Introduction
Understanding cost classifications is essential for effective decision-making in management accounting. Costs are classified based on their relationship to cost objects and their relevance to decision-making processes. This lecture will explore direct and indirect costs, differential costs, opportunity costs, and sunk costs.
Cost Classifications for Assigning Costs to Cost Objects
A cost object is anything for which cost data are required, such as products, customers, jobs, or organizational units. Costs can be classified as either direct or indirect:
- Direct Cost: A cost that can be easily and directly traced to a specific cost object. Example: The salary of a sales manager in Reebok’s Tokyo office is a direct cost of that office.
- Indirect Cost: A cost that cannot be easily traced to a specific cost object. Example: The factory manager’s salary in a soup manufacturing facility is an indirect cost to a particular soup variety but a direct cost to the entire factory.
- Common Cost: A type of indirect cost incurred to support multiple cost objects but cannot be traced to any one individually.
Cost Classifications for Decision Making
Business decisions often involve choosing between alternatives, requiring an understanding of different cost classifications:
-
Differential Cost and Revenue:
- Differential Cost: The difference in cost between two alternatives.
- Differential Revenue: The difference in revenue between two alternatives.
- Example: Nature Way Cosmetics is considering switching from retailer-based sales to direct sales representatives. The differential revenue is $100,000, and the differential cost is $85,000, resulting in a $15,000 increase in net operating income.
Numerical Example: Differential Cost and Revenue
Scenario:
ABC Manufacturing is considering switching its production method from Method A (current) to Method B (proposed). The company wants to analyze the differential costs and revenues before making a decision.
| Cost/Revenue Item | Method A (Current) | Method B (Proposed) | Differential Amount |
|---|---|---|---|
| Revenue | $500,000 | $600,000 | $100,000 (Increase) |
| Direct Materials (Variable Cost) | $150,000 | $180,000 | $30,000 (Increase) |
| Direct Labor (Variable Cost) | $100,000 | $120,000 | $20,000 (Increase) |
| Factory Overhead (Fixed Cost) | $80,000 | $90,000 | $10,000 (Increase) |
| Marketing & Sales (Fixed Cost) | $50,000 | $40,000 | -$10,000 (Decrease) |
| Total Costs | $380,000 | $430,000 | $50,000 (Increase) |
| Net Operating Income | $120,000 | $170,000 | $50,000 (Increase) |
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Analysis:
- Differential Revenue = $600,000 - $500,000 = $100,000
- Differential Cost = $430,000 - $380,000 = $50,000
- Differential Net Operating Income = $50,000 (Increase in profit)
Decision:
Since switching to Method B results in an additional $50,000 profit, ABC Manufacturing should adopt the new production method.
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Opportunity Cost:
- The potential benefit lost when one alternative is chosen over another.
- Examples:
- A student giving up a $200 weekly job to take a vacation.
- A company investing in land instead of securities.
- An employee quitting a $38,000 job to return to school.
-
Sunk Cost:
- A cost that has already been incurred and cannot be recovered or changed.
- Example: A company that spent $50,000 on a now-obsolete machine should not factor this sunk cost into future decisions.
Summary
Understanding different cost classifications helps managers make better business decisions. Key takeaways include:
- Direct vs. Indirect Costs: Direct costs are easily traceable to a cost object, while indirect costs are not.
- Differential Costs: Only relevant costs should be considered when comparing alternatives.
- Opportunity Costs: Every decision has an implicit cost in terms of foregone opportunities.
- Sunk Costs: Should always be ignored in decision-making, as they cannot be changed.
By focusing on relevant costs, managers can optimize profitability and operational efficiency.
References: This text is attributed to Managerial Accounting :
Ray H. Garrison
Eric W. Noreen
Peter C. Brewer
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