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Chapter 2

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ACC 410
Peggy Woo

Chapter 2: The Cost Function Q1: What are different ways to classify costs? Classifying Costs Classifications Applications Cost Terms Relevance Decision-making Relevant vs. irrelevant cost Behaviour Cost estimation Fixed vs. variable cost Traceability Cost assignment Direct vs indirect cost Function Cost determination Product vs period cost Controllability Performance evaluation Controllable vs. uncontrollable cost • Relevant costs: costs that differentiate between two alternatives (e.g., opportunity cost) • Irrelevant costs: will not make a difference to either alternative and has no bearing on decision making (e.g., sunk cost) • Opportunity cost: the benefits an organization forgoes when it chooses one alternative over another • Sunk cost: expenditures made in the past • Fixed costs: behaves such that the total cost will not change within the relevant range • Variable costs: varies in proportion to the production level • Cost object: anything or activity for which we measure costs (e.g., products, projects, customers, processes) • Direct cost: a cost that can be easily traced to a cost object • Indirect cost: incurred for the benefit of more than one cost object and not easily or economically traced to a particular cost object • Product cost (manufacturing cost): costs that are easily traced to a product (e.g., direct labour, direct materials, manufacturing overhead costs) • Period cost (non-manufacturing cost): costs that cannot be assigned to products • Controllable costs: managers have the authority to cut and manage costs • Uncontrollable costs: managers do not have the authority to cut or manage these costs • Relevant range: a span of activity for a given cost object where total fixed costs remain constant and variable costs per unit of activity remain constant • Marginal costs: the incremental cost of an activity – When costs are linear and the level of activity is within the relevant range, marginal cost is the same as variable cost per unit – Are often relevant in decision making Q2: What are different ways to describe cost behaviour? Cost Behaviour • Cost behaviour is the variation in costs relative to the variation in an organization’s activities • Useful for decision making such as production, merchandise sales, and services • A cost driver is some input or activity that causes changes in total cost for a cost object • Linear Cost Behaviour Terminology • Total variable costs: change proportionally with changes in activity levels • Total fixed costs: do not vary with small changes in activity levels (e.g. rent) • Mixed costs: costs that are partly fixed and partly variable • Total costs: total variable costs plus total fixed costs • A cost function is an algebraic representation of the total cost of a cost object over a relevant range of activity TC = F + VQ where: – TC = total cost – F = total fixed cost – V = variable cost per unit of activity – Q = volume of activity • Some costs are fixed at one level for one range of activity and fixed at another level for another range of activity. These are known as stepwise linear costs. • Some variable costs per unit are constant at one level for one range of activity and constant at another level for another range of activity. These are known as piecewise linear costs. • Discretionary costs: periodic costs incurred for activities that management may or may not determine are worthwhile – Examples include advertising, research & development, executive travel – May be variable or fixed costs – Relevant for decision making only if they vary across the alternatives under consideration Q3: What is a learning curve? Learning Curve • A learning curve is – The rate at which labour hours per unit decrease as the volume of activity increases – The relationship between cumulative average hours per unit and the cumulative number of units produced • A learning curve can be represented mathematically as: Y = α X r where: – Y = cumulative average labour hours used for X units – α = time required for the first unit – X = cumulative number of units produced – r = an index for learning = ln(% learning)/ln(2) and ln is the natural logarithmic function Q4: What process is used to estimate future costs? Estimating Future Costs • Past costs are often used to estimate future, non-discretionary, costs. In these instances, one must also consider: – Whether the past costs are relevant to the decision at hand – Whether the future cost behaviour is likely to mimic the past cost behaviour – Whether the past fixed and variable cost estimates are likely to hold in the future Q5: How are the engineered estimate, account analysis, and two-point methods used to estimate cost functions? Engineered Estimates of Cost • Use accountants, engineers, employees, and/or consultants to analyze the resources used in the activities required to complete a product, service, or process • For example, a company making inflatable rubber kayaks would estimate some of the following: – Amount and cost of the rubber required – Amount and cost of labour required in the cutting department – Amount and cost of labour required in the assembly department – Overhead costs and the best cost allocation base to use – Selling costs, including commissions and advertising – Distribution costs Account Analysis • Review past costs in the general ledger and past activity levels to determine each cost’s past behaviour • For example, a company producing c
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