BU247 Chapter Notes -Sunk Costs, Cost Driver, Marginal Cost

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13 Apr 2014
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BU247 Lectures 3-5 May 14, 16, and 23, 2013
Chapter 3 Using Costs in Decision Making
How Mgmt. Accounting Supports Internal Decision Making
cost info affects strategy development and monitoring the results of implementing the strategy
Pricing: organizations use cost info in the pricing decision in 2 ways
1) In markets where the company faces a market-determined price, the organization will use
product cost info to decide whether its cost structure will allow it to compete profitably
2) In markets where organizations can set its price, companies will set a price that is an increment
of its product’s cost (cost plus pricing)
Product planning: organizations use target costing to focus efforts in product and process design on
developing a product that has a good profit potential in view of market requirements
Budgeting: (most widespread use of cost info) projects or forecasts costs for various levels of
production and sales activity set direction for budget period, provide basis for earnings forecasts
Performance evaluation: compare actual results from budget period with expectations
Contracting: the cost reimbursement contracts organizations are reimbursed their cost + an
increment for the good/service they provide under the contract governments enforce specific
costing standards to avoid cost manipulation
Variable vs. Fixed Costs
Variable Cost (VC): increases proportionally with changes in the activity level of some variable (e.g.
unit of products, number of clients, operating hours) = VC per unit of cost driver * cost driver units
o Cost Driver: a variable that causes a cost
o Ex: if wood used to build chair is $25/chair, then VC = 25 * (# chairs made)
o Straight line that starts at origin and has a constant slope that = VC per unit of cost driver
Fixed Cost: does not vary in the short run with respect to a specific activity
o It depends on the amount of a resource that is acquired rather than amount used. Thus, it is
often called Capacity-Related costs depreciation, salaries, etc.
o Total cost = VC + FC
Cost-Volume-Profit (CVP) Analysis
uses VC & FC to identify the profit associated with various levels of activity
Decision makers use probability of breaking even or earning a target profit as a
measure of a project’s risk
Contribution margin (CM) = total revenue total VC
Contribution margin per unit = contribution that each unit makes to
covering FC & providing profit (selling price per unit VC per unit)
Contribution margin ratio = total CM/ total sales
The total mixed cost line can be expressed as an equation Y = a + bx
o Y is the total mixed cost, X is the level of activity
o a is the total fixed cost (vertical intercept of the line)
o b is the variable cost per unit of activity (the slope of the line)
Profit = income = revenue VC FC = [(CM* units) FC] * (1 tax rate)
Note: by “sales” we mean “production”
Units needed to be sold = (target profit + FC)/(unit CM) target = 0 for breakeven equation
There are many combinations of sales levels for multiple products that would allow the organization
to break even or reach a target profit
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Document Summary

Chapter 3 using costs in decision making. Product planning: organizations use target costing to focus efforts in product and process design on developing a product that has a good profit potential in view of market requirements. Budgeting: (most widespread use of cost info) projects or forecasts costs for various levels of production and sales activity set direction for budget period, provide basis for earnings forecasts. Performance evaluation: compare actual results from budget period with expectations. Contracting: the cost reimbursement contracts organizations are reimbursed their cost + an increment for the good/service they provide under the contract governments enforce specific costing standards to avoid cost manipulation. Fixed cost: does not vary in the short run with respect to a specific activity. It depends on the amount of a resource that is acquired rather than amount used. Thus, it is often called capacity-related costs depreciation, salaries, etc: total cost = vc + fc.

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