1

The Nature of Costs

Understanding is the Key to Control

2

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)

3

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

4

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

5

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

6

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

7

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

8

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

9

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

10

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

11

Cost Behavior

Fixed Constant in total Per unit decreases with increased activity

Variable Constant per unit Total increases with activity

12

Cost Behavior

Step variable Increases when some threshold of activity is

crossed

Mixed Contains both fixed and variable components

13

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

14

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

15

Direct vs. Indirect Cost

Direct Can be easily and conveniently associated with a

particular cost object

Indirect 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

16

Disaggregation of an Organization

NotCompany Division A Division B Product 1 Product 2 traceable

Revenue 2,000$ 1,400$ 600$ 900$ 500$ Variable costs 1,100 900 200 500 400 Contribution margin 900$ 500$ 400$ 400$ 100$ Controllable fixed costs 650 400 250 280 90 30$ Controllable margin 250$ 100$ 150$ 120$ 10$ (30)$ Non-controllable fixed costs 100 75 25 40 30 5 Contribution by SBU 150$ 25$ 125$ 80$ (20)$ (35)$

Untraceable costs 80 Operating income 70$

Division A

17

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.

18

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.

19

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

20

Prevention, Appraisal and Failure Costs

1 3 5 7 9 11 13 15 17 19 21

Defects per 100,000

Co

st

Prevention andappraisal costs

Failure costs

Total costs

21

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.

22

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

23

Organizational Models

Units

Co

sts

and

rev

enu

es

Fixed costs

Revenue

Total costs

Variable costs

Profit

Loss

24

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

25

Organizational Models

Units

Co

sts

and

rev

enu

es

Fixed costs

Revenue

Total costs

Variable costs

Profit

Loss

26

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

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

Variable costs = 65% of revenueFixed costs = $10,000

Ownership ModelVariable costs = 25% of revenue

Fixed costs = $50,000

Rental Model

27

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

28

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

29

Management of Costs

Long-term perspective Misguided short-term cost cutting can have long-

term 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

30

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

31

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

32

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

33

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