Cost Classification and Cost Behavior

1. Cost Classification and Cost Behavior EMBA 5403 Fall 2010 Mugan

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. Product Cost Flows Mugan

9. Conversion Costs Product Cost Flows Prime Costs Mugan

10. Product Cost Flows Mugan

11. Product Cost Flows Mugan

12. Product Cost Flows Mugan

13. 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

14. 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

15. 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

16. 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

17. 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

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19. Cost Classifications for Predicting Cost Behavior Mugan

20. 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

21. 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

22. 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

23. Y Total mixed cost Total MobilePhoneCost Fixed MonthlyPhone Charge X Fixed MonthlyPhone Charge Mixed Costs Activity (minutes) Mugan

24. Y X Mixed Costs Total mixed cost Total Mobile PhoneCost Variable Cost per minute Fixed MonthlyPhone Charge Activity (minutes) Mugan

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. Summary of the Types of Cost Classifications • Financial reporting • Predicting cost behavior • Assigning costs to cost objects- products- determining unit costs • Decision making Mugan

36. Used primarily forexternal reporting. Used primarily bymanagement. Income Statement Presentation Mugan

37. Idle Time Machine Breakdowns Material Shortages Power Failures The labor costs incurred during idle time are ordinarily treated as manufacturing overhead. Mugan

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

39. 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

40. 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

41. 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

42. 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

43. Numerical Example Management at THD believes that indirect costs are actually caused by the following five activities: Mugan

44. 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

45. PDOR and MOVH Mugan

46. Unit Costs – Traditional Mugan

47. Numerical Example-MOVH by ABC The following activity data was supplied by the management of THD Mugan

48. Numerical Example-MOVH by ABC This activity data can be used to develop application rates for each of the five activities. Mugan

49. Numerical Example-MOVH by ABC Mugan

50. 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