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2.4: Summary and Key Terms

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  • Section Summaries

    2.1 Distinguish between Merchandising, Manufacturing, and Service Organizations

    • Merchandising, manufacturing, and service organizations differ in what they provide to consumers; however, all three types of firms must control costs in order to remain profitable. The type of costs they incur is primarily determined by the product/good, or service they provide.
    • As the type of organization differs, so does the way they account for costs. Some of these differences are reflected in the income statement.

    2.2 Identify and Apply Basic Cost Behavior Patterns

    • Costs can be broadly classified as either fixed or variable costs. However, in order for managers to manage effectively, these two cost classifications are often further expanded to include mixed, step, prime, and conversion costs.
    • For manufacturing firms, it is essential that they differentiate among direct materials, direct labor, and manufacturing overhead in order to identify and manage their total product costs.
    • For planning purposes, managers must be careful to consider the relevant range because it is only within this relevant range that total fixed costs remain constant.

    2.3 Estimate a Variable and Fixed Cost Equation and Predict Future Costs

    • In order to make business decisions, managers can utilize past cost data to predict future costs employing three methods: scatter graphs, the high-low method, and least-squares regression analysis.
    • Scatter graphs are used as a diagnostic tool to determine if the relationship between activity and cost is a linear relationship.
    • Both the high-low method and the least-squares regression method separate mixed costs into their fixed and variable components to allow managers to predict future costs from historical costs.

    Key Terms

    average fixed cost (AFC)
    total fixed costs divided by the total number of units produced, which results in a per-unit cost
    average variable cost (AVC)
    total variable costs divided by the total number of units produced, which results in a per-unit cost
    conversion costs
    total of labor and overhead for a product; the costs that “convert” the direct material into the finished product
    cost driver
    activity that is the reason for the increase or decrease of another cost; examples include labor hours incurred, labor costs paid, amounts of materials used in production, units produced, or any other activity that has a cause-and-effect relationship with incurred costs
    direct labor
    labor directly related to the manufacturing of the product or the production of a service
    direct materials
    materials used in the manufacturing process that can be traced directly to the product
    fixed cost
    unavoidable operating expense that does not change in total, regardless of the level of activity
    high-low method
    technique for separating the fixed and variable cost components of mixed costs
    indirect labor
    labor not directly involved in the active conversion of materials into finished products or the provision of services
    indirect materials
    materials used in production but not efficiently traceable to a specific unit of production
    intangible good
    good with financial value but no physical presence; examples include copyrights, patents, goodwill, and trademarks
    manufacturing organization
    business that uses parts, components, or raw materials to produce finished goods
    manufacturing overhead
    costs incurred in the production process that are not economically feasible to measure as direct material or direct labor costs; examples include indirect material, indirect labor, utilities, and depreciation
    merchandising firm
    business that purchases finished products and resells them to consumers
    mixed costs
    expenses that have a fixed component and a variable component
    period costs
    typically related to a particular time period instead of attached to the production of an asset; treated as an expense in the period incurred (examples include many sales and administrative expenses)
    prime costs
    direct material expenses and direct labor costs
    product costs
    all expenses required to manufacture the product: direct materials, direct labor, and manufacturing overhead
    relevant range
    quantitative range of units that can be produced based on the company’s current productive assets; for example, if a company has sufficient fixed assets to produce up to 10,000 units of product, the relevant range would be between 0 and 10,000 units
    scatter graph
    plot of pairs of numerical data that represents actual costs incurred for various levels of activity, with one variable on each axis, used to determine whether there is a relationship between them
    service organization
    business that earns revenue primarily by providing an intangible product
    stepped cost
    one that changes with the level of activity but will remain constant within a relevant range
    tangible good
    physical good that customers can handle and see
    total cost
    sum of all fixed and all variable costs
    total fixed costs
    sum of all fixed costs
    total variable costs
    sum of all variable costs
    variable cost
    one that varies in direct proportion to the level of activity within the business