AB03 Chapter 2.docx

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Financial Accounting
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G.Quan Fun

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MGAB03 Week 1 & 2 09/06/13 Chapter Two: Cost Concepts, Behaviour, and Estimation Cost Concepts & Terminology  5 categories of cost: i. Relevance ii. Behaviour iii. Traceability iv. Function v. controllability  relevant revenues & costs: r revs & costs that will differentiate btwn alternatives that will occur in the future  Irrelevant revs & costs:will not make a difference to either alternatice  they have no bearing on the decision  Sunk costs: irrelevant cost bc the cost has already been incurred & cannot b avoided now  Cost object: a thing r activity for which we measure costs  Diret costs: costs that r directly traced back to a cost object n is incurred for the benefit of a particular object  Indirect costs: incurred for the benefit of more than 1 cost object & cant b easily traced back to a particular cost object  Direct materials & direct labour  aka. Prime costs  Direct labour & manufacturing overhead  aka. Conversion costs Exhibit 2.1: Cost classifications, Applications, and Cost Terms Classifications Applications Cost Terms Relevance Decision making Relevant cost vs. irrelevant cost Behaviour Cost estimation Fixed cost vs. variable cost Tracceability Cost assignment Direct cost vs. indirect cost Function Cost detemination Manufacturing cost vs. nonmanufacturing cost (product vs. period) Controllability Performance evaluation Controllable cost vs. uncintrollable cost Relevant Range  Relevant Range: is a span of activity for a given cost object, where total fixed costs remain constant & variable costs per unit of activity remain constant  Marginal cost: the incremental cost of an activity  Variable costs approximate marginal costs Estimating Relevant Cost  It is hard to do cant b perfectly predicted  One way to identify relevant cost is to search acc’ting systems forcosts that might b affects by a decision 1 | P a g e MGAB03 Week 1 & 2 09/06/13 Direct & Indirect Costs  Direct Costs: eailty traced to individual cost objects bc a clear cause-&-affect relationship generally exists btwn the cost object n the cost  Indirect costs: not easily traced to individual cost objects  Overhead costs: costs that r combined into a group (cost pooling) Sunk Costs  Sunk Costs: expenditures made in the past  Unavoidable cost that rnt relevan to decision making Cost Behaviour  Cost behaviour: thevariation in costs relative to the variation in an organization’s activities. Variable, FIed, and Mixed Costs  Variable costs: change proportionately w/ changes in activity level  Fixed costs: do not vary w/ small changes in activity level  Fixed costs often increase in a stepwise manner  Mixed costs: partly fixed & partly variable Cost Funciton  Cost F : an algebraic representation of the total cost of a cost object over a relevant range of activity  Wen the cost is very low/high the total cost f is nonlinear.  Wen volume is in relevant range, the cost f is linear r close to it  Cost function :  Where  TC = total cost  F = total fixed cost  V = the variable cost per unit of activity  Q = the volume of activity  Piecewise llinear cost function: the slope of a variable cost funtion changes at some pt but remains linear after the   Involves more than 1 relevant range  Stepwise linear cost function: a fixed cost function that changes at some pt but remains constant after the change Cost Drivers  Cost Drivers: is some input r activity that causes change in total cost for a cost object  R difficult to identify some time r there r none Discretionary Costs  Discretionary Costs: relect periodic (unsually annual) decisions about the max amount that will b spent on costs for activities such as advertising, executive travel, r R&D  Considered managed fixed r managed variable costs, bc managers decide how much to spend on them 2 | P a g e MGAB03 Week 1 & 2 09/06/13 Cost Estimation Techniques  Past costs rnt directly relevant but r useful for estimating future cost  Techniques to estimate a cost function  Engineered estimate of cost  each activity is analyzed according to the amount of labour time, materials, n other resources used  Analysis at the account level  Reviewing the pattern of past costs in the acc’ting system & using knowledge of operations to classify the cost as variable, fixed, r mixed  Scatter plots (used for mixed)  Is a graphical technique in which data pts for past costs r plotted against a potential cost driver  Two-point method  Uses any two sets of data pts for cost & a cost driver to algebraically calculate a mixed cost function  TC = F + V * Q  V= slope = change in cost /change in the cost driver  High-low method  A specific application of the two-point method that uses the highest & lowest data points of the cost driver  They r often atypical and the observation might lie outside of the normal range  Frequently distorts the cost function  If u only have 2 r 3 point then use this  Regression analysis (used for mixed) Regression Analysis  A statistical technique that measures the average change in a dependent variable for every unit change in one or more independent variable  Uses all available data points so it is often mre accurate  Simple regression analysis: u develop a cost function by calculating values for the statistical relationship btwn total cost n a single cost driver  Multiple regression analysis: develop a cost function by calculating values for the statistical relationship btwn total cost n 2 or mre cost drivers Simple Regression Analysis  Error term: the distance btwn each observation & the line  Simple regression analysis estimates the following equation :  Y = dependant variable (total cost)   (alpha) = the intercept (fixed cost)   (beta)= the slope (variable cost per unit)  X = independent variable (the cost driver)   (epsilon) =error term ( aka. Residual )  T-statistic compares the coefficient with its standard error 3 | P a g e MGAB03
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