Chapter 1-2 - The nature of costs

Firms with high operating leverage have

1. Rapid increases in profits if sales expand 2. Rapid increase in losses when sales fall 3. Longer to break even

Define direct cost.

Direct cost are those items that are easily traced to the product or service. Direct labour and direct material costs are direct costs.

Define fixed costs

Fixed costs are the costs that do not change with units. Or rather, the costs incurred when there is no production. Like property taxes.

Operating leverage

Fixed costs/total costs

What are the underlying assumptions in a cost-volume-profit analysis?

It assumes linear cost and revenue. Instead of allowing price to vary with quantity, it assumes a constant price, P.

Why are opportunity costs costly to estimate?

It is costly because to estimate opportunity cost one must formulate all possible actions and forgone net receipts from each of those alternatives so that the highest net cash flow from the set of alternatives not taken can be calculated. This yields opportunity cost of the selected action. Such an exercise requires a special study for every decision, which is time-consuming and costly.

Define mixed cost and give an example

Many costs cannot be neatly categorized as purely as fixed or variable costs. Mixed or semi-variable costs are cost categories that cannot be classified as fixed or variable. Electricity is a good example. Producing more output requires some additional electricity. But some part of the electric bill is just for turning on the lights and heating or cooling the plant, whether the plant produces 1 unit or 1500 units. In this case, the cost of electricity is a mix of fixed and variable cost

Define overhead costs. How are they allocated?

Overhead includes indirect labor and indirect material costs as well as other types of general manufacturing costs that cannot be directly traced, or are not worth tracing, to units being produced. The distinction between direct costs and overhead can be difficult to determine at times. Managers allocate cost to products and they usually do so by choosing an allocation base that most closely approximated the factors that cause overhead to vary in the long run.

What are period costs?

Period costs are those costs expensed in the period in which they are incurred. They include all non-manufacturing costs incurred to sell the product. Period costs are not included in the product's cost in inventory.

Define step cost and give an example

Step cost is cost that is fixed over a range of output levels, e.g. each supervisor can monitor a fixed nr of employees. As output expands and the number of employees increase, there is the need to hire more supervisors. Therefor the expenditure of paying supervisors is a sep expenditure.

Opportunity costs

The cost of doing anything consists of the receipts that could have been obtained if that particular decision had not been taken. Opportunity costs are different from accounting expenses. Opportunity cost is the sacrifice of the best alternative for a given action. An (accounting) expense is a cost incurred to generate revenue.

Define variable costs. Is it the same as marginal costs? Explain

Variable cost is the additional cost incurred when output is expanded. Variable cost is not the same as marginal cost. Marginal cost is the cost of producing one additional unit or the last unit produced. Variable cost and marginal cost are close in the so called "relevant range", that is the range of normal production. There the slopes of the total cost and variable cost is similar. In the relevant range, variable cost can be used to estimate the cost of making one additional unit.

Opportunity costs also include intangibles

but it does not include sunk cost or already forgone opportunities.

Internal accounting system should have the following characteristics

1. Provide information necessary to assess the profitability of products or services and to optimally price and market these products or services. 2. Provide information to detect product inefficiencies to ensure that the proposed products and volumes are produced at minimum cost. 3. When combined with the performance evaluation and reward systems, create incentives for managers to maximize firm value. 4. Support the financial accounting and tax accounting reporting functions. (Very important factor.) 5. Contribute more to firm value than it costs.

What are the benefits and limitations of cost volume-profit analysis?

Benefits: Cost-volume-profit analysis offers a useful place to start analyzing business problems. It gives managers an ability to do sensitivity analysis and ask simple what-if questions. Limitations: Three main limitations. 1. Price and variable cost per unit must not vary with volume 2. Cost-volume-profit is a single period analysis. All revenues and costs occur in the same time period. 3. Cost-volume-profit analysis assumes a single-product firm. All costs are incurred to produce a single product. With multiple products and common fixed costs, it is not meaningful to discuss the break-even point for just one product.