November 4, Part 2 The microeconomic foundations of management accounting Cost classifications and...
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Transcript of November 4, Part 2 The microeconomic foundations of management accounting Cost classifications and...
November 4, Part 2November 4, Part 2
• The microeconomic foundations of management accounting
• Cost classifications and cost behavior
• Cost-Volume-Profit analysis
The microeconomic foundationsThe microeconomic foundations of management accountingof management accounting
Sunk Costs:
Costs that have already been incurred. Sunk costs are irrelevant for all decisions, because they cannot be changed.
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.
The microeconomic foundationsThe microeconomic foundations of management accountingof management accounting
Relevant 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.
The microeconomic foundationsThe microeconomic foundations of management accountingof management accounting
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.
The Jennie Mae Frog FarmJennie Mae’s Frog Farm has fixed costs of $5,000 per month and variable costs of $2 per frog. All fixed costs are avoidable, in the sense that Jennie Mae could close the farm tomorrow, and not incur any fixed costs next month. However, she doesn’t want to do that because times are good in the frog business: she is operating at capacity, making and selling 1,000 frogs per month. Jennie Mae’s usual sales price is $9 per frog. The U.S. Army has approached Jennie Mae and proposed a one-time purchase of 300 frogs for $7 per frog. The sale would occur next month. Jennie Mae’s $2 per frog variable cost includes $0.25 of product packaging that would be unnecessary for frogs designated for the Army.
The Jennie Mae Frog FarmQuestion #1: With respect to Jennie Mae’s decision of whether to accept the Army’s offer, what is Jennie Mae’s opportunity cost?
The Jennie Mae Frog FarmQuestion #1: With respect to Jennie Mae’s decision of whether to accept the Army’s offer, what is Jennie Mae’s opportunity cost?
Since Jennie Mae is operating at capacity, her opportunity cost is her profit foregone from the regular sales that are displaced by the sales to the Army. These profits are calculated either as $9 sales price minus $2 variable costs = $7 per frog, multiplied by 300 frogs = $2,100; or as the difference between this $7 per frog contribution margin and her contribution margin from sales to the Army of the $7 sales price less $1.75 in variable costs = $5.25 per frog. This difference is $7 minus $5.25 = $1.75, multiplied by 300 frogs = $525.
The Jennie Mae Frog FarmQuestion #2: With respect to Jennie Mae’s decision of whether to accept the Army’s offer, which costs are sunk, and hence, are irrelevant to her decision?
The Jennie Mae Frog FarmQuestion #2: With respect to Jennie Mae’s decision of whether to accept the Army’s offer, which costs are sunk, and hence, are irrelevant to her decision?
No costs are sunk. Even the fixed costs are avoidable. Hence, although the fixed costs are irrelevant to Jennie Mae’s decision, they are not sunk.
The Jennie Mae Frog FarmQuestion #3: With respect to Jennie Mae’s decision of whether to accept the Army’s offer, which costs are differential costs (i.e., relevant, or incremental costs)?
The Jennie Mae Frog FarmQuestion #3: With respect to Jennie Mae’s decision of whether to accept the Army’s offer, which costs are differential costs (i.e., relevant, or incremental costs)?
The differential costs are the $0.25 product packaging costs. Nothing else is differential, because whether or not Jennie Mae sells to the Army, she will produce at capacity.
The Jennie Mae Frog FarmQuestion #4: Now assume that times are not so good, and Jennie Mae has excess capacity to make 500 frogs. The Army approaches Jennie Mae and proposes a one-time purchase of 300 frogs. What is the lowest price Jennie Mae should be willing to charge the Army per frog?
The Jennie Mae Frog FarmQuestion #4: Now assume that times are not so good, and Jennie Mae has excess capacity to make 500 frogs. The Army approaches Jennie Mae and proposes a one-time purchase of 300 frogs. What is the lowest price Jennie Mae should be willing to charge the Army per frog?
$1.75 per frog, the variable cost of production, assuming Jennie Mae was going to continue operations. However, with only 500 customers, she is not covering her costs, and the price to the Army that will allow her to break even is $6.75, as follows:
Revenues:from the Army: $6.75 x 300 = 2,025from normal customers: $9 x 500 = 4,500
Costs: Variable costs (500 x $2) + (300 x $1.75) = 1,525 Fixed costs 5,000
Income $ 0
The Jennie Mae Frog FarmQuestion #5: Now assume that times are really bad, the market for frogs crashes, and Jennie Mae gets out of the frog business and starts producing platypuses instead. Jennie Mae has an aging inventory of frogs sufficient to meet market demand for 10 months (300 frogs per month), but unfortunately, frogs only have a useful life of 5 months and her inventory becomes obsolete after that. These frogs cost $7 each to make, consisting of $2 in variable costs and $5 in allocated fixed overhead. What is the lowest price Annie should accept from the Air Force for a one-time-only purchase of 300 frogs? What is her opportunity cost?
The Jennie Mae Frog FarmQuestion #5: Now assume that times are really bad, the market for frogs crashes, and Jennie Mae gets out of the frog business and starts producing platypuses instead. Jennie Mae has an aging inventory of frogs sufficient to meet market demand for 10 months (300 frogs per month), but unfortunately, frogs only have a useful life of 5 months and her inventory becomes obsolete after that. These frogs cost $7 each to make, consisting of $2 in variable costs and $5 in allocated fixed overhead. What is the lowest price Annie should accept from the Air Force for a one-time-only purchase of 300 frogs? What is her opportunity cost?
Jenny should accept any price above zero. Her opportunity cost is zero.
November 4, Part 2November 4, Part 2
• The microeconomic foundations of management accounting
• Cost classifications and cost behavior
• Cost-Volume-Profit analysis
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
Three ways to classify costs
• Direct and Indirect Costs
• Fixed and Variable Costs
• The Value Chain
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
Three ways to classify costs
• Direct and Indirect Costs
• Fixed and Variable Costs
• The Value Chain
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
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.
When are Costs andWhen are Costs and Revenues Relevant?Revenues Relevant?
Hence, variable costs may be relevant, or not, depending on whether the variable costs will differ in the future, as between the alternatives under consideration.
Also, fixed costs may be relevant, or not, depending on whether the fixed costs will differ in the future, as between the alternatives under consideration.
Three ways to classify costs
• Direct and Indirect Costs
• Fixed and Variable Costs
• The Value Chain
Costs by Business Functiona.k.a. the value chain
R & D
Manufacturing
Marketing Distribution Sales
November 4, Part 2November 4, Part 2
• The microeconomic foundations of management accounting
• Cost classifications and cost behavior
• Cost-Volume-Profit analysis
Cost-Volume-Profit AnalysisCost-Volume-Profit Analysis
• Contribution Margin
• The Basic Profit Equation
• Break-even Analysis
• Solving for targeted profits
Contribution Margin
• Contribution Margin
total sales revenue - total variable costs
• Unit Contribution Margin
unit sales price - unit variable costs
The Basic Profit Equation
profit = sales - costs
profit = sales - variable costs - fixed costs
profit + fixed costs = sales - variable costs
profit + fixed costs = # of units x
(unit selling price - unit variable cost)
P + FC = Q x (SP - VC)
Break-Even Analysis
Set profit = 0, plug in total fixed costs, unit selling price and unit variable cost, and solve for # of units. This is break-even analysis.
P + FC = Q x (SP - VC)
FC = Q x (SP - VC)
Target Dollar Profits
Plug in for profits, total fixed costs, unit selling price and unit variable cost, and solve for # of units (Q). This calculates unit sales to achieve a targeted profit.
P + FC = Q x (SP - VC)
Target Selling Prices
Plug in for profits, total fixed costs, unit variable cost, and sales volume, and solve for targeted selling price. This calculates the unit sales price to achieve a targeted profit.
P + FC = Q x (SP - VC)