Cost ManagementMSCM8615

Definition of cost

• A monetary measure of the resources given up to acquire a good or service

Why Incur Costs?

• If the organization believes that incurring a cost provides a future benefit that exceeds the cost, then it would be a worthwhile use of the company’s resources

The Value of Cost Info

• Cost information assists management in the decision making, planning, directing, and controlling functions

• Examples of the use of cost info:– Pricing services or activities– deciding among program alternatives– how much of a raise to give employees– income measurement and asset valuation– etc.

Cost Concepts

• Cost object: the entity (product, service, department, process, decision, etc.) which we want to know the cost of

• Cost accumulation: gathering cost data in an organized manner

• Cost allocation: assigning costs to a cost object based on a cost driver

• Cost driver: a characteristic of an event or activity that causes costs to be incurred

Direct vs. Indirect Costs

• Direct cost: a cost that can be traced in an economically feasible manner to a cost object

• Indirect cost: a cost that cannot be traced in an economically feasible manner to a cost object

• Note that the choice of the cost object determines whether a particular cost is considered direct or indirect

• Example

Example of Direct vs. Indirect Costs

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A cco u n ta n cyC h a irm a n 's S a la ry

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N u rs in g

V illa n o v a U n iv ers ityP res id en t's S a la ry

Cost Behavior

• Fixed costs: those costs that, in total, do not change when the level of activity changes

• Variable costs: those costs that, in total, change in direct proportion to changes in the level of activity

What is the benefit of understanding how costs behave?

• Having knowledge of how costs behave is useful for planning purposes (cost prediction)

• Having knowledge of how costs should behave is useful for control purposes (comparing what actual costs were to what we thought they should have been)

• Having knowledge of how costs behave is useful for decision making

Cost Behavior Basics

• Fundamental to cost behavior is trying to understand what causes or influences cost changes

• Sometimes, management has influence over the level of cost incurred

• Other times, accountants try to determine what is driving (influencing or causing) cost changes

• We refer to the activity or process or output factor that influences cost behavior as the cost driver

Management Influence on Cost Behavior

• Discretionary vs. committed costs• Discretionary costs are those costs that

management has the option of incurring or not incurring and at different levels. However, once the decision has been made as to what level of cost to incur, they are viewed as fixed, locked-in costs– an example would be advertising costs or training costs

• Committed costs are the basic costs necessary just to have the capacity or potential to operate– an example would be the salary of the VP-

Manufacturing

Fixed Costs

Fixed costs remain unchanged as the activity level (cost driver) varies.

Examples of fixed costs include rent, salaries and property taxes.

Example of Fixed Costs

Month Activity Level Total Cost Cost Per UnitJan 1200 $4,000 $3.33 Feb 1400 $4,000 $2.86 Mar 1100 $4,000 $3.64 Apr 800 $4,000 $5.00 May 900 $4,000 $4.44 Jun 1300 $4,000 $3.08

Graph of Total Fixed Costs

Monthly Rental Costs as a Function of Activity Level

$0$1,000$2,000$3,000$4,000$5,000

1200

1400

1100 80

090

013

00

Activity Level

Mon

thly

Ren

tal

Cos

t

Monthly Rent

Graph of Fixed Costs per Unit

Rental costs per unit as a Function of Activity Level

$0.00

$2.00

$4.00

$6.00

0 500 1000 1500

Activity Level

Ren

tal C

osts

per

un

it Rental costs perunit

Variable Costs

Total variable costs change in direct proportion to changes in the activity level (cost driver)

Example of Variable Costs

Month Activity Level Total Photocopying Cost Cost per Unit

Jan 1200 $ 6,000 $ 5.00 Feb 1400 $ 7,000 $ 5.00 Mar 1100 $ 5,500 $ 5.00 Apr 800 $ 4,000 $ 5.00 May 900 $ 4,500 $ 5.00 Jun 1300 $ 6,500 $ 5.00

Graph of Total Variable Costs

$-$2,000 $4,000 $6,000 $8,000

0 1000 2000

Tot

al M

ater

ial

Cos

ts

Activity Level

Total Copying Costs as a Function of Activity Level

Total Material Costs

Graph of Variable Costs per Unit

Material Costs per unit as a Function of Activity Level

$-$2.00$4.00$6.00

800 900 1100 1200 1300 1400

Activity level

Mat

eria

l Cos

ts

per

Uni

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MaterialCosts perunit

Is this a graph of a fixed or variable cost?

800 900 1100 1200 1300 1400

Series1

Determining How Costs Behave

• There are several approaches to determining cost behavior– account classification: expert judgment but

subjective, not very analytical– industrial engineering methods: works well when

there is a well-defined input-output relationship, time consuming, intrusive

– historical cost analysis

• Focus is usually on mixed costs

Historical Cost Analysis

• Visual Fit method• High-low method• Simple linear regression

Example of Historical Cost Analysis

Month Activity Level Utility CostJan 5000 13000Feb 8000 22000Mar 6000 14500Apr 12000 29000May 11000 24000June 14000 34000

Plot of the Data

Utility Costs as a Function of Activity Level

0

10000

20000

30000

40000

0 5000 10000 15000

Activity Level

Tot

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tili

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osts

Utility Costs

Visually Fitting a Line

Utility Costs as a Function of Activity Level

0

10000

20000

30000

40000

0 5000 10000 15000

Activity Level

Tot

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osts

Utility Costs

Linear (UtilityCosts)

Simple Linear Regression for Cost Estimation

• Accountants take advantage of the power of linear regression techniques to assist them in cost estimation

• Once again, accountants will assume that the slope of the regression equation is the variable cost estimate and that the Y-intercept is the fixed cost estimate

• You should be aware that the Y-intercept data point is most likely outside of the relevant range!

Linear Regression Example

Utility Costs as a Function of Activity Level

y = 1823.7 +2.2421x

0

10000

20000

30000

40000

0 5000 10000 15000

Activity Level

Tot

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tili

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osts

Utility Costs

Linear (UtilityCosts)

Using Historical Data - Comments

• First and foremost, does the relationship between the activity level (cost driver) and the cost make sense (is it PLAUSIBLE)

• Make sure the data is accurate and available• Make sure you are using matching time

periods• Be aware of outliers• Be careful of your interpretation of the results

Other Ways of Classifying Costs• Robin Cooper has developed what is referred to

as a cost hierarchy. This was done in response to observing actual cost behavior and noting that the simple distinction between fixed and variable cost was not sufficient

• The cost hierarchy:– unit level: costs respond to changes in activity level in a one-to one

relationship– batch level: cost respond not to individual changes in activity levels, but

changes in the number of batches– product sustaining level: costs respond to activities related to product

lines, not individual or batch output levels– facility level: costs related to the basic ability of the firm to operate

Cost Hierarchy

• The cost hierarchy is more reflective of the relationship that exists between costs and activity. It is a basic building block for Activity-Based Costing (ABC) systems

• The cost hierarchy will be discussed more as part of ABC

Activity Based Costing and Management Systems

• ABC systems focus on the activities and the business processes as the foundation for determining the cost of goods, services, processes, or any cost object

• ABC systems attempt to address the problems found with traditional costing systems, such as ignoring volume differences, diversity, and resource demands of different cost objects

ABC Basics• ABC systems use the cost hierarchy discussed

earlier: unit level, batch level, product sustaining level, and facility sustaining level

• ABC systems, as part of identifying the relevant activities, also classify these activities into value-added and non-value added activities, so it becomes a management tool

• ABC systems recognize not only economies of scale but economies of scope

• At the heart of ABC is a two stage allocation process

The Two Stage Process in ABC

• Stage 1: Create homogeneous cost pools; e.g., group all purchasing costs together, all set-up costs together, all delivery costs together. This may take some work since most accounting systems gather cost by account categories such as salaries, depreciation, supplies, etc. and these accounts have to be studied in order to break them down into homogeneous costs pools

• Stage 2: Allocate from the cost pools to the cost object (usually a product) using second stage cost drivers; e.g., number of deliveries, number of setups

Mapping Resource Expenses to Activities: Stage One

Salaries and Fringes$313,000

Occupancy$111,000

Equipment and Technology$146,000

Materials and Supplies$30,000

ActivitySalaries andFringes Occupancy

Equipment andTechnology

Materials and Aupplies Total

Process Customer Orders 31,000$ 5,300$ 12,600$ 800$ 49,700$ Purchase Materials 34,000 6,900 8,800 1,500 51,200Schedule Production Orders 22,000 1,200 18,400 300 41,900Move Materials 13,000 2,100 22,300 3,600 41,000Set-up Machines 42,000 700 4,800 200 47,700Inspect Items 19,000 13,000 19,700 800 52,500Maintain Product Info 36,000 2,800 14,500 400 53,700Perform Engineering Changes 49,000 32,000 26,900 2,400 110,300Expedite Orders 14,000 900 700 500 16,100Introduce New products 35,000 44,000 16,100 18,700 113,800Resolve Quality Problems 18,000 2,100 1,200 800 22,100Total 313,000$ 111,000$ 146,000$ 30,000$ 600,000$

Total$600,000

An ABC ExampleSupermarkets Drugstores MA and Pa Total

Average Revenue per delivery $30,900 $10,500 $1,980

Average CGS per delivery 30,000 10,000 1,800

Gross Margin per delivery 900 500 180

Number of Deliveries 120 300 1,000 1,420

Total Gross margin $108,000 $150,000 $180,000$438,000

Gross Margin % 2.9% 4.8% 9.1%

Other operating Costs 301,080

Operating Profit 136,920

Allocation of Other Costs 74,239 103,110 123,731 301,080

Distribution Line Profit 33,761 46,890 56,269 136,920

Profit Margin 0.9% 1.5% 2.8%

Other Costs are allocated in proportion to Gross Margin. Supermarkets’ share of gross margin is (108,000/438,000), or 24.66%. Thus, Supermarkets are allocated 24.66% of Other Costs, which equals 74,239.

An ABC Example, 2

The manager of this pharmaceutical distribution company heard about ABC and thought it may be useful for his operations. He identified 5 key activities, and their corresponding cost drivers.

Activity Cost Driver

Order Processing Number of Orders

Line Item Ordering Number of Line Items

Store Delivery Number of Store Deliveries

Cartons Shipped to Stores Number of Cartons shipped/delivery

Shelf Stacking at Store Number of hours of shelf stacking

An ABC Example, 3Each order consists of one or more line items. A line item represents a single product (such as Extra Strength Tylenol. Each Store delivery entails delivery of one or more cartons of products. Each product is delivered in one or more separate cartons. The delivery staff stock cartons directly onto display shelves in a store. Currently there is no charge for this service, and not all customers use this service.

An ABC Example, 4

The firm has finished Stage 1 and has assigned the following costs to each of the five activity areas

Activity Area Total Costs Total Units of Cost Driver

Order Processing $80,000 2,000 orders

Line Item Ordering 63,840 21,280 line items

Store Deliveries 71,000 1,420 store deliveries

Carton Deliveries 76,000 76,000 cartons

Shelf Stacking 10,240 640 hours

An ABC Example, 5

Other useful data by distribution line

Supermarkets Drugstores Ma and Pa

1. Total number of orders 140 360 1,500

2. Average number of line

items per order 14 12 10

3. Total number of store

deliveries 120 300 1,000

4. Average number of

cartons shipped per delivery 300 80 16

5. Average number of hours

of shelf stacking per delivery 3 0.6 0.1

An ABC Example, 6

First, calculate the cost driver rate for each cost pool.Activity Area Total Costs Total Units of Cost Driver Cost Driver Rate

Order Processing $80,000 2,000 orders $40/order

Line Item Ordering 63,840 21,280 line items 3/line item

Store Deliveries 71,000 1,420 store deliveries 50/store delivery

Carton Deliveries 76,000 76,000 cartons 1/carton

Shelf Stacking 10,240 640 hours 16/hour

An ABC Example, 7

Next, allocate these costs to each distribution channel

Supermarkets Drugstores Ma and Pa

1. Orders 140*40=5,600 360*40=14,400 1,500*40=60,000

2. Average line items 14 12 10

2a. Total line items 1,960*3=5,880 4,320*3=12,960 15,000*3=45,000

3. Deliveries 120*50=6,000 300*50=15,000 1,000*50=50,000

4. Average # of cartons 300 80 16

4a. Total cartons 36,000*1=36,000 24,000*1=24,000 16,000*1=16,000

5. Average stacking hours 3 0.6 0.1

5a. Total Stacking hours 360*16=5,760 180*16=2,880 100*16=1,600

Totals (= 301,080) 59,240 69,240 172,600

An ABC Example, 10

Comparing ABC to Traditional Costing Profit: Ma and Pa

Traditional ABC

Average Revenue per delivery $1,980 $1,980

Average CGS per delivery 1,800 1,800

Gross Margin per delivery 180 180

Number of Deliveries 1,000 1,000

Total Gross margin $180,000 $180,000

Allocation of Other Costs 123,731 172,600

Distribution Line Profit 56,269 7,400

Profit Margin 2.8% 0.4%

An ABC Example, 10

Summary Profit Comparison of Traditional vs. ABC

Traditional ABC

Supermarket 33,761 (0.9%) 48,760 (1.3%)

Drugstores 46,890 (1.5%) 80,760 (2.6%)

Ma and Pa 56,269 (2.8%) 7,400 (0.4%)

Total 136,920 136,920

An ABC Example, 11

• Note that the total profit for the firm has not changed at all as a result of using ABC vs. traditional costing techniques

• So what’s the big deal??• Some people argue that for many firms using

ABC is analogous to re-arranging the chairs on the deck of the Titanic - it really doesn’t stop a firm from failing– also, ABC is not GAAP– also, implementing ABC is a significant task

• This is true if figuring out new product costs is the only thing ABC is used for

So What is the Value of ABC• Like any accounting system, ABC is an

INFORMATION system - it provides info to assist decision makers, but in and of itself this info DOES NOTHING, unless management acts upon it

• ABC provides insights into your business that management was probably not aware of before

• The old system simply charged each line 68.7% (301,080/438,000) of its gross margin to arrive at product line profitability - peanut butter costing

So What is the Value of ABC, 2

• The ABC system reveals however that the MA and PA stores actually consume 95.9% of its gross margin with other operating expenses

• This is because the MA and PA stores are more activity intense, and thus more cost intensive

• Under the old system, MA and PA stores were charged 41.1% (180,000/438,000) of overhead, since this was their share of gross margin

• However, if you look at the activities, you can see that MA and PA stores account for well over 41.1% of the activities (75% of the orders, 70% of the deliveries, etc)

How can managers act on this info• Now that managers know the cost of these

activities, they can work to try and reduce those costs

• Also, they can see why Ma and Pa stores are so expensive (they order more often, they have more deliveries, etc.) and they work with these stores to try and reduce those activities; i.e., less frequent ordering, less frequent deliveries

• Also, since part of ABC is activity identification and classification as VA or NVA, managers can attempt to eliminate or minimize NVA

When Would ABC not be Useful(at least from a product costing view)

• If the company only has one product• If all products use all resources in the same

proportions, which is the same proportion used to allocate costs in a traditional system (little diversity)

• Cost control is not critical at this stage for the company (growth stage companies)

When Would ABC be most Useful

• The Willie Sutton rule– large expenses in indirect and support resources

• High diversity (products, customers, processes)• When a firm wants to better understand its

activities and the costs of those activities, even if the firm only makes one product

Economic Characteristics of Costs• Out-of-pocket cost: the cost actually incurred that

required the expenditure of cash or other assets• Opportunity costs: the benefit passed up when

selecting one alternative over another– opportunity costs are ALWAYS relevant in decision

making• Sunk costs: the costs incurred in the past and

cannot be altered by any current or future decision– sunk costs are NEVER relevant in decision making, but

often are erroneously considered relevant– Example

• Marginal Cost

Example of Opportunity and Sunk Costs

• You have a ticket to the NCAA Men’s basketball championship game; you paid $85 (non-refundable) for the ticket. – What is the out-of-pocket cost for the ticket?

• Scenario 1: You are walking to the game and someone offers you $120 for your ticket. You refuse the offer and proceed into the game.– What is the opportunity cost of attending the game?– Would your answer differ if your out-of-pocket cost had been $60? What if it had

been $150?

• Scenario 2: On the day of the game, you become violently ill and would be better off staying in bed. However, you decide to go to the game, arguing that you can’t waste $85 just because you are sick.– The $85 is an example of what type of cost (besides out-of-pocket)?– If the $85 is not relevant to this decision, what costs are relevant in the decision to

go or not go to the game?

Relevant Costs for Decision Making

• When making a decision among alternatives, only those costs that DIFFER among the alternatives are relevant

• Example: You are trying to decide between offering a summer Bible camp or summer service camp. The office manager makes $65,000 per year. Her salary is irrelevant to your decision.

• Opportunity costs are always relevant, sunk costs are never relevant

Responsibility Accounting

• Costs can be considered controllable or non-controllable by a manager

• Controllable costs are those that a manager has some influence over

• Non-controllable costs are those that a manager has little or no influence over

• A manager should NOT be held responsible for non-controllable costs

Decision Making: Relevant Costs and Benefits

• Quantitative and qualitative information• Characteristics of information• Identifying relevant costs and benefits• Analysis of special decisions• Short-run vs. long-run• Pitfalls to avoid

Characteristics of information

• Relevance: future costs or benefits that are different between alternatives

• Accuracy• Timeliness

Identifying relevant costs and benefits

• Sunk costs are never relevant• Example: book value of assets• Costs/benefits that do not differ between

alternatives are not relevant• Opportunity costs are always relevant

Short-run vs. long-run

• Time frame does have an impact on decision making

• Some costs that are labeled fixed in the short run may be variable in the long run

• Time value of money becomes relevant

Pitfalls to avoid

• Sunk Costs• Fixed costs per unit• Allocated fixed costs vs. avoidable fixed costs• Opportunity costs

Cost Volume Profit (CVP) Analysis

• Once management has developed reasonable cost estimates, how can that knowledge be useful for estimating profits?

• What is meant by the breakeven point?• How can the simple concept of breakeven be

extended even further?• Is there a more meaningful way to display

operating results as compared to what you learned in financial accounting?

Assumptions of CVP

• Variable costs and revenues are linear and constant

• Fixed cost is constant• Sales and Production are equal• If multiple products, the sales mix is constant• No fundamental changes in the underlying

structure of the business• The analysis is within the relevant range

The Basic CVP Model Revenue (SP/unit X units sold)-Variable Costs -(VC/unit X units sold)Contribution Margin (CM/unit X units sold)-Fixed Costs -FCProfit Profit

This format is known as the contribution format. It is different than the format you learned in financial accounting.

Or, (SP-VC)/unit X units sold - FC = Profit

Calculating the Breakeven Point(SP-VC)/unit X units sold - FC = Profit(SP-VC)/unit X units sold = FC + ProfitIf you are trying to determine the number of

units sold:Units Sold = FC + Profit (SP-VC)/unitAt breakeven, profit = 0

Units sold = FC = Breakeven point (SP-VC)/unit

Example of Using CVP

• Program Fee Per Camper = 12/unit• Variable costs (food) = 4/unit• Variable costs (supplies) = 3/unit• Fixed costs (space rental)= 600• Fixed costs (staff member) = 900

• Calculate the breakeven point

Solution to example

Breakeven point = FC (SP-VC)/unit

Breakeven point = 1,500 (12-7)/unit

Breakeven Point = 300 campers

Extensions of the Basic CVP Model

• Solving for different profit levels, not just the breakeven point

• Solving for any one of the variables, as long as all the other variables are given (price, variable cost per unit, fixed cost)

CVP Example 2

• Program Fee Per Camper = 12/unit• Variable costs (food) = 4/unit• Variable costs (supplies) = 3/unit• Fixed costs (space rental)= 600• Fixed costs (staff member) = 900• Expected number of campers = 500• What should we charge to breakeven?

Solution to CVP Example 2 FC (Fee-VC)/unit = units

600+900 (Fee-7)/unit = 500 campers

1,500 = (Fee-VC)/camper = 3/camper500 campers

If VC = 7, then Fee would have to be 10/camper

Final Thoughts on CVP

• CVP is a useful starting point for analyzing different scenarios

• It is limited because of its underlying assumptions and these need to be remembered while you are doing the analysis

Make vs. Buy (Outsourcing)• The WWW Church prints 2,000 Sunday bulletins each week at the

following costs: variable costs: $2 per unit; fixed costs include a person whose sole responsibility is to print the bulletins and is paid $1,000 per week and other weekly fixed costs allocated to the bulletins equal $600

• Thus, cost per unit equals $2.80 ([2000*2 plus 1600]/2,000) • The Just Print Bulletins Co. has offered to print the bulletins for WWW at a

cost of $2.60• How should the Church print the bulletins?

Make vs. Buy, 2• One of the key issues is what will happen to fixed costs• If nothing happens, then you are comparing a variable

cost of printing the bulletin of $2 to a cost of paying an outside firm $2.60

• If the supervisor’s costs go away if we use the outside service, then what?– Fixed costs that go away are relevant!– The relevant cost to print the bulletin then is 2.50 (2.00

+.50)– This is till cheaper

• If the bid from the outside printer was 2.40, then it would be cheaper to go with the outside firm

• The allocated fixed costs are irrelevant to the decision, since they are the same no matter what our decision

Make vs. Buy, 4

• Other issues• Quality of vendor’s product• Delivery schedule• Maintaining/establishing vendor relationships• Cost control• Impact on organization of outsourcing