Section 2.) Cost Classifications
One of the most important concepts to understand in managerial accounting is that of cost. Much of managerial accounting is understanding what cost is, how it can be classified, how it behaves, and how to make decisions about it.
First of all, what exactly is cost? One definition is that cost is “the expenditure of something, such as money, time, or labor, necessary for the attainment of a goal.” It is important to understand that “cost” is not the same thing as expense. A cost often time leads to an expense when whatever you purchased is used up. However, that is not always the case. For example, there is a cost incurred in purchasing land, but that land will never be depreciated, thus never converted to an expense. Using that definition, cost and expense are mainly separated by time. Using an example from financial accounting, inventory has a cost when it is first purchased, but it is not recognized as an expense until that inventory is later sold.
In managerial accounting we will be discussing several different classifications of cost. We will introduce these classifications in this section and will dig into them more deeply in later sections.
Classification by Relationship of Total Cost to Total Volume/Activity (Variable vs. Fixed)
The terms fixed and variable help to explain how a particular cost changes as the activity level changes. For example, a fixed cost will not change as activity changes (within a certain range, known as the relevant range.) This relevant range can also be considered to be the “capacity” of the operation. For example, if we produce one unit, the fixed cost will be the same as if we produced 1,000 units, assuming we had the capacity to at least produce 1,000 units. Examples of fixed cost would be buildings, equipment, employee “salaries, etc.” Variable costs on the other hand, change as every new unit is produced. Some examples could be raw materials and direct labor.
Although fixed costs do not change in total as activity increases, you could divide fixed costs by the activity to determine a per unit amount. If you unitize fixed costs, you must be careful how you use the data and the per unit fixed cost must be understood before any decisions are made based on it. As activity increases, there is a larger base to divide the cost over, thus the cost per unit is less.
Although variable costs change in total, they remain the same on a per unit basis.
The concept of fixed versus variable cost relies on various assumptions, one being that cost behaves in a predictable straight line within the relevant range. Although this may not always hold perfectly true due to things such as volume discounts and economies of scale, it is a good enough estimate for managerial accounting.
There are two main simplifying assumptions that come into play in managerial accounting. These are the relevant range assumption and the linear cost assumption (linearity.)
“Relevant Range” Assumption – For many of these comparisons we “assume” that we are staying within the relevant range of activity levels, where fixed cost will not change with an increase or decrease of volume. Once we reach a certain point outside of this relevant range, costs will indeed increase to a new step. For example, at some point we may have to buy a new factory, etc. For this reason, in some cases fixed costs are also known as step costs because they remain flat until a certain level when they then “step up” or “down”.
Another way to think of the relevant range assumption is that it is the range of activity in which the cost classifications and assumptions hold true. In the relevant range, variable costs remain the same per unit and vary in total. Fixed costs remain the same in total.
“Linear Cost Behavior” Assumption - This assumes there are no volume discounts, economies of scale, etc. that would cause variable cost per unit to change over a level of activity. As such, it operates in a straight line.
Some costs are semi-variable (or mixed costs), which means they have both a fixed and a variable component. There are ways to find out both the fixed and variable components (discussed in later sections.)
Classification by Ability of Cost to be Traced to Individual Product (Direct vs. Indirect)
Direct Cost - A cost is said to be direct if it can be directly traced to a particular unit of product. For example, direct materials, such as the tires that go on a vehicle, can be directly traced to each vehicle, and you know how many tires it takes to produce a certain number of vehicles. Direct labor can also be traced to a particular unit, since the employee works on the car, and they take a certain number of hours to build.
Indirect Cost - A cost is said to be indirect if it cannot easily or conveniently be traced to a particular product. These indirect costs are often referred to as “overhead.” One example of this may be the factory supervisor’s salary. Although the supervisor works in the factory and oversees the production of many vehicles, there is no good way to determine exactly how many hours they spend on each vehicle, since they do not work directly on the vehicles. Instead, we find a way to allocate the cost over all productions in the most accurate way we can. Note that indirect costs can be either variable or fixed.
Classification by Relationship of the Cost to Production in General (Product vs. Period)
Product Cost - When we can closely relate a cost to the actual manufacturing of the product, we consider this a product cost (further subclassifications discussed shortly.) These types of costs are lumped in with the various inventory accounts and will not be considered an expense until the related product is sold (i.e., matching principle) Some examples of product costs are raw materials, direct labor, and factory or manufacturing overhead (any overhead incurred in the factory itself, NOT the sales offices, etc.)
Direct Materials-These represent materials directly traced to each product
Direct Labor-These represent labor directly traced to a product
Manufacturing/Factory Overhead-This could include indirect materials, indirect labor, or other costs that relate to the production, but not directly.
Period Cost - When a product doesn’t specifically relate to the product itself, but more to the company overall, it is said to be a period cost. This means that the cost will be considered an expense in the period in which it is incurred. Although this is somewhat of a violation of the matching principle, sufficient information often does not exist by which to match these period costs with a particular product. Some examples of period costs are sales salaries, general and administrative overhead, advertising, etc.
Classification by Controllability of Costs (Committed vs. Discretionary)
Committed costs are those fixed costs that cannot be changed in the short term. Some examples of these may be contracts that have been entered into, depreciation for a building that has been purchased with a long life, etc.
Discretionary costs are those that can be adjusted in the short run (e.g., on an annual basis, etc.) based on priorities in the budget. Note that these are still fixed costs but the time horizon for how long they are fixed is what this classification reflects.
There are some additional terms and concepts that become important in managerial accounting.
- Differential cost simply means that it is a cost that will actually differ between two alternatives. If the same cost will exist regardless of which option we choose, then it is not a differential cost, and as we will find it really doesn’t need to be considered in our choice between one alternative and another.
- Allocated costs are those that we couldn’t directly trace to a particular product or department, but instead we had to figure out the best way to allocate them. The problem is that the allocation is an estimate, and we have to consider this when making decisions.
- Sunk costs are those that have already been incurred based on earlier decisions. These can’t be changed with any future decision we make; thus, we don’t need to take them into consideration when making decisions in the future. These are sometimes the hardest ones to ignore, because people realize that they may have spent large amounts of money on certain assets that perhaps now they find to be no longer useful.
- Opportunity costs are those that are based on opportunities that we give up when we choose another alternative. One example is going to college. A person may be giving up the extra hours that could be spent working and earning additional wages in order to go to college to earn a degree and hopefully earn more later. Either alternative (go to college or not) has opportunity costs. Either you give up some money now in order to attend college or you give up the chance for higher earnings later by not going to college. Anyone making a decision needs to take these things into consideration.
The below video discusses the different cost classifications of Management Accountant
Section 3.) High Low Method
Earlier, we discussed the importance of understanding fixed vs. variable costs. In some cases, a particular cost is part variable and part fixed. A classic example of this would be utilities, since there is a standard base rate (regardless of how much is used.) That would be the fixed cost. There is also a portion of the cost that is charged on a per kilowatt-hour basis. That would be a variable cost.
Ultimately, the cost needs to be broken out into fixed and variable components. This will allow us to determine the cost equation of:
Total Cost = Fixed Cost + (Variable Rate * # of units)
Once we know that equation, we can then apply it to any desired activity level to determine the expected total costs.
There are multiple methods that can be used to break a cost into the fixed and variable components. The one we will use for this discussion is the High-Low Method.
High-Low Method of Analyzing Cost Volume Profit Relationships
When faced with a problem like this you need to gather cost and activity data from at least two periods, but often there are even more periods in the analysis.
Step 1: Out of a chart of activity and cost data, select the highest level of activity (and the related cost) and then the lowest level of activity (and the related cost.) Exclude any outliers (abnormally high or low amounts) before selecting these numbers. This high-low method will allow us to calculate the variable portion of a mixed cost.
Step 2: Calculate the variable rate by taking the difference between the cost at the high and low levels and dividing it by the difference in the activity level at the high and low levels.
Variable Rate = High Cost – Low Cost
High Activity – Low Activity
In other words, a change (i.e., variance) between two levels of cost should be explained by a change in the same levels of activity. The portion of that cost that increases with activity levels is the variable cost. The fixed portion would remain the same regardless of activity level (within the relevant range of course.)
Step 3: Once we have the variable rate from the equation above, we can then plug this into the data for either one of the two activity levels to determine the fixed portion of cost. We can take the total cost (which was given to us and which we had to use in our initial equation) and subtract the variable cost which we just retrieved from the equation, and the remainder is the fixed portion of the cost. We should be able to plug this variable cost into either the high or the low activity level data and get the exact same result. However, if we plugged it into any other activity level between the high and low levels we may get a similar result, but not likely the exact same. This is due to the assumptions we have to make not actually reflecting true reality.
Now that we know the fixed cost in total and the variable cost per unit, we can calculate (or predict) the actual total cost at any given activity level.
Again, the cost equation would be Total Cost = Fixed Cost + (Variable Rate * # of units)
This below video discusses the High Low Method in general
This below video goes trough an example of a High Low Method exercise.
Section 4.) Cost Volume Profit Analysis
Cost volume profit analysis is the analysis of what a change in cost or a change in volume (or both) does to profit. This is a VERY important method of analysis for management when they are choosing between certain alternatives such as increasing or decreasing sales price, changing sales mix, etc.
Although it seems obvious that an increase in the activity level of production (e.g., selling 200 units instead of 100) will lead to an increase in costs, the real question is how much increase would be expected? Although it may be tempting to think that a 200% increase in activity should lead to a 200% increase in cost, this is not always true. The reason is that some of the costs (fixed costs) do not change as activity levels increase.
An important factor in performing any cost-volume-profit analysis is the contribution margin. The contribution margin is the amount of revenue per unit that is available after subtracting the per unit variable costs. This amount is left to “contribute” to the total fixed costs and the profit.
Contribution Margin Format of Income Statement
Revenues per unit * units sold
- Variable costs per unit * units sold
= Contribution margin per unit * units sold
- Fixed Expenses
= Operating Income
Once you understand how much each unit sold contributes to covering fixed costs and profit you can then perform such analysis as break even analysis, which tells you how many units you need to sell to just exactly cover your fixed costs leaving zero profit.
Another related concept is the contribution margin ratio. This converts the contribution margin to a percentage instead of a dollar amount per unit.
Contribution Margin Ratio
Contribution margin per unit / Sales revenue = Contribution margin ratio
Break Even Analysis
Although no company wants to end up with zero profit, the break-even point analysis is intended to tell them how to do just that. The reason isn’t that it is the end goal; but rather it is the bare minimum they want to make sure they can hit. If they do not believe they can sell at least the number of break-even units, they should consider other opportunities. Note that up until the break-even point, every unit results in both fixed and variable costs. However, after the break-even point, the units incur only the additional variable costs. For this reason, after the break-even point, 100% of the contribution margin becomes profit.
Break Even Point in Units
Break Even Point in Units = Fixed Costs/Contribution Margin Per Unit
Break Even Point in Sales Dollars
Break Even Point in Sales Dollars = Fixed Costs/Contribution Margin Ratio
Another similar concept to this is the target profit calculation. This is the same basic calculation as the break-even calculation except that the numerator is not just fixed costs, but also the target profit. You can substitute total fixed expenses for fixed expenses plus a set $ amount of profit to determine that point (not called the breakeven point)
Target Profit Point in Units
Target Profit Point in Units = (Fixed Costs + Target Profit)/Contribution Margin Per Unit
Target Profit Point in Sales Dollars
Target Profit Point in Sales Dollars = Fixed Costs + Target Profit)/Contribution Margin Ratio
Operating Leverage = The higher a firm’s contribution margin ratio, the greater its operating leverage. The reason is that as soon as we cover our fixed expenses, we now have a large CM ratio to apply against profit. On the other hand, if we had a smaller CM ratio than even after we covered our fixed expenses our income would increase in much smaller intervals.
Operating Leverage is calculated by taking the Total Contribution Margin divided by the Operating Income
Generally, CM ratio is a tradeoff between high variable costs and high fixed costs. A company generally has to choose between one or the other. Keep in mind that although higher fixed costs (thus lower variable costs and higher CM ratio) equal higher operating leverage, this could be good OR bad depending on how the company operates.
Leverage equals Risk, just like it does when talking about financial leverage. The higher the operating leverage, the higher the risk (but also the higher the reward potential.)
This below video discusses CVP analysis
Wrap-Up
This week we start our discussion of managerial accounting. Pay especially close attention to the different classifications of cost, as these will all be discussed in later sections as well.
Section 1.) Introduction to Managerial Accounting
In this section, we will be discussing the topic of managerial versus financial accounting. Accounting in general is an information system used to assist users in making decisions. This holds true for both financial and managerial accounting. Although there is this main similarity, there are many differences.
One aspect to understand relates to who uses the accounting information.
Managerial- Managerial accounting is used solely by internal users. The information found in these reports is generally not publicly available knowledge. The main reason is that it does not go through the same scrutiny of audits that financial external information goes through.
Financial- Financial accounting is used mainly by external parties such as investors and creditors for the purpose of making decisions on which company to invest in or lend to. That being said, management and other internal users are certainly concerned with how external users see them, so they are also concerned with external information.
Another aspect to understand is the different types of reporting
Managerial- Special purpose reports are generated based on the needs of that company’s management. These needs may very well differ from the needs of another manager. There are no specific requirements for any sort of report.
Financial- Financial accounting requires the preparation of four general purpose financial statements. These include the Income Statement, Statement of Stockholder’s Equity, Balance Sheet, and Cash Flow Statement. The design of these statements is well prescribed to ensure that they can easily be compared between one company and another.
Another aspect to understand is the timeliness of reporting
Managerial- Managerial accountants require very detailed and timely reports. These depend on the needs of the managers that are making decisions and are not imposed upon them by some outside party. The time ranges include hourly reports, daily reports, weekly, monthly, and annual reports.
Financial- With financial accounting, it is high level summary data that is being used, and investors do not need these formal reports on nearly as frequently of a basis. Most commonly these financial statements are prepared on a quarterly and annual basis.
Another aspect to understand is the reporting standards that apply
Managerial- Although financial accounting is constrained by Generally Accepted Accounting Principles (GAAP), managerial accounting is not. Managerial accounting places more emphasis on timeliness than reliability. Managerial accounting information can be retrieved and used more quickly because it does not have to go through the same auditing procedures, etc.
Financial- Financial Accounting is heavily constrained by the Generally Accepted Accounting Principles (GAAP) promulgated by the Financial Accounting Standards Board (FASB.) The main reason for these principles is to ensure that all companies follow the same basic set of rules that can be understood by external users. Without a similar set of standards being used, it would be difficult or impossible to compare one company to another for investment purposes.
Another aspect to understand is the focus of the data
Managerial- Managerial accounting focuses more heavily on a very detailed scale of information, using past data and information about the future to predict future cost data. Basically, the focus is on the future.
Financial- Financial accounting focuses more heavily on historical costs and past decisions. Of course, investors themselves may decide to use the data to make predictions. In addition, financial accounting is more focuses on high level summary data as opposed to detailed cost information.
Finally, there are different certifications that apply to financial vs. managerial accounting
Managerial- Managerial Accountants are commonly certified as Certified Managerial Accountants (CMAs) by the Institute of Management Accountants (IMA.)
Financial- Financial Accountants are commonly certified as Certified Public Accountants (CPAs) by the American Institute of Certified Public Accountants (AICPA.)
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