The Nature of Costs
Understanding is the Key to Control
1
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)
2
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
3
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

Don’t try to do it cheaper, try to do less of it
4
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
5
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
6
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
7
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
8
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
9
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
10
Cost Behavior

Fixed



Constant in total
Per unit decreases with increased activity
Variable


Constant per unit
Total increases with activity
11
Cost Behavior

Step variable


Increases when some threshold of activity is
crossed
Mixed

Contains both fixed and variable components
12
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
13
Controllable vs. Non-controllable
Costs

Controllable


Non-controllable


Can be controlled or incurred by management at a
given level of the organization
Beyond the control of management at a given
level
More costs are controllable higher up in the
organization than at lower levels
14
Direct vs. Indirect Cost

Direct


Indirect


Can be easily and conveniently associated with a
particular cost object
Cannot be easily and conveniently associated
with a particular cost object
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
15
Disaggregation of an Organization
Division A
Revenue
Variable costs
Contribution margin
Controllable fixed costs
Controllable margin
Non-controllable fixed costs
Contribution by SBU
Untraceable costs
Operating income
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)
16
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.
17
Prevention, Appraisal and Failure
Costs

Failure costs

Internal failure costs


Costs resulting from the detrimental outcome while the
product is still within the company’s control
 Scrap, rework, etc.
External failure costs

Costs resulting from the detrimental outcome after the
product leaves the company’s control
 Warranty repairs, recalls, lawsuits, lost sales, etc.
18
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
19
Prevention, Appraisal and Failure
Costs
Cost
Prevention and
appraisal costs
Failure costs
Total costs
1
3
5
7
9
11
13
15
17
19
21
Defects per 100,000
20
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.
21
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
22
Organizational Models
Costs and revenues
Revenue
Total costs
Variable costs
Fixed costs
Units
23
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
24
Organizational Models
Costs and revenues
Revenue
Total costs
Variable costs
Fixed costs
Units
25
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
$ 120,000
78,000
$ 42,000
10,000
$ 32,000
$ 140,000
91,000
$ 49,000
10,000
$ 39,000
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
26
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
27
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
28
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
29
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
30
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


Present and future costs may be relevant


Incremental or differential costs
Previous (sunk) costs are always irrelevant
Opportunity costs are always relevant
31
Management of Costs

Impact of cost structure on profits

If a large proportion of costs are fixed

Little cost fluctuation with changes in activity


If a large proportion of costs are variable

Costs fluctuate with changes in activity


High risk, high reward
Low risk, low reward
It is often possible to substitute one type of cost
for another
32
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
33