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Cost Classification and Cost Behavior . EMBA 5403 Fall 2010 Mugan. The opportunity cost is the monetary amount associated with the next best use of the resource. Types of Costs. differential costs- (benefits) – costs or benefits that change between/among alternatives

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types of costs

The opportunity cost is the monetary amount associated with the next best use of the resource.

Types of Costs
  • differential costs- (benefits) – costs or benefits that change between/among alternatives
  • Irrelevant costs -Costs that don’t change areirrelevant to the decision
  • Choose the alternatives where differential benefitsexceeddifferential costs
  • Opportunity costs
  • Sunk costs
  • Controllable /avoidable costs/discretionary costs

Costs that have already been incurred and cannot be changed no matter what action is taken in the future.

Mugan

slide3

Problems in Identifying and Measuring Benefits

How do I measure the benefit of employee training?

How do I measure the benefit of improved quality?

What is the monetary benefit of a happy customer?

What is the monetary benefit of an improved working environment?

Mugan

slide4

Problems in Identifying and Measuring Costs

How do I measure the cost of poor quality?

What is the cost of a dissatisfied customer?

How do I measure the cost of setting my price too high?

What is the cost of postponing this year’s training program?

Mugan

classifications of costs
Classifications of Costs
  • Behavior – how costs react to changes in underlying cost driver
    • Variable or Fixed
  • Function – related to production or sales
    • Product or Period
    • Product costs –
      • Direct Material
      • Direct Labor
      • Factory Overhead
  • Traceability (cost of tracing cost to a cost driver directly should be lower than the benefits.

Mugan

non manufacturing costs

Marketing or Selling Costs

Administrative Costs

Costs necessary to get the order and deliver the product.

All executive, organizational, and clerical costs.

Non-manufacturing Costs

Mugan

product costs versus period costs
Product costs include direct materials, direct labor, and manufacturing overhead.

Period costs include all marketing or selling costs and administrative costs.

Product Costs Versus Period Costs

Inventory

Cost of Good Sold

Expense

Sale

IncomeStatement

IncomeStatement

BalanceSheet

Mugan

manufacturing cost flows

MaterialPurchases

RawMaterials

Direct Labor

Work in Process

ManufacturingOverhead

Cost of GoodsSold

FinishedGoods

Period Costs

Selling andAdministrative

Selling andAdministrative

Manufacturing Cost Flows

Income StatementExpenses

Balance Sheet Costs Inventories

Mugan

graphical analysis of activity costs and rate of output

Total Dollars

Output

Start-up Range

Normal Operations

Exceeding Capacity

Graphical Analysis of Activity Costs and Rate of Output

Curvilinear Total Cost Curve

Marginal Costs are the costs to produce one more additional unit of output=slope.

Mugan

slide15

Total Dollars

Output

Start-up Range

Normal Operations

Exceeding Capacity

Relevant Range

The relevant range is the portion of the curvilinear total cost curve that appears in the normal operations area.

Relevant Range

}

TotalCost

Mugan

the linearity assumption and the relevant range

A straight line closely approximates a curvilinear variable cost line within the relevant range.

RelevantRange

Accountant’s Straight-Line Approximation (constant unit variable cost)

The Linearity Assumption and the Relevant Range

Economist’sCurvilinear Cost Function

Total Cost

Activity

Mugan

cost classifications for predicting cost behavior
Cost Classifications for Predicting Cost Behavior

By reaction to changes in the level of activity within the relevant range.

  • Total variable costs change when activity changes.
  • Total fixed costs remain unchanged when activity changes.

Mugan

extent of variable costs
Extent of Variable Costs

The proportion of variable costs differs across organizations. For example . . .

A manufacturing companywill often have manyvariable costs.

A public utility withlarge investments inequipment will tendto have fewervariable costs.

A merchandising companyusually will have a high

proportion of variable costs

like cost of sales.

A service companywill normally have a high

proportion of variable costs.

Mugan

examples of variable costs
Examples of Variable Costs
  • Merchandising companies – cost of goods sold.
  • Manufacturing companies – direct materials, direct labor, and variable overhead.
  • Merchandising and manufacturing companies – commissions, shipping costs, and clerical costs such as invoicing.
  • Service companies – supplies, travel, and clerical

Mugan

types of fixed costs
Types of Fixed Costs

Committed

Long-term, cannot be significantly reduced in the short term.

Discretionary

May be altered in the short-term by current managerial decisions

Examples

Depreciation on Equipment and Real Estate Taxes

Examples

Advertising and Research and Development

Mugan

mixed costs

Y

Total mixed cost

Total MobilePhoneCost

Fixed MonthlyPhone Charge

X

Fixed MonthlyPhone Charge

Mixed Costs

Activity (minutes)

Mugan

mixed costs24

Y

X

Mixed Costs

Total mixed cost

Total Mobile PhoneCost

Variable Cost per minute

Fixed MonthlyPhone Charge

Activity (minutes)

Mugan

the scattergraph method

Y

20

*

*

*

*

*

*

*

*

Cost

*

*

10

0

X

0 1 2 3 4

Activity - output

The Scattergraph Method

Plot the data points on a graph (total cost vs. activity).

Mugan

the scattergraph method26

Y

20

*

*

*

*

*

*

*

*

Cost

*

*

10

0

X

0 1 2 3 4

Activity - output

The Scattergraph Method

Draw a line through the data points with about anequal numbers of points above and below the line.

Mugan

the scattergraph method27

Y

Total cost = TL11

20

*

*

*

*

*

*

*

*

Cost

*

*

10

Intercept = Fixed cost: TL 10

0

X

0 1 2 3 4

Activity - output

Activity 0.8 units

The Scattergraph Method

Use one data point to estimate the total level of activity and the total cost.

Mugan

the scattergraph method28

TL1 0.8

Variable cost per unit =

= TL1.25/ unit of output

Total cost

Number of units

The Scattergraph Method

Make a quick estimate of variable cost per unit and determine the cost equation.

Y = TL10 + TL1.25X

Mugan

the high low method
Assume the following hours of maintenance work and the total maintenance costs for six months.

High level of activity

Low level of activity

The High-Low Method

Mugan

assigning costs to cost objects
Direct costs

Costs that can beeasily and conveniently traced to a unit of product or other cost object.

Examples: direct material and direct labor

Indirect costs

Costs that cannot be easily and conveniently traced to a unit of product or other cost object.

Example: manufacturing overhead

Assigning Costs to Cost Objects

Mugan

cost classifications for decision making
Cost Classifications for Decision Making
  • Every decision involves a choice between at least two alternatives.
  • Only those costs and benefits that differ between alternatives are relevant in a decision. All other costs and benefits can and should be ignored.

Mugan

differential costs and revenues
Differential Costs and Revenues

Costs and revenues that differ among alternatives.

Example:You have a job paying TL 1,500 per month in your hometown. You have a job offer in a neighboring city that pays TL 2,000 per month. The commuting cost to the city is TL 300 per month.

Differential revenue is:

TL2,000 – TL1,500 = TL500

Differential cost is:

TL 300

Mugan

opportunity costs
Opportunity Costs

The potential benefit that is given up when one alternative is selected over another.

Example: If you were not attending this program, you could save TL 10,000 per year. Your opportunity cost?

Mugan

sunk costs
Sunk Costs

Sunk costs have already been incurred and cannot be changed now or in the future. They should be ignored when making decisions.

Example:You bought an automobile that cost TL10,000 two years ago. The TL10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the TL10,000 cost.

Mugan

summary of the types of cost classifications
Summary of the Types of Cost Classifications
  • Financial reporting
  • Predicting cost behavior
  • Assigning costs to cost objects- products- determining unit costs
  • Decision making

Mugan

idle time
Idle Time

Machine Breakdowns

Material Shortages

Power Failures

The labor costs incurred during idle time are ordinarily treated as manufacturing overhead.

Mugan

overtime
Overtime

The overtime premiums for all factory workers are usually considered to be part of manufacturing overhead.

Mugan

unit costs
Unit Costs
  • Direct Material- determined as actual usage of materials or by engineering estimates (standard costs)
  • Direct Labor- determined as actual usage of materials or by engineering estimates (standard costs)
  • MOVH – common production costs assigned to each unit
    • Traditional
    • ABC
  • Unit cost = DM + DL + MOVH per unit

Mugan

labor fringe benefits
Labor Fringe Benefits

Fringe benefits include employer paid costs for insurance programs, retirement plans, supplemental unemployment programs, Social Security, Medicare, workers’ compensation and unemployment taxes.

Some companies include all of these costs in manufacturing overhead.

Other companies treat fringe benefit expenses of direct laborers as additional direct labor costs.

Mugan

how to allocate indirect costs to products movh
How to allocate indirect costs to products MOVH
  • Depends on the nature of products and production system
  • Traditional- direct labor hours (DLH); number of units produced;
  • Automation and computer technology have increased the indirect costs in many organizations
  • Activity-Based Costing (ABC)- a procedure that attempts to provide a more precise indirect cost allocation

Mugan

numerical example unit cost
Numerical Example- Unit Cost
  • THD Company produces 4,000 units of Product A and 20,000 units of Product B each year.
  • Direct Material for Product A is TL 10; Product B 15
  • Total indirect product costs are TL 900,000, and total direct labor hours(DLH) are 50,000.
  • Product A requires 2.5 DLH and Product B requires 2.0 DLH to produce.
  • Direct labor cost per hour TL 30

Continue

Mugan

slide43

Numerical Example

Management at THD believes that indirect costs

are actually caused by the following five activities:

Mugan

unit cost traditional
Unit Cost - Traditional

THD uses DLH as the basis

1.determine the allocation of MOVH per unit = predetermined overhead rate(PDOR) PDOR= Total Overhead/ Total DLH

2. determine MOVH per unit = PDOR x DL Cost per hour

3. add DM,DL and MOVH per unit

Mugan

slide47

Numerical Example-MOVH by ABC

The following activity data was supplied by

the management of THD

Mugan

numerical example movh by abc
Numerical Example-MOVH by ABC

This activity data can be used to develop application

rates for each of the five activities.

Mugan

numerical example movh by abc50
Numerical Example-MOVH by ABC

Now that we have calculated the application rates, we

use the rates to assign indirect costs to Product A.

Mugan

numerical example movh by abc51
Numerical Example-MOVH by ABC

Now that we have calculated the application rates, we

use the rates to assign indirect costs to Product A.

Mugan

numerical example movh by abc52
Numerical Example-MOVH by ABC

MOVH costs for a unit of Product B

Mugan

slide56

Advantages of ABC

Activity-based costing is very useful in firms . . .

With multiple

products and

services.

That have products

and services that use

indirect activities

in different ways.

That have a high

percentage of indirect

product costs.

Mugan

slide57

Problems With ABC

Proper identification

of cost drivers is

difficult.

ABC ignores the

difference between

the fixed and variable

costs of an activity.

ABC is more costly

because additional

measurements and

observations must

be made.

Mugan

quality of conformance
Quality of Conformance

When the overwhelming majority of products produced conform to design specifications and are free from defects.

Mugan

prevention and appraisal costs

Support activities whose purpose is to reduce the number of defects

Incurred to identify defective products before the products are shipped

Prevention Costs

Appraisal Costs

Prevention and Appraisal Costs

Mugan

internal and external failure costs

Incurred as a result of identifying defects before they are shipped

Incurred as a result of defective products being delivered to customers

Internal Failure Costs

External Failure Costs

Internal and External Failure Costs

Mugan

examples of quality costs
Examples of Quality Costs
  • Prevention Costs
  • Quality training
  • Quality circles
  • Statistical process
  • control activities
  • Appraisal Costs
  • Testing & inspecting
  • incoming materials
  • Final product testing
  • Depreciation of testing
  • equipment
  • Internal Failure Costs
  • Scrap
  • Spoilage
  • Rework
  • External Failure Costs
  • Cost of field servicing &
  • handling complaints
  • Warranty repairs
  • Lost sales

Mugan

distribution of quality costs
Distribution of Quality Costs

When quality of conformance is low, total quality cost is high and consists mostly of internal and external failure.

Companies can reduce their total quality cost by focusing on prevention and appraisal. The cost savings from reduced defects usually swamps the costs of the additional prevention and appraisal efforts.

Mugan

slide63

Quality cost reports provide an estimate of the financial consequences of the company’s current defect rate.

Mugan

quality cost reports graphic form
Quality Cost Reports: Graphic Form

Quality reports can also be prepared in graphic form.

Mugan

uses of quality cost information
Uses of Quality Cost Information

Help managers see the financial significance of defects.

Help managers identify the relative importance of the quality problems.

Help managers see whether their quality costs are poorly distributed.

Mugan

iso 9000 standards
ISO 9000 Standards

ISO 9000 standards have become an international measure of quality. To become ISO 9000 certified, a company must demonstrate:

  • A quality control system is in use, and the system clearly defines an expected level of quality.
  • The system is fully operational and is backed up with detailed documentation of quality control procedures.
  • The intended level of quality is being achieved on a sustained basis.

Mugan

product life cycle
Product Life Cycle

Mugan

http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf

slide68
Mugan

http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf

slide69

Introduction Growth Maturity Decline

Mugan

http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf

slide70

http://www.ee.unb.ca/powereng/courses/EE2703/EE2703_DetailedDesign2.pdfhttp://www.ee.unb.ca/powereng/courses/EE2703/EE2703_DetailedDesign2.pdf

Mugan

slide71

http://www.ee.unb.ca/powereng/courses/EE2703/EE2703_DetailedDesign2.pdfhttp://www.ee.unb.ca/powereng/courses/EE2703/EE2703_DetailedDesign2.pdf

Mugan

appendix
Appendix

Least-Squares Regression Using Microsoft Excel.

Mugan

simple regression analysis example
Simple Regression Analysis Example

Matrix, Inc. wants to know its average fixed cost and variable cost per unit.

Using the data to the right, let’s see how to do a regression using Microsoft Excel.

Mugan

simple regression using excel
Simple Regression Using Excel
  • You will need three pieces of information from your regression analysis:
  • Estimated Variable Cost per Unit (line slope)
  • Estimated Fixed Costs (line intercept)
  • Goodness of fit, or R2

To get these three pieces information we will need to use three different Excel functions.

LINEST, INTERCEPT, & RSQ

Mugan

simple regression using excel75

Place your cursor in cell F4 and press the = key. Click on the pull down menu and scroll down to “More Functions . . .”

Simple Regression Using Excel

Mugan

simple regression using excel76
Simple Regression Using Excel

Scroll down to the “Statistical”, functions. Now scroll down the statistical functions until you highlight “LINEST”

Mugan

simple regression using excel77
Simple Regression Using Excel

1. In the Known_y’s box enter C4:C19 for the range.

2. In the Known_x’s box enter D4:D19 for the range.

Mugan

simple regression using excel78

Here is the estimate of the slope of the line.

Simple Regression Using Excel

1. In the Known_y’s box enter C4:C19 for the range.

2. In the Known_x’s box enter D4:D19 for the range.

Mugan

simple regression using excel79
Simple Regression Using Excel

With you cursor in cell F5, press the = key and go to the pull down menu for special functions. Select Statistical and scroll down to highlight the INTERCEPT function.

Mugan

simple regression using excel80

Here is the estimate of the fixed costs.

Simple Regression Using Excel

1. In the Known_y’s box enter C4:C19 for the range.

2. In the Known_x’s box enter D4:D19 for the range.

Mugan

simple regression using excel81
Simple Regression Using Excel

Finally, we will determine the “goodness of fit”, or R2, by using the RSQ function.

Mugan

simple regression using excel82

Here is the estimate of R2.

Simple Regression Using Excel

1. In the Known_y’s box enter C4:C19 for the range.

2. In the Known_x’s box enter D4:D19 for the range.

Mugan