November 4, Part 2 The microeconomic foundations of management accounting Cost classifications and cost behavior Cost-Volume-Profit analysis

November 4, Part 2November 4, Part 2

• The microeconomic foundations of management accounting

• Cost classifications and cost behavior

• Cost-Volume-Profit analysis

The microeconomic foundationsThe microeconomic foundations of management accountingof management accounting

Sunk Costs:

Costs that have already been incurred. Sunk costs are irrelevant for all decisions, because they cannot be changed.

Opportunity Costs:

The profit foregone by selecting one alternative instead of another; the net return that could be realized if a resource were put to its best alternative use.


Relevant Costs:

Also sometimes called Differential Costs or Incremental Costs

A differential cost for a particular decision is one that changes if an alternative decision is chosen.


When are Costs andWhen are Costs and Revenues Relevant?Revenues Relevant?

Answer: The relevant costs and revenues are those which, as between the alternatives being considered, are expected to be different in the future.

The Jennie Mae Frog FarmJennie Mae’s Frog Farm has fixed costs of $5,000 per month and variable costs of $2 per frog. All fixed costs are avoidable, in the sense that Jennie Mae could close the farm tomorrow, and not incur any fixed costs next month. However, she doesn’t want to do that because times are good in the frog business: she is operating at capacity, making and selling 1,000 frogs per month. Jennie Mae’s usual sales price is $9 per frog. The U.S. Army has approached Jennie Mae and proposed a one-time purchase of 300 frogs for $7 per frog. The sale would occur next month. Jennie Mae’s $2 per frog variable cost includes $0.25 of product packaging that would be unnecessary for frogs designated for the Army.

The Jennie Mae Frog FarmQuestion #1: With respect to Jennie Mae’s decision of whether to accept the Army’s offer, what is Jennie Mae’s opportunity cost?

The Jennie Mae Frog FarmQuestion #1: With respect to Jennie Mae’s decision of whether to accept the Army’s offer, what is Jennie Mae’s opportunity cost?

Since Jennie Mae is operating at capacity, her opportunity cost is her profit foregone from the regular sales that are displaced by the sales to the Army. These profits are calculated either as $9 sales price minus $2 variable costs = $7 per frog, multiplied by 300 frogs = $2,100; or as the difference between this $7 per frog contribution margin and her contribution margin from sales to the Army of the $7 sales price less $1.75 in variable costs = $5.25 per frog. This difference is $7 minus $5.25 = $1.75, multiplied by 300 frogs = $525.

The Jennie Mae Frog FarmQuestion #2: With respect to Jennie Mae’s decision of whether to accept the Army’s offer, which costs are sunk, and hence, are irrelevant to her decision?

The Jennie Mae Frog FarmQuestion #2: With respect to Jennie Mae’s decision of whether to accept the Army’s offer, which costs are sunk, and hence, are irrelevant to her decision?

No costs are sunk. Even the fixed costs are avoidable. Hence, although the fixed costs are irrelevant to Jennie Mae’s decision, they are not sunk.

The Jennie Mae Frog FarmQuestion #3: With respect to Jennie Mae’s decision of whether to accept the Army’s offer, which costs are differential costs (i.e., relevant, or incremental costs)?

The Jennie Mae Frog FarmQuestion #3: With respect to Jennie Mae’s decision of whether to accept the Army’s offer, which costs are differential costs (i.e., relevant, or incremental costs)?

The differential costs are the $0.25 product packaging costs. Nothing else is differential, because whether or not Jennie Mae sells to the Army, she will produce at capacity.

The Jennie Mae Frog FarmQuestion #4: Now assume that times are not so good, and Jennie Mae has excess capacity to make 500 frogs. The Army approaches Jennie Mae and proposes a one-time purchase of 300 frogs. What is the lowest price Jennie Mae should be willing to charge the Army per frog?

The Jennie Mae Frog FarmQuestion #4: Now assume that times are not so good, and Jennie Mae has excess capacity to make 500 frogs. The Army approaches Jennie Mae and proposes a one-time purchase of 300 frogs. What is the lowest price Jennie Mae should be willing to charge the Army per frog?

$1.75 per frog, the variable cost of production, assuming Jennie Mae was going to continue operations. However, with only 500 customers, she is not covering her costs, and the price to the Army that will allow her to break even is $6.75, as follows:

Revenues:from the Army: $6.75 x 300 = 2,025from normal customers: $9 x 500 = 4,500

Costs: Variable costs (500 x $2) + (300 x $1.75) = 1,525 Fixed costs 5,000

Income $ 0

The Jennie Mae Frog FarmQuestion #5: Now assume that times are really bad, the market for frogs crashes, and Jennie Mae gets out of the frog business and starts producing platypuses instead. Jennie Mae has an aging inventory of frogs sufficient to meet market demand for 10 months (300 frogs per month), but unfortunately, frogs only have a useful life of 5 months and her inventory becomes obsolete after that. These frogs cost $7 each to make, consisting of $2 in variable costs and $5 in allocated fixed overhead. What is the lowest price Annie should accept from the Air Force for a one-time-only purchase of 300 frogs? What is her opportunity cost?

The Jennie Mae Frog FarmQuestion #5: Now assume that times are really bad, the market for frogs crashes, and Jennie Mae gets out of the frog business and starts producing platypuses instead. Jennie Mae has an aging inventory of frogs sufficient to meet market demand for 10 months (300 frogs per month), but unfortunately, frogs only have a useful life of 5 months and her inventory becomes obsolete after that. These frogs cost $7 each to make, consisting of $2 in variable costs and $5 in allocated fixed overhead. What is the lowest price Annie should accept from the Air Force for a one-time-only purchase of 300 frogs? What is her opportunity cost?

Jenny should accept any price above zero. Her opportunity cost is zero.





Classification of Costs

All Costs of doing business

fabric

thre

ad

Sewing operator

wages

factory electricity

factory manager’s salary

Costs to ship product from factory to warehouse

Warranty expense

Sales commissions

depreciation on factory building

Desi

gn d

ept.

Legal dept

tele

vis

ion

com

merc

ials

Three ways to classify costs

• Direct and Indirect Costs

• Fixed and Variable Costs

• The Value Chain


Direct costs

Indirect costs (a.k.a. overhead)

Total Costs

Direct versus Indirect Costs• Defined in terms of a particular activity,

such as a product, product line, or factory.

• Direct costs can be traced to the activity in an economically feasible way.

• Indirect costs cannot be traced to the cost object.

• Indirect costs are sometimes allocated to the cost object.

EXAMPLE: LEVI STRAUSS FACTORY

FabricPlant Manager’s SalaryThreadSewing Operator’s LaborPlant Utilities

Are the following costs direct or indirect?

Direct versus Indirect Costs


Direct costs


Total Costs

Fabric

sewing operator wages

Plant utilities, thread,

Plant manager’s salary




• The Value Chain

Fixed Costs vs. Variable Costs

• Variable costs change in direct proportion to changes in volume of activity (e.g., production).

• Fixed costs remain the same in total, as volume changes.

• Linear relationship is assumed.

• Relevant range and time-span must be identified.

• Many costs are semi-variable or mixed.


$

units

units

$

0

0

- Fabric- Assistant Manager’s Salary- Electricity- Sewing Operator Labor- Repairs & Maintenance- Rent on building

EXAMPLE: LEVI STRAUSS FACTORY

Are the following costs fixed or variable?



Direct costs


Total Costs

fixed

fixed

variable

variable

Combinations of Variable & Fixed,Direct & Indirect

Yes

Fixed Variable

Direct

IndirectYesYes

Not very often


Direct costs


Total Costs

fixed

fixed

variable

variableFabric,

Sewing Wages

Electricity, Repairs Rent, Salaries


Answer: The relevant costs and revenues are those which, as between the alternatives being considered, are expected to be different in the future.


Hence, variable costs may be relevant, or not, depending on whether the variable costs will differ in the future, as between the alternatives under consideration.

Also, fixed costs may be relevant, or not, depending on whether the fixed costs will differ in the future, as between the alternatives under consideration.




• The Value Chain

Costs by Business Functiona.k.a. the value chain

R & D

Manufacturing

Marketing Distribution Sales





Cost-Volume-Profit AnalysisCost-Volume-Profit Analysis

• Contribution Margin

• The Basic Profit Equation

• Break-even Analysis

• Solving for targeted profits

Contribution Margin

• Contribution Margin

total sales revenue - total variable costs

• Unit Contribution Margin

unit sales price - unit variable costs

The Basic Profit Equation

profit = sales - costs

profit = sales - variable costs - fixed costs

profit + fixed costs = sales - variable costs

profit + fixed costs = # of units x

(unit selling price - unit variable cost)

P + FC = Q x (SP - VC)

Break-Even Analysis

Set profit = 0, plug in total fixed costs, unit selling price and unit variable cost, and solve for # of units. This is break-even analysis.


FC = Q x (SP - VC)

Target Dollar Profits

Plug in for profits, total fixed costs, unit selling price and unit variable cost, and solve for # of units (Q). This calculates unit sales to achieve a targeted profit.


Target Selling Prices

Plug in for profits, total fixed costs, unit variable cost, and sales volume, and solve for targeted selling price. This calculates the unit sales price to achieve a targeted profit.


Documents

November 4, Part 2 The microeconomic foundations of management accounting Cost classifications and cost behavior Cost-Volume-Profit analysis