It is important to distinguish between marginal costs and average costs. In the Comet Computer example, the marginal cost of the second computer is $1,900. However, the average cost per unit when two laptops are manufactured is $3,900 divided by 2, or
$1,950. Similarly, the marginal cost of the eleventh laptop is $1,690, but the average cost per unit when 11 laptops are produced is $1,790 (calculated by dividing $19,690 by 11).
What is the marginal cost of the 101st laptop computer? The average cost per unit when 101 laptops are manufactured?12
To summarize, the marginal cost of production is the extra cost incurred when one more unit is produced. The average cost per unit is the total cost, for whatever quantity is manufactured, divided by the number of units manufactured. Marginal costs and aver- age costs arise in a variety of economic situations. A University of Texas dean might be interested in the marginal cost of educating one additional student, and a Toyota exec- utive might want to know the marginal cost of producing one more Toyota Prius. An Amtrak route manager might be interested in the average cost per mile on the Boston to New York City route.
information. Some accountants, eager to show that they have not overlooked anything, tend to provide managers with too much information. But when managers receive more data than they can utilize effectively, information overload occurs. Struggling to process large amounts of information, managers may be unable to recognize the most important facts. In deciding how much and what type of information to provide, managerial accoun- tants should consider these human limitations.
Costs in the Service Industry
The cost terms and concepts that we have studied in this chapter are just as relevant in the service industry as in a manufacturing firm like Comet Computer Company. Here we will explore those cost issues in the context of a well-known fitness company.
Gold’s Gym is one of the world’s largest health and fitness center operators. The company has over 700 franchised and company-owned gyms worldwide, offering state- of-the-art equipment, coaching and personal training, group exercise programs, and a fitness-oriented community environment. Gold’s Gym works to stay relevant in the ever-changing global fitness industry, in recent years adding CrossFit-style training, spin classes, specialized exercise studios, boot camp programs, and 3-D body scanning. They also introduced a fitness app, called Gold’s AmpTM, that is intended to keep pace in the fast-growing digital coaching space. And they sell branded clothing and other products as an additional revenue source—and a good source of marketing, too!
In order to grow and thrive, the company has had to change from its early niche image as a bodybuilding mecca, going back to its origins in Venice Beach, California, in the 1960s, to become a fitness operation that is widely accessible and welcoming, empha- sizing “personalization and innovation.”15
A typical Gold’s Gym occupies several thousand square feet of space, features a huge variety of exercise equipment, and programs dozens of classes each week. It franchises many of its new locations via an independent franchisee network, and supports its fran- chisees with regional business managers who assist franchisees with operations, retail initiatives, promotion, training, and monitoring of the franchise agreement.
Now let’s think about how the various cost issues we have studied apply to Gold’s Gym, in a service-industry environment.
Product and Period Costs Gold’s Gym purchases several different kinds of prod- ucts for their gyms. The exercise equipment is a fixed asset that is recorded on the bal- ance sheet. Like all fixed assets, it is depreciated over time, and the depreciation expense becomes part of cost of services (or operating expenses, as discussed earlier). Supplies (paper towels, printer paper) and other operating costs (trainer salaries, music royalties, utilities, facility depreciation, etc.) are period costs, and they are expensed as operating expenses during the period when they are incurred. The costs of items that are ordered for resale, such as Gold’s Gym-branded merchandise, are stored in inventory as product costs (or inventoriable costs) until the time period when they are purchased by customers.
At that time, these product costs become part of cost of services.
Variable and Fixed Costs The costs incurred in a Gold’s Gym fitness center that vary directly with activity are variable costs. For example, the costs of disinfecting liquid and wipes for wiping down equipment after use is a variable cost, because the usage of disinfectant varies in proportion to the number of client visits. That doesn’t mean that every client wipes down their machines like they should, but it does mean that the more clients, the more disinfectant is used, and it’s likely to be proportional: twice as many
Costs in the Service Industry
15Information about the company and its services are from the Gold’s Gym website. For additional information about the transformation of Gold’s Gym, see Lee Bell, “Gold’s Gym: The Innovation Behind Transforming the World’s Most Iconic Fitness Club,” Forbes, February 23, 2018.
©James R. Martin/
Shutterstock
clients would use twice as much disinfectant. Thus, a likely cost driver for this cost would be the number of client visits during the period. On the other hand, the fees paid to the music service for the music played in the gym and in classes is a fixed cost, because this cost doesn’t vary with the amount of service activity (number of clients). The music is always on, no matter how many people are in the gym. Other fixed costs would include the Gold’s Gym managerial salaries, insurance, and property taxes. The exercise equip- ment depreciation mentioned above would be a fixed cost as well.
Direct and Indirect Costs In a spin class, participants ride a special fixed-gear sta- tionary exercise bike that provides a high-intensity cycling workout. The only direct cost of this spin class (the class is the cost object) is the payment to the instructor. But the many indirect costs of the spin class include the depreciation of the spin cycles (indirect because the exact amount of bike depreciation can’t be traced precisely to a particular class, only artificially divided among all of the spin classes), the location gym manager’s salary, the depreciation on the building, and targeted social media advertising purchased by the franchise.
Now consider a different cost object—a particular Gold’s Gym location. For this cost object, the location gym manager’s salary becomes a direct cost of the Gold’s Gym loca- tion. However, the Gold’s Gym CEO’s salary is an indirect cost of this particular location.
Controllable and Uncontrollable Costs Costs that are controllable by the gym manager of this Gold’s Gym location include local advertising, assuming the location manager is responsible for such local ad buys. A cost that is partially controllable by the location manager might include air conditioning costs. Although the manager has little control over electricity prices, she can ensure that the shop’s AC system is properly maintained and the temperature settings are properly managed. Many of the location’s costs are largely uncontrollable by the gym manager. The depreciation, insurance, and property taxes on the building, for example, are the result of company policies regarding location, insurance coverage, and gym size.
Opportunity, Out-of-Pocket, and Sunk Costs These cost types all are represented in the Gold’s Gym fitness service business. As part of its “personalization and inno- vation” strategy, Gold’s Gym decided to reduce the amount of space dedicated to free
©dolgachov/123RF
weights and use that space as a women-only workout area. Any customer business that was lost due to that decision was an opportunity cost of the decision. Note that the pres- ence of opportunity costs does not mean the decision was a poor one. The company believed that the opportunity cost of any lost business from weightlifters would be more than offset by increased business from clients, women and men, who prefer the more inclusive environment. But the opportunity cost does need to be considered in order to make sure the decision is the right one. The wages paid to trainers and costs of utili- ties are examples of out-of-pocket costs. The money spent last year to replace elliptical machines with newer models is an example of a sunk cost.
Differential, Marginal, and Average Costs Suppose a Gold’s Gym location owns a van to make short runs to pick up supplies, to take class groups to special events, and to help clients with the occasional transportation issue. The van needs to be replaced, and two vehicles are under consideration. The difference in the cost of these two alternative vehicles is a differential cost of the vehicle replacement decision (there may be other costs that affect the decision, such as the opportunity cost of one van only having 10 seats versus 12 seats in the other). The cost of buying one additional Gold’s Gym-branded gym bag to sell in the store is the marginal cost of an additional gym bag. The total cost of all Gold’s Gym-branded gym bags sold in a period, divided by the number of those bags, is the average cost of a Gold’s Gym-branded gym bag.
To summarize, although manufacturers, like Lululemon, Motorola, or Renault, and service-industry firms, like Allstate, Alamo Rent-a-Car, or Gold’s Gym, are in very dif- ferent businesses, they all must understand their costs in order to be successful in a com- petitive environment.
Focus on Ethics
ETHICS 101: IS “JUST FOLLOWING ORDERS” AN ACCEPTABLE EXCUSE?
In one of the classic ethics debacles of recent decades, the company Worldcom, Inc., was bankrupted when manipu- lation of expenses and income destroyed investor con- fidence, leaving the company unable to meet its financial obligations. Worldcom had grown through a series of merg- ers and acquisitions to become the nation’s second-largest long-distance telecommunications company. Its core com- munication services included network data transmission over public and private networks. Trouble arose for World- Com because of the immense overcapacity in the tele- communications industry due to overly optimistic growth projections during the early years of Internet growth.
In June 2002, the company disclosed that it had over- stated earnings for 2001 and the first quarter of 2002 to the tune of $3.8 billion. The overstatement arose because the company intentionally misclassified period expenses as capital expenditures. This maneuver had two major effects on the company’s financial statements: the com- pany’s assets were artificially inflated and the capitaliza- tion allowed the company to spread the recognition of its expenses into the future, which increased net income in
the current period. The expenses in question related to line costs—the fees that a telecom company pays to out- side providers for access to their communications net- works. In addition, the company announced in July 2002 that it had also manipulated reserve accounts, which affected another $3.8 billion in earnings in 1999 and 2000.
(A reserve account can be used to store costs as an asset on the balance sheet until they are subsequently con- verted to expenses, similar to the operation of fixed assets and depreciation. When the costs are held as reserves longer than they should be, income is overstated in the short run.)
The problems at WorldCom were discovered during an internal audit and brought to the attention of the com- pany’s new auditors, KPMG. A different firm, Arthur Andersen, served as WorldCom’s auditors during the period covered by the alleged accounting scandal. Arthur Andersen main- tained that the details of the accounting fraud were kept from them by senior WorldCom management. The firm’s controller and chief financial officer (CFO), who was a for- mer KPMG employee, were fired after the alleged account- ing frauds were revealed. WorldCom’s CEO maintained that he knew nothing of the accounting decisions made by the
61
expenses could slip by senior management.
According to an Associated Press article that ran on September 27, 2002, “the former controller of WorldCom, Inc., pleaded guilty to securities fraud charges, saying he was instructed by ‘senior management,’ to falsify records.
His plea was the first admission of guilt” to come out of what was at the time the largest corporate accounting scandal in U.S. history.17 Subsequently, the controller, the director of general accounting, the CFO, and the CEO were all sentenced to prison time, and the CFO and CEO for- feited personal assets valued at millions of dollars to settle lawsuits by investors.18
Why is this classic fraud still relevant today? Clearly, the answer to the question “Is ‘just following orders’ an acceptable excuse?” is an emphatic “No!” And yet, in the recent Volkswagen emissions scandal discussed in Chapter 1, we find the same issue yet again. As one reporter asked, “Is a culture of ‘just following orders’ so ironclad in VW that in six years no one questioned those orders and no one refused to obey them? If so, until the
16Jared Sandberg, Rebecca Blumenstein, and Shawn Young, “WorldCom Admits $3.8 Billion Error in Its Accounting—Firm Ousts Financial Chief and Struggles for Survival; SEC Probe Likely to Widen,” The Wall Street Journal, June 26, 2002, p. A1; Jared Sandberg, Deborah Solomon, and Rebecca Blumenstein, “Disconnected:
Inside WorldCom’s Unearthing of a Vast Accounting Scandal,” The Wall Street Journal, June 27, 2002, p. A1; and Jared Sandberg, “Leading the News: Was Ebbers Aware of Accounting Move at His WorldCom?” The Wall Street Journal, July 1, 2002, p. A3.
17Devlin Barrett, “Ex-WorldCom Exec Pleads Guilty,” Associated Press, September 27, 2002 (as it appeared in the Ithaca Journal). See also Kurt Eichenwald and Simon Romero, “Plea Deals Are Seen for Three WorldCom Execu- tives,” The New York Times, August 29, 2002, pp. C1, C4.
18T. Richardson, “Worldcom CFO Lied, He Admits in Court,” The Register, February 17, 2005; A. Latour, S. Young, and L. Yuan, “Ebbers Is Convicted in Massive Fraud,”The Wall Street Journal, March 16, 2005;
B. Cosgrove-Mather, “Former Worldcom Exec Gets Prison,” CBS News, August 10, 2005.
mental safety will remain unacceptably high.” Managers and accountants exist on the front lines of this ethical challenge.19
What ethical issues are involved here? What steps should managers at WorldCom and Volkswagen have taken? First, review the Institute of Management Accountants’
Statement of Ethical Professional Practice at the end of Chapter 1.
19Ira Chaleff, “VW’s culture of blind obedience: What went wrong and how to fix it’” MSBN.com, September 26, 2015.
LO2-1 Explain what is meant by the word cost. The word cost can have a variety of meanings in different situations. In general, a cost is the sacrifice made, usually measured by the resources given up, to achieve a particular purpose.
LO2-2 Distinguish among product costs, period costs, and expenses. A product cost is a cost assigned to manufactured or purchased goods. Period costs are those associated with the period of time in which they are incurred. An expense is the cost incurred when a resource (asset) is used up for the purpose of generating revenue.
LO2-3 Describe the role of costs in published financial statements. The cost of goods sold is an expense on the income statement. Inventory on the balance sheet is measured at its cost, as are all assets.
LO2-4 List and describe four types of manufacturing processes. The four basic types of manufac- turing processes are job shop, batch, assembly line, and continuous flow.
*The Ethics Unwrapped concepts videos are an entertaining and helpful resource published by the University of Texas at Austin. The videos and other material relating to ethical behavior by managers, accountants, and others in organizations can be found at https://
ethicsunwrapped.utexas.edu.
Ethics Unwrapped concept videos that particularly apply to this Focus on Ethics include Conformity Bias and Obedience to Authority.*
With permission of the University of Texas at Austin, McCombs School of Business
Chapter Summary
LO2-5 Give examples of three types of manufacturing costs. Manufacturing costs are catego- rized as direct-material, direct-labor, and manufacturing-overhead (which is also known as production overhead).
LO2-6 Prepare a schedule of cost of goods manufactured, a schedule of cost of goods sold, and an income statement for a manufacturer. These accounting schedules, which are illustrated in the chap- ter, provide information to management about the costs incurred in a production operation.
LO2-7 Understand the importance of identifying an organization’s cost drivers. A cost driver is any activity or event that causes costs to be incurred. Understanding the cost drivers in an organization is an essential component of managing those costs.
LO2-8 Describe the behavior of variable and fixed costs, in total and on a per-unit basis. As activ- ity in an organization increases, a variable cost increases proportionately to activity in total, but remains constant on a per-unit basis. In contrast, as activity in an organization increases, a fixed cost remains constant in total but decreases on a per-unit basis.
LO2-9 Distinguish among direct, indirect, controllable, and uncontrollable costs. Direct and indi- rect costs refer to the ability of the accountant to trace costs to various departments in the organization.
The terms controllable and uncontrollable are used to describe the extent to which a manager can influ- ence a cost.
LO2-10 Define and give examples of an opportunity cost, an out-of-pocket cost, a sunk cost, a differential cost, a marginal cost, and an average cost. An opportunity cost is the benefit forgone because the choice of one action precludes another action. An out-of-pocket cost requires the payment of cash or other assets. Sunk costs are costs incurred in the past that cannot be altered by a current or future decision. A differential (or incremental) cost refers to the difference in the costs incurred under two alternative actions. A marginal cost is the cost of producing one additional unit. Finally, the average cost per unit is the total cost for whatever quantity is produced, divided by the number of units produced.
Review Problems on Cost Classifications
Problem 1
Several costs incurred by Myrtle Beach Golf Equipment, Inc., are listed below. For each cost, indicate which of the following classifications best describe the cost. More than one classification may apply to the same cost item. For example, a cost may be both a variable cost and a product cost.
Cost Classifications a. Variable b. Fixed c. Period d. Product e. Administrative f. Selling g. Manufacturing
h. Research and development i. Direct material
j. Direct labor
k. Manufacturing overhead Cost Items
1. Metal used in golf clubs.
2. Salary of the plant manager.
3. Cost of electricity used to air condition the factory.
4. Commissions paid to sales personnel.
5. Wages paid to employees who assemble golf bags.
6. Salary of an engineer who is working on a prototype of a new self-driving golf cart.
7. Depreciation on the laptop used by the company president’s executive assistant.
Problem 2
Listed below are several costs incurred in the loan department of Suwanee Bank and Trust Company. For each cost, indicate which of the following classifications best describe the cost. More than one classification may apply to the same cost item.
Cost Classifications
a. Controllable by the loan department manager b. Uncontrollable by the loan department manager c. Direct cost of the loan department
d. Indirect cost of the loan department e. Differential cost
f. Marginal cost g. Opportunity cost h. Sunk cost i. Out-of-pocket cost Cost Items
1. Salary of the loan department manager.
2. Cost of office supplies used in the loan department.
3. Cost of the department’s desktop computers purchased by the loan department manager last year.
4. The portion of general advertising cost of the bank that has been allocated to the loan department.
5. Revenue that the loan department would have generated for the bank if a branch loan office had been located downtown instead of in the next county.
6. Difference in the cost incurred by the bank when one additional loan application is processed.
Solutions to Review Problems Problem 1
1. a, d, g, i 2. b, d, g, k 3. a, d, g, k 4. a, c, f 5. a, d, g, j 6. b, c, h 7. b, c, e Problem 2 1. b, c, i 2. a, c, i 3. a, c, h 4. b, d, i 5. g 6. e, f
Key Terms
For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text.
activity accounting, 52 activity-based costing (ABC)
system, 52
activity-based management (ABM), 52
average cost per unit, 57 controllable cost, 53 conversion costs, 44 cost, 36
cost driver, 48
cost management system (CMS), 52
cost object, 52 cost of goods
manufactured, 45
cost of goods sold, 45 differential cost, 56 direct cost, 52 direct-labor cost, 43 direct material, 43