Overview

1. Terminology
2. Cost Behavior
3. Cost Drivers
4. Breakeven Analysis
5. Summary
 Example
At the beginning of class today, I offer you
2 choices (A or B)

A. Continue pursuing your MBA and get a

job as an investment banker working for
Goldman (after you graduate in June 2002)
at a rate of $150,000 per year for 4 years.
(assume total tuition cost for 4 semesters at
Sloan is $80,000)

B. Quit pursuing your MBA in June and

get a job as an investment banker in
Goldman’s trainee program this June. You
will be earning $110,000 per year for 5
years

Assume there is no time value of money

and you are equally marketable under either
choice to the internal and external labor
markets at the end of five years.
 Terminology
Fixed Costs
Variable Costs
Average Costs
Marginal Costs

Opportunity Costs
Sunk Costs
Avoidable Costs

Period Costs
Product Costs

Direct costs
Indirect Costs

Direct Materials
Direct Labor
Overhead
 Emrich Processing (Prob 2-9)

Facts:
- GX-100 costs $1000 for 50 gallons.
- Emrich has 25 gallons that must be
discarded at a cost to them of $400.
- Emrich purchased 50 gallons and charged
their previous customer the purchase price
and cost of disposal.

What is the cost you assign to GX-100 in

this decision?
 Emrich Processing
Solution:

The $400 cost of disposal is an avoidable

cost, this is relevant to the decision.

The $1000 purchase price is a sunk cost

and is not relevant.

The revenue earned on the previous sale is

also not relevant.

Therefore the only relevant cost is the

disposal cost of $400, so Emrich should be
willing to pay $399 less any out of pocket
expenses to accept the order.
 J.P Max Department Stores
(Prob 2-3)

You have an opportunity to sublease store space at

$72 per square foot

Choose between the Appliance and Televisions

department

Appliance Television
Sq footage 1000 1200
Current Profits $64,000 $82,000

Fixed costs are $7 per square foot

 J.P Max Department
Stores (Prob 2-3)
Solution

Appliances Televisions
Lease Rev $72,000 $86,400
Less Fixed Costs 7,000 8,400
Profits from
Leasing 65,000 78,000
Current Profits 64,000 82,000

Because the fixed costs are not avoidable

(they will still be incurred even if we lease)
we should only lease the appliance space.
 Cost Behavior

How do total costs change with changes in

units of production?
Total Cost

Quantity
 Cost Behavior

How do per unit costs change with changes

in volume?
Total Cost

Quantity
 Fast Photo (P2-20)

4 Plants at the Film Company:

Why is Plant D less Profitable?

A B C D
# of Rolls 50,000 55,000 60,000 65,000
Revenue (000’s) 500 550 600 650
Variable Costs (195) (242) (298) (352)
Fixed Costs (300) (300) (300) (300)
Profit 5 8 2 (2)
 Fast Photo (P2-20)
Solution:
650

600

550

500

C 450

O 400
S 350
T
300

30 35 40 45 50 55 60 65

QUANTITY
 Fast Photo (P2-20)
Solution: Per Unit Basis
6

C 4
O
S 3
T

30 35 40 45 50 55 60 65

QUANTITY
 Breakeven Analysis
Consider the following format of the
income statement

Revenues
-Variable costs
Contribution Margin
-Fixed Costs
Profit

Where the contribution margin equals

fixed costs, we have hit the break even
point.

If we have some desired profit level, we

can “work backwards” to determine the
number of units we need to produce and
sell to reach the desired profit.
 Operating Leverage

Operating Leverage represents the ratio of

fixed costs to total costs.

Firms with higher operating leverage will

experience relatively larger changes in
income when there are changes in volume.

This because firms with more operating

leverage have relatively larger per unit
contribution margins.
 Amy’s Boards (Prob 2-36)
Facts:

If Laura Purchases boards then:

Purchase price = $550 Office expenses = 26000
Rent = 7200-1600= $5600 Resale price = $250
Revenue per rental = $75 Variable cost per rental= $7
She expects to rent 80% of the boards a week

Solution:
 Amy’s Boards (Prob 2-36)

Facts:

If Laura Purchases boards then:

Purchase price = $550 Office expenses = 26000
Rent = 7200-1600= $5600 Resale price = $250
Revenue per rental = $75 Variable cost per rental= $7
She expects to rent 80% of the boards a week

Solution:

• Break even
Revenue (75*.8Q)*20=48121.2
VC (7*.8Q)20 + Q* 300= 16521.2
CM 31600
Fixed Costs -31600
Profit 0
Quantity = 40.1
 Amy’s Boards (Prob 2-36)
Solution:
2. Quantity = 50 boards
Revenue
VC
CM
Fixed Costs
Profit

• Utilization Rate
Revenue
VC
CM
Fixed Costs
Profit

Utilization Rate=
 Amy’s Boards (Prob 2-36)

Solution:
2. Quantity = 50 boards
Revenue (75*.8*50)*20= 60000
VC (7*.8*50)20 + 50*300= 20600
CM 39400
Fixed Costs -31600
Profit 7800

• Utilization Rate
Revenue (75*U*50)*20= 51397
VC (7*U*50)20 + 50*300= 19797
CM 31600
Fixed Costs -31600
Profit 0
Utilization Rate=68.53%
 Cost Drivers

• Up until this point we have focused on

how costs change with changes in output
or units sold.

• There are other “cost drivers” that may

better describe the behavior of a cost than
the output of the manufacturing process.

• Consider the following manufacturing

process for insect traps (which I was
involved in as an undergraduate.)
 Cost Drivers

Most insect traps work because of

Pheromones.

Each insect has a different Pheromone,

thus to make a particular type of insect trap,
you need to mix different chemicals.

We can break up the production process

into the following activities.

To make an insect trap you must:

1. Set up for mixing
2. Mix chemicals
3. Kiln chemicals
4. Make the traps.
 Cost Drivers
To set up to mix 16 ounces to 1600 ounces
of a pheromone for kilning takes 50 hours
of labor @ $20 per hour.

An individual Kiln can only handle up to

100 pounds of a pheromone, then a new
kiln has to be setup.

Thus setup costs are fixed cost for up to

100 pounds of a pheromone.

So how much would it cost (in terms of

labor dollars) to make 250 lbs of fruit fly
pheromone?
 Cost Drivers
What was your first inclination to do
in calculating the cost of making the
fruit fly pheromone?

What happens in costing this product

when we add layers to the
production process like assembly,
disposal, shipping, receiving?

ABC costing suggests that instead of

tracking set-up costs per pound of
pheromone, it makes pore sense to
track set-up costs per batch kilned.
 X Corporation Jet (Prob 2-16)

Air Travel is unproductive. How

can a firm reduce the costs of air
travel?

What is the cost to the firm of flying

Commercial?

What is the cost to toe firm of flying

on LX-0100?

What is the cost to the firm for

flying LX-0200?

Should departments be billed for

time on the plane? If so at what rate?
X Corporation Jet (Prob 2-16)
Commercial Travel:
Airfare = $500*10= $5000
Opportunity cost =
20managers for 7
hours at $80 per hour = $10200
Total Cost $15200
 X Corporation Jet
(Prob 2-16)

Travel via LX-0100:

Airfare = $0
Opportunity cost
20managers for 6
hours at $80 per hour = $9600
Operating Cost = $5100
Total Cost $14700
 X Corporation Jet
(Prob 2-16)

Travel via LX-0200:

Airfare 3*500= $1500
Opportunity cost
14managers for 4
hours and 6 managers
for 7 hours at $80
per hour = $7840
Operating Cost = $5200
Total Cost $14540
 X Corporation Jet
(Prob 2-16)

Should departments be billed for

using the jet? If so at what rate?

No billing – Over utilized. Send

people to Arizona as a reward.

Bill at $500 – Under utilized.

While a plane trip costs $500…there

are frequent flier miles, and people
can travel on a more flexible
schedule.
 Eastern University
(P2-23)
Facts:

Faculty pay $180 a year to park behind the

building. Additional remote parking is
available at $124 a year.

Construction of a new parking deck

suggest that a new deck could be built at a
cost of $12000 per space.

The university asserts that they would have

to charge $1200 per space in the garage
compared to $90 per space on a surface lot
to cover the cost of capital to build the
garage

Should they build the garage?