1. Copyright 1998 Dekker, Ltd. 1

2. Copyright 1998 Dekker, Ltd. 2

3. 3 Cost Concepts Understand the difference between direct and indirect costs Classification of costs Understand and identify cost drivers Determine standard costs and understand the limitations of that system Understand the difference between direct and indirect costs Classification of costs Understand and identify cost drivers Determine standard costs and understand the limitations of that system

4. Copyright 1998 Dekker, Ltd. 4 Functional Cost Classifications

5. Copyright 1998 Dekker, Ltd. 5 Direct Costs Those costs easily traced to the product such as: Direct Material and Direct Labor Are typically value- added activities Those costs easily traced to the product such as: Direct Material and Direct Labor Are typically value- added activities

6. Copyright 1998 Dekker, Ltd. 6 Direct Cost Equation where –C = cost of input resource –P = price per unit of resource –Q = quantity (number of units) of resource where –C = cost of input resource –P = price per unit of resource –Q = quantity (number of units) of resource C = P * Q

7. Copyright 1998 Dekker, Ltd. 7 Indirect Costs Those costs not easily identified with individual products - also referred to as overhead or burden Often nonvalue-added activities Those costs not easily identified with individual products - also referred to as overhead or burden Often nonvalue-added activities

8. Copyright 1998 Dekker, Ltd. 8 Service Cost Structure Today –Direct Labor still a majority of the costs –Few Direct Materials –Indirect Labor can be considerable –Direct Labor still a majority of the costs –Few Direct Materials –Indirect Labor can be considerable 1 1 2 2 3 3

9. Copyright 1998 Dekker, Ltd. 9 Manufacturing Cost Structure Today –Direct Labor only a small portion of manufacturing costs –Direct materials still important (40% - 60%) in some plants –Overhead costs are proportionally higher than in the past –Direct Labor only a small portion of manufacturing costs –Direct materials still important (40% - 60%) in some plants –Overhead costs are proportionally higher than in the past 1 1 2 2 3 3

10. Copyright 1998 Dekker, Ltd. 10 Activity Cost Driver Unit of measurement for the level (or quantity) of the activity performed Unit of measurement for the level (or quantity) of the activity performed

11. Copyright 1998 Dekker, Ltd. 11 Types of Production Activities Unit-related Batch-related Product-sustaining Facility-sustaining Unit-related Batch-related Product-sustaining Facility-sustaining

12. Copyright 1998 Dekker, Ltd. 12 Unit-Related Activities Examining patients in a doctor’s office Inspecting products Baling hay Activities Examining patients in a doctor’s office Inspecting products Baling hay Cost Drivers Number of patients seen Number of units inspected Number of bales baled

13. Copyright 1998 Dekker, Ltd. 13 Batch-Related Activities Machine setup First-item inspection Purchase ordering Materials handling Production scheduling Activities Machine setup First-item inspection Purchase ordering Materials handling Production scheduling Cost Drivers Number of setups Number of inspections Number of orders Number of material moves Number of production runs

14. Copyright 1998 Dekker, Ltd. 14 Product-Sustaining Activities Product design Parts administration Engineering Expediting production orders Activities Product design Parts administration Engineering Expediting production orders Cost Drivers Number of products Number of parts Number of engineering change orders Number of orders produced

15. Copyright 1998 Dekker, Ltd. 15 Facility-Sustaining Activities Plant management Accounting and personnel Housekeeping Activities Plant management Accounting and personnel Housekeeping Cost Drivers Square feet of space Number of workers Number of rooms cleaned

16. Copyright 1998 Dekker, Ltd. 16 Basic Cost Driver Equation where –C = cost of input resource –R = output rate for the activity –X = the surrogate cost driver measure for the activity (activity driver “second stage”) where –C = cost of input resource –R = output rate for the activity –X = the surrogate cost driver measure for the activity (activity driver “second stage”) C = R * X C = R * X

17. Copyright 1998 Dekker, Ltd. 17 Activity Overhead Rate Equation where –C = cost of input resource –R = output rate for the activity –X = the surrogate cost driver measure for the activity (activity driver “second stage”) where –C = cost of input resource –R = output rate for the activity –X = the surrogate cost driver measure for the activity (activity driver “second stage”) R = C/X R = C/X

18. Copyright 1998 Dekker, Ltd. 18 Total Overhead Costs are a Function of All Activities Total Overhead = C 1 + C 2 + C 3 + C 4 + C 5 = R 1 X 1 + R 2 X 2 + R 3 X 3 + R 4 X 4 + R 5 X 5 Total Overhead = C 1 + C 2 + C 3 + C 4 + C 5 = R 1 X 1 + R 2 X 2 + R 3 X 3 + R 4 X 4 + R 5 X 5

19. Copyright 1998 Dekker, Ltd. 19 Determining Overhead Rates Identify the activities performed Determine the cost of performing each activity Identify the cost driver for each activity Determine the number of units of the cost driver made available by the resources committed to each activity Divide the activity cost by the number of cost driver units made available to determine the activity overhead rate Identify the activities performed Determine the cost of performing each activity Identify the cost driver for each activity Determine the number of units of the cost driver made available by the resources committed to each activity Divide the activity cost by the number of cost driver units made available to determine the activity overhead rate

20. Copyright 1998 Dekker, Ltd. 20 Standard Costs Benchmarks based on standards established in advance for: 1 The quantity of activity resources that should be consumed by each unit of output 2 The price of these resources Benchmarks based on standards established in advance for: 1 The quantity of activity resources that should be consumed by each unit of output 2 The price of these resources

21. Copyright 1998 Dekker, Ltd. 21 Principal Uses of Standard Cost Systems Estimate product costs Budget for costs and expenditures Control costs relative to standards Estimate product costs Budget for costs and expenditures Control costs relative to standards

22. Copyright 1998 Dekker, Ltd. 22 Level of Standards Standards should be efficient and attainable, depending on how standards influence the behavior of workers and managers whose performance is evaluated relative to the standards Types of Standards –Ideal –Practical –Actual Standards should be efficient and attainable, depending on how standards influence the behavior of workers and managers whose performance is evaluated relative to the standards Types of Standards –Ideal –Practical –Actual

23. Copyright 1998 Dekker, Ltd. 23 Limitations of Standard- Only Cost Systems Usefulness is restricted largely to settings in which the production technology is stable and the number of business changes taking place is small Overreliance on managing with a standard cost system creates a mind- set of “meeting the standards” All too often the standards are based on “ideal” not “practical” systems Usefulness is restricted largely to settings in which the production technology is stable and the number of business changes taking place is small Overreliance on managing with a standard cost system creates a mind- set of “meeting the standards” All too often the standards are based on “ideal” not “practical” systems

24. Copyright 1998 Dekker, Ltd. 24 Applying the Concepts Determining Activity Cost Driver Rates Exercise #1 What five steps must be performed to determine the activity cost driver rates? Determining Activity Cost Driver Rates Exercise #1 What five steps must be performed to determine the activity cost driver rates?

25. Copyright 1998 Dekker, Ltd. 25 Applying the Concepts Determining Activity Cost Driver Rates Exercise #1 What five steps must be performed to determine the activity cost driver rates? 1. Identify the activities performed by organizations. 2. Determine cost of performing each activity. 3. Identify cost driver for each activity. 4. Determine the number of units of the cost driver made available by the resources committed to each activity. 5. Divide activity cost by activity cost driver units to obtain activity cost driver rate. Determining Activity Cost Driver Rates Exercise #1 What five steps must be performed to determine the activity cost driver rates? 1. Identify the activities performed by organizations. 2. Determine cost of performing each activity. 3. Identify cost driver for each activity. 4. Determine the number of units of the cost driver made available by the resources committed to each activity. 5. Divide activity cost by activity cost driver units to obtain activity cost driver rate.

26. Copyright 1998 Dekker, Ltd. 26 Applying the Concepts Cost Classification by activity type Exercise #2 Classify the following costs as unit-related, batch-related, product-sustaining, or facility-sustaining activity costs: –Packing labor wages –Materials-handling labor wages –Part administrators’ salaries –Plant management salaries –Production scheduling staff salaries –Equipment maintenance –Property taxes –Production expediters’ salaries –Insurance for plant facility Cost Classification by activity type Exercise #2 Classify the following costs as unit-related, batch-related, product-sustaining, or facility-sustaining activity costs: –Packing labor wages –Materials-handling labor wages –Part administrators’ salaries –Plant management salaries –Production scheduling staff salaries –Equipment maintenance –Property taxes –Production expediters’ salaries –Insurance for plant facility

27. Copyright 1998 Dekker, Ltd. 27 Applying the Concepts Cost Classification by activity type Exercise #2 Classify the following costs as unit-related, batch-related, product-sustaining, or facility-sustaining activity costs: –Packing labor wagesUNIT RELATED –Materials-handling labor wagesBATCH RELATED –Part administrators’ salariesPRODUCT SUSTAINING –Plant management salariesFACILITY SUSTAINING –Production scheduling staff salariesBATCH RELATED –Equipment maintenanceUNIT RELATED –Property taxesFACILITY SUSTAINING –Production expediters’ salariesPRODUCT SUSTAINING –Insurance for plant facilityFACILITY SUSTAINING Cost Classification by activity type Exercise #2 Classify the following costs as unit-related, batch-related, product-sustaining, or facility-sustaining activity costs: –Packing labor wagesUNIT RELATED –Materials-handling labor wagesBATCH RELATED –Part administrators’ salariesPRODUCT SUSTAINING –Plant management salariesFACILITY SUSTAINING –Production scheduling staff salariesBATCH RELATED –Equipment maintenanceUNIT RELATED –Property taxesFACILITY SUSTAINING –Production expediters’ salariesPRODUCT SUSTAINING –Insurance for plant facilityFACILITY SUSTAINING

28. 28 Cost Behavior Identify the difference between fixed and variable costs How commitment and usage of activity resources influence cost variability Understand why activity costs are variable in the long run Identify the difference between fixed and variable costs How commitment and usage of activity resources influence cost variability Understand why activity costs are variable in the long run

29. Copyright 1998 Dekker, Ltd. 29 The Relevance of Cost Behavior Cost behavior, or how costs behave in response to changes in production volume, is a concern for decision makers in almost all industries

30. Copyright 1998 Dekker, Ltd. 30 Graphical Representation of Fixed Costs 0 5,000 10,000 15,000 $20,000 02004006008001000 Quarterly Production (Q) in thousands of gallons Quarterly Fixed Costs (FC) FC = $10,000

31. Copyright 1998 Dekker, Ltd. 31 Graphical Representation of Fixed Costs per Unit of Volume 0 0.0050 0.0100 0.0150 $0.0250 02004006008001,000 Quarterly Production (Q) in thousands of gallons Quarterly Fixed Costs per Gallon (FC/Q) 0.0200 $0.0250 0.0200 0.0167 0.0143 0.0125

32. Copyright 1998 Dekker, Ltd. 32 Graphical Representation of Variable Costs VC = $0.0384 * Q Slope = 0.0384 $15,360 $19,200 $23,040 $26,880 $30,720 0 10,000 20,000 30,000 $40,000 2004006008001,000 Quarterly Production (Q) in thousands of gallons Quarterly Variable Costs(VC) in dollars

33. Copyright 1998 Dekker, Ltd. 33 Graphical Representation of Variable Costs per Unit Volume 0.00 0.01 0.02 0.03 0.04 $0.05 0200400600800 1,000 Quarterly Production (Q) in thousands of gallons Quarterly Variable Costs per Gallon (VC/Q) VC/Q = $0.0384 per gallon

34. Copyright 1998 Dekker, Ltd. 34 Mixed Costs Costs comprised of both fixed and variable cost components Costs comprised of both fixed and variable cost components

35. Copyright 1998 Dekker, Ltd. 35 Graphical Representation of Mixed Costs C = $10,000+($0.0384 * Q) Slope = $0.0384 0 10,000 20,000 30,000 40,000 2004006008001,000 Quarterly Production (Q) in thousands of gallons Quarterly Costs (C) $50,000 $25,360 $29,200 $33,040 $36,880 $40,720 Variable cost Fixed cost

36. Copyright 1998 Dekker, Ltd. 36 Total Cost Equation where –C = total cost –F = fixed costs –V = variable cost rate –Q = quantity of production where –C = total cost –F = fixed costs –V = variable cost rate –Q = quantity of production C = F + VQ C = F + VQ

37. Copyright 1998 Dekker, Ltd. 37 Total Cost May Also be Represented by where –C = total cost –R = output rate for the activity –X = cost driver measure for the activity where –C = total cost –R = output rate for the activity –X = cost driver measure for the activity C = R 1 X 1 + R 2 X 2 + R 3 X 3 + R 4 X 4 + R 5 X5 C = R 1 X 1 + R 2 X 2 + R 3 X 3 + R 4 X 4 + R 5 X5

38. Copyright 1998 Dekker, Ltd. 38 Determining the Variable Cost Rate If X 1, X 2, and X 3 are cost drivers that vary with production volume, then Total Variable Costs = R1X1 R1X1 + R2X2 R2X2 + R3X3R3X3 And, the variable cost rate, V, can be determined V = R 1 X 1 + R 2 X 2 + R 3 X 3 Q

39. Copyright 1998 Dekker, Ltd. 39 Determining Total Fixed Costs And, assuming X4 and X5 are cost drivers that are independent of Q, then Total Fixed Cost = R 4 X 4 + R 5 X 5

40. Copyright 1998 Dekker, Ltd. 40 Economic Framework Considerations Cost curve Economies of scale Capacity of constraints Diseconomies of scale Relevant range Cost curve Economies of scale Capacity of constraints Diseconomies of scale Relevant range

41. Copyright 1998 Dekker, Ltd. 41 Graphical Representation of the Cost Curve V 0 Production Level (Q) Total Cost (C) F C = C(Q) Relevant Range C = F + (VQ)

42. Copyright 1998 Dekker, Ltd. 42 Graphical Representation of Step Fixed Costs Production Level (Q) Cost (C) Relevant Range

43. Copyright 1998 Dekker, Ltd. 43 Graphical Representation of Step Variable Costs Production Level (Q) Cost (C) Relevant Range

44. Copyright 1998 Dekker, Ltd. 44 Profit = Revenues - Costs = (P * Q) - (F + V * Q) or = (P - V) * Q - F = (P * Q) - (F + V * Q) or = (P - V) * Q - F Where F = fixed cost Q = production level in units V = variable cost rate per unit P = selling price per unit Where F = fixed cost Q = production level in units V = variable cost rate per unit P = selling price per unit

45. Copyright 1998 Dekker, Ltd. 45 Breakeven Analysis Breakeven analysis involves determining the level of production at which the profit resulting from one option is at least as large as the profit resulting from an alternative option.

46. Copyright 1998 Dekker, Ltd. 46 Determining the Breakeven Point Breakeven point (in units) = Fixed costs / Contribution margin per unit or Q 0 = F / (P - V) Breakeven point (in units) = Fixed costs / Contribution margin per unit or Q 0 = F / (P - V) Where Q 0 = Quantity of production in units F = Fixed Costs (P - V) = Contribution margin per unit Where Q 0 = Quantity of production in units F = Fixed Costs (P - V) = Contribution margin per unit

47. Copyright 1998 Dekker, Ltd. 47 Breakeven Chart Production and Sales Volume 0 Costs and Revenues Variable Costs Fixed Costs Total Sales Revenues Total Costs Breakeven Point Profit Loss

48. Copyright 1998 Dekker, Ltd. 48 Production Volume at Target Profit Where Q T = Target quantity of production in units F = Fixed Costs T = Target profit (P-V) = Contribution margin per unit Where Q T = Target quantity of production in units F = Fixed Costs T = Target profit (P-V) = Contribution margin per unit Production volume = (Fixed costs + Target profit)/Contribution margin/unit or Q T = (F+T) / (P - V) Production volume = (Fixed costs + Target profit)/Contribution margin/unit or Q T = (F+T) / (P - V)

49. Copyright 1998 Dekker, Ltd. 49 Normal Cost Equation Regular cost of providing capacity Capacity made available Normal Unit Cost =

50. Copyright 1998 Dekker, Ltd. 50 Refinement of Activity Cost Driver Rate R = Activity Costs Number of units of the activity cost driver Where: The activity costs by the regular cost only to provide the normal capacity of activity resources and The number of units of the cost driver represent the capacity made available by the resources committed to the activity Where: The activity costs by the regular cost only to provide the normal capacity of activity resources and The number of units of the cost driver represent the capacity made available by the resources committed to the activity

51. Copyright 1998 Dekker, Ltd. 51 Support Activity Resource Classification Flexible Discretionary Committed

52. Copyright 1998 Dekker, Ltd. 52 Applying the Concepts Classification of cost behavior Exercise #3 Classify each of the following as a variable, fixed, or mixed cost: –Salaries of production supervisors –Wages of production workers –Salary of the chief executive officer –Charges for janitorial services –Commissions paid to sales personnel –Advertising expenses –Salaries of billing clerks –Electricity used to generate machines – Lubricants for machines –Maintenance for machines Classification of cost behavior Exercise #3 Classify each of the following as a variable, fixed, or mixed cost: –Salaries of production supervisors –Wages of production workers –Salary of the chief executive officer –Charges for janitorial services –Commissions paid to sales personnel –Advertising expenses –Salaries of billing clerks –Electricity used to generate machines – Lubricants for machines –Maintenance for machines

53. Copyright 1998 Dekker, Ltd. 53 Applying the Concepts Classification of cost behavior Exercise #3 Classify each of the following as a variable, fixed, or mixed cost: –Salaries of production supervisorsVARIABLE –Wages of production workersVARIABLE –Salary of the chief executive officerFIXED –Charges for janitorial servicesFIXED –Commissions paid to sales personnelVARIABLE –Advertising expensesFIXED –Salaries of billing clerksFIXED –Electricity used to generate machinesVARIABLE – Lubricants for machinesVARIABLE –Maintenance for machinesVARIABLE or FIXED Classification of cost behavior Exercise #3 Classify each of the following as a variable, fixed, or mixed cost: –Salaries of production supervisorsVARIABLE –Wages of production workersVARIABLE –Salary of the chief executive officerFIXED –Charges for janitorial servicesFIXED –Commissions paid to sales personnelVARIABLE –Advertising expensesFIXED –Salaries of billing clerksFIXED –Electricity used to generate machinesVARIABLE – Lubricants for machinesVARIABLE –Maintenance for machinesVARIABLE or FIXED

54. Copyright 1998 Dekker, Ltd. 54 Applying the Concepts The effect of management decisions on cost behavior Exercise #4 Why are activity costs more likely to be variable when managers have greater flexibility in adjusting the level of resources committed for the activity? The effect of management decisions on cost behavior Exercise #4 Why are activity costs more likely to be variable when managers have greater flexibility in adjusting the level of resources committed for the activity?

55. Copyright 1998 Dekker, Ltd. 55 Applying the Concepts The effect of management decisions on cost behavior Exercise #4 Why are activity costs more likely to be variable when managers have greater flexibility in adjusting the level of resources committed for the activity? When the managers have greater flexibility in adjusting the level of resources committed for an activity, they can plan in advance to adjust the level of committed resources to meet anticipated changes in production volume and consequent demand for activity resources. Costs of activity resources are thus adjusted to match short run fluctuations in production levels. The effect of management decisions on cost behavior Exercise #4 Why are activity costs more likely to be variable when managers have greater flexibility in adjusting the level of resources committed for the activity? When the managers have greater flexibility in adjusting the level of resources committed for an activity, they can plan in advance to adjust the level of committed resources to meet anticipated changes in production volume and consequent demand for activity resources. Costs of activity resources are thus adjusted to match short run fluctuations in production levels.

56. Copyright 1998 Dekker, Ltd. 56

57. Copyright 1998 Dekker, Ltd. 57 Applying the Concepts Determining Activity Cost Driver Rates Exercise #1 What five steps must be performed to determine the activity cost driver rates? Determining Activity Cost Driver Rates Exercise #1 What five steps must be performed to determine the activity cost driver rates?

58. Copyright 1998 Dekker, Ltd. 58 Applying the Concepts Determining Activity Cost Driver Rates Exercise #1 What five steps must be performed to determine the activity cost driver rates? 1. Identify the activities performed by organizations. 2. Determine cost of performing each activity. 3. Identify cost driver for each activity. 4. Determine the number of units of the cost driver made available by the resources committed to each activity. 5. Divide activity cost by activity cost driver units to obtain activity cost driver rate. Determining Activity Cost Driver Rates Exercise #1 What five steps must be performed to determine the activity cost driver rates? 1. Identify the activities performed by organizations. 2. Determine cost of performing each activity. 3. Identify cost driver for each activity. 4. Determine the number of units of the cost driver made available by the resources committed to each activity. 5. Divide activity cost by activity cost driver units to obtain activity cost driver rate.