Opportunity costs are

Using Costs in Decision Making
Cost Classification
 Costs can be classified by:
 Financial reporting: product VS period
 Traceability: direct VS indirect costs
 Behavior: variable/fixed /mixed/step
 Other terms: incremental costs, sunk
costs, opportunity costs, avoidable
costs etc
Cost Categories Used in Financial
Common Cost Behavior Patterns
Variable Costs: total costs changes in proportion to
changes in quantity or activity.
E.g. DM, DL, & sales commissions.
Fixed Costs: total costs do not change in response to
changes in quantity or activity.
E.g. depreciation by straight line method, rent, and insurance etc.
Mixed Costs: costs that have both variable and fixed
E.g. a salesperson’s salary where he receives a base salary (fixed) plus
commissions (variable).
Step Costs: fixed for a range of output, but increase when
upper bound of range is exceeded.
E.g. company adds second or third production shift, fixed costs related to
supervisory salary, heat, light etc are expected to increase.
 How does the cost of your cell phone
plan behavior?
$0.50 per minute
$10 monthly fee, $0.10 per minute
$60 per month unlimited minutes
$20 monthly fee up to 200 minutes;
$40 monthly fee if 201 to 500 minutes;
and $50 monthly fee if 501-1000
 Matching questions #1
Other Useful Cost Definitions
 Incremental Cost—the cost of the
next unit of production, sometimes
referred to as the Marginal Cost
 Sunk costs—these are costs that have
occurred and no current action or
decision can change them
Other Useful Cost Definitions
 Relevant Costs—a cost that will
change as a result of a decision
 Opportunity Costs—the maximum
value forgone when a course of
action is chosen
 Avoidable Costs—costs that can be
avoided by taking a specific course
of action
Summary of Cost Concepts
 Sunk costs are never incremental or relevant
i.e. Do not differ between alternatives
 Avoidable costs are always incremental and
 Opportunity costs are also incremental and
Which of the following is often not an
incremental cost?
a. Material
b. Labor
c. Variable overhead
d. Fixed overhead
Opportunity costs are:
Never incremental costs
Always incremental costs
Sometimes sunk costs
Never avoidable costs
Slide 7-11
Learning objective 2: Define sunk cost, avoidable cost, and
opportunity cost, and understand how to use these concepts in
Which of the following costs should not be
taken into consideration when making a
a. Opportunity costs
b. Sunk costs
c. Relevant costs
d. Differential costs
“What Does This Product Cost?”
Answer: Why do you want to know?
 No single cost number is relevant for
all decisions
 Must find incremental information
that is applicable to the decision
- Some costs will change due to the
decision, some will not
- Only costs that change are relevant
Cost-Volume-Profit Analysis
 The Profit Equation
Profit (NI) = SP(x) – VC(x) – TFC
x = Quantity of units produced and sold
SP = Selling price per unit
VC = Variable cost per unit
TFC = Total fixed cost
 Fundamental to CVP analysis
Cost-Volume-Profit Analysis
 Break-Even Point
• # of units sold that allow the company
cover its total costs, with a profit of zero.
• NI= SP(x) – VC(x) – TFC = 0
• Break Even Unit (x0)=TFC/(SP-VC)
• Break-Even Sales= SP*x0
• Units to realize target profit:
• Target Profit = SP(xt) – VC(xt) – TFC
• xt= (Target Profit + TFC)/(SP-VC)
• Target Sales= SP*xt
Gabby’s Wedding Cakes creates elaborate
wedding cakes. Each cake sells for $500.
The variable cost of baking the cakes is $200
and the fixed cost per month is $6,000
1. Calculate the break-even point in units
2. How many cakes must be sold to earn a profit
of $9,000?
At Winford Corp., the selling price per lawn
mower is $120, variable cost per lawn mower
is $55. Fixed costs are $130,000. Break-Even
Point in units is?
a. 1,000 units
b. 1,083 units
c. 2,000 units
d. None of these
Break-Even Point
 Matching questions #2
Contribution Margin
Difference between revenue and
variable costs
 Contribution margin (CM):
 CM=Sales-TVC = SP(x) – VC(x)
 Unit contribution margin (Unit CM):
 Unit CM= SP– VC
 CM=Unit CM * x
 Unit CM measures the amount of
incremental profit generated by selling an
additional unit
At Winford Corp., the selling price per
lawn mower is $120, variable cost per
lawn mower is $55. Fixed costs are
$130,000. Contribution Margin per unit is?
a. $65
b. $75
c. $175
d. $30
Contribution Margin Ratio
The contribution margin ratio measures
the amount of incremental profit
generated by an additional dollar of sales
 Two methods to calculate the
contribution margin ratio
1. Contribution margin divided by sales
revenue (Sales – TVC) / Sales
2. Unit contribution margin divided by
selling price (SP – VC) / SP
Rhetorix, Inc. produces stereo speakers. The
selling price per pair of speakers is $800.
The variable cost of production is $300 and
the fixed cost per month is $50,000.
1. Calculate the unit contribution margin
associated with a pair of speakers
2.Calculate the contribution margin ratio for
Rhetorix associated with a pair of speakers
Rhetorix, Inc. produces stereo speakers. The
selling price per pair of speakers is $800. The
variable cost of production is $300 and the fixed
cost per month is $50,000.
1. If the company sells five more speakers than
planned, what is the expected effect on profit
of selling the additional speakers?
2.If the company has sales that are $5,000
higher than expected, what is the expected
effect on profit?
Variations in CVP Analysis
 Pg 68-71
Profit in percent
Impact of income tax
what-if analysis
Multiproduct firm
Analysis of Decisions Faced
by Managers
Four types of decisions that managers
frequently face:
1.Make or buy (outsourcing)
2.Short-term product mix with
3.Drop a product or not (death spiral)
4.Costing order (the floor price)
Save 3&4 for later chapters
Make or Buy Decisions
 A Case
 Picture this: you are new at the job and you
are eager to succeed. You go out and buy (after
convincing your boss) a new machine for $1
million. It’s a highly specialized machine, built
especially for your firm, with no resale value.
 You plan to use this machine to produce a part
that is used in every product the firm makes.
 It will cost you, thanks to this new machine,
only $4 per unit in variable costs and $1 in
depreciation (fixed cost) to make the part.
Make or Buy Decisions
 Case continued
 Great!!...until a salesman from a very
reputable firm comes to your office and offers
to sell you the same part you are making, same
quality, reliable delivery, etc. for $4.50 a part.
Her company is willing to sign a long-term
contract so the price is firm.
 Questions:
 Should you accept her offer (i.e., buy the part)
or continue to make the part yourself?
 Would your decision change if the fixed costs
could be avoided by selling the machine at
Make or Buy Decisions
 Decision involves no incremental
revenues; Analysis concentrates solely
on incremental costs.
 How much cost can be saved?
Make or Buy Decisions
 Cost savings (avoidable cost)
 Not all fixed cost are irrelevant. If they are
avoidable, then they should be factored into
the decision just like variable costs;
 Labor costs, even for direct labor (variable)
costs, could be unavoidable if workers cannot
be laid off because existing labor contract.
 An opportunity cost (benefit forgone by
selecting one decision alternative over
another) must also be considered in decision
 Chaps Company pg79-80
 Anjlee’s Catering Services pg80-81
 Practice 3-40 pg102
Short –Term Product Mix
Decisions with Constraints
 Constraining factor
 Fred’s wood products pg87-89
 Harris Chemical pg89-93
 Group Case: Excel Solver
 3-67 pg114