Cost Management Concepts and Cost Behavior

Chapter 2

What Does Cost Mean?• There is no single definition of cost

– Costs are developed and used for some specific purpose

– The way the cost is to be used will define the way it should be computed

• Management accountants have used different systems, or classifications, to develop cost information

Expenditures, Costs & Expenses

• Expenditure – company purchases raw materials for $100

• Cost – company reports $100 of raw materials on balance sheet

• Expense – company records $100 expense on income statement when it sells the product that uses the raw material

Financial Reporting - GAAP

• GAAP defines cost as the monetary value of goods and services expended to obtain current or future benefits

• Expenses are the costs of goods or services that have expired. i.e., used up in the process of creating goods or services

• Costs incurred to receive future benefits are recorded as assets

Financial reporting - GAAP

• The key issues for external users of accounting information:– Consistency– Reasonably accurate allocation of costs

between the income statement and the balance sheet

• GAAP prescribes how to determine costs for external reporting

Product Costs• Organizations incur product costs to

produce the volume and mix of products made during the period– Manufacturing costs– Materials costs, labor costs, and the cost of

equipment, machinery and buildings– Allocated between ending inventory and cost

of goods sold

Financial reporting - GAAP

• Only manufacturing costs included in calculation the cost of inventory

• Historical cost• Costing systems designed in the past conserved

on information-processing costs by adopting the structure imposed by GAAP

• Most cost accounting systems tend to be driven by the rules that determine product costs for inventory valuation and cost of goods sold under GAAP

Internal Use of Cost Information

• Costs are used for planning and evaluation.

• The objective is to determine all the components, both manufacturing and nonmanufacturing, of the costs associated with a cost object

Internal Use Of Cost InformationPlanning

• Using cost as a basis for determining the selling price of a prospective product

• Using cost in a budgeting model to forecast costs under different levels of activity

Evaluation• Deciding whether the market price for an existing

product makes the product profitable• Determining whether a process is cost efficient

compared to similar internal or external processes

Cost Object• Management accounting concept

• A cost object is something for which we want to compute a cost:– A product

– A product line

– An organizational unit

Different views of product cost

• Financial accounting is concerned with the total cost of inventory while management accounting is concerned with the cost of an individual unit of inventory.

• In financial accounting, product cost includes on manufacturing costs. In management accounting, product cost includes all product-related costs.

Cost behavior

Flexible resources are resources whose costs are proportional to the amount of the resources used

• Wood used to make furniture in a factory• Electrical power to operate machinery• Fuel used to deliver the furniture to

customers

Variable costs – proportional to the amount of resource used

Cost Behavior• Capacity-related resources are acquired

in advance of the work being done

• Capacity-related costs depend upon how much of the resource is acquired, not used

• Fixed costs

Understanding cost behavior to cost products

• Cost classification varies depending on the the chosen cost object Example - factory supervisor’s salary

• If the cost object is a product the factory supervisor’s salary is an indirect cost

• If the factory is the cost object, the factory supervisor’s salary is a direct cost

• A cost object can be any unit of analysis including product, product line, customer, department, division, geographical area, country, or continent

Direct Cost• A cost of a resource or activity that is

acquired for or used by a single cost object

Direct Costs

• Cost object - dining room table– Cost of the wood that went into the dining

room table

• Cost object - line of dining room tables– Manager’s salary would be a direct cost if a

manager were hired to supervise the production of dining room tables and only dining room tables

Indirect Cost• The cost of a resource that was acquired

to be used by more than one cost object

• Example - the cost of a saw used in a furniture factory to make different products

Direct costs, Indirect costs and Cost Behavior

• When the cost object is a product, variable costs can be direct or indirect.

• When the cost varies in proportion to some activity that supports several products, then the cost will be indirect to the individual products.

• Fixed costs can be direct or indirect as well.

CVP Analysis• Decision makers often like to combine

information about flexible and capacity-related costs with revenue information to project profits for different levels of volume

• Cost-volume-profit (CVP) analysis is based on the following assumptions:– All organization costs are either purely flexible

or capacity related– Units made equal units sold– Revenue per unit does not change as volume

changes

The CVP Profit EquationProfit:= Revenue - Variable costs - Fixed costs= (Units sold x Revenue per unit) - (Units sold x variable

cost per unit) – Fixed costs= [Units sold x (Revenue per unit-variable cost per unit)] –

Fixed costs= (Units sold x Contribution marginContribution margin per unit) - Fixed

costs

Breakeven Volume

• Breakeven volume is determined by calculating the volume where profit = 0

• Breakeven equation:Units sold to break even =

Fixed costs ÷ Contribution margin per unit

Contribution Margin Ratio

• Contribution margin per unit / revenue per unit• Fraction of each sales dollar that does towards

covering fixed costs

Breakeven sales revenue =

Fixed costs / Contribution margin ratio

The CVP Chart• Decision makers often summarize cost-

volume-profit information in a cost-volume-profit (CVP) chart

• The CVP chart provides a convenient way of summarizing the relationship between volumes, revenues, costs, and profits and provides a visual way to display the effect of volume changes on profits

CVP Chart(from Exhibit 2-5)

-150000

-100000

-50000

0

50000

100000

150000

200000

250000

300000

350000

0 2000 4000 6000

Units

Do

llars

Revenue Flexible Cost

Capacity-Related Cost Total Cost

Profit

CVP Analysis for Multiple Products• There are many combinations of sales levels for

multiple products that would allow the organization to break even

• These can be simulated on a spreadsheet by varying the sales levels of the multiple products and finding combinations that result in total profits being zero

• Before the use of spreadsheets became widespread, management accountants developed an extension of basic CVP analysis that allowed them to continue to use its basic profit equation and graphing techniques by developing a weighted average product based on the estimated sales mix

Weighted Average Product• Compute each product’s share of total sales• Multiply each product’s revenue per unit by its

proportion of total sales to get a weight• Add the weights for all the products to get the total

weighted revenue• Apply the same technique to compute the

weighted variable cost• Subtract the weighted variable cost from the

weighted revenue to get the weighted contribution margin per unit of “product”

Multi-Product Example

• The result of these calculations is a fictitious product that reflects the average revenue and variable cost characteristics of the real products

• Given that the total capacity-related costs at Lynn’s Landscaping is $300,000, use the formula for breakeven to compute the breakeven level of sales for this composite product

Multi-Product Example (3 of 4)

• Break-even quantity = 300,000/53.06 = 5,653.50• To translate this average product break-even

quantity to individual products, simply reverse the process of computing the average:

– Lawn Mowing = 5653.50 x 4600/6200 = 4194.529– Layout Design = 5653.50 x 350/6200 = 319.14892– Other Maintenance = 5653.50 x 1250/6200 1139.818

Cost-benefit Considerations

• Unlike external reporting, where the format is prescribed by GAAP, the format for determining costs for internal decision making is at the discretion of the decision maker

• Because the organization must pay someone to develop cost information, its expected benefits should exceed its development costs

• The cost-benefit consideration is important even if it is difficult to compute the value of using cost information in a particular decision

The Decision Defines “Cost”• An old adage states, “different costs for

different purposes”

• The specific decision at hand will define:– The nature of the required cost– The way it should be computed– The value of any cost number

• A cost number that is useful for one decision may be useless or perhaps even harmful if it is used for another decision

Can Conflicting “Costs” Cause Confusion, Conceivably Chaos?

• One challenge of working with costs is that they are used in many different contexts

• One might think it curious or even wrong that cost is not a rigid number calculated according to some formal rules

• Does “cost” mean a historical cost or a future cost; does it take into consideration any potential discounts; does it include implicit costs or only explicit costs?

• Note that GAAP accounting for external reporting is designed to avoid all these issues

Opportunity Cost• An opportunity cost is the sacrifice you make

when you use a resource for one purpose instead of another

• Opportunity costs are implicit costs that do not appear anywhere in the accounting records

• Machine time used to make one product cannot be used to make another, so a product that has a higher contribution margin per unit may not be more profitable if it takes longer to make.

• Management accountants often use the concept of opportunity cost

Cost Classifications Revisited

• The dividing of costs into direct and indirect costs and the dividing of costs into flexible and capacity-related costs are different systems

• All flexible costs are direct costs• Some direct costs, however, are treated as if

they were indirect because of cost-benefit considerations

• When treated as indirect costs, they are applied to production based on some measure of volume

Cost Classifications Revisited

• Capacity-related costs can be direct or indirect

• Most capacity-related costs are indirect

• Some of the most egregious costing errors have been committed, however, by treating direct capacity-related costs as if they were indirect

• Exclusivity of use by the cost object defines whether a cost is direct or indirect

Cost Classifications Revisited• A cost’s definition can change as the

perspective changes

• A decision maker might define a cost one way for one decision and another way for another

• Direct means that the resource that created the cost was acquired for, and used by, a single cost object

• It is important, then, to understand clearly how the cost object is defined

Effect of Time Frame

• Short run is the period over which a decision maker cannot adjust capacity– The level of capacity-related resources and

their cost is fixed– The only costs that vary in the short run are

those that vary in proportion to production or some activity that is related to production

– Short run costs are variable costs

Effect of Time Frame• Long-run costs are the sum of variable

and fixed costs associated with a cost object – which is usually a product– They are important for product planning

purposes as they are an estimate of the cost of all resources consumed to make the product

– The price charged for a product must cover its long-run cost for the organization to replace the capacity used to make the product when the capacity deteriorates

Creating Costs• An organization creates different costs at

different stages:– Starting up– Early growth– Reaching the boundaries of existing capacity– Expanding product lines– Expanding capacity– Redefining the business– Continued growth

• These costs are not created evenly over time and should be planned for

Changing Cost Structures

• The composition of manufacturing costs has changed substantially in recent years

• Many formal cost systems were first implemented in the early 1900’s:– Direct labor represented a large proportion,

sometimes 50% or more, of the total manufacturing costs

– Direct material costs were also substantial– Capacity-related (fixed) costs generally

represented a small fraction of total manufacturing costs

Changing Cost Structures

• Today, direct labor is only a small portion of manufacturing costs

• The cost of direct materials remains important, representing 40% to 60% of the costs in many plants

• The big change has been the vastly increased share of total costs from capacity-related costs

Changing Cost Structures

• The increase in fixed costs results from:– The shift toward greater automation, which requires

more production engineering, scheduling, and machine setup activities

– The emphasis on better customer service– The increase in support activities required by a

proliferation of multiple products

• Further, both variable and fixed costs associated with design, product development, distribution, selling, marketing, and administrative activities have increased

Changing Cost Structures

• Changing cost structures have caused cost systems allocating indirect costs using volume measures to become increasingly inaccurate in computing product costs

• Many costing systems take costs that did not vary proportionally with volume, accumulate them, and then allocate them using a measure of volume

• These systems often underallocate costs to cost objects (e.g., product lines) produced in low volumes

Types Of Production Activities• Traditional cost systems classified activities

into those that varied with volume and those that did not

• This simple dichotomy does not capture the variety of the types of activities that take place in organizations

• A new classification system, developed originally for manufacturing operations, gives a broader framework for classifying an activity and its associated costs

New Classification System

• The new classification system places activities and their associated costs into one of the following categories:

– Unit related– Batch related– Product sustaining– Customer sustaining– Business sustaining

Unit-Related Activities• Unit-related activities are those whose

volume or level is proportional to the number of units produced or to other measures, such as direct labor hours or machine hours that are themselves proportional to the number of units produced

• Unit-related activities apply to more than just production activities

Batch-Related Activities• In a production environment, batch-related

activities are triggered by the number of batches produced rather than by the number of units manufactured– Indirect labor for first-item quality inspections

involves testing a fixed number of units for each batch produced and is, therefore, associated with the number of batches

– Many shipping costs may be batch related if the organization pays the shipper a charge per container or truckload

Product-Sustaining Activities• Product-sustaining activities support the

production and sale of individual products• These activities provide the infrastructure the

enables the production, distribution, and sale of the product but are not involved directly in the production of the product

• Examples include:– Administrative efforts required to maintain

drawings and labor and machine routings for each part

– The process engineering required to implement engineering change orders (ECOs)

Customer-Sustaining Activities• Customer-sustaining activities enable the

company to sell to an individual customer but are independent of the volume and mix of the products and services sold and delivered to the customer

• Examples include:– Sales calls– Technical support provided to individual

customers

Business-Sustaining Expenses• Business-sustaining expenses are other

resource supply capabilities that cannot be traced to individual products and customers:– The cost of a plant manager and administrative staff– Channel-sustaining expenses, such as the cost of

trade shows, advertising, and catalogs

• The expenses can be assigned directly to the individual product lines, facilities, and channels, but should not be allocated down to individual products, services, or customers

Business-Sustaining Activities

• Business-sustaining activities are those required for the basic functioning of the business

• These core activities are independent of the size of the organization, or the volume and mix of products and customers

Using The Cost Hierarchy

• The cost hierarchy just discussed is a model of cost behavior that can be used in two ways:– To predict costs– To develop the costs for a cost object such as

a product or product line

Nonmanufacturing CostsAs Product Costs

• Although manufacturing costs often are the most significant component of total costs, nonmanufacturing costs are large and growing in many organizations

• The management of nonmanufacturing costs is an increasingly important contributor to an organization’s financial success

Nonmanufacturing Costs

• Traditionally management accountants have looked at nonmanufacturing costs as a large pool of costs that should be managed by periodic budget appropriations

• For example, expenditures on items such as advertising are determined by what the organization can afford rather than by the mission it has to accomplish with advertising

Nonmanufacturing Costs

• Nonmanufacturing costs include both variable and capacity-related components

• The nonmanufacturing costs that have attracted the most attention are customer-related costs

• Can be significant and they can vary widely across different customers

Nonmanufacturing Costs

• Many organizations have begun to undertake what they call customer accounting to determine the profitability of dealing with different customers or different types of customers

• Customer accounting systems have caused some organizations to abandon certain customers or to provide differential service fees based on the services that customers demand