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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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Open Q .2.46 on Pg.68
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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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Open Q .2.47 on Pg.68
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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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Open Q. 2.53 on Pg.71
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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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Open Q. 3.51 on Pg.105
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Open Q. 3.54 on Pg.106