CHAPTER 3CHAPTER 3CHAPTER 3CHAPTER 3

Using Costs in Decision MakingUsing Costs in Decision Making

Cost ClassificationCost Classification

Costs can be classified by: Financial reporting: product VS

period costs Traceability: direct VS indirect costs Behavior: variable/fixed /mixed/step

costs Other terms: incremental costs,

sunk costs, opportunity costs, avoidable costs etc

Cost Categories Used in Cost Categories Used in Financial ReportingFinancial Reporting

Cost Categories Used in Cost Categories Used in Financial ReportingFinancial Reporting

Variable Costs: total costs changes in proportion to changes in quantity or activity. E.g. DM, DL, & sales commissions.

Fixed Costs: total costs do not change in response to changes in quantity or activity.

• E.g. depreciation by straight line method, rent, and insurance etc.

Mixed Costs: costs that have both variable and fixed elements. E.g. a salesperson’s salary where he receives a base salary (fixed) plus

commissions (variable).

Step Costs: fixed for a range of output, but increase when upper bound of range is exceeded. E.g. company adds second or third production shift, fixed costs

related to supervisory salary, heat, light etc are expected to increase.

Common Cost Behavior Patterns

Common Cost Behavior Patterns

PracticePractice

How does the cost of your cell phone plan behavior? $0.50 per minute $10 monthly fee, $0.10 per minute $60 per month unlimited minutes $20 monthly fee up to 200 minutes;

$40 monthly fee if 201 to 500 minutes; and $50 monthly fee if 501-1000 minutes.

PracticePractice

Matching questions #1

Other Useful Cost Definitions

Other Useful Cost Definitions

Incremental Cost—the cost of the next unit of production, sometimes referred to as the Marginal Cost

Sunk costs—these are costs that have occurred and no current action or decision can change them

Other Useful Cost Definitions

Other Useful Cost Definitions

Relevant Costs—a cost that will change as a result of a decision

Opportunity Costs—the maximum value forgone when a course of action is chosen

Avoidable Costs—costs that can be avoided by taking a specific course of action

Summary of Cost ConceptsSummary of Cost Concepts Sunk costs are never incremental or

relevant i.e. Do not differ between alternatives

Avoidable costs are always incremental and relevant

Opportunity costs are also incremental and relevant

Which of the following is often not an incremental cost?

a. Materialb. Laborc. Variable overheadd. Fixed overhead

Slide 7-11

Opportunity costs are:a. Never incremental costsb. Always incremental costsc. Sometimes sunk costsd. Never avoidable costs

Learning objective 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in

analyzing decisions

Which of the following costs should not be taken into consideration when making a decision?

a. Opportunity costsb. Sunk costsc. Relevant costsd. Differential costs

“What Does This Product Cost?”

“What Does This Product Cost?”

Answer: Why do you want to know?

No single cost number is relevant for all decisions

Must find incremental information that is applicable to the decision- Some costs will change due to the decision, some will not

- Only costs that change are relevant

Cost-Volume-Profit AnalysisCost-Volume-Profit Analysis

The Profit Equation

Profit (NI) = SP(x) – VC(x) – TFC

Where: x = Quantity of units produced and

sold SP = Selling price per unit VC = Variable cost per unitTFC = Total fixed cost

Fundamental to CVP analysis

Cost-Volume-Profit AnalysisCost-Volume-Profit Analysis

Break-Even Point• # of units sold that allow the company cover its total costs, with a profit of zero.

• NI= SP(x) – VC(x) – TFC = 0• Break Even Unit (x0)=TFC/(SP-VC)

• Break-Even Sales= SP*x0

• Units to realize target profit:• Target Profit = SP(xt) – VC(xt) – TFC

• xt= (Target Profit + TFC)/(SP-VC)

• Target Sales= SP*xt

Gabby’s Wedding Cakes creates elaborate wedding cakes. Each cake sells for $500. The variable cost of baking the cakes is $200 and the fixed cost per month is $6,000

1.Calculate the break-even point in units

2. How many cakes must be sold to earn a profit of $9,000?

At Winford Corp., the selling price per lawn mower is $120, variable cost per lawn mower is $55. Fixed costs are $130,000. Break-Even Point in units is?

a. 1,000 units

b. 1,083 units

c. 2,000 units

d. None of these

Break-Even PointBreak-Even Point

PracticePractice

Matching questions #2

Contribution MarginContribution Margin

Difference between revenue and variable costs

Contribution margin (CM): CM=Sales-TVC = SP(x) – VC(x)

Unit contribution margin (Unit CM): Unit CM= SP– VC CM=Unit CM * x Unit CM measures the amount of incremental profit generated by selling an additional unit

At Winford Corp., the selling price per lawn mower is $120, variable cost per lawn mower is $55. Fixed costs are $130,000. Contribution Margin per unit is?

a. $65

b. $75

c. $175

d. $30

Contribution Margin RatioContribution Margin Ratio

The contribution margin ratio measures the amount of incremental profit generated by an additional dollar of sales

Two methods to calculate the contribution margin ratio1. Contribution margin divided by

sales revenue (Sales – TVC) / Sales2. Unit contribution margin divided by

selling price (SP – VC) / SP

Rhetorix, Inc. produces stereo speakers. The selling price per pair of speakers is $800. The variable cost of production is $300 and the fixed cost per month is $50,000.

1.Calculate the unit contribution margin associated with a pair of speakers

2.Calculate the contribution margin ratio for Rhetorix associated with a pair of speakers

Rhetorix, Inc. produces stereo speakers. The selling price per pair of speakers is $800. The variable cost of production is $300 and the fixed cost per month is $50,000.

1.If the company sells five more speakers than planned, what is the expected effect on profit of selling the additional speakers?

2.If the company has sales that are $5,000 higher than expected, what is the expected effect on profit?

Variations in CVP AnalysisVariations in CVP Analysis

Pg 68-71 Profit in percent Impact of income tax what-if analysis Multiproduct firm

Analysis of Decisions Faced by Managers

Analysis of Decisions Faced by Managers

Four types of decisions that managers frequently face:

1.Make or buy (outsourcing)2.Short-term product mix with

constraints3.Drop a product or not (death spiral)4.Costing order (the floor price)Save 3&4 for later chapters

Make or Buy DecisionsMake or Buy Decisions

A Case Picture this: you are new at the job and you

are eager to succeed. You go out and buy (after convincing your boss) a new machine for $1 million. It’s a highly specialized machine, built especially for your firm, with no resale value.

You plan to use this machine to produce a part that is used in every product the firm makes.

It will cost you, thanks to this new machine, only $4 per unit in variable costs and $1 in depreciation (fixed cost) to make the part.

Make or Buy DecisionsMake or Buy Decisions

Case continued Great!!...until a salesman from a very

reputable firm comes to your office and offers to sell you the same part you are making, same quality, reliable delivery, etc. for $4.50 a part. Her company is willing to sign a long-term contract so the price is firm.

Questions: Should you accept her offer (i.e., buy the

part) or continue to make the part yourself? Would your decision change if the fixed costs

could be avoided by selling the machine at cost?

Make or Buy DecisionsMake or Buy Decisions

Decision involves no incremental revenues; Analysis concentrates solely on incremental costs. How much cost can be saved?

Make or Buy DecisionsMake or Buy Decisions

Cost savings (avoidable cost) Not all fixed cost are irrelevant. If they are

avoidable, then they should be factored into the decision just like variable costs;

Labor costs, even for direct labor (variable) costs, could be unavoidable if workers cannot be laid off because existing labor contract.

An opportunity cost (benefit forgone by selecting one decision alternative over another) must also be considered in decision making.

ExamplesExamples

Chaps Company pg79-80 Anjlee’s Catering Services pg80-

81

Practice 3-40 pg102

Short –Term Product Mix Decisions with ConstraintsShort –Term Product Mix

Decisions with Constraints Constraining factor

Fred’s wood products pg87-89 Harris Chemical pg89-93 Group Case: Excel Solver

3-67 pg114