Lecture 2

Identifying and estimating

costs and benefits

What Do We Mean By a
Cost?
A Cost
is the measure of
resources given
up to achieve a
particular purpose.

Cost Drivers
Any
Anyoutput
outputmeasure
measure(for
(foractivities)
activities)that
thatcauses
causes
the
theuse
useof
ofcostly
costlyresources
resources
isisaacost
costdriver.
driver.

What to measure?
Controllable costs and benefits
Measured relative to status quo

Relevant costs and benefits

These are costs and benefits that
change across decision alternatives.

Sunk Costs
All costs incurred in the past that cannot be changed by
any decision made now or in the future.
Sunk costs should not be considered in decisions. They
are neither relevant nor controllable.
Example: You bought an automobile that cost $12,000
two years ago. The $12,000 cost is sunk because
whether you drive it, park it, trade it, or sell it, you cannot
change the $12,000 cost.

Time and Cost

Controllability
Control over costs and benefits increases with
passage of time
Commitments and contracts expire

Ability to change capacity resources varies

over time
Cannot change capacity level in the short-term
Can change capacity level in long-term

Because all decisions measure controllable

costs and benefits we can classify decisions
as to whether they are short term or long
term decisions

Cost estimation
The relationship between cost and activity
is cost behavior.
The process of determining cost behavior
is called cost estimation.
Finally, using the knowledge of cost
behavior to forecast the level of cost at a
particular level of activity is called cost
prediction.
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Steps in Estimating Costs

Cost
behavior
Build model of
expected relationship
between cost and
activity

Cost
estimation
Use historical data to
test model and to
determine parameters

Cost
prediction
Use estimated
parameters to forecast
costs at a particular
activity level.

Cost characteristics:
variability
Variability : What is the relation between a
cost and an activity?
Some costs change in the same proportion as
activities change variable costs
Some costs do not change as activities change
fixed costs
Some costs have both fixed and variable
components mixed costs or semi-variable costs
Some costs are called step costs they remain
fixed for a short interval of activity and change to
a new level for large change in activity.
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Total Variable Cost Example

Total cost of gasoline

per month

The cost of gasoline for your car is an

example of variable cost

Number of miles driven

per month

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The cost of
gasoline per
mile driven is
constant.

Per mile gasoline cost

Variable Cost Per unit

Number of miles driven per

11
month

Total Fixed Cost Example

Monthly Lease
payment

Your monthly lease payment does not

change with respect to miles driven.

Number of miles driven

per month

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Fixed Cost Per Unit Example

Per mile lease payment

The lease cost per mile driven decreases as

more miles are driven.

Number of miles
driven13per month

Step Costs
Rent Cost in
Thousands of Dollars

90

60

30
00

Total cost doesnt

change for a range
of activity, and then
jumps to a new
higher cost for the
next higher range of
activity.
1
2
Sales revenue (million $)
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Cost objective
A cost objective is something for which we
desire a separate measurement of costs. It
can be a product or department or a process
or a decision option or anything for which a
separate measurement of cost makes sense.
Direct costs can be identified specifically
and exclusively with a cost object in a
economically feasible manner.
If a cost is not direct cost, then it is an
indirect cost.
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Cost characteristics:
Traceability
Traceability: Degree to which we can
directly relate a cost to a decision
option. A decision option can be
anything for which we desire a
separate measurement of cost.
If the cost is uniquely related to a
decision option, then it is direct cost.
If only a portion of cost is related to a
decision option, then it is an indirect
cost.
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Hierarchical cost structure

Unit-level costs
Batch-level costs
Product-level costs
Facility-level costs

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