Classification of Cost

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
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 /avoidable
costs/discretionary costs
Costs
Coststhat
thathave
havealready
alreadybeen
beenincurred
incurredand
andcannot
cannotbe
be
Fall 2010
Mugan
changed
no
is
changed
nomatter
matterwhat
whataction
action
istaken
takenin
inthe
thefuture.
future.
2/82
Problems in Identifying and

Measuring Benefits
How
How do
doII
measure
measurethe
the
benefit
benefit of
of
improved
improved
quality?
quality?
Fall 2010
How
How do
do IImeasure
measure
the
thebenefit
benefit of
of
employee
employee training?
training?
What
What is
is the
the
monetary
monetarybenefit
benefit of
of
aahappy
happycustomer?
customer?
What
What is
isthe
the
monetary
monetary
benefit
benefit of
ofan
an
improved
improved
working
working
environment?
environment?
Mugan
3/82
Problems in Identifying and

Measuring Costs
How
How do
doIImeasure
measure
the
thecost
costof
ofpoor
poor
quality?
quality?
What
What is
isthe
the cost
cost of
of
aadissatisfied
dissatisfied
customer?
customer?
How
How do
do II
measure
measurethe
the
cost
costof
of setting
setting
my
myprice
pricetoo
too
high?
high?
What
Whatis
isthe
thecost
cost
of
of postponing
postponing
this
thisyears
years
training
training
program?
program?
Fall 2010
Mugan
4/82
Classifications of Costs
Behavior how costs react to changes in
underlying cost driver
Variable or Fixed
Function related to production or sales

Product or Period
Product costs
Direct Material
Direct Labor
Factory Overhead
Traceability (cost of tracing cost to a cost

driver directly should be lower than the
benefits.
Fall 2010
Mugan
5/82
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.
Fall 2010
Mugan
6/82
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
Income
Statement
Mugan
7/82
Product Cost Flows
Fall 2010
Mugan
8/82
Product Cost Flows
Prime Costs
Conversion Costs
Fall 2010
Mugan
9/82
Product Cost Flows
Fall 2010
Mugan
10/82
Product Cost Flows
Fall 2010
Mugan
11/82
Product Cost Flows
Fall 2010
Mugan
12/82
Manufacturing Cost Flows

Costs
Balance Sheet
Inventories
Material Purchases
Raw Materials
Direct Labor
Work in
Process
Manufacturing
Overhead
Selling and
FallAdministrative
2010
Finished
Goods
Period Costs
Mugan
Income
Statement
Expenses
Cost of
Goods
Sold
Selling and
Administrative
13/82
Graphical Analysis of Activity Costs and Rate of Output
Curvilinear
Curvilinear Total
Total
Cost
Cost Curve
Curve
Total
Dollars
Marginal
MarginalCosts
Costsare
arethe
thecosts
coststo
toproduce
produceone
one
more
moreadditional
additionalunit
unitof
ofoutput=slope
output=slope..
Output
Start-up Normal
Range Operations
Fall 2010
Exceeding
Capacity
Mugan
14/82
Relevant Range
Relevant
Relevant
Range
Range
Total
Cost
Total
Dollars
Startup
Range
Fall 2010
Normal
Operation
s
Exceeding
Capacity
Mugan
The
Therelevant
relevantrange
range
isisthe
theportion
portionof
ofthe
the
curvilinear
curvilineartotal
totalcost
cost
curve
curvethat
thatappears
appears
in
inthe
thenormal
normal
operations
operationsarea.
area.
Output
15/82
The Linearity Assumption and the

Relevant Range
Total Cost
A
A straight
straight line
line
Economists
closely
closely
Curvilinear Cost approximates
approximates aa
Function
curvilinear
curvilinear
Fall 2010
variable
variable cost
cost
line
line within
within the
the
relevant
relevant range.
range.
Relevant
Range
Accountants Straight-Line
Approximation (constant
unit variable cost)
Mugan
Activity
16/82
Cost Classifications for

Predicting Cost Behavior
By
By reaction
reaction to
to changes
changes in
in the
the level
level of
of
activity
activity within
within the
the relevant
relevant range.
range.
Total
Total variable
variable costs
costs change
change when
when activity
activity
changes.
changes.
Total
Total fixed
fixed costs
costs remain
remain unchanged
unchanged when
when
activity
activity changes.
changes.
Fall 2010
Mugan
17/82
Fall 2010
Mugan
18/82
Cost Classifications for

Predicting Cost Behavior
Fall 2010
Mugan
19/82
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
20/82
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
Fall 2010
Mugan
21/82
Types of Fixed Costs

Committed
Committed
Discretionary
Discretionary
Long-term,
Long-term, cannot
cannot be
be
significantly
significantly reduced
reduced
in
in the
the short
short term.
term.
May
May be
be altered
altered in
in the
the shortshortterm
term by
by current
current managerial
managerial
decisions
decisions
Examples
Examples
Examples
Depreciation on
Equipment and
Real Estate Taxes
Advertising
Advertising and
and
Research
Research and
and
Development
Development
Fall 2010
Mugan
22/82
Mixed Costs
Total Mobile Phone Cost
ta
o
T
xe
i
lm
os
c
d
t
Fixed Monthly
Phone Charge
X
Activity (minutes)
Fall 2010
Fixed Monthly
Phone Charge
Mugan
23/82
Mixed Costs
Total Mobile Phone Cost
ta
o
T
xe
i
lm
os
c
d
t
Variable
Cost per minute
Activity (minutes)
Fall 2010
Mugan
Fixed Monthly
Phone Charge
24/82
The Scattergraph Method

Plot
Plot the
the data
data points
points on
on aa graph
graph
(total
(total cost
cost vs.
vs. activity).
activity).
Cost
20
* *
* *
10
* ** *
**
Activity - output
Fall 2010
Mugan
25/82

Y
Draw
Draw aa line
line through
through the
the data
data points
points with
with about
about an
an
equal
equal numbers
numbers of
of points
points above
above and
and below
below the
the line.
line.
Cost
20
* *
* *
10
* ** *
**
Activity - output
Fall 2010
Mugan
26/82

Use
Useone
onedata
datapoint
pointto
toestimate
estimatethe
thetotal
total level
levelof
ofactivity
activityand
andthe
thetotal
total
cost.
cost.
Cost
Y Total cost = TL11

20
* *
* *
10
* ** *
**
Intercept = Fixed cost: TL 10
Activity - output
Fall 2010
Activity
0.8 units
Mugan
27/82

Make
Make aa quick
quick estimate
estimate of
of variable
variable cost
cost per
per unit
unit and
and determine
determine the
the cost
cost
equation
equation..
Variable cost per unit =
TL1
0.8
= TL1.25/ unit of output
Y = TL10 + TL1.25X
Total cost
Fall 2010
Number of units
Mugan
28/82
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
29/82
Assigning Costs to Cost Objects

Direct costs
Indirect costs
Costs that can be

easily and
conveniently traced
to a unit of product
or other cost object.
Costs that cannot be

easily and
conveniently traced
to a unit of product
or other cost object.
Examples: direct
material and direct
labor
Example:
manufacturing
overhead
Fall 2010
Mugan
30/82
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.
Fall 2010
Mugan
31/82
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
Fall 2010
Differential cost is:

Mugan
TL
300
32/82
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
33/82
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.
Fall 2010
Mugan
34/82
Summary of the Types of Cost

Classifications
Financial reporting
Predicting cost behavior
Assigning costs to cost objectsproducts- determining unit costs
Decision making
Fall 2010
Mugan
35/82
Income Statement Presentation
Used primarily for

external reporting.
Fall 2010
Used primarily by
management.
Mugan
36/82
Idle Time
Machine
Breakdowns
Material
Shortages
Power
Failures
The labor costs incurred

during idle time are ordinarily
treated as manufacturing
overhead.
Fall 2010
Mugan
37/82
Overtime
The overtime premiums for all factory
workers are usually considered to be part
of manufacturing overhead.
Fall 2010
Mugan
38/82
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
Unit cost = DM + DL + MOVH per unit

Fall 2010
Mugan
39/82
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.
40/82
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
Fall 2010
Mugan
41/82
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
Fall 2010
Mugan
42/82
Numerical Example
Management at THD believes that indirect costs
are actually caused by the following five activities:
Fall 2010
Mugan
43/82
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
44/82
PDOR and MOVH
Fall 2010
Mugan
45/82
Unit Costs Traditional
Fall 2010
Mugan
46/82
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
Fall 2010
Total
5,000
8,000
600
40,000
750
Mugan
Product A
3,000
5,000
200
12,000
150
Product B
2,000
3,000
400
28,000
600
47/82
Numerical Example-MOVH by
ABC
This activity data can be used to develop application
rates for each of the five activities.
Fall 2010
Mugan
48/82
ABC
Fall 2010
Mugan
49/82
ABC
Now that we have calculated the application rates, we
use the rates to assign indirect costs to Product A.
Fall 2010
Mugan
50/82
ABC
Now that we have calculated the application rates, we
use the rates to assign indirect costs to Product A.
Fall 2010
Mugan
51/82
ABC
MOVH costs for a unit of Product B
Fall 2010
Mugan
52/82
Reconciliation check
Reconciliation
Indirect costs assigned to Product A
Indirect costs assigned to Product B
Total indirect costs assigned
Fall 2010
Mugan
Amount
$ 392,200
507,800
$ 900,000
53/82
Unit Costs Using ABC
Fall 2010
Mugan
54/82
Comparison of Unit Costs
Fall 2010
Mugan
55/82
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
56/82
Problems With ABC
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
57/82
Quality of Conformance
When the overwhelming majority of
products produced conform to
design specifications and are free
from defects.
Fall 2010
Mugan
58/82
Prevention and Appraisal Costs

Support activities
whose purpose is to
reduce the number of
defects
Prevention
Costs
Incurred to identify
defective products
before the products are
shipped
Appraisal Costs
Fall 2010
Mugan
59/82
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
60/82
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
61/82
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
62/82
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
400,000
210,000
70,000
320,000
1,000,000
Year 1
Amount
Percent*
0.80% $ 270,000
0.42%
130,000
0.14%
40,000
0.64%
210,000
2.00%
650,000
0.54%
0.26%
0.08%
0.42%
1.30%
Appraisal costs:
Inspection
Reliability testing
Supervision of testing and inspection
Depreciation of test equipment
Total appraisal cost
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%
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
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%
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%
External failure costs:

Warranty repairs
Warranty replacements
Allowances
Cost of field servicing
Total external failure cost
Total quality cost
Fall 2010
400,000
870,000
130,000
600,000
2,000,000
7,500,000
* As a percentage of total sales. In each year sales totaled $50,000,000.
Quality cost
reports provide
an estimate of
the financial
consequences
of the
companys
current defect
rate.
63/82
Quality Cost Reports: Graphic

Form
9
Quality Cost (in millions)
8
7
6
External
Failure
External
Failure
5
Internal
Failure
4
3
Internal
Failure
2
1
0
Appraisal
Quality
reports
can also
be
prepared
in
graphic
form.
Appraisal
18
16
14
12
Prevention
2
Year
External
Failure
Internal
Failure
8
6
Internal
Failure
0
Mugan
External
Failure
10
Prevention
1
Fall 2010
20
Quality Cost as a Percentage of Sales
$10
Appraisal
Appraisal
Prevention
Prevention
1
Year
2
64/82
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
65/82
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
66/82
Product Life Cycle
Fall 2010
Mugan
http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf
67/82
Fall 2010
Mugan
68/82
Introduction
Fall 2010
Growth
Mugan
Maturity
Decline
69/82
http://www.ee.unb.ca/powereng/courses/E
E2703/EE2703_DetailedDesign2.pdf
Fall 2010
Mugan
70/82
http://www.ee.unb.ca/powereng/courses/E
E2703/EE2703_DetailedDesign2.pdf
Fall 2010
Mugan
71/82
Appendix
Least-Squares
Regression Using
Microsoft Excel.
Fall 2010
Mugan
72/82
Simple Regression Analysis

Example
Matrix,
Matrix, Inc.
Inc. wants
wants to
to
know
know its
its average
average
fixed
fixed cost
cost and
and
variable
variable cost
cost per
per unit.
unit.
Using
Using the
the data
data to
to the
the
right,
right, lets
lets see
see how
how to
to
do
do aa regression
regression using
using
Microsoft
Microsoft Excel.
Excel.
Fall 2010
Mugan
73/82
Simple Regression Using Excel

You
You will
will need
need three
three pieces
pieces of
of
information
information from
from your
your
regression
regression analysis:
analysis:
1.
1. Estimated
Estimated Variable
Variable Cost
Cost per
per
Unit
Unit (line
(line slope)
slope)
2.
2. Estimated
Estimated Fixed
Fixed Costs
Costs (line
(line
intercept)
intercept)
3.
3. Goodness
Goodness of
of fit,
fit, or
or R
R22
To
Toget
get these
these three
three pieces
pieces
information
information we
we will
will need
need to
to
use
use three
three different
different Excel
Excel
functions.
functions.
LINEST,
LINEST,INTERCEPT,
INTERCEPT,&& RSQ
RSQ
Fall 2010
Mugan
74/82

Place
Place your
your cursor
cursor in
in
cell
cell F4
F4 and
and press
press the
the
== key.
key. Click
Click on
on the
the
pull
pull down
down menu
menu and
and
scroll
scroll down
down to
to More
More
Functions
Functions .. .. ..
Fall 2010
Mugan
75/82

Scroll
Scroll down
down to
to the
the
Statistical
Statistical,,
functions.
functions. Now
Now
scroll
scroll down
down the
the
statistical
statistical
functions
functions until
until you
you
highlight
highlight
LINEST
LINEST
Fall 2010
Mugan
76/82
1.
1. In
In the
the Known_ys
Known_ys box
box enter
enter C4:C19
C4:C19 for
for the
the range.
range.
2.
2. In
In the
the Known_xs
Known_xs box
box enter
enter D4:D19
D4:D19 for
for the
the range.
range.
Fall 2010
Mugan
77/82

Here is the
estimate of the
slope of the line.
1.
1. In
In the
the Known_ys
Known_ys box
box enter
enter C4:C19
C4:C19 for
for the
the range.
range.
2.
2. In
In the
the Known_xs
Known_xs box
box enter
enter D4:D19
D4:D19 for
for the
the range.
range.
Fall 2010
Mugan
78/82
With
With you
you cursor
cursor in
in cell
cell
F5,
F5, press
press the
the == key
key
and
and go
go to
to the
the pull
pull
down
down menu
menu for
for
special
special functions.
functions.
Select
Select Statistical
Statistical and
and
scroll
scroll down
down to
to
highlight
highlight the
the
INTERCEPT
INTERCEPT function.
function.
Fall 2010
Mugan
79/82

Here is the
estimate of the
fixed costs.
1.
1. In
In the
the Known_ys
Known_ys box
box enter
enter C4:C19
C4:C19 for
for the
the range.
range.
2.
2. In
In the
the Known_xs
Known_xs box
box enter
enter D4:D19
D4:D19 for
for the
the range.
range.
Fall 2010
Mugan
80/82

Finally,
Finally, we
we will
will
determine
determine the
the
goodness
goodness of
of
22
fit
,
or
R
fit, or R ,, by
by
using
using the
the RSQ
RSQ
function.
function.
Fall 2010
Mugan
81/82

Here is the
estimate of R2.
1.
1. In
In the
the Known_ys
Known_ys box
box enter
enter C4:C19
C4:C19 for
for the
the range.
range.
2.
2. In
In the
the Known_xs
Known_xs box
box enter
enter D4:D19
D4:D19 for
for the
the range.
range.
Fall 2010
Mugan
82/82

Classification of Cost

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Classification of Cost

Uploaded by

Copyright:

Available Formats

Cost Classification and Cost

The opportunity cost is the monetary amount

differential costs- (benefits) costs or

Problems in Identifying and

Problems in Identifying and

Function related to production or sales

Traceability (cost of tracing cost to a cost

Costs necessary to get

Product Costs Versus Period

Period costs include

Product Cost Flows

Product Cost Flows

Product Cost Flows

Product Cost Flows

Product Cost Flows

Manufacturing Cost Flows

Graphical Analysis of Activity Costs and Rate of Output

The Linearity Assumption and the

Cost Classifications for

Cost Classifications for

Extent of Variable Costs

Examples of Variable Costs

Types of Fixed Costs

Total Mobile Phone Cost

Total Mobile Phone Cost

The Scattergraph Method

The Scattergraph Method

The Scattergraph Method

Y Total cost = TL11

Intercept = Fixed cost: TL 10

The Scattergraph Method

Variable cost per unit =

= TL1.25/ unit of output

The High-Low Method

Assigning Costs to Cost Objects

Costs that can be

Costs that cannot be

Cost Classifications for Decision

Differential Costs and Revenues

Differential revenue is:

Differential cost is:

Example: If you were not attending this

Example: You bought an automobile that

Summary of the Types of Cost

Income Statement Presentation

Used primarily for

The labor costs incurred

Unit cost = DM + DL + MOVH per unit

Labor Fringe Benefits

Other companies treat

How to allocate indirect costs to

Numerical Example- Unit Cost

Unit Cost - Traditional

PDOR and MOVH

Unit Costs Traditional

Numerical Example-MOVH by ABC

Unit Costs Using ABC

Comparison of Unit Costs

That have products

That have a high

Problems With ABC

ABC ignores the

ABC is more costly

Prevention and Appraisal Costs