Cost Classification and Cost Behavior

Cost Classification and Cost Behavior
EMBA 5403 Fall 2008 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 Irrelevant costs -Costs that dont change are irrelevant to the decision Choose the alternatives where differential benefits exceed differential costs Opportunity costs Sunk costs Controllable been incurred and Costs that have already /avoidable cannot be costs/discretionary costs Fall 2008 Mugan 2/ 85 changed no matter what action is taken in the future.
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?
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Problems in Identifying and Measuring Costs

How do I measure the cost of poor quality? What is the cost of a dissatisfied customer?
What is the cost of postponing this years training program?

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How do I measure the cost of setting my price too high?

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Classifications of Costs
Behavior how costs react to changes in underlying cost driver Function related to production or sales
Product or Period Product costs Direct Material Direct Labor Factory Overhead Variable or Fixed
Traceability (cost of tracing cost to a cost driver directly should be lower than the benefits.
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Non-manufacturing Costs
Marketing or Selling Costs Administrative Costs
Costs necessary to get the order and deliver the product.
All executive, organizational, and clerical costs.
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Product Cost Flows

Raw Materials
Beginning raw materials inventory Raw materials purchased Raw materials available for use in production Ending raw materials inventory Raw materials used in production
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Work In Process
Direct materials
+ =
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Product Cost Flows

Raw Materials
Work In Process
Beginning work in process inventory Direct materials + Direct labor + Mfg. overhead = Total manufacturing costs
+ =
Prime Costs
Conversion Costs
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Product Cost Flows

Raw Materials
Work In Process
Beginning work in process inventory Direct materials + Direct labor + Mfg. overhead = Total manufacturing costs
+ =
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Product Cost Flows

Raw Materials
Beginning raw materials inventory + Raw materials purchased = Raw materials available for use in production + + =
Work In Process
Beginning work in process inventory Total manufacturing costs Total work in process for the period Ending work in process inventory Cost of goods manufactured
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+ =
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Product Cost Flows

Work In Process
Beginning work in process inventory Manufacturing costs for the period Total work in process for the period Ending work in process inventory Cost of goods manufactured
Finished Goods
Beginning finished goods inventory + Cost of goods manufactured = Cost of goods available for sale - Ending finished goods inventory Cost of goods sold
+ = =
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Manufacturing Cost Flows

Costs
Material Purchases Direct Labor Manufacturing Overhead
Balance Sheet Inventories

Raw Materials Work in Process
Income Statement Expenses
Finished Goods
Cost of Goods Sold

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Selling and FallAdministrative 2008
Period Costs
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Graphical Analysis of Activity Costs and Rate of Output
Total Dollars
Curvilinear Total Cost Curve
Marginal Costs are the costs to produce one more additional unit of output=slope.
Output Start-up Normal Range Operations

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Exceeding Capacity
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Relevant Range
Total Dollars
Relevant Range
Total Cost
The relevant range is the portion of the curvilinear total cost curve that appears in the normal operations area.
}
Startup Range
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Output
Normal Operation s Exceeding Capacity
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The Linearity Assumption and the Relevant Range

A straight line Economists closely Curvilinear Cost approximates a Function curvilinear
Total Cost
Relevant Range
variable cost line within the relevant range.
Accountants Straight-Line Approximation (constant unit variable cost)

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Activity
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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.
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Cost Classifications for Predicting Cost Behavior

Behavior of Cost (within the relevant range)
Cost Variable In Total Total variable cost changes as activity level changes. Total fixed cost remains the same even when the activity level changes. Per Unit Variable cost per unit remains the same over wide ranges of activity. Average fixed cost per unit goes down as activity level goes up.
Fixed
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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 service company will normally have a high proportion of variable costs.
A merchandising company usually will have a high proportion of variable costs like cost of sales.
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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
Types of Fixed Costs

Committed
Long-term, cannot be significantly reduced in the short term.
Discretionary
May be altered in the shortterm by current managerial decisions
Examples
Depreciation on Equipment and Real Estate Taxes
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Examples
Advertising and Research and Development
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Mixed Costs
Y
Total Mobile Phone Cost
Fixed Monthly
Phone Charge
X Activity (minutes)
Fixed Monthly
Phone Charge
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Mixed Costs
The total mixed cost line can be expressed as an equation: Y = a + bX Where: Y = the total mixed cost a = the total fixed cost (the vertical intercept of the line) b = the variable cost per unit of activity (the slope of the line) X = the level of activity
Y
Total Mobile Phone Cost
Variable Cost per minute
Activity (minutes)
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Fixed Monthly Phone Charge

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The Scattergraph Method

Y 20
Plot the data points on a graph (total cost vs. activity).
10
* * * *
0 1 2
Cost
* ** * **
X
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3
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Activity - output
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Y 20
Draw a line through the data points with about an equal numbers of points above and below the line.
10
* * * *
0 1 2
Cost
* ** * **
X
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3
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Activity - output
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Use one data point to estimate the total level of activity and the total cost.
Y Total cost = TL11 20
10
* * * *
0 1 2
Cost
* ** * **
X
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Intercept = Fixed cost: TL 10
3
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Activity - output
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Make a quick estimate of variable cost per unit and determine the cost equation.
Total Cost at 0.8 units Less: Fixed cost Estimated total variable cost 0.8 units
11 TL 10 TL 1 TL
Variable cost per unit =
TL1 0.8
= TL1.25/ unit of output
Y = TL10 + TL1.25X
Total cost
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Number of units
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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
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Product Cost Estimation: Technique Classification and Methodology Review Niazi. Dai1. Balabani. Seneviratne Journal of Manufacturing Science and Engineering MAY 2006, Vol. 128,563-575 Fall 2008
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Product Cost Estimation: Technique Classification and Methodology Review Niazi. Dai1. Balabani. Seneviratne Journal of Manufacturing Science and EngineeringFall 2008Vol. 128,563-575 MAY 2006,
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Product Cost Estimation: Technique Classification and Methodology Review Niazi. Dai1. Balabani. Seneviratne Journal of Manufacturing Science and Engineering MAY 2006, Vol. 128,563-575 Fall 2008
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Assigning Costs to Cost Objects

Direct costs
Costs that can be easily and conveniently traced to a unit of product or other cost object. Examples: direct material and direct labor
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Indirect costs
Costs that cannot be easily and conveniently traced to a unit of product or other cost object. Example: manufacturing overhead
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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.
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: Mugan TL 300
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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?
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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.
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Summary of the Types of Cost Classifications Financial reporting Predicting cost behavior Assigning costs to cost objectsproducts- determining unit costs Decision making
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The Contribution Format
Used primarily for external reporting.

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Used primarily by management.

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Idle Time
Machine Breakdowns Power Failures Material Shortages
The labor costs incurred during idle time are ordinarily treated as manufacturing overhead.
Overtime
The overtime premiums for all factory workers are usually considered to be part of manufacturing overhead.
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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
2008 Unit cost = DM + DL + MOVH per unit Fall Mugan
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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.
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Other companies treat fringe benefit expenses of direct laborers as additional direct labor costs.
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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
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
Numerical Example
Management at THD believes that indirect costs are actually caused by the following five activities:
Activity Machine setups Quality inspections Production orders Machine-hours worked Material receipts Total Estimated Costs 255,000 TL 160,000 TL 81,000 TL 314,000 TL 90,000 TL 900,000 TL
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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
PDOR and MOVH

Total Overhead Direct Labor Hours: Product A - 2.5 DlH Product B - 2 DLH Total Direct Labor Hours Predetermined Overhead Rate Manufacturing Overhead per unit of A Manufacturing Overhead per unit of B 900,000 TL 10000 40000 50000 18 TL per DLH 2.5 DLH 2 DLH 45 TL per unit 36 TL per unit
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Unit Costs Traditional

UNIT COSTS Direct Material Direct Labor ( DLH x 30 TL / DLH) Manufacturing Overhead Unit Cost Product A Product B 10 15 75 60 45 36 130 111
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Numerical Example-MOVH by ABC

The following activity data was supplied by the management of THD
Activity Machine setups Quality inspections Production orders Machine-hours worked Material receipts Total 5,000 8,000 600 40,000 750 Product A 3,000 5,000 200 12,000 150 Product B 2,000 3,000 400 28,000 600
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This activity data can be used to develop application rates for each of the five activities.
Activity Machine setups Quality inspections Total Rate per Costs Transactions Transaction 255,000 TL 5,000 = 51 TL 160,000 8,000 ?
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Activity Costs Machine setups 255,000 TL Quality inspections 160,000 Production orders 81,000 Machine-hours worked 314,000 Material receipts 90,000
Total Transactions 5,000 8,000 600 40,000 750
= = = = =
Rate per Transaction 51 TL 20.00 135.00 7.85 120.00
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Now that we have calculated the application rates, we use the rates to assign indirect costs to Product A.
Activity Machine setups Quality inspections ABC Rate 51 TL 20.00 Usage 3,000 = 5,000 Amount 153,000 TL ?
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Now that we have calculated the application rates, we use the rates to assign indirect costs to Product A.
Activity ABC Rate Machine setups 51 TL Quality inspections 20.00 Production orders 135.00 Machine-hours worked 7.85 Material receipts 120.00 Total indirect costs assigned Number of units produced Indirect product costs per unit-MOVH Usage 3,000 5,000 200 12,000 150 Amount 153,000 TL 100,000 27,000 94,200 18,000 392,200 TL 4,000 98 TL
= = = = =
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MOVH costs for a unit of Product B
Activity ABC Rate Machine setups 51 TL Quality inspections 20.00 Production orders 135.00 Machine-hours worked 7.85 Material receipts 120.00 Total indirect costs assigned Number of units produced Indirect product costs per unit-MOVH Usage 2,000 3,000 400 28,000 600 = = = = = Amount 102,000 TL 60,000 54,000 219,800 72,000 507,800 TL 20,000 25 TL
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Reconciliation check
Reconciliation Indirect costs assigned to Product A Indirect costs assigned to Product B Total indirect costs assigned
Amount $ 392,200 507,800 $ 900,000
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Unit Costs Using ABC
UNIT COSTS Direct Material Direct Labor ( DLH x 30 TL / DLH) Manufacturing Overhead Unit Cost
Product A Product B 10 15 75 60 98.05 25.39 183.05 100.39
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Comparison of Unit Costs
Product A Product B
Traditional Using ABC 130 183.05 111 100.39
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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.

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Problems With ABC

Proper identification of cost drivers is difficult.
ABC ignores the difference between the fixed and variable costs of an activity.
ABC is more costly because additional measurements and observations must be made.
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Quality of Conformance
When the overwhelming majority of products produced conform to design specifications and are free from defects.
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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
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Internal and External Failure Costs

Internal Failure Costs
Incurred as a result of identifying defects before they are shipped
External Failure Costs
Incurred as a result of defective products being delivered to customers
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Examples of Quality Costs

Prevention Costs
Quality training Quality circles Statistical process control activities
Appraisal Costs
Testing & inspecting incoming materials Final product testing Depreciation of testing equipment
Internal Failure Costs

Scrap Spoilage Rework
External Failure Costs

Cost of field servicing & handling complaints Warranty repairs Lost sales
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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.
Ventura Company Quality Cost Report For Years 1 and 2 Year 2 Amount Percent* Prevention costs: Systems development Quality training Supervision of prevention activities Quality improvement Total prevention cost Appraisal costs: Inspection Reliability testing Supervision of testing and inspection Depreciation of test equipment Total appraisal cost Internal failure costs: Net cost of scrap Rework labor and overhead Downtime due to defects in quality Disposal of defective products Total internal failure cost External failure costs: Warranty repairs Warranty replacements Allowances Cost of field servicing Total external failure cost Total quality cost Fall 2008 $ 400,000 210,000 70,000 320,000 1,000,000
Year 1 Amount Percent* 0.54% 0.26% 0.08% 0.42% 1.30%
0.80% $ 270,000 0.42% 130,000 0.14% 40,000 0.64% 210,000 2.00% 650,000
600,000 580,000 120,000 200,000 1,500,000
1.20% 1.16% 0.24% 0.40% 3.00%
560,000 420,000 80,000 140,000 1,200,000
1.12% 0.84% 0.16% 0.28% 2.40%
900,000 1,430,000 170,000 500,000 3,000,000
1.80% 2.86% 0.34% 1.00% 6.00%
750,000 810,000 100,000 340,000 2,000,000
1.50% 1.62% 0.20% 0.68% 4.00%
400,000 870,000 130,000 600,000 2,000,000 7,500,000
0.80% 900,000 1.74% 2,300,000 0.26% 630,000 1.20% 1,320,000 4.00% 5,150,000 15.00% $ 9,000,000 Mugan
1.80% 4.60% 1.26% 2.64% 10.30% 18.00%
Quality cost reports provide an estimate of the financial consequences of the companys current defect rate.
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* As a percentage of total sales. In each year sales totaled $50,000,000.
Quality Cost Reports: Graphic Form

$10 9 8
Quality Cost (in millions) Quality Cost as a Percentage of Sales
7 6 5 4 3 2 1 0 Appraisal Prevention 1 Year Prevention 2 Internal Failure Appraisal Internal Failure External Failure External Failure
Quality reports can also be prepared in graphic form.
20 18 16 14 12 10 8 6 4 2 0 Appraisal Prevention 1 Year Prevention

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External Failure
External Failure
Internal Failure Internal Failure Appraisal
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Product Life Cycle
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http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf
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Introduction
Growth
Maturity
Decline
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http://www.ee.unb.ca/powereng/courses/E E2703/EE2703_DetailedDesign2.pdf
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http://www.ee.unb.ca/powereng/courses/E E2703/EE2703_DetailedDesign2.pdf
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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.
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.
Appendix
Least-Squares Regression Using Microsoft Excel.
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Simple Regression Analysis Example

Matrix, Inc. wants to know its average fixed cost and variable cost per unit.
Using the data to the right, lets see how to do a regression using Microsoft Excel.
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 R2 To get these three pieces information we will need to use three different Excel functions. LINEST, INTERCEPT, & RSQ

Place your cursor in cell F4 and press the = key. Click on the pull down menu and scroll down to More Functions . . .
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Scroll down to the Statistical, functions. Now scroll down the statistical functions until you highlight LINEST
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1. In the Known_ys box enter C4:C19 for the range.

2. In the Known_xs box enter D4:D19 for the range.

Here is the estimate of the slope of the line.
1. In the Known_ys box enter C4:C19 for the range.

2. In the Known_xs box enter D4:D19 for the range.

With you cursor in cell F5, press the = key and go to the pull down menu for special functions. Select Statistical and scroll down to highlight the INTERCEPT function.
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Here is the estimate of the fixed costs.
1. In the Known_ys box enter C4:C19 for the range. 2. In the Known_xs box enter D4:D19 for the range.

Finally, we will determine the goodness of fit, or R2, by using the RSQ function.
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Here is the estimate of R2.
1. In the Known_ys box enter C4:C19 for the range. 2. In the Known_xs box enter D4:D19 for the range.

Cost Classification and Cost Behavior

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Cost Classification and Cost Behavior

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Cost Classification and Cost Behavior

EMBA 5403 Fall 2008 Mugan

Problems in Identifying and Measuring Benefits

Problems in Identifying and Measuring Costs

What is the cost of postponing this years training program?

How do I measure the cost of setting my price too high?

Costs necessary to get the order and deliver the product.

All executive, organizational, and clerical costs.

Product Cost Flows

Product Cost Flows

Product Cost Flows

Product Cost Flows

Product Cost Flows

Manufacturing Cost Flows

Balance Sheet Inventories

Income Statement Expenses

Cost of Goods Sold

Selling and FallAdministrative 2008

Graphical Analysis of Activity Costs and Rate of Output

Curvilinear Total Cost Curve

Output Start-up Normal Range Operations

The Linearity Assumption and the Relevant Range

variable cost line within the relevant range.

Accountants Straight-Line Approximation (constant unit variable cost)

Cost Classifications for Predicting Cost Behavior

Cost Classifications for Predicting Cost Behavior

Extent of Variable Costs

A service company will normally have a high proportion of variable costs.

Examples of Variable Costs

Types of Fixed Costs

Variable Cost per minute

Fixed Monthly Phone Charge

The Scattergraph Method

Plot the data points on a graph (total cost vs. activity).

The Scattergraph Method

The Scattergraph Method

Y Total cost = TL11 20

Intercept = Fixed cost: TL 10

The Scattergraph Method

Variable cost per unit =

= TL1.25/ unit of output

The High-Low Method

High level of activity

Low level of activity

Assigning Costs to Cost Objects

Cost Classifications for Decision Making

Differential Costs and Revenues

The Contribution Format

Used primarily for external reporting.

Used primarily by management.

2008 Unit cost = DM + DL + MOVH per unit Fall Mugan

Labor Fringe Benefits

How to allocate indirect costs to products MOVH

Numerical Example- Unit Cost

Unit Cost - Traditional

PDOR and MOVH

Unit Costs Traditional

Numerical Example-MOVH by ABC

Numerical Example-MOVH by ABC

Numerical Example-MOVH by ABC

Total Transactions 5,000 8,000 600 40,000 750

Rate per Transaction 51 TL 20.00 135.00 7.85 120.00

Numerical Example-MOVH by ABC