The Nature Of Costs
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The Nature Of Costs

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The Nature Of Costs The Nature Of Costs Presentation Transcript

  • The Nature of Costs Understanding is the Key to Control
  • 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)
  • 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
  • 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
  • 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
  • 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
  • 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
  • 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
  • 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
  • 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
  • Cost Behavior
    • Fixed
      • Constant in total
      • Per unit decreases with increased activity
    • Variable
      • Constant per unit
      • Total increases with activity
  • Cost Behavior
    • Step variable
      • Increases when some threshold of activity is crossed
    • Mixed
      • Contains both fixed and variable components
  • 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
  • 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
  • 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
  • Disaggregation of an Organization
  • 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.
  • 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.
  • 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
  • Prevention, Appraisal and Failure Costs
  • 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.
  • 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
  • Organizational Models Units Costs and revenues Fixed costs Revenue Total costs Variable costs Profit Loss
  • 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
  • Organizational Models Units Costs and revenues Fixed costs Revenue Total costs Variable costs Profit Loss
  •  
  • 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
  • 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
  • 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
  • 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
  • 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
  • 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
  • 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