CHAPTER 2

Identifying andEstimating Costsand Benefits

Learning Objectives

After studying this chapter, you will be able to:

  1. Understand how to identify the costs and benefits of decision options.
  2. Consider how time affects the realization of costs and benefits.
  3. Explain the principles for estimating costs and benefits.
  4. Describe the hierarchical nature of costs and its implications for cost measurement.

Overview

As you learned in Chapter 1, the primary role of management accounting is to measure the costs and benefits of decision options. This step consists of two tasks—identifying the costs and benefits to measure, and then estimating the amount of each identified cost and benefit. In this chapter, we focus on the principles that help managers accomplish these two tasks. We begin with the principles, controllability and relevance, that determine which costs and benefits to measure. Using these principles, we offer a way for grouping business decisions by their horizon—the time span within which an organization reaps the benefits and incurs the costs of a decision. Next, we describe the two key principles for estimating costs and benefits: variability and traceability. Finally, we extend the principle of variability to develop a hierarchy of costs, which helps to increase the accuracy of estimated costs.

Learning Objective 1

Understand how to identify the costs and benefits of decision options.

Knowing What to Measure

Controllability

  1. Benefits and costs that arise from the decision maker’s choice of a particular option are controllable—the decision maker controls the costs that will be incurred and the benefits that will be received.
  2. Controllable benefitsand controllable costsfor these organizations are the incremental revenues and expenditures relative to current revenues and expenditures or status quo.
  3. In some situations, it is easier for us to consider only some of the controllable costs and benefits when making our choice.

Relevance

  1. You need only focus on controllable costs and benefits that differ.
  2. This narrows your attention to relevant costs and relevant benefits, which are the controllable costs and benefits that differ across decision options.
  3. The principle of relevance helps decision makers compare options by focusing on those costs and benefits that matter, and ignoring items that are common and irrelevant.

Comparing Controllability and Relevance

  1. If the status quo is a feasible option, then all controllable costs and benefits are relevant because, by definition, they differ from the status quo.
  2. Using the concept of relevance therefore does not reduce the number of costs and benefits to consider.
  3. However, if the status quo is not a feasible option, then some controllable costs and benefits might not be relevant, letting us ignore them in our analysis.
  4. We can use either controllability or relevance to make effective decisions.
  5. We can use the principle of controllability to
  6. identify the incremental costs and benefits relative to the status quo,
  7. calculate the value of each option,
  8. choose the one with the highest value.
  9. Often, however, we may want to identify the best choice quickly and efficiently; in such cases, relevance is the operative principle.
  10. We identify relevant costs and benefits by asking if they differ across the feasible options.
  11. Summing relevant costs and benefits associated with each option gives us the relative values of the options, enabling us to make the right choice.

Sunk Costs

  1. A sunk cost is not affected by decisions made today.
  2. Sunk costs:
  3. do not influence value because we cannot change the past.
  4. are neither controllable nor relevant.
  5. are never relevant because they pertain to the past.
  6. Sunk costs are never relevant because they pertain to the past.

Learning Objective 2

Consider how time affects the realization of costs and benefits.

Time and Controllability

Categorizing Decisions Based on Time

1.A decision maker’s control over costs and benefits increases as the time horizon increases.

2.Previously made commitments and obligations expire with time.

3.The time horizon affects whether a cost or benefit is controllable for that decision.

4.In the short term, capacity resources are fixed and noncontrollable; that is, organizations cannot substantially alter their abilities to deliver products or services in the short term.

5.In the long term, organizations can change capacity. Thus, capacity costs are controllable for long-term decisions—that is, organizations can alter their abilities to deliver products or services in the long term.

6.We could classify decisions as relating to the short or long term depending on the time over which we experience the costs and benefits.

7.Time helps us identify the costs and benefits we need to include in the decision—that is, the costs and benefits that are “on the table” and that we need to estimate.

Learning Objective 3

Explain the principles for estimating costs and benefits.

How to Estimate Costs and Benefits

1.The core idea underlying estimation is that costs and benefits are the result of performing activities.

2.We estimate costs and benefits by first estimating the change in activity for an option and then calculating the financial impact of this change in activity levels.

3.The principles of variability and traceability underlie the estimation of costs and benefits.

  1. Variability deals with how activities influence costs and benefits.
  2. Traceability is the degree to which we can directly relate a cost or benefit to a specific option.

Variability

1.Variabilityis the relation between a cost or a benefit and an activity.

2.A variable cost is proportional to the volume of activity

  1. A fixed cost does not change as the volume of activity changes.
  2. A mixed cost contains both fixed and variable components.

3.We can only classify a cost or benefit as variable, mixed, or fixed as it relates to a specific activity and/or a specific time horizon.

4.The specific activity we choose to estimate costs and benefits depends on the item that we want to measure, the decision context, and the organization.

Variability of Benefits

For most businesses, sales volume (i.e., number of units sold) determines revenues.

Variability of Costs

1.Costs can be variable, fixed, or mixed with respect to sales volume.

2.These costs are proportional to computer sales.

3.The principle of variability means that, when estimating costs and benefits, the first step is to estimate the change in activity.

Traceability

1.Traceabilityis the degree to which we can directly relate a cost or revenue to a decision option.

2.A cost or revenue that we can uniquely relate (trace) to a decision option is a direct cost or a direct benefit.

3.If only a portion of the cost or revenue pertains to a particular decision option, then it is an indirect cost or an indirect benefit.

Direct and Indirect Costs

1.It is important not to confuse direct and common costs with variable and fixed costs.

2.A direct cost can be fixed or variable.

3.We can identify direct and indirect costs in all functional areas.

  1. Example:
  2. Direct marketing expenses include sales commissions.
  3. The expense of maintaining sales offices, however, is an indirect cost.

4.It is easier to estimate direct costs and benefits than indirect costs and benefits. Why? By definition, direct costs and benefits relate entirely to a decision option.

Learning Objective 4

Describe the hierarchical nature of costs and its implications for cost measurement.

Hierarchical Cost Structure

1.Step costsstay at the same level for a certain activity range, but jump to a higher amount if the volume of activity increases beyond that range.

2.Step costs relate to fixed costs and variable costs in a straightforward way.

  1. A step cost behaves more like a variable cost as the step size decreases.
  2. It behaves more like a fixed cost as the step size increases.

3.In sum, when we classify all costs as fixed or variable with respect to sales volume, we are saying that all costs are either independent of or proportional to sales volume.

4.As a result, when decision makers need finer estimates, they use the cost hierarchy.

5.Generalizing the classification by using the cost hierarchy allows us to consider unit-, batch-, product-, and facility-level activities, which in turn helps us to estimate better the costs of a decision option.

6.Batch-level costs depend on the number of batches produced (number of setups) instead of units.

7.Product-level costsdo not depend on the number of batches and units.

8.Finally, costs that do not vary at the unit level, the batch level, or the product level are facility-level costs.

CHAPTER 2 REVIEW QUESTIONS

TRUE/FALSE

  1. You are applying the principle of relevance when controllable costs and benefits differ across decision options.
  1. If the status quo is a feasible option, then all controllable costs and benefits are irrelevant because, by definition, they differ from the status quo.
  1. Sunk costs do not influence value because they we cannot change the past.
  1. Capacity costs are non-controllable for long-term decisions because organizations can change capacity.
  1. A fixed cost is proportional to the volume of activity, while variable cost does not change as the volume activity changes.
  1. A step cost behaves more like a variable as the step size decreases, while it behaves more like a fixed cost as the step size increases.

MULTIPLE CHOICE

1. The following table presents total cost for three types of cost (x, y, and z) for two three different activity levels in a manufacturing process. Identify which cost type is fixed.

Cost:XY Z

2,000 units $10,000 $15,000 $20,000

3,000 units $11,000 $15,000 $20,000

4,000 units $12,000 $15,000 $20,000

  1. X
  2. Y
  3. Z
  4. X and Z

2. The following table presents total cost for three types of cost (x, y, and z) for two three different activity levels in a manufacturing process. Identify which cost type is variable.

Cost:XYZ

2,000 units$10,000$15,000$20,000

3,000 units$11,000$15,000$20,000

4,000 units$12,000$15,000$20,000

  1. X
  2. Y
  3. Z
  4. X and Z

3. Which of the following would be considered a direct cost for jet engine manufacturer?

  1. Salary of a plant manager.
  2. Plant Rent.
  3. Raw materials purchased to produce engine.
  4. Plant Utilities and Water.

4. The cost hierarchy divides costs into:

  1. Unit-level costs.
  2. Facility-level costs.
  3. Product-level costs.
  4. Batch-level costs.
  5. All of the above.

5. Fixed costs of operating a factory are examples of:

  1. Unit-level costs.
  2. Facility-level costs.
  3. Product-level costs.
  4. Batch-level costs.
  5. None of the above.

6. Advertising costs are examples of:

  1. Unit-level costs.
  2. Facility-level costs.
  3. Product-level costs.
  4. Batch-level costs.
  5. None of the above.

7. Amixed cost:

  1. Does not change as the volume of activity changes.
  2. Is proportional to the volume of activity.
  3. Contains both fixed and variable components.
  4. Is a sunk cost.

8. Suppose fixed costs are $200, variable cost is $2 per unit, and step costs are $40 for every 20 unit produced. What is the total cost of producing 30 units?

  1. $340
  2. $260
  3. $280
  4. $140

9. Which of the following is the best example of facility-level costs?

  1. Property taxes of a factory $260.
  2. Cost of plastic for bottled water.
  3. Research and development costs.
  4. Setup of machine drivers.

10. In August, a manufacturing plant produced 100 units of tubes for sale. The total variable costs were $6,000 and the fixed costs for the plant amounted to $5,000. How much is the unit variable cost for the tubes if 130 tubes are produced?

  1. $60.00
  2. $84.61
  3. $46.15
  4. $110.00

MATCHING

1.Match the items below by entering the appropriate code letter in the space provided.

A.Batch-level CostsF.Unit-level Cost

B.Sunk CostG.Variable Cost

C.Mixed CostH.Fixed Cost

D.Facility-level CostI.Product-level Costs

E.Cost HierarchyJ.Step Cost

____ 1. A cost that does not change as the volume of activity changes.

____ 2. A cost that contains both fixed and variable components.

____ 3. The classification of costs into unit-, batch-, product-, and facility-level.

____ 4. Setup of machine drivers.

____ 5. Rent and property taxes.

____ 6. A cost that increases in discrete steps as the volume of activity increases.

____ 7. A cost that is proportional to the volume of activity.

____ 8. Advertising, research, and development costs.

____ 9. Direct materials such as the cost of cotton.

____ 10. A past expenditure that cannot be changed.

SHORT PROBLEMS

1. Mike has decided to go to the museum tomorrow. His choices are to visit thelocal museum down the road from his house or visit the new museum 50 miles from his house. Both museums have the same admission price and the price for food is the same as well. Which of the following costs and benefits are controllable for this decision? Which of the following costs and benefits are relevant for visiting the new museum? Indicate your answer by marking Yes or No in the appropriate column.

ItemControllable? Relevant?

Travel cost to the museum

Amount spent for food at the museum

Admission price for the museum

Amount spent on breakfast today

Rent payment next month

2. Suppose fixed costs are $300, the unit variable cost is $9, and step costs are $300 for every 60 units produced. Fill in missing information below.

VolumeTotal Variable CostsTotal Step CostsTotal Fixed CostsTotal Cost

30 units????

130 units????

CHAPTER 2 REVIEW QUESTIONS ANSWER KEY

TRUE/FALSE

1. L01 – True

2. L01 – False

3. L01 – True

4. L02 – False

5. L03 – False

6. L04 – True

MULTIPLE CHOICE

1. LO3 – D

2. LO3 – A

3. LO3 – C

4. LO4 – E

5. LO4 – B

6. LO4 – C

7. LO4 – C

8. LO4 – A $200 + ($2 x 30) + ($40 x 2) = $340

9. LO3 – A

10. LO3 – A

MATCHING

1.H6. J

2.C7. G

3.E8. I

4.A9. F

5.D10. B

SHORT PROBLEMS

1. Controllable and Relevant (LO1)

ItemControllable?Relevant?

Travel cost to the museumYesYes

Amount spent for food at the museumYesNo

Admission price for the museumYesNo

Amount spent on breakfast todayNoNo

Rent payment next monthNoNo

2. Variable, Step, Fixed, and Total Costs (LO4)

VolumeTotal Variable CostsTotal Step CostsTotal Fixed CostsTotal Cost

30 units$270$300$300$870

130 units$1,170$900$300$2,370

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