o Sunk Cost are costs that were incurred in the past. Sunk costs are never relevant for decision making.

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1 Chapter 2 : Function Q1: What are the different ways to Describe ( Classify ) s? s can be described ( Classified ) by several ways depending on the purpose of Classification. The main purposes are: 1- Making Decisions. 2- Assigning s to cost Object. 3- Estimating future costs when activity changes. Making Decisions. - In Chapter 1 we learned the distinction between relevant and irrelevant cash flows. - In addition there are some other concepts we can use in making decisions such as: o Opportunity cost are the benefits of an alternative one gives up when that alternative is not chosen. Opportunity costs are difficult to measure because they are associated with something that did not occur. Opportunity costs are always relevant in decision making. o Sunk are costs that were incurred in the past. Sunk costs are never relevant for decision making. o Discretionary costs are periodic costs incurred for activities that management may or may not determine. (Advertising) These costs may be variable or fixed costs. Discretionary costs are relevant for decision making only if they vary across the alternatives under consideration. o Marginal cost is the incremental cost of producing the next unit. marginal cost is the same as variable cost per unit. Marginal costs are often relevant in decision making.

2 Chapter 2 : Function Assigning cost to cost object. - assignment is defined as Determining the costs that should attached to a cost object. - Object is defined as anything or activity for which we measure costs Estimating Future s. Example: Lari s Leather produces customized motorcycle jackets. The leather for one jacket costs $50, and Lari rents a shop for $450/month. Compute the total costs per month and the average cost per jacket if she makes: - One jacket per month - 10 jackets per month Leather Rent 1 Jacket 10 Jacket Leather Rent

3 Chapter 2 : Function 1 Jacket 10 Jacket Leather Leather Rent Rent The Function: = Fixed + ( Variable per unit Quantity ) TC = TFC + ( VC/U Q ) What is the total when 90 Jacket are produces? TC = TFC + ( VC/U Q ) TC = ( $ 50 90) = $4950 Very important Notes: To estimate costs in the future or when the level of activity changes we have to classify costs into Fixed and Variable Fixed s. are costs that do not change (in total) as activity levels change. Variable s. are costs that increase (in total) in proportion to the increase in activity levels. A third type of costs actually exist in practice which is Mixed Mixed. A cost that includes a fixed cost element and a variable cost element Managers uses a variety of methods to segregate the Variable component and the fixed component of the mixed costs. 1. Plots 2. Analysis at the Account Level 3. Engineered Estimate of 4. High-Low Method 5. Regression Analysis: Simple Regression Multiple Regression

4 Chapter 2 : Function 1- Plots (Scatter Plots) Example: The following data are from one of Magik Bicycles manufacturing plants. They include weekly costs for packing bikes, together with a possible cost driver, the number of bikes shipped. 2- High-Low Method

5 Direct Materials Chapter 2 : Function Solution A. Direct labor appears to be a fixed cost; therefore, the cost function is TC = $95,000. B. There are no apparent outliers; all of the observations appear to be close to or on the same slope line: $140,000 $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 Scatter Plot $0 0 1,000 2,000 3,000 4,000 5,000 6,000 Units Produced C. Using the high-low method: (125,000 75,000)/(5,000 3,000) = 50,000/2,000 = $25 per unit TC = F + VQ, so $125,000 = F + ($25 5,000) V Q = $125,000, so F = 0; Direct materials are a variable cost. The cost function is: TC = $0 + $25 Units Produced