Lecture 3 Relevant Cost Concepts and Terminology Cost Behavior Car Pooling

Terminology Sunk Costs: Costs that have already been incurred. Sunk costs are irrelevant for all decisions, because they cannot be changed.

Terminology Opportunity Costs: The profit foregone by selecting one alternative instead of another; the net return that could be realized if a resource were put to its best alternative use.

Terminology Relevant Costs: Also sometimes called Differential Costs or Incremental Costs A differential cost for a particular decision is one that changes if an alternative decision is chosen.

When are Costs and Revenues Relevant? Answer: The relevant costs and revenues are those which, as between the alternatives being considered, are expected to be different in the future.

Lecture 3 Relevant Cost Concepts and Terminology Cost Behavior Car Pooling

Classification of Costs All Costs of doing business television commercials thread Warranty expense Legal dept Sewing operator wages fabric Costs to ship product from factory to warehouse Sales commissions Design dept. factory electricity factory manager’s salary depreciation on factory building

Two ways to classify costs Direct and Indirect Costs Fixed and Variable Costs

Classification of Costs Total Costs Direct costs Indirect costs (a.k.a. overhead)

Direct versus Indirect Costs Defined in terms of a particular activity, such as a product, product line, or factory. Direct costs can be traced to the activity in an economically feasible way. Indirect costs cannot be traced to the cost object. Indirect costs are sometimes allocated to the cost object.

Direct versus Indirect Costs EXAMPLE: LEVI STRAUSS FACTORY Are the following costs direct or indirect? Fabric Plant Manager’s Salary Thread Sewing Operator’s Labor Plant Utilities

Classification of Costs Total Costs Direct costs Fabric sewing operator wages Indirect costs (a.k.a. overhead) Plant utilities, thread, Plant manager’s salary

Two ways to classify costs Direct and Indirect Costs Fixed and Variable Costs

Fixed Costs vs. Variable Costs Variable costs change in direct proportion to changes in volume of activity (e.g., production). Fixed costs remain the same in total, as volume changes.

Fixed Costs vs. Variable Costs Linear relationship is assumed. Relevant range and time-span must be identified. Many costs are semi- variable or mixed. $ units $ units

Fixed Costs vs. Variable Costs EXAMPLE: LEVI STRAUSS FACTORY Are the following costs fixed or variable? - Fabric - Assistant Manager’s Salary - Electricity - Sewing Operator Labor - Repairs & Maintenance - Rent on building

Classification of Costs Total Costs Direct costs variable fixed Indirect costs (a.k.a. overhead) variable fixed

Combinations of Variable & Fixed, Direct & Indirect Fixed Variable Yes Not very often Direct Indirect Yes Yes

Classification of Costs Total Costs Direct costs variable fixed Fabric, Sewing Wages Indirect costs (a.k.a. overhead) variable fixed Electricity, Repairs Rent, Salaries

Lecture 3 Relevant Cost Concepts and Terminology Cost Behavior Car Pooling

Carpooling Example Chestnut Ridge - N.Y.C.: 60 mi. r.t. Tenafly, NJ - N.Y.C.: 30 mi. r.t. 150 commutes per year Gas: $2 per gallon; 20 miles per gal Total miles driven per year: 18,000

Carpooling Direct Costs: Gasoline: 60 miles round trip x 150 days/yr  20 miles/gal = 450 gallons x $2.00 = $900 per year Parking: = $100 per mo. Speeding Tickets: driver pays

Carpooling Overhead Costs: Allocation base: might be miles driven. Insurance: $1,200 per year Repairs & Maintenance: $800 per year Depreciation Expense: $0 Allocation base: might be miles driven. 9,000 miles driven on the commute (60 mi. r.t. x 150 days) 18,000 miles driven in total, each year

Carpooling Overhead Costs: Allocation rate for insurance: Insurance: $1,200 per year Repairs & Maintenance: $800 per year Depreciation Expense: $0 Allocation rate for insurance: Overhead costs  total miles driven = $1,200  18,000 = $0.067 per mile Applying overhead insurance costs to the commute: $0.067 per mile x 9,000 miles = $600.

COMMUTE COSTS Gas Bridge Toll Parking Insurance Maintenance Traffic Tickets Opportunity Costs Variable, Indirect Variable, Direct Fixed, Direct Fixed, Indirect Mixed, Indirect

ALLOCATE GAS COSTS Total Annual Gas Expense Total Annual Miles Driven = Gasoline Cost per mile This is the “overhead rate” for applying gas expense to my commute. Multiply this rate/mile by the 4,500 shared miles of the commute to derive the “shared gas expense.”