Lecture 3Lecture 3

•Relevant Cost Concepts and Terminology

•Cost Behavior

•Car Pooling

TerminologyTerminology

Sunk Costs:

Costs that have already been incurred. Sunk costs are irrelevant for all decisions, because they cannot be changed.

TerminologyTerminology

Opportunity Costs:

The profit foregone by selecting one alternative instead of another; the net return that could be realized if a resource were put to its best alternative use.

TerminologyTerminologyRelevant Costs:

Also sometimes called Differential Costs or Incremental Costs

A differential cost for a particular decision is one that changes if an alternative decision is chosen.

When are Costs andWhen are Costs and Revenues Relevant?Revenues Relevant?

Answer: The relevant costs and revenues are those which, as between the alternatives being considered, are expected to be different in the future.

Lecture 3Lecture 3

•Relevant Cost Concepts and Terminology

•Cost Behavior

•Car Pooling

Classification of Costs

All Costs of doing business

fabric

thre

ad

Sewing operator

wages

factory electricity

factory manager’s salary

Costs to ship product from factory to warehouse

Warranty expense

Sales commissions

depreciation on factory building

Desi

gn d

ept.

Legal dept

tele

vis

ion

com

merc

ials

Two ways to classify costs

• Direct and Indirect Costs

• Fixed and Variable Costs

Classification of Costs

Direct costs

Indirect costs (a.k.a. overhead)

Total Costs

Direct versus Indirect Costs• Defined in terms of a particular activity,

such as a product, product line, or factory.

• Direct costs can be traced to the activity in an economically feasible way.

• Indirect costs cannot be traced to the cost object.

• Indirect costs are sometimes allocated to the cost object.

EXAMPLE: LEVI STRAUSS FACTORY

FabricPlant Manager’s SalaryThreadSewing Operator’s LaborPlant Utilities

Are the following costs direct or indirect?

Direct versus Indirect Costs

Classification of Costs

Direct costs

Indirect costs (a.k.a. overhead)

Total Costs

Fabric

sewing operator wages

Plant utilities, thread,

Plant manager’s salary

Two ways to classify costs

• Direct and Indirect Costs

• Fixed and Variable Costs

Fixed Costs vs. Variable Costs

• Variable costs change in direct proportion to changes in volume of activity (e.g., production).

• Fixed costs remain the same in total, as volume changes.

• Linear relationship is assumed.

• Relevant range and time-span must be identified.

• Many costs are semi-variable or mixed.

Fixed Costs vs. Variable Costs

$

units

units

$

0

0

- Fabric- Assistant Manager’s Salary- Electricity- Sewing Operator Labor- Repairs & Maintenance- Rent on building

EXAMPLE: LEVI STRAUSS FACTORY

Are the following costs fixed or variable?

Fixed Costs vs. Variable Costs

Classification of Costs

Direct costs

Indirect costs (a.k.a. overhead)

Total Costs

fixed

fixed

variable

variable

Combinations of Variable & Fixed,Direct & Indirect

Yes

Fixed Variable

Direct

IndirectYesYes

Not very often

Classification of Costs

Direct costs

Indirect costs (a.k.a. overhead)

Total Costs

fixed

fixed

variable

variableFabric,

Sewing Wages

Electricity, Repairs Rent, Salaries

Lecture 3Lecture 3

•Relevant Cost Concepts and Terminology

•Cost Behavior

•Car Pooling

• Chestnut Ridge - N.Y.C.: 60 mi. r.t.• Tenafly, NJ - N.Y.C.: 30 mi. r.t.• 150 commutes per year• Gas: $2 per gallon; 20 miles per gal• Total miles driven per year: 18,000

Carpooling Example

CarpoolingDirect Costs:

Gasoline: 60 miles round trip x 150 days/yr

= 9,000 miles

20 miles/gal

= 450 gallons x $2.00 = $900 per year

Parking: = $100 per mo.

Speeding Tickets: driver pays

Carpooling

Overhead Costs:

Insurance: $1,200 per year

Repairs & Maintenance: $800 per year

Depreciation Expense: $0

Allocation base: might be miles driven.

9,000 miles driven on the commute (60 mi. r.t. x 150 days)

18,000 miles driven in total, each year

Carpooling

Overhead Costs:

Insurance: $1,200 per year

Repairs & Maintenance: $800 per year

Depreciation Expense: $0

Allocation rate for insurance:

Overhead costs total miles driven =

$1,200 18,000 = $0.067 per mile

Applying overhead insurance costs to the commute: $0.067 per mile x 9,000 miles = $600.

COMMUTE COSTS

• Gas• Bridge Toll• Parking• Insurance• Maintenance• Traffic Tickets• Opportunity

Costs

• Variable, Indirect• Variable, Direct• Fixed, Direct• Fixed, Indirect• Mixed, Indirect

ALLOCATE GAS COSTS

Total Annual Gas Expense

Total Annual Miles Driven

= Gasoline Cost per mile

This is the “overhead rate” for applying gas expense to my commute.

Multiply this rate/mile by the 4,500 shared miles of the commute to derive the “shared gas expense.”