Due Sunday, 11/20: Problems from Zimmerman text: 2-11, 2-44, Case 2-3, 7-7, and 7-20

Chapter Two The Nature of Costs Chapter Outline A. Opportunity Costs 1. Characteristics of Opportunity Costs 2. Examples of Decisions Based on Opportunity Costs B. Cost Variation 1. Fixed, Marginal, and Average Costs 2. Linear Approximations 3. Other Cost Behavior Patterns 4. Activity Measures C. Cost-Volume-Profit Analysis 1. Copier Example 2. Calculating Break-Even and Target Profits 3. Limitations of Cost-Volume-Profit Analysis 4. Multiple Products 5. Operating Leverage D. Opportunity Costs versus Accounting Costs 1. Period versus Product Costs 2. Direct Costs, Overhead Costs, and Opportunity Costs E. Cost Estimation 1. Account Classification 2. Motion and Time Studies F. Summary Appendix: Costs and the Pricing Decision 22 zim25745_ch02_022-086.indd 22 14/11/12 2:55 PM The Nature of Costs 23 As described in Chapter 1, accounting systems measure costs that managers use for external reports, decision making, and controlling the behavior of people in the organization. Understanding how accounting systems calculate costs requires a thorough understanding of what cost means. Unfortunately, that simple term has multiple meanings. Saying a product costs $3.12 does not reveal what the $3.12 measures. Additional explanation is often needed to clarify the assumptions that underlie the calculation of cost. A large vocabulary has arisen to communicate more clearly which cost meaning is being conveyed. Some examples include average cost, common cost, full cost, historical cost, joint cost, marginal cost, period cost, product cost, standard cost, fixed cost, opportunity cost, sunk cost, and variable cost, just to name a few. We begin this chapter with the concept of opportunity cost, a powerful tool for understanding the myriad cost terms and for structuring managerial decisions. In addition, opportunity cost provides a benchmark against which accounting-based cost numbers can be compared and evaluated. Section B discusses how opportunity costs vary with changes in output. Section C extends this discussion to cost-volume-profit analysis. Section D compares and contrasts opportunity costs and accounting costs (which are very different). Section E describes some common methods for cost estimation. A. Opportunity Costs When you make a decision, you incur a cost. Nobel Prize-winning economist Ronald Coase noted, \"The cost of doing anything consists of the receipts that could have been obtained if that particular decision had not been taken.\"1 This notion is called opportunity costthe benefit forgone as a result of choosing one course of action rather than another. Cost is a sacrifice of resources. Using a resource for one purpose prevents its use elsewhere. The return forgone from its use elsewhere is the opportunity cost of its current use. The opportunity cost of a particular decision depends on the other alternatives available. The alternative actions comprise the opportunity set. Before making a decision and calculating opportunity cost, the opportunity set itself must be enumerated. Thus, it is important to remember that opportunity costs can be determined only within the context of a specific decision and only after specifying all the alternative actions. For example, the opportunity set for this Friday night includes the movies, a concert, staying home and studying, staying home and watching television, inviting friends over, and so forth. The opportunity cost concept focuses managers' attention on the available alternative courses of action. Suppose you are considering three job offers. Job A pays a salary of $100,000, job B pays $102,000, and job C pays $106,000. In addition, you value each job differently in terms of career potential, developing your human capital, and the type of work. Suppose you value these nonpecuniary aspects of the three jobs at $8,000 for A, $5,000 for B, and only $500 for C. The following table summarizes the total value of each job offer. You decide to take job A because it has the highest total pecuniary and nonpecuniary compensation. The opportunity cost of job A is $107,000 (or $102,000 + $5,000), representing the amount forgone by not accepting job B, the next best alternative. 1 R Coase, \"Business Organization and the Accountant,\" originally published in Accountant, 1938. Reprinted in L.S.E. Essays in Cost, ed. J Buchanan and G Thirlby (New York University Press, 1981), p. 108. zim25745_ch02_022-086.indd 23 14/11/12 2:55 PM 24 Chapter 2 Job Offer A B C Salary $ Equivalent of Intangibles Total Value $100,000 102,000 106,000 $8,000 5,000 500 $108,000 107,000 106,500 The decision to continue to search for more job offers has an opportunity cost of $108,000 if job offer A expires. If you declined job offer L last week, which had a total value of $109,000, this job offer is no longer in the opportunity set and hence is not an opportunity cost of accepting job A now. Besides jobs A, B, and C, you learn there is a 0.9 probability of receiving job offer D, which has a total value of $110,000. If you wait for job D and you do not get it, you will be forced to work in a job valued at $48,000. Job D has an expected total value of $103,800 (or $110,000 0.9 + $48,000 0.1). Since job D's opportunity cost of $108,000 (the next best alternative forgone) exceeds its expected value ($103,800), you should reject waiting for job offer D. 1. Characteristics of Opportunity Costs Opportunity costs are not necessarily the same as payments. The opportunity cost of taking job A included the forgone salary of $102,000 plus the $5,000 of intangibles from job B. The opportunity cost of going to a movie involves both the cash outlay for the ticket and popcorn, and also forgoing spending your time studying or attending a concert. Remember, the opportunity cost of obtaining some good or service is what must be surrendered or forgone in order to get it. By taking job A, you forgo job B at $107,000. Opportunity costs are forward looking. They are the estimated forgone benefits from actions that could, but will not, be undertaken. In contrast, accounting is based on historical costs in general. Historical costs are the resources expended for actions actually undertaken. Opportunity cost is based on anticipations; it is necessarily a forward-looking concept. Job offers B, C, and D are part of the opportunity set when you consider job A, but job offer L, which expired, is no longer part of the opportunity set. Your refusal of job L last week is not an opportunity cost of accepting job A now. Opportunity costs differ from (accounting) expenses. Opportunity cost is the sacrifice of the best alternative for a given action. An (accounting) expense is a cost incurred to generate a revenue. For example, consider an auto dealer who sells a used car for $7,500. Suppose the dealer paid $6,500 for the car and the best alternative use of cars like this one is to sell them at auction for $7,200. The car's opportunity cost in the decision to keep it for resale is $7,200, but in matching expenses to revenues, the accounting expense is $6,500. Financial accounting is concerned with matching expenses to revenues. In decision making, the concern is with estimating the opportunity cost of a proposed decision. We return to the difference between opportunity and accounting costs in section D. 2. Examples of Decisions Based on Opportunity Costs2 Several examples illustrate opportunity costs. The first four examples pertain to raw materials and inventories. Opportunity cost of materials (no other uses) What is the opportunity cost of materials for a special order if the materials have no other use and a firm has these materials in stock? The firm paid $16,000 for the materials and anticipates no other orders in which it can use these materials. The opportunity cost of these materials is whatever scrap value they may have. If the materials have no alternative use 2 Some of the examples presented here are drawn from Coase (1938), pp. 109-22. zim25745_ch02_022-086.indd 24 14/11/12 2:55 PM The Nature of Costs 25 and they have no storage or disposal cost, their opportunity cost is zero. In fact, the opportunity cost is negative if the firm incurs costs for storing the product and if disposal is costly. Opportunity cost of materials (other uses) The opportunity cost of materials not yet purchased for a job is the estimated cash outflow necessary to secure their delivery. If the materials are already in stock, their opportunity cost is their highest-valued use elsewhere. If the materials will be used in another order, using them now requires us to replace them in the future. Hence, the opportunity cost is the cost of replacement. Interest on inventory as an opportunity cost An automobile manufacturer plans to introduce a new car model. Included in the opportunity cost of the new model are the payments for materials, labor, capital, promotion, and administration. Opportunity cost also contains the interest forgone on the additional inventory of cars and parts the firm carries as part of the normal operations of manufacturing and selling cars. If the average inventory of materials, work in process, and finished cars is $125 million and the market rate of interest for this type of investment is 10 percent, then the opportunity cost of interest on this investment is $12.5 million per year. The next raw material example introduces the concept of sunk costs, expenditures that have already been made and are irrelevant for evaluating future alternatives. Sunk costs and opportunity costs A firm paid $15,000 for a coil of stainless steel used in a special order. Twenty percent (or $3,000 of the original cost) of the coil remains. The remaining steel in the coil has no alternative use; a scrap steel dealer is willing to haul it away at no charge. The remaining $3,000 of the original cost is a sunk cost. Sunk costs are expenditures incurred in the past that cannot be recovered. The $3,000 is sunk because it has already been incurred and is not recoverable. Because it cannot be recovered, the $3,000 should not influence any decision. In this case, the remaining steel coil has a zero opportunity cost. Sunk costs are irrelevant for future uses of this stainless steel. Suppose the scrap dealer is willing to pay $500 for the remaining coil. Using the remainder in another job now has an opportunity cost of $500. Remember that sunk costs are irrelevant for decision making unless you are the one who sunk them. However, sunk costs are not irrelevant as a control device. Holding managers responsible for past actions causes them to take more care in future decisions. Suppose $4 million was spent on new software that doesn't work and the firm buys a commercial package to replace it. The manager responsible for the failed software development will be held accountable for the failure and will have incentives to consume more firm resources trying to either fix it or cover up its failure before this knowledge becomes widely known. The next example applies the opportunity cost concept to evaluating alternatives regarding labor. Opportunity cost of labor Suppose a firm's work force cannot be changed because of existing labor agreements. Employees are guaranteed 40 hours of pay per week. For the next three weeks only 35 hours of work per week per employee exists. What is the cost of taking a special order that will add five hours of work per employee? One is tempted to cost the five hours of labor in the special order at zero because these employees must be paid anyway. But the question remains, what will these employees do with the five hours if this special order is rejected? If they would do preventive maintenance on the machines or do general maintenance or improve their skills through training, then the opportunity cost of the labor for the special order is not zero but the value of the best forgone alternative use of the employees' time. zim25745_ch02_022-086.indd 25 14/11/12 2:55 PM 26 Managerial Application: The Costs of the SarbanesOxley Act Chapter 2 Following the accounting scandal at Enron and the demise of Arthur Andersen, the U.S. government enacted the Sarbanes-Oxley Act of 2002, the \"Public Company Accounting Reform and Investor Protection Act.\" This law has many provisions, including the requirement that public companies and their auditors must report annually that management has \"an adequate internal control structure and procedures for financial reporting.\" This provision, known as section 404 of the act, is causing the greatest concern among publicly traded companies. In a survey of U.S. firms, CFO magazine reports that 48 percent of companies will spend at least $500,000 complying with Sarbanes-Oxley, with 52 percent reporting that their compliance has yielded no benefits for their company. Digene Corp., a biotech firm, has seen its audit bill jump 72 percent. Sarbanes-Oxley, by increasing both the duties and the liability of the officers and directors of public companies, has caused directors' fees and the insurance premiums of directors and officers to increase. Board-related costs, including director compensation and insurance, increased 50 percent. In addition to the direct costs of complying with Sarbanes-Oxley, the act is imposing significant opportunity costs on companies. The CFO of the $5 billion Constellation Energy Group believes that the law makes the \"fear of personal liability so great that managers are afraid to take risks on innovation.\" Some 33 percent of the CFO-surveyed companies have delayed or canceled projects so they can comply with the law. Financial executives have less time to make strategic decisions as compliance efforts absorb 10 percent of a CFO's time in 40 percent of the companies. More small, publicly traded companies are going private because the cost of remaining public has increased. This deprives these companies of the benefits of being public, such as access to public equity markets and liquidity for equity investments. But not everyone has been harmed by Sarbanes-Oxley. The law has been a windfall for auditors, lawyers, and software firms. Source: A Nyberg, \"Sticker Shock: The True Costs of Sarbanes-Oxley Compliance,\" CFO, September 2003, pp. 51-62. Public accounting firms confront this issue. The summer months tend to be lowdemand periods relative to year-end. How the firm prices summer (off-peak) audits depends in part on the perceived opportunity cost of the staff's time. If a firm owns long-lived assets such as buildings and equipment, understanding their opportunity costs involves alternative uses of these assets. The next three examples describe the opportunity costs of capital assets. Asset depreciation as an opportunity cost Using assets can affect their value. Suppose a delivery van used four days a week can be sold next year for $34,000. If additional business is taken and the delivery van is used six days a week, its market value next year will be $28,000. Depreciation due to use for the additional business is $6,000 ($34,000 $28,000). Additional labor for the driver's time, maintenance, gasoline, and oil are required. The opportunity cost of using an asset is the decline in its value. Accounting depreciation (such as straight-line depreciation) is based on historical costs. Accounting depreciation does not necessarily reflect the opportunity cost of the van (its decline in value from use). However, accounting depreciation can be a reasonably accurate approximation of the decline in the market value of the asset. In any given year, accounting depreciation may not exactly capture the decline in the asset's market value. However, over the asset's economic life, accumulated accounting depreciation equals the decline in value. Holding zim25745_ch02_022-086.indd 26 14/11/12 2:55 PM 27 The Nature of Costs managers responsible for accounting depreciation commits them to recovering the historical cost of the asset in either additional revenues or cost savings. Interest on an asset as an opportunity cost If the asset can be sold, then interest should be included as an opportunity cost. If the asset has no resale value, then obviously no interest is forgone. For example, a local area network and computers are purchased for $100,000. The interest rate is 8 percent. Should interest on the capital tied up in the hardware ($8,000) be included as a cost in the decision to continue to use the system? If the equipment has no market value, then interest is not a cost because the firm is not forgoing selling the hardware and earning interest on the proceeds. If the system can be sold, then the forgone interest on the proceeds is a cost. Chapter 3 presents an expanded discussion of the opportunity cost of a capital investment. Opportunity cost of excess capacity Suppose a plant operates at 75 percent capacity. Is the firm forgoing profits on the 25 percent of idle capacity? It is usually optimal to have some \"excess\" capacity in order to absorb random shocks to normal production, such as machine breakdowns and demand fluctuations, which increase production time and costs. When plants are built, rarely are they expected to run at 100 percent capacity. As plant utilization increases, per-unit costs increase as congestion rises. The opportunity cost of increasing the plant's expected utilization, say from 75 percent to 85 percent of capacity, is the higher production cost imposed on the existing units that currently utilize 75 percent of the capacity. Consider this illustration. The following table lists the output of a plant in units of production and the average cost per unit. Average costs rise as volume increases because congestion increases. This causes more machine breakdowns, and indirect labor (expediters, material handlers, production schedulers) must be hired to manage the increased congestion. The plant is currently operating at 75 percent capacity (150 units) and incurring average costs of $6.04 per unit. Units 130 140 150 160 170 180 190 200 Capacity 65% 70 75 80 85 90 95 100 Average Cost $6.00 6.02 6.04 6.06 6.08 6.11 6.15 6.20 Suppose production increases from 150 units (75 percent capacity) to 170 units (85 percent capacity). Increasing production by an extra 20 units causes the average cost of the base production of 150 units to rise from $6.04 to $6.08, or 4 per unit. The opportunity cost of producing 20 more units is not the average cost of $6.08 but the incremental cost of the last 20 units, $6.38 (or [(170 $6.08) (150 $6.04)] 20 units). Another way of computing the opportunity cost of the last 20 units is $6.38 = $6.08 + (4 150) 20 Or the opportunity cost of producing 20 more units is composed of their average cost ($6.08) plus the cost increase that each of the 20 units imposes on the first 150 units [(4 150) 20]. The final example describes evaluating the opportunity costs of introducing new products. zim25745_ch02_022-086.indd 27 14/11/12 2:55 PM 28 Chapter 2 Opportunity cost of product line cannibalization A company that produces personal computers (PCs) has 60 percent of a particular market niche. The company plans to introduce a new, high-end, faster computer with additional features. The major competition for the new PC is the firm's current high-end machine. In the first year, management projects sales of the new model to be 20,000 units. Sales of the existing machines are expected to fall by 7,000 units. Thus, the new PC \"cannibalizes\" the old PC's sales by 7,000 units. Are the forgone profits from the 7,000 units that could have been sold an opportunity cost of introducing the new computer? It depends on the opportunity set. If management expects competitors to introduce a machine that competes with the old machine, meaning that the company is likely to have lost those units anyway, then the profits forgone on the 7,000 units are not an opportunity cost of introducing the new machine. Concept Questions Q2-1 Define opportunity cost. Q2-2 What are some characteristics of opportunity costs? Q2-3 A firm paid $8,325 last year for some raw material it planned to use in production. When is the $8,325 a good estimate of the opportunity cost of the material? Q2-4 Define sunk cost and give an example. Q2-5 What are avoidable and unavoidable costs? How are they related to opportunity costs? B. Cost Variation Managers commonly decide how many units to produce or how much service to provide during a certain time period. Dell Computer must decide how many computers of a particular model to manufacture next quarter. United Airlines must decide whether to fly a 90-passenger jet or a 130-passenger jet between Denver and Palm Springs next month. Making these decisions requires an understanding of how costs change with volumethe topic of this section. 1. Fixed, Marginal, and Average Costs zim25745_ch02_022-086.indd 28 Cost behavior is defined relative to some activity, such as the number of units produced, hours worked, pounds of ore mined, miles driven, or meals served. Usually, units produced is the measure of activity. For example, consider Figure 2-1, which illustrates the general relation between cost and units produced. Two important points emerge from Figure 2-1. First, even with no units produced, the firm still must incur some costs. The costs incurred when there is no production are called fixed costs. If the plant is idle, some costs such as property taxes, insurance, plant management, security, and so on must be incurred to provide production capacity. For example, Intel acquires land and builds a plant to manufacture a specific quantity of computer processors. It pays annual property taxes of $1.75 million on this land. The $1.75 million expenditure on property taxes is part of the cost Intel pays to have this manufacturing capacity at this plant. Second, in general the cost curve is not a straight line as output expands, but rather is curvilinear. The particular shape of the curve arises because marginal cost varies with the level of production. Marginal cost is the cost of producing one more unit. In Figure 2-1, marginal cost is the slope of a line drawn tangent to the total cost curve. For the first few units, such as to the left of output level X, the slope of the tangent is quite steep. The 14/11/12 2:55 PM 29 The Nature of Costs FIGURE 2-1 Nonlinear cost curve Cost Total T cost B A Fixed cost X Y Units produced marginal cost for the first few units is high because employees must be hired, suppliers must be found, and marketing channels must be opened. Therefore, the cost of starting operations and producing the first few units may be extremely high. Expanding output beyond the first few units allows the organization to achieve smooth, efficient production techniques. At normal production rates, the marginal cost of making additional units is relatively low. At high levels of output (output level Y), additional costs are incurred because of constraints on the use of space, machines, and employees. Machines are more likely to fail when operating at or near capacity. Labor costs increase because employees are paid for overtime. Therefore, the marginal cost of making additional units when operating near capacity is higher than under normal operations. By definition a fixed cost is not an opportunity cost of the decision to change the level of output. The decision to expand output usually does not affect property insurance premiums. Therefore, property insurance is a fixed cost with respect to volume and is not a cost when deciding to increase output. The fact that a cost is fixed with respect to volume changes, however, does not mean that it cannot be managed or reduced. A firm can reduce insurance premiums by increasing deductibles or by lowering the risks being insured (installing fire alarms and sprinkler systems). Many fixed costs can be altered in the long run, in the sense that a particular plant can be closed. If a cost is fixed, this does not mean it is a constant and known with certainty. Fixed costs vary over time due to changes in prices. But fixed costs do not vary with changes in the number of units produced. Another important cost term is average cost. Average cost per unit is calculated by dividing total cost by the number of units produced. Average cost is the slope of the line drawn from the origin to the total cost curve and is depicted in Figure 2-2 as the slope of the line from point O through point C.3 The average cost at output level Z represents the cost per unit of producing Z units. For the pattern of costs in Figure 2-2, the average cost per unit is very high at low levels of output but declines as output increases. The average cost per unit only increases as output nears capacity. Notice that at Z units of production, the average cost is larger than the marginal cost. (The slope of OC is steeper than the slope of the tangent at point C.) 3 Recall that the slope of a line is the ratio of the change in its vertical distance divided by the change in its horizontal distance. In Figure 2-2, the slope of the line OC is the distance CZ divided by the distance OZ. CZ OZ is the total cost of producing Z units divided by Z units, which is the average cost of producing Z units. zim25745_ch02_022-086.indd 29 14/11/12 2:55 PM 30 Managerial Application: MetroGoldwynMayer Inc. Chapter 2 MGM produces and distributes entertainment products worldwide, including motion pictures, television programming, home video, interactive media, and music. The company owns the largest modern film library in the world, consisting of approximately 4,000 titles. MGM significantly improved its operating performance after a careful analysis of the fixed and variable costs of distributing movies to local cinemas. It reduced head count 10 percent and stopped distributing independent films through United International Pictures. It now distributes these films itself. This allowed MGM to convert a large fixed cost into a variable cost. Source: L Calabro, \"Everything in Moderation,\" CFO, February 2004, pp. 59-65. FIGURE 2-2 Average and marginal cost Cost Total T cost C Marginal cost at Z is the slope of the line tangent at C Fixed cost Average cost at Z is slope A op of the line from O to C O Z Units produced Exercise 2-1: Suppose that a plant making steam boilers has the following costs per month: Number of Boilers Total Cost 1 2 3 4 5 6 7 8 9 10 $ 50,000 98,000 144,000 184,000 225,000 270,000 315,000 368,000 423,000 480,000 continued zim25745_ch02_022-086.indd 30 14/11/12 2:55 PM 31 The Nature of Costs Required: a. What are the marginal and average costs for each level of output? b. The plant is currently making and selling eight boilers per month. The company can sell another steam boiler for $53,000. Should the company accept the offer? Solution: a. Number of Boilers 1 2 3 4 5 6 7 8 9 10 Total Cost Marginal Cost $ 50,000 98,000 144,000 184,000 225,000 270,000 315,000 368,000 423,000 480,000 $50,000 48,000 46,000 40,000 41,000 45,000 45,000 53,000 55,000 57,000 Average Cost $50,000 49,000 48,000 46,000 45,000 45,000 45,000 46,000 47,000 48,000 b. The company should reject the offer because the marginal cost of making the ninth boiler is $55,000, whereas the price is only $53,000. The average cost of $47,000 should not be used in this decision. 2. Linear Approximations The cost of changing production levels is not always easy to estimate. Estimating the total cost curve in Figure 2-1 requires knowledge of both fixed cost and how the total costs of facilities, labor, and materials varies as the rate of production increases. Such estimates are difficult to obtain, so managers often approximate these costs. One such approximation assumes the curve is linear instead of curvilinear. An approximation of total cost in Figure 2-1 using a linear cost curve is displayed in Figure 2-3. In this figure, estimating total cost requires an estimate of the y-axis intercept and the slope of the straight line. The intercept, FC, approximates the fixed costs. The slope of the line is the variable cost per unit. Variable costs are the additional costs incurred when output is expanded. When Honda expands the production of minivans at a particular plant from 200 to 250 vans per day, it must buy more parts, hire more employees, use more power, and so forth. All costs that increase when more vans are produced are variable costs.4 In Figure 2-3, the straight line is the sum of the fixed and variable cost approximations of total cost. The line is closest to the total cost in the range of normal operations. This range between output levels X and Y is called the relevant range. The relevant range encompasses the rates of output for which the sum of fixed and variable costs closely approximates total cost. Because the slopes of the total cost curve and the fixed and variable cost curve are about the same, the variable cost is a close approximation of the marginal cost. In the relevant range, variable cost can be used to estimate the cost of making additional units of output. 4 While most managers understand intuitively the difference between fixed and variable costs, not everyone does. When asked the difference between a fixed cost and a variable cost, one employee replied, \"A fixed cost? If it's broke, I fix it and it costs me.\" See R Suskind, \"Guys Holding Axes and Chainsaws Get to Use Any Name They Like,\" The Wall Street Journal, February 26, 1992, p. B-1. zim25745_ch02_022-086.indd 31 14/11/12 2:55 PM 32 FIGURE 2-3 Linear approximation of total cost Chapter 2 Costs Total T cost A Fixed cost, FC Total variable T cost at Y B Fixed cost X Relevant range Y Units produced Notice that variable cost per unit approximates marginal cost per unit. The slope of the variable cost line is constant as the activity measure increases. Variable cost per unit is usually assumed to be constant. Later chapters relax this assumption. The terms marginal cost and variable cost are often used interchangeably, but the two are not necessarily the same. Marginal cost refers to the cost of the last unit produced and in most cases varies as volume changes. In some situations, marginal cost per unit does not vary with volume. Then marginal cost (per unit) and variable cost per unit are equal. The straight-line approximation of total cost can be represented by the following equations: Total cost = Fixed cost + Variable cost Total cost = Fixed cost + (Variable cost per unit)(Units produced) TC = FC + VC Q where TC represents total cost, FC represents fixed cost, VC is variable cost per unit, and Q is the number of units. For example, suppose the fixed cost is $100,000 per month, the variable cost per unit is $3, and 15,000 units are to be manufactured. Total cost is calculated to be $145,000 (or $100,000 + $3 15,000 units). The total cost of $145,000 is an estimate of the cost of manufacturing 15,000 units. 3. Other Cost Behavior Patterns Some costs vary with output (variable costs) and others do not (fixed costs). Between these two extreme cases are step costs and mixed (semivariable) costs. Each of these is described in turn and illustrated in Figure 2-4. Step costs One type of cost behavior involves step costs, expenditures fixed over a range of output levels (line I in Figure 2-4). For example, each supervisor can monitor a fixed number of employees. As output expands and the number of supervisors increases with the number of employees, the resulting increases in supervisory personnel expenditures are a step function. Likewise, once the number of transactions a computer system can process is exceeded, a larger machine is required. Expenditures on computers often behave as step costs. Mixed (semivariable) costs Many costs cannot be neatly categorized as purely fixed or variable. The cost of electricity used by a firm is a good example. Producing more output requires some additional electricity. But some portion of the electric bill is just for turning on the lights and heating or zim25745_ch02_022-086.indd 32 14/11/12 2:55 PM 33 The Nature of Costs FIGURE 2-4 Step and mixed costs T Total dollars Step cost I II Mixed (semivariable) cost Units produced cooling the plant whether the plant produces 1 unit or 50,000 units. In this case the cost of electricity is a mixture of fixed and variable costs. Mixed or semivariable costs are cost categories that cannot be classified as being purely fixed or purely variable (line II in Figure 2-4). 4. Activity Measures zim25745_ch02_022-086.indd 33 The discussion so far has focused on how total cost varies with changes in output (units produced). Output is the measure of activity. Consider a steel mill that makes 1 million tons of two-inch steel plate in one month and 1 million tons of one-inch steel plate in the next month. The cost of the one-inch steel plate will likely be higher because more work is required to roll out the thinner plate. In this factory, costs vary not only with weight of the output but also with its thickness. In general, costs vary based on units produced as well as on the size, weight, and complexity of the product. In many costing situations, managers choose a single activity measure, such as the total number of toys painted or pounds of toys painted. This activity measure is then assumed to be the primary cost driver. The cost driver is that measure of physical activity most highly associated with variations in cost. For example, in the painting department, the quantity of paint used often will be chosen as the cost driver if it has the highest association with total costs in the painting department. An input measure, such as the quantity of paint used, is often used as a single cost driver to capture the many factors and to simplify the process of estimating total cost. The choice of the activity/volume measure is often critical to the perceived variation of costs. This issue is discussed in greater detail in Chapter 11. The problem with using a single activity measure is that it can be correct for one class of decisions but incorrect for others. Such categorizations indicate how costs vary but only for that particular decision. For example, expanding the volume of an existing product in a given plant will cause a different set of costs to vary than will adding a new product line in the same plant or expanding the volume of a given product by building a new plant. Consider an automobile assembly line producing a single car model. Adding 125 cars per day of a second car model costs more than increasing production of the existing model by 125 cars. More labor is required to schedule, order parts, and store them for two different models than if just one model is produced. Thus, the variable costs of 125 cars depend on whether the additional cars are for an existing model or a new model. Some costs are fixed with respect to some decisions but not others. Consider machine setups. Before a computer-controlled milling machine can begin milling parts, a technician must set up the machine by loading the proper computer program, loading the 14/11/12 2:56 PM 34 Chapter 2 correct tools into the machine, adjusting the settings, making a few parts, and checking their tolerances. Once set up, the machine can produce a large number of parts without another machine setup. The cost of the setup is the cost of the technician's time, the material used to check the machine, and the forgone profits of not using the machine while it is being set up. This setup cost is independent of the number of units produced and thus is a fixed cost. However, if the machine produces 1,000 parts per batch, expanding volume from 1,000 parts to 2,000 parts doubles the number of setups and doubles the setup costs. On the other hand, if the plant increases volume to 2,000 parts by doubling batch size, setup costs remain fixed. Therefore, classifying setup costs as being either fixed or variable can be right for some decisions and wrong for others, depending on whether batch sizes change. If some decisions cause batch sizes to change and others do not, then any classification of setup costs as fixed or variable will be wrong for some decisions. Exercise 2-2: Total cost in the painting department of a toy factory varies not only with the number of toys painted but also with the sizes of the toys, the types of surfaces painted, the kinds of paint applied, and so on. Paint costs $15 per gallon. To set up the painting machines to paint a part costs $500, which includes cleaning out the old color. Using the paint machine for one hour costs $70, which also includes the labor to operate it. A particular part with 4,200 pieces in the batch requires 10 gallons of paint and eight hours of paint machine time. Required: Calculate the total cost to paint this batch. Solution: Using multiple activity bases, the cost of painting this part is calculated as Setup cost Paint Machine time $ 500 150 560 Total painting cost $1,210 Notice that the cost of painting the parts includes a fixed setup cost of $500, which does not vary with the number of parts painted. Concept Questions zim25745_ch02_022-086.indd 34 Q2-6 Define mixed cost and give an example. Q2-7 Define step cost and give an example. Q2-8 Define fixed cost. Q2-9 Define variable cost. Is it the same as marginal cost? Explain. 14/11/12 2:56 PM 35 The Nature of Costs C. Cost-Volume-Profit Analysis 1. Copier Example Once costs are classified into fixed/variable categories, managers can perform cost- volume-profit analysis. The following example illustrates the essential features of this analysis. Suppose Xerox Corp. has a walk-up copy division that places coin-operated color photocopying machines in public areas such as libraries, bookshops, and supermarkets. Customers pay 25 per copy and the store providing the space receives 5 per copy. Xerox provides the machine, paper, toner, and service. Machines are serviced every 20,000 copies at an average cost of $200 per service call. Paper and toner cost 4 per copy. Xerox's walk-up copy division is charged $150 per month per machine placed (the opportunity cost of the machine). The variable costs per copy are Paper and toner Store owner Service ($200 20,000) $0.04 0.05 0.01 Variable costs $0.10 The contribution margin is the difference between the price and the variable cost per copy. The contribution margin is the net receipts per copy that are contributed toward covering fixed costs and providing profits. In this example, the contribution margin is calculated as Price Less variable costst $0.25 (0.10) Contribution margin $0.15 Given the contribution margin and monthly fixed costs, the number of copies each machine must sell monthly to recover fixed costs is the ratio of fixed costs to the contribution margin. This quantity of copies is called the break-even point and is calculated as Break-even point \u0002 Fixed costs $150 \u0002 \u0002 1,000 copies Contri t bution margin $0.15 In other words, if the copier makes 1,000 copies each month, it produces net receipts (after variable costs) of $150 (or 1,000 $0.15), which is just enough to recover the fixed costs. The Xerox copier example illustrates that classifying costs into fixed and variable components provides a simple decision rule as to where to place copiers. If a store is expected to produce (or actually produces) fewer than 1,000 copies per month, a copier should not be located there. The break-even volume provides a useful management tool for where to place machines. 2. Calculating Break-Even and Target Profits zim25745_ch02_022-086.indd 35 Let us study the cost-volume-profit analysis further. For simplicity, assume that production equals sales (to avoid inventory valuation issues such as the LIFO/FIFO choice). Also assume that the firm produces a single product. Figure 2-5 displays the total cost and revenue of producing various levels of output. The total revenue curve has a decreasing slope beyond some quantity because more unit sales can be achieved only at lower prices. At high prices, volumes are low. As prices fall, volume increases and the slope of the total revenue curve becomes less steep. The total cost curve, also nonlinear, is the same cost curve depicted in Figure 2-1. Break-even occurs when total revenues equal costs. In Figure 2-5, two break-even volumes exist, labeled \"Break-even point 1\" and \"Break-even point 2.\" The profit-maximizing point of 14/11/12 2:56 PM 36 FIGURE 2-5 Total cost and revenue curves Chapter 2 Total T cost Dollars MR T Total revenue MC FC Break-even point 1 Profit- Break-even maximizing point 2 point Units produced MC: Marginal cost is the slope of the total cost curve. MR: Marginal revenue is the slope of the total revenue curve. MC and MR are equal at the profit-maximizing point. output occurs when marginal revenue equals marginal cost (MC = MR). Marginal revenue refers to the receipts from the last unit sold. At any point, marginal revenue is the slope of the line just tangent to the total revenue curve. As described in section B, it is difficult to estimate nonlinear functions. Linear approximations are often used. Figure 2-6 substitutes linear cost and linear revenue approximations for nonlinear curves. Instead of allowing price to vary with quantity, assume a constant price, P. The total revenue function, TR, is then TR = P Q where Q is output. If the firm can sell as much as it wants without affecting price, then assuming a linear revenue function, TR, does not distort the analysis. Likewise, total cost is assumed to follow a linear function of the form TC = FC + VC Q where FC is the fixed cost and VC is the variable cost per unit. For the moment, ignore income taxes. Using linear functions allows managers to simplify analyzing how profits vary with output. In particular, Profit = TR TC = P Q VC Q FC Profit = (P VC) Q FC (2.1) (2.2) Break-even volume is the number of units sold that just covers fixed and variable costs. To find break-even volume, QBE, set equation (2.2) equal to zero and solve for QBE. Profit f t \u0002 0 (P \u0003 VC ) \u0004 QBE \u0003 FC FC F FC FC QBE \u0002 \u0002 \u0002 P \u0003 VC Contri t bution margin CM (2.3) Price minus variable costs (P VC), the contribution margin per unit (CM), is the profit per unit sold that can be used to cover fixed costs (FC). Contribution margin is important because it measures the incremental net receipts of selling one more unit. Refer zim25745_ch02_022-086.indd 36 14/11/12 2:56 PM 37 The Nature of Costs FIGURE 2-6 Linear approximations of cost and revenue curves and cost-volume-profit analysis Dollars TR Profit TC FC Loss Units produced Break-even point 1 FC: Fixed cost TR: T Total revenue equals a constant price times total output (P ( \u0004 Q) TC: T Total cost equals fixed costs plus the variable cost per unit times output (FC ( + VC \u0004 Q) to Figure 2-6. If units produced is less than the break-even point, a loss occurs. If output exceeds break-even quantity, a profit is earned. Note that the estimated break-even point, QBE, will not exactly correspond to the \"real\" break-even point, where total revenue equals total cost. The discrepancy occurs because TR and TC do not represent exactly total revenue and total costs, respectively. Suppose we want to make a target after-tax profit of ProfitT and the income tax rate is t. We can compute the number of units needed to make an after-tax profit by modifying equation (2.2) and solving for QT, target output: Profit f T \u0002[[ QT \u0002 T (P \u0003VC ) \u0004(1\u0003t ) Profit f T FC \u0005 (1\u0003tt ) C CM CM (2.4) (2.5) Instead of memorizing this formula, it is better to start with equation (2.1) or (2.2) and make the necessary modifications to solve the particular problem at hand. Exercise 2-3 illustrates how to modify the formula. Exercise 2-3: DGA Tile manufactures ceramic flooring tiles. DGA's annual fixed costs are $740,000. The variable cost of each tile is $0.25, and tiles are sold for $6.50. DGA has a combined state and federal tax rate of 45 percent. Required: a. How many tiles does DGA need to make and sell each year to earn an after-tax profit of $85,000? b. DGA must pay 10 percent of before-tax profits as a royalty payment to its founder. Now how many tiles must DGA make and sell to generate $85,000 after taxes? (Assume the royalty payment is not a tax-deductible expense.) continued zim25745_ch02_022-086.indd 37 14/11/12 2:56 PM 38 Chapter 2 Solution: a. Let Q denote the number of tiles made and sold that generates $85,000 of after-tax profit. Given the above data, we can write ($6.50Q $0.25Q $740,000) (1 0.45) = $85,000 (6.25Q $740,000) 0.55 = $85,000 Solving for Q: $3.4375Q = $85,000 + $740,000 0.55 Q = 143,127 tiles Therefore, to generate an after-tax profit of $85,000, about 143,000 tiles must be sold. b. The formula with the royalty payment, R, is ($6.25Q $740,000) 0.55 R = $85,000 where R = ($6.25Q $740,000) 0.10 Substituting R into the earlier equation, ($6.25Q $740,000) (0.55 0.10) = $85,000 Q = 148,622 The following exercise illustrates another use of contribution margins. It involves choosing the most profitable product to produce when capacity is constrained. Exercise 2-4: The Ralston Company produces three shirts. It only has 200 machine hours per day to produce shirts and has the following cost and production information: Selling price Variable cost of production Machine hours to complete one shirt Demand per day (shirts) Basic Deluxe Super $7.50 $6.00 0.6 50 $ 9 $ 7 2 50 $13 $ 7 3 50 Ralston has fixed costs of $75 per day. How many shirts of each type should be produced? Solution: The opportunity cost of producing one type of shirt arises from not using those machine hours to produce another type of shirt. In this problem, to maximize firm profits in light of a capacity constraint, we must produce those products with the highest contribution margin per unit of continued zim25745_ch02_022-086.indd 38 14/11/12 2:56 PM 39 The Nature of Costs capacity. First calculate the contribution margin per shirt and then convert this to the contribution margin per machine hour. Basic Deluxe Super Selling price Variable cost of production $7.50 $6.00 $9 $7 $13 $7 Contribution margin per shirt Hours to complete one shirt $1.50 0.6 $2 2 $6 3 Contribution margin per machine hour Demand per day (shirts) $2.50 50 $1 50 $2 50 Production schedule (shirts) Hours to complete one shirt 50 0.6 10 2 50 3 Hours consumed 30 20 150 To maximize profits Ralston should produce the shirt(s) with the highest contribution margin per unit of scarce resource (machine hours). This is an application of the opportunity cost principle. Even though super has the highest contribution margin per unit, basic has the highest contribution margin per machine hour. Therefore, to maximize profits, produce 50 units of basic, which will consume 30 hours (or 50 units 0.6 hours per unit). Next, produce 50 units of super, which consumes 150 hours of capacity. This leaves 20 hours of capacity to be used to produce 10 units of deluxe. The preceding analysis suggests producing the market demand for basic and super but not for deluxe. Fixed costs never enter the analysis. By definition, fixed costs are fixed and cannot be relevant to the decision, which depends only on selling price, variable cost, and the capacity constraint.* * One artificial aspect of this exercise is that the quantity demanded and the price are taken as constants. Clearly, at lower prices, more shirts will be demanded. Fixed demand is assumed to simplify the problem. The Ralston Company example illustrates a very simple situation in which there is only one constraint. If there are multiple constraints, linear programming is a useful technique for identifying the profit-maximizing mix of products. The next section describes some of the shortcomings of cost-volume-profit analysis. 3. Limitations of Cost-Volume- Profit Analysis Exercise 2-5: Using equation (2.2), find the output, Q, that maximizes profits. Solution: Profits are maximized by setting output to infinity. That is, equation (2.2) cannot be used to maximize profits. Exercise 2-5 illustrates that cost-volume-profit analysis is not useful for choosing the profit-maximizing output quantity when both revenues and costs are assumed linear. zim25745_ch02_022-086.indd 39 14/11/12 2:56 PM 40 Chapter 2 Given this conclusion, what good is it? Cost-volume-profit analysis offers a useful place to start analyzing business problems. It gives managers an ability to do sensitivity analysis and ask simple what-if questions. And, as we saw in the copier example, break-even analysis can prove useful for certain types of decisions. However, several limitations of cost-volume-profit analysis exist: 1. Price and variable cost per unit must not vary with volume. 2. Cost-volume-profit is a single-period analysis. All revenues and costs occur in the same time period. 3. Cost-volume-profit analysis assumes a single-product firm. All fixed costs are incurred to produce a single product. If the firm produces multiple products, and fixed costs such as property taxes are incurred to produce multiple products, then the break-even point or target profit for any one of the products depends on the volume of the other products. With multiple products and common fixed costs, it is not meaningful to discuss the break-even point for just one product. Although these limitations are important, cost-volume-profit analysis forces managers to understand how costs and revenues vary with changes in output. Notice in the earlier Xerox copier example that the assumptions underlying breakeven analysis are not violated: 4. Multiple Products Price does not vary with quantity. Variable cost per unit does not vary with quantity. Fixed costs are known. There is a single product (copies). All output is sold. As we saw above, one limitation of cost-volume-profit analysis is that it applies only to firms making a single product. One way to overcome this limitation is to assume a constant output mix of bundles with fixed proportions of the multiple products. Then a break-even or a target profit number of bundles can be calculated. For example, suppose a winery produces two types of wine: merlot and chablis. The following table summarizes prices and variable costs of the winery, which has fixed costs of $500,000 per year. Merlot Chablis Price per case Variable cost per case $30 20 $20 15 Contribution margin per case $10 $ 5 For every case of merlot produced, three cases of chablis are produced. Define a wine bundle to consist of four cases of which one is merlot and three are chablis. Each wine bundle has revenues of $90 (1 $30 + 3 $20), variable costs of $65 (1 $20 + 3 $15), and a contribution margin of $25 (1 $10 + 3 $5). The number of bundles required to break even is: eak-even number of bundles \u0002 zim25745_ch02_022-086.indd 40 Fixed costs $500,000 \u0002 \u0002 20,000 bundles Contri t butio u n margin $25 14/11/12 2:56 PM 41 The Nature of Costs Twenty thousand bundles needed to break even translate into 20,000 cases of merlot and 60,000 cases of chablis to break even. Hence, if a firm produces a variety of products in fixed proportions, then break-even analysis can be conducted by creating a standard bundle of products. Exercise 2-6: Using the winery example above, how many cases of merlot and chablis must be produced and sold to make an after-tax profit of $100,000 if the tax rate is 20 percent? Solution: The after-tax profit is calculated from the following equation: After-tax profit = (1 Tax rate) (Revenues Variable cost Fixed costs) $100,000 = (1 20%) ($90B $65B $500,000) where B is the number of bundles. Solving for B yields: $100,000 = .8 ($25B $500,000) $100,000 = $20B $400,000 B = $500,000/$20 B = 25,000 bundles In other words, 25,000 cases of merlot and 75,000 cases (3 25,000) of chablis must be sold to break even. At these production levels, $100,000 of after-tax profit is generated as demonstrated by the following income statement: RevenueMerlot RevenueChablis Total revenue Less: Variable costs Merlot Chablis Fixed costs Concept Questions zim25745_ch02_022-086.indd 41 25,000 $30 75,000 $20 $ 750,000 1,500,000 $2,250,000 25,000 $20 75,000 $15 $ 500,000 1,125,000 500,000 Total costs $2,125,000 Income before taxes Taxes (20%) $ 125,000 25,000 Net income after taxes $ 100,000 Q2-10 What are the underlying assumptions in a cost-volume-profit analysis? Q2-11 What are the benefits and limitations of cost-volume-profit analysis? 14/11/12 2:56 PM 42 Chapter 2 5. Operating Leverage Separating costs into fixed and variable components is useful for calculating break-even points and for pricing decisions, and for deciding to take new orders. Understanding a product's fixed and variable costs is also useful for strategic reasons. The higher a firm's fixed costs, the higher its operating leverage, which is the ratio of fixed costs to total costs. Operating leverage measures the sensitivity of profits to changes in sales. The higher the operating leverage, the greater the firm's risk. In firms with high operating leverage, small percentage changes in sales lead to large percentage changes in net cash flows (and profits). Therefore, firms with high operating leverage have greater variability in cash flows and hence greater risk than firms with a lower ratio of fixed costs to total costs. To illustrate the importance of operating leverage, consider the illustration in Table 2-1. Two companies, HiLev and LoLev, each sell 10,000 units of an identical product for $8 per unit. At that level of production, both companies have identical total costs of $70,000, and both companies are making $10,000 in profits. Since three-sevenths of LoLev's costs are fixed, whereas five-sevenths of HiLev's costs are fixed, HiLev has more operating leverage. Suppose volume falls 25 percent. Table 2-2 indicates the impact on net income. In LoLev, net income falls to zero; in HiLev, a loss of $5,000 results. Table 2-3 illustrates TABLE 2-1 Operating Leverage (Production and Sales Are 10,000 Units) Revenue Variable costs 10,000 units @ $8 10,000 units @ $4 10,000 units @ $2 Fixed costs Net income LoLev HiLev $80,000 40,000 $80,000 30,000 $10,000 20,000 50,000 $10,000 LoLev HiLev $60,000 30,000 $60,000 TABLE 2-2 Operating Leverage (Production and Sales Are 7,500 Units) Revenue Variable costs 7,500 units @ $8 7,500 units @ $4 7,500 units @ $2 Fixed costs Net income (loss) 30,000 $ 0 15,000 50,000 $(5,000) LoLev HiLev $100,000 50,000 $100,000 TABLE 2-3 Operating Leverage (Production and Sales Are 12,500 Units) Revenue Variable costs Fixed costs Net income zim25745_ch02_022-086.indd 42 12,500 units @ $8 12,500 units @ $4 12,500 units @ $2 30,000 $ 20,000 25,000 50,000 $ 25,000 14/11/12 2:56 PM 43 The Nature of Costs that when volume increases 25 percent, HiLev has a greater increase in profits than LoLev. Operating leverage amplifies the earnings impact of a given percentage change in volume. Firms with low variable costs per unit can sustain larger short-term price cuts when faced with increased competition. For example, a firm selling a product for $10 per unit that has a variable cost of $7 per unit can cut the price to just above $7 (for short periods of time) and still cover the variable costs of each unit. If that same firm has variable costs of $8 per unit, a price cut to below $8 causes a cash drain with each incremental unit. Knowledge of a competitor's cost structure is valuable strategic information in designing marketing campaigns. Estimating a firm's riskiness also requires knowledge of operating leverage. Exercise 2-7: Two Internet retailers have the following data: (millions) BuyEverything.com SportsWhere.com Sales Variable costs Fixed costs $120 70 40 $186 150 24 Net income $ 10 $ 12 Required: a. Which retailer has more operating leverage? b. Suppose the sales of each retailer double; which one's net income shows the greatest percentage increase? c. Calculate the percentage change in each retailer's net income if sales fall 50 percent. Solution: a. BuyEverything.com's operating leverage (as measured by the ratio of fixed to total cost) is .36 ($40/$110) and SportsWhere.com's operating leverage is .14 ($24/$174). Hence, BuyEverything.com has more operating leverage. b. The following table calculates how net income changes with a doubling of sales: (millions) BuyEverything.com SportsWhere.com Sales Variable costs Fixed costs Net income $240 140 40 $ 60 $372 300 24 $ 48 Prior net income % change $ 10 500%* $ 12 300% *($60 $10)/$10 ($48 $12)/$12 BuyEverything.com (which has more operating leverage from part a) shows the greatest percentage increase in net income. continued zim25745_ch02_022-086.indd 43 14/11/12 2:56 PM 44 Chapter 2 c. The following table calculates how net income changes when sales fall 50 percent: (millions) BuyEverything.com SportsWhere.com Sales Variable costs Fixed costs $60 35 40 $93 75 24 Net income ($15) ($ 6) Prior net income % change $10 250%* $12 150% *($15 $10)/$10 ($6 $12)/$12 BuyEverything.com (which has more operating leverage from part a) shows the greatest percentage decrease in net income. D. Opportunity Costs versus Accounting Costs The theoretically correct way to evaluate choices requires estimating opportunity costs. Estimating opportunity costs requires the decision maker to formulate all possible actions (the opportunity set) and the forgone net receipts from each of those alternatives so that the highest net cash flows from the set of actions not undertaken can be calculated. This yields the opportunity cost of the selected action. Such an exercise requires a special study for every decision, a time-consuming and costly activity. And after completing the study, the opportunity cost changes as the opportunity set changes. It is little wonder that managers devise shortcut approximations to estimating opportunity costs. Accounting-based costs are such a shortcut. Accounting systems record \"costs\" after making the decisions. Accounting systems track asset conversions. When the firm acquires assets such as raw material, accountants record them in monetary terms (historical cost valuation). As the raw inputs are converted into intermediate products, accountants value the intermediate products at the historical costs of the raw inputs converted into the intermediate products. The in-process, partially completed units flowing through departments, are recorded in the accounts at historical costs. If an employee who is paid $12 per hour completes an intermediate product in two hours, the accounting system increases the cost of the intermediate product by $24. Completion and sale of the manufactured unit causes the historical costs attached to it to be transferred from the inventory accounts to the expense account \"cost of goods sold.\" Accounting costs are not forward-looking opportunity costs; they look backward at the historical cost of the resources consumed to produce the product. Accounting systems produce accounting costs, not opportunity costs. However, accounting costs often provide a reasonable approximation of opportunity costs. Over short periods of time, prices and costs do not change very much. Thus, accounting costs can be reasonably accurate estimates of opportunity costs of producing the same products again. Besides providing data for decision making, internal accounting systems also provide data for controlling the behavior of people in organizations as well as the data for external financial reporting. The resources consumed to produce this textbook might differ from the opportunity cost of a new textbook. But the historical cost of this book provides information to senior managers as to how well the persons responsible for producing this book discharged their duties. Valuing the ending inventory of books, calculating taxes payable, and computing net income require the historical cost of this textbook. zim25745_ch02_022-086.indd 44 14/11/12 8:19 PM The Nature of Costs Managerial Application: New Economy Firms and High Operating Leverage 45 High-technology firms incur large fixed costs and relatively low variable costs to produce intellectual property such as software and Web sites. This combination creates high operating leverage that causes these firms to be very risky. In good times they are flying high. In weak times, there is very little they can do to trim expenses. Inktomi Corp. was a high-flying software company. It spent $10 million developing research engines and software to manage Web content. Once those fixed costs were incurred, each additional sale was almost pure profit. The president remarked, \"You have no cost of goods. We don't even ship a physical diskette anymore. Next to the federal government, this is the only business that's allowed to print money.\" All this has changed. Software development costs rose and sales nosedived, causing Inktomi to report a very large loss. Enormous fixed costs were required to research, develop, design, test, and market software. Intense competition and rapid obsolescence required high levels of spending each year. The result was a dramatic reversal of fortune leading to big swings in profits, stock prices, and hiring when sales sagged. Inktomi did not survive the Internet bubble and was sold to Yahoo! in 2002. Source: B McClure, \"Operating Leverage Captures Relationships,\" www.investopedia.com, Dec 28, 2006. Cost systems do not focus on opportunity costs, nor can they, since opportunity costs depend on the particular decision being contemplated. Accounting systems cannot anticipate all future decisions. For example, suppose you purchased land on a busy commercial street last month, paying $1 million. If you open a fast-food restaurant on this land, you estimate it will be worth $1.6 million. If, on the other hand, you open a gas station, its value is estimated at $1.7 million. Using the land for a gas station costs you $1.6 million in terms of the next best forgone opportunity (the fast-food restaurant). The $1 million historical cost of the land, even though only one month old, is not the opportunity cost. Thus, the term cost can refer to accounting cost (historical amounts) or to opportunity cost (the amount forgone by some decision), two very different concepts. In some cases, the user's meaning is obvious, but it is always important to question whether the term cost means opportunity cost or accounting cost. 1. Period versus Product Costs zim25745_ch02_022-086.indd 45 To further understand how accounting costs differ from opportunity costs, we distinguish between product costs and period costs. Product costs include all those accounting costs incurred to manufacture a product. Product costs are inventoried and expensed only when the product is sold. Period costs are those costs that are expensed in the period in which they are incurred. They include all nonmanufacturing accounting costs incurred to sell the product. For example, administration, distribution, warehousing, selling, and advertising expenditures are period costs. Research and development is a period cost. Period costs are not part of the product's cost included in inventory valuation. Product costs include both fixed and variable manufacturing components. Likewise, period costs, the costs of distributing and selling the product, contain both fixed and variable components. Fixed period costs include salespersons' salaries, advertising, and marketing costs. Examples of variable period costs include distribution costs and sales commissions. Accounting systems, even those used for internal purposes, distinguish between product and period costs. In most situations, unit cost figures refer to product costs excluding all period costs. Suppose that the unit manufacturing cost of a particular cell phone is $23. Selling and distributing this product costs an additional $4 per unit. This $4 period cost includes both fixed and variable period costs. The total cost of manufacturing and selling each unit is $27. Many firms refer to the $23 product cost as a unit manufacturing cost (UMC). For decision-making purposes both period ($4) and product ($23) costs must be considered, so it is important to remember that a UMC usually excludes period costs. 14/11/12 2:56 PM 46 Chapter 2 Period costs and product costs are historical costs. They are not opportunity costs. However, to the extent that the future looks a lot like the past, these historical costs can be useful predictors of opportunity costs. 2. Direct Costs, Overhead Costs, and Opportunity Costs The accounting concepts of direct costs versus overhead costs also illustrate the difference between opportunity and accounting costs. Direct costs and overhead costs form the core of this book, to which we will return in later chapters, particularly Chapters 9 through 13. But it is useful to introduce the terms now. Direct costs of a product or service are those items that are easily traced to the product or service. Direct labor and direct material costs are direct costs. An employee producing a product is classified as direct labor. If this employee is idled by a machine breakdown, that idle time is classified as indirect labor. Indirect materials include those us