Dashboard For Cost of Construction Projects Course

 

Managerial and Cost Accounting   FP&A

Cost Concepts: An Overview

Costs are generally defined as the financial assets surrendered to accomplish an objective (e.g., to acquire an asset or produce a product). For cost accounting purposes, it is helpful to think of these objectives as cost objects. A cost object is anything for which we desire to accumulate costs. A cost object may be an asset, a product line, a department, an activity or a process.

Managers use the cost information associated with cost objects to make management decisions. An actual cost is different from a budgeted cost. Actual costs are the historical amount paid or obligation made for an asset; budgeted costs are the predicted or forecast costs. Managers are usually interested in both types of costs.

Let’s consider possible cost objects associated with the production of ergonomic chairs.

Methods of performing a CVP sensitivity analysis are discussed next, followed by CVP scenario analysis. The topic concludes with a discussion of other uses of CVP analysis.

Sample Costs Objects

Costs can be accumulated for:

Product The Ergochair 5000

Department The R&D department that studies ergonomics Service The online help system to support chair retailers Customer ChairMania, Inc., a major retailer of the Ergochair 5000

Project The R&D project to improve ergonomics for the next generation chair

Activities The assembly line set up for the production of the Ergochair 5000

Cost Classifications

Cost includes all of the costs necessary to get the cost object in place and ready to produce financial benefits. For example, cost of goods sold includes not only the cash paid (or obligation made) for the raw materials used in production but also allocations for manufacturing supervision and overhead.

The distinction between the cost of the raw materials and the cost of supervision reflects the difference between direct and indirect costs.

Direct Costs 

Direct costs can be traced directly to the cost object. No intervening action is required to be able to assign the cost to the cost object. For example, the direct costs of producing an ergonomic chair can be identified by the invoice for the specific raw materials used and the time sheets of the specific laborers involved in the production of the chairs.

 

Indirect Costs

Indirect costs are also known as shared costs, and they cannot be traced directly to the cost object. Intervening action in the form of a cost allocation is necessary to link the indirect cost to the cost object. For example, the rent expense for the building where the ergonomic chair is manufactured cannot be directly tied to the chair if other furniture is also produced in the facility. In that circumstance the rent cost must be allocated to the various products produced, including the chair.

Cost allocation assigns indirect costs to cost objects on a logical basis. Cost allocation is discussed more later in this topic.

Classifications in a Manufacturing Business

To expand our understanding of cost concepts, this section will explore the common cost classifications used by manufacturing businesses. Similar concepts apply to both the merchandising and service sectors.

Cost classifications for manufacturing or any other business sector are built on the concepts of direct and indirect costs discussed earlier. The main manufacturing cost classifications are:

Direct material costs

These are the costs to obtain the raw materials used to produce the product. They include all the traceable costs incurred to get the product ready to produce financial benefits. This includes the costs of delivery, taxes and any other costs of acquiring the material. An example of a direct material cost is the cost of the mesh fabric for the seat and back of an ergonomic chair, the associated taxes and shipping charges.

These costs can be found on the invoice.

Direct manufacturing labor costs

These are the costs of the labor that is directly involved in the production of the product. This includes wages and benefits paid to workers who build the product or devote all of their time to working on the product.

Manufacturing overhead costs (indirect costs)

These are indirect costs that make up the remaining portion of the cost of goods sold (COGS) and/or inventory. This includes all the other costs related to the manufacture of the product that can be allocated to the products. This includes general supplies, indirect materials such glues and minor components that might be used in the production of multiple products, indirect labor such as plant supervision or

maintenance, plant rent and insurance, taxes, depreciation, etc.

Corporate overhead costs

These are indirect costs and include all the other costs and expenses that cannot be directly traced to the product. These are discussed below as period costs.Other business sectors have comparable cost classifications. The concepts of direct and indirect but allocable costs apply in the same way. Another distinction in costs that specifically applies to manufacturing and merchandising entities are inventoriable vs. period costs:

 

Inventoriable (product) costs

These are all the costs (direct and indirect) needed to get the cost object in place and ready to produce financial benefits. Inventoriable costs are also called product costs. When inventory is sold, these costs become the cost of goods sold (COGS). For a manufacturing concern, these costs include the direct material, direct labor and manufacturing overhead costs just discussed.

A merchandising business purchases products from suppliers and resells them without changing their form. For a merchandising concern, inventoriable costs include the costs of purchasing the product for resale plus all the other costs necessary to get the product in place and ready to sell, such as shipping, insurance and handling costs.

 

Period costs

Period costs cannot be assigned to a particular product (not included in COGS or the cost of inventory). They are expensed during the period because they are not expected to provide benefits in future periods. Corporate overhead is a period cost. Examples of period costs are marketing, selling, general administrative costs and interest expenses. For manufacturing entities, period costs are all the

non-inventoriable costs, such as the cost of shipping products to customers. For merchandising concerns, period costs include labor costs of sales personnel, advertising costs, etc.

Cost Behavior Patterns

The management decision processes of product planning, capital budgeting, cost/benefit analysis and financial plan development all require an understanding of cost behavior. Cost behavior describes the relationship between costs and business activities (i.e., cost drivers).

There are three basic cost behavior patterns:

●   Fixed costs. Fixed costs do not vary in total over a wide range of business activity levels. They are not immediately impacted by changes in business volume. An example of a fixed cost is the monthly fee banks charge on deposit accounts. The fee remains the same regardless of the number of transactions on the account.

●   A fixed cost is treated as a lump sum in decision analysis. However, the fixed cost per unit of activity decreases as the activity level increases. The account maintenance fee in our example will be the same regardless of the number of deposits made to an account. Consequently, the cost per deposit of a $100 maintenance fee is $10 if 10 deposits are made and only $1 if 100 deposits are made during the statement period.

●   Variable costs. Total variable costs change in direct proportion to the level of business activity. The cost of goods sold is a variable cost. COGS generally increases as sales and production levels increase and decreases if revenue and production levels decrease. Many companies express COGS as a cost per unit produced. The variable cost per unit does not change based on the volume of activity.

●  Semi-variable (or mixed) costs. Some costs are semi-variable (or mixed) and increase in stair-step fashion. Assume that an accounts receivable clerk can process 20 transactions per hour. Another clerk must be added to process 21 transactions, and those two clerks together can process up to 40 transactions. Three clerks are required to process between 41 and 60 transactions, and so on. Consequently, the semi-variable cost has both fixed and variable cost elements.

Exhibit I.A.5-1 shows the patterns of the three cost behaviors in relation to business volume. The horizontal axis measures output units, which may be any measurable activity. Examples include factory production in physical units and the number of transactions processed by tellers.

 

Exhibit I.A.5-1 – Cost Behaviors

Other Cost Concepts

Managers use both total costs (fixed and variable) and unit costs in decision making. Unit costs are calculated by dividing the total cost of the cost object by the quantity of the cost object.

Unit Cost = (Total Fixed Cost + Total Variable Cost) ÷ Quantity

For example, if the total cost to produce the ergonomic chairs is $1,000,000 and 2,000 chairs are produced, the unit cost is $500.

Fixed costs cause unit costs to fall as volume goes up. Variable costs have no impact on unit costs as volume changes. Unit costs are used in management decisions on pricing, product mix and profitability analyses, among other things. Managers should use unit costs cautiously, especially when forecasting. Because the fixed components of unit costs change based on volume, forecasts using a unit cost can be skewed if the intended volume is not reached.

 

Other cost concepts useful in decision making are those of sunk and incremental costs.

● Sunk costs. Sunk costs are costs that cannot be reversed or recovered. In making a decision, we should consider only the costs affected by that decision. Costs that are not affected and that are incurred regardless of the decision are sunk costs. For example, when determining whether to make a follow-on investment to expand a project, maintain it as it is, or terminate it, all costs of the first phase of the project are sunk costs and should not affect the decision. This is true even if the original project was over budget.

● Incremental costs. These costs reflect the additional cost that will be incurred based on a decision. Whereas sunk costs are incurred regardless of the decision, incremental costs are incurred only because a specific decision is made. These are the only costs that should be considered in decision making.

 

Contribution Margin

The impact of fixed and variable and total and unit costs comes into play when looking at the contribution margin. The contribution margin is calculated as revenue less total variable costs.

Contribution Margin = Revenue – Variable Costs

It represents the amount that an organization can use to cover fixed costs. The contribution margin is calculated at different sales levels to determine the volume of sales necessary to break even or reach a certain income level. Contribution margins can be calculated for each product in a product line to rank which products have the highest profitability per unit sold as well as which contribute most to overall profitability.

The contribution margin should not be confused with gross margin. The gross margin is gross profit as a percentage of sales. The gross margin is an entirely different unit of measure since it considers both fixed and variable costs. Contribution margins are discussed more in the next topic.

Cost Allocations

Measuring product cost is a difficult and inexact science. While some costs can be directly traced to products, such as direct labor and direct material costs, other indirect costs are difficult to connect to a product or customer segment in an economically feasible way. One approach, which involves subjective judgment, is to use cost allocations to approximate how much cost should be attributed to specific products or customers. Despite its difficulties, cost allocation can clarify a product’s potential profitability and value and provide information that will improve decision making and resource allocation.

 

Cost allocation can sometimes require the use of judgment, but the goal is to assign the costs based on the root causes of the cost. In the case of rent, the allocation might be based on the percentage of square feet of the cost object’s production space relative to the total square feet of the plant. However, it might be reasonable to allocate plant supervisory or other overhead costs based on the hours worked by laborers on each product, by the amount of space used to produce the product, or by the number of products produced.

 

Organizations allocate costs to cost objects (products, customers, etc.) in different ways. It is also important to keep in mind that a cost can be direct or indirect depending on the cost object to which it is being assigned. Take, for example, the cost of the supervisor in the plant producing the ergonomic chairs. If the cost object is the plant as a whole, the supervisor cost is a direct cost. If the cost object is the ergonomic chair, the supervisor cost is an indirect cost and would be allocated on a logical basis.