Lecture 2 Relevant Cost Concepts and Terminology The Jennie Mae Frog Farm Break Cost behavior

Lecture 2 Relevant Cost Concepts and Terminology The Jennie Mae Frog Farm Break Cost behavior

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

Terminology 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.

Terminology 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.

When are Costs and 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 2 Relevant Cost Concepts and Terminology The Jennie Mae Frog Farm Break Cost behavior

The Jennie Mae Frog Farm Jennie 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 Farm Question #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 Farm Question #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 Farm Question #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 Farm Question #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 Farm Question #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 Farm Question #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 Farm Question #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 Farm Question #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 =2,025 from normal customers: $9 x 500 =4,500 Costs: Variable costs (500 x $2) + (300 x $1.75) =1,525 Fixed costs5,000 Income$ 0

The Jennie Mae Frog Farm Question #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 Farm Question #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.

Lecture 2 Relevant Cost Concepts and Terminology The Jennie Mae Frog Farm Break Cost behavior

Lecture 2 Relevant Cost Concepts and Terminology The Jennie Mae Frog Farm Break Cost behavior

Classification of Costs All Costs of doing business fabric thread 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 Design dept. Legal dept television commercials

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 Fabric Plant Manager’s Salary Thread Sewing Operator’s Labor Plant 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 $ 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 variable

Combinations of Variable & Fixed, Direct & Indirect Yes Fixed Variable Direct Indirect Yes Not very often

Classification of Costs Direct costs Indirect costs (a.k.a. overhead) Total Costs fixed variable Fabric, Sewing Wages Electricity, RepairsRent, Salaries