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A&MIS 525 - Session 5 Cost drivers Cost behavior

April 5, 2002

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Agenda Today

Meet in room 315 of Schoenbaum Hall Turn in exercise 2-28 Take quiz on WebCT class before 5:00

p.m. on Friday, April 5th.

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Key Issues in Cost Behavior

Terminology (fixed, variable, semi-variable, semi-fixed, capacity, discretionary)

Unit of analysis (total vs. unit costs) Interpretation of cost drivers Implications of cost behavior for risk &

return Points of potential confusion

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Cost Drivers

There are seven primary cost drivers at the macro level. The one considered most often in accounting is the time-rate of activity. Think of this as the volume of activity experienced during a time period. This driver, volume, is considered next.

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Cost Drivers

The issue is: How should we expect total costs to behave (vary) with respect to changes in the time-rate of activity all else being equal. In traditional accounting terms: “How do total costs behave with respect to changes in volume,” all else being equal. First, we consider the effects of volume changes on total costs.

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Total variable cost

Activity Volume

Total cost

Slope is the rate of change

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Total variable cost

Variable costs are those costs that vary in direct proportion to changes in activity volume. Such costs are normally rep-resented by a simple affine linear equation, TC = vQ, where TC represents the total variable cost, v represents the variable cost per unit of activity and Q represents the volume of activity during a period.

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Total fixed cost

Activity Volume

Total cost

Fixed cost

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Total fixed cost

Fixed costs are those costs that do not vary in total with respect to modest changes in activity volume. Such costs are represented by TC = F, where TC represents total cost, and F represents total fixed cost. Fixed costs do change over time, due to price changes and as a result of decisions, but they are relatively constant with respect to changes in activity volume, all else being equal.

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Committed Fixed Costs

Committed fixed costs are costs incurred as a result to past decision to acquire and maintain productive capacity. Also, called capacity costs.

◈Depreciation on Plant & Equipment

◈Real estate taxes

◈Insurance

◈Compensation of executives

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Committed Fixed Costs

Committed costs are also called capacity costs.

These fixed costs are difficult to eliminate, even temporarily. Thus, committed fixed cost are the most difficult to eliminate.

Managers are very careful when increasing capacity due to the fixed nature and duration of the resulting fixed costs.

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Discretionary Fixed Costs

Discretionary fixed costs (also called managed fixed costs) are associated with decisions made by management at least annually. These cost are more controllable in that there is little immediate impact even though there may be a longer-term consequence.

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Discretionary Fixed Costs

Advertising programs Training programs Research programs Management development programs Public relations Employee recruiting

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Total mixed cost

Activity Volume

Total cost Total cost curve

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Total mixed cost

Activity Volume

Total cost

Total cost curve

Fixed component

Variable component

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Total mixed cost

Semivariable or mixed costs are those costs that contain both a fixed and a variable component. Such costs are normally represented by a simple linear equation of the form TC = F + vQ, where TC represents total cost, F represents total fixed cost, and v represents the variable cost per unit of activity, and Q is the volume of activity during a period.

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Total step-variable cost

Step-variable costs are those costs that vary in small increments with respect to changes in activity volume. Such costs are also normally represented by a simple affine linear equation, TC = vQ, where TC represents the total variable cost, v represents the variable cost per unit of activity and Q represents the volume of activity during a period.

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Total step-variable cost

However, at a micro level, the increments may be relatively large and a local manager might treat the cost like a semi-fixed cost. It is a matter of perspective and required level of precision. Manager’s salaries effectively are variable from McDonald’s corporate perspective, but not from the perspective of a local franchisee with two restaurants.

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Total semi-fixed cost

Activity Volume

Total cost

Total cost curve

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Functional forms of costs:

Fixed: TC = F Variable: TC = vQ, where Q is the

measure of the driver activity Semi-variable (mixed): TC = F + vQ Semi-fixed: TC = F1[1+Q/m], where the

brackets represent the greatest integer function, and m represents the number of units associated with each increment in cost, F1.

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Functional forms of costs:

TC = F1 + vQ + F2[1+Q/m]

For test purposes, focus on cost functions of the form TC = F + vQ, where F represent the total of all fixed costs for the activity under consideration, and v is the total per unit variable cost.

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Interpreting the greatest integer

Suppose we employ an additional supervisor for every 10 employees. If we must hire a minimum of 1 supervisor, and they earn $50,000 per year, then the cost of supervision varies with employment as follows

TC = $50,000[1+Q/10]

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Greatest Integer Function Values

EmploymentGI Function Fctn. Value

Case 1 0 [1+ 0/10] 1

Case 2 10 [1+10/10] 2

Case 3 15 [1+15/10] 2

Case 4 20 [1+20/10] 3

Case 5 35 [1+35/10] 3

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Semi-fixed cost example

Employment Supervisors Total Cost

Case 1 0 1 $ 50,000

Case 2 10 2 $100,000

Case 3 15 2 $100,000

Case 4 20 3 $150,000

Case 5 35 3 $150,000

For TC = $50,000[1+Q/10]

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Remember Economics?

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Total cost (micro)

Activity Volume

Total cost

Total cost curveRelevant range

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Average cost (micro)

Volume

Average Unit Cost Total cost curve

Relevant range

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Further Observations

The level of analysis will influence how a cost is modeled.

For strategic analyses, most costs will be considered variable. For tactical analyses, the same costs might be modeled as part fixed and part variable.

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Assumption

In the absence of evidence to the contrary, assume costs can be described as semi-variable.

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