Learning Objectives

1
Learning Objectives

• Describe the relationship between cost and value.
• Understand how costs affect the three
  profitability measures.
• Describe why costs are important in operations.
• State the dangers of using average costs.
• Explain why it is important to be able to assign
  operations costs.
• Explain the concepts of tracing and allocating
  costs.
• Define the components of product cost.
• Describe how cost reduction relates to
  productivity improvement.
• Explain the concepts of standards and variances.
• Compute usage, price, and total variances.
• Understand the difference between total cost and
  cost per unit.
• Conduct a breakeven analysis.

2
Cost versus Price
Cost A scarce resource given up in order to
obtain a current or future benefit. Price
Amount of money a seller agrees to accept in
return for something, like a product or service.
Cost
Tieiness
3
Paying for Value

• Cost includes all resource outlays over the life
  of the product or service
• The cost is not necessarily monetary
• Increasing cost detracts from value
• Cost includes all resource outlays over the life
  of the product or service.
• While most value attributes enhance value, cost
  is almost always viewed as an overriding negative
  factor.

4
Price vs. Total Cost Customer Perspective

• Non-Price dimensions of Cost
• Shipping/Distribution
• Repairs and maintenance
• Related expenditures (insurance, supplies, etc.)

5
Price vs. Total Cost Customer Perspective

• Non-financial costs
• Quality, flexibility, response time
• Non-financial costs are difficult to include in
  decision-making
• They are difficult to quantify
• In tradeoffs, quantifiable measures often win
• Firms struggle to incorporate non-monetary costs
  (and benefits) into decision-making
• Ignoring them implicitly says they are zero
• The balanced scorecard (coming later) is an
  approach to include non-financial issues.

6
Profitability and Cost

• Net income is in the numerator of Profit Margin,
  Return on Assets, and Return on Equity
• Net Income Net Sales - Cost of Goods Sold
• Selling and Administrative Costs Depreciation-
  Interest Paid Taxes

Higher NetIncome
GreaterProfitability
Reduced Costs
7
Types of Costs

• Expected costs Forecasted payments for future
  benefits.
• Actual costs Past payments for currently owned
  resources.
• Out-of-pocket costs Cash payments made for
  resources.
• Product costs Costs of resources used to make
  products.
• Period costs Costs of resources used in
  nonproduction elements of a business.
• Total costs Costs of all resources obtained in a
  particular period.

8
Average Costs

• Can be Great for comparing current costs to
  historic.
• Can be Great for making comparisons with
  competitors.
• Can be Dangerous because there is no average
  product or average customer.
• Can be Dangerous because they can lead to
  ignoring important details.

9
Costs and the Value Chain

• The Value Chain is a model of the way processes
  are linked together.
• It identifies all of the parts of the supply
  chain that add value.
• All value is added through processes, but all
  costs are not.

• What is missing?
• Administrative support functions like accounting,
  legal services, computer services, personnel
  functions, etc.

10
Costs and the Value Chain

• All activities directly and indirectly generate
  costs.
• An activity must generate more value than cost,
  or it should be eliminated
• Most businesses have a pretty good understanding
  of total costs (i.e., they know how much they
  spent last year)

11
Assigning Operations Costs

• Direct (value chain) and indirect cost generators
  need to be assigned and analyzed
• Resource Cost What the business spent on a
  particular resource

12
Assigning Operations Costs

• Cost object an item for which costs are measured
  or assigned.

13
Assigning Operations Costs

• Direct Tracing Costs (e.g., direct labor
  materials) are physically associated with a cost
  object
• For example direct labor or direct materials
• Or the link may be made by observation

14
Assigning Operations Costs

• Direct Tracing example
• A product requires eight hours of labor to
  assemble
• It uses 1,000 in materials
• Labor costs are 100 per hour
• Product Cost 1,000 (8 100) 1,800 for
  direct labor and material

15
Assigning Operations Costs

• Driver Tracing A resource (cost) driver is used
  to provide the link between the cost and the cost
  object
• Resource drivers measure demands placed on
  resources by activities and are used to assign
  costs of resources to activities

16
Assigning Operations Costs

• Activity drivers Measure demands that cost
  objects place on activities
• Activity Drivers are used to assign the costs of
  associated activities to cost objects

17
Assigning Operations Costs

• Driver Tracing example
• A company spends 50,000/month on Human Resources
• 80 of HR time is spent hiring and training
  direct labor personnel
• The plant consumes a total of 1600 direct labor
  hours/month
• (10 people 40 hours/week 4 weeks)
• Use Direct Labor hours as Activity Driver 25
  per hour
• (40,000/1600 direct labor hours)
• Recall 8 hours of direct labor per product 8
  25 200 in HR cost
• Product Cost 1,800 for direct labor and
  material
• 200 for HR costs
• 2,000 total cost

18
Components of Product Cost

• Production costs associated with actual
  production.
• Nonproduction costs associated with selling and
  administration.
• Direct materials materials that can be traced
  directly to the good or service being produced.
• Direct labor labor that can be traced directly
  to the good or service being produced.
• Overhead all other nondirect costs.

19
Putting Cost Information to Work for Operations
Standards and Variances

• Standards
• Are what should happen in terms of . . .
• Quantity (output or usage per unit of time)
• Price (price per unit)
• Actuals
• What actually got used in production
• May be more or less than standard
• Variance Analysis
• The comparison of standards to actuals in order
  to assess operating performance

20
Putting Cost Information to Work for Operations
Standards and Variances

• Example
• Company produced units at a total cost of 23.14
  per batch
• Their standards tell them it should only have
  cost them 18.00 per batch
• What went wrong?
• Did they pay too much for material?? Or use too
  much material??

21
Variance Analysis Materials Example 1

• Required information
• Standard usage rate (standard quantity) how much
  do you expect to use of the resource?
• Example 15 ounces per 50-gallon batch
• Standard price How much do you expect to pay for
  the resource?
• Example 1.20 per ounce
• Actual usage rate (actual quantity) how much
  did you actually use of the resource?
• Example 16.3 ounces per 50-gallon batch
• Actual price how much did you actually pay for
  the resource?
• Example 1.42 per ounce

22
Variance Analysis Materials Example 1
23
Variance Analysis Materials Example 2

• Same Standards
• Standard Quantity - 15 ounces per 50-gallon
  batch
• Standard Price - 1.20 per ounce
• New Actual Usage Assumptions
• Actual Quantity 12 ounces per 50-gallon batch
• Actual Price - 1.50 per ounce

24
Variance Analysis Materials Example 2

• What is the Total Variance?
• (Actual Quant Actual Price) (Standard Quant
  Standard Price)
• (12 1.50) (15 1.20) 18.00 - 18.00
• 0.00
• What is the Price Variance?
• (Actual Quant Actual Price) (Actual Quant
  Standard Price)
• (12 1.50) (12 1.20) 18.00 - 14.40
• Overage of 3.60 per 50-gallon batch on price
• What is the Usage Variance?
• (Actual Quant Standard Price) (Standard
  Quant. Standard Price)
• (12 1.20) (15 1.20) 14.40 - 18.00
• Underage of 3.60 per 50-gallon batch on
  materials

25
Variance Analysis Materials Example 3

• Same Standards
• Standard Quantity - 15 ounces per 50-gallon
  batch
• Standard Price - 1.20 per ounce
• New Actual Usage Assumptions
• Actual Quantity 12 ounces per 50-gallon batch
• Actual Price - 1.40 per ounce

26
Variance Analysis Materials Example 3

• What is the Total Variance?
• (Actual Quant Actual Price) (Standard Quant
  Standard Price)
• (12 1.40) (15 1.20) 16.80 - 18.00
• Underage of 1.20 per 50-gallon batch
• What is the Price Variance?
• (Actual Quant Actual Price) (Actual Quant
  Standard Price)
• (12 1.40) (12 1.20) 16.80 - 14.40
• Overage of 2.40 per 50-gallon batch on price
• What is the Usage Variance?
• (Actual Quant Standard Price) (Standard
  Quant. Standard Price)
• (12 1.20) (15 1.20) 14.40 - 18.00
• Underage of 3.60 per 50-gallon batch on
  materials

27
Variance Analysis

• Helps in determining where things did not go
  according to plan.
• Can be used for many kinds of resources,
  including
• Materials
• Labor
• Overhead

28
Variance Analysis

• When and how to update standards can be a big
  decision
• Line managers may not want to update quantity
  standards if they are getting better
  (sandbagging)
• Detecting the variance is the first step,
  understanding them can be much more complicated
• Are negative price variations due to poor
  practices or just generally rising prices?

29
Breakeven Analysis

• Breakeven analysis is an analytical process that
  compares the fixed and variable costs of
  alternatives in order to identify the best
  alternative for a given volume of output.
• Fixed costs are costs that are not affected by
  volume.
• Variable costs are costs that increase or
  decrease as units produced increase or decrease.
• The total cost curves are assumed to be linear
  and can be created by using the basic formula for
  a line
• y a bn
• Where y is the total cost for producing n units,
  a is the fixed cost, and b is the variable cost
  per unit.

30
Breakeven Analysis Example
Three alternatives
Insert Exhibit 5.7
31
Breakeven Analysis
Insert Exhibit 5.8
Prophecy is the low-cost alternative for volumes
greater than 387,097
Market Probe is the low-cost alternative for
volumes between 230,508 and 387,097
WEEZL is the low-cost alternative for
volumes below 230,508.
32
Nonfinancial Costs

• Some resources are difficult to quantify.
• Examples quality, flexibility, response time,
  etc.
• In tradeoffs, quantifiable measures often win.
• Balanced scorecard is an approach to include
  nonfinancial issues.

33
The Balanced Scorecard