Answers to Study Questions for Chapter 2 1. 2.

The three major elements of product costs in a manufacturing company are direct materials, direct labor, and manufacturing overhead. a. Direct materials are an integral part of a finished product and their costs can be conveniently traced to it. b. Indirect materials are generally small items of material such as glue and nails. They may be an integral part of a finished product but their costs can be traced to the product only at great cost or inconvenience. c. Direct labor consists of labor costs that can be easily traced to particular products. Direct labor is also called touch labor. d. Indirect labor consists of the labor costs of janitors, supervisors, materials handlers, and other factory workers that cannot be conveniently traced to particular products. These labor costs are incurred to support production, but the workers involved do not directly work on the product. e. Manufacturing overhead includes all manufacturing costs except direct materials and direct labor. Consequently, manufacturing overhead includes indirect materials and indirect labor as well as other manufacturing costs. A product cost is any cost involved in purchasing or manufacturing goods. In the case of manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead. A period cost is a cost that is taken directly to the income statement as an expense in the period in which it is incurred. a. Variable cost: The variable cost per unit is constant, but total variable cost changes in direct proportion to changes in volume. b. Fixed cost: The total fixed cost is constant within the relevant range. The average fixed cost per unit varies inversely with changes in volume. c. Mixed cost: A mixed cost contains both variable and fixed cost elements. a. b. c. d. Unit fixed costs decrease as volume increases. Unit variable costs remain constant as volume increases. Total fixed costs remain constant as volume increases. Total variable costs increase as volume increases.

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a. Cost behavior: Cost behavior refers to the way in which costs change in response to changes in a measure of activity such as sales volume, production volume, or orders processed. b. Relevant range: The relevant range is the range of activity within which assumptions about variable and fixed cost behavior are valid. An activity base is a measure of whatever causes the incurrence of a variable cost. Examples of activity bases include units produced, units sold, letters typed, beds in a hospital, meals served in a cafe, service calls made, etc. The linear assumption is reasonably valid providing that the cost formula is used only within the relevant range. A discretionary fixed cost has a fairly short planning horizonusually a year. Such costs arise from annual decisions by management to spend on certain fixed cost items, such as advertising, research, and management development. A committed fixed cost has a long planning horizongenerally many years. Such costs relate to a companys investment in facilities, equipment, and basic organization. Once such costs have been incurred, they are locked in for many years.

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Yes. As the anticipated level of activity changes, the level of fixed costs needed to support operations may also change. Most fixed costs are adjusted upward and downward in large steps, rather than being absolutely fixed at one level for all ranges of activity. The high-low method uses only two points to determine a cost formula. These two points are likely to be less than typical because they represent extremes of activity. The formula for a mixed cost is Y = a + bX. In cost analysis, the a term represents the fixed cost and the b term represents the variable cost per unit of activity. The contribution approach income statement organizes costs by behavior, first deducting variable expenses to obtain contribution margin, and then deducting fixed expenses to obtain net operating income. The traditional approach organizes costs by function, such as production, selling, and administration. Within a functional area, fixed and variable costs are intermingled. The contribution margin is total sales revenue less total variable expenses. A differential cost is a cost that differs between alternatives in a decision. An opportunity cost is the potential benefit that is given up when one alternative is selected over another. A sunk cost is a cost that has already been incurred and cannot be altered by any decision taken now or in the future. No, differential costs can be either variable or fixed. For example, the alternatives might consist of purchasing one machine rather than another to make a product. The difference between the fixed costs of purchasing the two machines is a differential cost. B) Fixed costs expressed on a per unit basis will decrease with increases in activity Total fixed cost is not dependent upon activity; it remains unchanged as activity increases or decreases. If, however, a fixed cost is put a per unit basis the cost is spread over the number of units produced. As production increases, each unit will carry less fixed costs. If production decreases, each unit will carry more fixed cost.

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B) The costs of staffing and operating the accounting department at Central Hospital would be considered by the Department of Surgery to be an indirect cost. Indirect costs are those costs that are not easily traced to the specific cost object.

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C) A cost incurred in the past that is not relevant to any current decision is classified as a sunk cost. A sunk cost is a cost that has been incurred and nothing can be done to change it. A sunk cost is not a relevant cost in decision making. It is a cost that is ignored when making decisions. A). As the level of activity increases, mixed cost will increase in total (due to the variable cost element in mixed costs) and decrease per unit (due to the fixed cost element in mixed cost). B). Since Anytime Pizza is open 24 hours a day, its pizza oven is constantly on and is, therefore, always using natural gas. However, when there is no pizza in the oven, the oven automatically lowers its flame and reduces its natural gas usage by 70%. The cost of natural gas would best be described as a mixed cost. The fixed portion is the constant cost at 70% usage, the variable portion is the amount of gas used above the 70%.

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B). Fixed costs will increase on a per unit basis when activity decreases (less units to spread the fixed cost over). Variable cost behave on a per unit basis, hence, they will remain unchanged. B). Identify the Fixed cost first. The fixed costs are the costs that do not change when activity changes. Cost X is a fixed cost it is $5000 at 100 units and $5000 at 140 units. Next, identify the variable cost. Variable costs do not change on a per unit basis, so put the remaining costs on a per unit basis to see if the cost per unit changes as activity changes. Cost W is $80 per unit at 100 units and $75.43 per unit at 140 units. It is a mixed cost Cost Y is $65 per unit at 100 units and $65 per unit units at 140 units. It is a variable cost. Cost Z is $67 per unit at 100 units and $61.29 per unit at 140 units. It is a mixed cost. Do not put cost X on a per unit basis since we already know it is a fixed cost. If we put fixed cost on a per unit basis we might think it is a mixed cost. A). Both the high-low method and Least-squares method can be used to analyze mixed costs. Both methods will provide a linear equation that estimates mixed costs.

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Find Variable Cost: X High 5500 Low 5000 change 500 HIGH Y= 91,87 5 91,87 5 85,00 0

Y $91,875 91,250 $625

Change Y Change X

$625 500

$1.25

The plug into either the high or the low to determine Fixed Costs a a a a + b X + 1.25 (5500) + 6875 LOW Y= 91,250 91,250 85,00 0 a + a a a b X + 1.25 (5000) + 6250

Cost Equation: Y = $85,000 + 1.25X 26. The High-low method needs total costs. The first thing to do is to put the costs into total costs: Year Miles Cost per mile Total Cost driven 20A 18,000 High $1.15 $20,700 20D 15,000 Low 1.20 18,000 Then separate out the variable and fixed cost using the high-low method. Find Variable Cost: X High 18,000 Low 15,000 change 3,000 Y $20,700 $18,000 $2,700

Change Y Change X

$2,700 3,000

$0.90

The plug into either the high or the low to determine Fixed Costs

HIGH Y= $20,7 00 20,70 0 4,500

b X + (18,000 a 0.90 ) + a 16,200 a

LOW Y= $18,00 0 18,000 4,500

a a a a

b X + (15,000 0.90 ) + 13500

Cost Equation: Y = $4,500 + 0.9X 27. Y = 4,500 + .9(16,000) Y = 4,500 + 14,400 Y = $18,900 Determine number of units sold: Sales/unit sales price = units sold $1,820,000/$182 per unit = 10,000 units sold Cost of goods sold (all variable) per unit = $1,000,000/10,000 units = $100 per unit Selling expenses are mixed: Variable cost per unit $3.00 (given) Fixed cost = Total cost total variable cost Fixed cost = $355,000 ($3 x 10,000 units) Fixed cost = $325,000 Administrative expenses are mixed (10%/90%) Total $300,000 x .9 = $270,000 fixed cost Total $300,000 x .1 = $30,000 total variable Total variable $30,000/10,000 units = $3 per unit KELR, Inc. Income Statement For the Quarter Ended June 30th $1,820,00 0 1,060,0 00 106.00 760,0 Contribution margin 00 76.00 595,0 Less fixed expenses ($325,000 + $270,000) 00 Net operating income 165,00 0 Unit contribution margin x increase in unit sales = increase in net operating income. $76 x 100 units = $7,600 increase in NOI Sales (10,000 units) Less variable expenses ($100 + $3.00 + $3.00 per unit) Unit $182.0 0

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