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Chapter 2

Chapter 2

5 Pages
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Department
Accounting
Course Code
ACC 410
Professor
Keith Whelan

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Chapter 2 The Cost Function
Cost Concepts and Terminology
-Cost Categorization
(1)Relevance(2) Behaviour (3) Traceability(4) function (5)
Controllability
Relevance revenues and costs that differentiate between two alternatives that
will occur in the future
Examples:
Relevant: Opportunity cost potential benefit given up by not taking one
alternative over another
Irrelevant: Sunk cost cost has already been incurred and cannot now be
avoided
Fixed costs behaves such that total cost will not change within a certain range
of activity so-called relevant range; do not vary
Variable costs varies in proportion to the production level; change
proportionately with changes in activity levels
Cost object thing or activity for which we measure costs
- Direct costs cost that can be directly traced to a cost object
- Indirect costs incurred for benefit of more than just one object
Manufacturing costs include:
- Prime costs: direct materials and direct labour
- Conversion costs: direct labour and manufacturing overhead
Relevant Range span of activity for a given cost object, where total fixed costs remain
constant and variable costs per unit of activity remain constant
Variable cost rates can also change across relevant ranges
Marginal cost incremental cost of an activity
Relevant costs for a cost object Managers identify one or more cost objects based on the
relevant information they need for a particular decision, for budgeting and planning, or for
valuing products or services
Identifying Relevant Costs from the Accounting System careful thought and judgement
are required to identify relevant costs; however, it helps to know whether costs are direct or
indirect
Direct and Indirect costs
Production costs except direct materials costs and direct labour costs are often
combined into groups (cost pools) in the accounting system and referred to as
overhead costs
Opportunity costs used when making decisions; difficult to measure
Sunk costs inclusion might occur because sunk costs are readily visible in the accounting
records or because managers become emotionally attached to prior decisions
www.notesolution.com
Cost behaviour variation in costs relative to the variation in an organizations activities
Cost Functions algebraic representation of total cost of a cost object over a relevant range
of activity
Within relevant range, the change in total costs as volume increases is nearly
linear
Within relevant range, we assume total fixed and variable cost per unit remain
constant
TC = F + VQ
Piecewise linear cost function when slope of a variable cost function changes at
some point but remains linear after the change
Stepwise linear cost function when a fixed cost function changes at some point
but remains constant after the change
Cost Driver some input or activity that causes changes in total cost for a cost object
Identifying potential cost drivers
- organizations information system can help identify cost drivers
Example ERP (Enterprise Resource Planning) helps track both financial and
nonfinancial information
No apparent cost drivers
- cant be easily associated with any type of cost driver
Discretionary costs reflect periodic (usually annual) decisions about the maximum
amount that will be spent on costs for activities such as advertising, executive travel, or
research and development
Can be either fixed or variable
Often based on past profitability
Can be altered during the period
Economies of Scale - refers to the cost advantages that a business obtains due to expansion
Factors that cause a producers average cost per unit to fall as the scale of output
increased
Learning Curves rate at which labour hours decrease as the volume of production/services
increases
Over time, goods/services produced more quickly and efficiently
Techniques to estimate a cost function:
Engineered estimate of cost
Analysis at the account level
Scatter plots
Two-point method
High-low method
Regression analysis
-Poor management decision can result if quality of cost estimates is not considered
www.notesolution.com

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Description
Chapter 2 – The Cost Function Cost Concepts and Terminology - Cost Categorization (1) Relevance (2) Behaviour (3) Traceability (4) function (5) Controllability • Relevance – revenues and costs that differentiate between two alternatives that will occur in the future Examples: Relevant: Opportunity cost – potential benefit given up by not taking one alternative over another Irrelevant: Sunk cost – cost has already been incurred and cannot now be avoided • Fixed costs – behaves such that total cost will not change within a certain range of activity – so-called relevant range; do not vary • Variable costs – varies in proportion to the production level; change proportionately with changes in activity levels • Cost object – thing or activity for which we measure costs - Direct costs – cost that can be directly traced to a cost object - Indirect costs – incurred for benefit of more than just one object • Manufacturing costs include: - Prime costs: direct materials and direct labour - Conversion costs: direct labour and manufacturing overhead Relevant Range – span of activity for a given cost object, where total fixed costs remain constant and variable costs per unit of activity remain constant • Variable cost rates can also change across relevant ranges • Marginal cost – incremental cost of an activity Relevant costs for a cost object – Managers identify one or more cost objects based on the relevant information they need for a particular decision, for budgeting and planning, or for valuing products or services Identifying Relevant Costs from the Accounting System – careful thought and judgement are required to identify relevant costs; however, it helps to know whether costs are direct or indirect Direct and Indirect costs • Production costs except direct materials costs and direct labour costs are often combined into groups (cost pools) in the accounting system and referred to as overhead costs Opportunity costs – used when making decisions; difficult to measure Sunk costs – inclusion might occur because sunk costs are readily visible in the accounting records or because managers become emotionally attached to prior decisions www.notesolution.com Cost behaviour – variation in costs relative to the variation in an organization’s activities Cost Functions – algebraic representation of total cost of a cost object over a relevant range of activity • Within relevant range, the change in total costs as volume increases is nearly linear • Within relevant range, we assume total fixed and variable cost per unit remain constant • TC = F + VQ • Piecewise linear cost function – when slope of a variable cost function changes at some point but remains linear after the change • Stepwise linear cost function – when a fixed cost function changes at some point but remains constant after the change Cost Driver – some input or activity that causes changes in total cost for a cost object • Identifying potential cost drivers - organization’s information system can help identify cost drivers Example – ERP (Enterprise Resource Planning) helps track both financial and nonfinancial information • No apparent cost drivers - can’t be easily associated with any type of cost driver Discretionary costs – reflect periodic (usually annual) decisions about the maximum amount that will be spent on costs for activities such as advertising, executive travel, or research and development • Can be either fixed or variable • Often based on past profitability • Can be altered during the period Economies of Scale - refers to the cost advantages that a business obtains due to expansion • Factors that cause a producer’s average cost per unit to fall as the scale of output increased Learning Curves – rate at which labour hours decrease as the volume of production/services increases • Over time, goods/services produced more quickly and efficiently • Techniques to estimate a cost function: • Engineered estimate of cost • Two-point method • Analysis at the account level • High-low method • Scatter plots • Regression analysis - Poor management decision can result if quality of cost estimates is not considered www.notesolution.com Engineered Estimates of Cost – each activity is analyzed according to the amount of labour time, materials and other resources used • Use accountants, engineers, employees, and/or consultants to analyze the resources used in the activities required to complete a product, service, or process Analyses at the Account Level – review the pattern of a cost over time in the accounting system and use our knowledge of operations to classify the cost as variable, fixed, or mixed Scatter plots – graphical technique in which data points for past costs are plotted against a potential cost driver Two-point method – uses any two sets of data points for cost and a cost driver to algebraically calculate a mixed cost function • It is much easier and less costly to use than account analysis or engineered estimates of cost, but: -It es
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