ACCTG340:

Written Communications in Accounting—Documenting Computations

Lesson 0 had a document titled Written Communication in Accounting. The advice there was intentionally kept short to avoid overwhelming you. Now, after submitting the Hair Dryer case, you are ready for more written communication guidance.

Three ways to document computations are displayed below with a fourth way to be covered later. All three use the Excel table format, which is preferable even when using Word or writing out computations. For clear communication, computations need to be documented on the printed page, in case a reader works with a printout. The numbers used in the examples are from the Hair Dryer Case in Lesson 0. Notice how easily you can understand the solutions presented. This is the point of good written communication—making it easy for the reader to understand what is presented.

Option 4

We will learn a fourth way to document your computations when we use a worksheet for the activity-based costing assignment.

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Introduction to Lesson 1: Cost Concepts and Categories

Lesson 1 has five parts (be sure to complete all parts):

• 1a: Cost Concepts
• 1b: Direct versus Indirect Costs
• 1c: Fixed versus Variable Costs
• 1d: Product versus Period Costs
• 1e: Income Statement: Traditional and Contribution Margin Format

I cannot overemphasize how critical it is that you learn this lesson well. You will use it throughout the remainder of the course. Those who start with a weak foundation will struggle more and more as the course progresses. 

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Learning Objectives

Research shows that learning objectives improve the learning process. They do this by helping the reader to focus on the major issues and to organize the new information efficiently in his or her memory. Please take the time to review and consider the learning objectives at the beginning of each lesson and make sure that you have accomplished them by the end of the lesson.

After completing this lesson, you should be able to

• use cost concepts that underlie managerial accounting;
• classify costs as direct or indirect with respect to a particular cost object;
• classify costs as fixed, variable, step, or mixed with respect to a particular cost object;
• distinguish between manufacturing, merchandising, and service firms;
• describe the difference between product costs and period costs; and
• prepare an Income Statement (Earnings Statement) for manufacturing, merchandising, and service firms.

Lesson 1 Readings and Activities

By the end of this lesson, make sure you have completed the readings and activities found in the Lesson 1 Course Schedule.

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Introduction to Cost Concepts

Lesson 1a covers cost terminology used throughout most cost or managerial accounting courses. These cost terms apply to all kinds of organizations: manufacturing, merchandising (whether wholesale or retail), service, not-for-profit, and governmental. In short, these terms apply to any organization that incurs costs. 

This lesson will discuss the following terms:

• Cost
• Cost objects
• Cost pools
• Unit or average cost
• Marginal and variable cost
• Cost assignment
• Cost tracing
• Cost allocation
• Cost drivers
• Cost allocation bases

After you have covered this material, you will see this same list at the end of the lesson. If there is a particular term you are unclear about, you can then go back directly to the discussion of that term.

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Learning Objectives

After completing this part of the lesson, you should be able to

• use cost concepts that underlie managerial accounting.

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Lesson 1a: Cost Concepts—Defining Cost Terms | Video

Throughout the lessons in this course, you will often encounter video and text. Unless you are told otherwise, the video will cover the same material as the text. You have the option to use whichever format works best for you. If you choose to watch the video, you may skip the text in lesson 1a and continue to lesson 1b.

Video 1.1: Cost Concepts: Defining Cost Terms.

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Cost

There are some very technical definitions of accounting terms. For example, when you start talking about assets, what makes something an asset in accounting has to do with its future utility. An automobile gives you future transportation and that's what makes it an asset. It's not listed as an asset simply because you own two thousand pounds of steel. You could get two thousand pounds of steel much more cheaply. But it's OK in accounting for day to day speaking to say an asset is something of value which you own, or in some cases control.

We're doing the same thing here. What is "cost"? A cost is what you give in return for something else. That's actually my favorite definition of a cost—what you give in return for something else. Another definition of cost is a sacrifice made for a specific purpose.

Let's review some specific examples:

1. You give $1,000 for equipment. What is your cost of that equipment? $1,000, the amount of cash you paid.
2. You sign a $100,000 mortgage note for land. What is the cost of the land? The $100,000 you gave a written promise to pay.
3. You pay factory workers $10,000 for last week's production—your cost is $10,000.
4. You pay sales staff $2,000 commissions for last month's sales—your cost is $2,000.
5. You pay office workers $5,000 salary for last month—your cost is $5,000.
6. On Saturday, you spent six hours helping a friend move. What is your cost? Your cost is six hours of your life.

There are two things you need to note from this:

First you want to note that cost does not mean expense. Only the fourth and fifth items, the sales staff commissions, which go into commissions expense, and the office workers salary, which goes into office salaries expense, are expenses at the time of payment. For the first item you've got equipment: a property, plant, and equipment asset. For the second item you've got land: a property, plant, and equipment asset. For the third item, you got work-in-process which is an inventory account among the current assets. And for the last item, where you helped your friend move, you've got an account receivable from your friend. However, if you do not have an account receivable for your friend you could have an expense, in that particular instance.

The second thing you should note from the above examples is that cost does not mean cash outlay. Take Number 2; there is no cash being paid in Number 2. There is a written promise to pay later. Yet we still have a cost. And take Number 6, where you gave up six hours of your life to help your friend move. There is a cost there, but there is no cash outlay. And in the case of Number 6, there never will be a cash outlay.

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Cost Objects and Cost Pools

Next, we will discuss cost objects and cost pools.

Cost Objects

A cost object is any item for which someone desires a cost. Now, to say any item for which someone desires a cost may be an overstatement. For example, the janitor at IBM could say, "I'd like to know what it costs to do something at the company." However, it is very unlikely that the janitor would have the power or the authority to go to accounting and demand that they compute and provide the cost. So, some people would say it is anything for which a manager desires a cost, or someone with the power to get the cost, desires a cost.

Let's review some specific examples:

Products

Products, such as a car. A product is a common example that anyone would have thought of immediately. Some additional examples will show cost is not just a narrow concept that's applied to a product at a manufacturing company.

Product Lines

Product lines, such as digital single lens reflex cameras. This example is included because it is a common practice among the Japanese. An American company that makes four different cameras would likely try to determine the profitability of each camera. A Japanese company will look at the profitability of the overall camera line. Assume Nikon has four cameras in its single lens reflex camera line. Nikon might sell the entry level camera near breakeven, the next level up might sell at a 30% profit, the third level at a 50% profit, and top level at an 80% profit. The company might take the position that it is willing to have very little profit on its entry level camera to get someone to buy Nikon. The profit margin goes up, because as people move up the line, they start buying for features, not cost. As long as the overall camera line is making a healthy profit, Nikon is happy.

The advantage this provides the Japanese is that when they treat the entire product line as the cost object, instead of individual cameras, they have a lot less cost allocation to do. For example, assume that all four cameras are made at the same plant. In an American computation by product, you'd have to allocate the plant depreciation among the four cameras. In the Japanese company, you simply charge the plant depreciation to the camera line. This discussion is not advocating that the Japanese practice of doing product lines in some cases, as opposed to individual products, is superior to the common American way of costing individual products. It is just presenting an alternative way to look at the world.

Services

Services. If you're going to open a Jiffy Lube, you need to know what it costs you to change the oil in a car.

Jobs

Jobs. If you're opening an accounting firm, each client is billed for the particular services he or she desires. To determine whether your work for Exxon is profitable, you need to know what it cost you to do the Exxon audit or the Exxon tax return. Note that you might charge based on time or based on particular services within a job. For example, an accountant might say, "I charge $100 per hour for tax return preparation" or "I charge $100 to prepare a Schedule D."

Projects

Projects, such as research and development to create a new drug to lower cholesterol.

Organizational Units

Organizational units. What does it cost to run the purchasing department or the human resources department? That would be especially important if an organization is considering outsourcing.

Activities or Processes

Activities or processes, such as credit card authorization or order entry. What does it cost to do a credit card authorization? If it costs you, say, 25 cents to do a credit card authorization, do you really want to do one on a 25 cent or $1 sale, or do you want to have some minimum level?

Distribution Channels

Distribution channels. What does it cost to do an Internet sale versus a retail outlet sale? This particular example comes from Dell, which years ago did an activity-based costing study and decided that Internet sales were more profitable than retail outlet sales and quit doing retail outlet sales. Although Dell has re-entered the retail outlet market, it has not eliminated use of the Internet.

Customers

Customers, such as Wal-Mart. What does it cost to service Wal-Mart? Is Wal-Mart a profitable customer? It is easy to know the sales revenue from Wal-Mart. If the organization can come up with the full cost of servicing Wal-Mart (the cost of goods sold, the shipping, the cost of calling on the customer, the cost of handling its orders, and everything else) the organization can decide how profitable Wal-Mart, or Sears, or some other company is as a customer.
This customer profitability analysis, which requires you to know customer cost, is actually a very interesting area, because studies show that for a lot of companies, 20% of customers provide 80% of the company's profit and another 60% of customers provide another 40% of the company's profit. If you are quick with your math, you are thinking, "Wait a minute, if I've got 80% and then 40%, that's 120%." You can't have more than 100%, and you're right. The remaining 20% of customers will actually eat away 20% of the company's profit; that is, the company is losing money on them. So, doing customer profitability analysis can be a good way to increase your profitability by making sure you treat your good customers well and either make your unprofitable customers profitable or let them go elsewhere.

Cost Pools

Cost pools. Accountants pool the costs together for various cost computations. So, a cost pool is simply a related group of costs that is meaningful to a particular entity. There are many ways to pool costs. Three examples are reviewed here:

Manufacturing Overhead

Manufacturing overhead is a good example. All of the costs of running a factory other than direct materials and direct labor are collectively called manufacturing overhead. All of the manufacturing overhead for the entire factory could be added into one pool.

On the other hand, some companies may accumulate overhead in separate pools for different factory departments, such as assembly and finishing.

Departments

Departments, such as accounting, human resources and shipping, are a common way that companies accumulate their costs and pool them together.

Geographical Regions

Geographical regions, such as the cost of North American operations versus Asian operations. In order for companies to know their profitability by geographic region, they have to have costs broken down that way.

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Unit Cost, Average Cost, Marginal and Variable Cost

 

Unit or Average Cost

In general, the unit cost equals the average cost. That is, you take the total cost for a batch of units of a product and divide it by the number of units produced, which gives you the average cost. So, if a company spent $1,000,000 and made 100,000 units, $1,000,000 divided by 100,000 units is $10 per unit. That is the unit or average cost. You can also compute the average cost for service units produced, such as the average cost of a cable installation at Comcast.

Marginal and Variable Cost

Marginal cost is not an average. It is the cost of providing one more unit of a good or service. We know that the marginal cost is not actually constant; that is, in economics we know that marginal cost is curvilinear, simply meaning a curved line. As shown in Figure 1.1, it looks like a backward "s." Also shown below (Figure 1.2 and 1.3) is how accountants convert the curvilinear marginal cost to a linear cost called variable cost.

Marginal Cost Converted to a Constant Variable Cost

 

As you can see in Figure 1.1, at very low levels of volume, cost is increasing, but at a decreasing rate.

Now that sounds odd, but here's an example of what is being said. You are buying automobile tires for your tire dealership from a tire manufacturer. Initially, you order 100 tires a month at $100 per tire. As you order more tires, you get a price break. So, when you increase your order above 100 tires a month, you start paying $98 per tire. Your total cost is increasing, but at a decreasing rate of $98 per tire.

At some point, the cost may level off. Assume from 6,000 to 10,000 tires per month, the price is at its lowest at $92 per tire. Above that level point, you start getting diseconomies of scale instead of economies of scale, meaning the cost per unit starts going up at an accelerating rate. So, for example, once you need over 10,000 tires per month, the manufacturer has to work overtime and offers additional tires at $102 each. Now costs are increasing at an increasing rate of $102 per tire. This explains why marginal costs are not constant.

In managerial accounting, we simplify things by assuming we will be on a part of the marginal cost curve that is relatively straight, as shown in Figure 1.2. This results in a linear cost (a straight line) replacing the marginal cost as shown in Figure 1.3. Continuing the tire example, assuming your tire needs are expected to be between 3,500 and 3,600 tires per month, your tire cost will be constant, at say $96 per unit. Note that this is not at the lowest cost per unit, because the relevant range for your tire dealership is not high enough for that.

To distinguish the accounting linear representation from the economics marginal cost, accountants refer to this linear representation of cost as variable cost.

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Cost Assignment

Cost assignment is a general term indicating the process of putting costs incurred into cost objects. Now, how do we assign costs? In general, there are two ways we do it: we either (1) trace the cost, or (2) allocate the cost.

Cost Tracing

Cost tracing is the placement of a cost that belongs to only one cost object into that cost object. To the extent that you can trace costs, determining cost is easy. The costs that can be traced are called direct costs, and they are covered in another presentation.

Cost Allocation

Cost allocation is the placement of a cost that belongs to two or more cost objects into those cost objects, which we will do extensively in future lessons. The costs that cannot be traced and, therefore, must be allocated are called indirect costs, and they are covered in another presentation.

Cost allocation involves a numerator and a denominator. The numerator is always money, while the denominator is always some measure of activity. The result of the division is always the amount of the numerator for every one of the denominators.

For example, your manufacturing overhead is $1,000,000 and you produce 100,000 units of a product. For the product cost object, the allocation would be $1,000,000/100,000 = $10 of manufacturing overhead per unit produced.

Product cost object allocation = $\frac{\$}{\mathrm{activity}}$

Product cost object allocation =  $\frac{\$1,000,\mathrm{000\; manufacturing\; overhead}}{100,\mathrm{000\; units\; produced}}=\$10$ of manufacturing overhead per unit produced

Here is an extremely important point about cost allocations that people do not always realize. Numbers look very precise, so if someone says that the product cost for making a particular part is $17.33, people tend to think of that as gospel; but a lot of cost allocations went into that $17.33. If you change how cost allocations are done, it might be $16.05 or $18.10, and these other amounts might be just as correct, that is just as defensible. So, what is the point?

The point is that there is more than one logically defensible way to allocate the same costs to the cost objects. And if there is more than one logically defensible way to allocate the cost, then there is more than one right answer. From the standpoint of an independent observer, the choice between multiple right answers is arbitrary. So, accountants say that all cost allocations are arbitrary.

A simple example is depreciation methods. One company might allocate depreciation of its machinery based on a ten-year life with no salvage value. Another might allocate depreciation on the same equipment based on 1,000,000 units of output. A third organization might allocate it based on a nine-year life with a 10% salvage value. Each time you change how you calculate depreciation or change any of the depreciation assumptions, you will get a different amount of depreciation allocated to each unit of product produced. Which cost per unit is correct? Well, they're all correct as long as your assumptions are reasonable. Notice that your assumptions need to be reasonable. You cannot simply say, "Ah, well, if all cost allocations are all right, I'm just going to use a 10,000-year life for my equipment." Of course, that's not reasonable.

Saying all cost allocations are arbitrary does not mean they are unnecessary. People need a reasonable estimate of cost in order to make decisions. But you want to remember that no matter how precise your costs look when you hand them to people, the number is not the right answer. In fact, if someone says, "The true cost is...", they are misspeaking, because there is no one true cost. At best, all you can reasonably say it that some cost calculations are more accurate than others for the particular decision to be made.

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Cost Drivers

Cost drivers. A cost driver is a cause of cost. If you do more of it, it drives your cost up. If you do less of it, it drives your cost down.

Let's review a couple of examples here, just to solidify the concept.

Setup Machines

Setup machines is one example. First, a little background: some companies have crews that go out and set up the machines to make the next batch of product. It can be something as simple as cleaning the paint tank to switch from painting red to painting green. It can be an auto company that is stamping bumpers, changing the dye in the machine so that it can start stamping doors.

What causes the cost? You've got a cost pool called "setup machines" and there's $1,000,000 in it. Where did that $1,000,000 in cost come from?

• Part of it is from the number production runs scheduled. Assuming that each production run requires a set up, then every time you schedule another production run, the setup crew has to go out and change the machine, and that's costly.
• The length of time it takes to do a set-up is another part. A four-hour setup is more costly than a one-hour setup.
• The scheduling of the setups is another factor. If you have your setup crew doing the setups while the facility is in full operation and they have to make production workers stand and wait, that's going to be a more costly setup than if you have the setup crew do the setup while the factory is closed or do the setup on an extra machine that is idle.
• The size and pay rate of the set-up crew affects the cost. If you give your setup crew a 5% raise, everything else held equal, your setups are going to be more expensive than they were before the raise.
• The equipment available for setups and its condition affects the cost. If you're using old forklifts that break down, it's going to affect the time and cost of doing a setup.

Shipping

Shipping is another example. Shipping cost is caused by a number of factors:

• The number or shipments: more shipments cost more money.
• The method of shipment: shipping overnight is more expensive than shipping a five-day delivery.
• The size of the shipment: if you have two boxes that are each ten pounds, and one is a square foot while the other is five square feet, the bigger one is more expensive to ship.
• The weight of the shipment: if you have two boxes that are each two square feet, and one weighs 10 pounds while the other weighs 40 pounds, the heavier one is more expensive to ship.
• The fragility of the shipment: assuming you are packing fragile items more carefully or with more materials to protect them, paying extra insurance for the fragility, or are replacing items that break in shipment, more fragile items are more expensive to ship.
• The size and pay rate of the shipping department staff.

So, there are a lot of things that drive cost.

Now, why are we covering this? If you're going to manage cost at an organization, the first thing you need to do is figure out what is driving that cost.

Let's take this shipping cost, I can look at this list and say, "Wow, we've got all these causes of shipping cost. What should I address first?" You need to ask, "What's the biggest contributor to shipping costs at our organization?" Let's say that you found out that your organization is so behind on customer orders that it is shipping overnight 40% of the time. Then, perhaps you should first address the method of shipment and try to fix the system, so you don't need to use overnight shipping frequently. After you fix the expedited shipping problem, you need to ask, "Now, what's the biggest contributor to shipping costs at our organization?" in order to determine what to work on next. For example, if you have a lot of breakage in shipment, which you have to replace at your cost, you could review how you pack your shipments.

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Cost Allocation Bases

This is an extremely important concept, meaning you will use it repeatedly during the rest of the course! Learn it well!

Cost allocation bases are an extremely important subject that any student of managerial or cost accounting must master early in the course. Because there is no single "correct" way to allocate a particular cost, there is no single "right" answer when doing allocation. Still, estimates of cost are needed, making cost allocations necessary.

You should know from your high school math that the top of a fraction is called the "numerator" and the bottom is called the "denominator." The cost allocation base is the bottom or the denominator of the cost allocation fraction. For example, $200,000 manufacturing overhead divided by 10,000 machine hours equals $20 of manufacturing overhead per machine hour. In this case, machine hours are the allocation base.

$\frac{\$}{\mathrm{cost\; allocation\; base}}$

Cost allocation =  $\frac{\$200,\mathrm{000\; manufacturing\; overhead}}{10,\mathrm{000\; machine\; hours}}=\$20$ of manufacturing overhead per machine hour

Notice that whenever you do a fraction, you're always suppressing the denominator to one and saying how much numerator you have for every one of the denominator. Let's just say that in your hometown there are 1,000 dogs and 100 cats. Well, 1,000 dogs divided by 100 cats is 10 dogs per cat. If you flip it, and put the 100 cats over the 1,000 dogs, it is 0.1 cats per dog. You're always ending up with one of the denominator and saying how much of the numerator there is for that one of the denominator. If you keep that in mind, any fraction you learn is a pretty simple thing.

If you get into financing, you learn the debt-to-equity ratio, which is debt divided by equity. What does it tell you? It tells you the amount of debt for every one dollar of equity. Now you have to know how debt is defined. Is it just long-term liabilities or all liabilities? What do we mean by equity? Is it just stockholder's equity or is it creditor and stockholder's equity? But the point is that the fraction, debt-to-equity, is simply the amount of debt for every one dollar of equity.

We have unit level allocation bases. What do we mean by unit level? The allocation base changes proportionally with changes in production—if production goes up 10%, the base goes up 10%, and if production goes down 4%, the base goes down 4%. It is called unit level because it changes along with the units.

Let's look at three unit-level allocation bases:

• Direct labor hours: if you're going to increase production by 10%, then you should need 10% more direct labor hours.
• Direct labor dollars: if you're using 10% more direct labor hours, you're going to pay 10% more in direct labor dollars.
• Machine hours: if you increase production 10%, you're going to need to run the machines 10% longer.

So, these are all called unit level because they vary with the number of units produced. You can also have unit-level allocation bases that vary with the number of units sold. Sales commissions vary with the number of dollars sold, so commissions are unit level with respect to sales revenue.

Some costs are unit level. For example, factory machinery electricity is unit level. If you make 10% more units, you run the machines 10% longer and your electric bill is going to go up about 10%. Allocating it based on a unit-level allocation base such as machine hours is logical.

However, a unit level allocation base is often used to allocate costs that do not vary with the number of units produced. Factory building depreciation is not unit level. Allocating it with a unit-level allocation base can lead to misleading cost calculations. For example, your building depreciation is $1,000,000 a year and you make 200,000 units, so you say it is $5 a unit. Well, it is $5 a unit if you make 200,000 units. If you make 100,000 units, it would be $10 per unit. If you make 500,000 units, it would be $2 a unit. When you start using a unit-level allocation base to allocate something that is not unit level, people can start thinking it is unit level and make some very bad business decisions. That's something you need to watch out for in this situation.

Using Cost Drivers for the Allocation Base

For any cost allocation, it's preferable to use a cost driver as the denominator; that is, use a factor that actually causes the particular cost in the numerator to change.

When using a cost driver, focus on the one cost driver considered best suited for allocation. You might allocate "setup machines" cost using the number of setups or the number of setup hours. You might allocate shipping costs using the number of shipments or the weight of shipments, if weight is the most important factor.

Something to remember is that the best cost driver for allocating the cost may not be the most important cost driver for managing the cost. You shouldn't forget that other cost drivers exist. For example, you might allocate "setup machines" cost based on the number of setups; however, you might decide that decreasing the time needed to do a setup—setup hours—is the most important cost driver for managing the cost.

Sometimes you cannot use a cost driver to allocate a cost, because there is no cost driver. An example is straight-line depreciation of a factory building, which is based on the passage of time. You cannot logically allocate it using direct labor hours or number of setups or any other denominator that drives the cost, because it is strictly a function of time. We might allocate it based on square footage used by different products, which is logical, but changing the square footage used by any product does not change the depreciation. Where a cost driver is not available, there are other criteria for selecting an allocation base that will be covered in another presentation.

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Lesson 1a Summary

You are now familiar with a variety of cost accounting terms. Think about your understanding of each one as we review the list.

• Cost
• Cost objects
• Cost pools
• Unit/average cost
• Marginal and variable cost
• Cost assignment
• Cost tracing
• Cost allocation
• Cost drivers
• Cost allocation bases

If you are not comfortable with any one of these terms, review it again. These terms are fundamental to any study of cost or managerial accounting and any lack of understanding will cause you problems later.

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Introduction to 1b: Direct versus Indirect Costs

This lesson discusses the segregation of costs into the mutually exclusive categories of direct and indirect. To do so, you must have a very good understanding of the desired cost object.

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Learning Objectives

After completing this lesson, you should be able to

• classify costs as direct or indirect with respect to a particular cost object.

Be aware that the distinction between direct and indirect costs is fundamental and is used throughout the study of cost or managerial accounting.

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Lesson 1b: Direct versus Indirect Costs | Video

If you choose to watch the video, you may skip the text in lesson 1b and continue to the instructor quiz on direct vs. indirect costs.

Video 1.2: Segregating Costs: Direct versus Indirect Costs.

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Direct vs. Indirect Costs: One Way to Segregate Costs

One way to segregate costs is direct versus indirect costs, which is covered here. Another way is fixed versus variable costs, which are covered separately. A third way is the segregation of cost in financial accounting for financial reporting purposes by functional categories such as separating rent expense from utilities expense from interest expense, which is not covered in managerial accounting. An important point is that there are different segregations of the same cost for different purposes. Note that these categories are not mutually exclusive. For example, a direct cost can be fixed or variable and an indirect cost can be fixed or variable.

Segregating Cost Overview

These methods used to segregate costs apply to all kinds of organizations (as well as to individuals such as you). Any organization that incurs costs—whether it is in manufacturing, merchandising, service, not-for-profit, or government—can segregate its costs. All organizations are likely to have some costs that are direct and some costs that are indirect with respect to a particular cost object.

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Direct versus Indirect Costs: Defined and Examples

Direct costs are costs that can be traced to one cost object and are material enough to be worthy of tracing. An indirect cost is a cost that cannot be traced to one cost object, meaning it belongs to more than one cost object. Or it belongs to one cost object but is not material enough to be worth tracing.

Examples

One way to understand direct versus indirect cost is to go through some examples. As you can see here, you have to first define the cost object.

If we are talking about a product cost object, direct materials can be directly traced to the product. Each car has around 2,000 pounds of steel, a windshield, seats, and other various components. The direct labor can also be traced to the particular product. As they go down the assembly line, each car uses, say, 11 hours of direct labor.

Indirect costs would include most of the manufacturing overhead. For example, take the plant depreciation. You have to have a plant to build your product, but the plant depreciation cannot be traced to the particular units of product built, so it has to be allocated among the units. The same would be true of the utility bill for the plant, the janitorial services for sweeping the plant, and most of the other costs of operating the plant.

Now, consider an accounting department cost object. The salaries of the accountants can be directly traced to the accounting department. The depreciation of computers and office equipment used solely by the accountants can be traced to the accounting department. However, what about the cost of human resources? After all, human resources personnel handle the hiring and termination of accountants, as well as take care of the accountant's employee benefits while employed. The cost of human resources, which also handles the non-accounting departments in the company, would have to be allocated among the various departments that benefit from the use of human resources. What about the cost of the payroll department? The payroll department pays all the employees and the cost of running the payroll department would have to be allocated among all the departments benefiting.

Finally, let's take a customer cost object, here numbered as Customer 21. We can trace the cost of goods sold to Customers 21; that is, we know what merchandise was sold to Customer 21. We can trace the shipping to Customer 21, assuming we used an outside shipper; that is, we know how much we paid the shipper to take merchandise to Customer 21. The sales commissions on sales to Customer 21 are also direct. If we sold $1,000,000 to Customer 21 and paid 5% in commissions, the $50,000 in sales commissions is clearly traceable to Customer 21.

Now, what if the sales department individuals, besides commissions, get a salary, Assume sales staff are paid $2,000 a month, and they call on various customers. So, the person who called on Customer 21 also called on 30 other customers during the year. We would have to allocate the base salary of the sales individual to the various customers who benefited. And most of the sales department overhead, like the depreciation of the equipment used by the sales department would also be indirect and require allocation. Returning to the shipping example, it would not be direct if the company used its own internal delivery trucks that delivered something to Customer 21 and then continued down the highway and delivered something to Customer 22. Then, delivery expense would be an indirect cost.

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Direct vs. Indirect Costs: Cost Objects—A Key

The cost object is a key. That is, you have to define the cost object before you can determine whether a cost is direct or indirect, because you have to ask yourself, "Direct or indirect with respect to what?" A cost that is direct with respect to one cost object can actually be indirect with respect to a different cost object. So, you can't just memorize the handling of a particular cost. For example, it is incorrect to make a statement like, "The depreciation of the plant is always indirect."

Let's take a product example: the salary of the plant manager. If the cost object is the plant, then the salary of the plant manager is directly traceable to the cost object. If the plant makes only one product, the salary of the plant manager would also be directly traceable to that product. If several products are made in the plant and the plant manager oversees the entire plant, the plant manager is indirect with respect to the individual products and the salary would have to be allocated among them, if you choose a product cost object.

Now, take a service example, the salary of an accountant. If the cost object is the accounting department—you are trying to keep track of the cost of running your accounting department—the salary of an accountant is directly traceable. If you are trying to determine the cost of having a human resources department (human resources does need the accountants to keep the financial records involving human resource salaries and other human resource department costs) you cannot trace the accountant's salary to the human resources department. A certain amount of the accountant's salary could be allocated to running the human resources department. Put another way, if you closed down, that is, outsourced human resources, at least in theory there would be a little less accounting to do and as you outsource departments you might be able to reduce the number of accountants you need.

Again, do not just memorize. Review the particular situation. If you have an accountant whose only job is to keep records for human resources, that accountant's salary would be directly traceable to the human resources department.

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Direct vs. Indirect Costs: Classification Practice

Here's an opportunity for you to make sure you understand direct versus indirect costs.

Classify each of the following costs with respect to a purchasing department cost object. That is, you want to determine the cost of running the purchasing department.

1. The purchasing department has its own building. Is depreciation on the building direct or indirect?

2. Purchasing has several purchasing agents. Is the salary of a purchasing agent direct or indirect?

3. What about office building utilities, where purchasing uses approximately 10% of the building space?

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Introduction to 1c: Product versus Period Cost

This lesson discusses the segregation of costs into the mutually exclusive categories of product versus period. All organizations that have any costs have period costs. Product costs only exist for those organizations that build their own inventory.

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Learning Objectives

After completing this lesson, you should be able to

• distinguish between manufacturing, merchandising, and service firms; and
• describe the difference between product costs (inventoriable meaning asset) and period costs (expenses).

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Lesson 1c: Product vs. Period Costs | Video

If you choose to watch the video, you may skip the text in lesson 1c and continue to the instructor quiz on product vs. period cost.

Video 1.3: Segregating Costs: Product versus Period Costs.

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Product vs. Period Cost: A Way to Segregate Costs

In order to do this segregation of costs, you need to understand the difference between manufacturing, merchandising, and service firms.

Then, you will be able to understand the difference between a product cost, which is a cost that goes into inventory on the balance sheet, and a period cost, which is a cost that goes into expenses on the income statement.

Product costs are only for manufacturers. That is, the product costs category only applies to companies that build their inventory. Period costs apply to all companies, since these are primarily the operating expenses on any income statement.

Manufacturing vs. Merchandising vs. Service

A manufacturing organization is one that buys raw materials and builds its inventory and then sells the inventory that it built. Therefore, these organizations will have three separate inventories among their current assets on the balance sheet. They will have raw materials, which are goods awaiting use in production; that is, waiting to be used inside the factory. They will have work-in-process, an account for the partially completed units inside the factory. And they will have finished goods, which are units that have been completed and are awaiting sale to the customers.

Merchandisers, on the other hand, do not build anything. They buy finished goods and sell them. They add what economists call place utility. Having a Toyota dealership in Harrisburg, PA saves you from having to make a trip to the factory to pick up a Toyota. Merchandisers have one inventory, which is the manufacturer's finished goods. But instead of calling it finished goods, it is called merchandise inventory.

Since they provide a service and do not sell goods, service companies technically do not have an inventory. However, they might have a parts or supplies inventory, which they might call parts or supplies or they might call inventory. If they do carry parts or supplies, it is not considered an inventory on the level of a merchandiser.

A company can have more than one type of business. For example, an automobile dealer carries a large parts inventory, and sells to the public as well as uses parts internally. The parts department is a merchandiser and the repair shop is a service business. As another example, Sam's Club is a large merchandiser. Several of its stores also have service centers for automobiles.

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Product vs. Period Costs Defined

 

Product (Manufacturing) vs. Period (Non-manufacturing) Costs

Product costs only exist in manufacturing, whereas period costs exist outside manufacturing and therefore, as said earlier, apply to any organization that incurs costs.

Product costs are the cost of items used up inside the factory where the manufacturing takes place.

Period costs are the cost of items used up outside the factory and are expenses on the income statement.

There are four things you need to understand here.

Used-up Costs

The first thing you need to understand is what is meant by "used up."

When a company buys a building, it doesn't matter if it's buying a factory building or an office building—it's buying an asset. That building goes into property, plant, and equipment on the balance sheet. How does the company show that building being used up? Depreciation is the term describing the process of writing off plant and equipment assets over the years benefited by their use. Depreciation is the amount considered used up. But, as we will see shortly, what the company does with that depreciation is different if it is depreciation of a factory versus depreciation of an office building.

Let's take another example. As you are already aware, you pay your car insurance in advance. A company pays its fire insurance for the next year. At the time the company pays the insurance, it is prepaid insurance, a current asset on the balance sheet. It doesn't matter if the company is prepaying factory insurance or prepaying office building insurance—it is prepaid insurance on the balance sheet. What does the company do when that insurance expires? As we will see shortly, used-up insurance goes to a different place if it's on the factory building versus on the office building.

It is the used-up costs that are of concern in our discussion here.

Product Costs

The second thing you need to understand is the three categories of product costs. Raw materials are sent into the factory. When those raw materials go into the factory, the assembly-line workers work on those raw materials to turn them into finished goods. The labor of the assembly-line workers is called direct labor. All the other costs of running that factory, other than direct materials or direct labor, are called factory overhead or manufacturing overhead.

So, we have three categories

• direct materials, which is the materials you can see in the finished product;
• direct labor, which is the labor of the people who physically work on the assembly line to build the product, and
• factory or manufacturing overhead, which are all the other costs of running the factory that are not direct materials and direct labor.

Factory or Manufacturing Overhead

The third thing you need to understand is what is meant by factory or manufacturing overhead. You have factory materials that don't end up in the finished product, such as oil used in the machines that make the product. These are referred to as indirect materials and are included in factory overhead. You've got people who do things in the factory other than the assembly-line workers, such as janitors that sweep up the factory and maintenance workers who maintain the machines. These are referred to as indirect labor and are included in factory overhead. If you own the factory building, factory overhead will include depreciation on the factory building. If you rent the factory equipment, factory overhead would include rent on the factory equipment. It would include factory building insurance, insurance covering the factory employees, and factory gas, electricity, water, and telephone. There are many costs of running a factory other than the direct materials and direct labor, and they are all lumped together in manufacturing or factory overhead.

Period Costs

The fourth and last thing you need to understand is period costs. As stated earlier, period costs are items used up outside the factory, and these costs primarily go into operating expenses on the income statement. Office supplies, office labor, office building depreciation, office equipment rent, office building insurance, insurance covering the office employees, and office gas, electricity, water, and telephone are examples.

In financial accounting, we break the operating expenses into two basic sub-categories; selling expenses and general and administrative expenses. In cost accounting, we don't concern ourselves with the breakdown of operating expenses. We leave that to financial accounting. It's enough for you to know when a cost is an operating expense, which is a period expense. On the product costs though, you do need to know the categories, i.e.., be able to distinguish raw materials, direct labor, and manufacturing overhead.

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Product Cost Flow through the General Ledger

Garrison, Noreen, and Brewer's Managerial Accounting shows the flow of costs, along with the related journal entries, in Chapter 3. At this time, we will just cover the logic of the flow.

An important precedent to understanding accounting is to understand that accounting is simply keeping records to show what resources went through the organization. That is, the physical flow of goods and services into and out of the organization requires recognition in the accounting records. 

For a manufacturing company, raw materials are acquired for use in production. On the books these will go into a raw materials inventory account until they are used.

These raw materials are sent into the factory where direct labor (the labor cost of those who actually build the product) and manufacturing overhead (all of the costs of running the factory other than direct materials and direct labor) are added. On the books these costs are accumulated in a work-in-process inventory account.

The completed production is transferred to an area where the product awaits sell and delivery to customers. On the books, a transfer is made out of work-in-process inventory and into finished goods inventory.

As the goods are sold, they are transferred out of the finished goods inventory and into cost of goods sold, an expense account.

The exhibits in the textbook only reflect the flow of costs. Of course, as the goods are sold there is also an entry to record the revenue from the sale, which is not reflected in the exhibits.

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Product vs. Period Costs: Classification Practice

 

Product Costs (inventory asset) vs. Period Costs (expenses)

Now comes an opportunity to make sure you clearly understand the distinction between product costs and period costs.

Required: Classify each of the following manufacturing company cost items as a product cost or a period cost and click on the link of your choice to see if you are correct.

1. Office Building Depreciation

2. Factory Assembly Line Wage

3. Factory Janitorial Salaries

4. Office Property Taxes

5. Office Supplies Used

6. Factory Building Depreciation

7. Factory Property Taxes

8. Office Janitorial Salaries

9. Factory Supplies Used

10. Advertising Cost

In summary, the distinction between product and period costs is very clear. If the cost is incurred to run the factory, it is a product cost and will go into the inventory asset account. If it's incurred outside the factory, it's a period cost and will go into expenses on the income statement.

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Introduction to 1d: Fixed versus Variable Cost

This lesson discusses the segregation of costs into the mutually exclusive categories of fixed and variable. Mixed and step costs are also covered, but ultimately these are also broken down into fixed or variable.

To use this classification, one must have a very good understanding of the time frame and the relevant range. 

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Learning Objectives

After completing this lesson, you should be able to

• classify costs as fixed, variable, step, or mixed with respect to a particular cost object. Be aware that the distinction between fixed and variable costs is fundamental and is used throughout the study of cost or managerial accounting; and
• recognize how mixed and step costs are converted into fixed and variable.

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Lesson 1d: Fixed vs. Variable Costs | Video

If you choose to watch the video, you may skip the text in lesson 1d and continue to the instructor quiz on fixed vs. variable costs.

Video 1.4: Segregating Costs: Fixed versus Variable Costs.

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Fixed vs. Variable Costs: Another Way to Segregate Costs

Another way to segregate costs is fixed versus variable costs, including mixed and step costs, which is covered here. Another way is direct versus indirect costs, which are covered separately. A third way is the segregation of cost in financial accounting for financial reporting purposes by functional categories such as separating rent expense from utilities expense from interest expense, which is not covered in managerial accounting. An important point is that there are different segregations of the same cost for different purposes.

Note that these categories are not mutually exclusive. For example, a fixed cost can be direct or indirect and a variable cost can be direct or indirect.

Segregating Costs Overview

These methods used to segregate costs apply to all kinds of organizations (as well as to individuals such as you). Any organization that incurs costs—whether it is in manufacturing, merchandising, service, not-for-profit, or government—can segregate its costs.

All organizations are likely to have some costs that are fixed and some that are variable with respect to a particular cost object.

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Fixed vs. Variable Costs: Two Key Factors

The concept of fixed and variable costs does not make any sense unless you first consider two factors: the time frame and the relevant range.

Time Frame

Most costs are fixed in the extreme short run. Given a 24-hour time frame, it would be difficult to change most costs. For example, terminating an employee generally requires severance pay that stops the cost from disappearing immediately.

On the other hand, all costs are variable in the extreme long run. Given a 40-year time frame, even multi-billion dollar plants can be retired and added.

Managerial accounting generally uses a time frame of one year for classification of a cost as fixed or variable.

Relevant Range

Given an infinite range of activity, no cost would be fixed. Let's consider depreciation of manufacturing facilities. If it takes one $2 billion-dollar plant to make 500,000 automobiles per year, then it will take two such plants to make 1,000,000, three such plants to make 1,500,000, and so on. No organization expects to operate over an infinite range of activity. If the above auto company expects "the relevant range" of demand for its vehicles to be between 1,300,000 and 1,500,000 vehicles, then it will attempt to operate with three plants, no more and no less. With $6 billion invested in plants, depreciation will be fixed for quite a few years, even though we are only interested in one year.

Keep in mind that different organizations have different relevant ranges. For example, Toyota and GM build more cars than BMW, so their relevant range would be much higher than BMW's relevant range. Also, because different organizations have different relevant ranges, a fixed cost for one organization can be a step cost for another. This will be more apparent when you cover the part of this presentation on step costs.

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Fixed vs. Variable Costs: Overview

The formula for a straight line comes from your math courses earlier in life and is used in your college statistics course when covering linear regression. This would be a great time to use Google to revisit the Cartesian plane. At the time this was prepared, one good place to go is "Line (geometry)" in Wikipedia.

The formula for a straight line utilizes the northeast quadrant of that Cartesian plane.

The formula is Y = a + bX, where  

• Y = the dependent variable, because its value depends on the value of the other variables in the equation. When graphing, the vertical axis is the Y-axis. In accounting, Y is usually monetary, representing either revenue or cost. Most often, in cost or managerial accounting, Y will be a cost.
• X = the independent variable, because it comes from outside the equation, meaning its value does not depend on any other values in the equation. X is a measure of activity. When graphing, the horizontal axis is the X-axis. In accounting, X is usually units sold where Y is revenue or units produced where Y is cost. However, X could be something else, such as miles driven, where Y is automobile operating cost. Most often, in cost or managerial accounting, X will be units produced.
• a = the intercept. It is the value of Y when X is zero. In accounting, it is the fixed cost portion of the equation.
• b = the slope, defined as rise divided by run or the change in Y over the change in X. It is the rate of change in Y as X changes. In accounting, it is the variable cost portion of the equation.

An overview of fixed, variable, mixed, and step cost is presented here. Examples are presented and discussed on the slides that follow.

A fixed cost is a cost that remains unchanged in total when activity changes. In terms of the equation Y = a + bX, it is the value of Y when X = zero, which is Y = a. The example we will cover shortly is straight-line depreciation on a factory building.

A variable cost is a cost that changes in total proportionally (linearly) as activity changes. In terms of the equation Y = a + bX, it is the value of Y when a = zero, which is Y = bX. The example we will cover shortly is direct material used in a product.

A mixed cost is a cost that is partially fixed and partially variable. In terms of the equation, it is the value of Y when both a and b exist, which is Y = a + bX. The example we will cover shortly is factory utilities. To use Excel to separate a mixed cost, see the article "Forecasting with Excel: Regression Analysis Can Help Predict Revenues and Costs" by James A. Weisel, Journal of Accountancy, February 2009, pp. 62–67.

A step cost (also known as step-variable or step-fixed) is a cost that varies in batches as activity changes. It does not fit into the equation presented, because it is not linear. The example we will cover shortly is salary for factory supervisors.

Fixed Cost

The graph in Figure 1.4 shows that straight-line deprecation of a factory building displays a fixed cost. The plant depreciation will remain at $20,000 during the next year regardless of the level of units produced. In terms of the equation for a straight line, Y = a = $20,000.

Variable Cost

The graph in Figure 1.5 shows that direct-material cost displays a variable cost. The direct-material cost changes proportionally with any change in the units produced. To change proportionally, the cost has to be linear, meaning it has to plot as a straight line. In terms of the equation for a straight line, Y = bX = $2X.

The variable cost is the slope of the blue line that is going up the graph, assuming you are looking at a color version of the graph. Slope is rise over run, and this comes from mathematics, not from accounting. We're simply using mathematics to do this plot. Note that the cost rises from $0 to $10,000 as the activity runs from 0 to 5,000 units. Rise over run is $\frac{\left(\$10,000-\$0\right)}{\left(5,000-0\right)}=\frac{\$10,000}{5,000}=\$2$ or $2 of cost rise for every 1 unit produced.

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Fixed vs. Variable Costs: Mixed and Step Costs

 

Mixed Costs

This graph of factory electricity shown in Figure 1.6 displays a mixed cost—a cost that is partially fixed and partially variable. The factory electricity costs $4,000 even when there is no activity. This might be the cost of heating and cooling the building and having the lights on, independent of production. In addition, the cost changes proportionally with any change in the units produced, which is the activity level. An additional $2 in electricity is used each time a unit is produced. In terms of the equation for a straight line, Y = a + bX = $4,000 + $2X.

You can easily divide a mixed cost into its fixed and variable components. For example, if you were doing a budget, and you wanted to divide this factory electricity into fixed and variable, you would say, "Fixed factory electricity is $4,000 and variable factory electricity is $2X or 2 times the number of units produced."  Once you have the formula for the mixed cost, it is easy to divide it into fixed and variable.

The hard part with the mixed cost is getting that formula. The utility company does not send you a bill saying, "You owe $9,500. $4,000 was fixed and $5,500 was variable."  No, it sends you a bill simply saying, "You owe $9,500."  You have to figure out how much is fixed and how much is variable. The good news is that it's easy to do that using the regression function within Excel. That is, you could take your last 12 utility bills and throw in the amount you paid for utilities (the Y values) and your volume of output (the X values). And Excel will estimate the a and b values for Y = a + bX.

You may not remember this from your statistics, but the problem is that if you only have only 12 data points, your estimates of a and b don't tend to be stable. Statisticians would tell you that you need about 60 data points. To get 60 data points, you would need 5 years of monthly electric bills. The problem with long periods of time is that the data may not be stable. That is, your electric rates may have changed during the last five years, so you're comparing apples and oranges, and that doesn't work well. As long as you realize you're probably going to end up using the last 12 months of electric bills to get values for a and b that are not perfect, and you can live with that imperfection, that's probably the way to go.

Step Costs

A step cost is a cost that increases after a batch of units. In this case, consider the example of factory supervisor salary (see Figure 1.7).

Let's assume one supervisor can supervise up to 10 workers. Supervisors cost $20,000 per year each. (I know this is a ridiculously low number.) Let's also assume that one worker can make 200 units per day.

If the company is going to make between 1 and 2,000 units, it is going to need between 1 and 10 employees. At this level, it is going to need one supervisor at a cost of $20,000. So, the line starts at $20,000 and goes out until it hits 2,000 units.

Once the company exceeds 2,000 units, it will need to hire more employees and, therefore, more supervisors. From 2001 to 4,000 units will require 11 to 20 employees and two supervisors at a total cost of $40,000. From 4001 to 6,000 units will require 21 to 30 employees and three supervisors at a total cost of $60,000.

The stair-step look of the graph is what gives this cost its name.

Now, what can you do with that step cost? There are a couple of ways to handle it, but any way you handle it, you have to break it down into fixed or variable cost. We will cover two ways.

One way, the simple way, to handle it is to have a relevant range that is on a single step. So, if production is expected to be between 4,000 and 6,000 units, then the organization needs three supervisors at a fixed cost of $60,000.

Often, a step cost cannot be converted into a fixed cost, because the relevant range cannot be restricted to one step. So, a second way to handle it is to draw a line starting at the minimum of $20,000 for one supervisor through the center of the remaining steps, and then use the slope of that line as the variable cost. What you end up doing is turning the step cost into a mixed cost. In this case, you only get the correct cost at the midpoint of each step. Below the midpoint of the step, you underestimate the cost and above the midpoint of the step you overestimate the cost.

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Fixed vs. Variable Costs: Classification Practice

Now you have an opportunity to practice what you've gone through to make sure you understand the concept.

Required: Classify each of the following costs as fixed, variable, mixed, or step with respect to the units of product produced.

1. Factory maintenance crew salaries

2. Factory electricity

3. Factory building straight-line depreciation

4. Factory machinery units-of-output depreciation

5. Factory supervisor's salaries

6. Factory land and building property taxes

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Introduction to 1e: Income Statement

This lesson discusses the income statement as used in managerial accounting. It requires an understanding of the distinction between variable and fixed cost.

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Learning Objectives

After completing this lesson, you should be able to

• differentiate between operating income used in managerial accounting and net income used in financial accounting; and
• recognize the traditional/Generally-Accepted-Accounting-Principles format of the income statement used in financial accounting and the contribution format income statement often used in managerial accounting.

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Lesson 1e: Operating Income vs. Net Income | Video

Unlike the lessons before this one, there is no text alternative to watching this less-than-3-minute video—you need to watch it.

Video 1.5: Operating Income vs Net Income.

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Lesson 1e: Contribution Margin vs. Gross Margin | Video

Again, there is no text alternative to watching this less-than-3-minute video—you need to watch it.

Video 1.6: Contribution Margin vs Gross Margin.

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Contribution Margin Versus Gross Margin and Operating Income Versus Net Income

As discussed in the video, contribution margin and gross margin represent two different ways to slice the same pie.

+ Figure 1.8. Text Description

Contribution margin

Revenues

− Variable costs

= Contribution margin

− Fixed operating costs

= Operating income

 

Financial accounting

Revenues

- Cost of goods sold

= Gross margin

− Operating expenses

= Operating income

Figure 1.8 presents the same operating income broken down two different ways.

Sometimes it is unclear to individuals how the accounting information used in managerial accounting is related to the accounting information used in financial accounting. One area where the connection is lost is in the constant use of operating income in managerial accounting. However, this concept of operating income is the same in financial accounting and managerial accounting as shown in the video and below.

Summary of the Income Statement Format Used in Financial Accounting

+ Figure 1.9 Text Description

Total revenues from operations
− Cost of goods sold
= Gross margin or gross profit
− Operating expenses (excluding income taxes which are deducted later)
= Income from operations (Operating income as shown above in managerial/cost accounting)
+ Nonoperating revenues (such as interest revenue)
− Nonoperating costs/expenses (such as interest expense)
= Income before income taxes in financial accounting
− Income taxes
= Income from continuing operations in financial accounting
± Discontinued operations
= Net Income in financial accounting

 

In managerial accounting, these non-operating items that can appear on the income statement are generally irrelevant to the decision at hand and, therefore, are ignored.

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Written Communication Guidance—Additional Points

Pay attention to examples in the textbook and in Canvas as most display good written communication. The additional guidance below can easily be verified by reviewing examples.

• For layout, use portrait when possible. Financial statements are almost always done in portrait. Use landscape when a table is too wide to fit portrait and be readable.
• Pennies on large numbers do not add useful information. Notice that most examples do not have pennies. If the information given is in dollars, that is a strong indication that the pennies do not matter.
• Avoid partial pennies in most cases. Obviously, with small numbers, like 0.40 per unit or 2.65 per equivalent unit, pennies do add useful information and you should show them. But, if you say the item cost 10.654, that last digit does not add useful information and an accountant cannot record that partial penny in a journal entry.
• Right justify numbers. This makes it easier to read.
• Use comma separators on amounts 1,000 or greater. This makes it easier to read.
• Brackets are superior to minus. This makes it easier to read. Sometimes minus done by words instead of brackets or a minus sign. For example, when you say "deduct": Ending merchandise inventory, the word "deduct" removes the need for the brackets or minus sign.

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