Further Classification of Labor Costs:

Learning Objective of the Article:

1. Properly classify labor costs associated with idle time, overtime and fringe benefits.
   Idle time, overtime, and fringe benefits associated with direct labor workers pose particular problems in accounting for labor costs. Are these costs a part of the costs of direct labor or are they something else?
2. Idle Time
3. Overtime
4. Fringe Benefits

Idle Time:

Machine beak downs, materials shortages, power failure, and the like result in idle time. The labor costs incurred during idle time are ordinarily treated as manufacturing overhead cost rather than as a direct labor cost. Most managers feel that such costs should be spread over all the production of a period rather than just the jobs that happen to be in process when breakdown or other disruptions occur.

Example:

To give an example of how the cost of idle time is handled, assume that a press operator earns $12 per hour. If the press operator is paid for a normal 40-hour workweek but is idle for 3 hours during a given week due to breakdowns, labor cost would be allocated as follows.

Direct labor $12 per hour × 37 hours) Manufacturing overhead (idle time: $12 per hour × 3 hours) Total cost for the week

$444     36 ----- $480 ====

Overtime Premium:

The overtime premium paid to all factory workers (direct labor as well as indirect labor) is usually considered to be part of manufacturing overhead and is not assigned to any particular order. At first glance this may seem strange, since overtime is always spent working on some particular order. Why not charge that order for the overtime cost? The reason is that it would be considered unfair and arbitrary to charge an overtime premium against a particular order simply because the order happened to fall on the tail end of the daily production schedule.

Example:

Assume that a press operator in a plant earns $12 per hour. she is paid time and half for over time (time in excess of 40 hours a week). During a given week, she worked 45 hours and has no idle time. Her labor cost would be allocated as follows:

Direct labor ($12 × 45 hours) Manufacturing overhead (overtime premium: $6 per hour × 5 hours) Total Cost for the week

$540    30 ----- $570 ====

Observe from this computation that only the overtime premium of $6 per hour is charged to overhead account--not the entire $18 earned for each hour of overtime work ($12 regular rate × 1.5 = $18)

Labor Fringe Benefits:

Labor fringe benefits are made up of employment-related costs paid by the employer and include the cost of insurance programs, retirement plans, various supplemental unemployment benefits, and hospitalization plans. The employer also pays employer's share of Social Security, Medicare, workers' commission, federal employment tax, and state unemployment insurance. These costs often add up to as much as 30% to 40% of base pay.

Many firms treat all such costs as indirect labor by adding them in total to manufacturing overhead. Other firms treat the portion of fringe benefits that relates to indirect labor as additional direct labor cost. This approach is conceptually superior, since the fringe benefits provide to direct labor workers clearly represent an added cost of their service. 

1. 
   

International Aspects of Quality-ISO 9000 Quality Standards:

Many of the tools used in quality management today were developed in Japan after World War II. In statistical process control, Japanese companies borrowed heavily from the work of Edwards Deming, However, Japanese companies are largely responsible for quality circles, JIT, the idea the the quality is everyone's responsibility, and the emphasis on prevention rather than on inspecti
In 1980s, quality reemerged as a pivotal factor in the market. Many companies find that it is impossible to effectively compete without a very strong quality program in place. This is particularly true of companies that wish to compete in the European market.

The ISO 9000 Standards:

The International standards Organization (ISO), based in Geneva, Switzerland, has established quality control guidelines known as the ISO 9000 standards. Many companies and organizations in Europe will buy only from ISO 9000 standard certified suppliers. This means that the suppliers must demonstrate to a certifying agency that:

1. A quality system is in use, and the system clearly defines an expected level of quality
2. The system is fully operational and is backed up with detailed documentation of quality control procedures.
3. The intended level of quality is being achieved on a sustained, consistent basis.

The key to receiving certification under the ISO 9000 standard is documentation. It's one thing for a company to say that is has a quality control system in operation, but it's quite a different thing to be able to document the steps in that system. Under ISO 9000, this documentation must be so detailed and precise that if all the employees in a company were suddenly replaced, the new employees could use the documentation to make the product exactly as it was made by the old employees. Even companies with good quality control system find that it takes up to two years of painstaking work to develop this detailed documentation. But companies often find that compiling this documentation results in improvements in their quality system.

The ISO 9000 has become an international measure of quality, Although the standards were developed to control the quality of goods sold in European countries, they have become widely accepted elsewhere as well. Companies in the United States that export to Europe often expect their own suppliers to comply with the ISO 9000 standards, since these exporters must document the quality of the materials going into their products as a part of their own ISO 9000 certification.

The ISO program for certification of quality management programs is not limited to manufacturing companies. The American Institute of Certified Public Accountants was the first professional membership organization in the United States to win recognition under an ISO certification program.

Real Business Example: How ISO 9000 can Improve Quality:
Over the years, E. I. du Pont de Nemours & Company has been a leader in quality control systems. Despite this emphasis on quality, for many years the engineers at one of Du Pont's plants were unable to control a high defect rate in the output from a press that makes plastic connectors for computers. As part of the documentation needed for certification under the ISO 9000 standards, workers on the press were required to detail in writing how they do their jobs. When engineers compared the workers' notes, they fond that the workers were in consistent in the way they calibrated probes that measure press temperature. As a result, the press temperature were often set incorrectly. When this problem was corrected, the defect rate for the press fell from 30% to 8% of output.

Distribution of Quality Costs/Quality Cost Report:

Learning Objectives:

1. Prepare and interpret a quality cost report.

   How to Distribute Quality Costs?

   A company's total quality cost is likely to be very high unless management gives this area special attention. Experts say that these costs should be more in 2% to 4% range. How does a company reduces its total quality cost? The answer lies in how the quality costs are distributed. Total quality cost is a function of quality of conformance. A high quality of conformance means that a product is free of defects and a low quality of conformance means that a product has defects. In this sense an economy car may have a quality of conformance same as a very expensive car if it has no defects. Like wise an  expensive car may have less quality of conformance if it has defects that effect its use. When the quality of conformance is low, total quality cost is high and most of this cost consists of cost of internal and external failure. A low quality of conformance means that a high percentage of units is defective and hence the company must incur high failure costs. However, as a company spends more and more on prevention and appraisal activities, the percentage of defective units drops. This results in lower costs of internal and external failure costs. Ordinarily total quality cost drops rapidly as the quality of conformance increases.
   Thus, a company can reduce its total quality cost by focusing its efforts on prevention and appraisal. The cost savings from reduced defects usually swamp the costs of the additional prevention and appraisal efforts.
   As a company's quality program becomes more refined and as its failure costs begin to fall, prevention activities usually become more effective than appraisal activities. Appraisal can only find defects, whereas prevention can eliminate them. The best way to prevent defects from happening is to design processes that reduce the likelihood of defects and to continually monitor processes using statistical process control methods.

   Quality Cost Report:

   A quality cost report details the prevention costs, appraisal costs, and internal failure cost and external failure cost that arise from company's current level of defective products or services. Companies often construct a quality cost report that provides an estimate of the financial consequences of the company's current level of defects. A simple quality cost report is shown in the following example:

   Example of Quality Cost Report

   Ventura Company
   Quality Cost Report
   For the Year1 & 2
    

   Prevention Cost Appraisal Costs Internal Failure Costs External Failure Costs Total Quality Cost	Year 2		Year 1
   	Amount 1,000,000 1,500,000 3,000,000 2,000,000 ----------- 7,500,000 ======	Percent 2.00% 3.00% 6.00% 4.00% --------- 15.00% =====	Amount 650,000 1,200,000 2,000,000 5,150,000 ---------- 9,000,000 ======	Percent 1.30% 2.40% 4.00% 10.30% --------- 18.00% =====

   Prevention cost increased by (1,000,000 – 650,000) = 350,000
   Appraisal cost increased by (1,500,000 – 1,200,000) = 300,000
   Internal Failure cost (3,000,000 – 2,000,000) = 1,000,000
   Total Increase = 1,650,000
   External failure cost decreased by = 3,150,000
   Net Quality Cost Benefit = 3,150,000 – 1,650,000
   = 1,500,000
   Several things should be noted from the data in the quality cost report. First, note that the quality costs are poorly distributed in both years, with most of costs being traceable to either internal or external failure. The external failure costs are particularly high in year 1 in comparison to other costs. Second note that the company increased its spending on prevention and appraisal activities in year 2. As a result, internal failure costs went up in that year (from $2 million in first year to $3 million in year 2), but external failure costs dropped sharply (from $5.15 million in year 1 to $3 million in year 2). Because of the increase in appraisal activates in year 2,more defects were caught inside the company before they were shipped to the customers. This resulted in more cost for scrap, rework, and so forth, but saved huge amounts in warranty repairs, warranty replacements, and external failure costs. Third, note that as a result of greater emphasis on prevention and appraisal, total quality cost decreased inyear2.As continued emphasis is placed on prevention and appraisal in future years, total quality cost should continue to decrease. That is , future increases in prevention and appraisal costs should be more than offset by decreases in failure costs. Moreover, appraisal costs should also decrease as more effort is placed into prevention.
    

Quality Costs:

Learning objective of the article:

1. Identify the four types of quality costs and explain how they interact.

2. Definition and Explanation of Quality Costs:

   A product that meets or exceeds its design specifications and is free of defects that mar its appearance or degrade its performance is said to have high quality of conformance. Note that if an economy car is free of defects, it can have a quality of conformance that is just as high as defect-free luxury car. The purchasers of economy cars cannot expect their cars to be as opulently as luxury cars, but they can and do expect to be free of defects.
   Preventing, detecting and dealing with defects cause costs that are called quality costs or costs of quality. The use of the term "quality cost" is confusing to some people. It does not refer to costs such as using a higher grade leather to make a wallet or using 14K gold instead of gold plating in jewelry. Instead the term quality cost refers to all of the costs that are incurred to prevent defects or that result from defects in products.
   Quality costs can be broken down into four broad groups. These four groups are also termed as four (4) types of quality costs. Two of these groups are known as prevention costs and appraisal costs. These are incurred in an effort to keep defective products from falling into the hands of customers. The other two groups of costs are known as internal failure costs and external failure costs. Internal and external failure costs are incurred because defects are produced despite efforts to prevent them therefore these costs are also known as costs of poor quality.
   The quality costs do not just relate to just manufacturing; rather, they relate to all the activities in a company from initial research and development (R & D) through customer service. Total quality cost can be quite high unless management gives this area special attention.
   Four types of quality cost are briefly explained below:

   Prevention Costs:

   Generally the most effective way to manage quality costs is to avoid having defects in the first place. It is much less costly to prevent a problem from ever happening than it is to find and correct the problem after it has occurred. Prevention costs support activities whose purpose is to reduce the number of defects. Companies employ many techniques to prevent defects for example statistical process control, quality engineering, training, and a variety of tools from total quality management (TQM).
   Prevention costs include activities relating to quality circles and statistical process control. Quality circles consist of small groups of employees that meet on a regular basis to discuss ways to improve quality. Both management and workers are included in these circles.
   Statistical process control is a technique that is used to detect whether a process is in or out of control. An out of control process results in defective units and may be caused by a miscalibrated machine or some other factor. In statistical process control, workers use charts to monitor the quality of units that pass through their workstations. With these charts, workers can quickly spot processes that are out of control and that are creating defects. Problems can be immediately corrected and further defects prevented rather than waiting for an inspector to catch the defect later.
   Some companies provide technical support to their suppliers as a way of preventing defects. Particularly in just in time (JIT) systems, such support to suppliers is vital. In a JIT system, parts are delivered from suppliers just in time and in just the correct quantity to fill customer orders. There are no stockpiles of parts. If a defective part is received from a supplier, the part cannot be used and the order for the ultimate customer cannot be filled in time. Hence every part received from suppliers must be free from defects. Consequently, companies that use just in time (JIT) often require that their supplier use sophisticated quality control programs such as statistical process control and that their suppliers certify that they will deliver parts and materials that are free of defects.

   Appraisal Costs:

   Any defective parts and products should be caught as early as possible in the production process. Appraisal costs, which are sometimes called inspection costs, are incurred to identify defective products before the products are shipped to customers. Unfortunately performing appraisal activates doesn't keep defects from happening again and most managers realize now that maintaining an army of inspectors is a costly and ineffective approach to quality control.
   Employees are increasingly being asked to be responsible for their own quality control. This approach along with designing products to be easy to manufacture properly, allows quality to be built into products rather than relying on inspections to get the defects out.

   Internal failure Costs:

   Failure costs are incurred when a product fails to conform to its design specifications. Failure costs can be either internal or external. Internal failure costs result from identification of defects before they are shipped to customers. These costs include scrap, rejected products, reworking of defective units, and downtime caused by quality problem. The more effective a company's appraisal activities the greater the chance of catching defects internally and the greater the level of internal failure costs. This is the price that is paid to avoid incurring external failure costs, which can be devastating.

   External Failure Costs:

   When a defective product is delivered to customer, external failure cost is the result. External failure costs include warranty, repairs and replacements, product recalls, liability arising from legal actions against a company, and lost sales arising from a reputation for poor quality. Such costs can decimate profits.
   In the past, some managers have taken the attitude, "Let's go ahead and ship everything to customers, and we'll take care of any problems under the warranty." This attitude generally results in high external failure costs, customer ill will, and declining market share and profits.
   External failure costs usually give rise to another intangible cost. These intangible costs are hidden costs that involve the company's image. They can be three or four times greater than tangible costs. Missing a deadline or other quality problems can be intangible costs of quality.
   Internal failure costs, external failure costs and intangible costs that impair the goodwill of the company occur due to a poor quality so these costs are also known as costs of poor quality by some persons.

   Examples of four types of quality cost are given below:

   Prevention Costs	Internal Failure Costs
   Systems development Quality engineering Quality training Quality circles statistical process control Supervision of prevention activities Quality data gathering, analysis, and reporting Quality improvement projects Technical support provided to suppliers Audits of the effectiveness of the quality system	Net cost of scrap Net cost of spoilage Rework labor and overhead Re-inspection of reworked products Retesting of reworked products Downtime caused by quality problems Disposal of defective products Analysis of the cause of defects in production Re-entering data because of keying errors Debugging software errors
   Appraisal Costs	External Failure Costs
   Test and inspection of incoming materials Test and inspection of in-process goods Final product testing and inspection Supplies used in testing and inspection Supervision of testing and inspection activities Depreciation of test equipment Maintenance of test equipment Plant utilities in the inspection area Field testing and appraisal at customer site	Cost of field servicing and handling complaints Warranty repairs and replacements Repairs and replacements beyond the warranty period Product recalls Liability arising from defective products Returns and allowances arising from quality problems Lost sales arising from a reputation for poor quality.

   Real Business Example: SIMPLE SOLUTION:
   Very simple and inexpensive procedures can be followed to prevent defects. Yamada Electric Company had a persistent problem assembling a simple push button switch. The switch has two buttons, an on button and an off button, with a small spring under each button. Assembly is very simple. A worker inserts the small spring in the device and then installs the buttons. However the workers some time forget to put in one of the springs. When the customers discover such a defective switch in a shipment from Yamada, an inspector has to be sent to the customer's plan to check every switch in the shipment. After each such incident, workers are urged to be more careful, and for a while quality improves. But eventually, someone forgets to put in a spring, and Yamada gets into trouble with the customers again. This chronic problem was very embarrassing to Yamada.
   Shigeo Shingo, an expert on quality control, suggested a very simple solution. A small dish was placed next to the assembly station. At the beginning of each operation, two of the small springs are taken out of a parts box containing hundreds of springs and placed in the dish. The worker then assembles the switch. If a spring remains on the dish after assembling the switch, the worker immediately realizes a spring has been left out, and the switch is reassembled. This simple change in procedures completely eliminated the problem.
   Source: Shigeo Shingo and Dr. Alan Robinson, editor-in-chief, Modern Approaches to Manufacturing Improvement: The Shingo System, (Cambridge, MA: Productivity Press, 1990), 
   

Cost Classification for Decision Making or Decision Making Costs:

Learning objective of the article:
Define, explain, and give examples of cost classifications used in making decisions: differential costs, opportunity costs, and sunk cost

Costs can be classified for decision making. Costs are important feature of many business decisions. For the purpose of decision making, costs are usually classified as differential cost, opportunity cost, and sunk cost. It is essential to have a firm grasp of the concepts differential cost & differential revenue, opportunity cost, and sunk cost.

Differential Cost and Differential Revenue:

Definition and Explanation of Differential Cost and Differential Revenue:

Decisions involve choosing between alternatives. In business, each alternative will have certain costs and benefits that must be compared to the costs and benefits of the other available alternatives. A difference in cost between any two alternatives is known as differential cost. A difference in revenue between any two alternatives is known as differential revenues. Differential cost includes both cost increase (incremental cost) and cost decrease (decremental cost). In general the difference (cost and revenue) between alternatives are relevant in decision making. Those items that are the same under all alternatives can be ignored.

The accountant's differential cost concept can be compared to the economist's marginal cost concept. In speaking of changes in cost and revenue, the economists employ the term marginal cost and marginal revenue. The revenue that can be obtained from selling one more unit of product is called marginal revenue, and the cost involved in producing one more unit of a product is called marginal cost. The economists marginal cost is basically the same as the accountant's differential concept applied to a single unit of out put.

Example:

Differential cost can be either variable or fixed. To illustrate assume that a company is thinking about changing its marketing method from distribution through retailers to distribution by door to door direct sale. Present cost and revenues are compared to projected costs and revenues in the following table.

Description	Retailer Distribution (Present)	Direct Sale Distribution (Proposed)	Differential Costs and Revenues
Revenue (variable)	$700,000	$800,000	$100,000
	---------	---------	---------
Cost of goods sold (V)	350,000	400,000	50,000
Advertising (V)	80,000	45,000	(35000)
Commissions (F)*	-0-	40,000	40,000
Warehouse depreciation (V)**	50,000	80,000	30,000
Other Expenses (F)	60,000	60,000	-0-
	----------	----------	----------
Total	540,000	625,000	85,000
	----------	----------	----------
Net Operating Income	$160,000	$175,000	$15,000
	=======	=======	=======
*F = Fixed **V = Variable

According to the above analysis, the differential revenue is $100,000 and the differential cost is $85,000,leaving a positive differential net operating income of $15,000 under the proposed marketing plan. The net operating income under the present distribution is $160,000, whereas the net operating income under door to door direct selling is estimated to be $175,000. Therefore the door to door direct distribution method is preferred, since it would result in $15,000 higher net operating income. Note that we would have arrive at exactly the same conclusion by simply focusing on the differential revenue, differential cost, and differential net operating income, which also shows a net operating advantage of $15,000 for the direct selling method. The company can ignore other expenses of $60,000. Because it has no effect on the decision. If it were removed from the calculation, the door to door selling method would still be preferred by $15,000. This is an extremely important principle in management accounting.

In Business: Using Those Empty Seats Many corporate jets fly with only one or two executives on board. Priscilla Blum wondered why some of the empty seats could not be used to fly cancer patients who specialized treatment outside their home area. Flying on a regular commercial airline can be an expensive and grueling experience for cancer patients. Taking the initiative, she helped found the Corporate Angle Network, an organization that arranges free flights on some 1,500 jets from over 500 companies. Since the jets fly anyway, filling a seat with cancer patient does not involve any significant incremental cost for the companies that donate the service. Since its founding in 1981, the Corporate Angel Network has arranged over 14,000 free flights. Source: Scott McCormack, "Waste not," Forbes, July 26, 1999, p. 118.

Opportunity Cost:

Definition:

Opportunity cost is the potential benefit that is given up when one alternative is selected over another. To illustrate this important concept, consider the following examples:

Example 1:

Vicki has a part-time job that pays her $200 per week while attending college. She would like to spend a week at the beach during spring break, and her employer has agreed to give her the time off, but without pay. The $200 in lost wages would be an opportunity cost of taking week off to be at the beach.

Example 2:

Suppose that Neiman Marcus is considering investing a large sum of money in land that may be a site for future store. Rather than invest the funds in land, the company could invest the funds in high-grade securities. If the land is acquired, the opportunity cost will be the investment income that could have been realized if the securities had been purchased instead.

Example 3:

You are employed in a company that pays you $30,000 per year. You are thinking about leaving the company and returning to school. Since returning to school would require that you give up $30,000 salary. The forgone salary would be an opportunity cost of seeking further education.

Opportunity cost is not usually entered in the accounting records of an organization, but it is a cost that must be explicitly considered in every decision a manager makes. Virtually every alternative has some opportunity cost attached to it.

Sunk Cost:

Definition:

A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in future.

Example:

Sunk costs cannot be changed by any decision. These are not differential costs and should be ignored in decision making. To illustrate a sunk cost, assume that a company paid $50,000 several years ago for a special purpose machine. The machine was used to make a product that is now obsolete and is no longer being sold. Even though in hindsight the purchase of the machine may have been unwise, no amount of regret can undo that decision. And it would be folly to continue making the obsolete product to recover the original cost of the machine. In short, the $50,000 originally paid for the machine has already been incurred and cannot be differential cost in any future decision. For this reason, such costs are said to be sunk costs and should be ignored in decision making.

Cost Classifications for Assigning Costs to Cost Objects (Direct and Indirect Cost):

Learning Objective of the article:

1. Define and explain direct and indirect cost. Give examples of direct and indirect costs.
2. What is the difference between direct and indirect cost.

3. Definition of Cost Object?

   Costs are assigned to objects for a variety of purposes including pricing, profitability studies, and control of spending. A cost object is any thing for which cost data are desired including products, product lines, customers, jobs, and organizational subunits. For the purpose of assigning costs to cost objects, costs are classified as direct cost and indirect cost.
   

   Direct Cost:

   Definition and explanation of direct cost:

   A direct cost is a cost that can be easily and conveniently traced to the particular cost object under consideration. A cost object is any thing for which cost data is required including products, customers jobs and organizational subunits. For example, if a company is assigning costs to its various regional and national sales offices, then the salary of the sales manager in its Tokyo office would be a direct cost of that office.
   

   Indirect Cost:

   Definition and explanation of indirect cost:

   An indirect cost is a cost that cannot be easily and conveniently traced to the particular cost object under consideration. For example a soup factory may produce dozens of verities of canned soups. The factory manager's salary would be an indirect cost of a particular verity such as chicken noodle soup. The reason is that the factory manager's salary is not caused by any one variety of soup. To be traced to a cost object such as a particular product, the cost must be caused by the cost object. This salary of manger is called common cost of producing the various products of the factory. A common cost is a cost that is incurred to support a number of costing objects but cannot be traced to them individually. A common cost is a particular type of indirect cost.
   A particular cost may be direct or indirect, depending on the cost object. While, in the above example, the soup factory manager's salary is an indirect cost of manufacturing chicken noodle soup, it is a direct cost of the manufacturing division. In the first case, the cost object is the chicken noodle soup product. In the second case, the cost object is the entire manufacturing division.
    

Definition and explanation of mixed or semi variable cost:

A mixed cost is one that contains both variable and fixed cost elements. Mixed cost is also known as semi variable cost. Examples of mixed costs include electricity and telephone bills. A portion of these expenses are usually consists line rent. Line rent normally is fixed for each month. Variable portion consists units consumed or calls made. The relationship between mixed cost and level of activity can be expressed by the following equation.

Y = a + bX

In this equation,

• Y = The total mixed cost
• a = The total fixed cost
• b = The variable cost per unit
• X = The level of activity

The equation makes it very easy to calculate what the total mixed cost would be for any level of activity within the relevant range For example, Suppose that the company expects to produce 800 units and company has to pay a fixed cost of $25,000 and a variable manufacturing cost is $3.00 per unit. The total mixed cost would be calculated as follows:

Y = a + bX
Y = $25,000 + ($3.00 × 800 units)
= $27,400

A characteristic of mixed cost that needs to be understood is that we usually have to separate fixed and variable components of the total mixed cost.

The analysis of mixed costs:

In practice the mixed costs are very common. For example the cost of providing X-ray services to patients is a mixed cost. There are substantial fixed costs for equipment depreciation and for salaries for radiologist and technicians, but there are also variable costs for X-ray film, power and supplies. Maintenance costs of machineries and plants are also mixed costs. Companies incur costs for renting maintenance facilities and for keeping skilled mechanics on the payroll, but the costs of replacement parts, lubricating oil, tires, and so forth are variable with respect to how often and how far the machineries and plants are used.

The fixed portion of the mixed cost represents the basic, minimum cost of just having a service available for use. The variable portion represents the cost incurred for actual consumption of the service. The variable element varies in proportion to the amount of service that is consumed .

High and Low Point Method- Separation of Fixed and Variable Components of Mixed or Semi-variable Cost:

The fixed and variable elements of a mixed cost can be estimated by using high and low point method. To analyze mixed costs with the high and low point method, we begin by identifying the period with the lowest level activity and the period with the highest level of activity. The period with lowest level of activity is selected as first point and the period with the highest activity is selected as the second point. Consequently the formula becomes:

Variable Costs = (Y2 − Y1) ÷ (X2 − X1)

• Y2 = Cost at the high level of activity
• Y1 = Cost at the low level of activity
• X1 = High activity level
• X2 = Low activity level

Formula can also be written as:

Variable cost = Change in cost / Change in activity

Therefore, when high and low point method is used, the variable cost is estimated by dividing the difference in cost between the high and low activity levels by the change in activity between those two points. We can apply high and low point method on the following data to spare fixed and variable costs.

Month	Activity Level: (Hours Worked)	Mixed Cost (Maintenance Cost)
January February March April May June July	5,600 7,100 5,000 6,500 7,300 8,000 6,200	$7,900 8,500 7,400 8,200 9,100 9,800 7,800

Using the high and low point method we first identify the period with the highest and lowest activity-in the following data June and March. We then use the activity and cost data from these two periods to estimate the variable cost component as follows:

Activity Levels	Patient	Maintenance Cost
High activity level (June) Low activity level (March)	8,000 5,000	$9,800 7,400

Variable Cost = Change in Cost / Change in Activity

$2,400 / 3,000 hours

= $ 0.80 Per hour

Variable rate is $0.80 per unit according to above calculation under high and low point method. We can now determine the amount of fixed cost as follows:

Fixed cost element = Total cost − variable cost element
$9,800 − ($0.80 per unit × 8,000 hours)

= $3,400

Both the elements, variable and fixed , have now been isolated. The cost of maintenance can now be expressed as $3,400 per month plus $0.80 per hour. The cost of maintenance can also be expressed in terms of the equation for a straight line as follows:

Y = $3,400 + $0.80X

Some times the high and low levels of activity don't coincide with the high and low amounts of cost. For example, the period that has the highest level of activity may not have the highest amount of cost. Nevertheless, the highest and lowest levels of activity are always used to analyze a mixed cost under the high and low point method. the reason is that the analyst would like to use data that reflect the greatest possible variation in activity.

Limitations / Disadvantages of High and Low Point Method:

The high and low point method is easy to apply and its simplicity is its main advantage, but it suffers from a major defect. It utilizes only two points and generally two points are not enough to produce accurate results in cost analysis work. Additionally, Periods in which the activity level is unusually low or unusually high will tend to produce inaccurate results. A cost formula that is estimated solely using data from these unusual periods may seriously misrepresent the true cost relationship that holds during normal periods.

Cost Classifications for Predicting Cost Behavior (Variable and Fixed Cost):

Learning objectives of the article:

1. Define and explain variable cost and fixed cost. Give examples of variable and fixed costs.
2. What is the difference between variable and fixed cost.
3. What are the types of variable and fixed costs.

4. Definition of cost behavior:

   Cost behavior refers to how a cost will react or respond to changes in the level of business activity. As the level of activity rises and falls, a particular cost may rise and fall as well--or it may remain constant. Quite frequently, it is necessary to predict how a certain cost will behave in response to a change in activity. For planning purposes, a manager must be able to anticipate which of these will happen; and if a cost can be expected to change, the manager must know by how much it will change. To help make such distinctions, costs are often characterized as variable or fixed.
   

   Variable Cost:

   Definition and Explanation:

   A variable cost is a cost that varies, in total, in direct proportion to changes in the level of activity. The activity can be expressed in many ways, Such as units produced, units sold, miles driven, beds occupied, hours worked and so forth. Direct material is a good example of variable cost.
   
   The cost of direct materials will vary in direct proportions to the number of units produced. When we speak the term variable cost we mean that the total cost rises and falls as the activity rises and falls. One interesting aspect of variable cost is that a variable cost is constant if expressed on a per unit basis. For a cost to be variable, it must be variable with respect to something. That some thing is its activity base. An activity base is a measure of whatever causes the incurrence of variable cost. An activity base is sometimes referred to as cost driver. Some of the most common activity bases are direct labor hours, machine hours, units produced, and units sold. Other activity bases (cost drivers) might include the number of miles driven by sales persons, the number of pounds of laundry cleaned by a hotel, the number of calls handed by technical support staff at a software company, and the number of beds occupied in a hospital. To plan and control variable costs, a manger must be well acquainted with the various activity bases within the firm. .
   People some times get the notion that if a cost doesn't vary with production or with sales, then it is not really a variable cost. This is not correct. As suggested by the range of bases listed below, costs are caused by many different activities within an organization. whether a cost is considered to be variable depends on whether it is caused by the activity under consideration. For example, if a manager is analyzing the cost of service calls under a product warranty, the relevant activity measure will be the number of service calls made. Those costs that vary in total with the number of service calls made are the variable cost of making service calls.  Nevertheless, unless stated otherwise, you can assume that the activity base under consideration is the total volume of goods and services provided by the organization.
   Some of the most frequently encountered variable costs are listed below. This is not a complete list of all costs that can be considered variable. More, some costs listed here may behave more like fixed than variable costs in some organizations.

   Most Frequently Encountered Variable Costs
   Type of organization	Costs that are normally variable with respect to volume of output
   Merchandising company	Cost of goods (merchandise) sold
   Manufacturing company	Manufacturing costs: Direct materials Direct labor Variable portion of manufacturing overhead: Indirect materials Lubricants Supplies Power
   Both merchandising and manufacturing companies	Selling, general and administrative costs: Commissions clerical costs, such as invoicing Shipping costs
   Service organizations	Supplies, travel, clerical

   True Variable Versus Step Variable Costs:

   Not all variable costs have exactly the same behavior pattern. Some variable costs behave in a true variable or proportionately variable pattern. Other variable costs behave in a step-variable pattern.
   True Variable Cost:
   A cost that varies in direct proportion to the level of activity is called true variable cost. Direct material is an example of true variable cost because the amount used during a period will vary in direct proportion to the level of production activity. Moreover, any amounts of direct materials purchased but not used can be stored and carried forward to the next period as inventory.
   Step-Variable Cost:
   The wages of maintenance workers are often considered to be a variable cost, but this variable cost does not behave in quite the same way as the cost of direct materials. unlike direct materials, the time of maintenance workers is obtainable only in large chunks. More any maintenance time not utilized cannot be stored as inventory and carried forward to the next period. If the time is not used effectively it is gone forever. Furthermore, a maintenance crew can work at a fairly leisurely pace if pressures are light but intensify its efforts if pressures build up. For this reason small changes in the level of production may have no effect on the number of maintenance people employed by the company. A resource that is obtained only in large chunks (such as maintenance workers) and whose costs increase or decrease only in response to fairly wide changes in activity is known as a step-variable cost.

   Fixed Cost:

   Definition and Explanation:

   A fixed cost is a cost that remains constant, in total, regardless of changes in the level of activity. Unlike variable costs, fixed costs are not affected by changes in activity. Consequently, as the activity level rises and falls, the fixed costs remain constant in total amount unless influenced by some outside forces, such as price changes. Rent is a good example of fixed cost. Fixed cost can create confusion if they are expressed on per unit basis. This is because average fixed cost per unit increases and decreases inversely with changes in activity. Examples of fixed cost include straight line depreciation, insurance property taxes, rent, supervisory salary etc.

   Committed Fixed Vs Discretionary Fixed Costs:

   Fixed costs are some time referred to as capacity costs since they result from out lays made for building, equipment, skilled professional employees, and other items indeed to provide the basic capacity for sustained operations. For planning purposes, fixed costs can be viewed as being either committed or discretionary.
   Committed Fixed Cost:
   Committed fixed costs relate to the investment in facilities, equipment, and the basic organizational structure of a firm. Examples of such costs include depreciation of buildings and equipment, taxes on real estate, insurance and salaries of top management and operating personnel.
   The two key characteristics of committed fixed cost are 1. They are long term in nature. 2. They cannot be significantly reduced even for short period of time without seriously impairing the profitability or long run goals of the organization. Even if operations are interrupted or cut back, the committed fixed costs will still continue largely unchanged. During a recession, for example, a firm shall not usually discharge key executives or sell of key facilities.
   Since it is difficult to change a committed fixed cost once the commitment has been made, management should approach these decisions with particular care. Decisions to acquire major equipment or to take on other committed fixed costs involve a long planning horizon. Management should make such commitments only after careful analysis of the available  alternatives. Once a decision is made to build a certain size facility, a firm becomes locked into that decision for many years to come.
   While not much can be done about committed fixed costs in the short run, management is concerned about how these resources are utilized. The strategy of management must be to utilize the capacity of the organization as effectively as possible.
   Discretionary Fixed Cost:
   Discretionary fixed costs (often referred to as managed fixed costs) usually arise from annual decisions by management to spend in certain fixed cost areas. Examples of discretionary fixed costs include advertising, research, public relations, management development programs, and internships for students.
   Basically two key differences exist between committed fixed cost and discretionary fixed cost. First, the planning horizon of a discretionary fixed cost is fairly short term usually single year. By contrast committed fixed cost has a planning horizon that encompasses many years. Second, the discretionary fixed costs can be cut for short period of time with minimal damage to the long run goals of the organization. For example spending of management development programs can be reduced because of poor economic conditions. Although some unfavorable consequences may result from the cutback, it is doubtful that these consequences would be as great as those would result if the company decided to economize during the year by laying off key personnel.
   Weather a fixed cost is regarded as committed or discretionary may depend on management's strategy. For example during recessions when the level of home building is down, many construction companies may lay off most of their workers and virtually disband operations. Other construction companies retain large number of employees on the pay roll, even though the workers have little or no work to do. While these latter companies may face short term cash flow problems, it will be easier for them to respond quickly when economic conditions improve. And the higher moral and loyalty of their employees may give these companies significant competitive advantage.
   The most important characteristics of discretionary cost is that management is not locked into a decision regarding such costs. They can be adjusted from year to year or even perhaps during the course of a year if circumstances may demand such a modification.
   Summary of variable and fixed cost behavior
    

   Cost	Behavior of the cost (within the relevant range)
   	In Total	Per Unit
   Variable Cost Fixed cost	Total variable cost increases and decreases in proportion to changes in the activity level. Total fixed cost is not affected by changes in the activity level within the relevant range.	Variable cost remains constant per unit Fixed cost per unit decreases as the activity level rises and increases as the activity level falls

    

Cost Classifications on Financial Statements:

Learning Objectives of the Article:

1. Prepare a schedule of cost of goods manufactured.
2. Prepare income statement including a schedule of cost of goods sold.
3. balance sheet and income statement.

   Balance Sheet:

   The balance sheet or statement of financial position of a manufacturing company is similar to that of a merchandising company. However, the inventory accounts differ between two types of companies. A merchandising company has only one type of inventory-goods purchased from suppliers that are awaiting resale to customers. In contrast manufacturing companies have three classes of inventories-raw materials, work-in-process, and finished goods.
   

   Example:

   We will use the data of two companies A and B-to illustrate the concept discussed in this section. Company A is involved in manufacturing a product Alpha and B is involved in purchasing books about business and finance from publishers and authors and reselling them to customers.
   The footnotes to A's annual reports reveal the following information concerning its inventories.
   

   A Manufacturing Corporation Inventory Accounts
   	Beginning Balance	Ending Balance
   Raw materials Work in process Finished goods	$60,000 $90,000 $125,000	$50,000 $60,000 $175,000

   A's inventory largely consists of  raw materials used in manufacturing product alpha. The work in process inventory consists of partially completed alpha. The finished goods inventory consists of alpha that is ready to be sold to the customers or whole sellers.
   In contrast the inventory account at B--a book reseller-- consists entirely of the costs of books the company has purchased from publishers for resale to the public. In merchandising companies like B these inventories may be called merchandising inventories. The beginning and ending balances in this account appears as follows:
   

   B-Bookstore Inventory Accounts
   	Beginning Balance	Ending Balance
   Merchandising Inventory	$100,000	$150,000

   Income Statement:

   Following are comparative income statements of merchandising and manufacturing companies.
   

   Merchandising Company B-Bookstore
   Sales Cost of good sold: Beginning merchandising inventory Add: PurchasesGoods available for sale Less: Ending merchandising inventory Gross margin Less operating expenses: Selling expenses Administrative Expenses Net operating income	$100,000 $550,000 ---------- $750,000 $150,000 ---------- $100,000 $200,000 ----------	$1,000,000 $600,000 ---------- $400,000 300,000 --------- $100,000 =======
   Manufacturing Company A-Manufacturing Co.
   Sales Cost of good sold: Beginning finished goods inventory Add: Cost of goods manufactured* (See schedule) Goods available for sale Less: Ending finished goods inventoryGross margin Less operating expenses: Selling expenses Administrative expenses Net operating income	$125,000 $850,000 ---------- $975,000 $175,000 ---------- 250,000 300,000 ----------	$150,000 $800,000 ---------- $700,000 550,000 ---------- $150,000 =======
   *Schedule of Cost of Goods Manufactured A-Manufacturing Co.
   Direct Materials: Beginning raw materials inventory Add: Purchases of raw materialsRaw materials available for use Less: Ending raw materials inventory Raw materials used in production Direct Labor Manufacturing overhead: Insurance factory Indirect labor Machine rental Utilities factory Supplies Depreciation, factory Property taxes, factory Total overhead costs Total manufacturing cost Add: Beginning work in process Less: Ending work-in-process Cost of goods manufactured	$60,000 400,000 ---------- 460,000 50,000 ----------- 6,000 100,000 50,000 75,000 21,000 90,000 8,000 ---------	$410,000 60,000   350,000 ---------- $820,000 90,000 ---------- 910,000 60,000 --------- $850,000 =======

   At first glance, the income statements of merchandising and manufacturing firms like A and B companies are very similar. The only apparent difference is in the labels of some of the entries in the computation of cost of goods sold. In this example, the computation of cost of goods sold relies on the following basic equation for the inventory accounts:
   
   Basic Equation for Inventory Accounts:
   Beginning balance + Additions to inventory = Ending balance + withdrawals from inventory
   At the beginning of the period, the inventory contains some beginning balances. During the period, additions are made to the inventory through purchases or other means. The sum of the beginning balance and additions to the account is the total amount of inventory available. During the period, withdrawals are made from inventory. Whatever is left at the end of the period after these withdrawals is the ending balance.
   These concepts are applied to determine the cost of goods sold for a merchandising company like B-bookstore as follows:
   Cost of Goods Sold in a Merchandising Company:
   
   Beginning merchandising inventory + Purchases = Ending merchandising inventory + Cost of goods sold
   Or
   Cost of goods sold = Beginning merchandising inventory + Purchases − Ending merchandising inventory
   To determine the cost of goods sold in a merchandising company, we only need to know the beginning and ending merchandising inventory account and the purchases. Total purchases can be easily determined in a merchandising company by simply adding together all purchases from suppliers.
   The cost of goods sold for a manufacturing company like A manufacturing company is determined as follows:
   
   Cost of Goods Sold Equation in a Manufacturing Company:
   Beginning finished goods inventory + Cost of goods manufactured = Ending finished goods inventory + Cost of goods sold
   Or
   Cost of goods sold = Beginning finished goods inventory + Cost of goods manufactured − Ending finished goods inventory
   To determine the cost of goods sold in a manufacturing company like A manufacturing company, we need to know the cost of goods manufactured and the beginning and ending balances of finished goods inventory account. The cost of goods manufactured consists of the manufacturing costs associated with goods that were finished during the period. The cost of goods manufactured figure for A manufacturing company is derived from the schedule of  cost of goods manufactured below the comparative income statements.
   

   Schedule of Cost of Goods Manufactured:

   At first glance the schedule of cost of goods manufactured (below comparative income statements) appears complex and perhaps even intimating. However, it is all quite logical. The schedule of cost of goods manufactured contains the three elements of cost--direct materials, direct labor, and manufacturing overhead. The direct materials cost is not simply the cost of materials purchased during the period rather is the cost of materials used during the period. The purchase of raw materials are added to the beginning balance to determine the cost of the materials available for use. The ending materials inventory is deducted from this amount to arrive at the amount of materials used during the period. This is further explained by the following equation:
   
   Materials available for use  =  Beginning balance of materials + materials purchased during the period
   The sum of three cost elements (materials, labor and overhead) is the total manufacturing cost. See the following equation:
   
   Manufacturing cost = Direct materials + Direct labor + Manufacturing overhead
   This manufacturing cost is not equal to the cost of goods manufactured. Some of the materials, direct labor and manufacturing overhead costs incurred during the period relate to goods that are not yet completed. The cost of goods manufactured consists of the manufacturing costs associated with the goods that were finished during the period. Consequently adjustments need to be made to the total manufacturing cost of the period for the partially completed goods that were in process at the beginning and at the end of the period. Beginning work in process inventory must be added to the total manufacturing cost and ending work in process inventory must be deducted to arrive at the cost of goods manufactured. This is further explained by the following equation:
   
   Cost of goods manufactured = Manufacturing cost + Beginning balance of work in process inventory − Ending balance of work in process inventory