Classification of Costs Lecture No 27 Chapter Contemporary Engineering Economics Copyright © 2016 Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Chapter Opening Story: What Does It Cost to Make an iPhone? Apple’s 16GB iPhone is priced at $649 Do you know the profit margin for Apple from selling an iPhone 6? At Issue: The 16GB iPhone costs Apple about $200 to build How does Apple come up with such an estimate of various component costs before pricing their product? Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved General Cost Terms in Manufacturing Setting Manufacturing Costs Direct Raw Materials Direct Labor Manufacturing Overhead Nonmanufacturing Costs Overhead Marketing Administrative Functions Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Components of Manufacturing Cost Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Classifying Costs for the Financial Statements • Matching concept: 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 matched against revenues on a time period basis • Product costs: Those costs that are matched against revenues on a product basis Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example • Period costs • General and administrative expenses • Marketing expenses • Insurance premiums • Income taxes • Nonmanufacturing costs • Product costs • Direct material costs • Direct labor costs • Manufacturing overhead Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved How the Period Costs and Product Costs Flow Through the Financial Statements Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Cost Flows and Classifications of a Manufacturing Company Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 8.1: Classifying Costs for Uptown Ice Cream Shop • Given: Breakdown of unit cost items • Find: Classify the cost items to product costs and period costs Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Solution • Breakdown of unit cost items • Product costs • Period costs Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Cost Classification for Predicting Cost Behaviors Volume index Cost behaviors o o o Fixed costs Variable costs Mixed costs Average unit costs Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Volume Index • Definition: The unit measure used to define “volume” • Examples • Automobile • Miles driven • Generating plant • kWh produced • Stamping machine • “Parts” stamped • Assembly plant • Units assembled Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Fixed Costs • Definition: The costs of providing a company’s basic operating capacity • Cost behavior: Remains constant over the relevant range Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Variable Costs • Definition: Costs that vary depending on the level of production or sales • Cost behavior: Increases or decreases proportionally according to the level of volume Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Mixed Costs Contemporary Engineering Economics, th edition Park Mixed cost behavior Depreciation Expenses ($) • Definition: Costs are fixed for a set level of production or consumption, becoming variable after the level is exceeded • Cost behavior: Increases or decreases after maintaining a fixed level of expense 6000 5000 4000 3000 2000 1000 15 25 Miles Driven (Unit: 1,000) Copyright © 2016 by Pearson Education, Inc All Rights Reserved Average Unit Cost • Definition: activity cost per unit basis • Cost behaviors: • Fixed cost per unit varies with changes in volume • Variable cost per unit of volume is a constant • Mixed cost per unit of volume contains both the constant and variable elements Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 8.2: Average Driving Cost per Mile • Given: Owning and Operating a 4WD SportUtility vehicle • Find: Average driving cost per mile as a function of mileage Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Solution Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Cost-Volume Chart Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Average Cost Per Mile Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Future Costs for Business Decisions •Differential (incremental) cost •Opportunity cost •Sunk cost •Marginal cost Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Differential (Incremental) Costs • Definition: Costs that represent the difference in total costs, which results from selecting one alternative instead of another • Cost behavior: Increases or decreases with the overall change that a company experiences by producing one additional unit of goods Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved 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 four-years’ potential earnings given up Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Sunk Costs • Definition: Cost that has already been incurred by past actions • Economic implications: Not relevant to future decisions • Example: $500 spent to replace brakes last year—not relevant to making a sales decision in the future Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Marginal Costs • Definition: Added costs that result from increasing rates of output, usually by a single unit • Example: Cost of electricity —decreasing marginal rate Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved ... Period costs • General and administrative expenses • Marketing expenses • Insurance premiums • Income taxes • Nonmanufacturing costs • Product costs • Direct material costs • Direct labor costs. .. know the profit margin for Apple from selling an iPhone 6? At Issue: The 16GB iPhone costs Apple about $200 to build How does Apple come up with such an estimate of various component costs before... Breakdown of unit cost items • Product costs • Period costs Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Cost Classification