ACTG 6310

Chapter 2 – The Nature of Costs

What is a cost?

• “A resource sacrificed or forgone to achieve a specific objective

• Not necessarily an expense; could go to asset first then be expensed. Example: inventory

• Actual outlays - resources have been sacrificed• Examples: average cost, common cost, full

cost, historical cost, joint cost, marginal cost, period cost, product cost, standard cost, fixed cost, opportunity cost, sunk cost, variable cost

Opportunity Costs

• Benefit forgone by choosing one course of action over another.

• This is not recorded in the accounting records.

• Sometimes the alternatives are easy to determine, other times not.

• There is always something else you can do with your money, time, space, etc.

Opportunity Costs

• Forward looking – not historical costs

• Not sunk, past costs– Inventory– Depreciation – Includes interest

Cost Variation

• Cost behavior– Variable– Fixed– Mixed (semivariable)– Step costs

• Relevant Range• Choice of Cost Driver• Marginal costs – cost of producing one more unit• Average cost – Total costs/units produced• Marginal cost DOES NOT equal average cost.

Cost-Volume-Profit Analysis

• Procedure that examines changes in costs -- variable and fixed-- and volume levels and the resulting effects on net income.

• Used for planning -- to determine effects of anticipated changes in revenues, variable costs, fixed costs and volume

• Used for controlling -- what happens to net income when changes occur

Contribution Margin

• Sales - Variable Costs

• Per unit – Sales Price per unit - var. costs per unit– Tells us how much in $ is contributed to firm

• Ratio– CM per unit/Sales price per unit– Tells us what % of each dollar is contributed

to the firm

Example of Contribution Margin

• Billy Bob’s Bicycles (Sales of 200 bikes)

• Sales Revenues $100,000

• Var. Costs 40,000

• Contr. Margin 60,000

• Less Fixed costs 30,000

• Net Income $30,000

Contribution Margin

• CM in total = $60,000• CM per unit =

– $100,000/200 bikes = $500 sales price per bike– $ 40,000/200 bikes = $200 var.costs per bike– $ 60,000/200 bikes = $300 CM per bike

• CM Ratio =– $300/$500 = 60% OR– $60,000/$100,000 = 60%

Break-even Analysis

• Algebraic equation method:

• Sales = Var. Costs + Fixed Costs

• $500x = $200x + $30,000

• $300x = $30,000• x = 100 bikes

• Check• Sales $50,000

(100 x $500) • Var. Costs 20,000

(100 x $200)• CM $30,000• - Fixed 30,000 • Net Income -0-

Equation MethodBreak-even in sales dollars

• Sales = 100% x

• Variable costs = VC/SP = 200/500 = 40%x

• Fixed costs are the same for all sales levels

• Therefore, equation :

• 1X = .40X + $30,000

• .60X = $30,000

• x = $50,000 Break-even in sales dollars

Break-even Analysis

• Contribution Margin Method

• 1) Determine the CM per unit

• $500 - $200 = $300

• 2) Calculate how many units must be sold to break even by the following formula:

• Fixed costs $30,000 = 100 bikes

• CM per unit $300

Break-even Analysis

• In Sales Dollars

• B.E. in units x Sales price per unit

• OR

• Fixed Costs

• CM ratio

• = $30,000/.60 = $50,000

Target Profit AnalysisAdd desired profit to fixed costs

Before-Tax

• Equation Method• $500x = $200x +

$30,000 fixed + $60,000 Desired profit

• $300x = $90,000• x = 300 bikes

• Contribution Margin Approach

• $30,000 + $60,000• $300 • = $90,000/300 =• 300 bikes

Target Net Profit Analysis(After-tax)

• Desired After-Tax Profit

• 100% - Tax rate

• = Before-tax profit

• Example for after-tax profit of $36,000:

• $36,000/1-.40

• =$36,000/.60

• =$60,000 Before tax profit

C-V-P in a Multiproduct Environment

• Sales Mix - more than one product sold– Ratio of each product sold to total– Example: Pizza Hut sells pizza, breadsticks,

etc.– How many pizzas sold per breadsticks?– Assume four pizzas to one breadstick– Sales mix = 4P + 1B– This equation is called a “basket” of goods

C-V-P in a Multiproduct Environment

• Breakeven/Target Profit analysis for multiproducts - use the CM per basket of goods

• Example: Assume the CM for pizzas is $4 and the CM for breadsticks is $2, equation would be:

• 4P ($4) + 1B ($2) = $18 CM per basket of goods

• Proceed as usual with break-even analysis

C-V-P for MultiproductsBasket of Goods Approach

• Example: Fixed costs = $90,000

• Break-even point = $90,000/18 CM

• = 5,000 baskets of goods

• 1 basket = 4 P + 1B, therefore

• Break-even is 4 x 5000 = 20,000 pizzas and 1 x 5000 = 5,000 breadsticks

• All analysis is based on baskets of goods!!!

C-V-P for Multiproducts Weighted Average Approach

• Can weight the basket of goods to get a weighted average CM per unit

• (4/5 x $4) + (1/5 x $2) = $3.60

• $90,000/ $3.60 = 25,000 baskets of goods

• 25,000 x 4/5 = 20,000 pizzas

• 25,000 x 1/5 = 5,000 breadsticks

Cost Structure- what portions of costs are fixed or variable

• Company 1 - Pizza Pizza

• Sales$200,000• -Var. costs 150,000• CM 50,000• -Fixed costs 20,000• Net income 30,000

• Company 2 - Pizza oven manufacturers

• Sales$200,000• -Var. costs 50,000• CM 150,000• -Fix. costs 120,000• Net income 30,000

Cost Structure

• What is CM ratio for each company?

• Company 1 = 50,000/200,000

• Company 2 = 150,000/200,000

• Which company is riskier?

• Operating Leverage = Contribution Margin Net Income

• Higher operating leverage, more risky company

Product/Period Costs

• Product costs– Included in inventory until sold

• Manufacturing Costs– Direct material (DM)– Direct labor (DL)– Manufacturing overhead (OH)

• Prime costs – DM and DL– Conversion costs – DL and OH

• Period costs – Entire amount is expensed in period incurred– Selling, marketing and administrative costs

Direct/Indirect Costs

• Direct - costs directly related to cost object– Always direct materials and direct labor

• Indirect - costs not specifically associated with the cost object; varies based on cost object

• Cost objects: 1 Nissan truck, the Nissan truck division, the Smyrna Nissan plant

Problems/Cases

• P2-4 Silky Smooth Lotions

• P2-8 Taylor Chemicals

• P2-34 Candice Company

• ALL DUE NEXT WEDNESDAY, JANUARY 28