1. Cost Management MSCM8615

2. Definition of cost A monetary measure of the resources given up to acquire a good or service

3. 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

4. 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.

5. 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

6. 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

7. Example of Direct vs. Indirect Costs

8. 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

9. 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

10. 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

11. 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

12. Fixed Costs Fixed costs remain unchanged as the activity level (cost driver) varies. Examples of fixed costs include rent, salaries and property taxes.

13. Example of Fixed Costs MonthActivity LevelTotal CostCost Per Unit Jan1200$4,000 $3.33 Feb1400$4,000 $2.86 Mar1100$4,000$3.64 Apr800$4,000 $5.00 May900$4,000 $4.44 Jun1300$4,000 $3.08

14. Graph of Total Fixed Costs

15. Graph of Fixed Costs per Unit

16. Variable Costs Total variable costs change in direct proportion to changes in the activity level (cost driver)

17. Example of Variable Costs MonthActivity Level Total Photocopying Cost Cost per Unit Jan1200 $ 6,000 $ 5.00 Feb1400 $ 7,000 $ 5.00 Mar1100 $ 5,500 $ 5.00 Apr800 $ 4,000 $ 5.00 May900 $ 4,500 $ 5.00 Jun1300 $ 6,500 $ 5.00

18. Graph of Total Variable Costs

19. Graph of Variable Costs per Unit

20. Is this a graph of a fixed or variable cost?

21. 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

22. Historical Cost Analysis Visual Fit method High-low method Simple linear regression

23. Example of Historical Cost Analysis Month Activity Level Utility Cost Jan500013000 Feb800022000 Mar600014500 Apr1200029000 May1100024000 June1400034000

24. Plot of the Data

25. Visually Fitting a Line

26. 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!

27. Linear Regression Example

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. An ABC Example SupermarketsDrugstores MA and Pa Total Average Revenue per delivery$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 1,420 Total Gross margin$108,000 $150,000 $180,000$438,000 Gross 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 Margin0.9%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.

36. 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. ActivityCost Driver Order ProcessingNumber of Orders Line Item OrderingNumber of Line Items Store DeliveryNumber of Store Deliveries Cartons Shipped to StoresNumber of Cartons shipped/delivery Shelf Stacking at StoreNumber of hours of shelf stacking

37. 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.

38. An ABC Example, 4 The firm has finished Stage 1 and has assigned the following costs to each of the five activity areas Activity AreaTotal CostsTotal Units of Cost Driver Order Processing$80,000 2,000 orders Line Item Ordering 63,84021,280 line items Store Deliveries 71,000 1,420 store deliveries Carton Deliveries 76,00076,000 cartons Shelf Stacking 10,240 640 hours

39. An ABC Example, 5 Other useful data by distribution line SupermarketsDrugstoresMa and Pa 1. Total number of orders1403601,500 2. Average number of line items per order141210 3. Total number of store deliveries1203001,000 4. Average number of cartons shipped per delivery 3008016 5. Average number of hours of shelf stacking per delivery 30.60.1

40. An ABC Example, 6 First, calculate the cost driver rate for each cost pool. Activity AreaTotal Costs Total Units of Cost DriverCost Driver Rate Order Processing$80,000 2,000 orders$40/order Line 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

41. An ABC Example, 7 Next, allocate these costs to each distribution channel SupermarketsDrugstoresMa and Pa 1. Orders140*40=5,600360*40=14,4001,500*40=60,000 2. Average line items141210 2a. Total line items1,960*3=5,8804,320*3=12,96015,000*3=45,000 3. Deliveries 120*50=6,000300*50=15,0001,000*50=50,000 4. Average # of cartons 3008016 4a. Total cartons36,000*1=36,00024,000*1=24,00016,000*1=16,000 5. Average stacking hours 30.60.1 5a. Total Stacking hours360*16=5,760180*16=2,880100*16=1,600 Totals (= 301,080)59,24069,240172,600

42. An ABC Example, 10 Comparing ABC to Traditional Costing Profit: Ma and Pa TraditionalABC 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 Distribution Line Profit 56,269 7,400 Profit Margin2.8%0.4%

43. An ABC Example, 10 Summary Profit Comparison of Traditional vs. ABC TraditionalABC Supermarket 33,761 (0.9%) 48,760 (1.3%) Drugstores46,890 (1.5%) 80,760 (2.6%) Ma and Pa 56,269 (2.8%) 7,400 (0.4%) Total136,920136,920

44. 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

45. 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

46. 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)

47. 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

48. 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)

49. 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

50. 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

51. 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?

52. 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

53. 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

54. 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

55. Characteristics of information Relevance: future costs or benefits that are different between alternatives Accuracy Timeliness

56. 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

57. 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

58. Pitfalls to avoid Sunk Costs Fixed costs per unit Allocated fixed costs vs. avoidable fixed costs Opportunity costs

59. 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?

60. 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

61. 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-FCProfit 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

62. 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

63. 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

64. Solution to example Breakeven point = FC (SP-VC)/unit Breakeven point = 1,500 (12-7)/unit Breakeven Point = 300 campers

65. 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)

66. 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?

67. 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

68. 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

69. 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?

70. 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

71. Make vs. Buy, 4 Other issues Quality of vendor’s product Delivery schedule Maintaining/establishing vendor relationships Cost control Impact on organization of outsourcing