Chapter 8: Managerial Cost Concepts and Cost Behaviour

Analysis

1 Introduction
Purpose: Managerial accounting provides cost information to help managers plan, direct,
and control operations, make decisions, and answer questions like:
• What costs are involved in making a product/service?

• How do costs change with production volume?

• Should a product be discontinued or a new one added?

Cost Object: Anything for which costs are accumulated (e.g., a hamburger, a haircut, a tax
return, a house).
Example: A bakery tracks costs for producing a batch of cookies (cost object) to set pricing
and assess profitability.

2 Manufacturing Costs
Manufacturing involves converting raw materials into finished goods, unlike merchandis-
ing (selling purchased goods). Manufacturing costs are classified into three categories:

2.1 Direct Materials

• Definition: Raw materials physically and directly associated with the finished product.

• Characteristics: Easily traceable to the product in significant quantities.

• Examples:
– Flour for bread in a bakery.

– Steel for car manufacturing.

– Syrup for soft drink bottling.

• Example: In a furniture factory, wood used for tables is a direct material, as it’s a major
component of the final product.

2.2 Direct Labour

• Definition: Labour costs for employees directly involved in converting raw materials into
finished goods.

• Characteristics: Physically traceable to the production process.

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• Examples:
– Mechanics assembling cars.

– Bakers mixing dough in a bakery.

– Typesetters at a printing press.

• Example: In a shoe factory, workers stitching leather are direct labour, as their work
directly shapes the product.

2.3 Manufacturing Overhead

• Definition: All manufacturing costs not classified as direct materials or direct labour,
including indirect materials, indirect labour, and other factory-related costs.

• Characteristics: Not easily traceable to specific units; supports the production process.

• Subcategories:
– Indirect Materials: Materials used in production but not part of the finished product
or too minor to trace (e.g., lubricants, cleaning supplies, polishing compounds).

– Indirect Labour: Labour not directly tied to product creation (e.g., wages for mainte-
nance workers, janitors, factory supervisors, security guards).

– Other Costs: Depreciation on factory buildings, factory utilities, insurance, taxes, and
maintenance on factory facilities.

• Examples:
– Glue used in furniture assembly (indirect material).

– Salary of a factory supervisor (indirect labour).

– Electricity for factory machines (other overhead cost).

• Example: In a car factory, paint thinner (indirect material), a janitor’s wages (indirect
labour), and factory rent (other cost) are overhead.

3 Product Costs vs. Period Costs

Costs are classified as product costs (related to manufacturing) or period costs (related to
business operations).

3.1 Product Costs

• Definition: Costs incurred to produce the cost object, including direct materials, direct
labour, and manufacturing overhead.

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• Characteristics:
– Necessary for production.

– Recorded as inventory (asset) on the balance sheet when incurred.

– Become an expense (Cost of Goods Sold) on the income statement when the product is
sold.

– Also called inventoriable costs.

• Examples:
– Wood, labour, and factory utilities for making chairs.

– Flour, bakers’ wages, and oven depreciation for bread.

• Types of Expenses:
1. Direct Materials: As described above (e.g., steel for cars).
2. Direct Labour: As described above (e.g., assembly line workers).
3. Manufacturing Overhead: Includes indirect materials (e.g., glue), indirect labour
(e.g., supervisors), and other costs (e.g., factory rent).

• Example: A phone manufacturer incurs $100 for materials, $50 for labour, and $30 for
overhead per phone. These $180 product costs are recorded as inventory until the phone
is sold, then expensed as Cost of Goods Sold.

3.2 Period Costs

• Definition: Non-manufacturing costs incurred to run the business, not tied to production.

• Characteristics:
– Matched with revenue in the period incurred and expensed immediately on the income
statement.

– Include selling, marketing, and administrative expenses.

• Examples:
– Sales commissions for a retail store.

– Salaries of head office staff.

– Advertising costs for a product launch.

• Types of Expenses:
1. Selling and Marketing Expenses:

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 – Costs to promote and sell products/services.

– Examples: Sales commissions, advertising, shipping to customers, sales staff salaries.

– Example: A company pays $5,000 for a TV ad campaign to promote a new product.

2. General and Administrative Expenses:
– Costs to manage the business, not tied to production or sales.

– Examples: CEO salary, head office rent, accounting staff salaries, legal fees.

– Example: A firm pays $10,000 monthly for head office utilities and administrative
staff.

• Example: A clothing retailer incurs $2,000 in sales commissions (selling expense) and
$3,000 in office rent (administrative expense). These $5,000 period costs are expensed
immediately.

3.3 Prime and Conversion Costs

• Prime Costs: Sum of direct materials and direct labour (all direct manufacturing costs).
– Example: For a table, $50 wood + $20 labour = $70 prime costs.

• Conversion Costs: Sum of direct labour and manufacturing overhead (costs to convert
raw materials into finished goods).
– Example: For a table, $20 labour + $30 overhead = $50 conversion costs.

• Note: Direct labour is included in both prime and conversion costs.

4 Cost Behaviour Analysis

• Definition: The study of how costs respond to changes in business activity levels (e.g.,
sales volume, production units).

• Purpose: Helps managers plan operations, set budgets, and make decisions by under-
standing cost responses.

• Activity Index: A measure of activity causing cost changes (e.g., sales dollars, kilometres
driven, room occupancy).

• Types of Costs:
1. Variable Costs:
– Definition: Costs that vary in total directly and proportionately with activity level
but remain constant per unit.

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 – Examples: Direct materials (e.g., $10 camera per tablet), direct labour, sales com-
missions.

– Example: Damon Company uses $10 cameras. At 2,000 tablets, cost = $20,000; at
10,000 tablets, cost = $100,000. Per-unit cost remains $10.
2. Fixed Costs:
– Definition: Costs that remain constant in total within the relevant range but vary
per unit inversely with activity.

– Examples: Rent, property taxes, insurance, depreciation.

– Example: Damon Company’s $10,000 monthly rent is fixed. At 2,000 tablets, per-
unit rent = $5; at 10,000 tablets, per-unit rent = $1.
3. Mixed Costs:
– Definition: Costs with both fixed and variable components, changing in total but
not proportionately with activity.

– Examples: Factory utilities (fixed base rate + variable usage), head office utilities.

– Example: A factory’s utility bill has a $1,000 fixed fee plus $0.10 per machine hour,
varying with production.

4.1 Relevant Range

• Definition: The range of activity where cost behaviour (fixed or variable) remains linear
and predictable, typically the expected operating range for a year.

• Importance: Ensures cost assumptions hold true for planning.

• Example: Damon Company assumes fixed rent of $10,000 holds for 0–15,000 tablets. Be-
yond this, additional facilities may increase fixed costs.

5 High-Low Method
• Purpose: Separates mixed costs into fixed and variable components using the highest
and lowest activity levels.

• Steps:
1. Calculate Variable Cost per Unit: (High Total Cost - Low Total Cost) ÷ (High Activity
- Low Activity).
2. Calculate Fixed Cost: Total Cost at High/Low Activity - (Variable Cost per Unit ×
Activity Level).
3. Form Cost Equation: Total Cost = Fixed Cost + (Variable Cost per Unit × Activity).

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• Example (Metro Transit Company):
– Data: High (80,000 km, $41,000 maintenance cost), Low (20,000 km, $8,000 cost).

– Step 1: Variable Cost = ($41,000 - $8,000) ÷ (80,000 - 20,000) = $33,000 ÷ 60,000 = $0.55/km.

– Step 2: Fixed Cost = $41,000 - ($0.55 × 80,000) = $41,000 - $44,000 = $8,000 (using high
activity).

– Equation: Maintenance Cost = $8,000 + ($0.55 × km).

– At 45,000 km: Cost = $8,000 + ($0.55 × 45,000) = $32,750.

6 Cost of Goods Manufactured

• Definition: The total cost of goods completed during a period, calculated for the income
statement’s cost of goods sold section.

• Formula:
– Total Manufacturing Costs (Direct Materials + Direct Labour + Manufacturing Over-
head)

– + Beginning Work in Process Inventory

– - Ending Work in Process Inventory

– = Cost of Goods Manufactured.

• Example: A factory has $100,000 total manufacturing costs, $20,000 beginning work in
process, and $15,000 ending work in process. Cost of Goods Manufactured = $100,000 +
$20,000 - $15,000 = $105,000.

• Cost of Goods Available for Sale: Beginning Finished Goods Inventory + Cost of Goods
Manufactured.
– Example: $10,000 beginning finished goods + $105,000 = $115,000.

7 Financial Statements for Manufacturers

• Balance Sheet:
– Lists three inventory accounts: Raw Materials, Work in Process, Finished Goods (vs.
one merchandise inventory for merchandisers).

– Example: A manufacturer reports $50,000 raw materials, $30,000 work in process, and
$70,000 finished goods.

• Income Statement:

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 – Cost of Goods Sold section reflects manufactured costs: Beginning Finished Goods + Cost
of Goods Manufactured - Ending Finished Goods.

– Example: $10,000 beginning finished goods + $105,000 manufactured - $20,000 ending

finished goods = $95,000 cost of goods sold.

8 Regression Analysis (Appendix 2A)

• Purpose: Estimates mixed cost components using all data points for greater accuracy
than the high-low method.

• Method: Uses statistical tools (e.g., Excel’s Intercept and Slope functions) to find a cost
equation minimizing the sum of squared distances from data points to the regression
line.

• Example (Hanson Trucking):

– High-Low: Variable cost = $0.48/km, Fixed cost = $31,800.

– Regression: Variable cost = $0.49/km, Fixed cost = $30,781.

– Regression equation: Cost = $30,781 + ($0.49 × km), more accurate as it uses all 12
months’ data.

• Limitations:
– Assumes linear cost relationships, which may not hold if costs are curvilinear.

– Sensitive to outliers (extreme data points).

– Requires sufficient data points for reliability.

• Example: If Hanson’s data includes an outlier (e.g., $100,000 cost due to a one-time re-
pair), regression may skew results unless adjusted.

9 Detailed Types of Expenses

Expenses in managerial accounting are categorized as product costs (expensed when sold)
or period costs (expensed immediately). Below are the detailed types with examples:

9.1 Product Costs (Inventoriable Costs)

• Direct Materials:
– Description: Major raw materials directly traceable to the product.

– Examples:

* Steel for car frames ($500 per car).

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 * Fabric for clothing ($10 per shirt).

* Sugar for candy production ($2 per batch).

– Context: Essential for the product’s physical makeup.

• Direct Labour:
– Description: Wages for workers directly producing the product.

– Examples:

* Assembly line workers’ wages ($20/hour for phone assembly).

* Bakers’ salaries ($15/hour for bread production).

* Welders’ pay ($25/hour for machinery).

– Context: Labour directly shaping the product.

• Manufacturing Overhead:
– Description: Indirect costs supporting production, not traceable to specific units.

– Subcategories:
1. Indirect Materials:

* Examples: Glue in furniture ($0.50/table), cleaning supplies in a factory ($100/month),

lubricants for machines ($200/month).

* Context: Minor materials or those not part of the final product.

2. Indirect Labour:

* Examples: Factory janitors’ wages ($12/hour), supervisors’ salaries ($5,000/month),

security guards’ pay ($15/hour).

* Context: Labour supporting production but not product creation.

3. Other Overhead Costs:

* Examples: Factory rent ($10,000/month), machine depreciation ($1,000/month),

factory utilities ($2,000/month), insurance ($500/month).

* Context: Facility and equipment costs for production.

– Example: A bike manufacturer incurs $200 for steel (direct materials), $50 for assembly
wages (direct labour), and $30 for glue, supervisor salary, and factory rent (overhead)
per bike.

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9.2 Period Costs (Non-Manufacturing Costs)
• Selling and Marketing Expenses:
– Description: Costs to promote and distribute products/services.

– Examples:

* Sales commissions (5% of sales, e.g., $1,000 for $20,000 sales).

* Advertising costs ($5,000 for a radio campaign).

* Shipping to customers ($500 per delivery).

* Sales staff salaries ($3,000/month).

– Context: Directly tied to sales efforts, expensed in the period incurred.

• General and Administrative Expenses:

– Description: Costs to manage the business, unrelated to production or sales.

– Examples:

* CEO salary ($10,000/month).

* Head office rent ($4,000/month).

* Accounting staff salaries ($2,500/month).

* Legal fees ($1,000 for contract review).

* Office utilities ($500/month).

– Context: Supports overall business operations, expensed immediately.

• Example: A software company spends $2,000 on online ads (selling expense) and $6,000
on head office staff salaries (administrative expense), both expensed in the current period.

10 Key Takeaways
• Manufacturing Costs: Direct materials, direct labour, and manufacturing overhead (in-
cluding indirect materials, indirect labour, and other costs) are product costs, recorded
as inventory until sold.

• Product vs. Period Costs: Product costs (direct materials, direct labour, overhead) be-
come Cost of Goods Sold when sold; period costs (selling, administrative) are expensed
immediately.

• Cost Behaviour: Variable costs change in total with activity (constant per unit), fixed
costs remain constant in total (vary per unit), and mixed costs combine both.

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• High-Low Method: Separates mixed costs into fixed and variable components for cost
estimation.

• Financial Statements: Manufacturers report three inventories (raw materials, work in

process, finished goods) and calculate cost of goods manufactured for the income state-
ment.

• Regression Analysis: Provides more accurate mixed cost estimates using all data points,
though limited by linearity assumptions and outliers.

• Expense Types: Product costs (direct materials, labour, overhead) and period costs (sell-
ing, administrative) guide cost management and financial reporting.

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