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Classifying Costs (a)
By Element Material Labour Expense
By Traceability Direct Indirect
Classification by element
TheProduct
Material Labour Expense
Classification of Costsby Traceability
Direct CostsCosts that can
be easily and conveniently tracedto a unit of product or other cost object.
Examples: Direct material
Direct labor
Indirect Costs
Costs cannotbe easily and conveniently tracedto a unit of product or other cost object.
Example: Manufacturing
overhead
Direct and Indirect Costs
Direct costsCosts that can be
easily and conveniently traced to a product or department.
Example: cost of paint in the paint department of an automobile assembly plant.
Indirect costsCosts that must be
allocated in order to be assigned to a product or department.
Example: cost of national advertising for an airline is indirect to a particular flight.
Classification by element or traceability
Materials
Direct Indirect
Labour
Direct Indirect
Expenses
Direct Indirect
Current
Product costs =
Materials+Labour+Expenses
Or
Direct costs + Indirect costs
Classifications of Costs in Manufacturing Companies
PrimeCost
ConversionCost
Manufacturing costs are oftencombined as follows:
DirectMaterial
Direct Labour &
Direct Expenses
ManufacturingOverhead
Classifying Costs (b)
By FunctionProduct Period
Manufacturing Cost Flows
ManufacturingOverhead
Material Purchases
Direct Labor
Balance Sheet Costs Inventories
FinishedGoods
Cost of GoodsSold
Income StatementExpenses
Selling andAdministrative
Selling andAdministrative
Period Expenses
Work in Process
Raw Material
Cost Classification by Function Product costsInclude expenditures
that arenecessary and integralto finished products.
Capitalized on thebalance sheet until sold.
Period costsInclude expendituresidentified more with atime period than with
finished products.
Expensed on theincome statement.
Inventory Cost of Good Sold
BalanceSheet
IncomeStatement
Sale
Expense
IncomeStatement
Classification of Costs by Function
Product Costs
Direct materials
Direct labor
Overhead
Period Costs
Selling
General and administrative expenses
Classifying Costs (c)
By Behaviour Fixed Variable Semi-fixed Semi-variable
Cost Classificationsby Behaviour
Cost BehaviourHow a cost will react to
changes in the level of business activity.
Cost BehaviourHow a cost will react to
changes in the level of business activity.
Total variable costs change when the level of activity changes.
Total fixed costs remain unchanged when the level of activity changes.
Total variable costs change when the level of activity changes.
Total fixed costs remain unchanged when the level of activity changes.
Total Variable Cost
Your total long distance telephone billis based on how many minutes you talk.
Minutes Talked
Tot
al L
ong
Dis
tanc
eT
elep
hone
Bill
A variable cost is one that changes in total in proportion to changes in the volume of activity.
Variable Cost Per Unit
Minutes Talked
Per
Min
ute
Tel
epho
ne C
harg
e
The cost per long distance minute talked is constant.For example, 10 cents per minute.
On a per unit basis, a variable cost remains constant over a wide range of activity.
Cost Behaviour
Merchandisers
Cost of Goods Sold
Manufacturers
Direct Material, Direct Labor, and Variable
Manufacturing Overhead
Merchandisers and Manufacturers
Sales commissions and shipping costs
Service Organizations
Supplies and travel
Examples of variable costs
Total Fixed Cost
Your monthly basic telephone bill probably does not change when you make more local calls.
Number of Local Calls
Mon
thly
Bas
ic
Tel
epho
ne B
illA fixed cost is one that remains constant in total
even when the volume of activity changes.
Fixed Cost Per Unit
Number of Local Calls
Mon
thly
Bas
ic
Tel
epho
ne B
ill p
er
Loca
l Cal
l
The average cost per local call decreases as more local calls are made.
On a per unit basis, a fixed cost changesas the volume of activity changes.
Examples of fixed costs
Merchandisers, manufacturers, and service organizations
Real estate taxesInsurance
Sales salariesDepreciationAdvertising
Cost Behaviour
Cost Classifications for Predicting Cost Behavior
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit
Variable Total variable cost is Variable cost per unit remainsproportional to the activity the same over wide ranges
level within the relevant range. of activity.
Fixed Total fixed cost remains the Fixed cost per unit goessame even when the activity down as activity level goes up.
level changes within therelevant range.
Ren
t C
ost
in
T
ho
usa
nd
s o
f D
oll
ars
0 1,000 2,000 3,000 Rented Area (Square Feet)
0
30
60
Fixed Costs and Relevant Range
90
Relevant
Range
Total cost doesn’t change for a wide range of activity.It then jumps to a new higher cost
for the next higher range of activity.
The company’s normal operating range
How does this type of fixed cost differ from a step-variable (or step-
wise) cost?
Step-variable (or step-wise) costs
can be adjusted more quickly and . . .
The width of the activity steps is
much wider for the fixed cost.
Fixed Costs and Semi-fixed (or Step-Wise or Step-Variable) Costs
Semi-fixed Costs(or Step-Variable or Step-Wise)
Activity
Co
st
Total costremains constant within a narrow range of activity.
Total cost increasesto a new higher cost
for the next higher range of activity.
Fixed Monthly
Utility Charge
Variable
Utility Charge
Activity (Kilowatt Hours)
To
tal
Uti
lity
Co
st
Total semivariable cost
Semivariable Cost Slope is
variable costper unit
of activity.
Curvilinear CostCurvilinear
Cost Function
Relevant Range
Activity
To
tal
Co
stCurvilinear
Cost Function
A straight-Line(constant unit
variable cost) closely approximates a
curvilinear line withinthe relevant range.
Relevant Information
Information is relevant to a decision problem when . . .
It has a bearing on the future, It differs among competing alternatives.
Information is relevant to a decision problem when . . .
It has a bearing on the future, It differs among competing alternatives.
Identifying RelevantCosts and Benefits
Sunk costsCosts that have already been incurred. They do not affect any future cost and cannot be changed by any current or
future action.
Sunk costsCosts that have already been incurred. They do not affect any future cost and cannot be changed by any current or
future action.
Sunk costs are irrelevant to decisions.Sunk costs are irrelevant to decisions.
Relevant CostsRelevant Costs
Relevant costs are those costs and/or benefits that differ between alternatives.
Costs that can be eliminated (in whole or in part) by choosing one alternative over another are avoidable costs.
Avoidable costs are relevant costs. Unavoidable costs include:
Sunk costs.Future costs that do not differ between the
alternatives. Unavoidable costs are never relevant.
Add or Drop a Product Incremental Incremental CostsCosts
Summary
DECISION RULEDECISION RULE
Swick should drop the digital watch segment Swick should drop the digital watch segment only if its fixed cost savings exceed lost only if its fixed cost savings exceed lost
contribution margin.contribution margin.
Marginal Costs and Average Costs
The extra costincurred to produceone additional unit.
The total cost toproduce a quantity
divided by thequantity produced.
Marginal and average costs arelargely a function of cost behavior
-- variable and fixed costs.
Costs and Benefits of Information
Costs Benefits
More information does not mean more benefits if information overload results.