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Lecture

# Ch 3 Using Costs in Decision Making Part 2

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Department
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BU247
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Semester
Fall

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BU247 Lectures 3-5 Chapter 3 – Using Costs in Decision Making How Mgmt. Accounting Supports Internal Decision Making  cost info affects strategy development and monitoring the results of implementing the strategy  Pricing: organizations use cost info in the pricing decision in 2 ways 1) In markets where the company faces a market-determined price, the organization will use product cost info to decide whether its cost structure will allow it to compete profitably 2) In markets where organizations can set its price, companies will set a price that is an increment of its product’s cost (cost plus pricing)  Product planning: organizations use target costing to focus efforts in product and process design on developing a product that has a good profit potential in view of market requirements  Budgeting: (most widespread use of cost info) projects or forecasts costs for various levels of production and sales activity  set direction for budget period, provide basis for earnings forecasts  Performance evaluation: compare actual results from budget period with expectations  Contracting: the cost reimbursement contracts organizations are reimbursed their cost + an increment for the good/service they provide under the contract  governments enforce specific costing standards to avoid cost manipulation Variable vs. Fixed Costs  Variable Cost (VC): increases proportionally with changes in the activity level of some variable (e.g. unit of products, number of clients, operating hours) = VC per unit of cost driver * cost driver units o Cost Driver: a variable that causes a cost o Ex: if wood used to build chair is \$25/chair, then VC = 25 * (# chairs made) o Straight line that starts at origin and has a constant slope that = VC per unit of cost driver  Fixed Cost: does not vary in the short run with respect to a specific activity o It depends on the amount of a resource that is acquired rather than amount used. Thus, it is often called Capacity-Related costs  depreciation, salaries, etc. o Total cost = VC + FC Cost-Volume-Profit (CVP) Analysis  uses VC & FC to identify the profit associated with various levels of activity  Decision makers use probability of breaking even or earning a target profit as a measure of a project’s risk  Contribution margin (CM) = total revenue – total VC  Contribution margin per unit = contribution that each unit makes to covering FC & providing profit (selling price per unit – VC per unit)  Contribution margin ratio = total CM/ total sales  The total mixed cost line can be expressed as an equation Y = a + bx o Y is the total mixed cost, X is the level of activity o a is the total fixed cost (vertical intercept of the line) o b is the variable cost per unit of activity (the slope of the line)  Profit = income = revenue – VC – FC = [(CM* units) – FC] * (1 – tax rate)  Note: by “sales” we mean “production”  Units needed to be sold = (target profit + FC)/(unit CM)  target = 0 for breakeven equation  There are many combinations of sales levels for multiple products that would allow the organization to break even or reach a target profit BU247 Lectures 3-5 Financial Modeling and What-If Analysis  Financial circumstances are modeled by an equation that can be manipulated when answering questions used in a what-if analysis  Incremental profit = total incremental contribution margin – incremental cost o Where total incremental CM = CM per unit * units sold  An extension of basic CVP analysis called the Bundle Approach assumes a constant product mix The Assumptions Underlying CVP Analysis 1) Prices per unit and VC per unit (& thus the VM per unit) remain same over all levels of production 2) All costs are either FC or VC, and can be decomposed into FC and VC 3) Fixed costs remain the same over all contemplated levels of production 4) Sales equal production Other Useful Cost Definitions  Mixed Costs: a cost that has a fixed component and a variable component o ex: phone bill has fixed cost (monthly), plus a variable cost depending on quality of calls o cost of electricity, cost of labor (fixed salary + overtime), cost of shipping (FC + weight dependent)  Step Variable Costs: increases in steps as quantity increases4 o ex: every 20 factory workers has a supervisor. If each factory supervisor is paid 60k, total cost of supervisory salaries rises in a series of steps with the number of workers (the middle picture) o the graph on the far right shows what the actual cost looks like, as well as the approximation, which can over/under represent costs but is correct on average  Incremental Costs: cost of the next unit of production and is similar to marginal cost o similar to the variable cost of a unit of production, but not as simple because 1) VC per unit may change as production volume changes (ex: pay rate during overtime rises) 2) If the cost is a step variable, treating the cost as a VC will lead to estimation errors (over/under representation) o If a railroad car can have 50 people, each car costs \$1000, & the incremental fuel cost for adding a person is \$0.5, and 200 passengers are expected FC = 4000, VC = 0.5*(# people who show up)  Sunk cost: results from a previous commitment and cannot be recovered (ex: lease payment) o Should not be considered in subsequent decisions because they cannot be changed BU247 Lectures 3-5 o Sunk cost phenomenon (concorde effect/fallacy): people keep investing money because they had already invested huge sums of money o Continued belief in potential success despite evidence for the contrary o People want to cover up a cost resulting from a bad decision  Relevant Cost: changes as a result of some decision, future cost that differs between alternatives o You bought a \$100 concert ticket; if you go, you’ll spend \$120 on transportation and food o Realize that the \$100 is a sunk cost  don’t go and spend an extra \$120 which is the relevant cost, or also called the incremental cost o Also called differential cost, avoidable cost, and incremental cost  Opportunity cost: (a relevant cost) maximum value forgone when a course of action is chosen o Used to identify the best uses
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