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					        Chapter 3
Cost Concepts and Behaviors

        (c) 2002 Contemporary Engineering   1
              Topics to Cover
• General Cost Terms

• Classifying Costs for
  Financial Statements

• Cost Classification for
  Predicting Cost

                 (c) 2002 Contemporary Engineering   2
            Topics to Cover
• Thinking on the
  Margin: Fundamental
  Economic Decision-

               (c) 2002 Contemporary Engineering   3
                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‖

                 (c) 2002 Contemporary Engineering   4
         Unit Price of an Ice Cream Cone:
             Uptown Ice Cream Shop
                  Items                   Total Cost Unit Price % of Price
Ice cream (cream, sugar, milk and
milk solids)                               $120,250       $0.65      26%     120250 / 0.65 =
Cone                                          9,250        0.05       2%     Or
Rent                                        112,850        0.61      24%     9250/ 0.05 =
Wages                                        46,250        0.25      10%
                                                                             Or …
Payroll taxes                                 9,250        0.25       2%
                                                                             185000 Cones
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%

                             (c) 2002 Contemporary Engineering                          5
General Cost Terms

   (c) 2002 Contemporary Engineering   6
                      General Cost Terms
• Manufacturing Costs
     Direct materials
     Direct labor
     Mfg. Overhead include
Indirect materials, indirect labor; maintenance and
Repairs on production equipment; heat and light;
property taxes; depreciation; insurance, etc.,

• Non-manufacturing Costs
Heat and light, property taxes, depreciation
             Marketing or selling
Advertising, shipping, sales travel, sales salaries
Executive compensation, general accounting,
Public relations, and secretarial support.

                                     (c) 2002 Contemporary Engineering   7
   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
• 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
                                  (c) 2002 Contemporary Engineering   8
  Classifying Costs for Uptown Ice Cream Shop
                      Example 3.1
                                Unit Price of an Ice Cream
              Ice cream (cream, sugar, milk, and milk solids)    $0.65
              Cone                                                0.05
Product       Rent                                                0.61
 Cost         Wages                                               0.25
              Payroll taxes                                       0.25
              Sales taxes                                         0.23
              Business taxes                                      0.08
              Debt service                                        0.23
  Period      Supplies                                            0.09
   Cost       Utilities                                           0.08
              Other (insurance, advertising,professional fees)    0.05
              Profit                                              0.13

                (c) 2002 Contemporary Engineering                        9
Cost Flows and Classifications in a Mfg. Co.

  Cost of revenue =
  Cost of goods

• Raw materials
• Work-in-process
• Finished goods

                      (c) 2002 Contemporary Engineering   10
        Cost Classification for Predicting Cost Behavior
         (describes how cost item will respond to changes in the level of
                                business activity)
• Volume index
Operating 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 Behaviors
   Fixed costs
   Variable costs
   Mixed costs
In the car case, Depreciation, occur from
passage 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)
                                (c) 2002 Contemporary Engineering           11
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.

                    (c) 2002 Contemporary Engineering       12
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

•   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.

                              (c) 2002 Contemporary Engineering                            13
     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.

                 (c) 2002 Contemporary Engineering   14
              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.

                 (c) 2002 Contemporary Engineering   15
            Average Unit Cost
• Definition: activity
  cost on a per unit basis

• Cost Behaviors:
   – Fixed cost per unit
     varies with changes in
   – Variable cost per unit
     of volume is constant.
     See example 3.2

                   (c) 2002 Contemporary Engineering   16
Cost Classification of Owning and Operating a Passenger Car
   Cost Classification                             References          Cost
   Variable Costs:
      Standard miles per gallon                    20 miles/ gallon
      Average fuel price per gallon                $1.34/ gallon
      Fuel and oil per mile                                            $0.0689
      Maintenance per mile                                             $0.0360
      Tires per mile                                                   $0.0141
   Annual Fixed Costs:
        Comprehensive                              $250 Deductible     $90
        Collision                                  $500 Deductible     $147
        Body injury & Property damage                                  $960
      License & Registration                                           $95
      Property tax                                                     $372
                                                               total   $1,064
   Mixed Costs: Depreciation
      Fixed portion per year                                           $3,106
      Variable portion per mile                                        $0.04
                           (c) 2002 Contemporary Engineering                     17
           Cost-Volume Relationship

    Volume Index (miles)                5,000        10,000     15,000    20,000

Variable costs ($0.1190/mile)            $595        $1,190     $1,785    $2,380
Mixed costs:
   Variable portion                       200            400       600       800
   Fixed portion                        3,106          3,106     3,106     3,106
Fixed costs:                            1,064          1,064     1,064     1,064
Total variable cost                       795          1,590     2,385     3,180
Total fixed cost                        4,170          4,170     4,170     4,170
Total costs                           $4,965         $5,760     $6,555    $7,350
Cost per mile                        $0.9930        $0.5760    $0.4370   $0.3675

                         (c) 2002 Contemporary Engineering                    18
Cost-Volume Relationship


     (c) 2002 Contemporary Engineering   19
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

                        (c) 2002 Contemporary Engineering   21
     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

                   (c) 2002 Contemporary Engineering     22
  Differential (Incremental) Costs and Revenues

• Definition: Difference
  in costs between any
  two alternatives
  known as Differential
• Difference in revenues
  between any two
  alternatives is known
  as differential
                  (c) 2002 Contemporary Engineering   23
     Differential (Incremental) Costs Revenues

• 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

                    (c) 2002 Contemporary Engineering    24
     Differential (Incremental) Costs Revenues

• 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
                    (c) 2002 Contemporary Engineering     25
      Differential (Incremental) Costs Revenues

•   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

                    (c) 2002 Contemporary Engineering   26
Example 3.3: Differential Cost Associated with Adopting a New
                     Production Method

                                Current Dies           Better Dies   Differential Cost

       Variable costs:
          Materials                 $150,000             $170,000             $20,000
          Machining labor             85,000               64,000             -21,000
          Electricity                 73,000               66,000              -7,000
       Fixed 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

                            (c) 2002 Contemporary Engineering                            27
       Example 3.4 Break-Even Volume Analysis
 In 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 +
• Break-even volume:
  36Q = $13,000 + 31.50Q
    Q = 3,000 units

                              (c) 2002 Contemporary Engineering                              28
                Example 3.5 -Make or Buy
Many 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

   Example 3.5 - Make or Buy Decision

                               Make Option             Buy Option       Differential Cost
   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               340,000
   Fixed 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
                           (c) 2002 Contemporary Engineering                            29
              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

                    (c) 2002 Contemporary Engineering   30
                   Sunk Costs
• Definition: Cost that has
  already been incurred by
  past actions
• Economic Implications:
  Not relevant to future
• Example: $200 spent to
  replace water-pump last
  year—not relevant in
  making selling decision in
  the future

                   (c) 2002 Contemporary Engineering   31
              Marginal Analysis

• Principle: ―Is it
  worthwhile?‖                                       Product A
• Decision rule: To
  justify any course of            Marginal Revenue $12/unit
                                   Marginal Cost    $8/unit
  Marginal revenue >
  Marginal cost                    Profit margin     $4/unit

                 (c) 2002 Contemporary Engineering             32
           Marginal Costs (example 3.6)

• Definition: Added costs
  that result from increasing
  rates of outputs, usually
  by single unit
• Example 3.6: Cost of
  marginal rate
• Compare it with
  Differential cost
  (Account’s) / Marginal

                    (c) 2002 Contemporary Engineering   33
       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
• Application: Break-even volume

                           Fixed costs
   Break - even volume =
                            (c) 2002 Contemporary Engineering   34
    Example 3.7 Profit Maximization Problem

                 Branded Generic
Marginal Revenue $30/case $10/case
Marginal Cost    $7/case $7/case
Profit margin    $23/case $3/case

                 Sunday Operation
Marginal Revenue $10/case
Marginal Cost    $12/case
Profit margin    ($2) /case (loss)

                       (c) 2002 Contemporary Engineering   35
• General Cost Terms used in manufacturing:
  – Manufacturing costs
     • Direct materials
     • Direct labor
     • Manufacturing overhead
  – Nonmanufacturing costs
     • Administrative expenses
     • Marketing
     • Nonmanufacturing overhead

                (c) 2002 Contemporary Engineering   36
• Classifying Costs for Financial Statements:
  – Period costs
  – Product costs

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

                (c) 2002 Contemporary Engineering   37
• Cost Concepts Relevant to Decision-Making
  –   Differential cost and revenue
  –   Opportunity costs
  –   Sunk costs
  –   Marginal costs

• Thinking on the Margin: Fundamental Economic
  – The basic question to any economic decision: Is it
  – Marginal revenues must exceed marginal costs.

                    (c) 2002 Contemporary Engineering    38