ACCTG 533, Section 1: Module 1: Costs and Cost Allocation: Lecture 1: Costs and Cost Behavior Costs and Cost Behavior Costs and Cost Behavior. Cost [Graphic Shown] a sacrifice or giving up of resources for a particular purpose Successful management of an entity requires effective cost management Understanding of costs and cost behavior Cost is defined as a sacrifice or giving up of resources for a particular purpose. Organizations incur many different types of costs, from paying for supplies and inventory to salaries, rent and utilities. The management of costs is critical to the successful management of an entity whether that entity is a for-profit, a not-for-profit, or a governmental entity. Effective cost management requires an understanding of costs and cost behavior. Key Cost Concepts and Terminology Cost behavior Fixed costs Variable costs Cost driver [Picture Shown] Cost behavior refers to how costs react to changes in an underlying factor known as a cost driver. Fixed costs remain the same and do not vary while variable costs change directly with changes in the cost driver. A cost driver is simply an activity or factor that is associated with a cost and can be used to predict how that cost will change. 1
Let s use a pet food store, Wags, as an example. For Wags, rent is a fixed cost the amount of rent paid is the same every month regardless of how many days per week Wags is open or the level of sales. The pet food costs, on the other hand, are variable costs they will increase or decrease with the level of sales. Since pet food costs are variable, what would the cost driver be? The cost driver would likely be the number of bags of pet food sold or perhaps the number of pounds or some other variation reflecting the different sizes and types of pet food sold. Pet food costs will increase directly with the amount of pet food sold. Key Cost Concepts and Terminology [Picture Shown] Mixed costs Step costs Costs can also be a blend of fixed and variable. Mixed costs have both a fixed and a variable component while step costs are fixed but increase in stages. For example, the cost of electrical service to Wags is a mixed cost with a minimum charge per month plus a usage charge per kilowatt hour over a certain number of kilowatt hours. An example of a step cost is the cost of a delivery truck for customer purchases. The delivery truck can deliver a maximum of 150 customer purchases per month. If 200 deliveries are needed, a second truck will have to be added. Cost Identification Methods Mathematical modeling, e.g., high-low, graphing, regression Engineering analysis Account analysis Theory is always easier to understand than to apply. How do you know which costs are fixed and which are variable? It may be easy to see - the amount is the same all the time so it is a fixed cost. Often, however, some analysis is required. Different methods are employed to measure cost behavior, ranging from very simple to highly complex. These include: mathematical modeling (for example, high-low, graphing, and regression are all examples of mathematical models), engineering analysis which determines cost behavior based on production specifications 2
and related cost estimates, and account analysis which employs accounting data and subjective judgments. Relevant range [Picture Shown] Cost behavior only over specified range of activity or production Long run all costs variable The notion of a relevant range must also be added. Fixed costs and variable costs are only fixed and variable over a specified range of activity or production, the relevant range. In the long run, all fixed costs are variable as you could always close the business and eliminate all of your fixed costs. Similarly, a variable cost may apply only to given level of activity and may change for other levels of activity. Think about your water charges in the summer. Now where I live, the water rates in the summer go up and there s a certain rate for the first 10,000 gallons and then there s a higher rate for the next 10,000 gallons and then it continues to go up after that. The idea is to restrict our use of the water, but that would be an example of a relevant range, 10,000 gallons. The relevant range is thus the level of activity or production to which the fixed and variable costs are applicable. No easy way! Costs and cost behavior are entity-driven Differ by entity, industry, country Can t memorize by type In order to determine the nature of costs, you MUST look at the entity. It differs from one entity to another, from industry to industry, and from country to country. For example, in the retail sales industry, rent is often a mixed cost instead of a fixed cost. It consists of a base or minimum amount plus a percentage of sales. A German pharmaceutical company, Schering AG, categorized labor as a fixed cost due to regulations which made layoffs difficult. Japanese auto manufacturing companies are noted for their extremely low fixed costs due to Just-In-Time and outsourcing practices. As a result, simply memorizing which costs are fixed and which are variable isn t possible. A careful analysis of costs must be performed by each organization before they can be properly classified. 3
Period Costs and Income Statement [Income Statement Shown] Another key concept is the effect of costs on the financial statements. Period costs are expensed meaning they show up on the income statement. They typically include the organization s operating costs such as salaries, utilities, and insurance. Product costs, however, are capitalized. They show up on the statement of financial position or the balance sheet. They show up as inventory, which is an asset, until they are sold. When sold, the inventory costs become cost of goods sold, an expense. More on Product Costs [Graphic Shown] Direct materials Direct labor Overhead The last topic is product costs. The manufacture of a product involves the accumulation of three different types of product costs: direct materials, direct labor, and overhead. Direct materials and direct labor are costs that can be directly traced to the product. Overhead includes everything else, all other product-related costs that are not directly traceable or easily measurable. Overhead is also known as manufacturing overhead, factory overhead, and factory burden. Product Costs for a Cake [Picture of Cake] Direct Materials: Flour Butter Sugar Eggs Cake box 4
Direct labor: baker Overhead: Rent Utilities Insurance Mixing bowls Baking pans For example, consider a bakery and the production of a cake. The direct materials would include the cake ingredients (flour, butter, sugar, eggs, for example) and the box that the cake will be sold in. The direct labor would include the wages paid to the baker who mixed and baked the cake. The rest of the costs would be lumped into overhead. They would include the rent and other costs of the premises such as insurance and utility costs, and the mixing bowls, baking pans and other cooking utensils. Overhead? [Picture of Pam as Indirect materials] [Picture of Janitor as Indirect labor] Not directly traceable Not easily measurable Cost-benefit rule Sounds straight-forward, doesn t it? There is actually quite a bit of judgment that can come into play here. Two things to remember: Overhead includes the costs that are either not directly traceable or not easily measurable and two, the Cost-benefit rule you don t want to spend more time figuring out how much cost to allocate than it is worth. Before the batter is placed in the pan, the pans are misted with a nonstick spray. The spray comes in a 28-ounce can and lasts for several days depending on the number of batches. The cost of a can is less than $15 and it would cost more than that to figure out the amount used and related cost per cake. The cost of the nonstick spray is an example of an indirect material that will be included in overhead. 5
A janitor comes in at night to thoroughly clean the bakery premises including the baking area and equipment. Clearly, this work is essential to the production of high quality cakes. But the cost of the janitor is not easily traceable to each cake. It is an example of indirect labor that will be included in overhead. Other indirect labor costs that are commonly included in overhead are: supervisors, material handlers, security staff, and maintenance workers. Other Labor Costs Other Labor Cost Overhead Direct Labor Idle time X Overtime premiums X Fringe benefits X X Some other labor costs are worth mentioning. Idle time costs are costs incurred when direct labor employees are unable to work due to power outages, material shortages, machine breakdowns, or other problems. These costs are generally treated as overhead rather than being assigned as direct costs to a specific production run. The rationale for this treatment is that idle costs should be spread over all production for a period as the problems impact the entire period rather than just the jobs that were in process at the time. Overtime premiums for both direct and indirect labor are similarly treated as overhead following a similar rationale. Overtime that occurs relates to the period as a whole, not the particular jobs that were in process when the overtime was worked. Finally, the treatment of labor-related benefits or fringe benefits such as insurance, retirement, Social Security and Medicare taxes, workers compensation, etc., varies. Some entities treat them as indirect labor (in other words, overhead) while others consider them to be an additional direct labor cost. Given the size of these costs which can approach 30-40% or even more of the base pay, however, it would seem more appropriate to classify them as direct labor costs. 6