Ch 2 Summary.docx

6 Pages
Unlock Document

University of Waterloo
Accounting & Financial Management
AFM 481
Grant Russell

Cost Concepts and Terminology Five broad categories of cost 1. Relevance 2. Behaviour 3. Traceability 4. Function 5. Controllability  Relevant info for revenues and costs to make decisions  Amounts that differentiate between alternatives that will occur in the future  Irrelevant are those that don’t change depending on the decision  A sunk cost is irrelevant because it’s always been incurred and can’t be avoided  Fixed cost are costs that won’t change depending on the level of activity  Variable costs changes in proportion to production level  Example: cost of leasing an airplane is fixed (doesn’t matter on the # of miles traveled)  The cost of fuel depends on the distance traveled – variable cost  Cost object is some thing or activity used to measure costs (individual products, product lines, projects, etc)  Direct cost are costs that can be directly traced to a cost object and incurred for a particular cost object  Indirect costs are costs incurred for more than one cost object  Manufacturing companies need to know the costs by function (manufacturing or nonmanufacturing costs)  Manufacturing costs include direct labour, direct material and overhead costs  DM and DL are prime costs  Overhead are conversion costs Classifying Costs  Identify cost object, understand the nature of the business  Variable costs are easily traceable (units/service produced) – usually automatically direct costs  If cost of tracking is more than the benefit, then just classify as indirect costs (some things are hard to separate) Relevant Range  Relevant range: span of activity for a given cost object (total fixed costs and variable costs per unit are constant)  When fixed costs and/or variable costs per unit change (could be a result of a change in strategy for example), then the company is operating outside of the relevant range  Variable costs per unit may change outside the relevant range too  Cost per unit may decrease after reaching a certain threshold  Marginal cost: incremental cost of an activity  In the relevant range, the variable cost is a good approximation of marginal cost Estimating Relevant Costs  Carefully identify and estimate how the costs affect decisions  Managers need to measure the effects on costs of alternative cost-cutting scenarios  Not always easy to do Relevant Costs for a Cost Object  Managers to identify what costs would be affected by a cost-cutting scenario (i.e. what are the relevant costs)  Determine these by looking at relevant information for each decision, budget and planning, or valuing products/services Identifying Relevant Costs from the Accounting System  Can search accounting system to see what will be affected by the decision  Caution: not all costs are in the accounting systems, while some are irrelevant  Example: severance costs would be shown until after the decision has been made; also, HR costs would not change if only a few are laid off Direct and Indirect Costs  Direct costs: easily traced to cost objects (clear cause-and-effect relationship)  Indirect costs: not easily traced as usually relates to more than one cost object  Example: maintenance and electricity and the facility is a indirect costs (applies to all products produced – can’t trace it to the specific unit produced)  All production costs (exempt DM and DL) can be pooled – aka overhead costs  Costs are common to many different aspects of the operations Opportunity Costs  The benefits that are lost when one option is chosen over another  Difficult to measure  Managers need to formally value opportunity costs of each action when making decisions Sunk Costs  Expenditures made in the past that can’t be undone  Cannot be changed by any future decision  Readily visible in accounting records  Improve d-m process by identifying sunk costs and not letting it affect future decisions Cost Behaviour  Cost behaviour is the variation in costs relative to the variation in activities  Anticipate changes in costs to make decisions  Analyze the effects on costs of changes Variable, Fixed and Mixed Costs  Total variable costs change relative to activity levels  Assume that variable costs per unit stay constant within the relative range  Total fixed costs don’t change with changes in activity level  Fixed cost per unit decreases as the activity level increase (kind of like more people carpooling)  If the relevant range changes (the company expands and needs more space), then total fixed costs will change  Mixed costs: partially fixed, partially variable  For example: fixed cost of $10,000 for commercials on TV, and $500 extra each time the commercial is aired Cost Functions  Algebraic representation of the total cost of a cost object over a relevant range  Total cost = fixed costs + variable costs × quantity  TC = F + VQ  Piecewise linear cost function occurs when the slope of a variable cost function changes at some point, but remains linear after the change  Stepwise linear cost function is when the fixed cost function change, and the remains constant again Cost Drivers  Input or activity that causes a change in total costs  Activity is a cost driver  Sales, number of flights, number of passengers are all cost drivers (but for different costs)  Cost object can have different cost drivers for different situations Discretionary Costs  Periodic (annual) decisions about the maximum amount that will be spent  Considered managed fixed or managed variable costs (mangers decide the amount)  Based on past profitability but it might not be relevant anymore for future behaviour Economies of Scale  When the total costs per unit decreases as we increase activity level  Example: double HR department, then it might be able to handle 3 times the employees Cost Estimation Techniques  Past costs are useful in estimating future costs (but not directly relevant)  Begin with past cost information (if available), gather other relevant information and use one of the following techniques Engineered Estimates of Cost  Each activity is analyzed according to the amount of labour time, materials and other resources  Use design specifications to estimate the cost of direct and indirect materials of a production  Estimate the number of labour hours required (keep in mind the learning curve) and develop a labour cost function for each product Analyses at the Account Level  Review the pattern of a cost over time, combine with knowledge of operations to classify costs  Managers’ salaries are usually fixed and associated with
More Less

Related notes for AFM 481

Log In


Don't have an account?

Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.