ACC1

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Chapter 2

Relevant Costs and Benefits, Fixed/Mixed/Variable Cost

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Lecture Outline •  Which cost and benefits should we focus on in

decision-making? Ø  relevant costs and benefits

§  sunk costs §  time horizon: short-term vs long-term

•  How do costs behave? Ø  fixed, mixed, and variable costs

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Evaluating decisions •  Our general framework:

Ø for each option, compute Value = Benefits – Costs

(or Profit = Revenue – Costs for for-profit firms) Ø choose the best option (highest value or profit)

•  To evaluate decisions, we measure how they affect costs and benefits (=> value or profit): Ø which costs/benefits should we focus on?

(relevant costs and benefits) Ø how do they change? (fixed / mixed / variable costs)

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Which costs/benefits should we focus on?

•  Relevant costs and benefits: Ø  A cost or a benefit is relevant (for a specific decision

situation) if it differs across the decision options. Ø  Only focus on relevant costs and benefits in making

decisions (irrelevant costs and benefits will be the same regardless of what you choose, and can be ignored)

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Sunk Costs •  Sunk costs = costs that have been incurred in the past

•  Our decisions today will not change them •  They are no longer relevant => IGNORE THEM

•  Example: you have spent 10 years and $2 billion trying to develop a vaccine for cancer. You vaccine does not work (it turns patients into zombies). Your have two options: do nothing (status quo), or invest $10 million more to weaponize the vaccine and then sell it to the Pentagon for $50 million. What should you do?

status quo sell to Pentagon revenues $0 $50 million costs $0 $10 million profit (value) $0 $40 million

you can ignore the sunk costs ($2billion)

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Time Horizon: Short-term vs Long-term •  Whether a cost is relevant depends on the time horizon:

short-term versus long-term

•  Capacity resources (buildings, equipment, skilled salaried staff) are difficult to adjust on short notice due to technological and contractual constraints •  In the short term, capacity resources are non-controllable

(cannot be adjusted) => capacity costs (rent, depreciation, salaries) are non- controllable => irrelevant

•  In the long term, capacity resources are controllable (can be adjusted) => capacity costs are controllable => can be relevant

•  Resources like materials and unskilled hourly workers can be adjusted on short notice => controllable both in the short-term and in the long-term => can be relevant regardless of the time horizon

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How do costs change with our decisions? Fixed, mixed and variable costs

•  production costs for iPhone 5: Ø  components and materials* (purchased from suppliers):

§  LCD display: $28.50, from LG §  touch screen: $10, from Wintek §  processor: $10.75, from Samsung §  flash memory: $27, from Samsung §  etc... §  Total components and materials = $187.50 per iPhone

Ø  rent for production facilities Ø  depreciation on production equipment Ø  assembly labor (paid per hour) Ø  production supervisors (paid a fixed salary per month) Ø  electricity

•  Question: suppose Apple decided to increase production by 10% for the next month. How will this affect the costs (total $ amount spent) for each item above? (+10%, no change, other)

* source: iSuppli.com

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How do costs change with our decisions? Fixed, mixed and variable costs

•  Most decisions involve changes in activity volume (# units sold or produced, depending on the context) => we look at how costs change with activity volume.

•  Variable cost: cost is proportional to activity volume e.g., cost of components and materials used in production

•  Fixed cost: cost does not change with activity volume e.g., rent, depreciation, salaries

•  Mixed cost: contains both fixed and variable components e.g., electric bills, manager’s total compensation (salary+bonus)

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Exercise • Which of the following is a fixed, mixed or

variable cost:

a.  Assembly worker’s wages (“wage” = per-hour basis) b.  Production supervisors’ salaries (“salary” = monthly basis) c.  The cost of materials used in production d.  Rent e.  Depreciation on production equipment f.  Advertising on TV g.  Sales commissions (a fixed percentage of sales)

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Variable, Fixed, and Mixed Costs

activity volume (# units)

co st

variable costs

activity volume (# units)

co st

fixed costs

activity volume (# units)

co st

mixed costs

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Exercise • Which of the following is a fixed, mixed or

variable cost: activity volume

(#units) cost A cost B cost C

10 $20 $50 $80

20 $40 $50 $90 30 $60 $50 $100

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Total Costs •  Total costs are usually mixed costs:

TC = FC + unit VC × volume TC – total costs FC – fixed costs unit VC – variable costs per unit volume – # units produced or sold, depending on the context

activity volume (# units)

co st

Total costs

FC

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Exercise: Why do we care about fixed/ variable costs?

At current production volume of 100 units, the unit cost (i.e., total cost per unit) is $10 per unit. Question: How much will total costs change if we increase production by 10 units? Additional info on fixed/variable costs: The unit cost of $10 consists of: fixed costs of $6 per unit, and variable costs of $4 per unit. Same Question