Classification of Costs Lecture No. 29 Chapter 8 Contemporary Engineering Economics Copyright © 2006 Contemporary Engineering Economics, 4th edition, © 2007

Chapter Opening Story – High Hopes for Plastic Beer Bottles What is the least expensive way to make a 0.5L PET barrier beer bottle? Types of Production Method 5-layer 3-layer Internal coating External coating Capital investment (20,000 bottles/hr) Direct Mfg Cost (per 1,000 units) $10.8M $59.35 $9.9M $66.57 $9.2M $46.90 $7.5M $55.34 Comments Need a bottle that provides shelf life of over 120 days with less than 15% loss of CO2 and admittance of no more than 1 ppm of oxygen Contemporary Engineering Economics, 4th edition, © 2007

Contemporary Engineering Economics, 4th edition, © 2007 General Cost Terms Manufacturing Costs Direct Raw Materials Direct Labor Manufacturing Overhead Nonmanufacturing Costs Overhead Marketing Administrative Functions Contemporary Engineering Economics, 4th edition, © 2007

Various Types of Manufacturing Costs Figure: 08-01 Contemporary Engineering Economics, 4th edition, © 2007

Classifying Costs for 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. Contemporary Engineering Economics, 4th edition, © 2007

Contemporary Engineering Economics, 4th edition, © 2007 Example Period Costs: General and administrative expenses Marketing expenses Insurance premiums Income taxes Nonmanufacturing costs Product Costs: Direct material costs Direct labor costs Manufacturing overhead Contemporary Engineering Economics, 4th edition, © 2007

Contemporary Engineering Economics, 4th edition, © 2007 How the Period Costs and Product Costs Flow Through Financial Statement Figure: 08-02 Contemporary Engineering Economics, 4th edition, © 2007

Cost Flows and Classifications in a Manufacturing Company Figure: 08-03 Contemporary Engineering Economics, 4th edition, © 2007

Example 8.1 Classifying Costs for Uptown Ice Cream Shop Unit Price of an Ice Cream Ice cream (cream, sugar, milk, and milk solids) $0.65 Cone 0.05 Product Cost Rent 0.61 Wages 0.25 Payroll taxes 0.25 Sales taxes 0.23 Business taxes 0.08 Debt service 0.23 Period Cost Supplies 0.09 Utilities 0.08 Other (insurance, advertising,professional fees) 0.05 Profit 0.13 $2.50 Contemporary Engineering Economics, 4th edition, © 2007

Cost Classification for Predicting Cost Behavior Volume index Cost Behaviors Fixed costs Variable costs Mixed costs Average unit costs Contemporary Engineering Economics, 4th edition, © 2007

Contemporary Engineering Economics, 4th edition, © 2007 Volume Index Def: The unit measure used to define “volume” Examples: Automobile – “miles” driven Generating plant – “kWh” produced Stamping machine – “parts” stamped Contemporary Engineering Economics, 4th edition, © 2007

Contemporary Engineering Economics, 4th edition, © 2007 Fixed Costs Def: The costs of providing a company’s basic operating capacity Cost behavior: Remain constant over the relevant range Contemporary Engineering Economics, 4th edition, © 2007

Contemporary Engineering Economics, 4th edition, © 2007 Variable Costs Def: Costs that vary depending on the level of production or sales Cost behavior: Increase or decrease proportionally according to the level of volume Contemporary Engineering Economics, 4th edition, © 2007

Contemporary Engineering Economics, 4th edition, © 2007 Mixed Costs Def: 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 expense Mixed cost behavior 6000 5000 4000 Depreciation Expenses ($) 3000 2000 1000 5 15 25 Miles Driven (Unit: 1,000) Contemporary Engineering Economics, 4th edition, © 2007

Contemporary Engineering Economics, 4th edition, © 2007 Average Unit Cost Def: 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 Contemporary Engineering Economics, 4th edition, © 2007

Contemporary Engineering Economics, 4th edition, © 2007 Practice Problem You have 3000 units to produce. Total labor cost = $20,000 Total material cost = $25,000 Total overhead cost = $15,000 Total fixed cost = $40,000 What is the average cost per unit? Average cost = ($100,000)/3,000 = $33.33/unit Contemporary Engineering Economics, 4th edition, © 2007

Future Costs for Business Decisions Differential (Incremental) cost Opportunity cost Sunk cost Marginal cost Contemporary Engineering Economics, 4th edition, © 2007

Differential (Incremental) Costs Def: Costs that represent the differences in total costs, which results from selecting one alternative instead of other Cost behavior: Increase or decrease with the overall change that a company experiences by producing one additional unit of good Contemporary Engineering Economics, 4th edition, © 2007

Contemporary Engineering Economics, 4th edition, © 2007 Opportunity Costs Def: 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 a 4-year’s potential earnings foregone. Contemporary Engineering Economics, 4th edition, © 2007

Contemporary Engineering Economics, 4th edition, © 2007 Sunk Costs Def: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 in making a selling decision in the future Contemporary Engineering Economics, 4th edition, © 2007

Contemporary Engineering Economics, 4th edition, © 2007 Marginal Costs Def: Added costs that result from increasing rates of outputs, usually by single unit Example: Cost of electricity—decreasing marginal rate Contemporary Engineering Economics, 4th edition, © 2007