The Difference between Economic and Accounting Costs

Accounting costs the costs most often associated with the costs of producing. These
costs include direct payments to labor and capital to produce output. Accounting costs are
the costs that appear on the income statement. Historic cost is an accounting cost
measure. The historic cost of an activity is the sum of the costs the firm actually attributes
to providing that activity in a given accounting period.

Accounting costs can be represented by the following equation:
Accounting costs = direct costs + indirect costs

Accounting costs include all explicit costs plus some of the implicit costs. For example,
depreciation expenses (which are not explicit because they are not out-of-pocket expenses)
are counted as part of the accounting costs.

Economic costs the costs of production include not only the accounting costs but also the
opportunities forgone by producing a given product. By choosing to produce one good,
producers give up the opportunity for producing some other good. Sunk cost is an
economic cost concept. Sunk costs are historic costs that are irreversibly spent and
independent of the future quantity of service supplied.

Economic costs can be represented by the following equation:
Economic costs = explicit costs + implicit costs

The major difference between accounting and economic costs is the inclusion
of opportunity costs as a part of economic costs.
Contribution Analysis and its role in Decision Making
Contribution Analysis is defined as the payment made by individual products towards
recovering the fixed cost of a business, this payment quickly become profits once the fixed
cost of a business has been fully met.
It is calculated thus: unit selling price of a particular product less variable cost of producing
that product.
The concept of contribution analysis is centered on variable costs as they are the relevant
costs as far as decision making is concerned. Relevant costs are cost that can be avoided if
not for taking up a task or project just like relevant cash flows.
Uses of Contribution Analysis
Generally, contribution analysis is a powerful decision making and budgeting process tool
that management accountant functions and managers use to aid most managerial decision
making processes. Following are some specific situations where contribution analysis is
handy.
1) Fixing minimum selling price.
2) Breakeven Calculation.
3) It helps to draw a profit volume chart.
4) It is useful in knowing how low a sale can be before a company starts making losses.
Introduction to break-even analysis
Introduction
Break-even analysis is a technique widely used by production management and
management accountants. It is based on categorizing production costs between those
which are "variable" (costs that change when the production output changes) and those
that are "fixed" (costs not directly related to the volume of production).
Total variable and fixed costs are compared with sales revenue in order to determine
the level of sales volume, sales value or production at which the business makes neither
a profit nor a loss (the "break-even point").
The Break-Even Chart
In its simplest form, the break-even chart is a graphical representation of costs at
various levels of activity shown on the same chart as the variation of income (or sales,
revenue) with the same variation in activity. The point at which neither profit nor loss
is made is known as the "break-even point" and is represented on the chart below by
the intersection of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of
production activity ("output"). OB represents the total fixed costs in the business. As
output increases, variable costs are incurred, meaning that total costs (fixed + variable)
also increase. At low levels of output, Costs are greater than Income. At the point of
intersection, P, costs are exactly equal to income, and hence neither profit nor loss is
made.
Fixed Costs
Fixed costs are those business costs that are not directly related to the level of
production or output. In other words, even if the business has a zero output or high
output, the level of fixed costs will remain broadly the same. In the long term fixed costs
can alter - perhaps as a result of investment in production capacity (e.g. adding a new
factory unit) or through the growth in overheads required to support a larger, more
complex business.
Examples of fixed costs:
- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs
Variable Costs
Variable costs are those costs which vary directly with the level of output. They
represent payment output-related inputs such as raw materials, direct labor, fuel and
revenue-related costs such as commission.
A distinction is often made between "Direct" variable costs and "Indirect" variable
costs.
Direct variable costs are those which can be directly attributable to the production of a
particular product or service and allocated to a particular cost center. Raw materials
and the wages those working on the production line are good examples.
Indirect variable costs cannot be directly attributable to production but they do vary
with output. These include depreciation (where it is calculated related to output - e.g.
machine hours), maintenance and certain labor costs.
Semi-Variable Costs
Whilst the distinction between fixed and variable costs is a convenient way of
categorizing business costs, in reality there are some costs which are fixed in nature but
which increase when output reaches certain levels. These are largely related to the
overall "scale" and/or complexity of the business. For example, when a business has
relatively low levels of output or sales, it may not require costs associated with
functions such as human resource management or a fully-resourced finance
department. However, as the scale of the business grows (e.g. output, number people
employed, number and complexity of transactions) then more resources are required. If
production rises suddenly then some short-term increase in warehousing and/or
transport may be required. In these circumstances, we say that part of the cost is
variable and part fixed.
Cost Estimation
Mixed costs contain both a fixed component and a variable component. In order to
determine the two components, managers must separate the mixed cost into the two
manageable components--fixed costs and variable costs. There are a handful of methods
used by managers to achieve this. The process of breaking mixed costs into fixed and
variable portions allows managers to use the costs to predict and plan for the future given
the insight on that cost behavior provides. Managers label the process of separating mixed
costs into fixed and variable components, cost estimation.


Cost Estimation Methods

The four methods of cost estimation to be discussed in managerial accounting are listed
below. The first three will be covered in this chapter, with regression covered in the next
chapter.
Account analysis
Scatter graphs
High-low method
Linear regression
Cost estimation methods are necessary only for costs that are identified as mixed costs.
There is no need to apply an estimation method to break a cost into fixed and variable
portions if you have already determined it is solely fixed or solely variable. Even though
actual data may be used to determine the fixed and variable components of mixed costs, all
four methods produce estimates of amounts of fixed and variable costs.


The Goal of Cost Estimation

The ultimate goal of cost estimation is to determine the amount of fixed and variable costs
so that a cost formula can be used to predict future costs. The cost formula, or cost
equation, is the output of the cost estimation process. Because you have only one variable
(number of units), the formula will be a straight line, or linear equation. (You should
remember the concept of functions from your high school algebra classes.
1
) The formula
that represents the equation of a line will appear in the format of:

y = mX + b
where y = total cost
m = the slope of the line, i.e., the unit variable cost
X = the number of units of activity
b = the y-intercept, i.e., the total fixed costs
Recall that the y = VCx + TFC is the equivalent equation used in accounting for estimating
costs.

The total cost side of the equation (y) can also be expressed as f(x) so that the formula
appears as:

f(x) = VCx + TFC

As such, the equation is often referred to as a function. In accounting, it is referred to as a
cost function because the 'y' equates to total cost.

Determining a linear function is useful in predicting cost amounts at different levels of
activity. This is useful because managers must be able to predict costs to plan for future
operations. This is often accompanied by what-if analysis that assists with the preparation
of budgets, pricing of products or services, and other key management functions.


Cost Equation Components

Your goal it to determine the cost equation for a particular cost. Because our ultimate goal
is to determine the 'total' cost, the cost equation must use cost amounts that remain the
same at every level of activity, as you do want to be able to calculate the total cost at every
activity level. As such, the cost equation will contain the variable cost per
unit and total fixed costs. These two amounts remain the same at all levels of activity within
the relevant range.

The VC component of the cost equation is displayed with two decimals in standard form
because this variable cost amount is a unit cost (and unit costs are always displayed with
two decimal places). The TFC component of the cost equation is displayed with no
decimals.


Account Analysis Method

The account analysis method of estimating fixed and variable costs is likely the approach
you have used to identify cost behavior so far in your study of managerial accounting, by
simply looking at a cost and guessing its most likely type of cost behavior. This method
requires considerable subjective judgment and insight. It is most often used by accountants
or managers who are familiar with the nature of costs within a general ledger account
(often multiple accounts). Account analysis is the only method you can use to estimate
costs when only one one period of data are known.

The account analysis approach requires that each individual cost is examined and based on
judgment, is categorized as a fixed or a variable cost. Variable cost per unit is calculated by
dividing the total of all variable costs by the number of units produced/sold.

Total Variable Costs
= Variable cost per unit
Number of Units Produced/Sold

The variable cost per unit is plugged into the cost formula, y = VCx + TFC, as the variable
cost (VC). The fixed costs are totaled separately and replace the y-intercept (TFC)
component of the equation. This results in a cost equation that can be used to estimate
costs for future periods.

Note that the determination of 'cost per unit' is literal. The calculation is performed exactly
how it reads: 'Cost' is on the numerator; 'Per' means divide; and 'units' appears on the
denominator.


Account Analysis Walk Through Problem

Home Shine is estimating its fixed and variable costs. The following costs were incurred
during the month of May by Home Shine when 200 homes were cleaned:

Cleaning supplies $ 2,400
Hourly wages 4,850
Depreciation - cleaning equipment 650
Managers salary 1,400
Auto commuting expenses 1,600
Office rent 850
Total costs $11,750

Use the account analysis method to determine the total cost equation for Home Shine.

Solution
Step 1: Classify each amount as variable or fixed based on judgment. By definition, variable
costs increase in total when more activity occurs. The activity for this problem is number of
homes cleaned. By definition, fixed costs are the same in total regardless of the activity
level.
Cleaning supplies = variable cost. The total cost of cleaning supplies increases when more
homes are cleaned.
Hourly wages = variable cost. The total cost of hourly wages increases when more homes
are cleaned.
Depreciation = The total cost of depreciation is $650 regardless of the number of homes
cleaned.
Manager's salary = The manager's salary is the same regardless of the number of hours
worked or the number of homes cleaned.
Auto commuting expenses = variable cost. The total cost of commuting expenses such as
gasoline and maintenance increases when more homes are cleaned.
Office rent = The monthly office rent is the same regardless of the number of homes
cleaned.
Step 2: Total the amount of the costs you identified as variable.

$2,400 + $4,850 + $1,600 = $8,850

Calculate variable cost per unit by dividing the total of all the variable costs by the number
of units (homes) produced/sold (cleaned).
$8,850
= $44.25
200
Step 3: Total the amount of the costs you identified as fixed costs.

$650 +$1,400 + $850 = $2,900

Step 4: Plug your answers to steps 2 and 3 into the cost formula by replacing the slope (m)
with variable cost per unit and the y-intercept (b) with total fixed costs in the cost
equation:
y = 44.25X + 2,900
The cost equation indicates that the total cost of cleaning homes is $44.25 per home plus a
monthly cost of $2,900.

Scatter Graph Method

Creating a scatter graph is another method of estimating fixed and variable costs. It
provides a good visual picture of the total costs at different activity levels. However, it is
often hard to visualize the line through the data points, especially if the data is varied. This
approach requires multiple data points and requires five steps:
Step 1: Draw a graph with the total cost on the y-axis and the activity (units) on the x-
axis. Plot the total cost points for each activity points.
Step 2: Visualize and draw a straight line through the points.

Step 3: Determine variable costs per unit by identifying the slope thorough a measure of
rise over run.
Rise
= Variable cost per unit
Run
Step 4: Identify where the line crosses the y-axis. This is the total fixed cost amount.

Step 5: Plug your answers to steps 3 and 4 into the cost formula by replacing the slope (m)
with variable cost per unit and the y-intercept (b) with total fixed costs in the following
format:
y = VCx + TFC

Note: If you have forgotten how to graph data points, review graphing concepts.


High-Low Method

The high-low method uses the highest and lowest activity levels over a period of time to
estimate the portion of a mixed cost that is variable and the portion that is fixed. Because
this method uses only the high and low activity levels to calculate the variable and fixed
costs, it may be misleading if the high and low activity levels are not representative of the
normal activity, i. e., they may be extremes, or outliers. For example, if most data points lie
in the range of 60 to 90 percent for a particular accounting test, and one student scored a
20, the use of the low point might distort the actual expectation of costs in the future. The
high-low method is most accurate when the costs incurred at the high and low levels of
activity are representation of the majority of the other points. The steps below guide you
through the high-low method:
<="" p="" style="color: rgb(0, 0, 0); font-family: 'Times New Roman'; font-size: medium;
font-style: normal; font-variant: normal; font-weight: normal; letter-spacing: normal; line-
height: normal; orphans: auto; text-align: start; text-indent: 0px; text-transform: none;
white-space: normal; widows: auto; word-spacing: 0px; -webkit-text-stroke-width: 0px;">
Step 1: Determine which set of data represents the total cost (dependent variable, y) and
which represents the activity (independent variable, x). Find the lowest and highest activity
points in the data representing the x variable.
Step 2: Determine variable costs per unit by using the mathematical slope formula, by
dividing the change in cost by the change in activity:
Y2 -Y1 = Variable cost per unit
X2 - X1
Where X2 is the high activity level
X1 is the low activity level
Y2 is the total cost at the high activity level
Y1 is the total cost at the low activity level
Step 3: Plug your answer to step 2 and the amounts from either the high or the low point
into the cost formula by replacing the slope (VC) with the variable cost per unit, the total
cost (at the highest activity point) for the y variable, and the high activity for the x variable.
Then solve for fixed costs (TFC).

Step 4: Plug your answers to steps 2 and 3 into the cost formula by replacing the slope (VC)
with variable cost per unit and the y-intercept (TFC) with total fixed costs in the following
format:
y = VC x + FC

If you have forgotten algebra concepts relating to the slope-intercept form, you can review
those concepts here.
2



High-Low Method Walk Through Problem

Information concerning units sold and total delivery costs for Bridges, Inc. for five months
of 2015 appears below:

Units Costs
January 1,200 $74,150
February 1,150 71,000
March 1,190 72,400
April 1,300 80,600
May 1,310 79,040

Use the high-low method to answer the following:
A. How much is the variable cost per unit?
B. How much are total fixed costs?
C. Write the cost equation in proper form.
Solution
Step 1: The Units column is the activity. The Costs column is the Total cost. Because
the Units column represents activity, select the high and low data points from
the Units column. May generated the largest activity with 1,310 units, and February
generated the lowest activity with 1,150 units.

Step 2: Use the slope formula by subtracting the smallest from the largest activity on the
denominator. Use the corresponding total costs for May and February and subtract the
smallest from the largest cost on the numerator:

Y2 - Y1
=
$79,040 - $71,000
= $50.25 per unit
Y2 - Y1 1,310 - 1,150

The variable cost per unit is $50.25.

Step 3: Select either of the two data points that you chose in Step 1 to plug into the cost
equation. Both data points will result in the same answer. Using the low data point
(February), the total cost of $71,000 is substituted for y in the cost equation, and 1,150
units is substituted for 'x', the units variable. Substitute the unit variable cost from step 2
into the formula for VC. Substitute the number of activity units for the low data point for
x You should now have the following equation:
y = VC x + TFC
71,000 = (50.25 x 1,150) + TFC

Solve for total fixed costs (TFC), which results in $13,212.50.
Step 4: Write the cost formula in standard form by plugging in the variable cost per unit
and total fixed cost as follows:
y = 50.25x + 13,213

The standard format is to express variable cost per unit using two decimal places and total
fixed costs with no decimal places.


Using a Cost Equation to Estimate Future Costs

Once a cost equation is determined, it can be used to estimate costs at various levels of
activity. For example, assume Bridges, Inc. expects to sell 1,240 units of product in June.
Using the total cost equation determined in the high-low method walk through problem,
the total estimated cost would be:

y = (50.25 x 1,240) + 13,213 = $75,523

Bridges, Inc. estimates that the total delivery cost for June will be $75,523.

Definition of Forecasting

The use of historic data to determine the direction of future trends. Forecasting is used by
companies to determine how to allocate their budgets for an upcoming period of time. This
is typically based on demand for the goods and services it offers, compared to the cost of
producing them. Investors utilize forecasting to determine if events affecting a company,
such as sales expectations, will increase or decrease the price of shares in that company.
Forecasting also provides an important benchmark for firms which have a long-term
perspective of operations.
Stock analysts use various forecasting methods to determine how a stock's price will move
in the future. They might look at revenue and compare it to economic indicators, or may
look at other indicators, such as the number of new stores a company opens or the number
of orders for the goods it manufactures. Economists use forecasting to extrapolate how
trends, such as GDP or unemployment, will change in the coming quarter or year. The
further out the forecast, the higher the chances that the estimate will be less accurate.
Forecast: A prediction, projection, or estimate of some future activity, event, or
occurrence.
Types of Forecasts
- Economic forecasts
o Predict a variety of economic indicators, like money supply, inflation
rates, interest rates, etc.
- Technological forecasts
o Predict rates of technological progress and innovation.
- Demand forecasts
o Predict the future demand for a companys products or services.

Since virtually all the operations management decisions (in both the strategic
category and the tactical category) require as input a good estimate of future
demand, this is the type of forecasting that is emphasized in our textbook and in
this course.
TYPES OF FORECASTING METHODS
Qualitative methods: These types of forecasting methods are based on
judgments, opinions, intuition, emotions, or personal experiences and are
subjective in nature. They do not rely on any rigorous mathematical
computations.
Quantitative methods: These types of forecasting methods are based on
mathematical (quantitative) models, and are objective in nature. They rely heavily
on mathematical computations.
QUALITATIVE FORECASTING METHODS



Executive
Opinion
Approach in which
a group of
managers meet
and collectively
develop a forecast
Market
Survey
Approach that
uses interviews
and surveys to
judge preferences
of customer and
to assess demand
Delphi
Method
Approach in which
consensus
agreement is
reached among a
group of experts

Sales Force
Composite
Approach in which
each salesperson
estimates sales in
his or her region
Qualitative Methods
QUANTITATIVE FORECASTING METHODS



Time-Series Models
Time series models look at past
patterns of data and attempt to
predict the future based upon the
underlying patterns contained within
those data.
Associative Models
Associative models (often called
causal models) assume that the
variable being forecasted is related to
other variables in the environment.
They try to project based upon those
associations.
Quantitative Methods