The Cost Function

March 14, 2019

Golden Papers

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* A cost object is a thing or activity for which we measure costs. Cost objects include such things as individual products, product lines, projects, customers, departments, and even the entire company. * Direct cost: a cost that can be directly traced to a cost object and is incurred for the benefit of a particular cost object * Indirect cost: a cost that is incurred for the benefit of more than one cost object and therefore cannot be easily and economically traced to a particular cost object * Prime costs: direct materials and direct labour

Conversion costs: direct labour and manufacturing overhead Classifications| Applications| Cost Terms| Relevance| Decision-making| Relevant cost vs. irrelevant cost| Behaviour| Costs estimation| Fixed cost vs. variable cost| Traceability| Costs assignment| Direct cost vs. indirect cost| Function| Cost determination| Manufacturing cost vs. non-manufacturing cost| Controllability| Performance evaluation| Controllable cost vs. ncontrollable cost| * Traceability: the ability to trace in an economically feasible way by means of a cause and effect relationship * Tracing: is the actual assignment of costs to a cost object using an observable measure of the resources consuming the cost object

* Direct tracing: is the process of identifying and assigning costs that are specifically or physically associated with a cost object to that cost object. Costs that are physically associated with a product (Direct costs) are the easiest to trace, since we can visually observe and measure the relationship * Driver Tracing: is the use of drivers to assign costs to cost objects. This is less exact than direct tracing * Drivers: are observable casual factors that measure a cost object’s resource consumption * Cost allocation – costs that cannot be easily traced (i. e. some indirect costs) are “allocated”. This is the least accurate method of attaching a cost to a cost object.

Ex. Rent might be allocated on the basis of space, sales ollars, or number of products * Relevant costs: costs that differentiate between two alternatives * Irrelevant costs: will not make a difference to either alternative and has no bearing on decision making * Fixed costs: behaves such that the total cost will not change within the relevant range * Variable costs: varies in proportion to the production level * Product cost (manufacturing cost): costs that are easily traced to a product * Period cost (non-manufacturing cost): costs that cannot be assigned to products * Controllable costs: managers have the authority to cut and manage costs * Uncontrollable costs: managers do not have the authority to cut or manage these costs

* Relevant Range: is a span of activity for a given cost object, where total fixed costs remain constant and variable costs per unit of activity remain constant * Marginal cost: is the incremental cost of an activity, such as producing a unit of goods or services. Marginal cost is often relevant for decision-making * Sunk costs: are expenditures made in the past. When deciding whether to keep already existing equipment, the original cost of the equipment is not a factor; it is a sunk cost.

Because sunk costs cannot be changed by any future decisions, these costs are unavoidable and therefore not relevant to decision-making * Cost behaviour: is the variation in costs relative to the variation in an organization’s activities * Useful for decision making such as production, merchandise sales, and services * Mixed costs: costs that are partly fixed and partly variable * Cost function: is an algebraic representation of the total cost of a cost object over a relevant range of activity TC = F + VQ

* Stepwise linear costs: fixed at one level for one range of activity and fixed at another level for another range of activity * Piecewise linear costs: some variable costs per unit are constant at one level for one range of activity and constant at another level for another range of activity * Discretionary costs: periodic costs incurred for activities that management may or may not determine are worthwhile * Examples include advertising, research and development, etc. * May be variable or fixed costs * Relevant for decision making only if they vary across the alternatives under consideration * Past costs are often used to estimate future, non-discretionary, costs. In these instances, one must also onsider:

* Whether the past costs are relevant to the decision at hand * Whether the future cost behaviour is likely to mimic the past cost behaviour * Whether the past fixed and variable cost estimates are likely to hold in the future * Two-Point Method: use the information contained in two past observations of cost and activity to separate mixed and variable costs * It is much easier and less costly to use than account analysis or engineered estimates of cost, but: * It estimates only mixed cost functions * It is not very accurate * It can grossly misrepresent costs if the data points come from different relevant ranges of activity * High-Low Method: is a two point method

The two data points used to estimate costs are observations with the highest and the lowest activity levels * The extreme points for activity levels may not be representative of costs in the relevant range * This method may underestimate total fixed costs and overestimate variable costs per unit or vise versa * Scatter plot: shows cost observations plotted against levels of a possible cost driver * A scatter plot can assist in determining * Which cost driver might be the best for analyzing total costs

* The cost behaviour of the cost against the potential cost driver * Regression Analysis: is a statistical technique that measures the average change in a dependent variable (e. g. cost) for every unit change in one or more independent variables (e. g. ost drivers) * When there is only one independent variable, it is called a simple regression * When there is more than one independent variable, it is called multiple regression * Adjusted R-square: statistic shows the percentage of variation in the Y variable that is explained by the regression equation – shows goodness of fit

* Uses and Limitations: the future is always unknown, so there are uncertainties when estimating future costs: * Information quality: is the accounting system able to directly trace costs to individual cost objects? * Average costs: avoid use of financial statement costs for decision-making. Use of average costs will result in either underestimation or overestimation of future costs * Quality of estimation techniques: there are advantages and disadvantages of each cost behaviour analysis approach introduced * Reliance on cost estimates: quality of information affects the alternatives that managers may consider and the weight they place on various pieces of information