Cost Management
MSCM8615
Definition of cost
• A monetary measure of the resources given
up to acquire a good or service
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 company’s resources
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.
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
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
Example of Direct vs. Indirect Costs
Organizational Chart for Villanova University
Villanova University
President's Salary
Engineering
Accountancy
Chairman's Salary
Finance
C&F
Dean's Salary
Marketing
Management
Nursing
Economics
Business Law
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
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
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
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 VPManufacturing
Fixed Costs
Fixed costs remain unchanged as the activity level (cost driver) varies.
Examples of fixed costs include rent, salaries and property taxes.
Example of Fixed Costs
Month
Jan
Feb
Mar
Apr
May
Jun
Activity Level
1200
1400
1100
800
900
1300
Total CostCost Per Unit
$4,000 $3.33
$4,000 $2.86
$4,000 $3.64
$4,000 $5.00
$4,000 $4.44
$4,000 $3.08
Graph of Total Fixed Costs
$5,000
$4,000
$3,000
$2,000
$1,000
$0
13
00
0
90
0
80
00
11
00
14
00
Monthly Rent
12
Monthly Rental
Cost
Monthly Rental Costs as a Function of
Activity Level
Activity Level
Graph of Fixed Costs per Unit
Rental Costs per
unit
Rental costs per unit as a Function of
Activity Level
$6.00
$4.00
$2.00
$0.00
Rental costs per
unit
0
500
1000
Activity Level
1500
Variable Costs
Total variable costs change in direct proportion to changes in the activity level (cost driver)
Example of Variable Costs
Month
Activity Level
Jan
Feb
Mar
Apr
May
Jun
1200
1400
1100
800
900
1300
Total Photocopying
Cost
Cost per Unit
$ 6,000 $ 5.00
$ 7,000 $ 5.00
$ 5,500 $ 5.00
$ 4,000 $ 5.00
$ 4,500 $ 5.00
$ 6,500 $ 5.00
Graph of Total Variable Costs
Total Material Costs
Total Copying Costs as a Function of
Activity Level
$8,000
$6,000
$4,000
$2,000
$-
Total Material
Costs
0
1000
Activity Level
2000
Graph of Variable Costs per Unit
Material Costs
per Unit
Material Costs per unit as a Function of
Activity Level
$6.00
$4.00
$2.00
$800 900 1100 1200 1300 1400
Activity level
Material
Costs per
unit
Is this a graph of a fixed or variable
cost?
Series1
800
900
1100
1200
1300
1400
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
Historical Cost Analysis
• Visual Fit method
• High-low method
• Simple linear regression
Example of Historical Cost Analysis
Month
Jan
Feb
Mar
Apr
May
June
Activity Level
5000
8000
6000
12000
11000
14000
Utility Cost
13000
22000
14500
29000
24000
34000
Plot of the Data
Total Utility Costs
Utility Costs as a Function of Activity Level
40000
30000
20000
Utility Costs
10000
0
0
5000
10000
Activity Level
15000
Visually Fitting a Line
Total Utility Costs
Utility Costs as a Function of Activity Level
40000
Utility Costs
30000
20000
Linear (Utility
Costs)
10000
0
0
5000
10000
Activity Level
15000
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!
Linear Regression Example
Total Utility Costs
Utility Costs as a Function of Activity Level
y = 1823.7 +2.2421x
40000
Utility Costs
30000
20000
Linear (Utility
Costs)
10000
0
0
5000
10000
Activity Level
15000
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
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
Cost Hierarchy
• The cost hierarchy is more reflective of the
relationship that exists between costs and
activity. It is a basic building block for ActivityBased Costing (ABC) systems
• The cost hierarchy will be discussed more as
part of ABC
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
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
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
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
Salaries and
Activity
Fringes
Occupancy
Process Customer Orders
$
31,000 $
5,300
Purchase Materials
34,000
6,900
Schedule Production Orders
22,000
1,200
Move Materials
13,000
2,100
Set-up Machines
42,000
700
Inspect Items
19,000
13,000
Maintain Product Info
36,000
2,800
Perform Engineering Changes
49,000
32,000
Expedite Orders
14,000
900
Introduce New products
35,000
44,000
Resolve Quality Problems
18,000
2,100
Total
$ 313,000 $ 111,000
Equipment and
Technology
$
12,600
8,800
18,400
22,300
4,800
19,700
14,500
26,900
700
16,100
1,200
$
146,000
Materials
and
Aupplies
Total
$
800 $
49,700
1,500
51,200
300
41,900
3,600
41,000
200
47,700
800
52,500
400
53,700
2,400
110,300
500
16,100
18,700
113,800
800
22,100
$ 30,000 $ 600,000
An ABC Example
Supermarkets
Drugstores MA and Pa
$30,900
$10,500
$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
Total Gross margin
$108,000
$150,000
Gross Margin %
2.9%
4.8%
Average Revenue per delivery
Total
1,420
$180,000$438,000
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.
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
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.
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
Order Processing
$80,000
Total Units of Cost Driver
2,000 orders
Line Item Ordering
63,840
21,280 line items
Store Deliveries
71,000
Carton Deliveries
76,000
76,000 cartons
Shelf Stacking
10,240
640 hours
1,420 store deliveries
An ABC Example, 5
Other useful data by distribution line
1. Total number of orders
Supermarkets
Drugstores
Ma and Pa
140
360
1,500
14
12
10
120
300
1,000
80
16
0.6
0.1
2. Average number of line
items per order
3. Total number of store
deliveries
4. Average number of
cartons shipped per delivery 300
5. Average number of hours
of shelf stacking per delivery 3
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
$40/order
2,000 orders
Line Item Ordering
63,840
21,280 line items
Store Deliveries
71,000
Carton Deliveries
76,000
76,000 cartons
Shelf Stacking
10,240
640 hours
1,420 store deliveries
3/line item
50/store delivery
1/carton
16/hour
An ABC Example, 7
Next, allocate these costs to each distribution channel
Supermarkets
Drugstores
Ma and Pa
1. Orders
140*40=5,600
360*40=14,400
1,500*40=60,000
2. Average line items
14
12
10
2a. Total line items
1,960*3=5,880
4,320*3=12,960
15,000*3=45,000
3. Deliveries
120*50=6,000
300*50=15,000
1,000*50=50,000
4. Average # of cartons
300
80
16
4a. Total cartons
36,000*1=36,000 24,000*1=24,000 16,000*1=16,000
5. Average stacking hours
5a. Total Stacking hours
Totals (= 301,080) 59,240
3
360*16=5,760
69,240
0.6
0.1
180*16=2,880
100*16=1,600
172,600
An ABC Example, 10
Comparing ABC to Traditional Costing Profit: Ma and Pa
Traditional
ABC
$1,980
$1,980
Average CGS per delivery
1,800
1,800
Gross Margin per delivery
180
180
Average Revenue per delivery
Number of Deliveries
1,000
1,000
Total Gross margin
$180,000
$180,000
Allocation of Other Costs
123,731
172,600
Distribution Line Profit
Profit Margin
56,269
2.8%
7,400
0.4%
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
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 what’s 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 doesn’t 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
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
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)
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
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)
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
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
Example of Opportunity and Sunk
Costs
• You have a ticket to the NCAA Men’s 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 can’t 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?
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
Responsibility Accounting
• Costs can be considered controllable or noncontrollable 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
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
Characteristics of information
• Relevance: future costs or benefits that are
different between alternatives
• Accuracy
• Timeliness
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
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
Pitfalls to avoid
•
•
•
•
Sunk Costs
Fixed costs per unit
Allocated fixed costs vs. avoidable fixed costs
Opportunity costs
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?
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
The Basic CVP Model
Revenue
-Variable Costs
Contribution Margin
-Fixed Costs
Profit
(SP/unit X units sold)
-(VC/unit X units sold)
(CM/unit X units sold)
-FC
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
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 =
(SP-VC)/unit
Breakeven point
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
Solution to example
Breakeven point =
FC
(SP-VC)/unit
Breakeven point =
1,500
(12-7)/unit
Breakeven Point = 300 campers
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)
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?
Solution to CVP Example 2
FC
(Fee-VC)/unit = units
600+900
(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
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
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 ([2000*2 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?
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 supervisor’s 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
Make vs. Buy, 4
•
•
•
•
•
•
Other issues
Quality of vendor’s product
Delivery schedule
Maintaining/establishing vendor relationships
Cost control
Impact on organization of outsourcing