Chapter 3 Cost Concepts and Behaviors

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Chapter 3Cost Concepts and Behaviors
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Topics to Cover

• General Cost Terms
• Classifying Costs for Financial Statements
• Cost Classification for Predicting Cost Behaviors

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Topics to Cover

• Thinking on the Margin Fundamental Economic
  Decision-Making

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An Example

• We will start with an example to understand the
  concepts covered in this chapter
• The example is of a ice-cream producer producing
  ice-cream cones
  Uptown Ice Cream Shop

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Unit Price of an Ice Cream Cone Uptown Ice Cream
Shop
120250 / 0.65 Or 9250/ 0.05 Or 185000 Cones
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General Cost Terms
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General Cost Terms

• Manufacturing Costs
• Direct materials
• Direct labor
• Mfg. Overhead include
• Indirect materials, indirect labor maintenance
  and
• Repairs on production equipment heat and light
• property taxes depreciation insurance, etc.,
• Non-manufacturing Costs
• Overhead
• Heat and light, property taxes, depreciation
• Marketing or selling
• Advertising, shipping, sales travel, sales
  salaries
• Administrative
• Executive compensation, general accounting,
• Public relations, and secretarial support.

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Classifying Costs for Financial Statements

• In financial accounting, the Matching Concept
  states that the costs incurred to generate
  particular revenue should be recognized as
  expenses in the same period that the revenue is
  recognized.
• Period costs Those costs that are charged to
  expenses in the time period basis (advertising,
  executive salaries, sales commissions, public
  relations, other non manufacturing costs).
• Product costsThose costs that are involved in
  the purchase or manufacturing of goods. Since
  product costs are assigned to inventories, known
  as inventory costs. (all costs related to
  manufacturing process).

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Example 3.1
Classifying Costs for Uptown Ice Cream Shop
Product Cost
Period Cost
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Cost Flows and Classifications in a Mfg. Co.

• Cost of revenue Cost of goods sold
• Raw materials inventory
• Work-in-process inventory
• Finished goods inventory

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Cost Classification for Predicting Cost Behavior
(describes how cost item will respond to changes
in the level of business activity)

• Volume index
• Operating cost respond in some way to changes in
  its operating volume. Need to determine some
  measurable volume or activity which has strong
  Influence on the amount of cost incurred. (volume
  index may be based on production inputs/out puts.
  Energy consumption, labor hours OR KWhr generated
  or miles per year driven by a car)
• Cost Behaviors
• Fixed costs
• Variable costs
• Mixed costs
• In the car case, Depreciation, occur from
• passage of time (fixed portion) and also
• More miles are driven a year, loses its
• Market value (variable portion)
• Average unit costs
• (example 3.2 Calculating average cost per mile)

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• Volume index
• It is necessary to distinguish between changes
  arising solely from price changes and those
  arising from other influences such as quantity
  and quality, which are referred to as changes in
  volume.
• A volume index is presented as a weighted average
  of the proportionate changes in the quantities of
  a specified set of goods or services between two
  periods of time.
• The quantities compared must be homogeneous,
  while the changes for different goods and
  services must be weighted by their economic
  importance as measured by their values in one or
  other, or both, periods.

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• Volume index (Illustrated Example)
• Consider an industry that produces two different
  models of automobile, one selling for twice the
  price of the other.
• From an economic point of view these are two
  quite different products even though described by
  the same generic term "automobile". Suppose
  that between two periods of time
• (a) The price of each model remains constant
  (b) The total number of automobiles produced
  remains constant (c) The proportion of higher
  priced models produced increases from 50 to 80
  
• .It follows that
• the total value of the output produced increases
  by 20 because of the increase in the proportion
  of higher-priced models. This constitutes a
  volume increase of 20 . As each higher-priced
  automobile constitutes twice as much output as
  each lower-priced automobile, a switch in
  production from low- to high-priced models
  increases the volume of output even though the
  total number of automobiles produced remains
  unchanged. The fact that the value increase is
  entirely attributable to an increase in volume
  also follows from the fact that no price change
  occurs for either model. The price index must
  remain constant in these circumstances.
• cost cheaper 50 cost expansive 50
• Before 1 50 2 50 150 ? After
  1 30 2 80 16030 180
• 180-150/150 100 20 increase in volume index.

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Fixed Costs or capacity cost

• Definition The costs of providing a companys
  basic operating capacity
• Cost behavior Remain constant over the time
  though volume may change.
• Some examples Annual insurance premium, property
  tax, and license fee, building rents,
  depreciation of buildings, salaries of
  administrative and production personnel.

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Variable Costs

• Definition Costs that vary depending on the
  level of production or sales
• Cost behavior Increase or decrease according to
  the level of volume change.
• Example Ice cream cone company, wages, payroll
  taxes, sales tax, and supplies. Fuel consumption
  is directly related to miles driven.

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Average Unit Cost

• Definition activity cost on a per unit basis
• Cost Behaviors
• Fixed cost per unit varies with changes in
  volume.
• Variable cost per unit of volume is constant. See
  example 3.2

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Cost Classification of Owning and Operating a
Passenger Car
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Cost-Volume Relationship
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Cost-Volume Relationship
10640.04M
1064
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Average Cost per Mile
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Cost Concepts relevant to the decision making.

• Costs are an important feature of many business
  decisions. In order to make such decisions
  following cost needed to be well understood
• Differential costs
• Opportunity costs
• Sunk costs
• Marginal costs

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Differential (Incremental) Costs Revenues

• Decision involve selection among alternatives.
• Each alternative have certain costs / benefits
  that are needed to be compared to the costs /
  benefits of the other alternatives

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Differential (Incremental) Costs and Revenues

• Definition Difference in costs between any two
  alternatives known as Differential cost.
• Difference in revenues between any two
  alternatives is known as differential revenue.

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Differential (Incremental) Costs Revenues

• Cost-volume relationship based on differential
  costs find many engineering applications such as
  short term decision making. Example
• The base case is the status quo (current
  operation). We propose an alt. to the base case.
  If alt. has lower cost we accept the alt.
  assuming non-quantitative factors do not offset
  the cost advantage.

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Differential (Incremental) Costs Revenues

• Differential cost difference in total cost that
  results from selecting one alt. instead of the
  other.
• Problem of this type are generally called trade
  off problems because one type of cost is traded
  by another type of cost
• KEY FEATURES New investment in physical assest
  not required, planning horizon short, relatively
  few cost items are subject to change by the
  decision

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Differential (Incremental) Costs Revenues

• Common examples
• Method change Example 3.3 page 75
• Operations planning Example 3.4 page 76
• Make or buy decision Example 3.5 page 77

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Example 3.3 Differential Cost Associated with
Adopting a New Production Method
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Example 3.4 Break-Even Volume AnalysisIn typical
manufacturing environment, when demand is high,
managers are interested in whether to use a
one-shift plus overtime operations or to add a
second shift. When demand is low, it is possible
to explore whether to operate temporarily at a
very low volume or to shut down until operations
at normal volume become economical. In a
chemical plant, several routes exist for
scheduling products through the plant. The
problem is in which route provides the lowest
cost.

• Option 1 Adding overtime or Saturday operations
  36Q
• Option 2 Second-shift operation 13,000
  31.50Q
• Break-even volume
• 36Q 13,000 31.50Q
• Q 3,000 units

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Example 3.5 -Make or Buy Many firms perform
certain activities using their own resources, and
pay outside firms to perform certain other
activities. It is a good policy to constantly
seek to improve the balance between these two
types of activities.
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Opportunity Costs

• Definition The potential benefit that is given
  up as you seek an alternative course of action
• Example When you decide to pursue a college
  degree, your opportunity cost would include the
  4-years potential earnings foregone.

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Sunk Costs

• Definition Cost that has already been incurred
  by past actions
• Economic Implications Not relevant to future
  decisions
• Example 200 spent to replace water-pump last
  yearnot relevant in making selling decision in
  the future

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Marginal Analysis

• Principle Is it worthwhile?
• Decision rule To justify any course of action,
• Marginal revenue gt
• Marginal cost

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Marginal Costs (example 3.6)

• Definition Added costs that result from
  increasing rates of outputs, usually by single
  unit
• Example 3.6 Cost of electricitydecreasing
  marginal rate
• Compare it with Differential cost (Accounts) /
  Marginal (Economists)

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Unit Marginal Contribution (MC)

• Definition Difference between the unit sales
  price and the unit variable cost, also known as
  marginal income or producers marginal
  contribution (MC). This means each unit sold
  contributes toward absorbing the companys fixed
  cost.
• MC U Sales price U Variable cost
• Application Break-even volume analysis

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Example 3.7 Profit Maximization Problem
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Summary

• General Cost Terms used in manufacturing
• Manufacturing costs
• Direct materials
• Direct labor
• Manufacturing overhead
• Nonmanufacturing costs
• Administrative expenses
• Marketing
• Nonmanufacturing overhead

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• Classifying Costs for Financial Statements
• Period costs
• Product costs
• Cost Classification for Predicating Cost
  Behaviors
• Fixed costs
• Variable costs
• Mixed costs

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• Cost Concepts Relevant to Decision-Making
• Differential cost and revenue
• Opportunity costs
• Sunk costs
• Marginal costs
• Thinking on the Margin Fundamental Economic
  Decision-Making
• The basic question to any economic decision Is
  it worthwhile?
• Marginal revenues must exceed marginal costs.