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

!penditures, Costs " !penses

Expenditure company purchases raw materials for #$%% Cost company reports #$%% of raw materials on balance sheet Expense company records #$%% e!pense on income statement when it sells the product that uses the raw material

&inancial 'eporting ( )**+

)**+ defines cost as the monetary value of goods and services e!pended to obtain current or future benefits Expenses are the costs of goods or services that have e!pired, i,e,, used up in the process of creating goods or services Costs incurred to receive future benefits are recorded as assets

&inancial reporting ( )**+

The -ey issues for e!ternal users of accounting information.
Consistency 'easonably accurate allocation of costs between the income statement and the balance sheet

)**+ prescribes how to determine costs for e!ternal reporting

+roduct Costs
/rgani0ations incur product costs to produce the volume and mi! of products made during the period
Manufacturing costs Materials costs, labor costs, and the cost of e1uipment, machinery and buildings *llocated between ending inventory and cost of goods sold

&inancial reporting ( )**+

/nly manufacturing costs included in calculation the cost of inventory 2istorical cost Costing systems designed in the past conserved on information(processing costs by adopting the structure imposed by )**+ Most cost accounting systems tend to be driven by the rules that determine product costs for inventory valuation and cost of goods sold under )**+

3nternal 4se of Cost 3nformation

Costs are used for planning and evaluation, The ob5ective is to determine all the components, both manufacturing and nonmanufacturing, of the costs associated with a cost ob5ect

3nternal 4se /f Cost 3nformation

+lanning
4sing cost as a basis for determining the selling price of a prospective product 4sing cost in a budgeting model to forecast costs under different levels of activity

valuation
Deciding whether the mar-et price for an e!isting product ma-es the product profitable Determining whether a process is cost efficient compared to similar internal or e!ternal processes

Cost /b5ect
Management accounting concept * cost ob5ect is something for which we want to compute a cost.
* product * product line *n organi0ational unit

Different views of product cost

&inancial accounting is concerned with the total cost of inventory while management accounting is concerned with the cost of an individual unit of inventory, 3n financial accounting, product cost includes on manufacturing costs, 3n 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 ma-e furniture in a factory lectrical power to operate machinery &uel used to deliver the furniture to customers

Variable costs proportional to the amount of resource used

Cost 6ehavior
Capacity-related resources are ac1uired in advance of the wor- being done Capacity(related costs depend upon how much of the resource is ac1uired, not used Fixed costs

 Cost classification varies depending on the the chosen cost ob5ect

4nderstanding cost behavior to cost products

!ample ( factory supervisor7s salary 3f the cost ob5ect is a product the factory supervisor7s salary is an indirect cost 3f the factory is the cost ob5ect, the factory supervisor7s salary is a direct cost

* cost ob5ect can be any unit of analysis including product, product line, customer, department, division, geographical area, country, or continent

Direct Cost
* cost of a resource or activity that is ac1uired for or used by a single cost ob5ect

Direct Costs
Cost ob5ect ( dining room table
Cost of the wood that went into the dining room table

Cost ob5ect ( line of dining room tables

Manager7s salary would be a direct cost if a manager were hired to supervise the production of dining room tables and only dining room tables

3ndirect Cost
The cost of a resource that was ac1uired to be used by more than one cost ob5ect !ample ( the cost of a saw used in a furniture factory to ma-e different products

Direct costs, 3ndirect costs and Cost 6ehavior

When the cost ob5ect 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, &i!ed costs can be direct or indirect as well,

C8+ *nalysis
Decision ma-ers often li-e to combine information about fle!ible and capacity( related costs with revenue information to pro5ect profits for different levels of volume Cost(volume(profit 9C8+: analysis is based on the following assumptions.
*ll organi0ation costs are either purely fle!ible or capacity related 4nits made e1ual units sold 'evenue per unit does not change as volume changes

The C8+ +rofit 1uation

+rofit.
; 'evenue ( 8ariable costs ( &i!ed costs ; 94nits sold ! 'evenue per unit: ( 94nits sold ! variable cost per unit: &i!ed costs ; <4nits sold ! 9'evenue per unit(variable cost per unit:= &i!ed costs ; 94nits sold ! Contribution margin per unit: ( &i!ed costs

6rea-even 8olume
6rea-even volume is determined by calculating the volume where profit ; % Breakeven equation:
4nits sold to brea- even ; &i!ed costs > Contribution margin per unit

Contribution Margin 'atio

Contribution margin per unit ? revenue per unit &raction of each sales dollar that does towards covering fi!ed costs 6rea-even sales revenue ; &i!ed costs ? Contribution margin ratio

The C8+ Chart

Decision ma-ers often summari0e cost( volume(profit information in a cost(volume( profit 9C8+: chart The C8+ chart provides a convenient way of summari0ing the relationship between volumes, revenues, costs, and profits and provides a visual way to display the effect of volume changes on profits

C8+ Chart
9from !hibit @(A:
BA%%%% B%%%%% @A%%%% @%%%%%

Dollars

$A%%%% $%%%%% A%%%% % (A%%%% ($%%%%% ($A%%%% % @%%% C%%% D%%%

Units 'evenue Capacity('elated Cost +rofit &le!ible Cost Total Cost

C8+ *nalysis for Multiple +roducts

There are many combinations of sales levels for multiple products that would allow the organi0ation to brea- 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 0ero 6efore the use of spreadsheets became widespread, management accountants developed an e!tension of basic C8+ analysis that allowed them to continue to use its basic profit e1uation and graphing techni1ues by developing a weighted average product based on the estimated sales mi!

Weighted *verage +roduct

Compute each product7s share of total sales Multiply each product7s revenue per unit by its proportion of total sales to get a weight *dd the weights for all the products to get the total weighted revenue *pply the same techni1ue to compute the weighted variable cost Eubtract the weighted variable cost from the weighted revenue to get the weighted contribution margin per unit of FproductG

Multi(+roduct !ample
The result of these calculations is a fictitious product that reflects the average revenue and variable cost characteristics of the real products )iven that the total capacity(related costs at Hynn7s Handscaping is #B%%,%%%, use the formula for brea-even to compute the brea-even level of sales for this composite product

Multi(+roduct !ample 9B of C:
6rea-(even 1uantity ; B%%,%%%?AB,%D ; A,DAB,A% To translate this average product brea-(even 1uantity to individual products, simply reverse the process of computing the average.
Hawn Mowing ; ADAB,A% ! CD%%?D@%% ; C$IC,A@I Hayout Design ; ADAB,A% ! BA%?D@%% ; B$I,$CJI@ /ther Maintenance ; ADAB,A% ! $@A%?D@%% $$BI,J$J

Cost(benefit Considerations
4nli-e e!ternal reporting, where the format is prescribed by )**+, the format for determining costs for internal decision ma-ing is at the discretion of the decision ma-er 6ecause the organi0ation must pay someone to develop cost information, its e!pected benefits should e!ceed 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 FCostG

*n old adage states, Fdifferent costs for different purposesG The specific decision at hand will define.
The nature of the re1uired cost The way it should be computed The value of any cost number

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

Can Conflicting FCostsG Cause Confusion, Conceivably Chaos?

/ne challenge of wor-ing with costs is that they are used in many different conte!ts /ne might thin- it curious or even wrong that cost is not a rigid number calculated according to some formal rules Does FcostG mean a historical cost or a future costK does it ta-e into consideration any potential discountsK does it include implicit costs or only e!plicit costs? Lote that )**+ accounting for e!ternal reporting is designed to avoid all these issues

/pportunity Cost
*n opportunity cost is the sacrifice you ma-e when you use a resource for one purpose instead of another /pportunity costs are implicit costs that do not appear anywhere in the accounting records Machine time used to ma-e one product cannot be used to ma-e another, so a product that has a higher contribution margin per unit may not be more profitable if it ta-es longer to ma-e, Management accountants often use the concept of opportunity cost

Cost Classifications 'evisited

The dividing of costs into direct and indirect costs and the dividing of costs into fle!ible and capacity(related costs are different systems *ll fle!ible costs are direct costs Eome 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 'evisited

Capacity(related costs can be direct or indirect Most capacity(related costs are indirect Eome of the most egregious costing errors have been committed, however, by treating direct capacity(related costs as if they were indirect !clusivity of use by the cost ob5ect defines whether a cost is direct or indirect

Cost Classifications 'evisited

* cost7s definition can change as the perspective changes * decision ma-er might define a cost one way for one decision and another way for another Direct means that the resource that created the cost was ac1uired for, and used by, a single cost ob5ect 3t is important, then, to understand clearly how the cost ob5ect is defined

ffect of Time &rame

Ehort run is the period over which a decision ma-er cannot ad5ust capacity
The level of capacity(related resources and their cost is fi!ed 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 Ehort run costs are variable costs

ffect of Time &rame

Hong(run costs are the sum of variable and fi!ed costs associated with a cost ob5ect 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 ma-e the product The price charged for a product must cover its long(run cost for the organi0ation to replace the capacity used to ma-e the product when the capacity deteriorates

Creating Costs
*n organi0ation creates different costs at different stages. Etarting up arly growth 'eaching the boundaries of e!isting capacity !panding product lines !panding capacity 'edefining the business Continued growth These costs are not created evenly over time and should be planned for

 The composition of manufacturing costs has changed substantially in recent years Many formal cost systems were first implemented in the early $I%%7s.
Direct labor represented a large proportion, sometimes A%M or more, of the total manufacturing costs Direct material costs were also substantial Capacity(related 9fi!ed: costs generally represented a small fraction of total manufacturing costs

Changing Cost Etructures

Changing Cost Etructures

Today, direct labor is only a small portion of manufacturing costs The cost of direct materials remains important, representing C%M to D%M of the costs in many plants The big change has been the vastly increased share of total costs from capacity(related costs

Changing Cost Etructures

The increase in fi!ed costs results from.
The shift toward greater automation, which re1uires more production engineering, scheduling, and machine setup activities The emphasis on better customer service The increase in support activities re1uired by a proliferation of multiple products

&urther, both variable and fi!ed costs associated with design, product development, distribution, selling, mar-eting, and administrative activities have increased

Changing Cost Etructures

Changing cost structures have caused cost systems allocating indirect costs using volume measures to become increasingly inaccurate in computing product costs Many costing systems ta-e 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 ob5ects 9e,g,, product lines: produced in low volumes

Types /f +roduction *ctivities

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 ta-e place in organi0ations * new classification system, developed originally for manufacturing operations, gives a broader framewor- for classifying an activity and its associated costs

Lew Classification Eystem

The new classification system places activities and their associated costs into one of the following categories.
4nit related 6atch related +roduct sustaining Customer sustaining 6usiness sustaining

4nit('elated *ctivities
4nit(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 4nit(related activities apply to more than 5ust production activities

6atch('elated *ctivities
3n a production environment, batch(related activities are triggered by the number of batches produced rather than by the number of units manufactured
3ndirect labor for first(item 1uality inspections involves testing a fi!ed 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 organi0ation pays the shipper a charge per container or truc-load

+roduct(Eustaining *ctivities
+roduct(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 !amples include. *dministrative efforts re1uired to maintain drawings and labor and machine routings for each part The process engineering re1uired to implement engineering change orders 9 C/s:

Customer(Eustaining *ctivities
Customer(sustaining activities enable the company to sell to an individual customer but are independent of the volume and mi! of the products and services sold and delivered to the customer !amples include.
Eales calls Technical support provided to individual customers

6usiness(Eustaining !penses
6usiness(sustaining e!penses 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 e!penses, such as the cost of trade shows, advertising, and catalogs

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

6usiness(Eustaining *ctivities
6usiness(sustaining activities are those re1uired for the basic functioning of the business These core activities are independent of the si0e of the organi0ation, or the volume and mi! of products and customers

4sing The Cost 2ierarchy

The cost hierarchy 5ust discussed is a model of cost behavior that can be used in two ways.
To predict costs To develop the costs for a cost ob5ect such as a product or product line

Lonmanufacturing Costs *s +roduct Costs

*lthough manufacturing costs often are the most significant component of total costs, nonmanufacturing costs are large and growing in many organi0ations The management of nonmanufacturing costs is an increasingly important contributor to an organi0ation7s financial success

Lonmanufacturing Costs
Traditionally management accountants have loo-ed at nonmanufacturing costs as a large pool of costs that should be managed by periodic budget appropriations &or e!ample, e!penditures on items such as advertising are determined by what the organi0ation can afford rather than by the mission it has to accomplish with advertising

Lonmanufacturing Costs
Lonmanufacturing 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

Lonmanufacturing Costs
Many organi0ations have begun to underta-e 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 organi0ations to abandon certain customers or to provide differential service fees based on the services that customers demand