EMBA 5403 Managerial WK 2

Cost Classification and Cost
Behavior
EMBA 5403
Fall 2010
Mugan
Types of The opportunity cost is the monetary amount
Costs associated with the next best use of the
resource.
 differential costs- (benefits) – costs or

benefits that change between/among
alternatives
 Irrelevant costs -Costs that don’t
change are irrelevant to the decision
 Choose the alternatives where
differential benefits exceed differential
costs
 Opportunity costs
 Sunk costs
 Controllable
Costs that have already /avoidable
been incurred and cannot be
costs/discretionary
changed
Fall 2010 no matter what actionMugan costs
is taken in the future. 2/82
Problems in Identifying and
Measuring Benefits
How do I measure
the benefit of
employee training?
How do I What is the
measure the monetary benefit of
benefit of a happy customer?
improved
quality? What is the
monetary
benefit of an
improved
working
environment?
Fall 2010 Mugan 3/82
Problems in Identifying and
Measuring Costs
How do I measure What is the cost of
the cost of poor a dissatisfied
quality? customer?
What is the cost How do I

of postponing measure the
this year’s cost of setting
training my price too
program? high?
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.

Non-manufacturing Costs
Marketing or Administrative
Selling Costs Costs
Costs necessary to get All executive,

the order and deliver organizational, and
the product. clerical costs.

Product Costs Versus Period
Costs
Product costs include Period costs include

direct materials, direct all marketing or
labor, and selling costs and
manufacturing administrative
Inventory Cost of.Good Sold
overhead costs.
Expense
Sale
Income Income
Balance
Statement Statement
Sheet

Product Cost Flows
Work
Raw Materials In Process
Beginning raw Direct materials

materials inventory
+ Raw materials
purchased
= Raw materials
available for use
in production
– Ending raw materials
inventory
= Raw materials used
in production

Product Cost Flows
Work
Beginning raw Beginning work in

materials inventory process inventory
+ Raw materials Direct materials Prime Costs
purchased + Direct labor
= Raw materials + Mfg. overhead
available for use = Total manufacturing
Conversion Costs
in production costs
– Ending raw materials
inventory
in production

Product Cost Flows
Work

materials inventory process inventory
+ Raw materials
purchased Direct materials
= Raw materials + Direct labor
available for use + Mfg. overhead
in production = Total manufacturing
– Ending raw materials costs
inventory
in production
Product Cost Flows
Work

materials inventory + process inventory
+ Raw materials + + Total manufacturing
purchased = costs
= Raw materials = Total work in
available for use process for the
in production period
– Ending work in
process inventory
= Cost of goods
manufactured

Product Cost Flows
Work
In Process Finished Goods
Beginning work in Beginning finished

process inventory goods inventory
+ Manufacturing costs + Cost of goods
for the period manufactured
= Total work in process = Cost of goods
for the period available for sale
– Ending work in - Ending finished
process inventory goods inventory
= Cost of goods Cost of goods
manufactured sold

Manufacturing Cost Flows
Balance Sheet Income
Costs Inventories Statement
Expenses
Material Purchases Raw Materials
Direct Labor Work in

Process
Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold
Selling and Period Costs Selling and

FallAdministrative
2010 Mugan Administrative
13/82
Graphical Analysis of Activity Costs and Rate of Output
Curvilinear Total
Total Cost Curve
Dollars
Marginal Costs are the costs to produce one

more additional unit of output=slope.
Output
Start-up Normal Exceeding
Range Operations Capacity
The relevant range
Relevant Range is the portion of the
curvilinear total cost
Total curve that appears
Dollars Relevant in the normal
Range Total operations area.
Cost
}
Output
Start- Normal Exceeding
up Operation Capacity
Range s

The Linearity Assumption and the
Relevant Range
Economist’s A straight line

closely
Curvilinear Cost approximates a
Function curvilinear
variable cost
line within the
Relevant
Total Cost
relevant range.
Range
Accountant’s Straight-Line
Approximation (constant
unit variable cost)
Fall 2010 Mugan Activity 16/82

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.

Cost Classifications for
Predicting Cost Behavior
Behavior of Cost (within the relevant range)

Cost In Total Per Unit
Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Average fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.

Extent of Variable Costs
The proportion of variable costs differs across organizations. For
example . . .
A public utility with A manufacturing company

large investments in will often have many
equipment will tend variable costs.
to have fewer
variable costs.
A merchandising company
A service company usually will have a high
will normally have a high proportion of variable costs
proportion of variable costs. like cost of sales.

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 Discretionary
Long-term, cannot be May be altered in the short-
significantly reduced term by current managerial
decisions
in the short term.
Examples Examples
Depreciation on Advertising and
Equipment and Research and
Real Estate Taxes Development

Mixed Costs
Y
Total Mobile Phone Cost
Fixed Monthly
Phone Charge
X Fixed Monthly
Activity (minutes) Phone Charge

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
Y vertical intercept of the line)
b = the variable cost per unit of
Total Mobile Phone Cost
activity (the slope of the line)

X = the level of activity
Variable
Cost per minute
Fixed Monthly
X
Activity (minutes) Phone Charge

The Scattergraph Method
Plot the data points on a graph
Y (total cost vs. activity).
20
* * * ** *
**
Cost
10 * *
0 X
0 1 2 3 4
Activity - output
Draw a line through the data points with about an
Y equal numbers of points above and below the line.
20
* * * ** *
**
Cost
10 * *
0 X
0 1 2 3 4
Activity - output

Use one data point to estimate the total level of activity and the total
cost.
Y Total cost = TL11
20
* * * ** *
**
Cost
10 * *
Intercept = Fixed cost: TL 10
0 X
0 1 2 3 4
Activity - output
Activity
Fall 2010 0.8 units Mugan 27/82
Make a quick estimate of variable cost per unit and determine the cost
equation.
Total Cost at 0.8 units 11 TL

Less: Fixed cost 10 TL
Estimated total variable cost 0.8 units 1 TL
TL1
Variable cost per unit = = TL1.25/ unit of output
0.8
Y = TL10 + TL1.25X
Total cost Number of units

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

Assigning Costs to Cost Objects
Direct costs Indirect costs

 Costs that can be  Costs that cannot be
easily and easily and
conveniently traced conveniently traced
to a unit of product to a unit of product
or other cost object. or other cost object.
 Examples: direct  Example:
material and direct manufacturing
labor overhead

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:

Fall 2010 TL 300
Mugan 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?

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.

Summary of the Types of Cost
Classifications
 Financial reporting
 Predicting cost behavior
 Assigning costs to cost objects-
products- determining unit costs
 Decision making

Income Statement Presentation
Used primarily for Used primarily by

external reporting. management.
Idle Time
Machine Material
Breakdowns Shortages
Power
Failures
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.

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

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 Other companies treat

include all of these fringe benefit
costs in expenses of direct
manufacturing laborers as additional
overhead. direct labor costs.
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:
Estimated
Activity Costs
Machine setups 255,000 TL
Quality inspections 160,000 TL
Production orders 81,000 TL
Machine-hours worked 314,000 TL
Material receipts 90,000 TL
Total 900,000 TL

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

Manufacturing Overhead per unit of B 2 DLH 36 TL per unit

Unit Costs – Traditional
UNIT COSTS Product A Product B

Direct Material 10 15
Direct Labor ( DLH x 30 TL / DLH) 75 60
Manufacturing Overhead 45 36
Unit Cost 130 111

Numerical Example-MOVH by ABC
The following activity data was supplied by
the management of THD
Activity Total Product A Product B

Machine setups 5,000 3,000 2,000
Quality inspections 8,000 5,000 3,000
Production orders 600 200 400
Machine-hours worked 40,000 12,000 28,000
Material receipts 750 150 600

Numerical Example-MOVH by
ABC
This activity data can be used to develop application
rates for each of the five activities.
Total Rate per
Activity Costs Transactions Transaction
Machine setups 255,000 TL ÷ 5,000 = 51 TL
Quality inspections 160,000 ÷ 8,000 ?

ABC
Total Rate per

Activity Costs Transactions Transaction
Machine setups 255,000 TL ÷ 5,000 = 51 TL
Quality inspections 160,000 ÷ 8,000 = 20.00
Production orders 81,000 ÷ 600 = 135.00
Machine-hours worked 314,000 ÷ 40,000 = 7.85
Material receipts 90,000 ÷ 750 = 120.00

ABC
Now that we have calculated the application rates, we
use the rates to assign indirect costs to Product A.
Activity ABC Rate Usage Amount
Machine setups 51 TL × 3,000 = 153,000 TL
Quality inspections 20.00 × 5,000 ?

ABC
Now that we have calculated the application rates, we
use the rates to assign indirect costs to Product A.

Quality inspections 20.00 × 5,000 = 100,000
Production orders 135.00 × 200 = 27,000
Machine-hours worked 7.85 × 12,000 = 94,200
Material receipts 120.00 × 150 = 18,000
Total indirect costs assigned 392,200 TL
Number of units produced ÷ 4,000
Indirect product costs per unit-MOVH 98 TL

ABC
MOVH costs for a unit of Product B
Quality inspections 20.00 × 3,000 = 60,000
Production orders 135.00 × 400 = 54,000
Machine-hours worked 7.85 × 28,000 = 219,800
Material receipts 120.00 × 600 = 72,000
Total indirect costs assigned 507,800 TL
Number of units produced ÷ 20,000
Indirect product costs per unit-MOVH 25 TL

Reconciliation check
Reconciliation Amount
Indirect costs assigned to Product A $ 392,200
Indirect costs assigned to Product B 507,800
Total indirect costs assigned $ 900,000

Unit Costs – Using ABC
UNIT COSTS Product A Product B

Direct Material 10 15
Direct Labor ( DLH x 30 TL / DLH) 75 60
Manufacturing Overhead 98.05 25.39
Unit Cost 183.05 100.39

Comparison of Unit Costs
Traditional Using ABC

Product A 130 183.05
Product B 111 100.39

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.
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.
Quality of Conformance
When the overwhelming majority of

products produced conform to design
specifications and are free from
defects.

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

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

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

Internal Failure Costs
• Cost of field servicing &
• Scrap
handling complaints
• Spoilage
• Warranty repairs
• Rework
• Lost sales

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 Year 1
Amount Percent* Amount Percent*
Prevention costs:
Systems development $ 400,000 0.80% $ 270,000 0.54%
Quality training 210,000 0.42% 130,000 0.26%
Supervision of prevention activities 70,000 0.14% 40,000 0.08%
Quality improvement 320,000 0.64% 210,000 0.42%
Total prevention cost 1,000,000 2.00% 650,000 1.30%
Appraisal costs:
Quality cost
Inspection
Reliability testing
600,000
580,000
1.20%
1.16%
560,000
420,000
1.12%
0.84%
reports provide
Supervision of testing and inspection
Depreciation of test equipment
120,000
200,000
0.24%
0.40%
80,000
140,000
0.16%
0.28%
an estimate of
Total appraisal cost 1,500,000 3.00% 1,200,000 2.40% the financial
Internal failure costs: consequences
Net cost of scrap 900,000 1.80% 750,000 1.50%
Rework labor and overhead 1,430,000 2.86% 810,000 1.62% of the
Downtime due to defects in quality 170,000 0.34% 100,000 0.20%
Disposal of defective products 500,000 1.00% 340,000 0.68% company’s
Total internal failure cost 3,000,000 6.00% 2,000,000 4.00%
current defect
External failure costs:
Warranty repairs 400,000 0.80% 900,000 1.80% rate.
Warranty replacements 870,000 1.74% 2,300,000 4.60%
Allowances 130,000 0.26% 630,000 1.26%
Cost of field servicing 600,000 1.20% 1,320,000 2.64%
Total external failure cost 2,000,000 4.00% 5,150,000 10.30%
Total quality cost $ 7,500,000 15.00% $ 9,000,000 18.00%
* As a percentage of total sales. In each year sales totaled $50,000,000.
Quality Cost Reports: Graphic
Form
$10 20
Quality
9 18
reports
Quality Cost as a Percentage of Sales

8 16
can also
Quality Cost (in millions)
7 14
6
External
Failure
External
Failure
be 12
External
Failure
External
Failure
5
prepared 10
4 Internal
in 8 Internal
3 Internal
Failure
graphic 6 Internal
Failure
Failure Failure
2
Appraisal
form. 4
Appraisal
Appraisal Appraisal
1 2
Prevention Prevention Prevention Prevention
0 0
1 2 1 2
Year Year
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.

Product Life Cycle

http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf
Introduction Growth Maturity Decline

http://www.ee.unb.ca/powereng/courses/E
E2703/EE2703_DetailedDesign2.pdf

http://www.ee.unb.ca/powereng/courses/E
E2703/EE2703_DetailedDesign2.pdf

Appendix
Least-Squares
Regression Using
Microsoft Excel.

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.
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 . . .”

Scroll down to the
“Statistical”,
functions. Now
scroll down the
statistical
functions until you
highlight
“LINEST”

1. In the Known_y’s box enter C4:C19 for the range.

2. In the Known_x’s box enter D4:D19 for the range.

Here is the
estimate of the
slope of the line.


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.

Here is the
estimate of the
fixed costs.

Finally, we will
determine the
“goodness of
fit”, or R2, by
using the RSQ
function.

Here is the
estimate of R2.


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Cost Classification and Cost

 differential costs- (benefits) – costs or

What is the cost How do I

Fall 2010 Mugan 5/82

Costs necessary to get All executive,

Fall 2010 Mugan 6/82

Product costs include Period costs include

Fall 2010 Mugan 7/82

Beginning raw Direct materials

Fall 2010 Mugan 8/82

Beginning raw Beginning work in

Fall 2010 Mugan 9/82

Beginning raw Beginning work in

Beginning raw Beginning work in

Fall 2010 Mugan 11/82

Beginning work in Beginning finished

Fall 2010 Mugan 12/82

Direct Labor Work in

Selling and Period Costs Selling and

Marginal Costs are the costs to produce one

Fall 2010 Mugan 15/82

Economist’s A straight line

Fall 2010 Mugan Activity 16/82

Fall 2010 Mugan 17/82

Behavior of Cost (within the relevant range)

Fall 2010 Mugan 19/82

A public utility with A manufacturing company

Fall 2010 Mugan 20/82

Fall 2010 Mugan 21/82

Fall 2010 Mugan 22/82

Fall 2010 Mugan 23/82

Where: Y = the total mixed cost

activity (the slope of the line)

Fall 2010 Mugan 24/82

Fall 2010 Mugan 26/82

Total Cost at 0.8 units 11 TL

Total cost Number of units

Fall 2010 Mugan 29/82

Direct costs Indirect costs

Fall 2010 Mugan 30/82

 Only those costs and benefits that

Fall 2010 Mugan 31/82

Costs and revenues that differ

Differential revenue is:

Differential cost is:

The potential benefit that is given up when

Example: If you were not attending this

Fall 2010 Mugan 33/82

Sunk costs have already been incurred and cannot

Example: You bought an automobile that

Fall 2010 Mugan 34/82

Fall 2010 Mugan 35/82

Used primarily for Used primarily by

The labor costs incurred

Fall 2010 Mugan 38/82

Fall 2010 Mugan 39/82

Fringe benefits include employer paid costs for

Some companies Other companies treat

Fall 2010 Mugan 43/82

Fall 2010 Mugan 44/82

Manufacturing Overhead per unit of A 2.5 DLH 45 TL per unit

Fall 2010 Mugan 45/82

UNIT COSTS Product A Product B