Cost concepts and behaviors

(c) 2002 Contemporary Engineering Economics

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Chapter 3Cost Concepts and Behaviors


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Topics to Cover

• General Cost Terms

• Classifying Costs for Financial Statements

• Cost Classification for Predicting Cost Behaviors


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Topics to Cover

• Thinking on the Margin: Fundamental Economic Decision-Making


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An Example

• We will start with an example to understand the concepts covered in this chapter

• The example is of a ice-cream producer producing ice-cream cones “Uptown Ice Cream Shop”


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Unit Price of an Ice Cream Cone: Uptown Ice Cream Shop

Total Cost Unit Price % of PriceIce cream (cream, sugar, milk andmilk solids) $120,250 $0.65 26%Cone 9,250 0.05 2%Rent 112,850 0.61 24%Wages 46,250 0.25 10%Payroll taxes 9,250 0.25 2%Sales taxes 42,550 0.23 9%Business taxes 14,800 0.08 3%Debt service 42,550 0.23 9%Supplies 16,650 0.09 4%Utilities 14,800 0.08 3%Other expenses (insurance,advertising, fees) 9,250 0.05 2%Profit 24,050 0.13 5%Total $462,500 $2.50 100%

Items

120250 / 0.65 =Or 9250/ 0.05 =Or …185000 Cones


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General Cost Terms


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General Cost Terms• Manufacturing Costs

Direct materialsDirect laborMfg. Overhead include

Indirect materials, indirect labor; maintenance andRepairs on production equipment; heat and light; property taxes; depreciation; insurance, etc.,

• Non-manufacturing CostsOverhead

Heat and light, property taxes, depreciation

Marketing or sellingAdvertising, shipping, sales travel, sales salaries

AdministrativeExecutive compensation, general accounting, Public relations, and secretarial support.


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Classifying Costs for Financial Statements• In financial accounting, the

Matching Concept states that the costs incurred to generate particular revenue should be recognized as expenses in the same period that the revenue is recognized.

• Period costs: Those costs that are charged to expenses in the time period basis (advertising, executive salaries, sales commissions, public relations, other non manufacturing costs).

• Product costs:Those costs that are involved in the purchase or manufacturing of goods. Since product costs are assigned to inventories, known as inventory costs. (all costs related to manufacturing process).


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Ice cream (cream, sugar, milk, and milk solids) $0.65Cone 0.05Rent 0.61Wages 0.25Payroll taxes 0.25Sales taxes 0.23Business taxes 0.08Debt service 0.23Supplies 0.09Utilities 0.08Other (insurance, advertising,professional fees) 0.05Profit 0.13

$2.50

Unit Price of an Ice Cream

Classifying Costs for Uptown Ice Cream Shop

Product Cost

Period Cost

Example 3.1


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Cost Flows and Classifications in a Mfg. Co.

Cost of revenue = Cost of goods sold

• Raw materials inventory

• Work-in-process inventory

• Finished goods inventory


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Cost Classification for Predicting Cost Behavior (describes how cost item will respond to changes in the level of

business activity)• Volume indexOperating cost respond in some way to changes in its operating volume.

Need to determine some measurable volume or activity which has strong Influence on the amount of cost incurred. (volume index may be based on production inputs/out puts. Energy consumption, labor hours OR KWhr generated or miles per year driven by a car)

• Cost BehaviorsFixed costsVariable costsMixed costs

In the car case, Depreciation, occur frompassage of time (fixed portion) and also More miles are driven a year, loses its Market value (variable portion)• Average unit costs

(example: 3.2 Calculating average cost per mile)


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Volume index: • It is necessary to distinguish between changes arising

solely from price changes and those arising from other influences such as quantity and quality, which are referred to as changes in “volume”.

• A volume index is presented as a weighted average of the proportionate changes in the quantities of a specified set of goods or services between two periods of time.

• The quantities compared must be homogeneous, while the changes for different goods and services must be weighted by their economic importance as measured by their values in one or other, or both, periods.


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Volume index: (Illustrated Example) • Consider an industry that produces two different models of automobile, one

selling for twice the price of the other. • From an economic point of view these are two quite different products even

though described by the same generic term "automobile". Suppose that between two periods of time:

• (a) The price of each model remains constant; (b) The total number of automobiles produced remains constant; (c) The proportion of higher priced models produced increases from 50 % to 80 %

• .It follows that:– the total value of the output produced increases by 20 % because of the increase in

the proportion of higher-priced models. This constitutes a volume increase of 20 %. As each higher-priced automobile constitutes twice as much output as each lower-priced automobile, a switch in production from low- to high-priced models increases the volume of output even though the total number of automobiles produced remains unchanged. The fact that the value increase is entirely attributable to an increase in volume also follows from the fact that no price change occurs for either model. The price index must remain constant in these circumstances.

• cost cheaper * 50 + cost expansive * 50• Before: 1 * 50 + 2 * 50 =150 After: 1* 30 + 2 * 80 = 160+30 = 180• 180-150/150 * 100 = 20% increase in volume index.


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Fixed Costs or capacity cost

• Definition: The costs of providing a company’s basic operating capacity

• Cost behavior: Remain constant over the time though volume may change.

• Some examples; Annual insurance premium, property tax, and license fee, building rents, depreciation of buildings, salaries of administrative and production personnel.


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Variable Costs• Definition: Costs that vary depending on the

level of production or sales

• Cost behavior: Increase or decrease according to the level of volume change.

• Example: Ice cream cone company, wages, payroll taxes, sales tax, and supplies. Fuel consumption is directly related to miles driven.


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Average Unit Cost• Definition: activity

cost on a per unit basis

• Cost Behaviors:– Fixed cost per unit

varies with changes in volume.

– Variable cost per unit of volume is constant. See example 3.2


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Cost Classification CostVariable Costs: Standard miles per gallon Average fuel price per gallon Fuel and oil per mile $0.0689 Maintenance per mile $0.0360 Tires per mile $0.0141

$0.12Annual Fixed Costs: Insurance: Comprehensive $90 Collision $147 Body injury & Property damage $960 License & Registration $95 Property tax $372

total $1,064Mixed Costs: Depreciation Fixed portion per year $3,106 Variable portion per mile $0.04

$500 Deductible

References

20 miles/ gallon$1.34/ gallon

$250 Deductible

Cost Classification of Owning and Operating a Passenger Car


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Cost-Volume Relationship

5,000 10,000 15,000 20,000

Variable costs ($0.1190/mile) $595 $1,190 $1,785 $2,380Mixed costs: Variable portion 200 400 600 800 Fixed portion 3,106 3,106 3,106 3,106Fixed costs: 1,064 1,064 1,064 1,064Total variable cost 795 1,590 2,385 3,180Total fixed cost 4,170 4,170 4,170 4,170

Total costs $4,965 $5,760 $6,555 $7,350Cost per mile $0.9930 $0.5760 $0.4370 $0.3675

Volume Index (miles)


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Cost-Volume Relationship

$1064

1064+0.04M


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Average Cost per Mile


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Cost Concepts relevant to the decision making.

• Costs are an important feature of many business decisions. In order to make such decisions following cost needed to be well understood…– Differential costs– Opportunity costs– Sunk costs– Marginal costs


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Differential (Incremental) Costs Revenues

• Decision involve selection among alternatives.• Each alternative have certain costs / benefits that

are needed to be compared to the costs / benefits of the other alternatives


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Differential (Incremental) Costs and Revenues

• Definition: Difference in costs between any two alternatives known as Differential cost.

• Difference in revenues between any two alternatives is known as differential revenue.


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• Cost-volume relationship based on differential costs find many engineering applications such as short term decision making. Example:

• The base case is the status quo (current operation). We propose an alt. to the base case. If alt. has lower cost we accept the alt. assuming non-quantitative factors do not offset the cost advantage.


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• Differential cost = difference in total cost that results from selecting one alt. instead of the other.

• Problem of this type are generally called trade off problems because one type of cost is traded by another type of cost

• KEY FEATURES: New investment in physical assest not required, planning horizon short, relatively few cost items are subject to change by the decision


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• Common examples:• Method change – Example 3.3 page 75• Operations planning – Example 3.4 page 76• Make or buy decision – Example 3.5 page 77


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Example 3.3: Differential Cost Associated with Adopting a New Production Method

Variable costs: Materials $150,000 $170,000 $20,000 Machining labor 85,000 64,000 -21,000 Electricity 73,000 66,000 -7,000Fixed costs: Supervision 25,000 25,000 0 Taxes 16,000 16,000 0 Depreciation 40,000 43,000 3,000

Total $392,000 $387,000 -$5,000

Current Dies Better Dies Differential Cost


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Example 3.4 Break-Even Volume AnalysisIn typical manufacturing environment, when demand is high, managers are interested in

whether to use a one-shift plus overtime operations or to add a second shift. When demand is low, it is possible to explore whether to operate temporarily at a very low

volume or to shut down until operations at normal volume become economical. In a chemical plant, several routes exist for scheduling products through the plant. The

problem is in which route provides the lowest cost.

• Option 1: Adding overtime or Saturday operations: 36Q

• Option 2: Second-shift operation: $13,000 + 31.50Q

• Break-even volume: 36Q = $13,000 + 31.50Q Q = 3,000 units


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Example 3.5 -Make or BuyMany firms perform certain activities using their own resources, and pay outside firms to

perform certain other activities.

It is a good policy to constantly seek to improve the balance between these two types of activities.

Example 3.5 - Make or Buy Decision

Variable cost Direct materials $100,000 -$100,000 Direct labor 190,000 -190,000 Power and water 35,000 -35,000 Gas filter 340,000 340,000Fixed costs Heating light 20,000 20,000 0 Depreciation 100,000 100,000 0 Rental income -35,000 -35,000

Total cost $445,000 $425,000 -$20,000

Unit cost $22.25 $21.25 -$1.00

Make Option Buy Option Differential Cost


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Opportunity Costs

• Definition: The potential benefit that is given up as you seek an alternative course of action

• Example: When you decide to pursue a college degree, your opportunity cost would include the 4-year’s potential earnings foregone.


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Sunk Costs• Definition: Cost that has

already been incurred by past actions

• Economic Implications: Not relevant to future decisions

• Example: $200 spent to replace water-pump last year—not relevant in making selling decision in the future


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Marginal Analysis

• Principle: “Is it worthwhile?”

• Decision rule: To justify any course of action,

Marginal revenue > Marginal cost

Product A

Marginal Revenue $12/unitMarginal Cost $8/unit

Profit margin $4/unit


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Marginal Costs (example 3.6)

• Definition: Added costs that result from increasing rates of outputs, usually by single unit

• Example 3.6: Cost of electricity—decreasing marginal rate

• Compare it with Differential cost (Account’s) / Marginal (Economist’s)


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Unit Marginal Contribution (MC)

• Definition: Difference between the unit sales price and the unit variable cost, also known as marginal income or producer’s marginal contribution (MC). This means each unit sold contributes toward absorbing the company’s fixed cost.

MC = U Sales price – U Variable cost

• Application: Break-even volume analysis:

Break - even volume = Fixed costsMC


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Example 3.7 Profit Maximization Problem

Branded Generic

Marginal Revenue $30/case $10/caseMarginal Cost $7/case $7/case

Profit margin $23/case $3/case

Sunday Operation

Marginal Revenue $10/caseMarginal Cost $12/case

Profit margin ($2) /case (loss)


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Summary

• General Cost Terms used in manufacturing:– Manufacturing costs

• Direct materials• Direct labor• Manufacturing overhead

– Nonmanufacturing costs• Administrative expenses• Marketing• Nonmanufacturing overhead


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• Classifying Costs for Financial Statements:– Period costs– Product costs

• Cost Classification for Predicating Cost Behaviors:– Fixed costs– Variable costs– Mixed costs


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• Cost Concepts Relevant to Decision-Making– Differential cost and revenue– Opportunity costs– Sunk costs– Marginal costs

• Thinking on the Margin: Fundamental Economic Decision-Making:– The basic question to any economic decision: Is it

worthwhile?– Marginal revenues must exceed marginal costs.