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Topic 1: Financial Management: Classifications of Costs

This document discusses different classifications of costs that organizations consider when making financial decisions. It defines direct and indirect costs, fixed and variable costs, average and marginal costs, sunk costs, and operating expenses. Key points include that marginal cost is the most relevant figure for production decisions, fixed costs remain constant regardless of production levels, and sunk costs which cannot be changed should be ignored when deciding between current options.

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Mohd Jamal Mohd Moktar
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14 views14 pages

Topic 1: Financial Management: Classifications of Costs

This document discusses different classifications of costs that organizations consider when making financial decisions. It defines direct and indirect costs, fixed and variable costs, average and marginal costs, sunk costs, and operating expenses. Key points include that marginal cost is the most relevant figure for production decisions, fixed costs remain constant regardless of production levels, and sunk costs which cannot be changed should be ignored when deciding between current options.

Uploaded by

Mohd Jamal Mohd Moktar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Topic 1: Financial Management

Classifications of Costs

1
What Do Organizations
Produce?
• Physical output (products)
• Monetary income (profits)

2
What Inputs Do They Use?
• People’s services (labor)
• Materials and supplies
– Raw materials used to make their final products
– Indirect materials (lubrication oil, etc.)
– Electric power and other energy inputs
• Capital (money), which is used to pay for:
– Land and buildings
– Producer goods (e.g., tools, equipment)
– Taxes (why are taxes an “input”?)

3
What Inputs Do We Need to
Consider?
• Direct costs:
– Costs associated with providing a particular product or service
– Typically materials and labor (wages and salaries)
• Overhead (or indirect costs):
– Costs that cannot be traced directly to a particular product/service, because they
help support multiple products or services
– Examples: Depreciation, taxes, insurance, maintenance
– Supervisors, engineers, and other administrative/clerical personnel
– Can also include materials and labor for inspection, testing, etc.
• Operating expenses:
– The costs of doing business (typically not including depreciation)
– Includes both direct and indirect costs, but not capital
– Examples: Materials and supplies, wages and salaries, fuel, water, electric
power, taxes, insurance

4
First Cost
• The cost or total amount of investment required
for getting an activity started:
– Occurs only once for any given activity
– Typically assumed to be paid in year 0
– Typically used for capital (land, buildings, tools,
equipment), not operating expenses

5
Fixed Costs
• Costs that remain constant:
– Don’t vary with level of production
• Examples:
– Depreciation, maintenance, taxes, insurance,
lease rentals, interest, sales programs,
administrative expenses, research, heat, light,
janitorial services
• Fixed costs are only relatively fixed

6
Variable Costs
• Costs that vary with activity level:
– E.g., with number of units produced
– Typically only direct costs
– May (or may not) remain constant per unit of
product
• Examples:
– Materials costs, direct labor, direct electric
power

7
Incremental or Marginal Cost
• Refer to essentially the same concept:
– Additional cost of making one more unit
• Let’s say:
– Fixed cost $50, variable cost $1 per unit
• If we make 10 units:
– Total cost is $60 (e.g. Fixed + variable c)
– Average cost is total cost/number of units:
• $60/10 = $6 per unit
– Marginal cost is the extra cost of increasing
production by 1 unit: $1 per unit

8
Average Versus Marginal Cost
Number Total Average Marginal Cost vs. Number of Units
1 51 51.00 1
2 52 26.00 1 80
3 53 17.67 1
4 54 13.50 1 70
5 55 11.00 1
6 56 9.33 1 60
7 57 8.14 1
8 58 7.25 1 50
9 59 6.56 1 Total
10 60 6.00 1 Cost 40 Average
11 61 5.55 1 Marginal
12 62 5.17 1 30
13 63 4.85 1
20
14 64 4.57 1
15 65 4.33 1
10
16 66 4.13 1
17 67 3.94 1 0
18 68 3.78 1 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
19 69 3.63 1
20 70 3.50 1 Number of Units

9
Incremental or Marginal Cost
• This is the correct value to look at in deciding
whether to increase production
– It’s the extra cost we would have to pay!
• In our example:
– Marginal cost << average cost
– High fixed cost creates economies of scale
• Marginal cost can be > average cost:
– ?
– ?

10
Sunk Costs
• Sunk cost is any cost that occurred in the past:
– Cannot be changed by a future decision or action
• Examples:
– ?
– ?
• Sunk costs are irrelevant for making decisions:
– Sunk costs should be ignored in your choice!
– (Except if they affect tax liability and depreciation)

11
Sunk Costs
• Why are sunk costs irrelevant?
– Decisions should be made on the basis of differences
between choices
– Identical factors can be canceled out
• Sunk costs are already spent:
– Remain constant regardless of what you do
– Should be ignored in making decisions
• This principle is difficult to apply:
– Why: ?

12
Sunk Costs
• How should you consider sunk costs?
– To learn what went wrong!
– So you can avoid that in future decisions
• Example:
– Ignore sunk costs in deciding whether to finish a half-
completed project
– Study them to learn:
• Why your project went wrong
• How to avoid similar problems in the future

13
Review
• Categories of cost:
– Capital costs, operating expenses
– Direct and indirect costs
– First cost, fixed cost, variable cost
– Sunk cost!
• Ways to measure the cost of an activity:
– Total cost
– Average cost (total cost/number of units)
– Incremental or marginal cost

14

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