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

Expenditures, Costs & Expenses

Expenditure company purchases raw
materials for $100
Cost company reports $100 of raw
materials on balance sheet
Expense company records $100
expense on income statement when it
sells the product that uses the raw
material

Financial Reporting - GAAP

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

Financial reporting - GAAP

The key issues for external users of
accounting information:
Consistency
Reasonably accurate allocation of costs
between the income statement and the
balance sheet

GAAP prescribes how to determine costs

for external reporting

Product Costs
Organizations incur product costs to
produce the volume and mix of products
made during the period
Manufacturing costs
Materials costs, labor costs, and the cost of
equipment, machinery and buildings
Allocated between ending inventory and cost
of goods sold

Financial reporting - GAAP

Only manufacturing costs included in calculation
the cost of inventory
Historical cost
Costing systems designed in the past conserved
on information-processing costs by adopting the
structure imposed by GAAP
Most cost accounting systems tend to be driven
by the rules that determine product costs for
inventory valuation and cost of goods sold under
GAAP

Internal Use of Cost Information

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

Internal Use Of Cost Information

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

Cost Object
Management accounting concept
A cost object is something for which
we want to compute a cost:
A product
A product line
An organizational unit

Different views of product cost

Financial accounting is concerned with the
total cost of inventory while management
accounting is concerned with the cost of
an individual unit of inventory.
In financial accounting, product cost
includes on manufacturing costs. In
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 make furniture in a factory
Electrical power to operate machinery
Fuel used to deliver the furniture to
customers

Variable costs proportional to the

amount of resource used

Cost Behavior
Capacity-related resources are acquired
in advance of the work being done
Capacity-related costs depend upon how
much of the resource is acquired, not
used
Fixed costs

Understanding cost behavior to

cost products

Cost classification varies depending on the the

chosen cost object

Example - 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

Direct Cost
A cost of a resource or activity that is
acquired for or used by a single cost
object

Direct Costs
Cost object - dining room table
Cost of the wood that went into the dining
room table

Cost object - line of dining room tables

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

Indirect Cost
The cost of a resource that was acquired
to be used by more than one cost object
Example - the cost of a saw used in a
furniture factory to make different products

Direct costs, Indirect costs

and Cost Behavior
When the cost object 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.
Fixed costs can be direct or indirect as
well.

CVP Analysis
Decision makers often like to combine
information about flexible and capacityrelated costs with revenue information to
project profits for different levels of volume
Cost-volume-profit (CVP) analysis is based
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

The CVP Profit Equation

Profit:
= Revenue - Variable costs - Fixed costs
= (Units sold x Revenue per unit) - (Units sold x variable
cost per unit) Fixed costs
= [Units sold x (Revenue per unit-variable cost per unit)]
Fixed costs
= (Units sold x Contribution margin per unit) - Fixed
costs

Breakeven Volume
Breakeven volume is determined by
calculating the volume where profit = 0
Breakeven equation:
Units sold to break even =
Fixed costs Contribution margin per unit

Contribution Margin Ratio

Contribution margin per unit / revenue per unit
Fraction of each sales dollar that does towards
covering fixed costs
Breakeven sales revenue =
Fixed costs / Contribution margin ratio

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

CVP Chart
(from Exhibit 2-5)

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

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 variable cost
Subtract the weighted variable cost from the
weighted revenue to get the weighted contribution
margin per unit of product

Multi-Product Example
The result of these calculations is a
fictitious product that reflects the average
revenue and variable cost characteristics
of the real products
Given that the total capacity-related costs
at Lynns Landscaping is $300,000, use
the formula for breakeven to compute the
breakeven level of sales for this composite
product

Multi-Product Example (3 of 4)
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

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

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

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

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

Cost Classifications Revisited

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

Cost Classifications Revisited

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

Cost Classifications Revisited

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

Effect of Time Frame

Short run is the period over which a
decision maker cannot adjust capacity
The level of capacity-related resources and
their cost 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 variable costs

Effect of Time Frame

Long-run costs are the sum of variable
and fixed 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

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

Changing Cost Structures

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 (fixed) costs generally
represented a small fraction of total
manufacturing costs

Changing Cost Structures

Today, direct labor is only a small portion
of manufacturing costs
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

Changing Cost Structures

The increase in fixed 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 variable and fixed costs associated

with design, product development, distribution,
selling, marketing, and administrative activities
have increased

Changing Cost Structures

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

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

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

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

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
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

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
The process engineering required to implement
engineering change orders (ECOs)

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 include:
Sales calls
Technical support provided to individual
customers

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

Business-Sustaining Activities
Business-sustaining activities are those
required for the basic functioning of the
business
These core activities are independent of
the size of the organization, or the volume
and mix of products and customers

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

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
The management of nonmanufacturing
costs is an increasingly important
contributor to an organizations financial
success

Nonmanufacturing Costs
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

Nonmanufacturing Costs
Nonmanufacturing costs include both
variable and capacity-related components
The nonmanufacturing costs that have
attracted the most attention are customerrelated costs
Can be significant and they can vary
widely across different customers

Nonmanufacturing Costs
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