Week 2 chapter notes

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University of Toronto Scarborough
Financial Accounting
Liang Chen

Chapter 2 The Cost Function Notes Using Relevant Costs to Make Decisions About the Future Key Decision Factors for Air Canada N managers need to be able to respond quickly to changes in the environment N if they understand the relationship between changes in an organizations activities and changes in the costs of those activities, they can better lead the organization through uncertain times Cost Concepts and Terminology N managers need to understand cost concepts and how costs are incurred in order to assist their analysis and to manage their costs N costs can be classified into 5 broad categories: (1) relevance, (2) behaviour, (3) traceability, (4) function, and (5) controllability N managers need relevant information on both revenues and costs to make decisions N relevant revenues and costs are the revenues and costs that differentiate between 2 alternatives that will occur in the future N irrelevant revenues and costs will not make a difference to either alternative, and they therefore have no bearing on the decision N opportunity cost is a relevant cost because it is the potential benefit given up by not taking one alternative over another N a sunk cost is an irrelevant cost because the cost has already been incurred and cannot now be avoided N managers need to know how costs behave in order to estimate costs at a given production level N a fixed cost behaves such that the total cost will not change within a certain range of activitythe so-called relevant range N a variable cost varies in proportion to the production level N managers need to know whether a cost can be traced to a cost object; this helps managers more accurately estimate the cost N cost object 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 N 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 N 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 N 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 N manufacturing costs include direct materials, direct labour, and manufacturing overhead costs N direct materials and direct labour are called prime costs, and direct labour and manufacturing overhead are called conversion cost N 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 N because variable costs are easily traceable to the units or services produced, they are often automatically considered direct costs N as a result, many people mistakenly believe that direct costs are always variable and that indirect costs are always fixed N yet fixed and variable costs can each be either direct or indirect, depending on the cost object N in addition, some direct variable costs are very small per unit and are pooled with a variety of indirect costs N some direct variable costs are difficult to separate from other costs, which may be difficult to track, so are classified as indirect Relevant Range N relevant range span of activity for given cost object where TFC remain constant and VC per unit of activity remains constant N variable cost rates can change across relevant ranges and, in many cases, the variable cost will be lower at a higher relevant range N marginal cost incremental cost of an activity, such as producing the next unit of goods or services N marginal cost is often relevant for decision making as, within the relevant range, variable cost approximates marginal cost N accordingly, accountants often use variable cost as a measure of marginal cost N 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 N 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 N one way to identify relevant costs is to search the accounting system for types of costs that might be affected by a decision N however, not all relevant costs appear in the accounting system and some costs from the accounting system are irrelevant N 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 N direct costs cost that is traced to cost object; clear cause-and-effect relationship usually exists between cost object and cost N indirect costs 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 N overhead costs 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 N opportunity costs benefit forgone when one alternative is chosen over the next best alternative www.notesolution.com
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