The Nature of Costs

Understanding is the Key to Control

What is Cost?
Assume you purchased a bottle of wine several years ago for $25. Today the same wine is selling for $100. You give your bottle of wine to your friend as a gift. What is the cost of your gift? $0 $25 $25+ $100 $(75)

Types of Costs

Assets

Potential future benefit

Expenses

Amounts consumed to produce revenue

No future benefit

Proper cost management involves the effective use of both types

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Cost Drivers

Cost driver is the thing that causes the cost to be incurred

All costs are the result of some decision or activity

Cost is a function of the amount of resource consumed and the price per unit of the resource

Control efforts should focus on control of the underlying cost drivers and the unit costs

Dont try to do it cheaper, try to do less of it

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Cost Drivers

Capacity driver

Cost is incurred to provide the capacity to perform some activity

Transaction driver

Cost is incurred each time the activity is performed

Each output makes essentially the same demand on the resource

Cost Drivers

Duration driver

Amount of cost incurred depends on how long the activity is conducted

Intensity driver

Amount of cost incurred depends on numerous factors

One activity may require the same amount of time as another, similar activity, but may consume different resources
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Levels of Cost Incurrence

Unit level

Each additional unit of activity causes a corresponding increase in cost

Examples: materials, commissions, etc. in which the cost benefits or relates to only one unit

Traditional view of variable costs

Frequently incorrect because many variable costs do not occur at the unit level

Levels of Cost Incurrence

Batch level

Each additional batch of activity causes a corresponding increase in cost

Examples: setups, material handling, labor, packaging, shipping, etc. in which the cost benefits or is related to several units

Often referred to as step costs

Levels of Cost Incurrence

Product level

Each additional product or change to a product causes a corresponding increase in cost

Examples: design, engineering, tooling, etc. in which the cost benefits or is related to all units of the product or process

Often misallocated to time periods

Failure to consider the benefit of the cost to future periods

Levels of Cost Incurrence

Facility level

Change in the facility, capacity, etc. causes a corresponding change in the cost

Examples: depreciation, administration, property taxes, insurance, etc. in which the cost benefits or is related to the entire facility or overall operations

Often referred to as fixed costs Typically incorrectly allocated to products or processes on an arbitrary basis

Reduces reliability and usefulness of information

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Cost Behavior

Fixed

Constant in total Per unit decreases with increased activity

Variable

Constant per unit Total increases with activity

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Cost Behavior

Step variable

Increases when some threshold of activity is crossed

Mixed

Contains both fixed and variable components

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Committed vs. Discretionary Costs

Committed

Cost must be incurred by the organization or is largely unavoidable

Often fixed in nature

Discretionary

Cost is incurred because management chooses to incur it

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Controllable vs. Non-controllable Costs

Controllable

Can be controlled or incurred by management at a given level of the organization

Non-controllable

Beyond the control of management at a given level

More costs are controllable higher up in the organization than at lower levels
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Direct vs. Indirect Cost

Direct

Can be easily and conveniently associated with a particular cost object Cannot be easily and conveniently associated with a particular cost object

Indirect

A cost may be directly related to one cost object but indirectly related to another

More costs can be directly related to higher levels than to lower levels
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Disaggregation of an Organization

Division A Company $ 2,000 1,100 $ 900 650 $ 250 100 $ 150 80 $ 70 Division A $ 1,400 900 $ 500 400 $ 100 75 $ 25 Division B $ 600 200 $ 400 250 $ 150 25 $ 125 Product 1 $ 900 500 $ 400 280 $ 120 40 $ 80 Not Product 2 traceable $ 500 400 $ 100 90 $ 30 $ 10 $ (30) 30 5 $ (20) $ (35)

Revenue Variable costs Contribution margin Controllable fixed costs Controllable margin Non-controllable fixed costs Contribution by SBU Untraceable costs Operating income

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Prevention, Appraisal and Failure Costs

Prevention costs

Costs incurred to prevent some detrimental outcome

Training, product or system design, etc.

Appraisal costs

Costs incurred to detect the occurrence of a detrimental outcome

Inspection, quality control, etc.

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Prevention, Appraisal and Failure Costs

Failure costs

Internal failure costs

Costs resulting from the detrimental outcome while the product is still within the companys control Scrap, rework, etc.

External failure costs

Costs resulting from the detrimental outcome after the product leaves the companys control Warranty repairs, recalls, lawsuits, lost sales, etc.

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Prevention, Appraisal and Failure Costs

Prevention and appraisal costs are inversely related to failure costs

Spending on prevention can reduce appraisal and failure costs Spending on appraisal can reduce external failure costs

Failures cannot be eliminated

Goal is to minimize total costs

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Prevention, Appraisal and Failure Costs

Prevention and appraisal costs Failure costs Total costs

Cost
1 3

11

13

15

17

19

21

Defects per 100,000

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Prevention, Appraisal and Failure Costs

Prevention, appraisal and failure costs are most often linked to quality control
The concept can also relate to

Environmental management Customer retention Employee retention Etc.

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Organizational Models

Ownership model

Large investment in capital assets

High fixed costs

Costs do not fluctuate proportionately with changes in activity

High risk, high return

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Organizational Models
Revenue Costs and revenues

Total costs Variable costs Fixed costs

Units
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Organizational Models

Rental model

Rent capacity as needed (outsource)

High variable costs

Costs fluctuate with changes in activity

Rent more when more is needed, rent less when less is needed

Low risk, low return

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Organizational Models
Revenue Costs and revenues

Total costs

Variable costs

Fixed costs
Units
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Ownership Model Variable costs = 25% of revenue Fixed costs = $50,000 Revenue Variable costs Contribution margin Fixed costs Net income $ $ $ 60,000 $ 15,000 45,000 $ 50,000 (5,000) $ 80,000 20,000 60,000 50,000 10,000 $ 100,000 25,000 $ 75,000 50,000 $ 25,000 $ 120,000 30,000 $ 90,000 50,000 $ 40,000 $ 140,000 35,000 $ 105,000 50,000 $ 55,000

Rental Model Variable costs = 65% of revenue Fixed costs = $10,000 Revenue Variable costs Contribution margin Fixed costs Net income $ $ $ 60,000 39,000 21,000 10,000 11,000 $ $ $ 80,000 52,000 28,000 10,000 18,000 $ 100,000 65,000 $ 35,000 10,000 $ 25,000 $ 120,000 78,000 $ 42,000 10,000 $ 32,000 $ 140,000 91,000 $ 49,000 10,000 $ 39,000

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Management of Costs

Proper cost management requires

understanding what causes costs to be incurred

a long-term perspective a holistic approach a focus on relevant costs understanding the impact of cost structure on costs and profits

understanding that cost cutting is only one method of cost management

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Management of Costs

Understand the cost drivers

Understand what activities you perform, why, and what they cost

Everything you do costs money, and doing nothing also costs money Do not try to do unnecessary activities cheaper, try to do less of the activity

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Management of Costs

Long-term perspective

Misguided short-term cost cutting can have longterm implications

Wise spending on investments may save money in the long run Focusing on quarterly or annual results hinders investment in projects with long lead times

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Management of Costs

Holistic approach

Must consider costs in relation to overall operations and other costs

Cutting costs in one area may cause an even greater increase in costs in another area Spending more in one area may reduce costs in another area

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Management of Costs

Identification of relevant costs

If a cost will not alter a decision, it is irrelevant and should be ignored

Relevant costs differ between alternatives

Incremental or differential costs

Present and future costs may be relevant

Previous (sunk) costs are always irrelevant

Opportunity costs are always relevant

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Management of Costs

Impact of cost structure on profits

If a large proportion of costs are fixed

Little cost fluctuation with changes in activity

High risk, high reward

If a large proportion of costs are variable

Costs fluctuate with changes in activity

Low risk, low reward

It is often possible to substitute one type of cost for another

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Management of Costs

Cost cutting is a subset of cost management

Cost management involves resource management

Proper cost management involves knowing when, where and how much to spend

You can cut your way into a downward spiral

You may spend your way out of a downward spiral

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