Concept of Costs:

Chapter Summary:

Conventional accounting statements do not all the time give all the information on costs essential for efficient business decisions. Managers must use the principles represented in this chapter to build up accurate information regarding costs.

Economies of scale occur from either noteworthy fixed costs or variable costs which reduce with the scale of production. An industry where businesses show scale economies will tend to be concentrated. Economies of scope occur from important joint costs across the production of two or more items. The scope economies drive businesses to supply multiple products.

Opportunity cost is the total revenue from the most excellent alternative course of action.  Sunk costs are costs which have been committed and can’t be avoided. For efficient business decisions, managers must consider opportunity costs and ignore the sunk costs.

The transfer price of an item in an organization must be set equivalent to the marginal cost. 
 
Key Concepts:

General Chapter Objectives:

A) Appreciate that conventional accounting statements do not all time present the information required for efficient managerial decisions.

B) Discuss the idea of scale economies, relate it to fixed costs, and apply it to the business strategy.

C) Discuss about the concept of scope economies, relate it to joint costs, and apply it to the business strategy.

D) Appreciate and apply the idea of opportunity cost, and particularly to the capital of an organization.

E) Describe the objective and application of the transfer pricing.

F) Appreciate and apply the idea of sunk cost.

G) Differentiate direct and indirect costs.

H) Apply the statistical method of multiple regressions to the cost analysis.

Notes:

1) Introduction:

a) Costs based on the scale (that is, production rate) and scope (that is, diversity of various products) of the business.

i) Fixed cost: It is the cost of inputs which do not change with scale.

ii) Variable cost: It is the cost of inputs which change with scale.

iii) Note: Certain costs are partially fixed and partially variable.

iv) Marginal cost: Modifications in total cost due to the production of an additional unit; equivalents the rate of change of variable cost.

v) Average cost: It is the total cost divided by scale; equivalents to the sum of average fixed cost and average variable cost.

b) The decision on scale based on market competition and demand.

c) Managers must consider simply the relevant costs.

d) To recognize the relevant costs, alternative courses of action require to be considered.
 
2) Classification of costs:

a) Must ignore the sunk costs. They are irrelevant.

b) Must consider just avoidable costs (fixed in respect of variable, direct in relation to indirect costs).

c) The division of costs into sunk and avoidable based on past commitments and planning horizon.

d) The division of avoidable costs into variable and fixed elements based on the technology of business.

e) The costs are indirect or direct based on the marginal benefit relative to cost of identification. Each of indirect and direct costs might be either variable or fixed.
 
3) Economies of scale:

a) Definition: It is the situation where average cost reduces with the scale of production.

i) The Marginal cost will be lower than average cost.
ii) Any rise in production will decrease the average cost.
iii) The average cost curve slopes downward.
iv) “Increasing returns to scale” and “Economies of scale” are synonymous.

b) Intuitive factors:

i) Important fixed inputs:

• At a bigger scale, the cost of fixed inputs will be spread over more units, and hence the average fixed cost will be lower,
• When the average variable cost is constant or doesn’t raise much with scale,
• The average cost will drop with scale.

ii) Average variable costs which drop with scale, example: pipeline.

c) Strategic implications:

i) Big scale operations (or lower average cost).
ii) Mass marketing, comparatively low pricing.
iii) Some suppliers. Extreme case: monopoly.
 
4) Diseconomies of scale:

a) Definition: It is the situation wherein average cost rises with the scale of production.

i) Average cost curve is U-shaped (that is, a perfectly competitive business).
ii) “Diseconomies of the scale” and “reducing returns to scale” are synonymous.

b) Intuitive factors:

i) Insignificant fixed cost and variable costs increase more proportionately than with scale.

• Cost of fixed inputs will spread over more units; therefore the average fixed cost will be lower,
• The average variable cost increases more proportionately than scale.
• There is a scale where falling average fixed cost is outweighed by the raising average variable cost.
• The average cost reaches at minimum and increases with further raise in scale.

c) Strategic implications:

i) Small scale.
ii) Niche marketing, comparatively high pricing.
iii) Fragmented industries. Extreme situation: perfect competition.
 
5) Economies of scope:

a) Definition: It is the situation in which the total cost of production is lower with joint than separate production.

i) Joint cost: It is the cost of inputs which do not change with the scope of production (example: core competence).

b) Intuitive factors:

i) Important joint costs.

c) Strategic implications:

i) Multiproduct suppliers rule the market.
ii) Core competence.
iii) Brand extension.
 
6) Diseconomies of scope:

a) Definition: It is the situation where the net cost of production is higher with joint than with separate production.

b) Intuitive factors:

i) Unimportant joint costs.

c) Strategic implications:

i) Generate products separately: Specialized production.
 
7) Opportunity cost:

a) What costs are appropriate based on the alternative courses of action for the assessment at hand.

b) Explicit approach: It considers the costs and revenues of alternative courses of the action.

c) Opportunity cost approach: the total revenue from the best alternative course of action.

d) Opportunity cost of the capital.

i) Economic value added: the total operating profit subsequent to tax subject to adjustments for accounting conventions less a charge for the cost of capital. This is an enhanced measurement of business performance than the accounting earnings.

ii) The failure to account for the cost of capital leads to an association to invest exceptionally relative to the economically efficient level (might also be biased in favor of the capital intensive activities).

8) Transfer pricing:

a) To maximize the gain of a whole organization, the transfer price of an internally generated input must be set equivalent to its marginal cost.

b) Perfectly competitive market for the input.

i) Set transfer price equivalent to the market price (as well equivalents marginal cost).

c) The production of input is subject to full capacity.

i) Marginal cost curve is vertical and the marginal cost is not well stated.
ii) Set transfer price equivalent to the opportunity cost of inputs that is the marginal benefit that input gives to the present user.
 
9) Sunk cost:

a) Sunk cost: a cost which has been committed and can’t be avoided once acquired.

b) Recognized by considering the alternative courses of the action.

i) The longer the planning horizon is, the more time there will be for the past commitments to unwind and bigger the freedom of action.
ii) In long run, all inputs are freely adjustable; therefore there will be no sunk costs.

c) Division of costs into sunk and avoidable based on past commitments and the planning horizon.

d) Two ways of dealing with the sunk costs.

i) Explicitly consider an alternative course of action.
ii) Eliminate all sunk costs from the income statement.

e) Strategic implications:

i) Employ sunk costs to deter the entry by competitors.
ii) Managers must be careful regarding committing costs which will become sunk.

f) Dissimilar from fixed cost:

i) Fixed cost: The cost of inputs which do not change with production rate.

• Tend to give mount to economies of scale in long run.

ii) Several fixed costs become sunk once acquired, example: design cost for shoe molds.
iii) Not all the sunk costs are fixed, example: the second pair of shoe mold as production rises.
iv) Not all the fixed costs become sunk whenever incurred.
 
10) Direct and indirect costs:

a) Direct cost: It is a cost which can be relatively easily recognized with a particular product or job, example: production line labor and materials.

b) Indirect (or overhead) cost: It is a cost which can’t be simply recognized with a specific product or job, example: cost of grease in the car repair business.

c) Use activity-based costing to assign indirect costs among different products in a multiproduct business:

i) Recognize the expenses and activities incurring the indirect costs,

ii) Divide the expenditures (example: telephone and fax charges) among the activities (example: shipment in respect of customer enquiries)

iii) Assign the indirect cost of each activity between the products (that is, product A and product B)

iv) Join the assigned indirect costs with direct costs.

v) Conventional cost accounting assigns indirect costs in proportion to the direct costs.

• This ignores the prospect that there are fixed elements in the approach indirect activities support products.
• Tendency to overstate the costs of high volume products and minimize the costs of low volume products.

11) Multiple regression:

a) To examine statistical data on costs.

b) Illustration: To understand, predict, and forecast the relationship between costs and scale of production.

i) Multiple regression: dependent variable = direct cost, and independent variables = factors which affect direct costs.
ii) When the intercept term is positive and statistically important, then there is a fixed cost. 
iii) Employ the estimated coefficients from a multiple regression to predict costs at different combinations of the independent variables.

c) It as well applies multiple regressions to detect joint costs and to assign indirect costs.

Question-Answer:

Pluto Hotel has a single 100-seat restaurant, for which the annual revenue is of $2.16 million and expenditures are $1.08 million in salaries and wages and $648,000 in produce, other utilities and supplies. The restaurant seating area engages 1000 square feet whilst the kitchen engages 400 square feet. Management consultants McMars have suggested that Pluto decrease the restaurant to 500 square feet, with room for 50 seats. McMars suggests that Pluto lease the 500 square feet additional space to a jeweler at $20 per square foot a month.

a) Which of the following best explains the potential rental income from the jeweler: (i) fixed cost, (ii) variable cost or (iii) opportunity cost?

b) Assume that McMar’s proposal would decrease the restaurant’s revenue and expenditures by 40percent. Make an income statement exhibiting the two alternatives-current operations and McMars plan.

c) McMars further suggests that Pluto introduce room service to serve some of the guests who would currently eat in the restaurant. Now, the McMars plan would just decrease the restaurant’s revenue and expenditures by 20percent relative to the present situation. Should Pluto adopt the McMars plan?

d) The same kitchens can support both restaurants and room service. Does this exemplify economies of scale or scope?

Answer:

a) Opportunity cost.
b) Income exhibiting alternatives (in thousand $)

c) See the table above. Pluto must adopt the McMars plan with room service.
d) Economies of scope.

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