04 134 CO5 pp3 Costs and Decision Making Chapter 5 Cost Behavior and Relevant Costs Chapter 6 Cost Volume Profit Analysis and Variable Costing Chapter 7 Short Term Tactical Decision Making Chapter 8 L[.]
139 Part Costs and Decision Making Chapter Cost Behavior and Relevant Costs Chapter Cost-Volume-Profit Analysis and Variable Costing Chapter Short-Term Tactical Decision Making Chapter Long-Term (Capital Investment) Decisions 140 Chapter Cost Behavior and Relevant Costs Chapter U 141 Cost Behavior and Relevant Costs nderstanding the behavior of costs is of vital importance to managers Understanding how costs behave, whether costs are relevant to specific decisions, and how costs are affected by income taxes allows managers to determine the impact of changing costs and other factors on a variety of decisions This chapter introduces concepts and tools that will be used in Chapters through Chapter begins with a definition of cost behavior and illustrates the concepts of fixed costs, variable costs, and mixed costs Next, the chapter revisits the concept of relevant costs (introduced in Chapter 1) as it applies to variable and fixed costs The chapter also describes the impact of income taxes on costs Learning Objectives After studying the material in this chapter, you should be able to: Describe the nature and behavior of fixed, variable, and mixed costs Analyze mixed costs using regression analysis and the high/low method Distinguish between relevant and irrelevant costs and apply the concept to decision making Illustrate the impact of income taxes on costs and decision making 142 Part Costs and Decision Making Introduction KEY CONCEPT Costs behave in predictable ways In Part I, we defined and determined the cost of a product or a service We now focus our attention on the nature of those costs and how they are used in decision making As production volume changes, some costs may increase or decrease and other costs may remain stable, but specific costs behave in predictable ways as volume changes This concept of predictable cost behavior based on volume is very important to the effective use of accounting information for managerial decision making The Behavior of Fixed and Variable Costs Objective Describe the nature and behavior of fixed, variable, and mixed costs Fixed costs are costs that remain the same in total but vary per unit when production volume changes Facility-level costs, such as rent, depreciation of a factory building, the salary of a plant manager, insurance, and property taxes, are likely to be fixed costs Summarizing this cost behavior, fixed costs stay the same in total but vary when expressed on a per unit basis Rent is a good example If the cost to rent a factory building is $10,000 per year and 5,000 units of product are produced, the rent per unit is $2.00 ($10,000/5,000) If production volume decreases to 2,500 units per year, the cost per unit will increase to $4.00 ($10,000/2,500) If production volume increases to 7,500 units, the cost per unit decreases to $1.33 ($10,000/7,500) per unit However, the total rent remains $10,000 per year (see Exhibit 5-1) On the other hand, variable costs vary in direct proportion to changes in production volume but are constant when expressed as per unit amounts As production increases, E XHIBIT 5-1 The Behavior of Fixed Costs $ $ $10,000 $4.00 $2.00 $1.33 2,500 5,000 7,500 Volume Fixed Cost in Total 2,500 5,000 7,500 Volume Fixed Cost per Unit variable costs increase in direct proportion to the change in volume; as production decreases, variable costs decrease in direct proportion to the change in volume Examples include direct material, direct labor (if paid per unit of output), and other unit-level costs, such as factory supplies, energy costs to run factory machinery, and so on Consider the behavior of direct material costs as production increases and decreases If the manufacture of a standard classroom desk requires $20 of direct material (wood, hardware, etc.), the total direct material costs incurred will increase or decrease proportionately with increases and decreases in production volume If 5,000 desks are produced, the total direct material cost will be $100,000 (5,000 $20) If production volume is increased to 7,500 units (a 50 percent increase), direct material costs will also increase 50 percent to $150,000 (7,500 $20) However the cost per unit is still $20 Likewise, if production volume is decreased to 2,500 desks, direct material costs will decrease by 50 percent to $50,000 But once again, the cost per unit remains $20 (see Exhibit 5-2) Although direct labor is often treated as a variable cost, in reality it may behave more like a fixed cost in many companies Companies may be reluctant to lay off highly skilled workers for a short period of time, and labor unions are increasingly successful in negotiating long-term contracts for their members, making it difficult to adjust workforce size as sales Chapter E XHIBIT 5-2 Cost Behavior and Relevant Costs The Behavior of Variable Costs $ $ $150,000 $100,000 $20.00 $50,000 2,500 5,000 7,500 Volume Variable Cost in Total 2,500 5,000 7,500 Volume Variable Cost per Unit (and production) increase or decrease For example, companies may agree to employment contracts that guarantee workers a minimum number of hours each week This contract means that even if an employee is not working, direct labor costs are still incurred On the other hand, if employees are paid only for the actual work hours and not guaranteed a minimum salary, the cost would be considered a variable cost In addition, a trend in manufacturing is to automate, or to replace direct factory labor with robotics and other automated machinery and equipment This trend has the effect of increasing fixed costs (depreciation) and decreasing variable costs (direct labor) Although there are many advantages to automation, the impact of automation on the employee work force and on day-to-day decisions made by managers must not be ignored The impact of cost behavior on decision making is discussed in more detail in Chapter THE ETHICS OF B US I NE S S They’re Seeing Red in Dearborn F ord Motor Company is the second largest automobile manufacturer in the world with annual revenues of more than $160 billion To put that number in perspective, think of this: Ford generated $18.3 million in revenue each hour of the day in 2003! You might think that such a large company would have plenty of profits Ford did earn $759 million in 2003, but those profits were not earned equally by all of the company’s divisions In fact, in spite of its revenue of some $19 billion, Ford of Europe has not turned a profit in the last three years The company has slashed costs by reengineering its facilities to reflect capacity consistent with reduced demand for its cars and trucks and cut its workforce by 10 percent in Germany, Britain, and Belgium The company insists that these actions will benefit the company in the long run and will return the division to profitability It’s Your Choice—Like many companies, Ford cut its workforce to reduce costs and increase profits Few days pass without another story of a merger of mega-companies and the requisite employee layoffs due to the inevitable “duplicate positions.” What ethical obligations companies such as Ford have to displaced workers? Do you think such mass layoffs are simply part of the world in which we now live? Why should companies be so concerned with profits? Is Ford Motor Company an end in and of itself, or is the company merely the means by which employees make their living? And, is that enough? 143 144 Part I T P AYS D TO Costs and Decision Making C O UNT Y O UR B E A N S ue to the higher costs of fertilizer and chemicals, the costs of and less reliance on machinery and equipment variable costs of growing soybeans in Brazil are 68 While Brazil’s soybean production now rivals that of the percent higher than the variable costs of growing soy- United States, much of the cost savings enjoyed by Brazil’s beans in the U.S heartland However, the fixed costs in soybean farmers is offset by the additional transportation Brazil are 90 percent lower than in the United States, pri- and shipping costs incurred due to poor roads and the in- marily as a result of lower costs of leasing land and lower creased distance from major markets in Europe and China Variable Costs per Acre of Soybeans U.S Heartland Brazil Seed $ 19.77 $ 11.23 8.22 44.95 Chemicals 27.31 39.97 Machinery 20.19 18.22 Labor 1.29 5.58 Other 1.81 12.11 $ 78.59 $132.06 Equipment depreciation $ 47.99 $ Land costs (lease costs) 87.96 5.84 6.97 55 Fertilizer Total variable costs Fixed Costs per Acre of Soybeans Taxes and insurance Farm overhead Total fixed costs 13.40 $156.32 Average yield per acre (in bushels) 8.97 — 0— $ 15.36 46 41.65 Variable costs per bushel $ 1.71 Fixed costs per bushel $ 3.40 $ 37 Total costs per bushel $ 5.11 $ 3.54 Source: “Who Feeds the World,” The News and Observer, April 11, 2004, Raleigh, NC, 19A $3.17 ... Heartland Brazil Seed $ 19 .77 $ 11 .23 8 .22 44. 95 Chemicals 27 . 31 39.97 Machinery 20 .19 18 .22 Labor 1 .29 5. 58 Other 1. 81 12 . 11 $ 78 .59 $1 32. 06 Equipment depreciation $ 47.99 $ Land costs (lease costs) ... and Relevant Costs The Behavior of Variable Costs $ $ $ 15 0,000 $10 0,000 $20 .00 $50 ,000 2, 50 0 5, 000 7 ,50 0 Volume Variable Cost in Total 2, 50 0 5, 000 7 ,50 0 Volume Variable Cost per Unit (and production)... 15 .36 46 41. 65 Variable costs per bushel $ 1. 71 Fixed costs per bushel $ 3.40 $ 37 Total costs per bushel $ 5 .11 $ 3 .54 Source: “Who Feeds the World,” The News and Observer, April 11 , 20 04, Raleigh,