A&MIS 525 - Session 5

1. A&MIS 525 - Session 5 • Cost drivers • Cost behavior April 5, 2002 A&MIS 525

2. Agenda Today • Meet in room 315 of Schoenbaum Hall • Turn in exercise 2-28 • Take quiz on WebCT class before 5:00 p.m. on Friday, April 5th. A&MIS 525

3. Key Issues in Cost Behavior • Terminology (fixed, variable, semi-variable, semi-fixed, capacity, discretionary) • Unit of analysis (total vs. unit costs) • Interpretation of cost drivers • Implications of cost behavior for risk & return • Points of potential confusion A&MIS 525

4. Cost Drivers • There are seven primary cost drivers at the macro level. The one considered most often in accounting is the time-rate of activity. Think of this as the volume of activity experienced during a time period. This driver, volume, is considered next. A&MIS 525

5. Cost Drivers • The issue is: How should we expect total costs to behave (vary) with respect to changes in the time-rate of activity all else being equal. In traditional accounting terms: “How do total costs behave with respect to changes in volume,” all else being equal. First, we consider the effects of volume changes on total costs. A&MIS 525

6. Total cost Slope is the rate of change Activity Volume Total variable cost A&MIS 525

7. Total variable cost Variable costs are those costs that vary in direct proportion to changes in activity volume. Such costs are normally rep-resented by a simple affine linear equation, TC = vQ, where TC represents the total variable cost, v represents the variable cost per unit of activity and Q represents the volume of activity during a period. A&MIS 525

8. Total cost Fixed cost Activity Volume Total fixed cost A&MIS 525

9. Total fixed cost Fixed costs are those costs that do not vary in total with respect to modest changes in activity volume. Such costs are represented by TC = F, where TC represents total cost, and F represents total fixed cost. Fixed costs do change over time, due to price changes and as a result of decisions, but they are relatively constant with respect to changes in activity volume, all else being equal. A&MIS 525

10. Committed Fixed Costs • Committed fixed costs are costs incurred as a result to past decision to acquire and maintain productive capacity. Also, called capacity costs. • Depreciation on Plant & Equipment • Real estate taxes • Insurance • Compensation of executives A&MIS 525

11. Committed Fixed Costs • Committed costs are also called capacity costs. • These fixed costs are difficult to eliminate, even temporarily. Thus, committed fixed cost are the most difficult to eliminate. • Managers are very careful when increasing capacity due to the fixed nature and duration of the resulting fixed costs. A&MIS 525

12. Discretionary Fixed Costs • Discretionary fixed costs (also called managed fixed costs) are associated with decisions made by management at least annually. These cost are more controllable in that there is little immediate impact even though there may be a longer-term consequence. A&MIS 525

13. Discretionary Fixed Costs • Advertising programs • Training programs • Research programs • Management development programs • Public relations • Employee recruiting A&MIS 525

14. Total cost Total cost curve Activity Volume Total mixed cost A&MIS 525

15. Total cost Total cost curve Variable component Fixed component Activity Volume Total mixed cost A&MIS 525

16. Total mixed cost Semivariable or mixed costs are those costs that contain both a fixed and a variable component. Such costs are normally represented by a simple linear equation of the form TC = F + vQ, where TC represents total cost, F represents total fixed cost, and v represents the variable cost per unit of activity, and Q is the volume of activity during a period. A&MIS 525

17. Total step-variable cost Step-variable costs are those costs that vary in small increments with respect to changes in activity volume. Such costs are also normally represented by a simple affine linear equation, TC = vQ, where TC represents the total variable cost, v represents the variable cost per unit of activity and Q represents the volume of activity during a period. A&MIS 525

18. Total step-variable cost However, at a micro level, the increments may be relatively large and a local manager might treat the cost like a semi-fixed cost. It is a matter of perspective and required level of precision. Manager’s salaries effectively are variable from McDonald’s corporate perspective, but not from the perspective of a local franchisee with two restaurants. A&MIS 525

19. Total semi-fixed cost Total cost Total cost curve Activity Volume A&MIS 525

20. Functional forms of costs: • Fixed: TC = F • Variable: TC = vQ, where Q is the measure of the driver activity • Semi-variable (mixed): TC = F +vQ • Semi-fixed: TC = F1[1+Q/m], where the brackets represent the greatest integer function, and m represents the number of units associated with each increment in cost, F1. A&MIS 525

21. Functional forms of costs: • TC = F1 + vQ + F2[1+Q/m] • For test purposes, focus on cost functions of the form TC = F + vQ, where F represent the total of all fixed costs for the activity under consideration, and v is the total per unit variable cost. A&MIS 525

22. Interpreting the greatest integer • Suppose we employ an additional supervisor for every 10 employees. If we must hire a minimum of 1 supervisor, and they earn $50,000 per year, then the cost of supervision varies with employment as follows TC = $50,000[1+Q/10] A&MIS 525

23. Greatest Integer Function Values EmploymentGI FunctionFctn. Value Case 1 0 [1+ 0/10] 1 Case 2 10 [1+10/10] 2 Case 3 15 [1+15/10] 2 Case 4 20 [1+20/10] 3 Case 5 35 [1+35/10] 3 A&MIS 525

24. Semi-fixed cost example EmploymentSupervisorsTotal Cost Case 1 0 1 $ 50,000 Case 2 10 2 $100,000 Case 3 15 2 $100,000 Case 4 20 3 $150,000 Case 5 35 3 $150,000 For TC = $50,000[1+Q/10] A&MIS 525

25. Remember Economics? A&MIS 525

26. Total cost (micro) Total cost Total cost curve Relevant range Activity Volume A&MIS 525

27. Average cost (micro) Average Unit Cost Relevant range Total cost curve Volume A&MIS 525

28. The level of analysis will influence how a cost is modeled. For strategic analyses, most costs will be considered variable. For tactical analyses, the same costs might be modeled as part fixed and part variable. Further Observations A&MIS 525

29. Assumption • In the absence of evidence to the contrary, assume costs can be described as semi-variable. A&MIS 525

30. A&MIS 525