1. Lecture 3 Relevant Cost Concepts and Terminology Cost Behavior
Car Pooling

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

3. 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.

4. 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.

5. 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.

6. Lecture 3 Relevant Cost Concepts and Terminology Cost Behavior
Car Pooling

7. Classification of Costs
All Costs of doing business
television commercials
thread
Warranty expense
Legal dept
Sewing operator wages
fabric
Costs to ship product from factory to warehouse
Sales commissions
Design dept.
factory electricity
factory manager’s salary
depreciation on factory building

8. Two ways to classify costs
Direct and Indirect Costs
Fixed and Variable Costs

9. Classification of Costs
Total Costs
Direct costs
Indirect costs (a.k.a. overhead)

10. 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.

11. Direct versus Indirect Costs
EXAMPLE: LEVI STRAUSS FACTORY
Are the following costs direct or indirect?
Fabric
Plant Manager’s Salary
Thread
Sewing Operator’s Labor
Plant Utilities

12. Classification of Costs
Total Costs
Direct costs
Fabric
sewing operator wages
Indirect costs (a.k.a. overhead)
Plant utilities, thread,
Plant manager’s salary

13. Two ways to classify costs
Direct and Indirect Costs
Fixed and Variable Costs

14. 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.

15. Fixed Costs vs. Variable Costs
Linear relationship is assumed.
Relevant range and time-span must be identified.
Many costs are semi- variable or mixed. $
units $
units

16. Fixed Costs vs. Variable Costs
EXAMPLE: LEVI STRAUSS FACTORY
Are the following costs fixed or variable?
- Fabric
- Assistant Manager’s Salary
- Electricity
- Sewing Operator Labor
- Repairs & Maintenance
- Rent on building

17. Classification of Costs
Total Costs
Direct costs
variable
fixed
Indirect costs (a.k.a. overhead)
variable
fixed

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

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

20. Lecture 3 Relevant Cost Concepts and Terminology Cost Behavior
Car Pooling

21. Carpooling Example Chestnut Ridge - N.Y.C.: 60 mi. r.t.
Tenafly, NJ - N.Y.C.: 30 mi. r.t.
150 commutes per year
Gas: $2 per gallon; 20 miles per gal
Total miles driven per year: 18,000

22. Carpooling Direct Costs: Gasoline: 60 miles round trip x 150 days/yr
 20 miles/gal
= 450 gallons x $2.00 = $900 per year
Parking: = $100 per mo.
Speeding Tickets: driver pays

23. Carpooling Overhead Costs: Allocation base: might be miles driven.
Insurance: $1,200 per year
Repairs & Maintenance: $800 per year
Depreciation Expense: $0
Allocation base: might be miles driven.
9,000 miles driven on the commute (60 mi. r.t. x 150 days)
18,000 miles driven in total, each year

24. Carpooling Overhead Costs: Allocation rate for insurance:
Insurance: $1,200 per year
Repairs & Maintenance: $800 per year
Depreciation Expense: $0
Allocation rate for insurance:
Overhead costs  total miles driven =
$1,200  18,000 = $0.067 per mile
Applying overhead insurance costs to the commute: $0.067 per mile x 9,000 miles = $600.

25. COMMUTE COSTS Gas Bridge Toll Parking Insurance Maintenance
Traffic Tickets
Opportunity Costs
Variable, Indirect
Variable, Direct
Fixed, Direct
Fixed, Indirect
Mixed, Indirect

26. ALLOCATE GAS COSTS Total Annual Gas Expense Total Annual Miles Driven
= Gasoline Cost per mile
This is the “overhead rate” for applying gas expense to my commute.
Multiply this rate/mile by the 4,500 shared miles of the commute to derive the “shared gas expense.”