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Chapter 2

ACC 410 Chapter Notes - Chapter 2: Sunk Costs, Cost Driver, Indirect Costs


Department
Accounting
Course Code
ACC 410
Professor
Maurizio Di Maio
Chapter
2

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Chapter 2 The Cost Function
Cost Concepts and Terminology
Costs can be classified into give broad categories
1)Relevance (Relevant cost vs. Irrelevant cost)
2)Behaviour (Fixed cost vs. Variable cost)
3)Traceability (Direct cost vs. Indirect cost)
4)Function (Product cost vs. Period cost)
5)Controllability (Controllable cost vs. Uncontrollable cost)
Relevant cost: because it is the potential benefit given up by not taking one
alternative over the other.
Irrelevant cost: because the cost has already been incurred and cannot now be
avoided
Fixed cost: behaves such that total cost will not change within a certain range of
activity (relevant range)
oExample: cost of renting a car per month is fixed, regardless of the distance
travelled
Variable cost: varies in proportion to the production level
oExample: cost of gas vary depending on the distance travelled is a variable
cost
Cost object: thing or activity for which we measure costs
Direct cost: a cost that can be directly traced to a cost object, and it is incurred for
the benefit of a particular cost object
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oExample: Salaries of the pilots for Air Canada Flight 1050 can be traced
directed to the flight (cost object)
Indirect cost: are incurred for the benefit of more than one cost object, is cannot be
easily and economically traced to a particular cost object
Example: Salaries of the ground crew are indirect cost to Flight 1050
Manufacturing (Product) cost:
include 1. Direct materials,
2. Direct labour,
3. Manufacturing overhead costs
oPrime costs: Direct material & Direct labour
oConversion costs: Direct labour & Manufacturing overhead costs
Controllable cost: managers may have the authority to cut costs, if the costs are
controllable (Flea Market, able to reduce price)
Uncontrollable cost: they may not be able to change the commitment made by
their senior managers and therefore may be unable to cut cost (tax rate)
Classifying Costs
When Air Canada managers want to add a flight to their existing route from Toronto
to Vancouver, the cost object is that flight, the cost of baggage handling at each
airport is a mixed cost. Part of it is fixed (e.g. depreciation on equipment), and part f
it is variable (labour costs for baggage handling
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Relevant Range
Relevant range: a span of activity for a given cost object, where total fixed costs
remain constant (the same) and variable costs per unit of activity remain constant7
Marginal cost: is the incremental (changing) cost of an activity, such as producing a
unit of goods or services
oWithin the relevant range, variable cost approximates marginal cost
oExample: the first $30,000 in sales has a fixed cost of $6,000 for rental of
retail space. The next incremental sales (above $30,000) require an expansion
of retail space, costing an addition $2,000 in fixed costs. Thus, the marginal
sales would increase fixed costs by $2,000
Direct vs. Indirect costs
Direct costs: easily traced to individual cost objects because a clear cause-
and0effect relationship generally exists between the cost object and the cost
Indirect costs: are not easily traced to individual cost objects, maintenance and
electricity at the manufacturing facility are indirect costs when the cost object is an
individual bicycle
Overhead costs: all production costs expect direct materials costs and direct labour
costs are often combined into groups (cost pools) in the accounting system
Opportunity Costs vs. Sunk Costs
Opportunity costs: the benefits we forgo when we choose one alternative over the
next best alternative
oExample: attend a basketball game. You pay cash for a ticket and spend time
at the game. You forgo the opportunity to spend that money and time on
something else, such as studying, going to a movie or concert, or hanging out
with friends or family.
oThe benefits forgone from the next best alternative are the opportunity costs
of attending the basketball game
Sunk costs: are expenditures made in the past. Costs are already incurred. Sunk
costs cannot be changed by any future decisions, these costs are unavoidable and
therefore not relevant to decision making
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