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Chapter 6

Chapter 6 - ACTG 2020.docx

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York University
ACTG 2020
Sylvia Hsingwen Hsu

Chapter 6 - Cost behaviour introduces description and analytical techniques needed for all areas of managerial accounting, including costing, planning and control, and decision making - Variable cost, fixed cost, and mixed cost (semivariable) - Relative proportion of each type of cost present in a firm is known as – firm’s cost structure Types of cost behaviour patterns Variable Costs - Total dollar amt varies in direct proportion to changes in activity level (if activity doubles, so does the total dollar amt of variable cost) - Remains constant if expressed on per unit basis - It is possible for variable cost per unit to change once activity levels are outside the relevant range o E.g. discount once an order has surpassed the required amount - Activity Base - For cost to be variable, it must be variable with respect to something o This ‘something’ = activity base - Activity base: measure of w.e causes the incurrence of a variable cost - cost driver* o DLH, MH, units produced/sold - Costs therefore do not have to be correlated with production/sales; there are a variety of cost drivers and costs are thus caused by many different activities within an organization - Whether cost is variable or not depends on whether it is caused by the activity under consideration - unless stated otherwise, you can assume that the activity base under consideration is the total volume of goods and services produced or sold by the organization. So, for example, if we ask whether the cost of direct materials at Ford Canada is a variable cost, the answer is yes, since the cost of direct materials is variable with respect to Ford's total volume of production. We will specify the activity base only when it is something other than total production or sales. Extent of variable costs - Number and type of variable costs present in an organization will depend in large part on the organization's structure and purpose - Public utility will have few variable costs and lots in fixed costs in terms of the equipment and other machinery True variable vs step-variable costs - True variable: DM is a true or proportionately variable cost b/c amt used varies in direct proportion to level of production activity o Amts purchased but unused can be stored and carried forward to next period as inventory - Step variable: obtainable only in large chunks (like maintenance workers) and increases/decreases only in response to fairly wide changes in activity o Wages of maintenance workers are considered to be variable costs but this cost doesn’t behave like COGS, for instance o Unlike DM, the time of maintenance workers is obtainable only in large chunks and cannot be stored and carried forward to next period o If time is not used effectively, it’s gone forever o The maintenance crew can also work in varying intensity (i.e. slowly when less goods to produce or more intensely for the opposite reason)  Small changes in the level of production might have no effect on the number of maintenance workers employed by the company o The need for maintenance help changes only with fairly wide changes in volume and that when additional maintenance time is obtained; it comes in large, indivisible chunks.  Strategy for mgmt must thus be: to obtain fullest use of services possible for each sep step; care must be taken with these kinds of cost to prevent ‘fat’ from building up in an organization  Tendency might be to employ additional help more quickly than needed and there is a natural reluctance to lay people off when volume declines Linearity assumption and relevant range - In dealing with variable costs, we have assumed strictly linear relationship between cost and volume; except in case of step-variable costs - Economists actually say that variable cost (many of em) behave in a curvelinear fashion – curvelinear cost can be satisfactorily approximated w/ straight line within the relevant range - Relevant range is range of activity within which the assumptions made about cost behaviour are valid - Managers should keep in mind that a particular assumption made about cost behaviour may be invalid if activity falls outside of the relevant range Fixed cost - Total fixed costs remain constant within the relevant range of activity o Same regardless of how much something is used - TOTAL = same - But on a PER UNIT basis, the cost is declining with respect to volume/production (this is the average fixed cost per unit) - Although the average unit cost drops, it drops at a decreasing rate - Caution against expressing fixed costs on an average per unit basis in internal reports because it creates the false impression that fixed costs are like variable costs and that total fixed costs actually change as the level of activity changes. - **Fixed costs should be expressed in total rather than on a per unit basis Types of fixed costs - Referred sometimes as “capacity costs” – result from outlays made for buildings, equipment, skilled professional employees, and other items needed for basic sustained operations - Can be viewed as either committed or discretionary Committed fixed costs - Investments in facilities, equipment, and basic orgs structure that cannot be significantly reduced, even for ST periods, w/o making fundamental changes that would impair a firm’s long- run goals or profitability o Ex. Depreciation of equipment, property taxes, salaries, insurance - Even during interruption or cut back, still remain unchanged in the ST - Costs of restoring are usually > than ST savings realized - Once decision made to get them, the co may be locked into that decision for many yrs to come - So such commitments should only be made after careful analysis of available alternatives Discretionary Fixed Costs - Managed fixed costs – arise from annual decisions by management to spend in certain fixed cost areas; ex. Advertising, R/D, mgmt training - Two key difference b/w committed and discretionary: o Planning horizon for discretionary fixed cost is ST (usually one yr)  Committed though are for many years o Discretionary can be cut for ST time periods with minimal damage to long-run organizational goals; like spending on management training programs can be reduced due to poor economic conditions - But discretionary aren’t the same as UNNECCESSARY COSTS - - e.g. cutting down R/D can be equally threatening as cutting down committed costs - Whether cost is committed or discretionary depends on depends on management’s strategy; example: during recessions when the level of home building is down; many construction co’s lay off most their workers on payroll but other co’s retain large number of workers even though workers may have no work to do o The latter co’s can respond quicker when conditions improve - MOST IMPORTANT CHARACTERISTIC OF discretionary costs is that management is not locked to its decisions regarding such costs*** meaning, can be adjusted year to year or even throughout the period Trend toward fixed costs - Nowadays, fixed costs are more relevant now for co’s than variable; this is because tasks that used to be done by hand are now done by machines o E.g. scanners at cash registers - Competition has created pressure to give customers more value for their money – a demand that can often be satisfied only by automating business processes - Demand for knowledge workers is increasing as well – costs of compensating them are fixed and committed rather than discretionary costs (cause co might be so dependent on them) Labour is variable or fixed? - Management may choose to treat as fixed cost for many reasons: o 1 : mgers are reluctant to decrease the workforce in response to ST declines in sales  Highly skilled workers are required to run a successful business and these workers might not be easy to replace  Trained workers who laid off may never return, and layoffs undermine the morale of these workers who remain o 2 : mgers don’t want to be caught w/ bloated payroll in economic downturn; so reluctance to add workers in response to ST sales increases  Co’s are turning to temp and PT workers to take up slack in when their perm, FT workers unable to handle all of demand for co’s g/s  Labour costs are thus a mix of variable and fixed costs - Many major co’s have been downsized in recent years, particularly during recession – in which mgers lost their jobs o But this is just because of the economy o Thus: fixed costs can change, but they don’t change in response to small changes in activity*** - We assume that DL is a variable cost for the text Fixed costs and relevant range - The concept of the relevant rage, is important for fixed costs – esp discretionary fixed costs - The levels of discretionary fixed costs are typically decided at beginning of year and depend on support needs of planned programs – like advertising and training o PLANNE
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