Providence Regional Medical Center's "single stay" ward is lowering healthcare costs and improving patient satisfaction by keeping postoperative patients in one room throughout their recovery. Equipment and staff are brought to stationary patients rather than transporting patients around the hospital. This has led to higher patient satisfaction scores and shorter average hospital stays of over one day.

1. BUSINESS FOCUS
Lowering Healthcare Costs and Improving Patient Care
Source: Catherine Arnst, “Radical Surgery,” Bloomberg
Businessweek, January 18, 2010, pp. 40–45.
Providence Regional Medical Center’s (PRMC) “single stay”
ward is lowering healthcare costs and increasing patient
satisfaction. Rather than transporting post-surgical patients to
stationary equipment throughout the hospital, a “single stay”
ward brings all required equipment to stationary patients. For
example, “after heart surgery, cardiac patients remain in one
room throughout their recovery, only the gear and staff are in
motion. As the patient’s condition stabilizes, the beeping
machines of intensive care are removed and physical therapy
equipment is added.” The results of this shift in orientation
have been impressive. Patient satisfaction scores have
skyrocketed and the average length of a patient’s stay in the
hospital has declined by more than a day.
LEARNING OBJECTIVES
After studying Chapter 2, you should be able to:
LO2–1
Understand cost classifications used for assigning costs to cost
objects: direct costs and indirect costs.
LO2–2
Identify and give examples of each of the three basic
manufacturing cost categories.
LO2–3
Understand cost classifications used to prepare financial
statements: product costs and period costs.
LO2–4
Understand cost classifications used to predict cost behavior:
variable costs, fixed costs, and mixed costs.
LO2–5

2. Analyze a mixed cost using a scatter-graph plot and the high-
low method.
LO2–6
Prepare income statements for a merchandising company using
the traditional and contribution formats.
LO2–7
Understand cost classifications used in making decisions:
differential costs, opportunity costs, and sunk costs.
LO2–8
(Appendix 2A) Analyze a mixed cost using a scattergraph plot
and the least-squares regression method.
LO2–9
(Appendix 2B) Identify the four types of quality costs and
explain how they interact.
LO2–10
(Appendix 2B) Prepare and interpret a quality cost report.
Page 28
This chapter explains that in managerial accounting the
termcost is used in many different ways. The reason is that
there are many types of costs, and these costs are classified
differently according to the immediate needs of management.
For example, managers may want cost data to prepare external
financial reports, to prepare planning budgets, or to make
decisions. Each different use of cost data demands a different
classification and definition of costs. For example, the
preparation of external financial reports requires the use of
historical cost data, whereas decision making may require
predictions about future costs. This notion ofdifferent costs for
different purposes is a critically important aspect of managerial
accounting.
Exhibit 2–1 summarizes the cost classifications that will be
defined in this chapter, namely cost classifications (1) for
assigning costs to cost objects, (2) for manufacturing
companies, (3) for preparing financial statements, (4) for
predicting cost behavior, and (5) for making decisions. As we
begin defining the cost terminology related to each of these cost

3. classifications, please refer back to this exhibit to help improve
your understanding of the overall organization of the chapter.
EXHIBIT 2–1
Summary of Cost Classifications
Cost Classifications for Assigning Costs to Cost Objects
LO2–1
Understand cost classifications used for assigning costs to cost
objects: direct costs and indirect costs.
Costs are assigned to cost objects for a variety of purposes
including pricing, preparing profitability studies, and
controlling spending. A cost object is anything for which cost

4. data are desired—including products, customers, jobs, and
organizational subunits. For purposes of assigning costs to cost
objects, costs are classified as either direct or indirect.
Direct Cost
A direct cost is a cost that can be easily and conveniently traced
to a specified cost object. For example, if Reebok is assigning
costs to its various regional and national sales offices, then the
salary of the sales manager in its Tokyo office would be a direct
cost of that office. If a printing company made 10,000
brochures for a specific customer, then the cost of the paper
used to make the brochures would be a direct cost of that
customer.
Page 29
Indirect Cost
An indirect cost is a cost that cannot be easily and conveniently
traced to a specified cost object. For example, a Campbell
Soup factory may produce dozens of varieties of canned soups.
The factory manager’s salary would be an indirect cost of a
particular variety such as chicken noodle soup. The reason is
that the factory manager’s salary is incurred as a consequence
of running the entire factory—it is not incurred to produce any
one soup variety. To be traced to a cost object such as a
particular product, the cost must be caused by the cost
object. The factory manager’s salary is called a common cost of
producing the various products of the factory. Acommon cost is
a cost that is incurred to support a number of cost objects but
cannot be traced to them individually. A common cost is a type
of indirect cost.
A particular cost may be direct or indirect, depending on the
cost object. While the Campbell Soup factory manager’s salary
is an indirect cost of manufacturing chicken noodle soup, it is
a direct cost of the manufacturing division. In the first case, the
cost object is chicken noodle soup. In the second case, the cost
object is the entire manufacturing division.

5. Cost Classifications for Manufacturing Companies
Manufacturing companies such as Texas Instruments, Ford,
and DuPontseparate their costs into two broad categories—
manufacturing and nonmanufacturing costs.
Manufacturing Costs
LO2–2
Identify and give examples of each of the three basic
manufacturing cost categories.
Most manufacturing companies further separate their
manufacturing costs into two direct cost categories, direct
materials and direct labor, and one indirect cost category,
manufacturing overhead. A discussion of each of these
categories follows.
Direct Materials The materials that go into the final product
are called raw materials. This term is somewhat misleading
because it seems to imply unprocessed natural resources like
wood pulp or iron ore. Actually, raw materials refer to any
materials that are used in the final product; and the finished
product of one company can become the raw materials of
another company. For example, the plastics produced by Du
Pont are a raw material used by Hewlett-Packard in its personal
computers.
Raw materials may include both direct and indirect
materials. Direct materials are those materials that become an
integral part of the finished product and whose costs can be
conveniently traced to the finished product. This would include,
for example, the seats that Airbus purchases from
subcontractors to install in its commercial aircraft and the
electronic components that Apple uses in its iPhones.
Sometimes it isn’t worth the effort to trace the costs of
relatively insignificant materials to end products. Such minor
items would include the solder used to make electrical
connections in a Sony HDTV or the glue used to assemble
an Ethan Allen chair. Materials such as solder and glue are
called indirect materials and are included as part of
manufacturing overhead, which is discussed shortly.

6. Direct Labor Direct labor consists of labor costs that can be
easily (i.e., physically and conveniently) traced to individual
units of product. Direct labor is sometimes called touch
labor because direct labor workers typically touch the product
while it is being made. Examples of direct labor include
assembly-line workers at Toyota, carpenters at the home
builderKB Home, and electricians who install equipment on
aircraft atBombardier Learjet.
Page 30
IN BUSINESS
FOOD PRICES HIT RECORD HIGHS FOR RESTAURANTS
Direct material costs are critically important to restaurants and
fast-food chains. In recent years, some food costs have spiked
to record highs. For example, unexpected freezing temperatures
in the southwestern portion of the United States caused the cost
of lettuce to increase 290%. Similarly, the costs of green
peppers, tomatoes, and cucumbers jumped 145%, 85%, and
30%, respectively. A large chain such as Subwaycan withstand
these price increases better than smaller competitors because of
its buying power and long-term contracts.
Source: Anne VanderMey, “Food For Thought,” Fortune, May
9, 2011, p. 12.
Labor costs that cannot be physically traced to particular
products, or that can be traced only at great cost and
inconvenience, are termed indirect labor. Just like indirect
materials, indirect labor is treated as part of manufacturing
overhead. Indirect labor includes the labor costs of janitors,
supervisors, materials handlers, and night security guards.
Although the efforts of these workers are essential, it would be
either impractical or impossible to accurately trace their costs
to specific units of product. Hence, such labor costs are treated
as indirect labor.
Manufacturing Overhead Manufacturing overhead, the third
manufacturing cost category, includes all manufacturing costs
except direct materials and direct labor. Manufacturing

7. overhead includes items such as indirect materials; indirect
labor; maintenance and repairs on production equipment; and
heat and light, property taxes, depreciation, and insurance on
manufacturing facilities. A company also incurs costs for heat
and light, property taxes, insurance, depreciation, and so forth,
associated with its selling and administrative functions, but
these costs are not included as part of manufacturing overhead.
Only those costs associated with operating the factory are
included in manufacturing overhead.
Various names are used for manufacturing overhead, such
as indirect manufacturing cost, factory overhead, and factory
burden. All of these terms are synonyms for manufacturing
overhead.
Nonmanufacturing Costs
Nonmanufacturing costs are often divided into two categories:
(1) selling costs and (2) administrative costs. Selling
costs include all costs that are incurred to secure customer
orders and get the finished product to the customer. These costs
are sometimes called order-getting and order-
fillingcosts. Examples of selling costs include advertising,
shipping, sales travel, sales commissions, sales salaries, and
costs of finished goods warehouses. Selling costs can be either
direct or indirect costs. For example, the cost of an advertising
campaign dedicated to one specific product is a direct cost of
that product, whereas the salary of a marketing manager who
oversees numerous products is an indirect cost with respect to
individual products.
Administrative costs include all costs associated with
the general management of an organization rather than with
manufacturing or selling. Examples of administrative costs
include executive compensation, general accounting, secretarial,
public relations, and similar costs involved in the overall,
general administration of the organization as a
whole.Administrative costs can be either direct or indirect
costs. For example, the salary of an accounting manager in
charge of accounts receivable collections in the East region is a

8. direct cost of that region, whereas the salary of a chief financial
officer who oversees all of a company’s regions is an indirect
cost with respect to individual regions.
Page 31
Nonmanufacturing costs are also often called selling, general,
and administrative (SG&A) costs or just selling and
administrative costs.
Cost Classifications for Preparing Financial Statements
LO2–3
Understand cost classifications used to prepare financial
statements: product costs and period costs.
When preparing a balance sheet and an income statement,
companies need to classify their costs as product costs or period
costs. To understand the difference between product costs and
period costs, we must first discuss the matching principle from
financial accounting.
Generally, costs are recognized as expenses on the income
statement in the period that benefits from the cost. For example,
if a company pays for liability insurance in advance for two
years, the entire amount is not considered an expense of the
year in which the payment is made. Instead, one-half of the cost
would be recognized as an expense each year. The reason is that
both years—not just the first year—benefit from the insurance
payment. The unexpensed portion of the insurance payment is
carried on the balance sheet as an asset called prepaid
insurance.
The matching principle is based on the accrual concept
that costs incurred to generate a particular revenue should be
recognized as expenses in the same period that the revenue is
recognized. This means that if a cost is incurred to acquire or
make something that will eventually be sold, then the cost
should be recognized as an expense only when the sale takes
place—that is, when the benefit occurs. Such costs are
called product costs.
Product Costs
For financial accounting purposes, product costs include all

9. costs involved in acquiring or making a product. In the case of
manufactured goods, these costs consist of direct materials,
direct labor, and manufacturing overhead.1Product costs
“attach” to units of product as the goods are purchased or
manufactured, and they remain attached as the goods go into
inventory awaiting sale. Product costs are initially assigned to
an inventory account on the balance sheet. When the goods are
sold, the costs are released from inventory as expenses
(typically called cost of goods sold) and matched against sales
revenue on the income statement. Because product costs are
initially assigned to inventories, they are also known
asinventoriable costs.
We want to emphasize that product costs are not necessarily
recorded as expenses on the income statement in the period in
which they are incurred. Rather, as explained above, they are
recorded as expenses in the period in which the related
products are sold.
Period Costs
Period costs are all the costs that are not product costs. All
selling and administrative expenses are treated as period
costs. For example, sales commissions, advertising, executive
salaries, public relations, and the rental costs of administrative
offices are all period costs. Period costs are not included as part
of the cost of either purchased or manufactured goods; instead,
period costs are expensed on the income statement in the period
in which they are incurred using the usual rules of accrual
accounting. Keep in mind that the period in which a cost is
incurred is not necessarily the period in which cash changes
hands. For example, as discussed earlier, the costs of liability
insurance are spread across the periods that benefit from the
insurance—regardless of the period in which the insurance
premium is paid.
Page 32
Prime Cost and Conversion Cost
Two more cost categories are often used in discussions of
manufacturing costs—prime cost and conversion cost. Prime

10. cost is the sum of direct materials cost and direct labor
cost. Conversion cost is the sum of direct labor cost and
manufacturing overhead cost. The term conversion cost is used
to describe direct labor and manufacturing overhead because
these costs are incurred to convert materials into the finished
product.
To improve your understanding of these definitions, consider
the following scenario: A company has reported the following
costs and expenses for the most recent month:
d
These costs and expenses can be categorized in a number of
ways, including product costs, period costs, conversion costs,
and prime costs:
IN BUSINESS
WALMART LOOKS TO REDUCE ITS SHIPPING COSTS
Walmart hopes to lower its shipping costs, thereby enabling it
to reduce its “everyday low prices.” In years past, suppliers
would ship their merchandise to Walmart’s distribution centers,
and then Walmart would use its own fleet of trucks to ship
goods from its distribution centers to its retail store locations.
However, now Walmart wants to assume control of transporting
merchandise from its suppliers’ manufacturing facilities to its
distribution centers. Walmart believes it can lower these
shipping costs by carrying more merchandise per truck and by
taking advantage of volume purchase price discounts for fuel. In
exchange for assuming these shipping responsibilities, Walmart
is seeking price reductions from suppliers that it can pass along,
at least in part, to its customers.
Source: Chris Burritt, Carol Wolf, and Matthew Boyle, “Why
Wal-Mart Wants to Take the Driver’s Seat,” Bloomberg
Businessweek, May 31–June 6, 2010, pp. 17–18.
Cost Classifications for Predicting Cost Behavior

11. LO2–4
Understand cost classifications used to predict cost behavior:
variable costs, fixed costs, and mixed costs.
It is often necessary to predict how a certain cost will behave in
response to a change in activity. For example, a manager
at Under Armour may want to estimate the impact a 5 percent
increase in sales would have on the company’s total direct
materials cost. Cost behavior refers to how a cost reacts to
changes in the level of activity. As the activity level rises and
falls, a particular cost may rise and fall as well—or it may
remain constant. For planning purposes, a manager must be able
to anticipate which of these will happen; and if a cost can be
expected to change, the manager must be able to estimate how
much it will change. To help make such distinctions, costs are
often categorized as variable, fixed, or mixed. The relative
proportion of each type of cost in an organization is known as
its cost structure. For example, an organization might have
many fixed costs but few variable or mixed costs. Alternatively,
it might have many variable costs but few fixed or mixed costs.
Variable Cost
A variable cost varies, in total, in direct proportion to changes
in the level of activity. Common examples of variable costs
include cost of goods sold for a merchandising company, direct
materials, direct labor, variable elements of manufacturing
overhead, such as indirect materials, supplies, and power, and
variable elements of selling and administrative expenses, such
as commissions and shipping costs.2
For a cost to be variable, it must be variable with respect to
something.That “something” is its activity base. An activity
base is a measure of whatever causes the incurrence of a
variable cost. An activity base is sometimes referred to as a cost
driver. Some of the most common activity bases are direct
labor-hours, machine-hours, units produced, and units sold.
Other examples of activity bases (cost drivers) include the
number of miles driven by salespersons, the number of pounds
of laundry cleaned by a hotel, the number of calls handled by

12. technical support staff at a software company, and the number
of beds occupied in a hospital. While there are many activity
bases within organizations, throughout this textbook, unless
stated otherwise, you should assume that the activity base under
consideration is the total volume of goods and services provided
by the organization. We will specify the activity base only when
it is something other than total output.
To provide an example of a variable cost, consider Nooksack
Expeditions, a small company that provides daylong whitewater
rafting excursions on rivers in the North Cascade Mountains.
The company provides all of the necessary equipment and
experienced guides, and it serves gourmet meals to its guests.
The meals are purchased from a caterer for $30 a person for a
daylong excursion. The behavior of this variable cost, on both a
per unit and a total basis, is shown below:
d
IN BUSINESS
COST DRIVERS IN THE ELECTRONICS INDUSTRY
Accenture Ltd. estimates that the U.S. electronics industry
spends $13.8 billion annually to rebox, restock, and resell
returned products. Conventional wisdom is that customers only
return products when they are defective, but the data show that
this explanation only accounts for 5% of customer returns. The
biggest cost drivers that cause product returns are that
customers often inadvertently buy the wrong products and that
they cannot understand how to use the products that they have
purchased. Television manufacturer Vizio Inc. has started
including more information on its packaging to help customers
avoid buying the wrong product. Seagate Technologies is
replacing thick instruction manuals with simpler guides that
make it easier for customers to begin using their products.
Source: Christopher Lawton, “The War on Returns,” The Wall
Street Journal, May 8, 2008, pp. D1 and D6.
Page 34
IN BUSINESS

13. FOOD COSTS AT A LUXURY HOTEL
The Sporthotel Theresa (http://www.theresa.at/), owned and
operated by the Egger family, is a four star hotel located in Zell
im Zillertal, Austria. The hotel features access to hiking, skiing,
biking, and other activities in the Ziller alps as well as its own
fitness facility and spa.
Three full meals a day are included in the hotel room charge.
Breakfast and lunch are served buffet-style while dinner is a
more formal affair with as many as six courses. The chef, Stefan
Egger, believes that food costs are roughly proportional to the
number of guests staying at the hotel; that is, they are a variable
cost. He must order food from suppliers two or three days in
advance, but he adjusts his purchases to the number of guests
who are currently staying at the hotel and their consumption
patterns. In addition, guests make their selections from the
dinner menu early in the day, which helps Stefan plan which
foodstuffs will be required for dinner. Consequently, he is able
to prepare just enough food so that all guests are satisfied and
yet waste is held to a minimum.
Source: Conversation with Stefan Egger, chef at the Sporthotel
Theresa.
While total variable costs change as the activity level changes,
it is important to note that a variable cost is constant if
expressed on a per unitbasis. For example, the per unit cost of
the meals remains constant at $30 even though the total cost of
the meals increases and decreases with activity. The graph on
the left-hand side of Exhibit 2–2 illustrates that the total
variable cost rises and falls as the activity level rises and falls.
At an activity level of 250 guests, the total meal cost is $7,500.
At an activity level of 1,000 guests, the total meal cost rises to
$30,000.
EXHIBIT 2–2
Variable and Fixed Cost Behavior

14. Fixed Cost
A fixed cost is a cost that remains constant, in total, regardless
of changes in the level of activity. Examples of fixed costs
include straight-line depreciation, insurance, property taxes,
rent, supervisory salaries, administrative salaries, and
advertising. Unlike variable costs, fixed costs are not affected
by changes in activity. Consequently, as the activity level rises
and falls, total fixed costs remain constant unless influenced by
some outside force, such as a landlord increasing your monthly
rental expense. To continue the Nooksack Expeditions example,
assume the company rents a building for $500 per month to
store its equipment. The total amount of rent paid is the same
regardless of the number of guests the company takes on its
expeditions during any given month. The concept of a fixed cost
is shown graphically on the right-hand side of Exhibit 2–2.
Because total fixed costs remain constant for large variations in
the level of activity, the average fixed cost per unit becomes
progressively smaller as the level of activity increases. If
Nooksack Expeditions has only 250 guests in a month, the $500
fixed rental cost would amount to an average of $2 per guest. If
there are 1,000 guests, the fixed rental cost would average only
50 cents per guest. The table below illustrates this aspect of the
behavior of fixed costs. Note that as the number of guests
increase, the average fixed cost per guest drops.
Page 35
d
As a general rule, we caution against expressing fixed costs on
an average per unit basis in internal reports because it creates
the false impression that fixed costs are like variable costs and
that total fixed costs actually change as the level of activity
changes.
For planning purposes, fixed costs can be viewed as
either committed ordiscretionary. Committed fixed
costs represent organizational investments with
a multiyear planning horizon that can’t be significantly reduced

15. even for short periods of time without making fundamental
changes. Examples include investments in facilities and
equipment, as well as real estate taxes, insurance expenses, and
salaries of top management. Even if operations are interrupted
or cut back, committed fixed costs remain largely unchanged in
the short term because the costs of restoring them later are
likely to be far greater than any short-run savings that might be
realized. Discretionary fixed costs (often referred to as managed
fixed costs) usually arise from annual decisions by management
to spend on certain fixed cost items. Examples of discretionary
fixed costs include advertising, research, public relations,
management development programs, and internships for
students. Discretionary fixed costs can be cut for short periods
of time with minimal damage to the long-run goals of the
organization.
The Linearity Assumption and the Relevant Range
Management accountants ordinarily assume that costs are
strictly linear; that is, the relation between cost on the one hand
and activity on the other can be represented by a straight line.
Economists point out that many costs are actually curvilinear;
that is, the relation between cost and activity is a curve.
Nevertheless, even if a cost is not strictly linear, it can be
approximated within a narrow band of activity known as
the relevant rangeby a straight line. The relevant range is the
range of activity within which the assumption that cost behavior
is strictly linear is reasonably valid. Outside of the relevant
range, a fixed cost may no longer be strictly fixed or a variable
cost may not be strictly variable. Managers should always keep
in mind that assumptions made about cost behavior may be
invalid if activity falls outside of the relevant range.
Page 36
The concept of the relevant range is important in understanding
fixed costs. For example, suppose the Mayo Clinic rents a
machine for $20,000 per month that tests blood samples for the
presence of leukemia cells. Furthermore, suppose that the
capacity of the leukemia diagnostic machine is 3,000 tests per

16. month. The assumption that the rent for the diagnostic machine
is $20,000 per month is only valid within the relevant range of 0
to 3,000 tests per month. If the Mayo Clinic needed to test
5,000 blood samples per month, then it would need to rent
another machine for an additional $20,000 per month. It would
be difficult to rent half of a diagnostic machine; therefore, the
step pattern depicted in Exhibit 2–3 is typical for such costs.
This exhibit shows that the fixed rental expense is $20,000 for a
relevant range of 0 to 3,000 tests. The fixed rental expense
increases to $40,000 within the relevant range of 3,001 to 6,000
tests. The rental expense increases in discrete steps or
increments of 3,000 tests, rather than increasing in a linear
fashion per test.
EXHIBIT 2–3
Fixed Costs and the Relevant Range
This step-oriented cost behavior pattern can also be used to
describe other costs, such as some labor costs. For example,
salaried employee expenses can be characterized using a step
pattern. Salaried employees are paid a fixed amount, such as
$40,000 per year, for providing the capacity to work a
prespecified amount of time, such as 40 hours per week for 50
weeks a year (= 2,000 hours per year). In this example, the total
salaried employee expense is $40,000 within a relevant range of
0 to 2,000 hours of work. The total salaried employee expense
increases to $80,000 (or two employees) if the organization’s
work requirements expand to a relevant range of 2,001 to 4,000
hours of work. Cost behavior patterns such as salaried
employees are often called step-variable costs. Step-variable
costs can often be adjusted quickly as conditions change.
Furthermore, the width of the steps for step-variable costs is
generally so narrow that these costs can be treated essentially as
variable costs for most purposes. The width of the steps for
fixed costs, on the other hand, is so wide that these costs should
be treated as entirely fixed within the relevant range.
Exhibit 2–4 summarizes four key concepts related to variable

17. and fixed costs. Study it carefully before reading further.
EXHIBIT 2–4
Summary of Variable and Fixed Cost Behavior
Page 37
IN BUSINESS
HOW MANY GUIDES?
Majestic Ocean Kayaking, of Ucluelet, British Columbia, is
owned and operated by Tracy Morben-Eeftink. The company
offers a number of guided kayaking excursions ranging from
three-hour tours of the Ucluelet harbor to six-day kayaking and
camping trips in Clayoquot Sound. One of the company’s
excursions is a four-day kayaking and camping trip to The
Broken Group Islands in the Pacific Rim National Park. Special
regulations apply to trips in the park—including a requirement
that one certified guide must be assigned for every five guests
or fraction thereof. For example, a trip with 12 guests must have
at least three certified guides. Guides are not salaried and are
paid on a per-day basis. Therefore, the cost to the company of
the guides for a trip is a step-variable cost rather than a fixed
cost or a strictly variable cost. One guide is needed for 1 to 5
guests, two guides for 6 to 10 guests, three guides for 11 to 15
guests, and so on.
Sources: Tracy Morben-Eeftink, owner, Majestic Ocean
Kayaking. For more information about the company,
see www.oceankayaking.com.
Mixed Costs
A mixed cost contains both variable and fixed cost elements.
Mixed costs are also known as semivariable costs. To continue
the Nooksack Expeditions example, the company incurs a mixed
cost called fees paid to the state. It includes a license fee of
$25,000 per year plus $3 per rafting party paid to the state’s
Department of Natural Resources. If the company runs 1,000
rafting parties this year, then the total fees paid to the state

18. would be $28,000, made up of $25,000 in fixed cost plus $3,000
in variable cost. Exhibit 2–5 depicts the behavior of this mixed
cost.
EXHIBIT 2–5
Mixed Cost Behavior
Even if Nooksack fails to attract any customers, the company
will still have to pay the license fee of $25,000. This is why the
cost line in Exhibit 2–5intersects the vertical cost axis at the
$25,000 point. For each rafting party the company organizes,
the total cost of the state fees will increase by $3. Therefore,
the total cost line slopes upward as the variable cost of $3 per
party is added to the fixed cost of $25,000 per year.
Because the mixed cost in Exhibit 2–5 is represented by a
straight line, the following equation for a straight line can be
used to express the relationship between a mixed cost and the
level of activity:
Page 38
Because the variable cost per unit equals the slope of the
straight line, the steeper the slope, the higher the variable cost
per unit.
In the case of the state fees paid by Nooksack Expeditions, the
equation is written as follows:
This equation makes it easy to calculate the total mixed cost for
any level of activity within the relevant range. For example,
suppose that the company expects to organize 800 rafting
parties in the next year. The total state fees would be calculated
as follows:
The Analysis of Mixed Costs

19. Mixed costs are very common. For example, the overall cost of
providing X-ray services to patients at the Harvard Medical
School Hospital is a mixed cost. The costs of equipment
depreciation and radiologists’ and technicians’ salaries are
fixed, but the costs of X-ray film, power, and supplies are
variable. At Southwest Airlines, maintenance costs are a mixed
cost. The company incurs fixed costs for renting maintenance
facilities and for keeping skilled mechanics on the payroll, but
the costs of replacement parts, lubricating oils, tires, and so
forth, are variable with respect to how often and how far the
company’s aircraft are flown.
Page 39
The fixed portion of a mixed cost represents the minimum cost
of having a service ready and available for use. The variable
portion represents the cost incurred for actual consumption of
the service, thus it varies in proportion to the amount of service
actually consumed.
Managers can use a variety of methods to estimate the fixed and
variable components of a mixed cost such as account
analysis, the engineering approach, the high-low
method, and least-squares regression analysis. Inaccount
analysis, an account is classified as either variable or fixed
based on the analyst’s prior knowledge of how the cost in the
account behaves. For example, direct materials would be
classified as variable and a building lease cost would be
classified as fixed because of the nature of those costs.
The engineering approach to cost analysis involves a detailed
analysis of what cost behavior should be, based on an industrial
engineer’s evaluation of the production methods to be used, the
materials specifications, labor requirements, equipment usage,
production efficiency, power consumption, and so on.
The high-low and least-squares regression methods estimate the
fixed and variable elements of a mixed cost by analyzing past
records of cost and activity data. We will use an example from
Brentline Hospital to illustrate the high-low method calculations
and to compare the resulting high-low method cost estimates to

20. those obtained using least-squares regression.Appendix
2A demonstrates how to use Microsoft Excel to perform least-
squares regression computations.
Diagnosing Cost Behavior with a Scattergraph Plot
LO2–5
Analyze a mixed cost using a scattergraph plot and the high-low
method.
Assume that Brentline Hospital is interested in predicting future
monthly maintenance costs for budgeting purposes. The senior
management team believes that maintenance cost is a mixed
cost and that the variable portion of this cost is driven by the
number of patient-days. Each day a patient is in the hospital
counts as one patient-day. The hospital’s chief financial officer
gathered the following data for the most recent seven-month
period:
d
The first step in applying the high-low method or the least-
squares regression method is to diagnose cost behavior with a
scattergraph plot. The scattergraph plot of maintenance costs
versus patient-days at Brentline Hospital is shown in Exhibit 2–
6. Two things should be noted about this scattergraph:
EXHIBIT 2–6
Scattergraph Method of Cost Analysis
1. The total maintenance cost, Y, is plotted on the vertical axis.
Cost is known as the dependent variable because the amount of
cost incurred during a period depends on the level of activity
for the period. (That is, as the level of activity increases, total
cost will also ordinarily increase.)
Page 40
2. The activity, X (patient-days in this case), is plotted on the
horizontal axis. Activity is known as the independent
variable because it causes variations in the cost.
From the scattergraph plot, it is evident that maintenance costs
do increase with the number of patient-days in an
approximately linear fashion. In other words, the points lie

21. more or less along a straight line that slopes upward and to the
right. Cost behavior is considered linear whenever a straight
line is a reasonable approximation for the relation between cost
and activity.
Plotting the data on a scattergraph is an essential diagnostic
step that should be performed before performing the high-low
method or least-squares regression calculations. If the
scattergraph plot reveals linear cost behavior, then it makes
sense to perform the high-low or least-squares regression
calculations to separate the mixed cost into its variable and
fixed components. If the scattergraph plot does not depict linear
cost behavior, then it makes no sense to proceed any further in
analyzing the data.
The High-Low Method
Assuming that the scattergraph plot indicates a linear relation
between cost and activity, the fixed and variable cost elements
of a mixed cost can be estimated using the high-low method or
the least-squares regression method. The high-low method is
based on the rise-over-run formula for the slope of a straight
line. As previously discussed, if the relation between cost and
activity can be represented by a straight line, then the slope of
the straight line is equal to the variable cost per unit of activity.
Consequently, the following formula can be used to estimate the
variable cost:
To analyze mixed costs with the high-low method, begin by
identifying the period with the lowest level of activity and the
period with the highest level of activity. The period with the
lowest activity is selected as the first point in the above formula
and the period with the highest activity is selected as the second
point. Consequently, the formula becomes:
Page 41
or
Therefore, when the high-low method is used, the variable cost

22. is estimated by dividing the difference in cost between the high
and low levels of activity by the change in activity between
those two points.
To return to the Brentline Hospital example, using the high-low
method, we first identify the periods with the highest and
lowest activity—in this case, June and March. We then use the
activity and cost data from these two periods to estimate the
variable cost component as follows:
d
Having determined that the variable maintenance cost is 80
cents per patient-day, we can now determine the amount of
fixed cost. This is done by taking the total cost at either the
high or the low activity level and deducting the variable cost
element. In the computation below, total cost at the high
activity level is used in computing the fixed cost element:
Both the variable and fixed cost elements have now been
isolated. The cost of maintenance can be expressed as $3,400
per month plus 80 cents per patient-day or as:
The data used in this illustration are shown graphically
in Exhibit 2–7. Notice that a straight line has been drawn
through the points corresponding to the low and high levels of
activity. In essence, that is what the high-low method does—it
draws a straight line through those two points.
EXHIBIT 2–7
High-Low Method of Cost Analysis
Sometimes the high and low levels of activity don’t coincide
with the high and low amounts of cost. For example, the period
that has the highest level of activity may not have the highest
amount of cost. Nevertheless, the costs at the highest and lowest
levels of activity are always used to analyze a mixed cost under
the high-low method. The reason is that the analyst would like

23. to use data that reflect the greatest possible variation in
activity.
Page 42
The high-low method is very simple to apply, but it suffers from
a major (and sometimes critical) defect—it utilizes only two
data points. Generally, two data points are not enough to
produce accurate results. Additionally, the periods with the
highest and lowest activity tend to be unusual. A cost formula
that is estimated solely using data from these unusual periods
may misrepresent the true cost behavior during normal periods.
Such a distortion is evident in Exhibit 2–7. The straight line
should probably be shifted down somewhat so that it is closer to
more of the data points. For these reasons, least-squares
regression will generally be more accurate than the high-low
method.
The Least-Squares Regression Method
The least-squares regression method, unlike the high-low
method, uses all of the data to separate a mixed cost into its
fixed and variable components. A regression line of the
form Y = a + bX is fitted to the data, where a represents the
total fixed cost and b represents the variable cost per unit of
activity. The basic idea underlying the least-squares regression
method is illustrated in Exhibit 2–8 using hypothetical data
points. Notice from the exhibit that the deviations from the
plotted points to the regression line are measured vertically on
the graph. These vertical deviations are called the regression
errors. There is nothing mysterious about the least-squares
regression method. It simply computes the regression line that
minimizes the sum of these squared errors. The formulas that
accomplish this are fairly complex and involve numerous
calculations, but the principle is simple.
EXHIBIT 2–8
The Concept of Least-Squares Regression
Page 43

24. Fortunately, computers are adept at carrying out the
computations required by the least-squares regression formulas.
The data—the observed values of X and Y—are entered into the
computer, and software does the rest. In the case of the
Brentline Hospital maintenance cost data, a statistical software
package on a personal computer can calculate the following
least-squares regression estimates of the total fixed cost (a) and
the variable cost per unit of activity (b):
Therefore, using the least-squares regression method, the fixed
element of the maintenance cost is $3,431 per month and the
variable portion is 75.9 cents per patient-day.
In terms of the linear equation Y = a + bX, the cost formula can
be written as
where activity (X) is expressed in patient-days.
Appendix 2A discusses how to use Microsoft Excel to perform
least-squares regression calculations. For now, you only need to
understand that least-squares regression analysis generally
provides more accurate cost estimates than the high-low method
because, rather than relying on just two data points, it uses all
of the data points to fit a line that minimizes the sum of the
squared errors. The table below compares Brentline Hospital’s
cost estimates using the high-low method and the least-squares
regression method:
d
When Brentline uses the least-squares regression method to
create a straight line that minimizes the sum of the squared
errors, it results in estimated fixed costs that are $31 higher
than the amount derived using the high-low method. It also
decreases the slope of the straight line resulting in a lower
variable cost estimate of $0.759 per patient-day rather than
$0.80 per patient-day as derived using the high-low method.
Page 44
IN BUSINESS
THE ZIPCAR COMES TO COLLEGE CAMPUSES

25. Zipcar is a car sharing service based in Cambridge,
Massachusetts. The company serves 13 cities and 120 university
campuses. Members pay a $50 annual fee plus $7 an hour to
rent a car. They can use their iPhones to rent a car, locate it in
the nearest Zipcar parking lot, unlock it using an access code,
and drive it off the lot. This mixed cost arrangement is
attractive to customers who need a car infrequently and wish to
avoid the large cash outlay that comes with buying or leasing a
vehicle.
Source: Jefferson Graham, “An iPhone Gets Zipcar Drivers on
Their Way,” USA Today, September 30, 2009, p. 3B.
Traditional and Contribution Format Income Statements
LO2–6
Prepare income statements for a merchandising company using
the traditional and contribution formats.
In this section of the chapter, we discuss how to prepare
traditional and contribution format income statements for a
merchandising company.3Merchandising companies do not
manufacture the products that they sell to customers. For
example, Lowe’s and Home Depot are merchandising companies
because they buy finished products from manufacturers and then
resell them to end consumers.
The Traditional Format Income Statement
Traditional income statements are prepared primarily for
external reporting purposes. The left-hand side of Exhibit 2–
9 shows a traditional income statement format for
merchandising companies. This type of income statement
organizes costs into two categories—cost of goods sold and
selling and administrative expenses. Sales minus cost of goods
sold equals the gross margin. The gross margin minus selling
and administrative expenses equals net operating income.
EXHIBIT 2–9
Comparing Traditional and Contribution Format Income
Statements for Merchandising Companies (all numbers are

26. given)
The cost of goods sold reports the product costs attached to the
merchandise sold during the period. The selling and
administrative expenses report all period costs that have been
expensed as incurred. The cost of goods sold for a
merchandising company can be computed directly by
multiplying the number of units sold by their unit cost or
indirectly using the equation below:
Page 45
For example, let’s assume that the company depicted in Exhibit
2–9purchased $3,000 of merchandise inventory during the
period and had beginning and ending merchandise inventory
balances of $7,000 and $4,000, respectively. The equation
above could be used to compute the cost of goods sold as
follows:
Although the traditional income statement is useful for external
reporting purposes, it has serious limitations when used for
internal purposes. It does not distinguish between fixed and
variable costs. For example, under the heading “Selling and
administrative expenses,” both variable administrative costs
($400) and fixed administrative costs ($1,500) are lumped
together ($1,900). Internally, managers need cost data organized
by cost behavior to aid in planning, controlling, and decision
making. The contribution format income statement has been
developed in response to these needs.
The Contribution Format Income Statement
The crucial distinction between fixed and variable costs is at the
heart of the contribution approach to constructing income
statements. The unique thing about the contribution approach is
that it provides managers with an income statement that clearly
distinguishes between fixed and variable costs and therefore
aids planning, controlling, and decision making. The right-hand
side of Exhibit 2–9 shows a contribution format income

27. statement for merchandising companies.
The contribution approach separates costs into fixed and
variable categories, first deducting variable expenses from sales
to obtain thecontribution margin. For a merchandising company,
cost of goods sold is a variable cost that gets included in the
“Variable expenses” portion of the contribution format income
statement. The contribution margin is the amount remaining
from sales revenues after variable expenses have been deducted.
This amount contributes toward covering fixed expenses and
then toward profits for the period.
The contribution format income statement is used as an internal
planning and decision-making tool. Its emphasis on cost
behavior aids cost-volume-profit analysis (such as we shall be
doing in a subsequent chapter), management performance
appraisals, and budgeting. Moreover, the contribution approach
helps managers organize data pertinent to numerous decisions
such as product-line analysis, pricing, use of scarce resources,
and make or buy analysis. All of these topics are covered in
later chapters.
Cost Classifications for Decision Making
LO2–7
Understand cost classifications used in making decisions:
differential costs, opportunity costs, and sunk costs.
Costs are an important feature of many business decisions. In
making decisions, it is essential to have a firm grasp of the
concepts differential cost, opportunity cost, and sunk cost.
Differential Cost and Revenue
Decisions involve choosing between alternatives. In business
decisions, each alternative will have costs and benefits that
must be compared to the costs and benefits of the other
available alternatives. A difference in costs between any two
alternatives is known as a differential cost. A difference in
revenues (usually just sales) between any two alternatives is
known asdifferential revenue.
Page 46
A differential cost is also known as an incremental cost,

28. although technically an incremental cost should refer only to an
increase in cost from one alternative to another; decreases in
cost should be referred to asdecremental costs. Differential cost
is a broader term, encompassing both cost increases
(incremental costs) and cost decreases (decremental costs)
between alternatives.
The accountant’s differential cost concept can be compared to
the economist’s marginal cost concept. In speaking of changes
in cost and revenue, the economist uses the terms marginal
cost and marginal revenue. The revenue that can be obtained
from selling one more unit of product is called marginal
revenue, and the cost involved in producing one more unit of
product is called marginal cost. The economist’s marginal
concept is basically the same as the accountant’s differential
concept applied to a single unit of output.
Differential costs can be either fixed or variable. To illustrate,
assume that Natural Cosmetics, Inc., is thinking about changing
its marketing method from distribution through retailers to
distribution by a network of neighborhood sales representatives.
Present costs and revenues are compared to projected costs and
revenues in the following table:
d
According to the above analysis, the differential revenue is
$100,000 and the differential costs total $85,000, leaving a
positive differential net operating income of $15,000 in favor of
using sales representatives.
In general, only the differences between alternatives are
relevant in decisions. Those items that are the same under all
alternatives and that are not affected by the decision can be
ignored. For example, in the Natural Cosmetics, Inc., example
above, the “Other expenses” category, which is $60,000 under
both alternatives, can be ignored because it has no effect on the
decision. If it were removed from the calculations, the sales
representatives would still be preferred by $15,000. This is an
extremely important principle in management accounting that
we will revisit in later chapters.

29. Opportunity Cost and Sunk Cost
Opportunity cost is the potential benefit that is given up when
one alternative is selected over another. For example, assume
that you have a part-time job while attending college that pays
$200 per week. If you spend one week at the beach during
spring break without pay, then the $200 in lost wages would be
an opportunity cost of taking the week off to be at the beach.
Opportunity costs are not usually found in accounting records,
but they are costs that must be explicitly considered in every
decision a manager makes. Virtually every alternative involves
an opportunity cost.
A sunk cost is a cost that has already been incurred and that
cannot be changed by any decision made now or in the future.
Because sunk costs cannot be changed by any decision, they are
not differential costs. And because only differential costs are
relevant in a decision, sunk costs should always be ignored.
Page 47
To illustrate a sunk cost, assume that a company paid $50,000
several years ago for a special-purpose machine. The machine
was used to make a product that is now obsolete and is no
longer being sold. Even though in hindsight purchasing the
machine may have been unwise, the $50,000 cost has already
been incurred and cannot be undone. And it would be folly to
continue making the obsolete product in a misguided attempt to
“recover” the original cost of the machine. In short, the $50,000
originally paid for the machine is a sunk cost that should be
ignored in current decisions.
IN BUSINESS
THE ECONOMICS OF DRIVING YOUR DREAM CAR
The costs of buying, insuring, repairing, and garaging ultra-
luxury vehicles can be very expensive. For example, the
purchase price alone for a new Lamborghini or Bentley can
easily exceed $300,000. Thus, Gotham Dream Cars offers an
alternative to customers who want to drive ultra-luxury cars
while avoiding the exorbitant costs of ownership. It sells
fractional shares in luxury cars—the minimum price starts at

30. $9,000 for 20 driving-days. George Johnson is a Gotham Dream
Cars customer who spent $30,000 for 90 driving-days in two
types of ultra-luxury vehicles. He noted that “it’s not worth it to
buy one of these cars when you have to fix them.” In essence,
Johnson compared the costs of ownership with the rental costs
and decided to rent.
Source: David Kiley, “My Lamborghini—Today,
Anyway,” BusinessWeek, January 14, 2008, p. 17.