Lecture 3

• Relevant Cost Concepts and

Terminology

• Cost Behavior • Car Pooling

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 3

• Relevant Cost Concepts and

Terminology

• Cost Behavior • Car Pooling

Classification of Costs

All Costs of doing business

Warranty expense Costs to ship product from factory to warehouse depreciation on factory building

Two ways to classify costs

• Direct and Indirect Costs • Fixed and Variable Costs

Classification of Costs

Total Costs Direct costs Indirect costs (a.k.a. overhead)

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 cost object.

cannot be traced to the • Indirect costs are sometimes

allocated

to the cost object.

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

Classification of Costs

Total Costs Direct costs

Fabric sewing operator wages

Indirect costs (a.k.a. overhead)

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.

Fixed Costs vs. Variable Costs

• Linear relationship is assumed.

$ 0

• Relevant range time-span must be identified.

and

units $

• Many costs are

semi variable

or

mixed.

0 units

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

Classification of Costs

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

Combinations of Variable & Fixed, Direct & Indirect

Fixed Variable Not very often Yes Direct Yes Yes Indirect

Classification of Costs

Total Costs Direct costs variable

Fabric, Sewing Wages

fixed Indirect costs (a.k.a. overhead) variable fixed

Electricity, Repairs Rent, Salaries

Lecture 3

• Relevant Cost Concepts and

Terminology

• Cost Behavior • Car Pooling

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

Carpooling

Direct Costs: Gasoline: 60 miles round trip x 150 days/yr = 9,000 miles  20 miles/gal = 450 gallons x $2.00 = $900 per year Parking: = Speeding Tickets: $100 per mo.

driver pays

Carpooling

Overhead Costs: Insurance: Repairs & Maintenance: Depreciation Expense: $1,200 per year $800 per year $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

Carpooling

Overhead Costs: Insurance: Repairs & Maintenance: Depreciation Expense: $1,200 per year $800 per year $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.

COMMUTE COSTS

• Gas • Bridge Toll • Parking • Insurance • Maintenance • Traffic Tickets • Opportunity Costs • Variable, Indirect • Variable, Direct • Fixed, Direct • Fixed, Indirect • Mixed, Indirect

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.”