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LearningObjectives
After studying Chapter 1, you will be able to:
Distinguish between �inancial accounting and managerial

accounting.
Recognize the primary roles and ethical responsibilities of the
management accountant.
De�ine, distinguish, and illustrate key cost concepts.
Understand the differences in cost �lows among service,
merchandising, and
manufacturing enterprises.
Distinguish between the behavior of variable and �ixed costs
and formulate cost
functions.
Understand cost terms relating to planning and control.
1 Managerial Accounting and Cost Concepts
DragonImages/iStock/Thinkstock
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Introduce the concept of contribution margin and its variations.
TheController’sWorkDay:WhereDidtheTimeGo?
It’s early October. Mary Rosen, Controller of Herschel Software
Products, has just arrived at her
of�ice at about 7:30 a.m. She scans her email messages, checks

her electronic calendar, and looks
through her in-basket. She says, “Wow, another ‘normal’ day!”
She wonders if she’ll make her tennis
date with her husband at 6 p.m. Her calendar shows:
9:00 Meet with division head of Customer Support to discuss
next year’s budget numbers.
Review preliminary budget numbers before meeting.
10:00 Meet with accounting systems analysts to discuss status
of a project to improve the �irm’s
monthly management “plan versus actual” reporting system.
11:30 Hold a quick session with Marketing Vice-President,
Gary Martin, to discuss pricing
negotiations with new customer.
12:15 Have working lunch with corporate attorney to discuss
customer contract wording for a
new product being introduced early next year.
2:00 With budget manager, review September’s actual results
and budget comparisons and
identify problem areas. Also, review third quarter results before
her presentation to the
President at Friday’s staff meeting.
4:00 Review a special cost-volume-pro�it study of Herschel
Software Products, relative to the
�irm’s strategic plan’s pro�itability goals.
Mary also knows that she needs to:
Respond to four email questions about product costs and
operating expenses.
Talk to Steve Simcha, New Product Development Vice-

President, about a serious cost-
overrun problem with a new product project.
Prepare a presentation on cash �lows for the �irm’s strategic
planning meeting next month.
Write a memo supporting the spending of $100,000 by the
Marketing Vice-President on
media contracts.
Every meeting, discussion, and decision that Mary has today,
and every day, uses accounting
information. She must generate relevant data in the right form
and at the right time. She and her
fellow managers must understand cost behavior, cost/bene�it
analyses, plan versus actual
comparisons, and how to use information to achieve Herschel
Software Products’ long-term and
short-term goals.
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Managers make decisions. Managers select one or more
alternatives from a set of choices. Making the best
choice depends on the manager’s goals, the expected results
from each alternative, and the information
available when the decision is made. Decision-making
information is the focus of this text. Collecting,
classifying, reporting, and analyzing relevant information are
fundamental to every action that managers
take. Management accountants prepare information for decision
makers. In this chapter, the stage is set

for discussing how management accountants are involved in
decision making. First, we discuss the
distinction between �inancial and managerial accounting.
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1.1TheDualRolesofAccountingInformation
The accounting system generates the information that satis�ies
two reporting needs that coexist within an
organization: �inancial accounting and managerial accounting.
Figure 1.1 shows the primary interested
parties and the typical reports generated to serve these two user
groups.
Figure1.1:Scopeof�inancialandmanagerialaccounting
FinancialAccounting
Financialaccounting is the branch of accounting that organizes
accounting information for presentation
to interested parties both inside and outside of the organization.
The primary �inancial accounting reports
are the balance sheet (often called a statement of �inancial
position), the income statement, and the
statement of cash �lows. The balance sheet is a summary of
assets, liabilities, and shareholders’ equity at a
speci�ied point in time. The income statement reports revenues
and expenses resulting from the
company’s operations for a particular time period. The
statement of cash �lows shows the sources and

uses of cash over a time period for operating, investing, and
�inancing activities.
Most businesses are complex, and guidelines (known as
generally accepted accounting principles or
GAAP) are provided for �inancial reporting. The Financial
Accounting Standards Board (FASB), the
Securities and Exchange Commission (SEC), and the Public
Company Accounting Oversight Board
(PCAOB) oversee the development of these principles,
corporate �inancial reporting responsibilities, and
internal control standards. Internationally, while some countries
have developed their own accounting
principles, many countries have adopted standards set by the
International Accounting Standards Board
(IASB).
Owners,Investors,andCreditors
Shareholder-owned �irms rely heavily on owners, investors,
and creditors (providers of short-term credit
and long-term loans) for sources of capital. Shareholders and
investors use accounting reports to decide
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whether to buy, sell, or hold the �irm’s stock. Also, creditors
assess whether the �irm is able to pay its debts
on time.
TaxingAuthorities

The assessment of many taxes is based on accounting
information submitted by the taxpayer. Examples of
such taxes include income taxes, sales taxes, use taxes,
franchise taxes, excise taxes, property taxes, and
gift and estate taxes. In most cases, the dominant taxing
authority is the federal government and its tax
collection agency, the Internal Revenue Service.
RegulatoryAgencies
Local, state, and federal agencies regulate a substantial portion
of business activity in the United States.
Much regulation is implemented through or involves accounting
reports.
IndustryAssociations
Most industries have an association that gathers important
statistics about the national and international
industry. A large part of the information they provide comes
from accounting reports provided by member
�irms. Examples include corporate annual reports, call reports
for banks, and auto dealership sales
reports.
ManagersandEmployees
Managers typically have direct vested interests in their �irms’
results. Performance bonuses, stock options,
and incentive compensation programs are common. Thus,
managers are not passive observers as to how
certain transactions are recorded. Firm policies, performance
evaluation methods, and compensation
systems should encourage managers to act in the best interests
of themselves and the �irm as a whole.
The �irm’s executives are responsible to the board of directors
and shareholders for the �irm’s �inancial
results. Numerous examples of changes in high-level executive

positions reaf�irm the importance of
achieving strong pro�its to remain in power and employed.
Based in part on �inancial statement
information, employees make decisions about continued
employment, union wage demands and contract
negotiations, adequacy of pension plans, and employee stock
purchase or savings plans. Pro�it sharing
may encourage employees to want the company to be
�inancially successful.
ManagerialAccounting
Managerialaccounting is the branch of accounting that meets
managers’ information needs. Whereas
�inancial accounting has a backwards focus, i.e., focusing on
historical information, managerial accounting
focuses more on the future. Because managerial accounting is
designed to assist the �irm’s managers in
making business decisions, relatively few restrictions are
imposed by regulatory bodies and generally
accepted accounting principles. Therefore, a manager must
de�ine which data are relevant for a particular
purpose and which are not.
DifferencesBetweenManagerialandFinancialAccounting
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Several important differences distinguish managerial accounting
from �inancial accounting. First,

managerial accounting is not subject to the same rules and
principles as is �inancial accounting. In many
cases, “common sense” is the most important guide for decision
makers.
A second difference is that �inancial accounting relies on
accounting principles structured around the
accounting equation. Management reports, on the other hand,
are designed to meet managers’ needs.
These reports often use estimates and forecasts, use different
values for the same events, do not balance in
a debit/credit sense, and are designed for particular decisions or
analyses. The expression “different costs
for different purposes” has long been used to describe
relevance. Relevant information has an impact on
the decision analysis. Irrelevant data have no impact.
Another difference is that managerial accounting focuses on
segments of the organization as well as on the
whole organization. The primary interest of �inancial
accounting is the company as a whole. In managerial
accounting, however, the segment is of major importance.
Segments may be products, projects, divisions,
plants, branches, regions, or any other subset of the business.
Tracing or allocating costs, revenues, and
assets to segments creates dif�icult issues for managerial
accountants.
Two important similarities do exist. The same transaction and
accounting information systems are used to
generate the data inputs for both �inancial statements and
management reports. Therefore, when the
system accumulates and classi�ies information, it should do so
in formats that accommodate both types of
accounting. The other similarity is the manner in which
accountants measure costs, de�ine assets, and

specify accounting periods. Many concepts underlie accounting
information, whether the data are later
used for �inancial or managerial reporting. Recording the
results of events is often based on rationales that
are common to both �inancial and managerial accounting. We
must understand what is a common thread
and what must be independently collected.
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1.2RoleoftheManagementAccountant
Although the top accounting-oriented people in an organization
are the chief �inancial of�icer and the
controller, the accounting and �inancial management functions
contain a range of jobs. A variety of careers
is available as shown in Figure 1.2; these careers can frequently
be paths to executive management.
Figure1.2:Managementaccountingjobtitles
A management accountant maintains accounting records,
prepares �inancial statements, generates
managerial reports and analyses, and coordinates budgeting
efforts. The management accountant is an
advisor, an internal consultant, and an integral part of
management. The controller is responsible for
managing the entire accounting function. The controller
in�luences management by answering questions
like: What information should be reported? What format best
displays the information? How can data be

collected and processed? By the nature of the job, the
management accountant applies management
principles and often is a major player in decision making itself.
Certi�iedManagementAccountant
The Certi�ied Management Accounting program recognizes a
person’s achievement of a speci�ic level of
knowledge and professional skill. Becoming a
Certi�iedManagementAccountant (CMA) is considered
an important professional step for anyone desiring to become a
management accounting or �inancial
executive. The CMA program was founded on the principle that
a management accountant is a contributor
to and a participant in management.
To qualify for the CMA designation, candidates must pass a
comprehensive examination and meet speci�ic
educational and professional standards and experience
requirements. To remain a CMA, a person must
meet continuing educational requirements and adhere to the
program’s “Statement of Ethical Professional
Practices.” The Institute of Management Accountants (IMA) is
the professional organization of
management accountants and sponsors the CMA designation.
EthicalConductofManagementAccountants
Earlier in the chapter, we discussed managers’ needs for
accounting information. We assumed that
whatever information the accounting system generates is
presented and used in an ethical manner. Ethical
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conduct is a necessary asset of a managerial accountant. The
credibility of the information provided,
analyses done, and opinions offered depends heavily on the
reputation of the responsible accountant.
Independence, competence, lack of bias or favoritism, trust, and
objectivity are key elements in
establishing credibility.
While true for all managers, management accountants in
particular must maintain integrity and ethical
behavior and must make top management aware of unethical
behavior on the part of others within the
organization. This does not mean the management accountant is
a police of�icer. Rather, the management
accountant promotes and encourages ethical behavior in all
aspects of business life.
Ethical standards of businesspersons have been given much
more visibility and scrutiny in recent years.
Issues that appear again and again in management careers test
the ethical standards of everyone. Among
common ethical issues are:
Businesspracticesandpolicies. Practices that seem harmless on
the surface may encourage or
require employees or managers to be deceitful or dishonest.
Objectivereporting. Because situations exist where prejudiced
reporting of certain numbers
may in�luence decisions, accountants are guided by goals of
unbiased reporting and professional
judgment.

Colleaguebehavior. Even if we have high ethical standards,
people around us may not be so
disposed. Many policies and internal controls are in place in
organizations to prevent wrongdoing
and to encourage proper behavior. In addition, you should not
compromise your personal
integrity by condoning unethical behavior in others.
Competitors. Winning is part of the business “game.” But to do
so in a fair environment is critical.
Using true product and competitor data; following corporate
policies; and abhorring bribes,
kickbacks, and other similar payments are easy examples. Many
�irms provide behavior guidelines
and policies to purchasing and sales personnel who are at
particular risk in giving and receiving
favors and improper inducements.
Taxavoidanceandevasion. Tax burdens can be signi�icant.
Proper planning and careful use of
tax laws to minimize the organization’s tax liability are
acceptable. Tax avoidance is legitimate.
Inappropriate use of the same laws or use of deceit to hide
income or overstate deductions is tax
evasion, which is unethical as well as illegal.
Con�identiality. Internal data are developed for managers’ use.
Disclosures outside the �irm often
require review and approvals. Privacy of competitive,
personnel, and negotiating data is critical.
Negative examples of overheard conversations in elevators, on
golf courses, and at lunches that
lead to lost business, embarrassment, and lawsuits are
unfortunately common. Con�identiality
also demands that “insider” information should not be used for
anyone’s personal advantage.
Appearanceofindependence. The accountant should be
independent in situations where the
resulting information is used for analysis and decision making.

Independence applies to both
actual independence and the appearance of independence. If it
appears that the management
accountant is biased because of that person’s conduct,
associations, or vested interests (possible
promotion, salary increases or bonuses, or investments), the
information provided is tainted and
open to doubt by other decision makers.
Corporateloyaltyandpersonaladvancement. Many situations exist
in which, because of an
unethical act, the reputation of the �irm itself is in danger.
Alternately, an unethical act may seem
to ensure your personal enhancement in some manner.
Sometimes reporting an unethical act will
endanger the future of the person reporting the act. These are all
dif�icult dilemmas, pitting right
against wrong, and not always in an obvious way.
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While space and time do not allow us to develop approaches for
resolving these problems here, it is clear
that ethical issues underlie management accountants’
professional and day-to-day activities. Each person
must develop a method of handling ethical problems. Of
primary importance is the ability to see an ethical
dilemma when it faces us. Once identi�ied, the situation may
cause us to request advice. Numerous sources
are available for guidance, including:

Personalvalues. We would like to think that our own value
system is “ethical” and provides
enough guidance. Clearly, this is our main line of defense
against “wrong.”
Corporatepoliciesandethicsstatements. Many �irms have
statements on expected employee
behavior or written policies and procedures on how a range of
situations should be handled.
These statements do set limits or barriers and may describe
expected levels of behavior. Some
companies also offer ethics seminars and classes to their
employees.
Laws. “If it’s legal, it must be okay” is often used a basis for
de�ining ethical behavior. This is
absolutely not true. Laws are developed in a political process,
often without much serious
consideration for the ethical conduct of any parties involved.
It’s highly probable that if the
behavior is illegal, it is also unethical.
Professionalstandards. Most professions have developed a
statement of ethical standards for
their members. Figure 1.3 presents a statement developed for
management accountants. These
statements are basic standards of behavior and give professional
guidance in many areas.
Supervisors,internalauditors,andothercompanyof�icials. These
are often persons with
more experience and broader understanding of con�licting
issues and of corporate attitudes. An
ethical situation, however, may involve a supervisor or other
corporate of�icial, which may make
the dilemma much more sensitive and severe. A few companies
have created an ombudsperson
position to assist employees in handling delicate situations.
Counselorsfromoutsideoftheorganization. This is a last resort
and generally violates

another ethical consideration—con�identiality. While close
friends, a spouse, or a personal
counselor may seem like logical sources of advice and support,
the nature of the dilemma may
require con�identiality until all other avenues of resolution are
exhausted. Merely consulting
outsiders presents serious risks of unauthorized disclosure that
may only further complicate an
issue.
Even though all of these options may exist, we each need to
develop a rational approach to identifying,
analyzing, and deciding on ethical issues that confront us.
Management accountants must be aware of
ethical dilemmas, perhaps more than the typical manager,
because of their responsibility for decision-
making information and their involvement in many decision-
making processes.
The Institute of Management Accountants believes ethics is a
cornerstone of its organization and
recognizes the importance of providing ethical guidance. The
IMA has developed Standards of Ethical
Professional Practice. That statement is presented in Figure 1.3.
The Standards are broken into four
sections: competence, con�identiality, integrity, and
credibility. Competence refers to the skills that the
accountant brings to the job. Con�identiality is de�ined as
protecting the access to and use of information.
Integrity focuses primarily on the personal behavior and
interactions of the management accountant.
Credibility, as de�ined here, is primarily directed toward
disclosure of unbiased information.
Figure1.3:InstituteofManagementAccountants’Standardsof
EthicalProfessionalPractice

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IMA(InstituteofManagementAccountants).Reprintedwithpermiss
ion.
UsingCostInformation
Much of managerial accounting deals with cost information.
Understanding cost behavior and knowing
which costs to consider and which to ignore are critical to
making decisions in business and in everyday
life situations. Managers use cost information in many different
ways. Cost data are especially important
in these areas:
Planning. Estimating future costs in preparing budgets and in
projecting operating activities.
Decisionmaking. Considering costs relevant to a wide variety of
decision-making processes.
Costcontrol. Measuring costs incurred; comparing these costs
with budgets, goals, targets, or
standards; and evaluating differences or variances.
Incomemeasurement. Determining the costs of products and
services sold to determine this
time period’s pro�itability for the entire business or some
segment of the business, such as a
contract, a product, or a customer.

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1.3TheNatureofCost
Cost, broadly de�ined, is the amount of resources given up to
gain a speci�ic objective or object. Generally,
cost refers to the monetary measurement (exchange price)
attached to acquiring goods and services
consumed by some activity. A cost need only be incurred and
not necessarily be paid for it to be
considered a cost. Cash outlays are monetary measurements;
occasionally, goods and services are also
obtained by exchanging other assets, such as receivables or
property, or by taking on debt. A costobject is
de�ined as anything for which one accumulates costs. A cost
object is the reason for making decisions,
costing products, planning spending levels, or evaluating actual
performances. It is the “why” of cost
analysis.
Business people undertake activities to achieve some output or
result. Often these activities incur costs—
purchasing materials, hiring people, and renting space—and are
known as costdrivers. Determining a
product’s cost involves �inding the cause-and-effect connection
between inputs and outputs. A cost driver
links activities that create outputs with the inputs that are used.
Figure 1.4 presents the fundamental relationship among
resources, activities, and products. Activities are
at the core of all we do in business. Activities drive the use of
resources; from the activities, come

products. This is the traditional input-to-output cycle,
understanding that work is done in the middle box
of Figure 1.4—meaning tasks are performed with labor,
machines, or hired resources. Costs are incurred
by cost drivers and are assigned to the products. These linkages
will be used over and over as we progress
through our costing analyses to aid decision making,
particularly in Chapter 9.
Figure1.4:Activity-centeredcostingrelationships
Cost, in many respects, is an elusive term. Cost has meaning
only for a particular purpose and situation.
Consequently, meaningful use of the term cost requires an
adjective—such as incremental, average, or
avoidable—to de�ine its use. Each adjective indicates certain
attributes, and those attributes dictate the
relevance of each cost.
Since costs are resources given up to obtain a speci�ic good or
service, that good or service may be
consumed or it may still be an asset at the end of an accounting
period. In many managerial analyses, the
distinction among cost, expense, and asset is clouded. The
words cost and expense are used
interchangeably, as is done throughout this text. Yet for pro�it
measurement, cost dollars imply assets, and
expenses are subtracted from revenues.
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1.4ComparingService,Merchandising,andManufacturingOrganiz
ations
Many similarities exist when we compare service,
merchandising, and manufacturing organizations.
Providing a service to a client in a law �irm or repairing a
washing machine in a �ix-it shop have strong
similarities to manufacturing automobiles in spite of different
physical and business settings. In service
industries, resources are brought together to provide the service,
just as they are brought together to
create a product in a factory environment.
Differences in measuring pro�its are largely a function of
inventoried costs. Service �irms have only
supplies inventories. Merchandising �irms buy and sell
products and hold merchandise inventories.
Manufacturing �irms buy materials and convert these inputs
into saleable products. Inventories here
include materials, work in process inventory (partially complete
products), and �inished goods inventory
(completed and ready-to-sell products). Figure 1.5 compares
income statements and selected balance
sheet accounts for the three business types.
Figure1.5:Measuringincomeinservice,merchandising,and
manufacturing�irms
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ServiceOrganizations
A service organization performs a business activity for a fee.
Costs of performing the service may include
salaries of professionals and support personnel, supplies,
purchased services, and routine costs such as
rent and utilities. In Figure 1.5, the expenses of Kalwerisky
Consultants, a public relations �irm, are
reported as either direct client expenses or operating expenses.
Some service organizations report all
expenses as operating expenses.
Essentially, all operating costs incurred by the �irm are
periodcosts; they become expenses of the time
period in which the costs are incurred. Receivables, payables,
supplies, depreciation, and perhaps costs
not yet billed to clients would cause accrual net income to differ
from operating cash �low. In a service
organization, the problems of measuring performance, such as
the pro�itability of speci�ic contracts, and
matching direct costs with speci�ic revenues are surprisingly
similar to manufacturing cost analyses.
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Internally, �inancial reports for service �irms often separate
revenues and expenses by type of service or
customer. For example, hospitals track revenues by procedure
type and attempt to measure costs of those
procedures. Professional �irms, such as accountants, lawyers,

and architects, measure the direct costs of
performing services by client. Lawyers record time spent on
each case, both for billing purposes and for
tracing salary costs. In Figure 1.5, Kalwerisky Consultants
apparently serves multiple clients and can
identify professional time, service costs, and other traceable
costs with speci�ic client contracts.
MerchandisingOrganizations
A merchandising business purchases products for resale.
Generally, a merchandising �irm is a link in the
physical distribution chain, acting as a wholesaler or retailer.
Figure 1.5 presents cost of goods sold on the
income statement of Burch�ield Supermarket, a retail grocery
store. Again, comprising the reported totals
are detailed revenues and costs of sales for various segments,
such as produce, hardware, meat, and
grocery departments. Merchandise costs are inventoriable or
product costs, meaning that they are an
asset until sold, after which they become cost of goods sold. All
other expenses in the supermarket
operation are treated as period costs.
ManufacturingOrganizations
Manufacturing generally occurs in a factory, de�ined as a place
where resources are brought together to
produce a product. Examples include:
Soft-drink bottling company—mixing batches and �illing
bottles of root beer
University cafeteria—preparing and serving food
Print shop—printing a variety of items such as brochures,
booklets, and business cards
Breakfast cereal manufacturer—processing grains into cereal

Automotive assembly plant—joining parts and subassemblies to
create a minivan
But, you can see how many service �irms really do “produce”
the service using our de�inition of a factory.
Landscaping company—cutting lawns and planting
Pharmacy—�illing prescriptions
Tax return preparation �irm—preparing tax returns
Hospital surgery department—performing heart bypass
operations
As Figure 1.5 illustrates, manufacturing �irms have more
complexity in determining cost of goods sold. A
new portion of the income statement, costofgoodsmanufactured,
is introduced. It includes:
The costs of inputs to the manufacturing process: direct
materials, direct labor, and manufacturing
overhead
Direct materials inventory and work in process inventory
needed for factory activities
The sum of the product inputs, manufacturing costs for the
period, is called totalmanufacturingcosts.
Figure 1.6 illustrates a simpli�ied version of the Holbrook
Products factory. Here resources are brought
together for producing aircraft components. An assembly line in
the factory is the focus of
“manufacturing” activities.
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Materials (primarily parts and components) are purchased for
production, and factory employees work to
convert parts into �inished products. Many support services are
used, and manufacturing overhead costs
are incurred for materials handlers, equipment maintenance
people, heat, power, employee bene�its,
factory accountants, supervisors, and depreciation on equipment
and the building.
Figure1.6:TheHolbrookProductsfactory
In Figure 1.6, the business is divided into of�ice and factory
areas. Obviously, this example is simpli�ied and
avoids many business complexities. But, it shows:
Productandperiodcosts. Any cost incurred in the manufacturing
process is a manufacturing
cost, an inventoriable cost, and a product cost. Any cost not
involved in the manufacturing process
is a nonmanufacturing cost, a noninventoriable cost, and a
period cost. Whereas the product costs
are treated as inventory until sold, the period costs are treated
as expenses immediately or as
noninventory assets such as of�ice supplies.
Locationofinventories. Manufacturing requires three production
inventories: materials, work in
process, and �inished products. Materials purchases are
received and stored in the materials
warehouse, and their costs recorded in MaterialsInventory.
When materials are sent to the
factory �loor, direct materials costs are transferred to
WorkinProcessInventory, which is

production that is started but not completed. Completed
products are physically sent to the
�inished goods warehouse; their work in process costs are
moved to FinishedGoodsInventory,
which are products that are ready for sale to customers. When a
sale occurs and is shipped,
�inished goods product costs are moved to CostofGoodsSold,
an expense account.
Flowofcostsandproducts. Figure 1.6 assumes an assembly
process, but many different
production systems exist. Materials are added, workers process,
and other activities support; a
physical �low and a cost �low coexist.
Figure 1.7 compares a factory to a large bucket. When the
whistle blows to start the production period, the
bucket already has resources in it—beginning work in process
inventory. During the period, more
resources are poured into the bucket—total manufacturing costs
(direct materials used, direct labor, and
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manufacturing overhead). Flowing out of the bucket are all
products that are �inished during the period
and added to �inished goods inventory. The cost transferred out
is called cost of goods manufactured.
When the whistle blows to end the period, ending work in
process inventory remains in the bucket.

Figure1.7:Thefactoryasa“bucket”ofcosts
To illustrate the determination of cost of goods manufactured,
suppose work in process inventory of Metz
Corporation changed from $21,000 to $23,500 during
November. Costs incurred during November were
$42,000 for direct materials used, $33,000 for direct labor, and
$51,000 for manufacturing overhead. The
cost of goods manufactured for November is determined as
follows:
Direct materials used $42,000
Direct labor 33,000
Factory overhead 51,000
Total manufacturing costs $126,000
+ beginning work in process 21,000
– ending work in process (23,500)
Cost of goods manufactured $123,500
Note that cost of goods manufactured represents the cost of
those goods that were �inished during
November. Since $21,000 of costs was incurred prior to
November, it must be added to the $126,000 in
costs that were incurred during November. Ending work in
process of $23,500 must be deducted from the
costs incurred during November because this amount represents
costs for goods that have not yet been
�inished, and the cost of goods manufactured includes only
costs pertaining to �inished goods.

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TraditionalGroupingsofProductCosts
Figure 1.5 illustrates the income measurement for Holbrook
Products. Product cost accounting combines
three groups of manufacturing costs: direct materials, direct
labor, and manufacturing overhead. While
automated manufacturing and cost systems can utilize many
more or fewer cost groups, these three have
historically been used in nearly all manufacturing costing.
Directmaterialscosts are costs of physical components of the
product. The range of materials includes
natural resources, such as oil, grain, or lumber, and partially
processed components (another company’s
�inished product). Often, a complete list of all materials used
in a product is prepared and is called a billof
materials. A materials requisition form is used as authorization
to transfer direct materials out of the
materials storeroom and into the production area. Direct
materials issued to production are direct
materialsused. To determine materials used, begin with
materials purchases, add beginning materials
inventory, and subtract ending materials inventory. Supplies
like nails, glue, lubricants, and paints are
usually not worth the effort of tracking as direct materials, so
most companies refer to these items as
indirect materials, and these are included as part of factory
overhead costs. At McDonald’s, potatoes used

to make French fries are direct materials, while the salt added to
the fries is an indirect material.
Directlaborcosts are wages paid to workers who directly process
the product. In Figure 1.7, assembly
line workers would be direct labor. At McDonald’s, the wages
paid to the cooks are direct labor costs.
Factory overhead costs include all manufacturing costs that are
not materials or direct labor.
Manufacturing overhead, factory burden, and indirect
manufacturing costs are other names for these
costs. Obviously, a wide variety of costs fall into this category,
such as maintenance staff wages, factory
managers’ salaries, factory utilities costs, and factory
equipment depreciation and repair costs. Hundreds
of different cost accounts could be grouped under
manufacturing overhead. Certain workers’ tasks could
be overhead in one company and direct labor in another. For
example, materials handlers and quality
control personnel costs could be accounted for as either direct
or indirect labor. Generally, if the worker
has direct contact with the product or the production process,
the cost is direct labor. Generally, support
tasks are indirect labor—part of overhead. At McDonald’s, a
particular restaurant manager’s salary is an
indirect labor cost.
Historically, the three cost groups were assumed to be about
equal portions of total product cost. Today,
automation reduces direct labor and causes factory overhead to
increase. As more production is generated
from the same capacity, materials as a percentage of total cost
may also increase. Thus, managers have
paid more attention to direct materials and overhead costs
because they have grown as a portion of total

manufacturing costs.
TypesofProductCosts
Direct materials and direct labor costs are often viewed as
direct product costs since they are easily
identi�ied with speci�ic products and units of product. Factory
overhead is usually thought of as indirect
productcosts. Factory overhead is not easily traced to speci�ic
products or units. For example, the plant
manager’s salary cannot be tied to speci�ic product units in a
multiproduct factory, since the manager is
responsible for all activities in the factory. An exception may
exist for a few overhead costs that may be
traced to speci�ic products and be considered direct costs.
Figure 1.8 illustrates these concepts and shows
a dotted line between factory overhead and direct costs to
indicate this possibility. At McDonald’s, the cost
of hamburger buns is a direct product cost, while the
restaurant’s electricity costs are indirect product
costs.
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Figure1.8:Productcostsandproductcostgroups
Direct materials and direct labor are also known as the
primecosts of a product. These costs are easily
traceable to a speci�ic product. Direct labor and factory
overhead are called conversion costs. In the
factory, materials are “converted” into �inished product using

labor and all of the factory’s supporting
resources—overhead costs.
ContemporaryPractice1.1:SurveyonIndirectCosts
In a survey of 185 European companies in various industries,
respondents ranked the importance
of indirect cost categories (other than personnel costs) as
follows:
Ranking CostCategory
1 Information Technology
2 Energy
3 Maintenance
4 Fleet Management
5 Marketing
6 Facility Management
7 Freight
8 Logistics
9 Telecommunications
10 Insurance
11 Travel Expenses
12 Tools/Supplies

Source:Wald,A.,Schneider,C.,Schulze,M.&Mar�leet,F.(2013,No
vember/December).Astudyonthestatusquo,currenttrends,and
successfactorsincostmanagement.Cost Management,28–38.
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CalculatingUnitCosts
Productcosting assigns costs to units of product. The approach
is to divide the number of units produced
into total manufacturing costs to obtain a cost per unit of
product. For example, a highly automated factory
produces a variety of tablet computers. The same production
processes are used for all models with
minimal costs to change over the production line. Three million
tablet computers are manufactured every
month. Different circuit boards distinguish the models. March
production data by product line are as
follows:
Deluxe SuperDeluxe Basic Total
Direct materials costs $3,600,000 $4,200,000 $1,500,000
$9,300,000
Indirect other costs 6,000,000
Total costs $15,300,000
Units produced 120,000 120,000 60,000 300,000

Direct materials costs per unit $30.00 $35.00 $25.00 $31.00
Indirect other costs per unit 20.00 20.00 20.00 20.00
Product cost per unit $50.00 $55.00 $45.00 $51.00
Note: The “Indirect other costs per unit” of $20.00 is obtained
from dividing $6,000,000 of “Indirect other costs” by the
300,000 units
produced.
The costing approach is to divide the total costs of $15,300,000
by 300,000 tablet computers. However,
the $51.00 average cost hides the different direct costs of each
model of circuit board. A second approach
identi�ies materials costs as direct to each model and averages
all other costs over all units. This produces
a high cost of $55.00 for Super Deluxe models and a low cost of
$45.00 for Basic models. More complex
costing is needed if different models use different amounts of
resources. The goal is to obtain the most
accurate unit cost, given managers’ decision-making needs.
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1.5CostBehavior
To say that a cost “behaves” in a certain way is somewhat
misleading. Costs result from taking actions or
from the mere passage of time. Something drives a cost—some
activity, decision, or event. Selling one

more hamburger involves a burger, a bun, a container, a napkin,
and any condiments used. But selling one
more hamburger has no impact on supervision, equipment
rental, or advertising costs. Building lease
expense will not change unless the lease includes a rental
payment based on a percentage of sales. Cost
behavior, then, is the impact that a cost driver has on a cost.
Which costs can be expected to remain constant when the
amount of work activity increases or decreases?
Also, which costs increase as more work is performed? If costs
are to be estimated and controlled, we
need to know whether or not costs will change if conditions
change, and, if so, by what amount. Cost
behavior is often viewed as a dichotomous pattern—either
variable or �ixed. But in the real world, many
behavior patterns exist since most costs are not strictly variable
or �ixed. Thus, the concepts of
semivariable and semi�ixed costs add complexity to cost
behavior studies. It may oversimplify the analysis,
but a split between variable and �ixed is common and is used
frequently.
VariableCosts
A variable cost changes in total in direct proportion to changes
in business activity such as units
produced or hours worked. A decrease in activity brings a
proportional decrease in total variable cost, and
vice versa. For example, direct materials costs are usually
variable costs since each unit produced requires
the same amount of materials. Thus, materials costs change in
direct proportion to the number of units
manufactured. At McDonald’s, the cost of raw hamburger meat
is a variable cost.

A proportional relationship between activity and cost has these
important characteristics:
Variable cost is a rate per unit of activity or output. A variable
cost per unit remains constant
across a reasonable range of activity. The slope of the total
variable cost curve is the variable cost
per unit—the added cost divided by the added units.
For example, if a product costs $4.00 per unit, the expression
$4X yields the total variable cost at X level.
Figure 1.9 shows the behavior of variable costs on a per unit
basis and in total, and also highlights the
variable cost line’s slope.
Figure1.9:Behaviorofvariablecosts
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FixedCosts
A �ixedcost is constant in total amount regardless of changes in
business activity level. Costs such as the
plant manager’s salary, depreciation, insurance, and rent usually
remain the same in total regardless of
whether the plant is above or below its expected level of
operations. At McDonald’s, the cost of heating the
restaurant is a �ixed cost since the cost does not change with
activity such as labor hours or amount of
food prepared.

Important characteristics of a �ixed cost are:
Fixed cost is a lump of costs that is not normally divisible and
does not change as activity or
volume changes. A �ixed cost remains constant across a
reasonable range of activity. The �ixed
cost per unit decreases as activity or volume increases and
increases as activity or volume
decreases.
For example, March’s rent is stated as a dollar amount for that
month, not as an amount per unit of output
or even per hour of use.
By de�inition, total �ixed costs are constant, causing the
�ixed cost per unit to vary at different levels of
activity. Figure 1.10 shows the behavior of �ixed costs on a per
unit basis and in total. When a company
produces a greater number of units, the �ixed cost per unit
decreases. Conversely, when fewer units are
produced, the �ixed cost per unit increases. This variability of
�ixed costs per unit creates problems in
product costing. The cost per unit depends on the number of
units produced or on level of activity.
Figure1.10:Behaviorof�ixedcosts
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Certain �ixed costs can be changed by management action.
These are discretionary �ixed costs.
Discretionary �ixed costs are expenditures that managers can
elect to spend or not to spend. For
example, a company might budget the cost of consultants at
$20,000 per month for the coming year. But
the contract states that the company can cancel the contract at
any time. Management maintains
discretionary control over the spending. On the other hand, if
the contract guarantees the consultant a 12-
month relationship and the contract has been signed, a
committed �ixed cost has been created. A
committed�ixedcost is one over which a manager has no
control and must incur. Advertising cost for
McDonald’s is a discretionary �ixed cost. Depreciation on
McDonald’s restaurant equipment is a
committed �ixed cost.
An interesting observation is necessary here. Managers can,
with time and intent, change the cost
behavior of certain activities. For example, variable direct labor
costs can be replaced by a �ixed cost by
guaranteeing full-time employment for some period, such as a
three-year union contract. Or equipment
could be leased on a short-term basis (day-to-day or even
hourly) instead of purchased—replacing a �ixed
cost with a variable cost. Also, automated equipment with a
�ixed rent or depreciation could replace
variable-cost manual labor. Thus, we recognize that managers
can act to change certain cost behavior,
particularly over time.
ContemporaryPractice1.2:FixedVersusVariableExpenses
“You can get quality people to invent, develop and design
products for you on a percentage of the

products’ billing—in other words, on a variable expense basis.
Many will want to work on upfront
fees only, a �ixed expense. Salesmanship on your part can get
them to charge your way. If they’re
sold on your company, you personally, or the product, they’re
more likely to comply with your
wishes. Sometimes a compromise is required where you pay a
modest upfront fee and a modest
percentage on sales of the product.”
Source:Reiss,B.(2010,November3).Outsourcingturns�ixedcostsi
ntovariablecosts.Entrepreneur.Retrievedfrom
http://www.entrepreneur.com/article/217487(http://www.entrepr
eneur.com/article/217487)
http://www.entrepreneur.com/article/217487
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ExpressingVariableandFixedCosts—ACostFunction
Since a variable cost is a rate, it is a function of an independent
variable—an activity or output level. Unit
variable costs can be converted into total variable costs only by
knowing the activity or output level. Fixed
costs are �irst expressed as a total, lump sum amount, a
constant. Total �ixed costs can be converted into a
rate per unit only if the activity or output level is known. In the
following example, the cost per unit of $7
and total costs of $700,000 can be found only if the output of
100,000 units is known.

Costsof100,000Units Costsof120,000Units
CostperUnit TotalCosts CostperUnit TotalCosts
Variable costs $4.00 ⟶$400,000 $4.00 ⟶$480,000
Fixed costs 3.00 ⟵300,000 2.50 ⟵300,000
Total $7.00 $700,000 $6.50 $780,000
If the production level increases to 120,000, both the cost per
unit and total costs change. A decrease in
the cost per unit from $7 to $6.50 results from spreading �ixed
costs of $300,000 over more units—
120,000 instead of 100,000. The increase in total cost equals the
variable costs for the additional 20,000
units. A decrease in volume has similar reverse impacts—the
cost per unit increases, but total costs
decline.
Three factors must generally be known to perform cost
analyses:
1. The variable cost rate
2. The �ixed cost amount
3. The level of activity or output
Notice that if we know the bold numbers in the example above
and the activity level, we can calculate all
other numbers. These factors can be brought together in a cost
function—an expression that
mathematically links costs, their behavior, and their cost driver.
In the example, the expression is:
Total costs = $300,000 + $4(X), where X is the number of units

produced.
This cost function can be symbolically shown as:
Total costs = a + b(X), where a is total �ixed costs and b is
variable cost per unit.
This is an important formula in managerial accounting.
Understanding these relationships can give insight
into cost behavior for planning, control, and decision making.
By knowing the activity level and cost
function, we can calculate either total costs or costs per unit.
DeterminingtheCostFunctionUsingTotalCostsandActivityLevels
In this example, let’s assume we know the total costs ($700,000
and $780,000) at both activity levels
(100,000 and 120,000 units). How do we obtain the cost
function? First, we calculate the variable cost per
unit as follows:
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The $4 per unit amount is the variable cost per unit in the cost
function. The change in cost from a change
in activity yields the slope of the total variable cost line.
To obtain the �ixed cost, which is a in the cost function, we
take the total costs at either activity level and
subtract the total variable costs at that level, as follows:

$780,000 – ($4 × 120,000 units) = $300,000
or
$700,000 – ($4 × 100,000 units) = $300,000
We now have both a and b. Total cost = $300,000 + $4 (X).
ObtainingtheCostFunctionUsingPerUnitCostsandActivityLevels
Using the same example, per unit costs were $7 at the 100,000
units activity level and $6.50 at 120,000
units. First, we calculate total costs at each level by multiplying
the cost per unit by the activity level as
follows:
$7 per unit × 100,000 = $700,000 and $6.50 per unit × 120,000
= $780,000
Second, we follow the same procedure as shown previously in
converting total costs into the cost function.
The same calculations could be applied separately to total
variable costs for b and to total �ixed costs for a.
Calculations at both levels produce the same cost function.
One danger in converting total �ixed costs into cost per unit is
that the unit cost can be misinterpreted. It
might be assumed that $7 is the variable cost—forgetting that
the $300,000 is a �ixed cost. At different
activity levels, the per unit cost will be different. Even in
solving homework problems, students are in
danger of missing the impact of volume changes on total costs
and unit costs if only costs per unit or total
costs are used.
RelevantRange

In Figures 1.9 and 1.10, activity is assumed to start at zero and
increase to very high levels. Realistically,
the cost function holds only for a much narrower range of
activity—a relevant range. A relevantrange is
the normal range of expected activity. Management does not
expect activity to exceed a certain upper
bound nor to fall below a lower bound. Production activity is
expected to be within this range, and costs
are budgeted for these levels. In cost analysis, costs are
expected to behave as de�ined within the relevant
range. The cost function is assumed to be valid for this range of
activity. Usually, past experience
establishes the relevant range.
Total �ixed costs are �ixed and total variable costs are variable
within the relevant range. In the above
example, the volume range was between 100,000 and 120,000
units. The cost function of $300,000 plus
$4 per unit is valid between 100,000 and 120,000 units as
shown in Figure 1.11. If planned production
were 130,000 units, our cost function might not be valid or
useful.
Figure1.11:Costpatternsusingarelevantrange
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SemivariableandSemi�ixedCosts
Figure 1.12 illustrates cost functions that are neither strictly

variable nor �ixed. In the real world, very few
costs are truly variable or �ixed. Semivariablecosts change but
not in direct proportion to the changes in
output. Some semivariable costs, called mixed costs, may be
broken down into �ixed and variable
components, thus making it easier to budget and control costs.
Using the cost function techniques shown
previously, �ixed and variable parts can be identi�ied. In
Example A of Figure 1.12, telephone expenses may
include a monthly basic connection fee (�ixed) plus a per-
minute charge for each call (variable).
Semi�ixedcosts or step-�ixedcosts are typi�ied by step
increases in costs with changes in activity as
shown in Example B. Activity can be increased somewhat
without a cost increase. However, at some
activity level, additional �ixed cost must be incurred to expand
capacity. An example is adding an
additional full-time worker when sales increase beyond a
certain level. If many narrow steps exist, a step-
cost pattern may approximate a variable cost. Or with wide
steps, one step may encompass the entire
relevant range and the step cost appears as a �ixed cost.
Figure1.12:Examplesofsemivariableandsemi�ixedcost
patterns
Example C shows a cost that increases but at a lower cost per
unit as activity increases. An example is
increased worker ef�iciency as activity increases, resulting in a
lower per unit cost. This is a nonlinear
cost. Example D shows a piece-wiselinearcost. It is a constant
variable rate until a certain activity level
is reached, then the variable cost per unit increases. Perhaps an
electric utility offers a low per kilowatt
rate for the �irst 500 kilowatts and a higher rate beyond that

level.
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1.6CostConceptsforPlanningandControlling
This section introduces terminology relating to traceability and
controllability of costs. These concepts are
useful for planning and control purposes.
DirectCostsVersusIndirectCosts
Costs are often de�ined as being direct or indirect with respect
to a cost object—an activity, a department,
or a product. If a cost can be speci�ically identi�ied with a
particular cost object, it is traced to the cost
object and is considered to be a direct cost. A direct cost is also
called a traceable cost. The cost of
installing a sunroof on a particular car is a direct cost of that
car because it is traceable to that particular
car. If no clear link between a cost and the cost object is
apparent, the cost is an indirectcost (also called a
commoncost). For example, the heating cost for a physical
therapy center is an indirect cost to each
patient being served there.
The same cost can be direct for one purpose and indirect for
another. For example, the salary of the St.
Louis of�ice manager is a direct cost of that branch. But within
the branch of�ice where numerous products
are sold, the manager’s salary is an indirect cost of speci�ic

products. At McDonald’s, cleaning supplies are
a direct cost for a particular restaurant, but corporate legal
expenses are an indirect cost for a particular
restaurant.
Indirect costs not traceable to particular products or
departments may need to be allocated to those cost
objects. A cost object may use a resource, but the amount used
may not be easily measured. For example, a
shoe department occupies 2,000 square feet of a 50,000 square
foot store and accounts for 10% of sales
and 6% of pro�its. If the rent for the entire store is $300,000
per year, how much should be allocated to the
shoe department—$12,000 (space), $18,000 (pro�its), $30,000
(sales), or some other amount? No cost
allocation is absolutely correct, and different viewpoints will
argue for different allocations. The allocation
process should attempt to link the cost, the use of the resource,
and the activity or output.
ControllableCostsVersusNoncontrollableCosts
Another important aspect of cost is the distinction between
costs that can and cannot be controlled by a
given manager. This cost classi�ication, like the direct and
indirect cost classi�ication, depends on a point of
reference. If a manager is responsible for a cost, that cost is a
controllable cost with respect to that
manager. If that manager is not responsible for incurring a cost,
it is a noncontrollablecost with respect
to that manager. The entire cost control system rests on who can
control each cost.
All costs are controllable at some level of management. Every
cost in an organization is controllable by
some manager in that organization. Costs should be planned or

budgeted by the manager who has
responsibility for that cost. For a McDonald’s restaurant
manager, the cost of utilities usage is controllable,
while property insurance costs are noncontrollable.
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1.7ContributionMarginandItsManyVariations
Thus far, we have de�ined cost terms. But managerial
responsibility for pro�it measurement is even more
important. Revenue is added to the analysis. While net pro�it
evaluates the entire �irm, determining
pro�itability of parts of a �irm requires more precise pro�it
measures. The term we use is contribution
margin, which is the revenue minus certain costs, a margin. This
margin contributes to covering all
remaining costs and to earning a net pro�it. Figure 1.13 shows
�ive variations used in different situations.
Figure1.13:Variationsofcontributionmargin
VariableContributionMargin—PerUnit,Ratio,andTotalDollars
The basic and most common de�inition of contribution margin
is sales minus variable costs. Variable
contributionmargin is a more explicit term because only
variable items (revenue and costs) are included
in the calculation. This contribution margin contributes towards
covering �ixed costs and provides for a
net pro�it.

As an example, a salesperson is selling a product for $20 per
unit. The �irm buys the item for $12 per unit
and pays the salesperson a 10% commission on sales. The �irm
expects to sell 10,000 units. Variable
contribution margin can be shown as follows:
VariableContributionMargin
PerUnit Ratio TotalDollars
Sales (10,000 units) $20 100% $200,000
Variable costs:
Costs of sales and commissions ($12 plus 10% of $20) 14 70
140,000
Variable contribution margin $6 30% $60,000
Thus, the contribution margin can be expressed as either $6 per
unit, 30% of sales, or $60,000. Depending
on the analysis needed, we may use one, two, or all three
versions. From total variable contribution
margin, we subtract �ixed expenses—the remaining expenses—
to arrive at net pro�it.
ControllableandDirectContributionMargins
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The next contribution margin concept looks at managerial
control and is used when a manager has
revenue and cost responsibility. Costs controllable by the
manager are typically variable costs and
controllable �ixed costs. These costs are subtracted from sales
to yield controllablecontributionmargin
or controllable margin. This represents the amount available to
cover any noncontrollable expenses and
includes any company net pro�it. Note that the de�initions of
controllable and noncontrollable developed
previously are used for both revenue and costs. Controllable
contribution margin is used to evaluate
managerial performance. However, this is not the net pro�it
that the manager generates for the company,
since noncontrollable costs must be covered before any net
pro�it is earned.
Direct or segmentcontributionmargin or segment margin is a
segment’s revenue minus its direct costs.
A segment might be a product, a region, or a division.
De�initions of direct and indirect were discussed
earlier and focus on traceability. As an example, the direct
contribution margin of a product line is sales
less product-line cost of sales, product-line advertising costs,
and any other costs traceable to that product
line. The product line’s direct contribution margin is the amount
remaining to cover company common
costs and to earn company pro�its.
IllustrationofAllContributionMarginConcepts
Pearl Engel owns three Burgers Plus locations. Figure 1.14
presents a summary income statement,
expanded for the Grand Avenue location. Variable contribution
margin is shown in total dollars for each

store and also as a ratio for the Grand Avenue store.
Directcontrollable�ixedexpenses include assistant
managers’ salaries, maintenance services, and other �ixed costs
that the store manager controls. The
controllable contribution margin is the pro�it on which the
Grand Avenue manager will be evaluated and
rewarded (a bonus for meeting pro�it goals or pro�it
improvement). Direct noncontrollable �ixed
expenses include rent on the building and the outlet manager’s
salary, which are probably controlled by
Engel.
Figure1.14:Contributionmarginanalysisbystore
This direct or store contribution margin is used to measure the
pro�it performance of each store.
Measuring store pro�itability stops at the direct contribution
margin. Direct contribution margin is the
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�inest-tuned pro�it measure that is free of allocations.
Common corporate expenses, which include Engel’s
salary and other corporate expenses, cannot be traced to the
three locations.
Contribution margin per unit requires more detail. Engel has set
target contribution margins for her three
main burger products as follows:

Averagefor
CheapBurger DoubleBurger TripleBurger
Selling price per unit $1.00 $2.00 $3.00
Variable product costs per unit 0.65 1.20 1.50
Variable contribution margin per unit $0.35 $0.80 $1.50
Variable contribution margin ratio 35% 40% 50%
Note that the other variable expenses (probably supplies and
condiments) in Figure 1.14 cannot be traced
accurately to each product. As shown in Figure 1.14, actual
burger margins can be compared across all
stores and to margin targets.
Ms. Engel has numerous versions of pro�itability for each
location. She will use each to answer speci�ic
questions about her products, managers, and stores. Common
use of the term contribution margin
frequently means variable contribution margin. To avoid
misunderstanding, de�ine which contribution
margin you are using.
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Summary & Resources

ChapterSummary
Accounting information is provided from a system that handles
the requirements of two branches of
accounting: �inancial accounting and managerial accounting.
Financial accounting presents accounting
information to parties outside the organization. Managerial
accounting organizes accounting information
for internal management. Internal reporting is generally directed
to the decision areas mentioned earlier.
The ethical conduct and integrity of the management accountant
are critical to the success of the
accountant’s mission. Ethical situations are common and often
complex. Management accountants have a
special responsibility to their management colleagues and to
themselves to uphold high ethical standards.
Cost analysis and income measurement are equally important to
service, merchandising, or manufacturing
�irms. Tracing cost �lows is important to understanding the
conversion of materials, direct labor, and
overhead into a product or service. The cost driver is the link
between resources used and outputs.
Different decisions need different costs. A “cost” must have an
adjective attached to give it meaning. In
general, costs have many attributes, but the three most
important ones for using cost concepts are cost
behavior, traceability, and controllability.
Variable and �ixed costs behave differently when activity
levels change. Variable costs are naturally
expressed as a rate; �ixed costs are naturally a lump of costs.
Fixed and variable costs can be expressed as a
cost function, such as a + b (X), where a is the �ixed cost, b is
the variable rate, and X is the level of activity.

Direct costs are traceable; indirect costs are nontraceable.
Controllability refers to a speci�ic manager’s
authority to incur the cost and responsibility to use the resource
generating the cost.
Contribution margin is revenue minus a subset of costs.
Variable contribution margin can be expressed as
an amount per unit, a ratio, or total dollars. Controllable
contribution margin is used to evaluate the
manager, and direct or segment contribution margin is used to
evaluate the segment.
KeyTerms
billofmaterials
A complete list of all materials used in a product.
Certi�iedManagementAccountant(CMA)
A person who has passed a qualifying examination sponsored by
the Institute of Management
Accountants, has met an experience requirement, and
participates in continuing education.
committed�ixedcost
A �ixed cost over which a manager has no control and must
incur.
commoncost
A cost that has no clear link to a speci�ic cost object.
contributionmargin
Sales revenue less variable costs.

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controllablecontributionmargin
Variable contribution margin less direct controllable �ixed
expenses (represents the amount available to
cover any noncontrollable expenses and includes any company
net pro�it).
controllablecost
A cost that a manager has the ability to in�luence.
controller
The person responsible for managing the entire accounting
function.
conversioncosts
Direct labor plus manufacturing overhead (costs incurred to
convert raw materials into �inished
products).
cost
The amount of resource given up to gain a speci�ic objective or
object.
costbehavior
How a cost changes with changes in business activity.
costdrivers
Measures that link activities that create outputs to resources
that are used.
costfunction

An expression that mathematically links costs, their behavior,
and their cost driver.
costobject
Any purpose for accumulating costs.
costofgoodsmanufactured
Total cost of goods completed during the period.
costofgoodssold
The total of direct materials, direct labor, and manufacturing
overhead costs associated with the goods
that have been sold during the period.
directcontributionmargin
Controllable contribution margin less direct noncontrollable
�ixed expenses (re�lects the amount
remaining to cover common costs and earn pro�its).
directcontrollable�ixedexpenses
Fixed expenses that are traceable and that a manager has the
ability to in�luence.
directcost
A cost that is traceable to a cost object.
directlaborcosts
Wages paid to workers who work directly on the product.
directmaterialscosts
Costs of the physical components of the product.
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directmaterialsused
Materials issued to production.
directnoncontrollable�ixedexpenses
Fixed expenses that are traceable, but that a manager is not able
to in�luence.
directproductcosts
Costs that can be traced to speci�ic products.
discretionary�ixedcosts
Expenditures that managers can elect to spend or not to spend.
factoryoverheadcosts
All manufacturing costs that are not direct materials or direct
labor.
�inancialaccounting
The branch of accounting that organizes accounting information
for presentation to interested parties
outside of the organization.
�inishedgoodsinventory
Products that have been completed and are ready for sale.
�ixedcost
A cost that remains constant, regardless of changes in a
company’s activity.
indirectcost
A cost that has no clear link to a speci�ic cost object.

indirectproductcosts
Manufacturing costs that cannot be traced to a speci�ic
product.
managementaccountant
An accountant who prepares information for a company’s
decision makers.
managerialaccounting
The branch of accounting that meets managers’ information
needs.
materialsinventory
Materials that are stored by the company.
mixedcost
A cost that contains both variable and �ixed elements.
noncontrollablecost
A cost that a manager is not able to in�luence.
nonlinearcosts
A cost for which the cost function cannot be represented as a
straight line.
periodcosts
Operating costs that are expensed in the period in which they
are incurred.
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piece-wiselinearcost
A cost function consisting of connected straight lines with
differing slopes.
primecosts
Direct materials cost plus direct labor cost.
productcosting
The process of attaching costs to units of product.
productcosts
Costs that are treated as assets until the products are sold.
relevantrange
Normal range of expected activity.
segmentcontributionmargin
A segment’s revenues minus its direct costs.
semi�ixedcosts
Costs that are typi�ied by step increases in costs with changes
in activity.
semivariablecost
A cost composed of a mixture of �ixed and variable
components.
step-�ixedcosts
Costs that are typi�ied by step increases in costs with changes
in activity.
totalmanufacturingcosts
The sum of direct materials, direct labor, and factory overhead
costs.

traceablecost
A cost that can be directly linked to a cost object.
variablecontributionmargin
Sales revenues less all variable expenses.
variablecost
A cost that changes in proportion to a change in a company’s
activity.
workinprocessinventory
The cost of products that have been started in the manufacturing
process but have not yet been
completed.
ProblemforReview
Rabin Corporation operates sales, administrative, and printing
activities from a facility in Augusta. It
prints, prepares, and mails a wide variety of promotional
materials. The following selected costs relate to
the �irm’s activities and particularly to the factory’s Mail
Preparation Department.
a. Production paper used in Mail Preparation Department
b. Hourly wages of production personnel in Mail Preparation
Department
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c. Factory property taxes and insurance

d. Supplies used, which changes with printing volume in Mail
Preparation Department
e. Contract signed by Mail Preparation Department manager for
an annual maintenance fee on
postage application machinery
f. Equipment depreciation in Mail Preparation Department
g. Building depreciation
h. Sales commissions
i. Advertising agency contract costs for a special program
j. Annual computer staff; uses the same number of staff all
year—half for operations, which includes
the Mail Preparation Department, and half for administrative
work
Questions:
Based on reasonable assumptions about Rabin Corporation,
classify each cost as:
1. Variable or �ixed cost
2. Controllable or noncontrollable by the supervisor of the Mail
Preparation Department
3. Direct or indirect product costs or period costs
Solution
:
CostBehavior

UnderControlof
DepartmentManager ProductCost
Cost
Item
Variable
Cost
Fixed
Cost Yes No
Direct
Cost
Indirect
Cost
Period
Cost
(a) X X X
(b) X X X

(c) X X X
(d) X X X
(e) X X X
(f) X X X
(g) X X X
(h) X X X
(i) X X X
(j) X X X* X*
* An allocation between the operations and administration is
required.
QuestionsforReviewandDiscussion
1. Brie�ly describe three ways in which �inancial accounting
and managerial accounting are different.
Name two ways in which they are the same or similar.

2. Brie�ly describe the management accountant’s responsibility
for ethical behavior with respect to
competence, con�identiality, integrity, and credibility.
3. What are sources of counsel and guidance on ethical
dilemmas available to a manager?
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4. What characteristics distinguish accounting for revenues and
expenses for service,
merchandising, and manufacturing organizations?
5. What does the mathematical expression $100,000 + $12X
mean in terms of measuring product
cost?
6. Distinguish among the following terms: cost of goods
manufactured, cost of goods sold, and total

manufacturing costs.
7. Name the three traditional cost elements in a manufactured
product. How can these elements be
attached to the product?
8. Identify at least two ways in which �ixed costs pose
dif�iculties for cost accountants and managers.
9. (a) In a recent speech, controller Judy Koch said, “I rarely
see a real variable cost or a truly �ixed
cost.” What did she mean?
(b) She also commented, “Some of my friends de�ine
semivariable costs, semi�ixed costs, step
costs, and mixed costs differently. Other friends often use these
terms interchangeably. And I like
all of my friends.” Was she just trying to be funny, or is there
truth in her quip? Explain.
11. How can an individual cost be both a direct and an indirect
cost? A controllable and a
noncontrollable cost? Give examples.
12. Sybil Goldstein supervises the Admissions Department at
Tender Care Hospital. The hospital

accountant includes Sybil’s salary among the direct expenses in
her departmental expense report.
Sybil claims she cannot control her own salary; therefore, it
should not be in the Admissions
Department’s expense report. Is Sybil correct? Explain.
13. We have 15 subsidiaries. All corporate costs are allocated to
the subsidiaries. In evaluating the
pro�itability of our French subsidiary, we �ind it generates a
net loss. Why might this number not
be a good indicator of the pro�it contribution that this
subsidiary makes to the corporation as a
whole?
Exercises
1-1.EthicalDilemma. You are on your way to lunch and the
elevator is packed. Two persons from a �irm
that competes with your employer happen to be talking about a
business deal that involves one of your
customers. Your computer-like mind lists your alternatives:
Plug your ears, tell them that you are with a
competitor, listen and then delete the information from your
brain, immediately go back to the of�ice and
act on the new information, or call their supervisor and report
the conversation you just overheard. What

should you do?
1-2.EthicalConduct. Comment on the following frequently heard
statements about ethical conduct:
a. “You can’t teach ethics. If people don’t know right from
wrong by now, they’ll never learn.”
b. “It’s legal. My attorney says so. Therefore, it’s okay.”
c. “Are you trying to impose your values on me?”
d. “I believe in situational ethics. What’s right or wrong
depends on the situation.”
e. “I can’t be ethical all the time. My competitors would eat me
alive!”
f. “Everyone does it.”
1-3.CostFlows in Manufacturing. The following data are from
the Westerman Company for August
production activities:
Inventories August1 August31
Direct materials $18,000 $10,000

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Inventories August1 August31
Work in process 12,000 16,000
Finished goods 45,000 38,000
MonthofAugust
Factory overhead $120,000
Cost of goods manufactured ?
Direct materials purchased 80,000
Direct labor 30,000
Questions:
1. What was the cost of direct materials used during August?

2. What was the cost of goods manufactured?
1-4.CostofGoodsManufactured. The following data are available
for Marcellino Enterprises:
MarchBalances AprilBalances MayBalances
Beginning materials inventory $10,000 $ ? $15,000
Ending materials inventory 8,000 ? 11,000
Beginning work in process inventory 30,000 ? 18,000
Ending work in process inventory 24,000 ? 21,000
Direct labor 20,000
Factory overhead 40,000
Materials purchases 30,000
Question:
Determine the cost of goods manufactured for April.

1-5. Classifying Cost Behavior. Jonah Roberts operates a pizza
shop near Bronx University. During
critical periods like registration and �inal exams, he is open 24
hours a day. Half of his business is takeout.
He has these expenses:
a. Cost of supplies (e.g., napkins, toothpicks, and pizza boxes)
b. Cost of dough used in pizzas
c. Salary of the supervisor of the overnight shift when needed
d. Wages of the delivery persons
e. Straight-line depreciation on equipment
f. Power costs to operate the ovens
g. Monthly lease partially based on sales
h. Cost of drinks served
i. Insurance premiums covering his equipment
j. Equipment maintenance costs
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Question:
Classify each cost as variable, �ixed, semivariable, or
semi�ixed. Add any assumptions or comments you
need to clarify your answers.
1-6. Searching for Unknowns in Manufacturing Cost Flows.
Three Japanese �irms—Kumamoto,
Kawasaki, and Kanazawa—produce musical products. Operating
results for a recent year follow (all
numbers are in millions of yen):
KumamotoCo. KawasakiCo. KanazawaCo.
Sales ¥ ? ¥90,000 ¥ ?
Materials used 15,000 ? 22,000
Direct labor 25,000 20,000 15,000
Factory overhead 60,000 25,000 ?
Total manufacturing costs ? ? ?
Beginning work in process 4,000 9,000 9,000

Ending work in process 12,000 4,000 6,000
Cost of goods manufactured ? 69,000 61,000
Beginning �inished goods 6,000 ? 8,000
Ending �inished goods 21,000 22,000 ?
Cost of goods sold ? ? 68,000
Gross margin ? 24,000 24,000
Operating expenses 25,000 ? 13,000
Net income 6,000 (6,000) ?
Question:
Determine the missing values. Helpful hint: Format a
manufacturing cost of sales section, and insert the
known amounts.
1-7.ManufacturingCostFlows. Analyze the following cases:

A. In Jiao Company, costs incurred during November were
$25,000 for materials purchased,
$50,000 for direct labor, and $60,000 for overhead. Materials
inventory changed from $24,000 to
$18,000.
Question:
If cost of goods manufactured in November was $129,000 and
beginning work in process inventory was
$16,000, determine the ending work in process inventory.
B. In Tong Company, the cost of goods sold for November was
$186,000, �inished goods
inventory decreased from $30,000 to $21,000, and work in
process inventory increased from
$21,000 to $33,000.
Question:
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Calculate the total manufacturing costs for November.
1-8. Variable Contribution Margin. Bob David’s Lab performs
soil tests for toxic chemicals in its
laboratory. Data from the third quarter of the past year include:
Selling price $15 per test
Variable lab costs $8 per test
Variable administrative and shipping expenses $3 per test
Total �ixed lab costs $25,000 per quarter
Total �ixed administrative expenses $15,000 per quarter
Tests performed 15,000 tests
Question:
Prepare an income statement showing variable contribution
margin plus net income.

1-9.DirectandControllableCosts. Gus Undheidt is manager of
Allergy Relief Services in the Frankfurt,
Germany of�ice and has the authority to buy supplies, hire
labor, and maintain equipment for the of�ice.
Costs in euros for January appearing in the Frankfurt of�ice
performance report are:
Home of�ice general manager’s salary allocated to Frankfurt
of�ice €3,000
Home of�ice operating expenses allocated to Frankfurt of�ice
2,200
Home of�ice marketing costs allocated to Frankfurt of�ice
1,700
Equipment maintenance charges—Frankfurt of�ice 2,600
Supplies used—Frankfurt of�ice 1,400
Salary—Gus Undheidt 2,500
Labor costs—Frankfurt of�ice 14,600

Home of�ice depreciation allocated to Frankfurt of�ice 1,000
Equipment depreciation—Frankfurt of�ice 2,300
Total €31,300
Questions:
1. Identify costs that can be controlled by Gus Undheidt.
2. Identify costs that can be traced directly to the Frankfurt
of�ice.
3. Identify costs allocated to the Frankfurt of�ice from the
home of�ice. Suggest a cost driver that
might have been used to allocate these costs at the home of�ice
for each cost.
1-10.EthicsinCostControl. Zoya Arbiser, regional manager of
Gold Medal Sports Shops, is reviewing the
results of 15 stores in her region. Store managers are moved
annually. Each store manager’s income is
dependent on the direct contribution margin of that store. For
the past year, Store 9 has been managed by
a person who has operated several other pro�itable stores in
recent years and is about to be promoted to a

larger store. Zoya notices several items that bother her.
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1. Store 9 has almost no personnel training expenses relative to
other stores.
2. Store 9 has stopped participating in numerous community
events that gave the store signi�icant
visibility but did incur substantial expenses.
3. Store 6, where this store manager worked the prior year, has
had a severe drop in pro�its due to
higher operating expenses.
4. The advertising budget for Store 9 was spent almost entirely
in the �irst four months of the year,
with almost nothing spent in the last several months.

Question:
Comment on a possible negative managerial scenario that the
regional manager may be sensing. Might the
manager of Store 9 be an exceptional manager? Explain.
1-11.ManagingbyContributionMargin. We know the following
about March’s results for Location 18
for Alan’s Fine Gold Jewelry, a franchise operation operating in
Southern states:
Sales $480,000
Variable cost of jewelry 185,000
Other variable costs 55,000
Controllable �ixed costs 100,000
Direct noncontrollable �ixed costs 85,000
Home of�ice allocated costs 50,000
Questions:

1. Based on what contribution margin number would you
evaluate the Location 18 manager?
2. Based on what contribution margin number would you
evaluate Location 18?
1-12.ContributionMargin. As a recent marketing graduate of Big
Time University, you landed a job with
Food Mills, Inc. as product manager for Red Pop. Recent
operating results are:
Sales of Red Pop $2,000,000
Variable costs of Red Pop 600,000
Direct noncontrollable �ixed marketing expenses 500,000
Variable selling expenses 300,000
Direct controllable �ixed marketing expenses 100,000
Allocated corporate marketing expenses (percentage of sales)
400,000
Allocated corporate of�ice costs (per employee) 200,000

Questions:
1. Evaluate the pro�itability of Red Pop.
2. What data should be used to evaluate you as manager of Red
Pop?
Problems
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1-13. Determining Production Costs. Shirley Brickman knows
the following about the production
process in her plant:
Department1:
Conversion costs are $200,000.
Prime costs are $300,000.
Materials purchases are $200,000.
Increase in materials inventory is $20,000.

Decrease in work in process inventory is $40,000.
Question:
Calculate factory overhead costs.
Department2:
Direct product costs are materials and direct labor.
Conversion costs are 300% of materials.
Indirect product costs are 50% of conversion costs.
Total manufacturing costs are $600,000.
Question:
Calculate materials costs.
Department3:
Conversion costs are 40% of total manufacturing costs.
Direct labor is 25% of conversion costs.
Factory overhead is $600,000.
Question:
Calculate total manufacturing costs.

1-14.DeterminingUnknowns. Determine the missing values in
the following manufacturing income
statement:
2018 2019 2020
Sales $? $118,700 $?
Cost of goods sold:
Direct materials inventory 1/1 $8,000 $? $?
+ Direct materials purchased ? 20,000 30,000
Direct materials available $? $26,000 $?
– Less direct materials inventory 12/31 ? (9,000) (12,000)
Direct materials used $? $? $?
Direct labor 20,000 23,500 ?
Factory overhead 16,000 ? 24,000
Total manufacturing costs $53,000 $ ? $90,900

7/30/2019 Print
2018 2019 2020
+ Work in process inventory 1/1 12,000 18,000 ?
– Work in process inventory 12/31 ? (16,300) (22,300)
Cost of goods manufactured $ ? $63,500 $84,900
+ Finished goods inventory 1/1 ? ? ?
Goods available for sale $62,000 $84,500 $103,200
– Finished goods inventory 12/31 (21,000) ? ?
Cost of goods sold $ ? $ ? $78,200

Gross pro�it $60,000 $? $46,800
1-15.DeterminingCostofGoodsSold. Asnien Out�itters makes
Artic Hotsuits. The general manager has
a special board on his of�ice wall where he writes key
statistics. For March, the board shows the following:
Production output 25,000 suits
Materials costs $50,000
Direct labor costs 2,000 hours at $10 per hour
Factory overhead $2 per out�it plus $40,000 per month
Selling expenses $1 per out�it sold plus $50,000 per month
He heard the sales manager brag about selling 22,000 suits this
month.
Questions:
1. From the data, what was the cost of producing an Artic
Hotsuit in March?
2. What was cost of goods sold in March?

3. What are the total product and period costs that will appear
on Asnien Out�itters’ income
statement for March?
1-16. Income Statement Preparation. A partial list of account
balances for Ackerman Corporation
follows:
RevenueandExpenses: January1Inventories:
Purchases of direct materials $140,000 Direct materials $45,000
Direct labor 225,000 Work in process 30,000
Indirect labor 40,000 Finished goods 105,000
Rent – factory 84,000
Depreciation – machinery 35,000 December31Inventories:
Insurance – factory 18,000 Direct materials $40,000
Salespersons’ salaries 72,000 Work in process 35,000

Maintenance – machinery 12,000 Finished goods 110,000
7/30/2019 Print
RevenueandExpenses: January1Inventories:
Administrative salaries 50,000
Miscellaneous – factory 26,000
Miscellaneous – of�ice 40,000
Sales 850,000
Question:
Prepare an income statement with a cost of goods manufactured
section.

1-17. Identifying Cost Patterns. Match the graphs in Figure 1.15
with the numbered descriptions.
Indicate any assumptions you are making. The x-axis is activity;
the y-axis is total dollars of cost.
Figure1.15:Summaryofcostclassi�ications
1. _____ a+b (X), where “a” and “b” are not equal to zero.
2. _____ Straight-line depreciation expense (a classic �ixed
cost).
3. _____ Shift supervision salaries (shifts added as demand
increases).
4. _____ Municipal utility costs where the rate increases as
usage increases. Usage increases with
activity increases.
5. _____ Sales commissions paid to salespersons.
6. _____ Workers’ wages plus overtime premium. Overtime is
needed after a certain activity level is
reached. Workers are less ef�icient when they work a lot of
overtime.

7/30/2019 Print
7. _____ Water and waste water costs with a �ixed-cost base
charge plus a per-gallon rate beyond a
certain level.
8. _____ Payroll taxes that are based on the �irst $30,000 of
each employee’s wages. All employees earn
more than this at high activity levels.
9. _____ Mixed costs within a relevant range.
10. _____ Cost of hourly messenger service for a regional bank
with a reduced rate after 2,000 hours of
chargeable time.
11. _____ Wage costs as more hourly telephone callers are
added in a telemarketing campaign.
12. _____ Materials costs where cost per pound decreases as
larger quantities are purchased.
1-18.CostClassi�ication. Selected costs associated with a

variety of business situations are shown below:
a. Sales commissions of the marketing staff
b. Salary of the plant manager
c. Lubricating oils for machines
d. Brass rods used in making plumbing products
e. Property taxes on a building that includes both the factory
and home of�ice
f. Labor in the repairs and maintenance section
g. Salary of the supervisor in the grinding department
h. Crude oil used in a re�ining process that results in numerous
products
i. Wages of artists preparing ads for a grocery chain, working
for the grocery chain
j. Depreciation on administrative of�ice furniture
k. Salaries of quality assurance personnel who test products
during production
l. Salaries of software engineers in a production plant using
robots
m. Wages of union auto assembly workers guaranteed 2,000
hours of work per year
Question:

Create columns to classify each item by cost behavior (variable,
semivariable, or �ixed) with respect to
activity; as a product or period cost; and, if it is a product cost,
as a direct or indirect product cost.
1-19.CostAnalysisWithout Pro�it as a Bottom Line. Riverdale
Transport, Inc. runs passenger and
freight services between the Cleveland airport and other nearby
towns and cities. The owner, Serena
Bailey, is an operations-wise manager. She recently heard about
a “segment contribution margin”
approach at a university continuing education program. Her
actual results for the �irst half of this year
have just arrived.
Total revenue was $5.0 million, of which $3.5 million was
freight traf�ic and $1.5 million was passenger
traf�ic. Of the passenger revenue, 60% was generated by Route
1, 30% by Route 2, and 10% by Route 3.
Total direct controllable �ixed costs were $600,000, of which
$500,000 was spent on freight traf�ic. Of the
remainder, $40,000 could not be traced to speci�ic routes,
although it was clearly applicable to passenger

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