Classification of Costs Lecture No. 27 Chapter 8 Contemporary Engineering Economics Copyright © 2016

Chapter Opening Story: What Does It Cost to Make an iPhone? Apple’s 16GB iPhone 6 is priced at $649. Do you know the profit margin for Apple from selling an iPhone 6? At Issue: The 16GB iPhone 6 costs Apple about $200 to build. How does Apple come up with such an estimate of various component costs before pricing their product?

General Cost Terms in Manufacturing Setting Manufacturing Costs Direct Raw Materials Direct Labor Manufacturing Overhead Nonmanufacturing Costs Overhead Marketing Administrative Functions Mfg. Overhead Factory overhead Indirect Mfg. costs Burden

Components of Manufacturing Cost Figure: 08-01

Classifying Costs for the Financial Statements Matching 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 basis Product costs: Those costs that are matched against revenues on a product basis

Example General and administrative expenses Marketing expenses Period costs General and administrative expenses Marketing expenses Insurance premiums Income taxes Nonmanufacturing costs Product costs Direct material costs Direct labor costs Manufacturing overhead

How the Period Costs and Product Costs Flow Through the Financial Statements Figure: 08-02

Cost Flows and Classifications of a Manufacturing Company Figure: 08-03

Example 8.1: Classifying Costs for Uptown Ice Cream Shop Given: Breakdown of unit cost items Find: Classify the cost items to product costs and period costs.

Solution Breakdown of unit cost items Product costs Period costs

Cost Classification for Predicting Cost Behaviors Volume index Cost behaviors Fixed costs Variable costs Mixed costs Average unit costs

Volume Index miles kWh parts Volume Index Definition: The unit measure used to define “volume” Examples Automobile Miles driven Generating plant kWh produced Stamping machine “Parts” stamped Assembly plant Units assembled Volume Index miles kWh parts

Fixed Costs Definition: The costs of providing a company’s basic operating capacity Cost behavior: Remains constant over the relevant range

Variable Costs Definition: Costs that vary depending on the level of production or sales Cost behavior: Increases or decreases proportionally according to the level of volume

Mixed Costs Definition: Costs are fixed for a set level of production or consumption, becoming variable after the level is exceeded. Cost behavior: Increases or decreases after maintaining a fixed level of expense Mixed cost behavior 6000 5000 4000 Depreciation Expenses ($) 3000 2000 1000 5 15 25 Miles Driven (Unit: 1,000)

Average Unit Cost Definition: activity cost per unit basis Cost behaviors: 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.

Example 8.2: Average Driving Cost per Mile Given: Owning and Operating a 4WD Sport- Utility vehicle Find: Average driving cost per mile as a function of mileage

Solution

Cost-Volume Chart

Average Cost Per Mile

Future Costs for Business Decisions Differential (incremental) cost Opportunity cost Sunk cost Marginal cost

Differential (Incremental) Costs Definition: Costs that represent the difference in total costs, which results from selecting one alternative instead of another Cost behavior: Increases or decreases with the overall change that a company experiences by producing one additional unit of goods

Opportunity Costs Definition: The potential benefit that is given up as you seek an alternative course of action Example: When you decide to pursue a college degree, your opportunity cost would include four-years’ potential earnings given up.

Sunk Costs Definition: Cost that has already been incurred by past actions Economic implications: Not relevant to future decisions Example: $500 spent to replace brakes last year—not relevant to making a sales decision in the future

Marginal Costs Definition: Added costs that result from increasing rates of output, usually by a single unit Example: Cost of electricity—decreasing marginal rate