Lecture 07

Lecture 06

• Inventory Flows• Product Costs• Cost Classifications for Predicting Cost

Behavior

Cost Classifications for Predicting Cost Behavior

How a cost will react to changes in the level of

business activity.– Total variable costs

change when activity changes.

– Total fixed costs remain unchanged when activity changes.

How a cost will react to changes in the level of

business activity.– Total variable costs

change when activity changes.

– Total fixed costs remain unchanged when activity changes.

Total Variable Cost

Your telephone bill is based on how many minutes you talk.

Minutes Talked

Tele

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ill

Variable Cost Per Unit

The cost per call is constant. For example, 1 Rupee per minute.

Minutes Talked

Per

Min

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Tele

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Total Fixed Cost Your monthly basic telephone bill probably does

not change when you make more local calls.

Number of Local Calls

Mon

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Bas

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Tele

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Fixed Cost Per UnitThe average cost per local call decreases as more

local calls are made.

Number of Local Calls

Mon

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Bas

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B

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Cost Classifications for Predicting Cost Behavior

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remainsas activity level changes. the same over wide ranges

of activity.

Fixed Total fixed cost remains Fixed cost per unit goesthe same even when the down as activity level goes up. activity level changes.

Direct Costs and Indirect Costs

Direct costs• Costs that can be

easily and conveniently traced to a unit of product or other cost objective.

• Examples: direct material and direct labor

Indirect costs• Costs cannot be easily and

conveniently traced to a unit of product or other cost object.

• Example: manufacturing overhead

Differential Costs and Revenues

Costs and revenues that differ among alternatives.

Example: You have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The Transportion cost to the city is $300 per month.

Differential revenue is: $2,000 – $1,500 = $500

Differential cost is: $300

MCQs Test

Suppose you are trying to decide whether to drive or take the train to Lahore to attend a Marriage Ceremony. You have ample cash to do either, but you don’t want to waste money needlessly. Is the cost of the pizza you ate last night relevant in this decision? In other words, should the cost of the pizza affect the decision of whether you drive or take the train to Lahore?A. Yes, the cost of the pizza is relevant.B. No, the cost of the pizza is not relevant.

Answer

Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you don’t want to waste money needlessly. Is the cost of the pizza you ate last night relevant in this decision? In other words, should the cost of the pizza affect the decision of whether you drive or take the train to Portland?A. Yes, the cost of the pizza is relevant.B. No, the cost of the pizza is not relevant.

Note

• Every decision involves a choice from among at least two alternatives.

• Only those costs and benefits that differ between alternatives (i.E., Differential costs and benefits) are relevant in a decision. All other costs and benefits can and should be ignored.

MCQs

Suppose you are trying to decide whether to drive or take the train to Lahore to attend a marriage ceremony. You have ample cash to do either, but you don’t want to waste money needlessly. Is the annual cost of licensing your car relevant in this decision?A. Yes, the licensing cost is relevant.B. No, the licensing cost is not relevant.

Answer

Suppose you are trying to decide whether to drive or take the train to Lahore to attend a concert. You have ample cash to do either, but you don’t want to waste money needlessly. Is the annual cost of licensing your car relevant in this decision?A. Yes, the licensing cost is relevant.B. No, the licensing cost is not relevant.

MCQs

Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you don’t want to waste money needlessly. Is the depreciation on your car relevant in this decision?A. Yes, the depreciation is relevant.B. No, the depreciation is not relevant.

Answer

Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you don’t want to waste money needlessly. Is the depreciation on your car relevant in this decision?A. Yes, the depreciation is relevant.B. No, the depreciation is not relevant.

Depreciation thatis a function of miles driven

would be relevant.

Depreciation that is a function of the passage of

time would not be relevant.

Opportunity Costs The potential benefit that is given up when one

alternative is selected over another.

Example: If you were not attending college,you could be earning $15,000 per year. Your opportunity cost of attending college for one year is $15,000.

Sunk Costs Sunk costs cannot be changed by any decision. They are

not differential costs and should be ignored when making decisions.

Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost.

MCQs Test

Suppose that your car could be sold now for $5,000. Is this a sunk cost?A. Yes, it is a sunk cost.B. No, it is not a sunk cost.

Answer

Suppose that your car could be sold now for $5,000. Is this a sunk cost?A. Yes, it is a sunk cost.B. No, it is not a sunk cost.

• Cost– Sacrifice made to achieve a particular purpose measured by the

resources given up.

• Product cost– A cost assigned to goods that were either purchased or manufactured

for resale purpose

• Cost of goods sold– In the period of sale, the product costs are recognized as an

expense called cost of goods sold

• Period cost– Costs are identified with the period of time in which they are incurred.

Manufacturing Costs– Direct Material

• Raw Material, can be traced out in finished products

– Direct Labor• Salaries, wages, fringe benefits for people directly

working on production

– Manufacturing Overheads• Indirect material

– Insignificant to trace i.e. Cost of drill bits, glue, nails,

• indirect labor – Deptt supervisors, security guards etc

• and other manufacturing overheads. – Depreciation of plant and machinery, property taxes,

insurance, electricity, gas etc.

Cost of Goods Manufactured• Direct Material

– Raw material inventory, 1st January 500– Add – Material Purchased

1000– Raw Material available for use 1500– Deduct- Raw-material inventory, dec 31 200– Raw Material used 1300

• Direct Labor 1000

• Prime Cost2300

Cost of Goods Manufactured

• Prime Cost 2300• Manufacturing overheads

– Indirect Material 200– Indirect Labor 200– Depreciation on factory 50– Depreciation on equipment 10– Utilities 20– Insurance 20– Total manufacturing overheads 500

Total manufacturing costs 2800

Cost of Goods Manufactured• Direct Material

– Raw material inventory, 1st January 500– Add – Material Purchased 1000– Raw Material available for use 1500– Deduct- Raw-material inventory, dec 31 200– Raw Material used 1300

• Direct Labor 1000• Manufacturing overheads

– Indirect Material 200– Indirect Labor 200– Depreciation on factory 50– Depreciation on equipment 10– Utilities 20– Insurance 20– Total manufacturing overheads 500– Total manufacturing costs 2800

Cost of Goods Manufactured (con`t)

• Total manufacturing costs 2800• Add work in process inventory, Jan 01 500• Sub total 3300• Deduct, work in process inventory, dec, 31 300• Cost of goods manufactured 3000

Cost of Goods Sold

• Finished Goods inventory Jan 01, 1000• Add cost of goods manufactured 3000• Cost of goods available for sale 4000

• Deduct finished goods inventory Dec 31 500• Cost of Goods Sold 3500

Manufacturing Cost Flows

Direct Material

Direct Labor

Manufacturing Overheads

Work in Process Finished Goods inventory

Cost of Goods Sold

Journal Entries

Journal Entries

Income Statement• Sales Revenue 10000• Less Cost of Goods Sold 3500• Gross profit 6500• Operating Cost:

– Selling General Administration Expenses 100– Research and Development Expenses 50– Interest Expenses of financial assets 50– Other operating expenses 20

• Total Operating cost 220• Operating profit 6280• Less other interest expenses 40• Add other interest income 30• Profit before taxes 6270• Provision for income tax 70• Net Income 6200

Income Statement• Sales Revenue 1000• Less Cost of Goods Sold 500• Gross profit 500• Operating Cost:• Selling General Administration Expenses 100• Operating profit 400• Less other interest expenses 40• Profit before taxes 360• Provision for income tax 70• Less Minority interest 10• Net Income 280

Income Statement• Interest Income 1000• Interest Expenses 500• Net Interest Income 500

– Fees and Commission Income 500– Fees and Commission Expenses 200– Net Trading Income 50– Other operating income 50

• Total Non Interest Income 400• Operating Income 900

– Staff Cost 400– Premises Cost 100– General Administrative Expenses 50– Depreciation and amortization 50

• Operating Expenses 600• Operating profit before impairment losses and taxation 300

– impairment losses and taxation 50

• Profit before taxation 250– Taxation 50

• Profit for the year 200

Lecture 07

• Variable Cost• Fixed Cost• Cost Classifications for Predicting Cost Behavior• Direct Costs and Indirect Costs• Cost Concepts• Cost, Product Cost, Period Cost• Components of Manufacturing Products• Cost of Good Manufactured• Cost of Goods Sold• Income Statements

End of Lecture 07