Classification of Costs

Classification of Costs Ch8Contemporary Engineering EconomicsContemporary Engineering Economics, 5th edition, 20101General Cost TermsManufacturing CostsDirect Raw MaterialsDirect LaborManufacturing OverheadNonmanufacturing CostsOverheadMarketingAdministrative Functions

Contemporary Engineering Economics, 5th edition, 2010

2Various Types of Manufacturing Costs Contemporary Engineering Economics, 5th edition, 2010

3Figure: 08-01Classifying Costs for Financial StatementsMatching Concept: The costs incurred to generate particular revenue should be recognized as expenses in the same period that the revenue is recognized.Period Costs: Those costs that are matched against revenues on a time period basisProduct Costs: Those costs that are matched against revenues on a product basis. Contemporary Engineering Economics, 5th edition, 2010

4ExamplePeriod Costs:General and administrative expensesMarketing expensesInsurance premiumsIncome taxesNonmanufacturing costsProduct Costs:Direct material costsDirect labor costsManufacturing overhead

Contemporary Engineering Economics, 5th edition, 20105How the Period Costs and Product Costs Flow Through Financial StatementContemporary Engineering Economics, 5th edition, 2010

6Figure: 08-02Cost Flows and Classifications in a Manufacturing CompanyContemporary Engineering Economics, 5th edition, 2010

7Figure: 08-03Example 8.1 Classifying Costs for Uptown Ice Cream ShopBreakdown of Unit Cost itemsProduct Costs:

Period Costs:Contemporary Engineering Economics, 5th edition, 2010

8Cost Classification for Predicting Cost BehaviorsVolume indexCost Behaviors patternsFixed costsVariable costsMixed costsAverage unit costs

Contemporary Engineering Economics, 5th edition, 20109Volume IndexDef: The unit measure used to define volume that influence the amount of costExamples:Tons of coal processedAutomobile miles drivenGenerating plant kWh producedStamping machine parts stampedAssembly Plant units assembled

Contemporary Engineering Economics, 5th edition, 201010Fixed CostsDef: The costs of providing a companys basic operating capacityCost behavior: Remain constant over the relevant rangeExample: Insurance cost, property tax, and license fees

Contemporary Engineering Economics, 5th edition, 201011Variable CostsDef: Costs that vary depending on the level of production or salesCost behaviors: Increase or decrease proportionally according to the level of volumeExample: Gasoline , material cost, wages, payroll tax, sales taxes

Contemporary Engineering Economics, 5th edition, 201012Mixed CostsDef: Costs are fixed for a set level of production or consumption, becoming variable after the level exceeded.Cost behavior: Increase or decrease after maintaining a fixed level of expenseExample: depreciation, utilitiesContemporary Engineering Economics, 5th edition, 2010100020003000400050006000051525Mixed cost behaviorMiles Driven (Unit: 1,000)Depreciation Expenses ($)13Average Unit CostPrevious costs were in terms of volume over given period. Average cost is used to express activity costDef: activity cost per unit basisCost Behaviors in terms of unit cost:Fixed cost per unit varies with changes in volume.Variable cost per unit of volume is a constant. Mixed cost per unit of volume contains both the constant and variable elements

Contemporary Engineering Economics, 5th edition, 201014Future Costs for Business DecisionsDifferential (Incremental) costOpportunity costSunk costMarginal cost

Contemporary Engineering Economics, 5th edition, 201015Differential (Incremental) CostsDef: Costs that represent the differences in total costs, which results from selecting one alternative instead of otherCost behavior: Increase or decrease with the overall change that a company experiences by producing one additional unit of goodExamples: Operational cost (to add overtime Saturday or second shift)Make or buy decisions

Contemporary Engineering Economics, 5th edition, 201016Opportunity CostsDef: The potential benefit that is given up as you seek an alternative course of actionExample: When you decide to pursue a college degree, your opportunity cost would include a 4-years potential earnings foregone.Company using a machine that has been already owned in a new project

Contemporary Engineering Economics, 5th edition, 201017Sunk CostsDef: Cost that has already been incurred by past actionsEconomic Implications: Not relevant to future decisionsExample: $500 spent to replace brakes last yearnot relevant in making a selling decision in the future

Contemporary Engineering Economics, 5th edition, 201018Marginal CostsDef: Added costs that result from increasing rates of outputs, usually by single unitExample: Cost of electricitydecreasing marginal rate

Contemporary Engineering Economics, 5th edition, 2010

19Illustration of Full Cost ConceptContemporary Engineering Economics, 5th edition, 2010

20Example 8.7 Marginal Analysis Financial Data:Daily demand 1,000 cases Fixed cost - $5,000 per week Variable cost: Weekdays - $7 per case Sundays - $12 per caseGeneric aspirin production:Unit price - $10 per case

Brand-name aspirin production: Weekly demand 1,000 cases per weekUnit price - $30 per case At Issue: (1) How to schedule the product mix and (2) Is it worth operating on Sundays?Contemporary Engineering Economics, 5th edition, 2010

Product Mix:Marginal contribution for GA: $10 - $7 = $3 per caseMarginal contribution for BA: $30 - $7 = $23 per caseSchedule the product with the highest MC, i.e., Brand-name AspirinMarginal Analysis on Sunday OperationMarginal revenue - $10 per caseMarginal cost - $12 per caseSunday operation not economicalBreak-Even Volume:21Weekly Profits as a Function of Time Total Revenue and Cost Functions:

Net Profit as a Function of production Volume

Contemporary Engineering Economics, 5th edition, 2010

Schedule Brand-name aspirin first Schedule Generic aspirin for 5 days Do not schedule anything on Sundays22Estimating Profit from ProductionContemporary Engineering Economics, 5th edition, 201023Calculation of Operating IncomeOperating revenue:The income earned by a business as a result of providing products or services to customersOperating expenses:The expenses incurred to generate the revenues of the specified operating period.Operating Income:The difference between the operating revenue and operating expensesContemporary Engineering Economics, 5th edition, 201024Process of Creating a Master Production BudgetContemporary Engineering Economics, 5th edition, 2010

25Sales Budget for a Manufacturing BusinessContemporary Engineering Economics, 5th edition, 2010Total annual volume = 5,000 unitsUnit sales price = $15

26Preparing the Production BudgetContemporary Engineering Economics, 5th edition, 2010Desired ending inventory units to carry: 20% of the budgeted unitsBeginning inventory position: 100 units

27Direct Materials BudgetContemporary Engineering Economics, 5th edition, 2010Year 2010 Product X

28Direct Labor BudgetContemporary Engineering Economics, 5th edition, 2010Labor cost per unit = $3.00

29Overhead BudgetContemporary Engineering Economics, 5th edition, 2010Variable overhead rate = $1.50 per unitFixed overhead rate = $230 per quarter

30Cost of Goods Sold BudgetContemporary Engineering Economics, 5th edition, 2010

31Selling Expenses BudgetContemporary Engineering Economics, 5th edition, 2010Variable commission rate = 5% of unit sales

32Administrative Expenses BudgetContemporary Engineering Economics, 5th edition, 2010

33The Budgeted Income StatementContemporary Engineering Economics, 5th edition, 2010

34Measures for ProfitabilityGross margin Gross margin = Gross income/Net sales = $31,580/$75,000 = 42.11%Operating margin Operating margin = Operating income/Net sales = $13,890/$75,000 = 18.52%Net profit margin Net profit margin = Net income/Net sales = $9,029/$75,000 = 12.04%

Contemporary Engineering Economics, 5th edition, 201035Questions?Contemporary Engineering Economics, 5th edition, 2010