cost behavior

Chapter2 summary

In this chapter, we have looked at some of the ways in which managers classify costs. How the costs will be used-for preparing external reports, predicting cost behavior, assigning costs to cost objects, or decision making-will dictate how the costs will be classified.

For purposes of valuing inventories and determining expenses for the balance sheet and income statement, costs are classified as either product costs or period costs. Product costs are assigned to inventories and are considered assets until the products are sold. At the point of sale, product costs become cost of goods sold on the income statement. In contrast, following the usual accrual practices, period costs are taken directly to the income statement as expenses in the period in which they are incurred.

In a merchandising company, product cost is whatever the company paid for its merchandise. For external financial reports in a manufacturing company, product costs consist of all manufacturing costs. In both kinds of companies, selling and administrative costs are considered to be period costs and are expensed as incurred.

For purposes of predicting cost behavior-how costs will react to changes in activity-managers commonly classify costs into two categories-variable and fixed. Variable costs, in total, are strictly proportional to activity. Thus, the variable cost per unit is constant. Fixed costs, in total, remain at the same level for changes in activity that occur within the relevant range. Thus, the average fixed cost per unit decreases as the number of units increases.

For purposes of assigning costs to cost objects such as products or departments, costs are classified as direct or indirect. Direct costs can be conveniently traced to the cost objects. Indirect costs cannot be conveniently traced to cost objects.

For purposes of making decisions, the concepts of differential cost and revenue, opportunity cost, and sunk cost are of vital importance. Differential cost and revenue are the cost and revenue items that differ between alternatives. Opportunity cost is the benefit that is forgone when one alternative is selected over another. Sunk cost is a cost that occurred in the past and cannot be altered. Differential cost and opportunity cost should be carefully considered in decisions. Sunk cost is always irrelevant in decisions and should be ignored.

These various cost classifications are different ways of looking at costs. A particular cost, such as the cost of cheese in a taco served at Taco Bell, could be a manufacturing cost, a product cost, a variable cost, a direct cost, and a differential cost-all at the same time

1 Identify and give examples of each of the three basic cost elements involved in the manufacture of a product.
2 Distinguish between period costs and product costs and give examples of each.
3 Prepare a schedule of cost of goods manufactured in good form.
4 Explain the flow of direct materials cost, direct labor cost, and manufacturing overhead cost from the point of incurrence to sale of the completed product.
5 Identify and give examples of variable costs and fixed costs and explain the difference in their behavior.
6 Define and give examples of direct and indirect costs.
7 Define and give examples of cost classifications used in making decisions — differential costs, opportunity costs, and sunk costs.
8 (Appendix 2A) Properly classify costs associated with idle time, overtime, and labor fringe benefits.
New in this Edition · A new exhibit, Exhibit 2-3, illustrates how costs flow through inventories. · Focus on Current Practice Boxes dealing with Planet Hollywood and Benetton illustrate how the structure of period and product costs can differ between companies. · The discussion of period and product costs has been strengthened. · The definition of common costs has been clarified.

Cost Classifications for Predicting Cost Behavior
How a cost will react to changes in the level of business activity.

o Total variable costs change when activity changes.
Your total long distance telephone bill is based on how many minutes you talk.

Minutes Talked
Total Long Distance Telephone Bill
Minutes Talked
Per Minute Telephone Charge
The cost per long distance minute talked is constant. For example, 10 cents per minute.
o Total fixed costs remain unchanged when activity changes
Total Fixed Cost
Your monthly basic telephone bill probably does not change when you make more local calls.

Monthly Basic Telephone Bill
Fixed Cost Per Unit
Number of Local Calls
Monthly Basic Telephone Bill per Local Call
The average cost per local call decreases as more local calls are made.
Cost Classifications for Predicting Cost Behavior
Behavior of Cost (within the relevant range)
Cost
In Total
Per Unit
Variable
Total variable cost changes
Variable cost per unit remains
as activity level changes.
the same over wide ranges
of activity.
Fixed
Total fixed cost remains
Fixed cost per unit goes
the same even when the
down as activity level goes up.
activity level changes.
Cost Behavior
Fixed costs are usually characterized by:

a. Unit costs that remain constant.
b. Total costs that increase as activity decreases.
c. Total costs that increase as activity increases.
d. Total costs that remain constant.
Cost Behavior
Variable costs are usually characterized by:

a. Unit costs that decrease as activity
increases.
b. Total costs that increase as activity decreases.
c. Total costs that increase as activity increases.
d. Total costs that remain constant.
Direct Costs and Indirect Costs
Direct costs

· Costs that can be easily and conveniently traced to a unit of product or other cost objective.
· Examples: direct material and direct labor
Indirect costs

· Costs cannot be easily and conveniently traced to a unit of product or other cost object.
· Example: manufacturing overhead
Differential Costs and Revenues
Costs and revenues that differ among alternatives.

Example: You have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month.
Differential revenue is:
$2,000 – $1,500 = $500
Differential Costs and Revenues
Costs and revenues that differ among alternatives.

Differential revenue is:
$2,000 – $1,500 = $500 Differential cost is: $300
Example: You have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month.
Opportunity Costs
The potential benefit that is given up when one alternative is selected over another. Example: If you were not attending college, you could be earning $15,000 per year. Your opportunity cost of attending college for one year is $15,000.
Sunk Costs
Sunk costs cannot be changed by any decision. They are not differential costs and should be ignored when making decisions.

Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost.