Cost classification for predicting cost behavior Cost behavior refers to how a cost reacts to changes in the level of activity. The most common classification are : .variable costs .Fixed costs .mixed costs Variable Cost : A cost that varies, in total, in direct proportion to changes in the level of activity.(cost structure) Variable Cost Per Unit is constant. the activity Base (Cost Driver) :A measure of what causes the incurrence of a variable cost, for example (units produced/kilometer driven/machine hours/labor hours/units sold). Fixed Cost : A cost that remains constant, in total, regardless of changes in the level of activity, not affected by changes in activity. Fixed Cost Per Unit: if expressed on a per units basis, the average fixed cost per units varies inversely with changes in activity. the average fixed cost decrease as more units made. There are two types of fixed costs for planning purpose (decision making): Committed (multiyear planning) Long-term, cannot be reduced in the sort term. Depreciation Discretionary (managed fixed costs) May be altered in the short term by current managerial decisions. Adverting and Research and development The linearity Assumption and the Relevant Range Relevant range is the range of activity within which the assumption that cost behavior is strictly linear is reasonably valid. Fixed cost & relevant range : relevant range good to understanding fixed cost Cost In total Per unit Variable Increase & decrease in proportion to changes in activity level constant Fixed Not affected by changes in the activity level within the relevant range Decrease when activity level arise increase when activity level falls Mixed costs : contains both variable and fixed cost elements. The total mixed cost line can be expressed as an equation : Y = a + bX Where : Y=the total mixed cost. a=the total fixed coast b=the variable coat per units of activity X=the level of activity The Analysis of Mixed Costs Account analysis : an account is classified as either variable of fixed based on the analyst's knowledge of how the account behaves. Engineering approach: classifies costs based upon industrial engineers evaluation of production methods, and material ,labor, and overhead requirement. 1-Diagnosing Cost behavior with a scatter graph plot month activity january 5600 february 7100 march 5000 april 6500 may 7300 june 8000 july 6200 cost 7900 8500 7400 8200 9100 9800 7800 12000 10000 8000 6000 4000 2000 0 0 1000 2000 3000 4000 5000 6000 7000 8000 9000 2-The High-low method month january february march april may june july activity 5600 7100 5000 6500 7300 8000 6200 cost 7900 8500 7400 8200 9100 9800 7800 High activity level (June)… 8000 $ 9800 Low activity level (march)……. 5000 $ 7400 Change …………………………….. 3000 2400 Variable cost = slope of the line = y2-y1 = change in cost = $2400 x2-x1 change in activity = $ 0.80 per day 3000 Total cost = Fixed cost + variable cost Total cost - variable cost = Fixed cost 9800- ($0.80* 8000) = 3400$ ………………….. (Y= $3400 + $.080X) 3-The least-square Regression Method : the goal is to fit a straight line to the data that minimize the errors Traditional & Contribution Format Income Statements The Traditional Format Income statement prepared primarily for external reporting purposes. Traditional format (GAAP) Sales(revenue) 12,000 cost of goods sold* 6,000 Gross margin 6,000 Selling and administration expenses Selling 3,100 Administrative 1,900 5000 Net operating income 1,000 contribution format sales variable expenses: cost of goods sold variable selling variable administrative contribution margin fixed expenses: fixed selling fixed administrative Net operating income Cost of goods sold =( b. inventory + purchase ) – ending inventory Available for sale Sales-variable expenses = Contribution margin 12,000 6,000 600 400 2,500 1,500 7,000 5,000 4,000 1,000 Cost classifications for assigning costs to cost objects A cost object is any thing for which cost data are desired (any thing you try to figure out accost for) that could be anything products(car/computer), customers, jobs Direct costs . Costs that can be easily and conveniently traced to a unit of product or other cost object. .Example: DM&DL Indirect costs . Costs that cannot be easily and conveniently traced to aspecific unit of product or other cost object.مشتركة مع منتجات أخرى . Example : manufacturing overhead Common costs Indirect costs incurred to support a number of cost objects. Theses costs cannot be traced to any individual cost object. cost classification for decision making : - Every decision involves a choice between at least two alternatives. - Only those costs and benefits that differ between alternatives are relevant in a decision. All others should be ignored. Differential Cost and Revenue Differential cost : a difference in costs between any two alternatives. -Incremental cost :increase cost. (between alternatives) -Decremental cost : decrease cost. (between alternatives) Differential revenue : a difference in revenue between any two alternatives. - The revenue can be obtained from selling on more unit of product (is called marginal cost. Opportunity Cost - The potential benefit that is given up when one alternative is selected over another. - These costs are not usually entered into the accounting records of an organization. But must be explicitly considered in all decision. Sunk cost Sunk cost have already been incurred and cannot be changed now or in the future. These costs should be always be ignored when making decision. Purpose of cost classification Preparing external financial statements cost classification .product costs (inventoriable) .direct material .direct labor .manufacturing overhand .period costs(expensed) .nonmanufacturing costs . Selling costs . Administrative costs Predicting cost behavior in . Variable cost (proportional to activity) response to changes in activity . Fixed cost (constant in total) .mixed cost(has variable & fixed cost) Assigning costs to cost objects . Direct cost (can be easily traced) (e.g. department or product) .Indirect cost (cannot be easily traced) Making decision .differential cost (differs between alternatives) .sunk cost (past cost not affected by a decision) . Opportunity cost (forgone benefit)