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Chapter 2

Chapter 2

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Ryerson University
ACC 410
Maurizio Di Maio

Chapter 2 – The Cost Function Cost Concepts and Terminology Costscan 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 costb :ecause it is the potential benefit given up by not taking one alternative over the other. Irrelevant costb :ecause 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) o Example: cost of renting a car per month is fixed, regardless of the distance travelled Variable costv :aries in proportion to the production level o Example: 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 www.notesolution.com o Example: 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 o Prime costs: Direct material & Direct labour o Conversion costs: Direct labour & Manufacturing overhead costs Controllable costm : anagers may have the authority to cut costs, if the costs are controllable (Flea Market, able to reduce price) Uncontrollable costt:hey 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 www.notesolution.com Relevant Range Relevant rangea : 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 o Within the relevant range, variable cost approximates marginal cost o Example: 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 costse :asily traced to individual cost objects because a clear cause- and0effect relationship generally exists between the cost object and the cost Indirect costsa : re 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 costsa :ll 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 costst:he benefits we forgo when we choose one alternative over the next best alternative o Example: 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. o The 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 www.notesolution.com Cost Behaviour The variation in costs relative to the variation in an organizations activity Variable, Fixed, and Mixed Costs Variable costsc :hange proportionately with changes in activity levels, for instance, for a bicycle company, the cost of tires varies with the number of bicycles produced Fixed Cost:do not vary with small changes in activity levels such as production, sales and services provided o Example: professional salaries, rent, insurance, and property taxes Mixed costsp :artly fixed and partly variable o Example: suppose a bicycle company incurs a fixed cost of $10,000 to generate a television advertisement and then a variable cost of $500 each time the advertisement is aired on television o Example: cell phone bill contains a flat rate + additional rate per additional minute Cost Functions It is easy to assume that costs behave linearly, fixed costs remain fixed and the variable cost per unit remains constant Cost function:algebraic representation of the total cost of a cost object over a relevant range of activity When we create a cost function, we assume that within a relevant range of activity, the total fixed costs remain fixed and the variable cost per unit remains constant The Cost Function expressed algebraically: TC = F + V*Q TC = Total cost F = Fixed cost www.notesolution.com V = Variable cost Q = Volume of activity Piecewise linear cost functionW s:hen the slope of a variable cost function changes at some point but remains linear after the change Stepwise linear cost functionw s:en a fixed cost function changes at some point but remains constant after the change Cost Drivers Cost drivers:some input or activity that causes changes in total cost for a cost object In the cost functions, Q represents the quantity of the cost driver o Example: For Air Canada, when the cost object is the entire organization, the number of passengers is a cost driver for in-flight beverage costs o For re
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