Chapter 5

1. Chapter 5 The Nature of Costs

2. Topics to be Discussed Introduction The Behavior of Fixed and Variable Costs The Cost Equation Cost Behavior and Decision Making

3. Introduction What is the nature of costs and how are they used in decision making? Do they increase or decrease as production volume changes? Do they remain stable?

4. Introduction Key Concept Costs behave in predictable ways. The concept of predictable cost behavior based on volume is very important to the effective use of accounting information for managerial decision making.

5. The Behavior of Fixed Costs Fixed Costs remain the same in total, but may vary per unit when production volume changes. Examples: Rent, Depreciation, Salary of a Plant Manager, Insurance, Property Taxes Total Fixed Costs Fixed Cost Per Unit $ $ Volume Volume

6. The Behavior of Variable Costs Variable Costs vary in direct proportion to changes in production volume, but are fixed when expressed as per-unit amounts. Examples: Direct material, direct labor, and other unit-level costs like factory supplies Total Variable Costs Variable Cost Per Unit $ $ Volume Volume

7. Curvilinear Costs and the Relevant Range Relevant Range Curvilinear Function Cost Straight-Line Approximation Volume

8. The Cost Equation Y = a + bx Y = total costs a = fixed costs b = slope of line (variable costs) x = units produced

9. Cost Behavior and Decision Making Last month, 2,100 pizzas cost $15,750 Amount $4,200 3,150 8,400 $15,750 Per Unit $2.00 1.50 4.00 $7.50 Direct materials Direct labor Overhead Total If all costs are variable, how much would 2,600 pizzas cost?

10. Cost Behavior and Decision Making Cost of Goods Sold for 2,600 pizzas: 2,600 x $7.50 = $19,500 Assume that the direct materials, direct labor, and overhead of $1.00 per pizza are variable costs, and that $6,300 is fixed. What would be the cost of goods sold for 2,600 pizzas?

11. Cost Behavior and Decision Making Direct materials Direct labor Variable overhead Fixed costs Total cost of goods sold $2.00 x 2,600 = $1.50 x 2,600 = $1.00 x 2,600 = = $5,200 3,900 2,600 6,300 $18,000 y = a+bx y = 6,300 + 4.50x

12. More Cost Topics Step Costs Mixed Costs Separating Mixed Costs into Their Fixed and Variable Components Regression Analysis

13. 0-7,500 desks 1 Janitor $25,000 7,501-15,000 desks 2 Janitors $50,000 Step Costs Step Costs remain constant within a relevant range of production. Example: Janitorial services within a company that manufactures desks

14. Mixed Costs Fixed and Variable Components Fixed: lease payment each month Variable: Gas, oil, maintenance costs, etc., that vary with the number of deliveries made (and miles driven)

15. Mixed Costs Pause and Reflect Can you think of other common examples of mixed costs?

16. Separating Mixed Costs into their Fixed and Variable Components Key Concept Within the relevant range, fixed costs are constant in total and vary per unit, variable costs vary in total and are constant per unit, and mixed costs vary in total and vary per unit.

17. Separating Mixed Costs into their Fixed and Variable Components Regression Analysis: A statistical technique used to estimate the fixed and variable components of a mixed cost is called least squares regression. Regression analysis uses statistical methods to fit a cost line (regression line) through a set of points which minimizes the sum of the squared distance from each data point to the line (hence the name least squares regression).

18. Regression Analysis Regression Line = Total Overhead Cost Costs Slope of Regression Line = Variable Cost per unit Fixed Cost

19. Using a Spreadsheet Program to Perform Regression Analysis Using the actual values of the mixed costs (dependent variable) and the volume of production (independent variable) and a spread sheet program such as Excel, you can compute the regression line using least squares regression. See Exhibits 5-6, 5-8, 5-9 in the text.

20. Regression Statistics Exhibit 5-9 shows R2 of less than 1.0 which implies that other independent variable might have an impact on the dependent variable. Examples: Outside temperature and other environmental factors might impact overhead costs incurred.

21. Regression Statistics Pause and Reflect Can you think of other variables that might have an impact on total overhead costs?

22. Regression Statistics Uses in other managerial decision making Marketing Managers predicting changes in sales based on changes in advertising expenditures. Production Managers interested in quality control might collect data on overtime worked in a factory vs. the number of defective items produced.

23. Estimating Regression Results Using the High-Low Method 1. Use only two data points, the high and low level of activity and their related total overhead costs. 2. Subtract the smallest from the largest for each 3. Change in cost = Variable cost per unit Change in volume

24. Estimating Regression Results Using the High-Low Method 4. Substitute the total cost of one of the points for “y” in the equation y = a + bx 5. Substitute the variable cost found previously for “b” 6. Substitute the number of activity units for “x” 7. Solve for fixed costs “a” 8. Determine the formula to use in estimating the mixed costs at various levels

25. Estimating Regression Results Using the High-Low Method If the high point of activity was 2,500 units and $12,450 of overhead costs and the low point of activity was 1,950 units and $10,300 of overhead costs, what would be the estimated total costs at 2,435 units of activity?

26. Estimating Regression Results Using the High-Low Method 1. High Point = 2,500 units at $12,450 Low Point = 1,950 units at $10,525 2. 2,500 - 1,950 = 550 units $12,450 - 10,525 = $1,925 3. $1,925 / 550 units = $3.50 var cost/unit

27. Estimating Regression Results Using the High-Low Method 4,5,6,7. Y = $12,450 = $12,450 = $3,700 = Y = a + bx a + $3.50 (2,500) a + $8,750 a $3,700 + $3.50x 8. Y = $3,700 + $3.50 (2,435) Y = $12,222.50 total overhead costs

28. More Cost Behavior Topics CB, ABC and ABM CB in Merchandising and Service Companies Relevant Costs and CB Impact of Income Taxes on Costs and Decision Making The Time Value of Money and Decision Making

29. CB, ABC and ABM Regression Analysis can be used to help identify the “best” cost drivers of activities for use in ABC and ABM. An activity such as processing customer orders might vary with the number of orders OR the number of customers. Regression analysis can help identify which best explains the dependent variable, costs of placing customer orders.

30. Relevant Costs and Cost Behavior Merchandising Sales revenue is a common cost driver. Cost of goods purchased is a variable cost. Service Airlines might look at the number of passengers or passenger miles as cost drivers.

31. Relevant Costs and Cost Behavior Key Concept It can be misleading to always view variable costs as relevant and fixed costs as non relevant.

32. Taxes and Decision Making Three Tax Considerations: 1. Costs of operating businesses are deductible for income tax and revenues are taxable. 2. Form of a transaction may impact the amount of tax paid or whether cost is tax deductible 3. Payment of tax requires cash outflow, thus reducing the amount of cash available for other purposes.

33. Taxes and Decision Making Key Concept Managers must consider the impact of taxes on decisions.

34. After-Tax Costs and Revenues After-Tax Cost of a tax deductible cash expenditure: after-tax cost = pretax cost X (1-tax rate) After Tax Benefit of a taxable cash receipt: after-tax benefit = pretax receipts X (1-tax rate)

35. Before and After-Tax Net Income After-Tax Income = Pretax Income X (1-Tax Rate) $700 = $1,000 x (1 -.30)

36. The Time Value of Money and Decision Making When cash flows are received or paid in different time periods, they are commonly discounted by finding their present value.

37. The Time Value of Money and Decision Making Key Concept Managers must consider the time value of money when making long-term decisions.

38. End of Chapter 5 Analyzing costs has to be a continuous process!