Cost Classification and Cost Behavior EMBA 5403 Fall

Cost Classification and Cost Behavior EMBA 5403 Fall 2010 Mugan

Types of Costs The opportunity cost is the monetary amount associated with the next best use of the resource. differential costs- (benefits) – costs or benefits that change between/among alternatives o Irrelevant costs -Costs that don’t change are irrelevant to the decision o Choose the alternatives where differential benefits exceed differential costs o Opportunity costs o Sunk costs o Controllable Costs that have already /avoidable been incurred and cannot be costs/discretionary costs Fall 2010 2 changed no matter what action. Mugan is taken in the future. o

Problems in Identifying and Measuring Benefits How do I measure the benefit of improved quality? Fall 2010 How do I measure the benefit of employee training? What is the monetary benefit of a happy customer? What is the monetary benefit of an improved working environment? Mugan 3

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? Fall 2010 Mugan 4

Classifications of Costs o Behavior – how costs react to changes in underlying cost driver n o Function – related to production or sales n n o Variable or Fixed Product or Period Product costs – o Direct Material o Direct Labor o Factory Overhead Traceability (cost of tracing cost to a cost driver directly should be lower than the benefits. Fall 2010 Mugan 5

Non-manufacturing Costs Marketing or Selling Costs Administrative Costs necessary to get the order and deliver the product. All executive, organizational, and clerical costs. Fall 2010 Mugan 6

Product Costs Versus Period Costs Product costs include direct materials, direct labor, and manufacturing overhead Cost of. Good Sold Inventory Period costs include all marketing or selling costs and administrative costs. Expense Sale Balance Sheet Fall 2010 Income Statement Mugan 7

Product Cost Flows Fall 2010 Mugan 8

Product Cost Flows Prime Costs Conversion Costs Fall 2010 Mugan 9

Product Cost Flows Fall 2010 Mugan 10

Product Cost Flows Fall 2010 Mugan 11

Product Cost Flows Fall 2010 Mugan 12

Manufacturing Cost Flows Costs Balance Sheet Inventories Material Purchases Raw Materials Direct Labor Work in Process Manufacturing Overhead Selling and Fall. Administrative 2010 Finished Goods Period Costs Mugan Income Statement Expenses Cost of Goods Sold Selling and Administrative 13

Graphical Analysis of Activity Costs and Rate of Output Curvilinear Total Cost Curve Total Dollars Marginal Costs are the costs to produce one more additional unit of output=slope. Output Start-up Normal Range Operations Fall 2010 Exceeding Capacity Mugan 14

Relevant Range Total Cost } Total Dollars Start-up Normal Range Operation s Fall 2010 Exceeding Capacity Mugan The relevant range is the portion of the curvilinear total cost curve that appears in the normal operations area. Output 15

The Linearity Assumption and the Relevant Range Total Cost A straight line Economist’s closely Curvilinear Cost approximates a Function curvilinear Fall 2010 variable cost line within the relevant range. Relevant Range Accountant’s Straight-Line Approximation (constant unit variable cost) Mugan Activity 16

Cost Classifications for Predicting Cost Behavior By reaction to changes in the level of activity within the relevant range. n n Fall 2010 Total variable costs change when activity changes. Total fixed costs remain unchanged when activity changes. Mugan 17

Fall 2010 Mugan 18

Cost Classifications for Predicting Cost Behavior Fall 2010 Mugan 19

Extent of Variable Costs The proportion of variable costs differs across organizations. For example. . . A public utility with large investments in equipment will tend to have fewer variable costs. A manufacturing company will often have many variable costs. A merchandising company usually will have a high proportion of variable costs like cost of sales. A service company will normally have a high proportion of variable costs. Fall 2010 Mugan 20

Examples of Variable Costs o o 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 Fall 2010 Mugan 21

Types of Fixed Costs Committed Discretionary Long-term, cannot be significantly reduced in the short term. May be altered in the shortterm by current managerial decisions Examples Depreciation on Equipment and Real Estate Taxes Advertising and Research and Development Fall 2010 Mugan 22

Mixed Costs Total Mobile Phone Cost Y t d l a t o xe i m s o c T Fixed Monthly Phone Charge X Activity (minutes) Fall 2010 Fixed Monthly Phone Charge Mugan 23

Mixed Costs Total Mobile Phone Cost Y t d l a t o xe i m s co T Variable Cost per minute X Activity (minutes) Fall 2010 Mugan Fixed Monthly Phone Charge 24

The Scattergraph Method Plot the data points on a graph (total cost vs. activity). Y Cost 20 * * 10 0 * ** 0 1 2 3 4 X Activity - output Fall 2010 Mugan 25

The Scattergraph Method Y Draw a line through the data points with about an equal numbers of points above and below the line. Cost 20 * * 10 0 * ** 0 1 2 3 4 X Activity - output Fall 2010 Mugan 26

The Scattergraph Method Use one data point to estimate the total level of activity and the total cost. Cost Y Total cost = TL 11 20 * * 10 * ** Intercept = Fixed cost: TL 10 0 0 1 2 3 4 X Activity - output Activity 0. 8 units Fall 2010 Mugan 27

The Scattergraph Method Make a quick estimate of variable cost per unit and determine the cost equation. Variable cost per unit = TL 1 0. 8 = TL 1. 25/ unit of output Y = TL 10 + TL 1. 25 X Total cost Fall 2010 Number of units Mugan 28

The High-Low Method Assume the following hours of maintenance work and the total maintenance costs for six months. High level of activity Low level of activity Fall 2010 Mugan 29

Assigning Costs to Cost Objects Direct costs o o Fall 2010 Indirect costs Costs that can be easily and conveniently traced to a unit of product or other cost object. Examples: direct material and direct labor o o Mugan Costs that cannot be easily and conveniently traced to a unit of product or other cost object. Example: manufacturing overhead 30

Cost Classifications for Decision Making o o 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. Fall 2010 Mugan 31

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: TL 2, 000 – TL 1, 500 = TL 500 Fall 2010 Differential cost is: Mugan TL 300 32

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? Fall 2010 Mugan 33

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 TL 10, 000 two years ago. The TL 10, 000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the TL 10, 000 cost. Fall 2010 Mugan 34

Summary of the Types of Cost Classifications o o Financial reporting Predicting cost behavior Assigning costs to cost objectsproducts- determining unit costs Decision making Fall 2010 Mugan 35

Income Statement Presentation Used primarily for external reporting. Fall 2010 Used primarily by management. Mugan 36

Idle Time Machine Breakdowns Material Shortages Power Failures The labor costs incurred during idle time are ordinarily treated as manufacturing overhead. Fall 2010 Mugan 37

Overtime The overtime premiums for all factory workers are usually considered to be part of manufacturing overhead. Fall 2010 Mugan 38

Unit Costs o o o 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 n n o Traditional ABC Unit cost = DM + DL + MOVH per unit Fall 2010 Mugan 39

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. Fall 2010 Mugan Other companies treat fringe benefit expenses of direct laborers as additional direct labor costs. 40

How to allocate indirect costs to products MOVH o o 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 Fall 2010 Mugan 41

Numerical Example- Unit Cost o o o 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 Fall 2010 Mugan 42

Numerical Example Management at THD believes that indirect costs are actually caused by the following five activities: Fall 2010 Mugan 43

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 Fall 2010 Mugan 44

PDOR and MOVH Fall 2010 Mugan 45

Unit Costs – Traditional Fall 2010 Mugan 46

Numerical Example-MOVH by ABC The following activity data was supplied by the management of THD Fall 2010 Mugan 47

Numerical Example-MOVH by ABC This activity data can be used to develop application rates for each of the five activities. Fall 2010 Mugan 48

Numerical Example-MOVH by ABC Fall 2010 Mugan 49

Numerical Example-MOVH by ABC Now that we have calculated the application rates, we use the rates to assign indirect costs to Product A. Fall 2010 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. Fall 2010 Mugan 51

Numerical Example-MOVH by ABC MOVH costs for a unit of Product B Fall 2010 Mugan 52

Reconciliation check Fall 2010 Mugan 53

Unit Costs – Using ABC Fall 2010 Mugan 54

Comparison of Unit Costs Fall 2010 Mugan 55

Advantages of ABC Activity-based costing is very useful in firms. . . With multiple products and services. That have products and services that use indirect activities in different ways. That have a high percentage of indirect product costs. Fall 2010 Mugan 56

Problems With ABC ignores the difference between the fixed and variable costs of an activity. Fall 2010 Proper identification of cost drivers is difficult. ABC is more costly because additional measurements and observations must be made. Mugan 57

Quality of Conformance When the overwhelming majority of products produced conform to design specifications and are free from defects. Fall 2010 Mugan 58

Prevention and Appraisal Costs Prevention Costs Support activities whose purpose is to reduce the number of defects Appraisal Costs Incurred to identify defective products before the products are shipped Fall 2010 Mugan 59

Internal and External Failure Costs Incurred as a result of identifying defects before they are shipped Internal Failure Costs Incurred as a result of defective products being delivered to customers External Failure Costs Fall 2010 Mugan 60

Examples of Quality Costs Appraisal Costs Prevention Costs • Testing & inspecting incoming materials • Final product testing • Depreciation of testing equipment • Quality training • Quality circles • Statistical process control activities External Failure Costs Internal Failure Costs • Cost of field servicing & handling complaints • Warranty repairs • Lost sales • Scrap • Spoilage • Rework Fall 2010 Mugan 61

Distribution of Quality Costs When quality of conformance is low, total quality cost is high and consists mostly of internal and external failure. Companies can reduce their total quality cost by focusing on prevention and appraisal. The cost savings from reduced defects usually swamps the costs of the additional prevention and appraisal efforts. Fall 2010 Mugan 62

Quality cost reports provide an estimate of the financial consequences of the company’s current defect rate. Fall 2010 Mugan 63

Quality Cost Reports: Graphic Form Quality reports can also be prepared in graphic form. Fall 2010 Mugan 64

Uses of Quality Cost Information Help managers see the financial significance of defects. Help managers identify the relative importance of the quality problems. Help managers see whether their quality costs are poorly distributed. Fall 2010 Mugan 65

ISO 9000 Standards ISO 9000 standards have become an international measure of quality. To become ISO 9000 certified, a company must demonstrate: 1. A quality control system is in use, and the system clearly defines an expected level of quality. 2. The system is fully operational and is backed up with detailed documentation of quality control procedures. 3. The intended level of quality is being achieved on a sustained basis. Fall 2010 Mugan 66

Product Life Cycle Fall 2010 Mugan http: //www. hss. caltech. edu/~mcafee/Classes/BEM 106/PDF/Product. Life. Cycle. pdf 67

Fall 2010 Mugan http: //www. hss. caltech. edu/~mcafee/Classes/BEM 106/PDF/Product. Life. Cycle. pdf 68

Introduction Fall 2010 Growth Mugan Maturity http: //www. hss. caltech. edu/~mcafee/Classes/BEM 106/PDF/Product. Life. Cycle. pdf Decline 69

http: //www. ee. unb. ca/powereng/courses/E E 2703/EE 2703_Detailed. Design 2. pdf Fall 2010 Mugan 70

http: //www. ee. unb. ca/powereng/courses/E E 2703/EE 2703_Detailed. Design 2. pdf Fall 2010 Mugan 71

Appendix Least-Squares Regression Using Microsoft Excel. Fall 2010 Mugan 72

Simple Regression Analysis Example Matrix, Inc. wants to know its average fixed cost and variable cost per unit. Using the data to the right, let’s see how to do a regression using Microsoft Excel. Fall 2010 Mugan 73

Simple Regression Using Excel You will need three pieces of information from your regression analysis: 1. Estimated Variable Cost per Unit (line slope) 2. Estimated Fixed Costs (line intercept) 3. Goodness of fit, or R 2 To get these three pieces information we will need to use three different Excel functions. LINEST, INTERCEPT, & RSQ Fall 2010 Mugan 74

Simple Regression Using Excel Place your cursor in cell F 4 and press the = key. Click on the pull down menu and scroll down to “More Functions. . . ” Fall 2010 Mugan 75

Simple Regression Using Excel Scroll down to the “Statistical”, functions. Now scroll down the statistical functions until you highlight “LINEST” Fall 2010 Mugan 76

Simple Regression Using Excel 1. In the Known_y’s box enter C 4: C 19 for the range. 2. In the Known_x’s box enter D 4: D 19 for the range. Fall 2010 Mugan 77

Simple Regression Using Excel Here is the estimate of the slope of the line. 1. In the Known_y’s box enter C 4: C 19 for the range. 2. In the Known_x’s box enter D 4: D 19 for the range. Fall 2010 Mugan 78

Simple Regression Using Excel With you cursor in cell F 5, press the = key and go to the pull down menu for special functions. Select Statistical and scroll down to highlight the INTERCEPT function. Fall 2010 Mugan 79

Simple Regression Using Excel Here is the estimate of the fixed costs. 1. In the Known_y’s box enter C 4: C 19 for the range. 2. In the Known_x’s box enter D 4: D 19 for the range. Fall 2010 Mugan 80

Simple Regression Using Excel Finally, we will determine the “goodness of fit”, or R 2, by using the RSQ function. Fall 2010 Mugan 81

Simple Regression Using Excel Here is the estimate of R 2. 1. In the Known_y’s box enter C 4: C 19 for the range. 2. In the Known_x’s box enter D 4: D 19 for the range. Fall 2010 Mugan 82