Cost concepts and behaviors

(c) 2002 Contemporary Engineering
Economics
1
Chapter 3
Cost Concepts and Behaviors

Economics
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Topics to Cover
• General Cost Terms
• Classifying Costs for
Financial Statements
• Cost Classification for
Predicting Cost
Behaviors

Economics
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Topics to Cover
• Thinking on the
Margin: Fundamental
Economic Decision-
Making

Economics
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An Example
• We will start with an example to understand the
concepts covered in this chapter
• The example is of a ice-cream producer
producing ice-cream cones
“Uptown Ice Cream Shop”

Economics
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Unit Price of an Ice Cream Cone:
Uptown Ice Cream Shop
Total Cost Unit Price %of Price
Ice cream (cream, sugar, milk and
milk solids) $120,250 $0.65 26%
Cone 9,250 0.05 2%
Rent 112,850 0.61 24%
Wages 46,250 0.25 10%
Payroll taxes 9,250 0.25 2%
Sales taxes 42,550 0.23 9%
Business taxes 14,800 0.08 3%
Debt service 42,550 0.23 9%
Supplies 16,650 0.09 4%
Utilities 14,800 0.08 3%
Other expenses (insurance,
advertising, fees) 9,250 0.05 2%
Profit 24,050 0.13 5%
Total $462,500 $2.50 100%
Items
120250 / 0.65 =
Or
9250/ 0.05 =
Or …
185000 Cones

Economics
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General Cost Terms

Economics
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General Cost Terms
• Manufacturing Costs
Direct materials
Direct labor
Mfg. Overhead include
Indirect materials, indirect labor; maintenance and
Repairs on production equipment; heat and light;
property taxes; depreciation; insurance, etc.,
• Non-manufacturing Costs
Overhead
Heat and light, property taxes, depreciation
Marketing or selling
Advertising, shipping, sales travel, sales salaries
Administrative
Executive compensation, general accounting,
Public relations, and secretarial support.

Economics
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Classifying Costs for Financial Statements
• In financial accounting, the
Matching Concept states that
the costs incurred to generate
particular revenue should be
recognized as expenses in the
same period that the revenue is
recognized.
• Period costs: Those costs that
are charged to expenses in the
time period basis (advertising,
executive salaries, sales commissions, public
relations, other non manufacturing costs).
• Product costs:Those costs that
are involved in the purchase or
manufacturing of goods. Since
product costs are assigned to
inventories, known as inventory
costs. (all costs related to manufacturing
process).

Economics
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Ice cream (cream, sugar, milk, and milk solids) $0.65
Cone 0.05
Rent 0.61
Wages 0.25
Payroll taxes 0.25
Sales taxes 0.23
Business taxes 0.08
Debt service 0.23
Supplies 0.09
Utilities 0.08
Other (insurance, advertising,professional fees) 0.05
Profit 0.13
$2.50
Unit Price of an Ice Cream
Classifying Costs for Uptown Ice Cream Shop
Product
Cost
Period
Cost
Example 3.1

Economics
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Cost Flows and Classifications in a Mfg. Co.
Cost of revenue =
Cost of goods
sold
• Raw materials
inventory
• Work-in-process
inventory
• Finished goods
inventory

Economics
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Cost Classification for Predicting Cost Behavior
(describes how cost item will respond to changes in the level of
business activity)
• Volume index
Operating cost respond in some way to changes in its operating volume.
Need to determine some measurable volume or activity which has strong
Influence on the amount of cost incurred. (volume index may be based
on production inputs/out puts. Energy consumption, labor hours OR KWhr
generated or miles per year driven by a car)
• Cost Behaviors
Fixed costs
Variable costs
Mixed costs
In the car case, Depreciation, occur from
passage of time (fixed portion) and also
More miles are driven a year, loses its
Market value (variable portion)
• Average unit costs
(example: 3.2 Calculating average cost per mile)

Economics
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Volume index:
• It is necessary to distinguish between changes arising
solely from price changes and those arising from other
influences such as quantity and quality, which are referred
to as changes in “volume”.
• A volume index is presented as a weighted average of the
proportionate changes in the quantities of a specified
set of goods or services between two periods of time.
• The quantities compared must be homogeneous, while the
changes for different goods and services must be
weighted by their economic importance as measured by
their values in one or other, or both, periods.

Economics
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Volume index: (Illustrated Example)
• Consider an industry that produces two different models of automobile, one
selling for twice the price of the other.
• From an economic point of view these are two quite different products even
though described by the same generic term "automobile". Suppose that
between two periods of time:
• (a) The price of each model remains constant; (b) The total number of
automobiles produced remains constant; (c) The proportion of higher priced
models produced increases from 50 % to 80 %
• .It follows that:
– the total value of the output produced increases by 20 % because of the increase in
the proportion of higher-priced models. This constitutes a volume increase of 20 %.
As each higher-priced automobile constitutes twice as much output as each lower-
priced automobile, a switch in production from low- to high-priced models
increases the volume of output even though the total number of automobiles
produced remains unchanged. The fact that the value increase is entirely
attributable to an increase in volume also follows from the fact that no price
change occurs for either model. The price index must remain constant in these
circumstances.
• cost cheaper * 50 + cost expansive * 50
• Before: 1 * 50 + 2 * 50 =150  After: 1* 30 + 2 * 80 = 160+30 = 180
• 180-150/150 * 100 = 20% increase in volume index.

Economics
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Fixed Costs or capacity cost
• Definition: The costs of providing a company’s
basic operating capacity
• Cost behavior: Remain constant over the time
though volume may change.
• Some examples; Annual insurance premium,
property tax, and license fee, building rents,
depreciation of buildings, salaries of
administrative and production personnel.

Economics
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Variable Costs
• Definition: Costs that vary depending on the
level of production or sales
• Cost behavior: Increase or decrease according to
the level of volume change.
• Example: Ice cream cone company, wages,
payroll taxes, sales tax, and supplies. Fuel
consumption is directly related to miles driven.

Economics
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Average Unit Cost
• Definition: activity
cost on a per unit basis
• Cost Behaviors:
– Fixed cost per unit
varies with changes in
volume.
– Variable cost per unit
of volume is constant.
See example 3.2

Economics
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Cost Classification Cost
Variable Costs:
Standard miles per gallon
Average fuel price per gallon
Fuel and oil per mile $0.0689
Maintenance per mile $0.0360
Tires per mile $0.0141
$0.12
Annual Fixed Costs:
Insurance:
Comprehensive $90
Collision $147
Body injury & Property damage $960
License & Registration $95
Property tax $372
total $1,064
Mixed Costs: Depreciation
Fixed portion per year $3,106
Variable portion per mile $0.04
$500 Deductible
References
20 miles/ gallon
$1.34/ gallon
$250 Deductible
Cost Classification of Owning and Operating a Passenger Car

Economics
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Cost-Volume Relationship
5,000 10,000 15,000 20,000
Variable costs ($0.1190/mile) $595 $1,190 $1,785 $2,380
Mixed costs:
Variable portion 200 400 600 800
Fixed portion 3,106 3,106 3,106 3,106
Fixed costs: 1,064 1,064 1,064 1,064
Total variable cost 795 1,590 2,385 3,180
Total fixed cost 4,170 4,170 4,170 4,170
Total costs $4,965 $5,760 $6,555 $7,350
Cost per mile $0.9930 $0.5760 $0.4370 $0.3675
Volume Index (miles)

Economics
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Cost-Volume Relationship
$1064
1064+0.04M

Economics
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Average Cost per Mile

Economics
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Cost Concepts relevant to the decision making.
• Costs are an important feature of many business
decisions. In order to make such decisions
following cost needed to be well understood…
– Differential costs
– Opportunity costs
– Sunk costs
– Marginal costs

Economics
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Differential (Incremental) Costs Revenues
• Decision involve selection among alternatives.
• Each alternative have certain costs / benefits that
are needed to be compared to the costs / benefits of
the other alternatives

Economics
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Differential (Incremental) Costs and Revenues
• Definition: Difference
in costs between any
two alternatives
known as Differential
cost.
• Difference in revenues
between any two
alternatives is known
as differential
revenue.

Economics
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• Cost-volume relationship based on differential
costs find many engineering applications such as
short term decision making. Example:
• The base case is the status quo (current operation).
We propose an alt. to the base case. If alt. has
lower cost we accept the alt. assuming non-
quantitative factors do not offset the cost
advantage.

Economics
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• Differential cost = difference in total cost that
results from selecting one alt. instead of the other.
• Problem of this type are generally called trade off
problems because one type of cost is traded by
another type of cost
• KEY FEATURES: New investment in physical
assest not required, planning horizon short,
relatively few cost items are subject to change by
the decision

Economics
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• Common examples:
• Method change – Example 3.3 page 75
• Operations planning – Example 3.4 page 76
• Make or buy decision – Example 3.5 page 77

Economics
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Example 3.3: Differential Cost Associated with Adopting a New
Production Method
Variable costs:
Materials $150,000 $170,000 $20,000
Machining labor 85,000 64,000 -21,000
Electricity 73,000 66,000 -7,000
Fixed costs:
Supervision 25,000 25,000 0
Taxes 16,000 16,000 0
Depreciation 40,000 43,000 3,000
Total $392,000 $387,000 -$5,000
Current Dies Better Dies Differential Cost

Economics
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Example 3.4 Break-Even Volume Analysis
In typical manufacturing environment, when demand is high, managers are interested in
whether to use a one-shift plus overtime operations or to add a second shift.
When demand is low, it is possible to explore whether to operate temporarily at a very low
volume or to shut down until operations at normal volume become economical.
In a chemical plant, several routes exist for scheduling products through the plant. The
problem is in which route provides the lowest cost.
• Option 1: Adding
overtime or Saturday
operations: 36Q
• Option 2: Second-shift
operation: $13,000 +
31.50Q
• Break-even volume:
36Q = $13,000 + 31.50Q
Q = 3,000 units

Economics
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Example 3.5 -Make or Buy
Many firms perform certain activities using their own resources, and pay outside firms to
perform certain other activities.
It is a good policy to constantly seek to improve the balance between these two types of
activities.
Example 3.5 - Make or Buy Decision
Variable cost
Direct materials $100,000 -$100,000
Direct labor 190,000 -190,000
Power and water 35,000 -35,000
Gas filter 340,000 340,000
Fixed costs
Heating light 20,000 20,000 0
Depreciation 100,000 100,000 0
Rental income -35,000 -35,000
Total cost $445,000 $425,000 -$20,000
Unit cost $22.25 $21.25 -$1.00
Make Option Buy Option Differential Cost

Economics
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Opportunity Costs
• Definition: The potential
benefit that is given up as
you seek an alternative
course of action
• Example: When you
decide to pursue a college
degree, your opportunity
cost would include the 4-
year’s potential earnings
foregone.

Economics
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Sunk Costs
• Definition: Cost that has
already been incurred by
past actions
• Economic Implications:
Not relevant to future
decisions
• Example: $200 spent to
replace water-pump last
year—not relevant in
making selling decision in
the future

Economics
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Marginal Analysis
• Principle: “Is it
worthwhile?”
• Decision rule: To
justify any course of
action,
Marginal revenue >
Marginal cost
Product A
Marginal Revenue $12/unit
Marginal Cost $8/unit
Profit margin $4/unit

Economics
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Marginal Costs (example 3.6)
• Definition: Added costs
that result from increasing
rates of outputs, usually
by single unit
• Example 3.6: Cost of
electricity—decreasing
marginal rate
• Compare it with
Differential cost
(Account’s) / Marginal
(Economist’s)

Economics
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Unit Marginal Contribution (MC)
• Definition: Difference between the
unit sales price and the unit variable
cost, also known as marginal income
or producer’s marginal contribution
(MC). This means each unit sold
contributes toward absorbing the
company’s fixed cost.
MC = U Sales price – U Variable
cost
• Application: Break-even volume
analysis:
Break -even volume =
Fixed costs
MC

Economics
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Example 3.7 Profit Maximization Problem
Branded Generic
Marginal Revenue $30/case $10/case
Marginal Cost $7/case $7/case
Profit margin $23/case $3/case
Sunday Operation
Marginal Revenue $10/case
Marginal Cost $12/case
Profit margin ($2) /case (loss)

Economics
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Summary
• General Cost Terms used in manufacturing:
– Manufacturing costs
• Direct materials
• Direct labor
• Manufacturing overhead
– Nonmanufacturing costs
• Administrative expenses
• Marketing
• Nonmanufacturing overhead

Economics
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• Classifying Costs for Financial Statements:
– Period costs
– Product costs
• Cost Classification for Predicating Cost
Behaviors:
– Fixed costs
– Variable costs
– Mixed costs

Economics
38
• Cost Concepts Relevant to Decision-Making
– Differential cost and revenue
– Opportunity costs
– Sunk costs
– Marginal costs
• Thinking on the Margin: Fundamental Economic
Decision-Making:
– The basic question to any economic decision: Is it
worthwhile?
– Marginal revenues must exceed marginal costs.

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