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 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
 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 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
 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)
350000
300000

250000

200000
Dollars

150000
100000

50000

0
0 2000 4000 6000
-50000

-100000
-150000

Units
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 Costs
As 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