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Textbook Notes
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Canada
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University of Toronto Scarborough
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Financial Accounting
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MGAB03H3
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G.Quan Fun
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Chapter 2

Department

Financial Accounting

Course Code

MGAB03H3

Professor

G.Quan Fun

Description

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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