integral part of the
finished product
o Direct Labor includes labor costs used to make the finished product
Indirect Costs- cannot be easily and conveniently traced to specified cost objects:
o Manufacturing Overhead includes all costs of manufacturing except direct
materials and direct labor; i.e., only those costs associated with operating
the factory are included in manufacturing overhead.
Prime Costs are Direct Materials + Direct Labor
Conversion Costs are Direct Labor + Manufacturing Overhead
Nonmanufacturing or Period Costs
Period costs, generally named Selling and Administrative Costs, consist of all other
costs not included in product costs. Period costs are expensed in the period
incurred.
Cost Classifications for Predicting Cost Behavior
In addition to classifying costs by function (manufacturing vs. nonmanufacturing), costs may be classified by how they behave in total when the
activity level changes:

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Variable Cost
Fixed Cost
Mixed Cost

In Total
Varies
The same
Varies

Per Unit
The same
Varies inversely
Varies
(often inversely)

The relevant range is the range of activity levels throughout which the
assumptions for cost behavior are valid. Outside the relevant range, total fixed
costs may change and/or variable costs per unit may change.
Committed fixed costs relate to costs that the company will incur over the longterm. These costs, such as depreciation expense, property tax expense and
insurance expense, cannot be changed during short periods of time and are only
somewhat under the control of management.
Discretionary fixed costs usually arise from annual decisions by management and
can be changed during short periods of time. Advertising, research and
development, public relations are some examples of discretionary fixed costs.
Mixed costs contain both variable and fixed cost elements. For example, a
companys selling expenses may include fixed expenses, such as the advertising
costs and the base salary of the sales manager; and variable costs, such as sales
commissions paid to the regional salesmen.
Cost Classifications for Decision Making
Differential Costs and Revenues differ among alternatives
Opportunity Costs are the potential benefits given up by making a decision
Sunk Cost is a cost previously incurred; it cannot be changed by a present or
future decision
Cost Classifications on the Income Statement
Certain activities in these accounts appear on the Income Statement as Cost of
Goods Sold or Cost of Goods Manufactured, a component of Cost of Goods Sold.
Contribution Margin Income Statement
The traditional income statement separates expenses by function emphasizing the
distinction between production and administrative and selling expenses.
Gross margin is the first key measure of profitability.
The contribution margin income statement separates expenses by behavior,
emphasizing the distinction between expenses that change when the level of
activity changes and those that are unaffected by it. Contribution margin is the
first key measure of profitability.

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Key Topics to Know


Separating Mixed Costs into Fixed and Variable
Elements
In order to predict the profits of a company, it is necessary to separate all costs
into either fixed costs or variable costs. Many costs are clearly variable, such as
direct labor, or clearly fixed, such as rent.
Mixed costs must be separated into their fixed and variable elements using one of
three methods and a regression line developed to predict total mixed costs at
various levels of activity.
The equation of the regression line takes the form:
Total Cost
Y

=
=

Fixed Cost
a

+
+

Variable Cost
b(X)

Least Squares Regression Method


A rigorous, mathematical approach in which a series of data points are used to
develop a regression line to predict total costs.

Scattergraph Method
Plots a series of data points for the mixed costs and the activity which produced
these costs. The Y axis is dollars of mixed cost and the X axis is the activity level.
A regression line is drawn by best guess through one of the data points and a
point on the Y axis with an approximately the same number of data points above
and below the line.
The point where the line crosses Y axis represents the fixed cost, the only cost
incurred at zero activity. For any data point, the difference between the total
mixed cost and the fixed cost is total variable cost and total variable cost divided
by the activity level for the data point is variable cost per unit.

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Revised Fall 2012

High-Low Method
From a series of data points, use only the high and low data points, based on
activity, to develop a regression line to predict total costs:
Variable cost per unit (b) is calculated first:

High Point Low Point =


Change
Cost $
$
$
$
Activity
activity
activity
activity
Change in Cost $
Change in Activity

Variable cost/unit

Using either the high point or low point, total fixed cost is calculated next:
Fixed Cost
a

=
=

Total Cost
Y

Variable Cost
b(X)

Example # 1:
Travis Inc. employed several maintenance engineers to keep the equipment running in
peak condition. Over the past eight months, Travis incurred the following maintenance
cost for these engineers. Plant activity is best measured by direct labor hours.
Month
January
February
March
April
May
June
July
August

Direct Labor Hours


1,700
1,900
1,800
1,600
1,500
1,300
1,100
1,400

Maintenance Cost
$14,300
$15,200
$16,700
$14,000
$14,300
$13,000
$12,800
$14,200

Required: Using the high-low method, determine the fixed and variable components of
the maintenance costs.

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Solution #1
High
Point*
$15,200
1,900

Cost $
Activity

Change in Cost $
Change in Activity

Low
Point*
$12,800
1,100

$2,400
800

Using either the high point or


Fixed Cost
=
$9,500
=
OR
$9,500
=

Change
$2,400
800

$3.00 variable cost/unit

low point, total fixed cost is calculated next:


Total Cost Variable Cost
$15,200
$5,700 = $3.00 (1,900)
$12,800

$3,300 = $3.00 (1,100)

* The high and low points are chosen by activity, not by cost.

Contribution Margin Income Statement


The contribution margin income statement separates expenses into fixed and
variable categories.
Contribution margin income statement takes the following form:
Sales

Sales
Variable Expenses:
Production
Selling
Administrative
Contribution Margin
Fixed Expenses:
Production
Selling
Administrative
Operating Income

Cost of Goods Sold


Gross Margin
Operating Expenses:
Selling
Administrative
Operating Income

Stays the same


Variable cost
Fixed cost

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Example #2:
Strummer Inc. manufactures and sells guitars for beginning students. Their income
statement for April, 2010 was as follows:
Sales
Cost of Goods Sold
Gross Margin
Selling and Administrative
Expenses:
Selling expense
Administrative expense
Operating Income

$600,000
400,000
200,000
60,000
90,000

150,000
$50,000

The product sells for $300 each. Variable selling expenses are $20 per unit sold with the
remaining selling expenses being fixed. The administrative expenses are 40% fixed.
The companys manufacturing costs are 25% fixed, with total variable manufacturing
costs of $150 per unit.
Required: Prepare an income statement using the contribution margin approach.
Solution #2:
Units sold
Sales
Variable Expenses:
Cost of goods sold
Selling expenses
Administrative expenses
Contribution Margin
Fixed Expenses:
Cost of goods sold
Selling expenses
Administrative expenses
Operating Income

$600,000/$300

2,000
$600,000

$400,000*75%
$20*2,000
$90,000*60%

300,000
40,000
54,000

$400,000-300,000
$60,000-40,000
$90,000*40%

100,000
20,000
36,000

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394,000
$206,000

156,000
$50,000

Revised Fall 2012

Cost Classifications for Decision-Making


Example #3
Classify the following costs according to the cost terms.
1. Wood used for making tables.
2. Wages of the assembly workers in a furniture factory.
3. Salary of the factory supervisor.
4. Electricity to run factory equipment.
5. Janitorial salaries.
6. Rent on a factory building.
7. Plastic parts used to make toys.
8. Glue used to make toys.
9. Lubricants on production machines.
Solution #3

Cost Behavior
To Units of Production
Variable
Fixed
Direct
Indirect
1.
X
X
2.
X
X
3.
X
X
4.
X
X
5.
X
X
6.
X
X
7.
X
X
8.
X
X*
9.
X
X
*
These materials would usually be considered indirect. They are insignificant in amount
and it would not be cost-effective to trace them to individual products.

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Practice Problems
Practice Problem #1:
Active Company accumulated the following data for a delivery truck.

January
February
Required:
a)
b)

Miles Driven

Total Cost

10,000
8,000

$15,000
$14,500

March
April

Miles
Driven
9,000
7,500

Total Cost
$12,500
$13,000

Determine the equation to predict total costs for the delivery truck.
What should total costs be if 12,187 miles were driven?

Practice Problem #2:


The Lawn Mower Shop is a retailer that sells lawn mowers. The income statement for
the month of June showed a gross margin of $60,000 and operating income of $20,000.
Selling and administrative expenses were 50% fixed. Two hundred mowers were sold at
an average price of $750 per unit. All mowers are purchased from Toro and John
Deere.
Required:
a)
b)

Prepare an income statement for the month using the contribution


approach.
What is the contribution margin per unit?

Practice Problem #3:


When the Tom-Tom Companys controller was asked to budget the cost of manufacturing
supplies for the next year, she plotted supplies cost and units produced by month for the year.
She then drew a regression line through the point she plotted for November when the supplies
cost was $21,000 and 5,000 drum sets were produced.
Required: If the regression line intersected the Y axis at $6,000, determine the equation of the
regression line.

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Revised Fall 2012

Sample True / False Questions


1.

Managerial accounting must follow GAAP.


True False

2.

Financial accounting reports to those inside the organization.


True False

3.

Managerial accounting emphasizes decisions affecting the future.


True False

4.

Manufacturing costs are product costs.


True False

5.

Period costs include direct materials, direct labor and manufacturing overhead.
True False

6.

Period costs are expensed in the period incurred.


True False

7.

Direct materials and direct labor are also called prime costs.
True False

8.

Conversion costs are manufacturing costs.


True False

9.

Sales commissions are a product cost.


True False

10. Manufacturing companies have one inventory account.


True False
11. Variable costs per unit remain constant.
True False
12. Fixed costs vary in total.
True False
13. A direct cost cannot be easily traced to a cost object.
True False

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14. A cost that differs between two alternatives is a sunk cost.


True False
15. A common cost is a type of indirect cost.
True False
16. Factory rent is part of manufacturing overhead.
True False
17. Depreciation on administrative offices equipment is a product cost.
True False
18. The relevant range is the range in which costs remain variable.
True False
19. The equation for a mixed cost is total fixed costs + variable cost per unit
units of activity.
True False
20. Contribution margin is defined as sales revenue less variable costs.
True False
21. The unit contribution margin tells how much each additional unit sold will
contribute to covering variable costs.
True False
22. If volume increases, all costs will increase
True False

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Sample Multiple Choice Questions


1. Which of the following is not a characteristic of managerial accounting:
a)
b)
c)
d)

Emphasizes decisions affecting the future


Mandatory for external reports
Need not follow GAAP
Reports to those inside the organization

2. Which of the following is not a manufacturing cost:


a)
b)
c)
d)

Direct materials
Manufacturing overhead
Administrative costs
Direct labor

3. How many classes of inventory accounts do manufacturing companies have:


a)
b)
c)
d)

One
Three
Two
Four

4. Costs that are taken directly to the income statement as expenses in the period
in which they are incurred are:
a) Product costs
b) Prime costs
c) Sunk costs
d) Period costs

5. Prime costs + Conversion Costs equals:

a) Product costs
b) Prime costs
c) Manufacturing costs
d) A meaningless total because direct labor is counted twice.

6.

The potential benefit given up when one alternative is selected over another is
a(n):
a) Prime cost
b) Sunk cost
c) Opportunity cost
d) Direct cost
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7.

A direct cost is one which:


a) Is not worth the effort of tracing to a specific cost object
b) Remains constant no matter the activity level
c) Can be easily and conveniently traced to a specific cost object
d) Always sunk

8.

At production level of 2,000 units a cost is $20,000; at production level of


4,500 units the same cost is $45,000. This is an example of a:
a) Variable cost
b) Direct cost
c) Fixed cost
d) Sunk cost

9.

Which of the following is an example of a fixed cost in a manufacturing


company:
a) The cost of raw materials
b) The cost of electricity for running machines
c) Wages of assembly line workers
d) Depreciation on factory equipment

10. Mary works at a convenience store and is paid $400 a week. She considers
enrolling in a college to earn a degree. She thinks she will have to quit her job
if she goes to college. The wages that she will lose if she chooses college are:
a) Sunk cost
b) Opportunity cost
c) Indirect cost
d) Prime cost
11. Which cost is not relevant to the decision whether to purchase a new chocolate
dipping machine or continue using the old one:
a) The cost of the new machine
b) Lower maintenance costs for the new machine
c) The cost of the old machine
d) Additional training required for operating the new machine
12. If sales revenue doubles, variable costs will
a) decrease in total
b) increase in total
c) decrease on a per unit basis
d) increase on a per unit basis

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13. A cost that remains the same in total, regardless of changes in activity level is
a:
a) variable cost
b) fixed cost
c) mixed cost
d) step-variable cost
14. A mixed cost
a) is fixed over a wider range of activity than a step cost.
b) is a fixed cost over the relevant range and a variable cost everywhere else.
c) contains both fixed and variable components.
d) always increases on a per unit basis.
15. The per-unit amount of three different production costs for Jones, Inc., are as
follows:
Production
Cost A
Cost B
Cost C
20,000
$12.00
$15.00
$20.00
80,000
$12.00
$11.25
$5.00
What type of cost is each of these three costs?
a) Cost A is fixed, Cost B is mixed, Cost C is variable.
b) Cost A is fixed, Cost B is variable, Cost C is mixed.
c) Cost A is variable, Cost B is mixed, Cost C is fixed.
d) Cost A is variable, Cost B is fixed, Cost C is mixed.
16. A graph of the relationship between total cost and activity level is called a
a) Relevant range.
b) Scattergraph.
c) Contribution margin graph.
d) Dependent variable.
17. Bud uses the high-low method of estimating costs. Bud had total costs of
$50,000 at its lowest level of activity, when 5,000 units were sold. When, at its
highest level of activity, sales equaled 12,000 units, total costs were $78,000.
Bud would estimate variable cost per unit as
a) $10.00
b) $6.50
c) $4.00
d) $7.53

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18. Arnold Corp has a selling price of $20, variable costs of $15 per unit, and fixed
costs of $25,000. Arnold expects profit of $300,000 at its anticipated level of
production. What is Arnold's unit contribution margin?
a) $5.00
b) $10.00
c) $27.50
d) $20.00.
19. When Stella, Inc. sells 40,000 units, its total variable cost is $96,000. What is
its total variable cost when it sells 45,000 units?
a) $84,000
b) $96,000
c) $108,000
d) It cannot be determined from the information given.
20. Which of the following is a variable cost?
a) A cost that is $20,000 when production
production is 70,000.
b) A cost that is $20,000 when production
production is 70,000.
c) A cost that is $20,000 when production
production is 70,000.
d) A cost that is $40,000 when production
production is 70,000.

is 50,000, and $20,000 when


is 50,000, and $28,000 when
is 50,000, and $40,000 when
is 50,000, and $40,000 when

21. Which of the following is a mixed cost?


a) A cost that is $20.00 per unit when production
unit when production is 80,000.
b) A cost that is $20.00 per unit when production
unit when production is 80,000.
c) A cost that is $20.00 per unit when production
unit when production is 80,000.
d) A cost that is $40.00 per unit when production
unit when production is 80,000.

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is 50,000, and $20.00 per


is 50,000, and $12.50 per
is 50,000, and $16.25 per
is 50,000, and $40.00 per

Revised Fall 2012

Solutions to Practice Problems


Practice Problem #1
a)
High Point
Cost $
$15,000
Activity
10,000
Change in Cost $
Change in Activity

Low Point
$13,000
7,500

$2,000
2,500

Change
$2,000
2,500

$0.80 variable cost/unit

Using either the high point or low point, total fixed cost is calculated next:
Fixed Cost
=
Total Cost
Variable Cost
$7,000
=
$15,000
$8,000 = $0.80 (10,000)
OR
$7,000
=
$13,000
$6,000 = $0.80 (7,500)
The equation is:
b)

Total Cost
Y
$16,750

Y = $7,000 + $0.80(X)
=
=
=

Fixed Cost
a
$7,000

+
+
+

Variable Cost
b(X)
$9,750 = $0.80 (12,187)

Practice Problem #2
a)

Total
200

Units sold
Sales
Variable expenses:
Cost of goods sold
S & A expenses
Contribution margin
Fixed expenses:
Cost of goods sold
S & A expenses
Operating income

750 units x 200 units


$150,000 60,000
(Sales - Gross Margin)
($60,000-20,000) x 50%
(Gross Margin-Op.Income)x50%

$150,000
90,000
20,000
$40,000

All variable for a retailer


($60,000-20,000) x 50%

b) $200.00
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0
20,000
$20,000

Revised Fall 2012

Practice Problem #3:


Since the Y intercept is known, use the equation to solve for the variable cost per unit:
Y = a + b(X)
$21,000 = $6,000 + 5000b
b= $3.00
The equation will be:
Y = $6,000 + $3(X) where X is the number of units produced and Y is the total mixed cost.

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Solutions to True / False Problems


1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.

False - because managerial accounting may use financial and nonfinancial information.
False - because financial accounting has an external focus.
True
True
False - period costs are non-manufacturing costs such as selling
and administrative expenses.
True
True
True
False - sales commissions are a selling expense.
False - manufacturing companies have three inventory accounts:
Direct materials, Work in Process, Finished Goods.
True
False - fixed costs are constant in total.
False - direct costs have a direct and easily traceable relationship
to cost objects.
False - costs that differ among alternatives are differential costs.
True
True
False - administrative costs are never product costs.
False - not only do total variable costs remain variable, but both
variable costs per unit and total fixed costs remain constant.
True
True
False - contribution margin contributes to covering fixed costs.
False fixed costs will not change.

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Solutions to Multiple Choice Questions


1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.

B
C
B
D
C
C
C
A
D
B
C
B
B
C
C
B
C
A
C
B

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