The Nature of Costs

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

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

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 Revenue Profit Total costs Costs and revenues Variable costs Fixed costs Loss Units

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 Revenue Profit Total costs Costs and revenues Variable costs Loss Fixed costs Units

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