Managing
Costs 
Types of Costs
 Direct Costs
 costs directly traceable to an operating department or
division
 direct costs are the responsibility of and controllable
by the department or division manager
 the majority of direct costs are variable costs
 Indirect Costs
 costs that are difficult to trace to a specific
department or division
 indirect costs are generally not controllable by the
department/division manager
 are also called undistributed costs
 Joint Cost
 cost shared by more than one operating department or
division
 an appropriate method should be used to distribute these
costs to the appropriate division
 Discretionary Cost
 a cost that may or may not be incurred based solely on
the decision of a particular person, normally the general manger or
owner
 example: should the exterior of the building be
painted this year
 Relevant Cost
 a cost that is different between one or more of
alternatives being evaluated
 if a cost item is the same for both alternatives it is
considered irrelevant and ignored
 Sunk Cost
 a cost that has already been incurred which cannot be
charged and cannot affect future decisions
 Opportunity Cost
 the cost of not taking advantage of an option that can
increase a revenue flow

Allocating Indirect Costs
 key is to make the allocation as equitable as possible for
the departments involved
 some popular allocation methods are based on...
 sales revenue
 square footage
 contributory income
 direct costs
 number of employees
 if indirect costs are allocated incorrectly, poor
management decision will result

Fixed and Variable Costs
 understanding the relationship of FC + VC = TC is a
key function involved in a variety of business decisions
 we can consider selling below total cost when variable
costs are covered and a contribution towards reducing fixed costs is
made
 selling below cost is a short term strategy
 is often used with "perishable" products (e.g.,
airline seats, hotel room nights, banquet room)
 can help answer the following question  should we close
during the off season

Operating Leverage
 operating leverage refers to a business that has high fixed
costs relative to variable costs
 being highly leveraged, a small change in sales revenues
generates a large change in operating income

3 Methods to Separate Mixed Costs
 maximumminimum method (also called the highlow
method)
 Plot the data.
 Determine the high and low points (based on cost
driver volume, not cost).
 Using the coordinates for these two points, calculate the
slope.
 Choosing one of the points, compute the intercept.
 Write the equation.
 multipoint graphical method (also called
the scattergraph method)
 Plot the data (cost driver volume on xaxis and
total cost
on yaxis).
 Visually draw a straight line through the data.
 Read the intercept.
 Calculate the slope by using the intercept and a
representative point’s
coordinates.
 Write the equation in “slopeintercept” form
 regression analysis method
 Using a computer program (or manually solving the
2 simultaneous equations),
calculate the slope and intercept.
 Write the equation

Comparing the Three Methods
 The multipoint graph approach
 is very simple in terms of the calculations
required.
 It also is subjective because each person will draw a
slightly differently
sloped line. Thus, it should only be used by managers that have a
very good understanding of the business. For example, extreme
conditions
are usually not considered. A period with excessive overtime,
holidays
or the introduction of new machinery may be outside the company’s
relevant
range. As the slope changes, so will the intercept. This
means
each person will have a different cost equation.
 This is really just
a roughcut approximation.
 The highlow method
 is objective
 Everyone will end up with the same
equation.
 It’s calculations are about as simple as the scattergraph
approach, making it a popular method prior to computers and handheld
calculators.
 However, the highlow method uses the two most extreme
points, which may
be statistical outliers. Again, this approach should only be used by
managers
that have a very good understanding of the business. For example,
extreme conditions are usually not considered. A period with
excessive
overtime, holidays or the introduction of new machinery may be outside
the company’s relevant range and should not be selected. If so, the
equation
will not accurately represent the actual cost behaviors.
 This approach
is still pretty much a roughcut approach.
 The regression method
 provides the most accurate equation in terms of
discriminate, but not predictive, ability because it uses all the data
points.
 It also is fairly simple to use with handheld
calculators,
spreadsheet programs, and statistical software like PCSAS and
Minitab.
 Managers need to eliminate data points that are outside
the company’s relevant
operating range of activity.
 All three statistical methods suffer from the same
limitation:
they
assume the past predicts the future.
 Given the current state of knowledge, the scattergraph and
highlow approaches
are only used to guide the selection of an appropriate statistical
model.
