Managerial Accounting Balakrishnan | Sivaramakrishnan | Sprinkle | Carty | Ferraro Chapter 2: Identifying and Estimating Costs and Benefits Prepared by Debbie Musil, Kwantlen Polytechnic University

Which Costs and Benefits to Measure? Controllability: Cost or benefit that changes because of the decision −Measured relative to status quo Relevance: A controllable cost or benefit that is different for at least one decision alternative −Relevance helps focus attention on specific costs and benefits LO1: Understand how to identify the costs and benefits of decision options.

Identifying Costs and Benefits Controllable costs and benefits −Compare to status quo (doing nothing) −Computes absolute change in profit Relevant costs and benefits −Helps focus on costs and benefits that matter −Preserves ranking of decision options with fewer measurements Why learn two concepts? −Controllability = Relevance if status quo is a choice Status quo is not a choice in many decisions LO1: Understand how to identify the costs and benefits of decision options.

Controllable TechnostarMillennium Relevance Base configuration$925$875($50) Flat panel display125 Memory upgrade GB External hard drive169 Upgrade to Vista175 Office 2007 Suite185 -3year service agreement Total$1,979$2,054$75 Example: Buying a PC LO1: Understand how to identify the costs and benefits of decision options.

Yes No Yes LO1: Understand how to identify the costs and benefits of decision options.

Sunk Costs Controllable costs and benefits pertain to the future Sunk costs are costs and benefits that have been incurred in the past −Our decisions today will not change them −They are not controllable or relevant! LO1: Understand how to identify the costs and benefits of decision options.

Time and Cost Controllability Control over costs and benefits increases with passage of time −Commitments and contracts expire Ability to change capacity resources varies over time −Cannot change capacity in the short-term −Can change capacity in long-term We can classify decisions as to whether they are short- or long-term LO2: Consider how time affects the realization of costs and benefits.

Example: Time and Controllability LO2: Consider how time affects the realization of costs and benefits.

Steps in Estimating Costs Cost behavior Cost estimation Cost prediction Build model of expected relationship between cost and activity Use estimated parameters to forecast costs at a particular activity level. Use historical data to test model and to determine parameters LO3: Explain the principles for estimating costs and benefits

Estimating Costs and Benefits Controllable costs and benefits are the outcomes of activities Two key principles −Variability: Relation between cost or a benefit and some underlying activity Variable cost changes with activity; fixed cost does not −Traceability: Extent to which we can identify cost or benefit with decision option LO3: Explain the principles for estimating costs and benefits

Revenue/Sales Volume Relationship

Variability Relation between cost/benefit and activity volume −If we know activity volume, we can estimate cost/benefit Terminology −Fixed and variable costs are extremes −Mixed costs LO3: Explain the principles for estimating costs and benefits

Variable, Fixed, and Total Costs LO3: Explain the principles for estimating costs and benefits

$12 $10 $8 $5 $4

Traceability Degree to which we can relate cost or benefit to decision option −Affects confidence in estimate Entire effect of direct cost/benefit pertains to decision option −Confidence is high Part effect for indirect cost/benefit −Role for allocations LO3: Explain the principles for estimating costs and benefits

Controllability, Variability & Traceability LO3: Explain the principles for estimating costs and benefits

Cost Hierarchy Broadens the principle of variability −Allows us to consider multiple activities Costs may be step costs −Stay the same for a certain activity range −Jump to a higher amount outside that range Recognizes four types of costs Unit-level costs Batch-level costs Product-level costs Facility-level costs LO 4: Describe the hierarchical nature of costs and its implications for cost measurement.

Behaviour of Step Costs LO 4: Describe the hierarchical nature of costs and its implications for cost measurement.

Why the Cost Hierarchy? Allows us to compute a more accurate estimate of costs −Can extend concept to other “levels” Customer level costs, channel level costs,… However: −Difficult to assign many costs to hierarchy categories Need finer data on operations −Wrong classification of levels introduces errors in cost estimation LO 4: Describe the hierarchical nature of costs and its implications for cost measurement.

$60043 x $7$250 x 1 step $1, = + + = $ x $7 $250 x 3 steps $2,134 +

Example: Deluxe Checks LO 4: Describe the hierarchical nature of costs and its implications for cost measurement.

An Example: Art.com

Problem 2.32 Controllability and relevance (LO1) Sam Walters is leaving tomorrow for a three-day business trip and is trying to decide the most economical way to get to and from the airport and his home. Sam could either drive (using his own car) or take the shuttle. If Sam drives, then he estimates that it will cost $0.30 per mile driven in operating costs (e.g., for gas and oil) and $7.50 per day for parking. The one-way cost of the shuttle is $25. Sam’s home is exactly 30 miles from the airport. Required: a)What are the controllable costs for Sam’s decision? b)What are the relevant costs and benefits for Sam’s decision? c)Are the controllable costs the same as the relevant costs for Sam’s decision? If so, why? Can controllability and relevance give the same costs and benefits even when the status quo is not a feasible option?

A cost is controllable if it changes relative to the status quo. Relative to not taking the business trip (the status quo where Sam does nothing), Sam expects to incur the following costs under each option: Problem 2.32 (Continued) a)What are the controllable costs for Sam’s decision?

Problem 2.32 (Continued) a)What are the controllable costs for Sam’s decision?  Thus, we find that Sam prefers driving to taking the shuttle. Sam’s preference for driving versus taking the shuttle changes as the length of his trip changes (e.g., for a five-day trip, the shuttle is cheaper as the cost of driving increases by $15 while the cost of taking the shuttle stays the same).  For short-duration trips, driving (and parking at the airport) is cheaper than taking the shuttle.  For trips that are longer in duration, taking the shuttle is cheaper than driving.  We can link this to students’ behavior – for winter break, it is likely that students take the shuttle to the airport to avoid 2-3+ weeks of parking costs. For shorter trips (e.g., Thanksgiving, long weekend at home), it is likely that many students drive and use the airport parking lot.

b)What are the relevant costs and benefits for Sam’s decision? Problem 2.32 (Continued) A cost is relevant if it differs across decision options. We also know that relevant costs are a subset of controllable costs. By examining the controllable costs in part [b], we find that all of the controllable costs are relevant – i.e., the options do not share any common costs. Thus, the relevant costs of driving = $40.50, and the relevant costs of taking the shuttle = $50. Thus, the relevant costs of driving = $40.50, and the relevant costs of taking the shuttle = $50.

Problem 2.32 (Concluded) Yes, for Sam’s decision, the set of controllable costs is the same as the set of relevant costs. Moreover, we find that controllability and relevance give us the same amounts even when the status quo is not part of the opportunity set. How can this happen? The answer is that controllability and relevance will give us the same amounts when decision options do not share any common costs or benefits. That is, when each cost or benefit is unique to a specific decision option. c)Are the controllable costs the same as the relevant costs for Sam’s decision? If so, why? Can controllability and relevance give the same costs and benefits even when the status quo is not a feasible option?

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