Managerial Accounting
Class Notes and Lecture Outline
Managing Costs 
Types of Costs
  1. Direct Costs
    • costs directly traceable to an operating department or division
    • direct costs are the responsibility of and controllable by the department or division manager
    • the majority of direct costs are variable costs
  2. Indirect Costs
    • costs that are difficult to trace to a specific department or division
    • indirect costs are generally not controllable by the department/division manager
    • are also called undistributed costs
  3. Joint Cost
    • cost shared by more than one operating department or division
    • an appropriate method should be used to distribute these costs to the appropriate division
  4. Discretionary Cost
    • a cost that may or may not be incurred based solely on the decision of a particular person, normally the general manger or owner
    • example:  should the exterior of the building be painted this year
  5. Relevant Cost
    • a cost that is different between one or more of alternatives being evaluated 
    • if a cost item is the same for both alternatives it is considered irrelevant and ignored
  6. Sunk Cost
    • a cost that has already been incurred which cannot be charged and cannot affect future decisions
  7. Opportunity Cost
    1. the cost of not taking advantage of an option that can increase a revenue flow
Allocating Indirect Costs
  1. key is to make the allocation as equitable as possible for the departments involved
  2. some popular allocation methods are based on...
    • sales revenue
    • square footage
    • contributory income
    • direct costs
    • number of employees
  3. if indirect costs are allocated incorrectly, poor management decision will result
Fixed and Variable Costs
  • understanding the relationship of  FC + VC = TC  is a key function involved in a variety of business decisions
  • we can consider selling below total cost when variable costs are covered and a contribution towards reducing fixed costs is made
  • selling below cost is a short term strategy
    • is often used with "perishable" products  (e.g., airline seats, hotel room nights, banquet room)
  • can help answer the following question -- should we close during the off season
Operating Leverage
  • operating leverage refers to a business that has high fixed costs relative to variable costs
  • being highly leveraged, a small change in sales revenues generates a large change in operating income
3 Methods to Separate Mixed Costs
  1. maximum-minimum method (also called the high-low method)
    • Plot the data.
    • Determine the high and low points (based on cost driver volume, not cost).
    • Using the coordinates for these two points, calculate the slope.
    • Choosing one of the points, compute the intercept.
    • Write the equation.
  2. multipoint graphical method  (also called the scattergraph method)
    • Plot the data (cost driver volume on x-axis and total cost on y-axis).
    • Visually draw a straight line through the data.
    • Read the intercept.
    • Calculate the slope by using the intercept and a representative point’s coordinates.
    • Write the equation in “slope-intercept” form 
  3. regression analysis method
    • Using a computer program (or manually solving the 2 simultaneous equations), calculate the slope and intercept.
    • Write the equation
Comparing the Three Methods
  • The multipoint graph approach 
    • is very simple in terms of the calculations required.  
    • It also is subjective because each person will draw a slightly differently sloped line.  Thus, it should only be used by managers that have a very good understanding of the business.  For example, extreme conditions are usually not considered.  A period with excessive overtime, holidays or the introduction of new machinery may be outside the company’s relevant range.  As the slope changes, so will the intercept.  This means each person will have a different cost equation.  
    • This is really just a rough-cut approximation.
  • The high-low method 
    • is objective  
    • Everyone will end up with the same equation.  
    • It’s calculations are about as simple as the scattergraph approach, making it a popular method prior to computers and hand-held calculators.  
    • However, the high-low method uses the two most extreme points, which may be statistical outliers. Again, this approach should only be used by managers that have a very good understanding of the business.  For example, extreme conditions are usually not considered.  A period with excessive overtime, holidays or the introduction of new machinery may be outside the company’s relevant range and should not be selected. If so, the equation will not accurately represent the actual cost behaviors.  
    • This approach is still pretty much a rough-cut approach. 
  • The regression method 
    • provides the most accurate equation in terms of discriminate, but not predictive, ability because it uses all the data points.  
    • It also is fairly simple to use with hand-held calculators, spreadsheet programs, and statistical software like PC-SAS and Minitab.  
    • Managers need to eliminate data points that are outside the company’s relevant operating range of activity.
  • All three statistical methods suffer from the same limitation:  they assume the past predicts the future.
  • Given the current state of knowledge, the scattergraph and high-low approaches are only used to guide the selection of an appropriate statistical model. 


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this page is maintained by Reed Fisher
last updated January 15, 2011