Cost Management Concepts and Cost Behavior

1. Cost Management Concepts and Cost Behavior Chapter 2

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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. Internal Use Of Cost Information Planning • 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

10. 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

11. 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.

12. 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

13. 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

14. 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

15. Direct Cost • A cost of a resource or activity that is acquired for or used by a single cost object

16. 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

17. 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

18. 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.

19. 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

20. The CVP Profit Equation Profit: • 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 margin per unit) - Fixed costs

21. 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

22. 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

23. 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

24. CVP Chart(from Exhibit 2-5)

25. 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

26. 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”

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. 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

47. 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)

48. 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

49. 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

50. 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