Lecture 3Lecture 3
•Relevant Cost Concepts and Terminology
•Cost Behavior
•Car Pooling
TerminologyTerminology
Sunk Costs:
Costs that have already been incurred. Sunk costs are irrelevant for all decisions, because they cannot be changed.
TerminologyTerminology
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.
TerminologyTerminologyRelevant 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.
Lecture 3Lecture 3
•Relevant Cost Concepts and Terminology
•Cost Behavior
•Car Pooling
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
Two ways to classify costs
• Direct and Indirect Costs
• Fixed and Variable Costs
Classification of Costs
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
Classification of Costs
Direct costs
Indirect costs (a.k.a. overhead)
Total Costs
Fabric
sewing operator wages
Plant utilities, thread,
Plant manager’s salary
Two ways to classify costs
• Direct and Indirect Costs
• Fixed and Variable Costs
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.
Fixed Costs vs. Variable Costs
$
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?
Fixed Costs vs. Variable Costs
Classification of Costs
Direct costs
Indirect costs (a.k.a. overhead)
Total Costs
fixed
fixed
variable
variable
Combinations of Variable & Fixed,Direct & Indirect
Yes
Fixed Variable
Direct
IndirectYesYes
Not very often
Classification of Costs
Direct costs
Indirect costs (a.k.a. overhead)
Total Costs
fixed
fixed
variable
variableFabric,
Sewing Wages
Electricity, Repairs Rent, Salaries
Lecture 3Lecture 3
•Relevant Cost Concepts and Terminology
•Cost Behavior
•Car Pooling
• Chestnut Ridge - N.Y.C.: 60 mi. r.t.• Tenafly, NJ - N.Y.C.: 30 mi. r.t.• 150 commutes per year• Gas: $2 per gallon; 20 miles per gal• Total miles driven per year: 18,000
Carpooling Example
CarpoolingDirect Costs:
Gasoline: 60 miles round trip x 150 days/yr
= 9,000 miles
20 miles/gal
= 450 gallons x $2.00 = $900 per year
Parking: = $100 per mo.
Speeding Tickets: driver pays
Carpooling
Overhead Costs:
Insurance: $1,200 per year
Repairs & Maintenance: $800 per year
Depreciation Expense: $0
Allocation base: might be miles driven.
9,000 miles driven on the commute (60 mi. r.t. x 150 days)
18,000 miles driven in total, each year
Carpooling
Overhead Costs:
Insurance: $1,200 per year
Repairs & Maintenance: $800 per year
Depreciation Expense: $0
Allocation rate for insurance:
Overhead costs total miles driven =
$1,200 18,000 = $0.067 per mile
Applying overhead insurance costs to the commute: $0.067 per mile x 9,000 miles = $600.
COMMUTE COSTS
• Gas• Bridge Toll• Parking• Insurance• Maintenance• Traffic Tickets• Opportunity
Costs
• Variable, Indirect• Variable, Direct• Fixed, Direct• Fixed, Indirect• Mixed, Indirect
ALLOCATE GAS COSTS
Total Annual Gas Expense
Total Annual Miles Driven
= Gasoline Cost per mile
This is the “overhead rate” for applying gas expense to my commute.
Multiply this rate/mile by the 4,500 shared miles of the commute to derive the “shared gas expense.”
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