Concepts

Professor Gil Sadka

 Agenda: Concepts

• Terminology
• Direct vs. indirect cost
• Variable vs. fixed cost
• “Death spiral”
 Terminology: Basics
• Cost versus expense
– Cost: resource sacrificed for a given purpose
– Expense: cost charged against revenues in a certain time
period
• Decision focus: relevant versus irrelevant cost
– Relevant cost: relevant for a certain decision
– Sunk/irrelevant cost: incurred in the past/ unaffected by
decision
– Opportunity cost: profit forgone by selecting one
alternative over another
 Agenda: Concepts

• Terminology
• Direct vs. indirect cost
• Variable vs. fixed cost
• “Death spiral”
 Terminology: Cost Objects

• Cost object: object for which we measure costs

– Product
– Product line
– Factory, office building
• Direct cost: directly traced to cost object
• Indirect cost (a.k.a. overhead, OH): cannot be
traced directly in an economically feasible way
 Example: Direct vs. Overhead Cost

• Branch manager’s salary in a retail bank:

– Overhead cost with respect to cost objects
“credit cards” or “savings accounts”
– Direct cost with respect to cost object “branch”
Same cost can be Direct as well as Indirect!

Salary of Dean of SOM

Direct cost with respect to Indirect cost with respect to

the cost object of SOM the cost object of “EMBA”

7
 Product and Period Costs

Characteristic Product costs Period costs

What constitutes Costs related to getting a Costs that are other than
this cost? product or service ready to be product costs. Related to
sold (i.e. costs incurred in the marketing and administration
production process)
Can they be Yes. They are inventoried until No. They can’t be inventoried
“inventoried”? the products or services are and therefore they can’t flow
sold to the customer. Called through inventory accounts
“inventoriable costs”
When are they Expensed when sold Expensed in the same period
expensed? that they are incurred. Called
“period costs”
Where do they Above the “gross margin” line Below the “gross margin” line
appear in the
income statement?
8
 Manufacturing Overhead

All other manufacturing costs

Indirect Indirect Other

Material Labor Costs

Materials used to support Cost of personnel who do Examples: depreciation

the production process. not work directly on the on plant and
Examples: lubricants and product. Examples: equipment, property
cleaning supplies used in an maintenance workers, taxes, insurance,
automobile assembly plant. janitors and security guards. utilities.
 Manufacturing Cost Flows
Income
Balance Sheet
Statement
Costs Inventories
Expenses

Material Purchases Raw Material

Direct Labor Work in

Process
Manufacturing
Overhead Product Cost of
Finished costs
Goods
Goods
Sold

Selling and Period Expenses Selling and

Administrative Administrative
 Agenda: Concepts

• Terminology
• Direct vs. indirect cost
• Variable vs. fixed cost
• “Death spiral”
 Terminology: Variability with Output

• Variable costs: costs that increase if output (or

sales) is increased
– Do not vary on a per-unit basis

• Fixed costs: remain constant if output (or

sales) changes
– Vary on a per-unit basis
 Variable and Fixed Cost

Total Cost

Variable
Cost

Fixed
Cost

q
 Total Variable Cost Example

The cost of gasoline for your car is an example of

variable cost
Total cost of gasoline
per month

Number of miles driven

per month 14
 Variable Cost Per unit

The cost of gasoline

per mile driven is
constant.

Per mile gasoline cost

Number of miles driven per

month 15
 Total Fixed Cost Example

Your monthly lease payment does not change

with respect to miles driven.
Monthly Lease
payment

Number of miles driven

per month 16
 Fixed Cost Per Unit Example

The lease cost per mile driven decreases as more miles

are driven.

Per mile lease payment

Number of miles
driven per month 17
 Step Costs

90
Thousands of Dollars

Total cost doesn’t

change for a range
Rent Cost in

60 of activity, and then

jumps to a new
higher cost for the
30 next higher range of
activity.

00 1 2 3
Sales revenue (million $)
18
 Death Spiral

Professor Gil Sadka

 Example: The “Death Spiral”

Products A B C D
Units produced/sold 1,000 1,000 1,000 1,000
Unit price $100 $200 $150 $120
DM cost per unit $25 $85 $80 $60
DL cost per unit $45 $45 $45 $45
Unit profit before OH 30 70 25 15

● Manufacturing OH costs of $80,000, all fixed

● DM (direct materials) and DL (direct labor) are all variable
● OH allocation base: DL cost
 “Death Spiral”: Initially

Products A B C D Total
Units produced/sold 1,000 1,000 1,000 1,000 4,000
Unit price $100 $200 $150 $120
DM cost per unit 25 85 80 60
DL cost per unit 45 45 45 45
Unit profit before OH 30 70 25 15
Total profit before OH 30,000 70,000 25,000 15,000 140,000
 “Death Spiral”: Initially

Products A B C D Total
Units produced/sold 1,000 1,000 1,000 1,000 4,000
Unit price $100 $200 $150 $120
DM cost per unit 25 85 80 60
DL cost per unit 45 45 45 45
Unit profit before OH 30 70 25 15
Total profit before OH 30,000 70,000 25,000 15,000 140,000
OH cost 80,000
Operating income 60,000
 “Death Spiral”: Initially

Products A B C D Total
Units produced/sold 1,000 1,000 1,000 1,000 4,000
Unit price $100 $200 $150 $120
DM cost per unit 25 85 80 60
DL cost per unit 45 45 45 45
Unit profit before OH 30 70 25 15
Total profit before OH 30,000 70,000 25,000 15,000 140,000
Allocated OH cost 20,000 20,000 20,000 20,000 80,000
Operating income 10,000 50,000 5,000 (5,000) 60,000

⇒ Eliminate product D !
 “Death Spiral”: First Round

Products A B C D Total
Units produced/sold 1,000 1,000 1,000 0 3,000
Unit price $100 $200 $150 $0
DM cost per unit 25 85 80 0
DL cost per unit 45 45 45 0
Unit profit before OH 30 70 25 0
Total profit before OH 30,000 70,000 25,000 0 125,000
Allocated OH cost 26,667 26,667 26,667 0 80,000
Operating income 3,333 43,333 (1,667) 0 45,000

⇒ Now eliminate product C !

 “Death Spiral”: Second Round

Products A B C D Total
Units produced/sold 1,000 1,000 0 0 2,000
Unit price $100 $200 $0 $0
DM cost per unit 25 85 0 0
DL cost per unit 45 45 0 0
Unit profit before OH 30 70 0 0
Total profit before OH 30,000 70,000 0 0 100,000
Allocated OH cost 40,000 40,000 0 0 80,000
Operating income (10,000) 30,000 0 0 20,000

⇒ Now eliminate product A !

 “Death Spiral”: Third Round

Products A B C D Total
Units produced/sold 0 1,000 0 0 1,000
Unit price $0 $200 $0 $0
DM cost per unit 0 85 0 0
DL cost per unit 0 45 0 0
Unit profit before OH 0 70 0 0
Total profit before OH 0 70,000 0 0 70,000
Allocated OH cost 0 80,000 0 0 80,000
Operating income 0 (10,000) 0 0 (10,000)

⇒ Oops?!
Good Luck on Your New Job!
 Takeaways: “Death Spiral”

• Decision-making:
– Beware of “unitized” fixed costs for (short-term)
decision purposes
– Distinguish between variable and fixed costs
• Organizational design:
– Try to avoid externalities
• Compensation for Managers A, B, C should not be
affected by keeping/dropping Div. D