The microeconomic foundations of management accounting

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ACTG 321Agenda for Lecture 2

• The microeconomic foundations of management
  accounting
  
• Break
• Cost classifications and cost behavior

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The microeconomic foundations of management
accounting

Sunk Costs Costs that have already been incurred
. Sunk costs are irrelevant for all decisions,
because they cannot be changed.
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The microeconomic foundations of management
accounting

Opportunity Costs The profit foregone by selecti
ng one alternative instead of another the net
return that could be realized if a resource were
put to its best alternative use.
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The microeconomic foundations of management
accounting

Relevant Costs Also sometimes called Differentia
l Costs or Incremental Costs A differential cost
for a particular decision is one that changes if
an alternative decision is chosen.
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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.
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The Jennie Mae Frog Farm
Jennie Maes Frog Farm has fixed costs of 5,000
per month and variable costs of 2 per frog. All
fixed costs are avoidable, in the sense that
Jennie Mae could close the farm tomorrow, and not
incur any fixed costs next month. However, she
doesnt want to do that because times are good in
the frog business she is operating at capacity,
making and selling 1,000 frogs per month. Jennie
Maes usual sales price is 9 per frog. The U.S.
Army has approached Jennie Mae and proposed a
one-time purchase of 300 frogs for 7 per frog.
The sale would occur next month. Jennie Maes 2
per frog variable cost includes 0.25 of product
packaging that would be unnecessary for frogs
designated for the Army.
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The Jennie Mae Frog Farm
Question 1 With respect to Jennie Maes
decision of whether to accept the Armys offer,
what is Jennie Maes opportunity cost?

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The Jennie Mae Frog Farm
Question 1 With respect to Jennie Maes
decision of whether to accept the Armys offer,
what is Jennie Maes opportunity cost?
Since Jennie Mae is operating at capacity, her o
pportunity cost is her profit foregone from the
regular sales that are displaced by the sales to
the Army. These profits are calculated either as
9 sales price minus 2 variable costs 7 per
frog, multiplied by 300 frogs 2,100 or as the
difference between this 7 per frog contribution
margin and her contribution margin from sales to
the Army of the 7 sales price less 1.75 in
variable costs 5.25 per frog. This difference
is 7 minus 5.25 1.75, multiplied by 300
frogs 525.
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The Jennie Mae Frog Farm
Question 2 With respect to Jennie Maes
decision of whether to accept the Armys offer,
which costs are sunk, and hence, are irrelevant
to her decision?
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The Jennie Mae Frog Farm
Question 2 With respect to Jennie Maes
decision of whether to accept the Armys offer,
which costs are sunk, and hence, are irrelevant
to her decision? No costs are sunk. Even the fi
xed costs are avoidable. Hence, although the
fixed costs are irrelevant to Jennie Maes
decision, they are not sunk.
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The Jennie Mae Frog Farm
Question 3 With respect to Jennie Maes
decision of whether to accept the Armys offer,
which costs are differential costs (i.e.,
relevant, or incremental costs)?
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The Jennie Mae Frog Farm
Question 3 With respect to Jennie Maes
decision of whether to accept the Armys offer,
which costs are differential costs (i.e.,
relevant, or incremental costs)?
The differential costs are the 0.25 product pac
kaging costs. Nothing else is differential,
because whether or not Jennie Mae sells to the
Army, she will produce at capacity.
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The Jennie Mae Frog Farm
Question 4 Now assume that times are not so
good, and Jennie Mae has excess capacity to make
500 frogs. The Army approaches Jennie Mae and
proposes a one-time purchase of 300 frogs. What
is the lowest price Jennie Mae should be willing
to charge the Army per frog?
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The Jennie Mae Frog Farm
Question 4 Now assume that times are not so
good, and Jennie Mae has excess capacity to make
500 frogs. The Army approaches Jennie Mae and
proposes a one-time purchase of 300 frogs. What
is the lowest price Jennie Mae should be willing
to charge the Army per frog? 1.75 per frog, th
e variable cost of production, assuming Jennie
Mae was going to continue operations. However,
with only 500 customers, she is not covering her
costs, and the price to the Army that will allow
her to break even is 6.75, as follows
Revenues from the Army 6.75 x 300 2,025
from normal customers 9 x 500 4,500 Costs
Variable costs (500 x 2) (300 x 1.75) 1
,525 Fixed costs 5,000 Income
0
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The Jennie Mae Frog Farm
Question 5 Now assume that times are really
bad, the market for frogs crashes, and Jennie Mae
gets out of the frog business and starts
producing platypuses instead. Jennie Mae has an
aging inventory of frogs sufficient to meet
market demand for 10 months (300 frogs per
month), but unfortunately, frogs only have a
useful life of 5 months and her inventory becomes
obsolete after that. These frogs cost 7 each to
make, consisting of 2 in variable costs and 5
in allocated fixed overhead. What is the lowest
price Annie should accept from the Air Force for
a one-time-only purchase of 300 frogs? What is
her opportunity cost?
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The Jennie Mae Frog Farm
Question 5 Now assume that times are really
bad, the market for frogs crashes, and Jennie Mae
gets out of the frog business and starts
producing platypuses instead. Jennie Mae has an
aging inventory of frogs sufficient to meet
market demand for 10 months (300 frogs per
month), but unfortunately, frogs only have a
useful life of 5 months and her inventory becomes
obsolete after that. These frogs cost 7 each to
make, consisting of 2 in variable costs and 5
in allocated fixed overhead. What is the lowest
price Annie should accept from the Air Force for
a one-time-only purchase of 300 frogs? What is
her opportunity cost? Jenny should accept any p
rice above zero. Her opportunity cost is zero.
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ACTG 321Agenda for Lecture 2

• The microeconomic foundations of management
  accounting
  
• Break
• Cost classifications and cost behavior

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ACTG 321Agenda for Lecture 2

• The microeconomic foundations of management
  accounting
  
• Break
• Cost classifications and cost behavior

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

• Direct and Indirect Costs
• Fixed and Variable Costs
• The Value Chain

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

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Direct versus Indirect Costs
EXAMPLE LEVI STRAUSS FACTORY
Are the following costs direct or indirect?
Fabric Plant Managers Salary Thread Sewing Ope
rators Labor
Plant Utilities
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Classification of Costs
Total Costs
Direct costs
Fabric sewing operator wages
Indirect costs (a.k.a. overhead)
Plant utilities, thread, Plant managers salary
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Three ways to classify costs

• Direct and Indirect Costs
• Fixed and Variable Costs
• The Value Chain

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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.

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Fixed Costs vs. Variable Costs

• Linear relationship is assumed.
• Relevant range and time-span must be identified.
• Many costs are semi-variable or mixed.

0
units

units
0
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Fixed Costs vs. Variable Costs
EXAMPLE LEVI STRAUSS FACTORY
Are the following costs fixed or variable?
- Fabric - Assistant Managers Salary - Electric
ity - Sewing Operator Labor - Repairs Maintena
nce
- Rent on building
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Classification of Costs
Total Costs
Direct costs
fixed
variable
Indirect costs (a.k.a. overhead)
fixed
variable
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Combinations of Variable Fixed,Direct
Indirect
Fixed Variable
Yes
Direct Indirect
Not very often
Yes
Yes
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Classification of Costs
Total Costs
Direct costs
fixed
variable
Fabric, Sewing Wages
Indirect costs (a.k.a. overhead)
fixed
variable
Electricity, Repairs
Rent, Salaries
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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.
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When are Costs and Revenues Relevant?
Hence, variable costs may be relevant, or not,
depending on whether the variable costs will
differ in the future, as between the alternatives
under consideration. Also, fixed costs may be rel
evant, or not, depending on whether the fixed
costs will differ in the future, as between the
alternatives under consideration.
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Three ways to classify costs

• Direct and Indirect Costs
• Fixed and Variable Costs
• The Value Chain

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Costs by Business Functiona.k.a. the value chain

• R D
• Manufacturing
• Marketing
• Distribution
• Sales