Cost Management Concepts and Cost Behavior

Cost Management Concepts and Cost Behavior
Chapter 2
2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University
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
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Computing The Cost Of Something
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Cost Object
A cost object is something for which we want to compute a cost:
A product
A pair of pants
A product line
Womens boot cut jeans
An organizational unit
The on-line sales unit of a clothing retailer
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Direct Cost
A cost of a resource or activity that is acquired for or used by a single cost object Cost object = A dining room table
Cost of the wood that went into the dining room table
Cost object = Line of dining room tables

A managers salary would be a direct cost if a manager were hired to supervise the production of dining room tables and only dining room tables
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Indirect Cost
The cost of a resource that was acquired to be used by more than one cost object The cost of a saw used in a furniture factory to make different products
It is used to make different products such as dining room tables, china cabinets, and dining room chairs
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Direct or Indirect?
A cost classification can vary as the chosen cost object varies
Consider a factory supervisors salary If the cost object is a product the factory supervisors salary is an indirect cost If the factory is the cost object, the factory supervisors 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
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Organizing Costs Based On The Way They Are Created
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Flexible Costs
The costs of using flexible resources
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
Always direct costs

If inconvenient to account for them as direct costs or when the cost is only a small part of total costs, flexible costs are treated as indirect costs
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Capacity-Related Costs
The costs associated with capacity-related resources Capacity-related resources are acquired in advance of the work being done
Most personnel costs Depreciation on machinery and buildings
Capacity-related costs depend upon how much of the resource is acquired, not used May be direct or indirect costs
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Labor Costs
Cause of both confusion and controversy in costing circles
Originally flexible costs, because workers were paid in proportion to how much they produced Scheduling and union considerations have changed most labor costs into capacityrelated costs
Most organizations now treat labor costs as capacity-related rather than flexible
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The Use of Cost Information Defines Its Focus and Form
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Calculating A Cost Is Not An End In Itself

A cost number is only valuable if it serves a purpose The use to which a cost is put defines its relevance and appropriate form It is useful to divide those purposes into external and internal purposes
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External Use of Cost Information

The key issues for external users of accounting information:
Consistency Reasonably accurate allocation of costs between the income statement and the balance sheet
Generally Accepted Accounting Principles prescribe how to determine costs for external reporting
Focus on process rather than the decision relevance of the resulting cost allocations
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Cost Classifications (External Use)

The structure of traditional cost accounting systems has reflected the need to determine product costs for external financial statements
Must satisfy external financial reporting requirements imposed by GAAP Also, where they differ from GAAP, must satisfy requirements of income tax regulations
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Traditional Cost System

External requirements specify which costs: To assign to products Cost of goods sold Inventory To exclude from product cost calculations Costs usually classified by Type Product and period costs Function Manufacturing and nonmanufacturing costs
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Classifying Costs by Type

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
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Product Costs
Organizations incur product costs to produce the volume and mix of products made during the period
Materials costs, labor costs, and the cost of equipment, machinery and buildings
GAAP focuses on valuing unsold goods in ending inventory (asset) Any remaining manufacturing costs allocated to cost of goods sold (expense)
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Period Costs
Nonmanufacturing costs such as:
Administrative -Marketing Research & development Selling Costs
Some nonmanufacturing costs, such as selling, clearly do not apply to inventory items since they relate to products that have been sold Other nonmanufacturing costs (e.g., administrative) have such an ambiguous relationship to inventory that GAAP refuses to include these elements of cost in valuing inventory
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Internal Use of GAAP Cost Types

Some GAAP notions of costs are not particularly useful in management accounting:
Product and period costs Manufacturing and nonmanufacturing
The objective is to determine all the components, both manufacturing and nonmanufacturing, of the costs associated with a cost object
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Classifying Costs by Function

GAAP uses two broad functional cost classifications: Manufacturing costs: all costs incurred inside the factory associated with transforming raw materials into a finished product Nonmanufacturing Costs: an organizations other costs
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Manufacturing Costs
Direct manufacturing costs are traced or assigned to the products that created those costs and include the cost of material and the cost of labor that is paid based on the amount of work done Indirect manufacturing costs include costs of equipment, as well as the wages and benefits paid to production supervisors and workers who provide the general capacity to undertake production activities in the factory
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Indirect Manufacturing Costs

More difficult to trace to products because these costs have a cause-and-effect relationship with capacity rather than with individual units of production Assigning to a product involves allocating what is deemed to be a fair share of the indirect cost to that product Generally allocated based on the products use of the various capacity resources
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Nonmanufacturing Costs (1 of 2)
Distribution costs involve delivering finished products to customers
Examples are freight and the salaries of shipping and delivery personnel
Selling costs include sales personnel salaries and commissions and other sales office expenses Marketing costs include advertising and promotion expenses
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After-sales costs involve dealing with customers after the sale and include warranty repairs and the cost of maintaining help and complaint lines Research and development costs include expenditures for designing and bringing new products to the market General and administrative costs include expenses, such as the chief executive officers salary and legal and accounting office costs, that do not fall into any of the above categories
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Influence of GAAP
GAAP considers all nonmanufacturing costs as period costs used to support the sales of products in the current period only GAAP only includes manufacturing costs in calculating the cost of inventory for external reporting purposes Costing systems designed in the past conserved on information-processing costs by adopting the structure imposed by GAAP Most cost accounting systems we observe in organizations today tend to be driven by the rules that determine product costs for inventory valuation and cost of goods sold under GAAP
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Internal Use Of Cost Information

Inside the organization costs serve many different purposes, broadly categorized as:
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
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Management Accountings Role

Decision makers use costs to make decisions and to control the processes they manage The cost calculation may be tailored to the specific decision that is being made Tailoring the cost calculation is the role of the management accountant and the management accounting system
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Cost-Volume-Profit Analysis
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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 Conventional cost-volume-profit (CVP) analysis rests 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
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The CVP Profit Equation

Profit: = Revenue - Flexible costs - Capacityrelated costs = (Units sold x Revenue per unit) - (Units sold x flexible cost per unit) - Capacityrelated costs = [Units sold x (Revenue per unit-Flexible cost per unit)] - Capacity-related costs = (Units sold x Contribution margin per unit) - Capacity-related costs
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Break-even Volume
Using the CVP profit equation, break-even volume is determined by calculating the volume where profit = 0 0 = (Units sold x Contribution margin per unit) - Capacity-related costs Units sold to break even = Capacity-related costs Contribution margin per unit
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The CVP Chart

Decision makers often summarize costvolume-profit information in a cost-volumeprofit (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
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CVP Chart
(from Exhibit 2-3)
111 111 111 111 111 111 111 111
Dollars
111 111 111 111 111 11 1 1 -11111 -111111 -111111 11 11 11 11 11 11
Units Revenue Flexible Cost Capacity-Related Cost Total Cost 2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University Profit
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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
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Weighted Average Product

Compute each products share of total sales Multiply each products 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 flexible cost Subtract the weighted flexible cost from the weighted revenue to get the weighted contribution margin per unit of product
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Joan's Landscaping Services (based on Exhibit 11 - )
Multi-Product Example (1 of 4)
Lawn Mowing Layout Design Other Maintenance Per Unit Total Per Unit Total Per Unit Total 44 4 , 4 11 1 11 1 , 1 $11 .11$11111$1111$44444$1111$11111 ,1 .1 ,4 .1 ,1 1 . 1 1 11 1 1 11 11 1, 1 1. 1 1, 1 11 1 1 11 1 11 1 1. 1 1, 1 1 11 1 1, 1 1, 1 11 1 1 11 1 1, 1 -$111 $11 ,111 -$1111 ,
Units Sold Revenues Flexible Costs Capacity-Related Costs Profit
Joan's Lawnscaping Services - Composite Product Calculation (based on Exhibit 11 - ) Lawn Mowing Layout Design Other Maintenance Per Unit % Total Per Unit Total Per Unit Total Total All 11 1 44 4 4 , 1 . 444 1 1 44 4 4 1 . 444 11 1 11 1 1 , 1 . 111 11 1 , 1 Per Unit Weight Per Unit Weight Per Unit Weight Total All $11 . 11 $11 . 11 $1111 $44 .1 . 44 $1111 $11 .1 . 11 $1111 .1 1. 1 11 1 . 1 1 11 11 1. 1 11 . 1 1 11 1. 1 1. 1 11 1. 1 11 $11 . 11
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Units Sold
Revenues Flexible Costs Contribution Margin
The result of these calculations is a fictitious product that reflects the average revenue and flexible cost characteristics of the real products Given that the total capacity-related costs at Joans Landscaping is $300,000, use the formula for breakeven to compute the breakeven level of sales for this composite product
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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
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Joan's Landscaping Services - Composite Product Calculation (based on Exhibit 11 Lawn Mowing Layout Design Other Maintenance Per Unit Total Per Unit Total Per Unit Total Total All 11. 1 1 11 1 1 11 1 1. 11 11 . 1 1 11 1 $44 . 44 $44444$1111 $11111$1111 $11111 $11111 ,4 .1 ,1 .1 ,1 ,1 1. 1 11 1 11 1 1 11 1, 1 1. 1 1, 1 11 1 1 11 1. 1 1 11 1 1, 1 1 11 1 1, 1 $11 , 111 $11111 ,1 $11 ,111 $11111 ,1 1 11 1 1, 1 $1 Units Sold Revenues Flexible Costs Contribution Margin Capacity-Related Costs Profit
Note that this breakeven calculation focuses on breakeven for the company as a whole and not for individual departments This breakeven calculation will remain valid so long as the sales mix remains constant
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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
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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
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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
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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
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Cost Classifications Revisited (1 of 3)

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
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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
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A costs 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
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Effect of Time Frame (1 of 2)

Short run is the period over which a decision maker cannot adjust capacity
The level of capacity-related resources, hence of capacity-related costs, 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 flexible costs
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Effect of Time Frame (2 of 2)

Long-run costs are the sum of flexible and capacity-related 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
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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
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The composition of manufacturing costs has changed substantially in recent years Many formal cost systems were first implemented in the early 1900s:
Direct labor represented a large proportion, sometimes 50% or more, of the total manufacturing costs Direct material costs were also substantial Capacity-related costs generally represented a small fraction of total manufacturing costs Usually accumulated in a single pool and allocated to products in proportion to some volume measure such as the labor or machine hours used by the product
Changing Cost Structures (1 of 4)
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Today, direct labor is only a small portion of manufacturing costs
E.g., in the electronics industry direct labor is often less than 5% of the total manufacturing cost
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
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The increase in capacity-related 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 flexible and capacity-related costs associated with design, product development, distribution, selling, marketing, and administrative activities have increased
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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
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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
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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
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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
Loading shipments onto a truck is an example of a unit-related activity because it is proportional to the volume of shipments
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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
E.g., Machine setups are required when beginning the production of a new batch of products 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
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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 Product engineering efforts to maintain coherent specifications such as the bill of materials for individual products and their component parts and their routing through different work centers in the plant Managing and sustaining the product distribution channel The process engineering required to implement engineering change orders (ECOs)
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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 of customer-sustaining activities include:
Sales calls Technical support provided to individual customers
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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
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Business-Sustaining Activities
Business-sustaining activities are those required for the basic functioning of the business For example, organizations need only one CEO irrespective of their size, and they need to perform certain basic functions, such as registration or reporting, that also are independent of the size of the organization These core activities are independent of the size of the organization, or the volume and mix of products and customers
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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
If we understand the underlying behavior of costs, we have a basis to predict costs and to understand how costs will behave as volume expands and contracts
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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
Research and development Selling Logistical activities
The management of nonmanufacturing costs is an increasingly important contributor to an organizations financial success
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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
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Nonmanufacturing costs include both flexible and capacity-related components The nonmanufacturing costs that have attracted the most attention are customerrelated costs
Cost of selling the product to the customer Putting the product in the customers hands Providing after-sales support to the customer
Can be significant and they can vary widely across different customers
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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
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Life-Cycle Costs
Life-cycle costing is a relatively new perspective that argues that organizations should consider a products costs over its entire lifetime when deciding whether to introduce a new product There are five distinct stages in a typical products life cycle
Not all products will follow this pattern Some products will fail early and have a truncated life cycle
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Product Life Cycle (1 of 6)

Product development and planning
The organization incurs significant research and development costs and product testing costs Because of the increasing costs of launching products, organizations are devoting more effort to the product development and planning phase The nature and magnitude of these costs should be identified so that when products are initially proposed, planners have some idea of the cost that new product development will inflict on the organization Shorter life cycles provide less time to recover costs
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Introduction phase
The organization incurs significant promotional costs as the new product is introduced to the marketplace At this stage the products revenue will often not cover the flexible and capacity-related costs that it has inflicted on the organization
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Growth phase
The products revenues finally begin to cover the flexible and capacity-related costs incurred to produce, market, and distribute the product There is often little or no price competition The focus of attention is on developing systems to deliver the product to the customer in the most effective way
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Product maturity phase
Price competition becomes intense and product margins begin to decline While the product is still profitable, profitability is declining relative to the growth phase The organization undertakes intense efforts to reduce costs to remain competitive and profitable
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Product decline and abandonment phase
Phase in which the product begins to become unprofitable Competitors begin to drop outthe least efficient firstand the remaining competitors find themselves competing for a share of a smaller and declining market The organization incurs abandonment costs, which can include selling off equipment no longer required or restoring an asset (e.g., land) prior to abandoning it
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Product-related costs occur unevenly over the products lifetime The motivation for considering total life cycle costs before the product is introduced is to ensure that the difference between the products revenues and its manufacturing and distribution costs cover the other costs associated with developing, supporting, and abandoning the product Life-cycle costing is a good example of a costing system designed for decision making that has little or no practical relevance in external reporting
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If you have any comments or suggestions concerning this PowerPoint presentation, please contact: Terry M. Lease (terry.lease@sonoma.edu) Sonoma State University
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Cost Management Concepts and Cost Behavior

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Cost Management Concepts and Cost Behavior

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Cost Management Concepts and Cost Behavior

What Does Cost Mean?

Computing The Cost Of Something

Cost object = Line of dining room tables

Organizing Costs Based On The Way They Are Created

Always direct costs

The Use of Cost Information Defines Its Focus and Form

Calculating A Cost Is Not An End In Itself

External Use of Cost Information

Cost Classifications (External Use)

Traditional Cost System

Classifying Costs by Type

Internal Use of GAAP Cost Types

Classifying Costs by Function

Indirect Manufacturing Costs

Internal Use Of Cost Information

Management Accountings Role

The CVP Profit Equation

The CVP Chart

111 111 111 111 111 11 1 1 -11111 -111111 -111111 11 11 11 11 11 11

CVP Analysis for Multiple Products

Weighted Average Product

Joan's Landscaping Services (based on Exhibit 11 - )

Units Sold Revenues Flexible Costs Capacity-Related Costs Profit

Revenues Flexible Costs Contribution Margin

The Decision Defines Cost

Can Conflicting Costs Cause Confusion, Conceivably Chaos?

Cost Classifications Revisited (1 of 3)

Cost Classifications Revisited (2 of 3)

Cost Classifications Revisited (3 of 3)

Effect of Time Frame (1 of 2)

Effect of Time Frame (2 of 2)

Changing Cost Structures (1 of 4)

Changing Cost Structures (2 of 4)

Changing Cost Structures (3 of 4)

Changing Cost Structures (4 of 4)

Types Of Production Activities

New Classification System

Using The Cost Hierarchy

Nonmanufacturing Costs As Product Costs

Product Life Cycle (1 of 6)

Product Life Cycle (2 of 6)

Product Life Cycle (3 of 6)

Product Life Cycle (4 of 6)

Product Life Cycle (5 of 6)

Product Life Cycle (6 of 6)

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