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Classifying Costs (a)

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  1. Classifying Costs (a) • By Element • Material • Labour • Expense • By Traceability • Direct • Indirect

  2. Expense Material Labour TheProduct Classification by element

  3. Direct Costs Costs that canbe easily and conveniently tracedto a unit of product or other cost object. Examples: Direct material Direct labor Indirect Costs Costs cannotbe easily and conveniently tracedto a unit of product or other cost object. Example: Manufacturing overhead Classification of Costsby Traceability

  4. Direct costs Costs that can beeasily and conveniently traced to a product or department. Example: cost of paint in the paint department of an automobile assembly plant. Indirect costs Costs that must be allocated in order to be assigned to a product or department. Example: cost of national advertising for an airline is indirect to a particular flight. Direct and Indirect Costs

  5. Classification by element or traceability Current Product costs = Materials+Labour+Expenses Or Direct costs + Indirect costs

  6. Classifications of Costs in Manufacturing Companies Manufacturing costs are oftencombined as follows: DirectMaterial Direct Labour & Direct Expenses ManufacturingOverhead PrimeCost ConversionCost

  7. Classifying Costs (b) • By Function • Product • Period

  8. Raw Material Work in Process Selling andAdministrative Period Expenses Manufacturing Cost Flows Income StatementExpenses Balance SheetCosts Inventories Material Purchases Direct Labor ManufacturingOverhead Cost of GoodsSold FinishedGoods Selling andAdministrative

  9. Product costs Include expendituresthat arenecessary and integralto finished products. Capitalized on thebalance sheet until sold. Period costsInclude expendituresidentified more with atime period than withfinished products. Expensed on theincome statement. Inventory Expense Cost of Good Sold Sale BalanceSheet IncomeStatement IncomeStatement Cost Classification by Function

  10. Product Costs Direct materials Direct labor Overhead Period Costs Selling General and administrative expenses Classification of Costs by Function

  11. Classifying Costs (c) • By Behaviour • Fixed • Variable • Semi-fixed • Semi-variable

  12. Cost Classificationsby Behaviour Cost Behaviour How a cost will react tochanges in the level of business activity. • Total variable costs change when the level of activity changes. • Total fixed costs remain unchanged when the level of activity changes.

  13. Total Long DistanceTelephone Bill Minutes Talked Total Variable Cost A variable cost is one that changes in totalin proportion to changes in the volume of activity. Your total long distance telephone billis based on how many minutes you talk.

  14. Per MinuteTelephone Charge Minutes Talked Variable Cost Per Unit On a per unit basis, a variable cost remains constant over a wide range of activity. The cost per long distance minute talked is constant.For example, 10 cents per minute.

  15. Merchandisers Cost of Goods Sold Service Organizations Supplies and travel Merchandisers and Manufacturers Sales commissions and shipping costs Manufacturers Direct Material, Direct Labor, and Variable Manufacturing Overhead Cost Behaviour Examples of variable costs

  16. Monthly Basic Telephone Bill Number of Local Calls Total Fixed Cost A fixed cost is one that remains constant in total even when the volume of activity changes. Your monthly basic telephone bill probably does not change when you make more local calls.

  17. Monthly Basic Telephone Bill per Local Call Number of Local Calls Fixed Cost Per Unit On a per unit basis, a fixed cost changesas the volume of activity changes. The average cost per local call decreases as more local calls are made.

  18. Merchandisers, manufacturers, and service organizations Real estate taxesInsuranceSales salariesDepreciationAdvertising Cost Behaviour Examples of fixed costs

  19. Cost Classifications for Predicting Cost Behavior

  20. Fixed Costs and Relevant Range The company’s normal operating range 90 Total cost doesn’t change for a wide range of activity.It then jumps to a new higher cost for the next higher range of activity. Relevant Range 60 Rent Cost in Thousands of Dollars 30 0 0 1,000 2,000 3,000 Rented Area (Square Feet)

  21. How does this type of fixed cost differ from a step-variable (or step-wise) cost? • Step-variable (or step-wise) costs can be adjusted more quickly and . . . • The width of the activity steps is much wider for the fixed cost. Fixed Costs and Semi-fixed (or Step-Wise or Step-Variable) Costs

  22. Total cost increasesto a new higher cost for the next higher range of activity. Total costremains constant within a narrow range of activity. Semi-fixed Costs(or Step-Variable or Step-Wise) Cost Activity

  23. Slope isvariable costper unitof activity. Semivariable Cost Total semivariable cost Variable Utility Charge Total Utility Cost Fixed MonthlyUtility Charge Activity (Kilowatt Hours)

  24. CurvilinearCost Function A straight-Line(constant unit variable cost) closely approximates a curvilinear line withinthe relevant range. Total Cost Relevant Range Curvilinear Cost CurvilinearCost Function Activity

  25. Relevant Information Information is relevant to a decision problem when . . . • It has a bearing on the future, • It differs among competing alternatives.

  26. Identifying RelevantCosts and Benefits Sunk costsCosts that have already been incurred. They do not affect any future cost and cannot be changed by any current or future action. Sunk costs are irrelevant to decisions.

  27. Relevant Costs • Relevant costs are those costs and/or benefits that differ between alternatives. • Costs that can be eliminated (in whole or in part) by choosing one alternative over another are avoidable costs. • Avoidable costs are relevant costs. • Unavoidable costs include: • Sunk costs. • Future costs that do not differbetween the alternatives. • Unavoidable costs are never relevant.

  28. Incremental Costs Add or Drop a Product

  29. Summary DECISION RULE Swick should drop the digital watch segment only if its fixed cost savings exceed lost contribution margin.

  30. Marginal Costs and Average Costs The extra costincurred to produceone additional unit. The total cost toproduce a quantitydivided by thequantity produced. Marginal and average costs arelargely a function of cost behavior -- variable and fixed costs.

  31. Benefits Costs Costs and Benefits of Information More information does not mean more benefits if information overload results.