CHAPTER 1 When you have finished studying this

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CHAPTER 1 When you have finished studying this chapter, you should be able to:

CHAPTER 1 When you have finished studying this chapter, you should be able to: • Define cost and understand the various cost behaviors including decision making and planning implications of: • Opportunity Costs • Differential Costs • Relevant Costs • Sunk Costs • Understand the decision making and operation implications of controllable versus uncontrollable costs; and direct versus indirect costs. • Explain how cost drivers affect cost behavior. • Show changes in cost-driver activity levels affect variable and fixed costs. 1

Definition of Cost: The sacrifice required to obtain a given object or objective. Uses

Definition of Cost: The sacrifice required to obtain a given object or objective. Uses of Cost/Accounting Data: 1. Planning - preparation of budget - decision making 2. Control - standard vs actual 3. Income measurement 2

DIFFERENTIAL COSTS The difference in costs between one course of action and another. •

DIFFERENTIAL COSTS The difference in costs between one course of action and another. • only for decision making purposes • does not have any value in costing or control Example: • Process A of making bread costs $200 • Process B of making bread costs $250 The differential costs between Process A & B is $50. OPPORTUNITY COSTS • The sacrificed returns from the rejected alternative. • Shows the estimated profits from different alternatives Example: ACME Hotel has two alternative sites in building a new unit. • Estimated profit from site 1 = $1 Million • Estimated profit from site 2 = $1. 2 Million If management chooses Site 2, the opportunity costs is $1 million. 3

SUNK COSTS Costs that has already been incurred and cannot be changed at present

SUNK COSTS Costs that has already been incurred and cannot be changed at present or in the future. • does not change from one alternative to another • it is not considered to be a relevant cost. • Example: promotion & advertising expense RELEVANT COSTS Costs which must be considered in a decision making situation. • Must be differential • Must be futuristic • Must be measurable other non accounting information should also be considered when making decisions. 4

CONTROLLABLE & UNCONTROALLBLE COSTS Controllable Costs • costs that can be changed in short

CONTROLLABLE & UNCONTROALLBLE COSTS Controllable Costs • costs that can be changed in short period of time • most but not all variable costs are controllable Uncontrollable Costs • costs that cannot be changed in short term • most but not all fixed costs are uncontrollable DIRECT & INDIRECT COSTS Direct Costs • costs that can be directly associated with a product or department. • These costs are charged directly to the department that produces the particular product. Indirect Costs • Cost that cannot be directly associated with a product or department. • These are sometimes allocated to various department by management. 5

FIXED COSTS Costs that cannot be changed in short period of time. Have little

FIXED COSTS Costs that cannot be changed in short period of time. Have little or no relation with volume of sale. TOTAL FIXED COSTS (TFC) All fixed costs incurred by the business. TFC does not change with volume of sales. UNIT FIXED COSTS (UFC) Total fixed costs divided by the total number of units produced or sold. Since TFC is constant, as production increases, the UFC will go down. 6

VARIABLE COSTS (VC) Costs that have direct relationship with volume of sales. For example,

VARIABLE COSTS (VC) Costs that have direct relationship with volume of sales. For example, hourly labor costs is a VC because more labor hours will be needed when sales volume go up. TOTAL VARIABLE COSTS (TVC) TVC is the total of all variable costs in a business establishment. TVC go up or down with volume of sales. Changes in TVC is possible by increasing or decreasing sales level or by better cost control. 7

UNIT VARIABLE COSTS (UVC) Total variable costs divided by the total number of units

UNIT VARIABLE COSTS (UVC) Total variable costs divided by the total number of units produced or sold. Since TVC increase or decrease proportionately with production, the UVC will remain constant. For Example, TVC = $100 when sales volume = 50 units, therefore the UVC = $100/50 = $2. 00 TVC = $200 when sales volume = 100 units, therefore the UVC = $200/100 = $2. 00 8

Calculating Semi-Variable Costs Managers may attempt to separate the fixed and variable elements from

Calculating Semi-Variable Costs Managers may attempt to separate the fixed and variable elements from the semi- variable costs for a more accurate figures. Two of the most common methods that are being used in calculating fixed and variable costs from semi-variable costs are: (1) the High-Low Method (2) the Regression Analysis. The High-Low Method 1 Identify high and low period of sales. 2 Calculate the difference of dollar and units between high and low month. 3 Calculate unit variable costs and total variable costs for high month. 4 Calculate total fixed costs for high month. 5 Cross checking total fixed costs of low month. 6 Calculate total fixed and variable costs for the year. 9

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Step 1. Identify the highest and lowest period of sales: Month Overhead Exp High

Step 1. Identify the highest and lowest period of sales: Month Overhead Exp High = July $2, 340 Low = January $1, 860 Pies Sold 3, 600 2, 400 Step 2. Calculate the differences in expenses and sales activity : High = July Low = January Difference $2, 340 $1, 860 $480 3, 600 2, 400 1, 200 Step 3. Calculate the Unit Variable Costs (UVC) and Total Variable Costs for high month (July). UVC = Difference in $/Difference in Units = $480/1200 = $0. 40 TVC = Unit Sold * UVC = 3, 600 * $0. 40 = $1, 440 Step 4. Calculate the TFC for the high month (July). TVC = $1, 440 TFC = Total Expenses - Total VC = $2, 340 - $1, 440 = $900 11

Step 5. Cross checking the TFC for the low month (Jan. ) TVC =

Step 5. Cross checking the TFC for the low month (Jan. ) TVC = UVC * Pie Sold = $0. 40 * 2400 = $960 TFC = Total Expenses - Total VC = $1, 860 - $960 = $900* Step 6. Calculate the TFC and TVC for the year: TVC = UVC * Total Number of Unit Sold = $0. 40 * 33, 700 = $13, 480 TFC = Total Overhead Expenses - TVC = $23, 900 - $13, 480 = $10, 420* * Cross checking reveal that by multiplying monthly fixed costs of $900 by 12, we will have a total fixed costs of $10, 800 which is $380 higher that the figure calculated in the table above. 12

Regression Analysis Regression analysis is another method to calculate the fixed costs elements in

Regression Analysis Regression analysis is another method to calculate the fixed costs elements in semi-variable costs. 13

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