Cost Management MSCM8615

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Cost ManagementMSCM8615
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Definition of cost

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

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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
  companys resources

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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.

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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

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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

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Example of Direct vs. Indirect Costs
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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

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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

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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

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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

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Fixed Costs
Fixed costs remain unchanged as the activity
level (cost driver) varies. Examples of fixed
costs include rent, salaries and property taxes.
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Example of Fixed Costs
Month Activity Level Total Cost Cost Per
Unit Jan 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
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Graph of Total Fixed Costs
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Graph of Fixed Costs per Unit
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Variable Costs
Total variable costs change in direct proportion
to changes in the activity level (cost driver)
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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
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Graph of Total Variable Costs
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Graph of Variable Costs per Unit
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Is this a graph of a fixed or variable cost?
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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

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Historical Cost Analysis

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

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Example of Historical Cost Analysis
Month Activity Level Utility
Cost Jan 5000 13000 Feb 8000 22000 Mar 600
0 14500 Apr 12000 29000 May 11000 24000 Ju
ne 14000 34000
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Plot of the Data
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Visually Fitting a Line
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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!

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Linear Regression Example
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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

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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

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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

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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

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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

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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

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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
Total 600,000
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An ABC Example
Supermarkets Drugstores MA and Pa
Total Average Revenue per delivery 30,900 10,5
00 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 G
ross 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.
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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
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An ABC Example, 3
Each 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.
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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
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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
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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 Li
ne 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
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An ABC Example, 7
Next, allocate these costs to each distribution
channel Supermarkets Drugstores Ma and Pa 1.
Orders 140405,600 3604014,400 1,5004060,00
0 2. Average line items 14 12 10 2a. Total line
items 1,96035,880 4,320312,960 15,000345,00
0 3. Deliveries 120506,000 3005015,000 1,000
5050,000 4. Average of cartons
300 80 16 4a. Total cartons 36,000136,000 24,
000124,000 16,000116,000 5. Average stacking
hours 3 0.6 0.1 5a. Total Stacking
hours 360165,760 180162,880 100161,600 Total
s ( 301,080) 59,240 69,240 172,600
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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 Distributio
n Line Profit 56,269 7,400 Profit
Margin 2.8 0.4
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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
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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 whats 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 doesnt 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

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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

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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)

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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

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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)

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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

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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

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Example of Opportunity and Sunk Costs

• You have a ticket to the NCAA Mens 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 cant 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?

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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

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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

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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

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Characteristics of information

• Relevance future costs or benefits that are
  different between alternatives
• Accuracy
• Timeliness

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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

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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

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Pitfalls to avoid

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

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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?

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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

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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 -FC
• Profit 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

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Calculating the Breakeven Point

• (SP-VC)/unit X units sold - FC Profit
• (SP-VC)/unit X units sold FC Profit
• If you are trying to determine the number of
  units sold
• Units Sold FC Profit
• (SP-VC)/unit
• At breakeven, profit 0
• Units sold FC Breakeven
  point
• (SP-VC)/unit

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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

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Solution to example

• Breakeven point FC
• (SP-VC)/unit
• Breakeven point 1,500
• (12-7)/unit
• Breakeven Point 300 campers

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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)

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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?

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Solution to CVP Example 2

• FC
• (Fee-VC)/unit units
• 600900
• (Fee-7)/unit 500 campers
• 1,500 (Fee-VC)/camper 3/camper
• 500 campers
• If VC 7, then Fee would have to be 10/camper

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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

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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 (20002 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?

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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 supervisors 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

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Make vs. Buy, 4

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