10/3/2019

Using Costs in Decision

Making

Chapter 3

How “Cost” is used

 Pricing – cost can determine if a firm can
profitably operate (price taker), or what the price
will be (price setter)
 Product Planning – targeting a cost as part of
design to produce a profitable product
 Budgeting – part of overall planning
 Contracting – some industries or contracts
require cost “plus” pricing.

What Does Cost Mean?

 There is no single definition of cost
– Costs are developed and used for some specific
purpose
– The way the cost is to be used will define the way
it should be computed
 Management accountants have used different
systems, or classifications, to develop cost
information

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Cost Object
 Management accounting concept

 A cost object is something for which we want

to compute a cost:
– A product
– A product line
– An organizational unit

Cost Behavior
 Variable Costs
– A cost that changes in direct proportion to the amount
of resources used
 Fixed Costs
– A cost that does not vary in the short run with a
specific activity
– The defining characteristic of fixed costs is that it
depends on the amount of a resource that is acquired
rather than amount used
– Fixed costs are often called Capacity-Related costs

 Variable costs (VC)

– Change in total in proportion to changes in output
within a relevant range (cost per unit is constant)
– Constant on a per unit basis
 Fixed costs (FC)
– Constant in total within a relevant range of output
– Change on a per unit basis as level of activity or
volume changes

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Different Views of Product Cost

 Financial accounting is concerned with the total cost
of inventory whereas management accounting is
concerned with the cost of an individual unit of
inventory
 In financial accounting, product cost includes all
manufacturing costs. In management accounting,
product cost includes all product-related costs

Direct Cost
 A cost of a resource or activity that is acquired for or
used by a single cost object, it can be traced to the cost
object
 Cost object – T-Shirt
– Cost of the fabric used in the shirt
– Fractional portion of labour to make shirt
– Supervisor of assembly line, if the assembly line only
makes T-Shirts

Indirect Cost
 The cost of a resource that was acquired to be used by
more than one cost object.
– Examples:
– the cost of a saw used in a furniture factory to make
different products
– Supplies that are used in various products,
occasionally but not material to “allocate directly”
– Labour that is not directly traceable to the cost object

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Direct Costs, Indirect Costs, and Cost Behavior

 When the cost object is a product, variable costs can be

direct or indirect
 When the cost varies in proportion to some activity that
supports several products, then the cost will be indirect
to the individual products
 Fixed costs can be direct or indirect as well

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Cost-Volume-Profit (CVP) Analysis

 CVP uses variable and fixed costs to identify the profit
generated at various levels of activity
 Assumptions underlying CVP analysis
– The unit selling price and variable cost remain the
same over all levels of production
– All costs are either variable or fixed
– Fixed costs remain the same over all levels of
production
– Sales equal production

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The CVP Profit Equation

 Profit
= Revenue —Variable Costs — Fixed Costs
= (Units Sold x Revenue per Unit) — (Units Sold x
Variable Cost per Unit) — Fixed Costs
= (Units Sold x [Revenue per Unit-Variable Cost per
Unit])—Fixed Costs
= (Units Sold x Contribution Margin per Unit) —
Fixed Costs

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Contribution Margin
 CM = Contribution Margin
 SP = Selling Price per Unit
 VC = Variable Cost per Unit
 FC = Fixed Cost for period
 Q = Quantity sold
 SP – VC = CM
 (CM X Q) – FC = Profit (Loss)

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Breakeven Volume
 Breakeven volume is determined by calculating the
volume where profit = 0
 Breakeven equation:
Units Sold to Break Even =
Fixed Costs ÷ Contribution Margin per Unit
FC/CM=BEP

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Required Profit
 Most firms do not want to simply break even, the want a
profit (required to justify use of capital)
 Breakeven volume is determined by calculating the
volume where profit = $0
 Substitute the Required Profit for the $0
 RP equation:
Units Sold to Earn Required Profit =
Fixed Costs + Required Profit
Contribution Margin per Unit

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Contribution Margin Ratio

 Contribution margin per unit / revenue per unit
 Fraction of each sales dollar that is available to
contribute to covering fixed costs
Breakeven Sales Revenue =
Fixed Costs / Contribution Margin Ratio

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Weighted Contribution Margin

 Most firms will sell more than one product or
products will share fixed costs.
 To calculate Weighted Contribution margin
– Calculate CM for each product
– Determine the relative weight of each product
to the Sales Mix
– Calculate the Weighted CM

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Margin of Safety
 The margin of safety is the excess of budgeted
revenues over breakeven revenues:

 Expressed as a percentage:

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Other Useful Cost Definitions

 Mixed Costs—a cost that has variable and fixed
components
 Step Variable—variable costs that increase in
steps as the quantity increases
 Incremental Cost—the cost of the next unit of
production, sometimes referred to as the
Marginal Cost
 Opportunity Costs—the maximum value
forgone when a course of action is chosen
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Other Useful Cost Definitions

 Avoidable Costs—costs that can be avoided by
taking a specific course of action
 Relevant Costs—a cost that will change as a
result of a decision
 Sunk costs—these are costs that have occurred
and no current action or decision can change
them

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The Decision Defines “Cost”

 An old adage states, “different costs for different
purposes”
 The specific decision at hand will define:
– The nature of the required cost
– The way it should be computed
– The value of any cost number
 A cost number that is useful for one decision may be
useless or perhaps even harmful if it is used for another
decision

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Can Conflicting “Costs” Cause Confusion, Conceivably Chaos?

 One challenge of working with costs is that they are

used in many different contexts
 One might think it curious or even wrong that cost is
not a rigid number calculated according to some
formal rules
 Does “cost” mean a historical cost or a future cost;
does it take into consideration any potential discounts;
does it include implicit costs or only explicit costs?
 Note that GAAP accounting for external reporting is
designed to avoid all these issues

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Cost Classifications Revisited

 A cost’s definition can change as the perspective
changes
 A decision maker might define a cost one way for one
decision and another way for another
 Direct means that the resource that created the cost was
acquired for, and used by, a single cost object
 It is important, then, to understand clearly how the cost
object is defined

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Effect of Time Frame

 Short run is the period over which a decision maker
cannot adjust capacity
– The level of capacity-related resources and their cost is
fixed
– The only costs that vary in the short run are those that
vary in proportion to production or some activity that is
related to production
– Short run costs are variable costs

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Effect of Time Frame

 Long-run costs are the sum of variable and fixed costs
associated with a cost object—which is usually a product
– They are important for product planning purposes as
they are an estimate of the cost of all resources
consumed to make the product
– The price charged for a product must cover its long-
run cost for the organization to replace the capacity
used to make the product when the capacity
deteriorates

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Make or Buy—the Outsourcing Decision

 The financial focus in the make or buy decision is

whether the costs avoided internally are greater than
the added external costs when purchasing a product or
service from a supplier
 Internal make costs that can be avoided
– Typically all variable costs
– Any avoidable fixed costs
 Internal make costs that cannot be avoided:
– Fixed Costs where the capacity cannot be
redeployed

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Make or Buy—the Outsourcing Decision

 External costs incurred to buy
– Cost to purchase the product or service
– Any transportation costs
– Costs involved with dealing with a supplier such
as ordering, receiving, and inspection
 Some are more difficult to quantify such as quality,
staff, reputation

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Manufacturing Costs
 Direct Material—materials that can be traced easily to
a unit of output and have a significant economic impact
on the final product costs
 Direct Labor—labor costs that can be traced easily to
the creation of a unit of output
 Manufacturing Overhead—all other costs incurred by
a manufacturing facility that are not direct such as:
– Indirect labor
– Supplies
– Equipment depreciation

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Costing Orders
 Order costing involves estimating the relevant costs
associated with a unique order
 Relevant cost analysis suggests that only costs that will
change as a result of changing from the existing
product to the proposed product should be considered
 The Floor Price is the minimum price that a company
would normally consider for the order
 Special orders can be considered if marginal revenue
covers marginal costs, but over long term, all costs
must be recovered

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Product-Sustaining Activities
 Product-sustaining activities support the production and
sale of individual products
 These activities provide the infrastructure that enables
the production, distribution, and sale of the product but
are not involved directly in the production of the
product
 Examples include:
– Administrative efforts required to maintain drawings and
labor and machine routings for each part
– The process engineering required to implement engineering
change orders (ECOs)

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