Cost Concepts and Behaviors

Cost Concepts and BehaviorsBy Amrit NakarmiEEP-Lecture #5MSREE

03 July 2011

11/07/031Need of cost estimationAt the level of plant operations, engineers must make decisions involving materials, plant facilities, and the in-house capabilities of the company personnel.All these operational activities require the costs associated with various production and manufacturing activities.It is important to understand how various costs respond to changes in levels of business activities.11/07/032General Cost TermsWe shall be focusing on costs and their behavior related to manufacturing because its basic activities such as purchasing raw materials, producing finished products, marketing are commonly found in most of the other businesses.11/07/033Manufacturing CostsManufacturing converts raw materials into finished goods and it incurs various costs of operating a factory or plants.11/07/034Manufacturing Costs11/07/035Direct material costs are costs of materials used in the final product and they can be easily traced into it.

Direct labor costs are costs of labor that go into the production of a product.

Manufacturing overhead costs are costs that are included except material and labor costs.Non-manufacturing OverheadsThere are other costs that are included in the cost of the product but are not manufacturing costs.Non-manufacturing overhead (administrative) heat and light, salary of non-manufacturing staff, stationery, insurance, depreciation, etc.Marketing & selling costs advertising, shipping, sales commission, salary of salesmen etc.11/07/036Cost Classification for Financial StatementsAs per matching principle, the costs incurred to generate particular revenue should be recognized as expenses in the same period that the revenue is recognized.Some costs are matched against periods and become expenses immediately. Other costs, however, are matched against products and don not become expenses until the products are sold.11/07/037Cost Classification for Financial StatementsPeriod Costs costs that are charged as expenses if they are incurred in the same period. Example: administrative expenses, income tax, VAT, selling expenses etc.Product Costs costs that are related to the products than periods. These costs are direct material costs, direct labor costs, and manufacturing overheads. Product costs are sometimes are also called inventory costs.11/07/03811/07/039Income Statement

RevenueCosts of Goods Sold (COGS)Gross ProfitExpensesNet Income

Balance Sheet

Current AssetsInventoryPeriod CostsProduct CostsWhen goods are soldClassification of operating costs (in a unit price of an Ice cream)Ice cream (cream, sugar, milk, and milk solids)$0.65Cone0.05Rent0.61Wages0.25Payroll taxes0.25Sales taxes0.23Business taxes0.08Debt service0.23Supplies0.09Utilities (water, electricity)0.08Other (insurance, advertising, fees etc)0.05Profit0.13Price of a unit cone of ice cream $2.5011/07/0310Product Costs & Period CostsProduct costs (costs incurred in preparing 185,000 cones/yearRaw materials:Ice cream @ $0.65 $120,250Cone @$0.05 9,250Labor:Wages @0.25 46,250Overhead:Supplies @ $0.09 16,650Utilities @ $0.08 14,850Total Product Cost$207,000All other are period costs incurred in running the shop regardless of the sales volume.

11/07/0311Cost BehaviorAn engineer needs to know what will happen if the production is increased by 5% and what will be the product cost?Cost behavior describes how a cost item will react or respond to changes in the level of business activity.Volume index the unit or measure used to define a volume is called volume index such as pieces produced or KWh electricity produced or used.11/07/0312Cost BehaviorFixed costs these costs do not change within a given time frame under a relevant range. (example ; rent, insurance, administrative expenses, depreciation etc.)Variable costs costs vary as per the volume of production. (example: direct material costs, direct labor costs, direct manufacturing costs etc.)Mixed costs these costs contain both the fixed and variable costs such as depreciation and utilities.11/07/0313Average Unit CostWe often use the term average cost to express activity cost on a per unit basis.The variable cost per unit volume is constant.Fixed cost per unit volume varies with change in volume: as volume increases, the fixed cost per unit decreases.The mixed cost per unit also changes as volume changes, but the amount of change is smaller than that for fixed costs.11/07/0314Cost Volume Diagram11/07/0315Fixed costsVolumeAmountVolumeAmountVariable costsCost Volume Diagram11/07/0316VolumeAmountTotal costs = fixed costs + variable costsBreak-Even Volume AnalysisSandstone Corp. has one of its manufacturing plants operating on a single shift 5-day week. The plant is operating at its full capacity (24,000 units of output per week) without the use of overtime or extra-shift operation. Fixed costs for single shift operation amount to $90,000 per week. The average variable costs is a constant $30 per unit, at all output rates upto 24,000 units per week. The company has received an order to produce extra 4,000 units per week beyond the current single shift maximum capacity.11/07/0317Break-Even Volume AnalysisTwo options are being considered to fill the new order.Option 1: Increase the plants output to 36,000 units a week by adding overtime or by adding Saturday operation or both. No increase in fixed costs is entailed, but the variable cost is $36 per unit for output in excess of 24,000 units per week upto 36,000 unit capacity.Option 2: Operate a second shift. The maximum capacity of the second shift is 21,000 units per week. The variable cost on the second shift is $31.50 per unit and operation of a second shift entails additional fixed costs of $13,500 per week.Determine the range of operating volume that will make option 2 profitable.11/07/0318Break-Even Volume AnalysisOption 1: Overtime and Saturday operation: $36QOption 2: Second shift operation: $13,500 + $31.50 QThen the breakeven volume Q:36Q = 13,500 + 31.5 QQ =3,000 units.11/07/0319Break-Even Volume Analysis11/07/0320VolumeIncreased Operating costQ =3,000 unitsCost $108,000Relevant prod range for Option 112,000 units21,000 unitsRelevant production rage for Option 213,500 +31.5 Q36 QMake or Buy DecisionConsider Benson Co., a farm equipment manufacturer that currently produces 20,000 units of gas filters annually for use in its lawnmower production. The expected annual production cost of the gas filters is summarized as follows:11/07/0321Make or Buy DecisionVariable costs:Direct materials$ 100,000Direct Labor 190,000Power & water 35,000Fixed costs:Heating & light 20,000Depreciation 100,000 Total cost $445,000Tompkins Co. has offered to sell Benson 20,000 units of gas filters for $17.00 per unit. If Benson accepts the offer, some of the manufacturing facilities currently used to manufacture the gas filters could be rented to a third party at an annual rent of $35,000. Should Benson accept Tompkins offer, and why?11/07/0322Make or Buy Decision (solution)Make OptBuy OptDifferential costVariable costsDirect materials$100,000-100,000Direct labor190,000-190,000Power & water35,000-35,000Gas filters340,000340,000Fixed costsHeating light20,00020,000Depreciation100,000100,000Rental income-35,000-35,000Total costs$445,000$425,000-$20,000Unit cost$22.50$21.50-$1.0011/07/0323Report on Financial Ratio AnalysisExecutive SummaryCompany BackgroundObjectiveMethodologyFindingsConclusionText body should contain 15 to 20 pages, laser printed with annex. The report should contain graphs of analysis and their explanation.The text lines should be 1.4 space and of 12 points.References should be given as done in the journal articles.11/07/0324AssignmentsChapter 2Page 562.1, 2.2, 2.3, 2.5, & 2.6Chapter 3Page 893.1 to 3.6, 3.8, 3.10, 3.11, & 3.1211/07/0325