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Identification and

Measurement of Costs

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Which Costs and Benefits to Measure?

Controllability: Cost or benefit that changes

because of the decision

Measured relative to status quo

Relevance: A controllable cost or benefit that is

different for at least one decision alternative

Relevance helps focus attention on few costs andbenefits

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Identifying Costs and Benefits

Controllable costs and benefits Compare to status quo or doing nothing Computes absolute change in profit

Relevant costs and benefits Compare across all options

Preserves ranking of decision options with fewermeasurements

Why learn two concepts? Controllability = Relevance if status quo is a choice

Status quo is not a choice in many decisions

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ControllableBrand D Brand H

RelevanceBrand H over D

Base configuration $925 $875 ($50)

Flat panel display 125 125

Memory upgrade 225 225

100GB External hard drive 169 169

Upgrade to Vista 175 175

Office 2007 Suite 185 185-3year service agreement 175 300 125

Total $1,979 $2,054 $75

Example: Buying a PC

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Controllability and Relevance

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Yes

No

No

No

No

No

No

YesYesYesYes

Yes

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Open Q .2.45 on Pg.67

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Sunk Costs Controllable costs and benefits pertain to the future

Sunk costs are costs and benefits that have been incurred

in the past

Our decisions today will not change them

They are not controllable or relevant!

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Time and Cost Controllability

Control over costs and benefits increases with passage of

time

Commitments and contracts expire

Ability to change capacity resources varies over time

Cannot change capacity level in the short-term

Can change capacity level in long-term

Because all decisions measure controllable costs andbenefits we can classify decisions as to whether they are

short term or long term decisions

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Example: Time and Controllability

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Open Q. 2.50 on pg.70

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Steps in Estimating Costs

Cost

behavior

Cost

estimation

Cost

prediction

Build model of

expected relationship

between cost and

activity

Use estimated

parameters to forecast

costs at a particular

activity level.

Use historical data to

test model and to

determine parameters

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Estimating Costs and Benefits Controllable costs and benefits are the outcomes

of activities

Two key principles

Variability: Relation between cost or a benefit andsome underlying activity

Traceability: Extent to which we can identify costor benefit with decision option

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Revenue/Sales Volume Relationship

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Variability

Relation between cost/benefit and activityvolume

If we know activity volume, we can estimate

cost/benefit

Terminology

Fixed and variable costs are extremes

Mixed costs

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Variable, Fixed, and Total Costs

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$12

$12

$12

$12

$10

$8

$5

$4

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Open Q. 2.52 on Pg.71

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Behavior of Step Costs

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43 x $7 $250 x 1 step $1,151+ + =

+ + =112 x $7 $250 x 3 steps $2,134

$600

$600

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Traceability

Degree to which we can relate cost or benefit to

decision option

Affects confidence in estimate

Entire effect of direct cost/benefit pertains to

decision option

Confidence is high

Part effect for indirect cost/benefit

Role for allocations

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Controllability, Variability & Traceability

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Cost Hierarchy The cost hierarchy broadens the principle of

variability Allows us to consider multiple activities

The cost hierarchy recognizes four types of costs

Unit-level costs

Batch-level costs

Product-level costs

Facility-level costs

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Why the Cost Hierarchy?

Allows us to compute a more accurate estimate of

costs

Can extend concept to other levels

Customer level costs, channel level costs,

However,

Difficult to assign many costs to hierarchy categories

Need finer data on operations Wrong classification of levels introduces errors in cost

estimation

E l D l Ch k

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Example: Deluxe Checks

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Open Q. 2.54 on pg. 71

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Financial Reporting

All three types of firms

Produce financial reports that conform to GAAP

Distinguish between product costs and period

costs

Have financial reports that are of limited use

for internal decisions

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Product and Period Costs

Product costs: Costs related to getting a product or serviceready for sale.

Appear above the line for gross margin in income statements

These costs can be inventoried

They flow through the inventory account in the balance sheet

Sometime called Inventoriable costs.

Period costs: Costs that are not product costs. Related tomarketing and administration

Appear below the line for gross margin

These costs are expensed in the period they are incurred.

These costs do not flow through inventory accounts

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Period Costs

Product Costs

A Traditional Income Statement

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Usefulness for Internal Decisions

The statement only considers expenses

Cost versus expense

An expense is a cost recognized in the income

statement

The gross margin income statement mingles

Controllable & non controllable costs

Variable and fixed costs

Direct and indirect costs

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Product Period

Controllability Materials to be bought One-time sales discount

Variability Direct labor Commissions

Plant manager salary Sales manager salary

Traceability Cost of components Transportation

Overhead Warehousing

Materials in hand (no other

use)

Discount set per long-term

contract

Relation to Earlier Ideas

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Service Firms

Products are not tangible or storable

Hotels, restaurants, consulting, airlines, gyms,universities, museums,

Generally, there is no inventory of their finalproduct

Exceptions exist

We can inventory costs of software projects that goacross accounting periods

Fl f C S i S i

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Flow of Costs: Service Settings

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Merchandising Firms

Examples include JC Penney, Sears, Kroger,

Office Depot, Staples,

These firms

Sell substantively the same product they

purchase.

Carry inventory to make goods available in the

quantities, varieties and delivery schedulesdemanded by customers.

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Inventory Equation

Need to flow costs via inventory account

Cost of purchase is NOT the cost of goods sold

We can capture flow as:

Cost of beginning inventory+ Cost of goods purchased during the period

Cost of ending inventory

= Cost of goods sold (COGS) during the period

Make inventory cost flow assumption

First In First Out (FIFO)

Last In First Out (LIFO)

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Cost of beginning inventory $3,450,200

+ Cost of goods purchased + 24,795,740

- Cost of ending inventory - 3,745,600= Cost of goods sold = $24,500,340

Solution

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Flow of Costs in Merchandising

Transportation

in, stocking

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Manufacturing Firms

Use labor and equipment to transform raw materials

into finished goods

Have work-in-process

Need inventory accounts for all three kinds ofstages in the production process

Much variation in

Nature of production process

Relative amounts of different costs

Cost Terms in Manufacturing

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Cost Terms inManufacturing

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Names for Groups of Costs

Cost Terms in Manufacturing P i

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Cost Terms inManufacturing PrimeCosts

ConversionCosts

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To verify the amounts specified above, THREE calculations need

to be made:

Procedure Result

Calculation

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Calculate Raw Materials Used1

2 Calculate Cost of Goods Manufactured

3 Calculate Cost of Goods Sold

Beginning materials inventory $240,000

+ Purchases + 1,200,000

- Ending materials inventory - 320,000= Raw materials used = $1,120,000

Beginning WIP inventory $50,000

+ Materials used + 1,120,000

+ Labor cost + 845,000+ Manufacturing overhead + 760,500- Ending WIP inventory - 100,000= Cost of goods manufactured = 2,675,500

Beginning FG inventory $375,000

+ COGM + 2,675,500- Ending FG inventory - 294,500= Cost of goods sold = $2,765,000

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Cost Allocations & Cost Flows

Overhead costs are

Not traceable

Part of product cost for individual products Problem: How to divide total overhead to

pieces that belong to individual products.

Solution: Perform a cost allocation

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Mechanics of Cost Allocations

Each allocation has four elements

Cost Pool

Denominator Volume

Cost Driver

Cost Object

Each allocation has two steps

Calculate rate

Rate = Cost in pool Denominator volume

Allocate cost to cost object

Allocated amount = # of driver units in object rate

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Cost Allocations: Properties

The percent of cost allocated to a cost object is thepercent of cost driver units in the cost object

The Smith and Jones family each contributes 50%of the cost driver units (families). Thus, eachfamily gets 50% of cost to it

Smith family has 60% of the cost driver units (inpersons). Thus, Smith family gets 60% of the costallocated to it

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Cost Allocations: Uses

Uses of allocations

Inventory valuation, decisions, behavioral

Allocation basis versus cost driver

GAAP needs allocations

Decisions need assignment

Two not the same

We study allocations in more detail in Chapter

9.

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Allocated Costs & Decisions

Allocations make it appear as if the allocated

cost is variable in the number of driver units

Cost allocated is variable in # of persons

But, the cost is fixed in the short run

Might not be controllable

Mixing the two can lead to errors

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Documents

Lec 2 to 4.pptx