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MGAB03H3 Chapter Notes -Sunk Costs

5 pages104 viewsSummer 2010

Department
Financial Accounting
Course Code
MGAB03H3
Professor
Liang Chen

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Chapter 2 The Cost Function Notes
Using Relevant Costs to Make Decisions About the Future
Key Decision Factors for Air Canada
x managers need to be able to respond quickly to changes in the environment
x if they understand the relationship between changes in an organization’s activities and changes in the costs of those activities,
they can better lead the organization through uncertain times
Cost Concepts and Terminology
x managers need to understand cost concepts and how costs are incurred in order to assist their analysis and to manage their costs
x costs can be classified into 5 broad categories: (1) relevance, (2) behaviour, (3) traceability, (4) function, and (5) controllability
x managers need relevant information on both revenues and costs to make decisions
x relevant revenues and costs are the revenues and costs that differentiate between 2 alternatives that will occur in the future
x irrelevant revenues and costs will not make a difference to either alternative, and they therefore have no bearing on the decision
x opportunity cost is a relevant cost because it is the potential benefit given up by not taking one alternative over another
x a sunk cost is an irrelevant cost because the cost has already been incurred and cannot now be avoided
x managers need to know how costs behave in order to estimate costs at a given production level
x a fixed cost behaves such that the total cost will not change within a certain range of activity—the so-called relevant range
x a variable cost varies in proportion to the production level
x managers need to know whether a cost can be traced to a cost object; this helps managers more accurately estimate the cost
x cost object Æ a thing or activity for which we measure costs, such as a particular production activity, an individual product, a
product line, a project, an individual or group of customers, a department, and even the entire company
x a cost that can be directly traced to a cost object is called a direct cost, and it is incurred for the benefit of a particular cost object
x on the other hand, indirect costs are incurred for the benefit of more than one cost object and therefore cannot be easily and
economically traced to a particular cost object
x in the manufacturing sector, managers need to know costs by functions, such as manufacturing (or product, or inventoriable) and
non-manufacturing (or period) costs as they can better determine the cost of goods manufactured and price products accordingly
x manufacturing costs include direct materials, direct labour, and manufacturing overhead costs
x direct materials and direct labour are called prime costs, and direct labour and manufacturing overhead are called conversion cost
x managers may have the authority to cut costs, if the costs are controllable; on the other hand, they may not be able to change the
commitment made by their senior managers and therefore may be unable to cut uncontrollable cost
Classifying Costs
x because variable costs are easily traceable to the units or services produced, they are often automatically considered direct costs
x as a result, many people mistakenly believe that direct costs are always variable and that indirect costs are always fixed
x yet fixed and variable costs can each be either direct or indirect, depending on the cost object
x in addition, some direct variable costs are very small per unit and are pooled with a variety of indirect costs
x some direct variable costs are difficult to separate from other costs, which may be difficult to track, so are classified as indirect
Relevant Range
x relevant range Æ span of activity for given cost object where TFC remain constant and VC per unit of activity remains constant
x variable cost rates can change across relevant ranges and, in many cases, the variable cost will be lower at a higher relevant range
x marginal cost Æ incremental cost of an activity, such as producing the next unit of goods or services
x marginal cost is often relevant for decision making as, within the relevant range, variable cost approximates marginal cost
x accordingly, accountants often use variable cost as a measure of marginal cost
x although the terms “variable cost” and “marginal cost” may be used interchangeably, they are not always the same, especially
when the incremental or marginal unit moves into the next relevant range
Identifying Relevant Costs for a Decision
Relevant Costs for a Cost Object
x managers identify one or more cost objects based on the relevant information they need for a particular decision, for budgeting
and planning, or for valuing products or services
Identifying Relevant Costs from the Accounting System
x one way to identify relevant costs is to search the accounting system for types of costs that might be affected by a decision
x however, not all relevant costs appear in the accounting system and some costs from the accounting system are irrelevant
x careful thought and judgment are required to identify relevant costs; yet, it helps to know whether costs are direct or indirect
Direct and Indirect Costs
x direct costs Æ cost that is traced to cost object; clear cause-and-effect relationship usually exists between cost object and cost
x indirect costs Æ cost that is not easily traced to a cost object; no clear cause-and-effect relationship exists between the cost
object and the cost, or the cost of tracing the cost to the cost object exceeds the benefit; also called common cost
x overhead costs Æ often refers to a pool of production costs other than direct materials and direct labour; may also refer to other
types of common costs, such as general and administrative costs
Opportunity Costs
x opportunity costs Æ benefit forgone when one alternative is chosen over the next best alternative
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x opportunity costs are often difficult to measure
x as individuals, we informally value opportunity costs each time we choose a particular course of action
x however, managers need to formally value opportunity costs to make higher-quality decisions; they need to anticipate and
develop estimates for future revenues and costs, regardless of whether they will later appear in the accounting system
Sunk Costs
x sunk costs Æ expenditures made in the past, which cannot be changed by any future decision; unavoidable and therefore not
relevant to decision making
Cost Behaviour
x the next step in estimating a relevant cost is to describe how that cost would change under different decision alternatives
x cost behaviour Æ the variation in costs relative to the variation in an organization’s activities
x accountants need to anticipate changes in costs as decisions are made about activities such as production, sales, and services
x to understand cot behaviour, accountants analyze the effects of changes in their organizations’ activities on costs
x the ability to analyze cost behaviour requires knowledge of an organization’s economic environment and operations
Variable, Fixed, and Mixed Costs
x variable costs Æ cost that changes proportionately with changes in volumes or activity levels
x fixed costs Æ cost that does not change with small changes in activity levels of a cost object
x some fixed costs are easy to classify, such as rent, insurance, and property taxes; however, some are more difficult to classify
x mixed costs Æ cost that is partly fixed and partly variable
Cost Functions
x it is easy to assume that costs behave linearly—in other words, that FC remain fixed and the VC per unit remains constant
x however, total costs more often resemble a large S-curve
x cost function Æ algebraic representation of total cost of cost object over relevant range of activity, illustrated as TC = F + V × Q
x piecewise linear cost function Æ cost function in which the VC per unit changes across relevant ranges of activity
x stepwise linear cost function Æ cost function in which fixed cost changes across relevant ranges of activity
Cost Drivers
x cost driver (CD) Æ some input or activity that causes changes in total cost for a cost object
x in cost functions, Q represents the quantity of the cost driver
x the same cost object might have different cost drivers in different settings
x identifying potential cost drivers is a process that is specific to the organization
x when cost object is product or service, people closest to manufacturing or service delivery process have best info about CDs
x an organization’s information system can help identify cost drivers
x large organizations often use enterprise resource planning (ERP) to track both financial and nonfinancial information
x ERP systems help identify potential cost drivers with detailed information
x some costs cannot be easily associated with any type of cost driver, which need to be estimated with expected costs
Discretionary Costs
x discretionary costs (DC) Æ reflects periodic (usually annual) decisions about maximum amount that will be spent on costs for
activities such as advertising, executive travel, or research and development; amount spent can easily be altered during the period
x discretionary costs are considered managed fixed or managed variable costs because managers decide amount to spend on DCs
x the past behaviour of discretionary costs might not be relevant to their future behaviour
Economies of Scale
x accountants need to investigate economies of scale when estimating a cost function, such as volume discounts
Learning Curves
x learning curve Æ rate at which labour hours decrease as the volume of production or services increases
x over time, the learning curve leads to greater productivity; goods and services are produced more quickly as workers and
supervisors learn more about their jobs and develop more efficient practices
Information Used to Estimate Costs
x although past costs are not directly related to decisions, they are often useful in estimating future cost behaviour
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