Chapter Three

Basic Cost-Management Concepts

Blocher,Stout,Cokins,Chen, Cost Management 4e The McGraw-Hill Companies 2008

Learning Objectives
Understand the strategic role of basic cost concepts Explain cost-driver concepts at the activity, volume, structural, and executional levels Explain the cost concepts used in product and service costing Demonstrate how costs flow through the formal accounting system
Blocher,Stout,Cokins,Chen, Cost Management 4e The McGraw-Hill Companies 2008

Learning Objectives (continued)

Prepare and interpret an income statement for both a manufacturing firm and a merchandising firm Explain the cost concepts related to the use of cost information in planning and decisionmaking Explain the cost concepts related to the use of cost information for control/feedback purposes
Blocher,Stout,Cokins,Chen, Cost Management 4e The McGraw-Hill Companies 2008

Basic Definitions
A cost is incurred when a firm uses a resource for some purpose Costs are assembled into meaningful groups called cost pools (e.g., by type of cost or source) Any factor that has the effect of changing the level of total cost is called a cost driver A cost object is any product, service, customer, activity, or organizational unit to which costs are assigned for some management purpose
Blocher,Stout,Cokins,Chen, Cost Management 4e The McGraw-Hill Companies 2008

Cost Concepts: Overview There are four main ways to classify costs (different costs for different purposes):
For product and service costing (GAAP) For strategic decision-making (cost-driver analysis) For planning and decision-making For control/feedback
Blocher,Stout,Cokins,Chen, Cost Management 4e The McGraw-Hill Companies 2008

Product/Service Costing: Cost Assignment

The process of assigning costs to cost pools or from cost pools to cost objects
Direct costs can be conveniently and economically traced to a cost pool or a cost object Indirect costs cannot be traced conveniently or economically to a cost pool or a cost object Because indirect costs cannot be traced, assignment is made through the use of cost drivers (cost allocation) These cost drivers are often called allocation bases
Blocher,Stout,Cokins,Chen, Cost Management 4e The McGraw-Hill Companies 2008

Cost Assignment: General Principles

Costs Electric Motor Materials Handling Supervision Packing Materials Final Inspection
Blocher,Stout,Cokins,Chen, Cost Management 4e The McGraw-Hill Companies 2008

Cost Drivers and Cost Assignment Cost Pools Cost Objects

Assembly

Dishwasher

Packing

Washing Machine

Product and Service Costing Concepts (GAAP)

Product costs include only the costs necessary to complete the product at the manufacturing step in the value chain (manufacturing) or to purchase and transport the product to the location of sale (merchandising) Period costs include all other costs incurred by the firm in managing or selling the product (indirect costs outside the manufacturing step of the value chain)
Blocher,Stout,Cokins,Chen, Cost Management 4e The McGraw-Hill Companies 2008

Direct and Indirect Product Costs for a Manufacturer

Direct material costs = cost of materials that can be readily traced to outputs = purchase price of materials + freight purchase discounts + reasonable allowance for scrap and defective units Indirect material costs = cost of materials that cannot readily be traced to outputs (e.g., rags, lubricants, and small tools) Direct labor costs = labor that can be readily traced to outputs = wages paid plus a reasonable allowance for nonproductive time Indirect labor costs = labor costs that cannot be readily traced to outputs (i.e., they are manufacturing support costs)
Blocher,Stout,Cokins,Chen, Cost Management 4e The McGraw-Hill Companies 2008

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Direct and Indirect Product Costs: Further Comments

All indirect costs for the manufacturer, including indirect materials, indirect labor, and other indirect items are often combined in a cost pool referred to as overhead (or, factory overhead, or indirect manufacturing costs) The three main types of costs, direct materials, direct labor, and overhead, are often condensed even further:
Direct materials + Direct labor = Prime costs Direct labor + Overhead = Conversion costs
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Manufacturing vs. Merchandising

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Inventory and Related Expense Accounts

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Costs for Strategic Decision-Making

Inventory valuation (GAAP) vs. strategic costing? Cost drivers provide two roles for the management accountant
Assigning costs to cost objects Explaining cost behavior, i.e., how total cost changes as the cost driver changes

There are four types of cost drivers:

Activity-based Volume-based Structural Executional
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Cost Drivers
Activity-based cost (ABC) drivers are developed at a detailed level of operations using activity analysisa cost driver is determined for each activity Volume-based cost drivers relate to the amount produced or quantity of service provided:
The relationship between the cost driver and total cost is approximately linear within the relevant range Outside of the relevant range, the Law of Diminishing Marginal Returns generally applies (i.e., non-linearities exist)
Blocher,Stout,Cokins,Chen, Cost Management 4e The McGraw-Hill Companies 2008

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Cost Drivers (continued)

Structural cost drivers facilitate strategic decision making because they involve plans and decisions that have long-term effects
Scale, experience, technology, and complexity are considered in hopes of improving competitive position

Executional cost drivers facilitate operational decision making by focusing on short-term effects
Workforce involvement, design of the production process, and supplier relationships are considered in an attempt to reduce costs
Blocher,Stout,Cokins,Chen, Cost Management 4e The McGraw-Hill Companies 2008

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Cost Information for Short-term Planning: Classification by Behavior

What is meant by cost behavior? Common classifications of cost behavior:
Fixed (capacity) cost is the portion of total cost that does not change with changes in output Variable cost is the change in total cost associated with each change in quantity of the cost driver Mixed cost is used to refer to a total cost figure that includes both a fixed and variable component Step costs vary with the cost driver but do so in steps

Applications:
Budgeting Cost-Volume-Profit analysis (profit planning)
Blocher,Stout,Cokins,Chen, Cost Management 4e The McGraw-Hill Companies 2008

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Fixed Costs
Total Cost
$6,600 $6,500 $3,000

Total Fixed Cost

3,500
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3,600
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Units of the Cost Driver

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Variable Costs
Total Cost
$6,600 $6,500

Total Cost

Total Variable Cost

$3,000 3,500 3,600

Units of the Cost Driver

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Short-Run Decision-Making Cost Concepts

Relevance is the most important characteristic for information used in decision making
Relevant costs have two properties: they differ for each decision option and they will be incurred in the future

Opportunity cost is the benefit lost when choosing one option precludes receiving the benefits from the alternative option Sunk costs are costs that have been incurred or committed in the past and are therefore irrelevant in current decision making
Blocher,Stout,Cokins,Chen, Cost Management 4e The McGraw-Hill Companies 2008

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Qualitative Characteristics of Cost Information for Planning and Decision-Making

There are three other characteristics that are important for planning and decision making
Accuracy (and the need to monitor internal accounting controls) Cost and value of cost information (the cost of information should be monitored by the management accountant to ensure that costs do not outweigh the associated benefits) Timeliness (often involves sacrificing in the other two areas)
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Cost Information for Control/Feedback Purposes

Controllability is a basic consideration in evaluating managers and providing feedback A cost is considered controllable if the manager or employee has discretion in choosing to incur it or can influence the amount in a short period of time The controllability of some costs is subject to debate, for example, changes in interest rates, foreign exchange fluctuations, or changes in state or local taxes; should the manager be responsible for these changes?
Blocher,Stout,Cokins,Chen, Cost Management 4e The McGraw-Hill Companies 2008

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Chapter Summary
There are different ways to classify (or categorize) cost information, depending on the information needs of management (different costs for different purposes):
To prepare financial statements (GAAP) For strategic decision-making For short-term planning For short-term decision-making For control/feedback purposes

Product and service costing (GAAP) focuses on differentiating product costs from period costs Costs flow through three inventory accounts in a manufacturing firm; merchandising firms have one inventory account
Blocher,Stout,Cokins,Chen, Cost Management 4e The McGraw-Hill Companies 2008

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Chapter Summary (continued)

For strategic decision-making, we think about costs in terms of the following types of drivers: activity-based, volume-based, structural, and executional Cost concepts used in short-term planning relate to the behavior of costs (i.e., how they change in response to one or more activities) For decision-making we generally classify costs into one of the following categories: relevant, opportunity, or sunk
Relevance, accuracy, timeliness, and value that exceeds cost are important information characteristics

Controllability and risk preferences must be assessed when using cost information for management and operational control
Blocher,Stout,Cokins,Chen, Cost Management 4e The McGraw-Hill Companies 2008