Chapter 6 Basic Cost Concepts

General Nature of Cost

•Cost, considered as an expense, is the reduction of an asset, generally for the ultimate purpose of increasing revenues.

•Costs include cost of food sold, labor expense, supplies expense, utilities expense, marketing expense, rent expense, depreciation expense, insurance expense, and many others.

•Because the profit margin for most hospitality operations is less than 10 percent, more than 90 percent of their revenues is used to pay these expenses or costs.

Costs in Relation to Sales Volume

Fixed costs

•Fixed costs are those that remain constant in the short run, even when sales volume varies.•Common examples of fixed costs include salaries, rent expense, insurance expense, property taxes, depreciation expense, and interest expense.

•Certain fixed costs may be reduced if a lodging facility closes for part of the year.

•Fixed cost that may be avoided when a company shuts down are called avoidable costs.•Fixed costs are often classified as either capacity or discretionary costs.

•Capacity fixed costs relate to the ability to provide goods and services.

•Discretionary fixed cost do not affect a lodging establishment’s current capacity.

•Fixed costs can also be related to sales volume by determining the average fixed cost per unit sold

•Although they are constant in the short run, all fixed costs change over longer periods.

Variable Costs

•Variable costs change proportionally with the volume of business.

•Theoretically, total variable costs vary with total sales, whereas unit variable costs remain constant.

Step Costs

•Step costs are constant within a range of activity but different among rages of activity. •Step costs resemble fixed costs when one step includes the operation’s probable rage of activity.

•When there are many steps and the cost differences between steps are small, then step costs, for analytical purposes, are considered mixed costs.

Mixed Costs

•The mixed cost’s fixed element is determined independently of sales activity, while the variable element is assumed to vary proportionally with sales volume.

•Total mixed costs = fixed costs + (variable cost per unit * unit sales)

Total Costs

•Total costs for a hospitality establishment consist of the sum of its fixed, variable, step, and mixed costs.

•TC= fixed costs + (variable cost per unit * unit sales)

Determination of Mixed Cost Elements

High/Low Two-Point Method

1.Select the two extreme periods of sales activity in the time span under consideration.

2.Calculate the differences in total mixed cost and activity for the two periods.

3.Divide the mixed cost difference by the activity difference to determine the variable cost

per activity unit.

4.Multiply the variable cost per activity unit by the total activity for the period of lowest sales

to arrive at the total variable cost for the period of lowest activity.

5.Subtract the result in step 4 from the total mixed cost for the period of lowest activity to

determine the fixed cost for that period.

6.Check the answer in step 5 by repeating steps 4 and 5 for the period with the greatest

activity.

7.Multiply the fixed cost per period by the number of periods in the time span to calculate the

fixed costs for the entire time period.

8.Subtract the total fixed costs from the total mixed costs to determine the total variable

costs.

•The high/low two-point method considers only two extreme periods and is a fairly simple way of estimating the variable and fixed elements of mixed costs.

•The results will be inaccurate to the degree that the two periods fail to represent fairly the high and low points of activity.

Scatter Diagram

1.Prepare a graph with the independent variable on the horizontal axis and the dependent

variable on the vertical axis.

2.Plot data on the graph by periods.

3.Draw a straight line through the points, keeping an equal number of points above and

below the line.

4.Extend the line to the vertical axis. The intersection indicates the fixed costs for the period.

5.Multiply the fixed costs for the period by the number of periods to determine the fixed

costs for the time span.

6.Determine total variable costs by subtracting total fixed costs from total mixed costs.

7.Determine variable costs per sales unit by dividing total variable costs by total units sold.

*The scatter diagram is an improvement over the high/low two-point approach because it includes data from all periods in the time span under consideration.

Regression Analysis

•Regression analysis is a mathematical approach to fitting a straight line to data points perfectly-that is, the difference in the distances of the data points from the line is minimized. •The formulas used in regression analysis allow us to make the calculations without plotting points or drawing lines.

(∑y)(∑x2) - (∑x)(∑xy)

Fixed costs =

n(∑x2)-(∑x)2

∑ the sum of

Y dependent variable