|Types of Costs
- Direct Costs
- costs directly traceable to an operating department or
- direct costs are the responsibility of and controllable
by the department or division manager
- the majority of direct costs are variable costs
- costs that are difficult to trace to a specific
department or division
- indirect costs are generally not controllable by the
- are also called undistributed costs
- cost shared by more than one operating department or
- an appropriate method should be used to distribute these
costs to the appropriate division
- a cost that may or may not be incurred based solely on
the decision of a particular person, normally the general manger or
- example: should the exterior of the building be
painted this year
- 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
- a cost that has already been incurred which cannot be
charged and cannot affect future decisions
- 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...
if indirect costs are allocated incorrectly, poor
management decision will result
- sales revenue
- square footage
- contributory income
- direct costs
- number of employees
|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
- 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 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
- maximum-minimum method (also called the high-low
multipoint graphical method (also called
the scattergraph 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
- Choosing one of the points, compute the intercept.
- Write the equation.
regression analysis method
- Plot the data (cost driver volume on x-axis and
- Visually draw a straight line through the data.
- Read the intercept.
- Calculate the slope by using the intercept and a
- Write the equation in “slope-intercept” form
- 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
- It also is subjective because each person will draw a
sloped line. Thus, it should only be used by managers that have a
very good understanding of the business. For example, extreme
are usually not considered. A period with excessive overtime,
or the introduction of new machinery may be outside the company’s
range. As the slope changes, so will the intercept. This
each person will have a different cost equation.
- This is really just
a rough-cut approximation.
- The high-low method
- is objective
- Everyone will end up with the same
- It’s calculations are about as simple as the scattergraph
approach, making it a popular method prior to computers and hand-held
- However, the high-low method uses the two most extreme
points, which may
be statistical outliers. Again, this approach should only be used by
that have a very good understanding of the business. For example,
extreme conditions are usually not considered. A period with
overtime, holidays or the introduction of new machinery may be outside
the company’s relevant range and should not be selected. If so, the
will not accurately represent the actual cost behaviors.
- This approach
is still pretty much a rough-cut approach.
- The regression method
- provides the most accurate equation in terms of
discriminate, but not predictive, ability because it uses all the data
- It also is fairly simple to use with hand-held
spreadsheet programs, and statistical software like PC-SAS and
- 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
assume the past predicts the future.
- Given the current state of knowledge, the scattergraph and
are only used to guide the selection of an appropriate statistical