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Chapter 2

Chapter 2

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ACC 410
Keith Whelan

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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