Session 2

Accounting 102

Cost Concepts & Terminology

Some Basic Cost Terminology and Concepts

Cost – resource(s) sacrificed to achieve a specific objective Cost Object – anything of interest for which a measure of cost is desired

Some examples of cost objects

Cost Object Example

Product BMW X5 SUV

Service Dealer-support telephone hotline

Project R&D project on DVD system enhancement

Customer BMW of the Main Line, a dealer that purchases a broad range of BMW vehicles

Activity Setting up production machines

Department Production Scheduling

Actual Costs vs Budgeted Costs vs Opportunity Costs

An actual cost is the amount of a resource actually used to achieve some goal

e.g. The cost of a resource that was used to produce a product; the cost to make an investment; the cost to conduct an advertising campaign

A budgeted cost is a predicted (expected future) cost that, typically, is incorporated in the “budget”, a managerial accounting report. An opportunity cost is a benefit foregone by taking one action rather than another. That is, the opportunity cost of doing one thing is not being able to do another.

e.g. One of the opportunity costs of your decision to come to Penn is the income that you could have earned otherwise.

Classifying Costs

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Direct Cost: A cost that can be traced directly and completely to a specific cost object, in a cost-effective way.

A direct cost is traced to a cost object

Example: The cost of the processor used to produce a computer where the computer is the cost object.

Indirect Cost: A cost that cannot be traced directly and completely to a specific cost object. (When the cost object is a product, indirect costs are referred to as (manufacturing) Overhead costs.) An indirect cost is allocated to a cost object

Example: The depreciation cost for production facilities used to produce a computer where the computer is the cost object.

Classification Based on Traceability to a Cost Object

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The traceability of costs is a particularly important idea when the objective is to measure the cost of something – a product or service, a department or division within an organization, etc.

For product costing the objective of the accounting system is to determine the cost of the item being produced as illustrated below.

TYPE OF COST ALLOCATION COST OBJECT

Cost Tracing

Material requisition documents Labor time records

Cost Allocation

No documentation

Direct Costs Example:

Cost of steel and tires Cost of assembly line labor

Indirect Costs Example: Depreciation cost for plant that makes the X5 and other models

Example: BMW X5

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Classification Based on Behavior

For some purposes (e.g. to estimate future costs for planning purposes or for decision making, in order to choose among alternative courses of action) it is useful to classify costs on the basis of their relationship with a cost driver. Cost Driver

A factor whose change “causes” a change in the total amount of a cost – that which “drives” the cost to be incurred, in the first place, or to change, subsequently.

Volume of production Hours worked by employees Weather

Note that some costs may have more than one cost driver.

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Relative to a cost driver, costs may be classified as: A. Variable

Variable costs are those that change in total in proportion to changes in the related cost driver (but are constant on a per unit basis)

e.g. To produce one unit of product requires 2 lbs of raw materials costing $3 per pound. So, the total cost of raw materials used changes in proportion to the number of units produced – the cost driver. (But, the cost per unit ($6) does not change.)

Graphically,

Cost Driver

Cost

Total cost changes as the cost driver changes

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B. Fixed

Fixed costs are those that, in total, do not change as a result of changes in the cost driver (but, on a per unit basis, vary inversely with the change in the level of the cost driver.)

e.g. The straight-line depreciation cost for the manufacturing plant is $400,000. That cost remains unchanged as the number of units produced changes. (But, as the number of units increases (decreases), that fixed cost is spread over more (fewer) units, causing the cost per unit to decrease (increase).)

Graphically,

Cost Driver

Cost

Total cost does not change

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In a manufacturing setting, the driver most commonly used to distinguish between fixed and variable costs is the number of units produced.

Whether a cost is fixed or variable with respect to the level of output can vary from one firm to another depending on how their operations are organized. For example

– Outsourcing – can turn fixed costs into variable

e.g. in-house photocopying vs outsourcing on a fee per copy basis.

– Labor contracts – can convert variable costs into fixed

e.g. A labor contract may restrict a company’s ability to lay-off employees when production levels decline

– Automating a production process may turn some variable labor costs into fixed costs – when production workers are replaced by machines (and labor costs which vary with the number of units produced are replaced by depreciation costs which do not).

Additional Terms and Concepts

Relevant Range The relevant range is the band of activity (of the cost driver) within which there is a specific relationship between the level of activity and a given cost

For example, fixed costs are likely to be fixed only within some relevant range of output.

Suppose that, with its existing facilities (PP&E), Apple has the capacity to produce 200,000 iPads per month and that the depreciation cost is $50,000 per month.

However, in order to produce more than 200,000 units per month, Apple would have to add facilities (more equipment), increasing its production capacity by 100,000 units and its depreciation cost by $30,000. So depreciation costs are fixed at $50,000 for any volume of production in the range of between 1 and 200,000 units. But that cost would change when production increases from 200,000 to 200,001 units and then would remain fixed at $80,000 for any production volume between 200,001 and 300,000 units.

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Depreciation Cost

$80,000

$50,000

200,000 300,000

Production Volume

The relationship between Apple’s depreciation cost and its production volume over the range of from 1 to 300,000 units of production is illustrated graphically below.

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Related to the classification of costs on the basis of their behavior, where the cost driver is the number of units (produced and) sold, is the concept of a contribution margin:

Contribution margin per unit = (Selling Price – Total Variable Costs) per unit

It is a measure of the “contribution” made by the production and sale of one unit of product toward covering the firm’s fixed costs and providing a profit.

Given the per unit selling price and the structure of the firm’s costs (variable vs fixed), the contribution margin per unit sold will be constant, but the total contribution margin will vary in proportion with the number of units sold.

Contribution Margin

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Costs and Decision Making

a. What costs will be affected by the decision (i.e. what costs are relevant to the decision)?

Relevant costs differ among alternatives and relate to the future

Sunk costs are past costs that have already been incurred and are irrelevant to future decisions because they cannot be changed no matter what decision is made.

b. How will costs be affected by the decision?

Are the relevant costs variable or fixed? What is the range of activity that is relevant for the decision?

c. What is the opportunity cost of choosing a particular course of action (i.e., What is the maximum that could have been earned/received if an alternative use of resources had been selected)?

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Key Considerations When Using Cost Data for Decision Making

A Decision Problem

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Gaming Corp. produces and sells the “Game-Box 720”, a digital gaming device. The selling price is $190 per unit. The firm’s costs are as follows:

Fixed production costs = $1,000 per period (depreciation, supervisor salaries, etc.) Variable production costs = $ 50 per unit produced (materials, labor, etc.) Variable marketing cost = $ 10 per unit sold in the normal market

The firm’s existing production facilities provide it with the capacity to produce a total of 15 units of product per period. However, given current market conditions, the firm expects to produce and sell 10 units.

a) At the expected level of output, what is the firm’s average production cost per unit?

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b) At the expected level of output, what is the firm’s contribution margin:

i) per unit of product?

ii) in total?

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c) At the expected level of output, what will the firm’s total profit be?

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c) The firm has received a special order for 2 units at a price of $140 per unit. The company making the offer wants to give the devices away next period as a part of an advertising promotion. The firm must decide whether to accept or reject the offer? What criterion do you think that the firm should use as the basis for its decision, in this case?

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Let’s evaluate the offer.

1) What are the costs that are relevant for this decision?

2) What is (are) the relevant cost driver(s) and the relevant range(s) of activity?

So, should the firm accept or reject the offer?

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d) Now, suppose that the order had been for 6 units at a price of $ 140 per unit.

In this case, should the firm accept or reject the offer?

1) What are the costs that are relevant for this decision?

2) What is (are) the relevant cost driver(s) and the relevant range(s) of activity?

So, should the firm accept the offer?