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  1. 1. 1. INTRODUCTION The theme of this chapter is "different cost for different purposes". On page 83 ABKY say that cost is like a chameleon. Most of the chapter is related to defining the terminology related to costs, i.e., the different types of costs that are associated with different types of decisions. Costs are assigned to cost objects following generally accepted accounting principles (GAAP) so that general purpose financial statements can be prepared for external reporting. Many other types of cost information are developed to support internal decisions. Illustrations 5 and 6 in the ABKY Chapter 1 summary show that different audiences need different types of information. In addition to defining a considerable number of cost types and other terms, the authors discuss why GAAP uses a functional approach to defining types of cost, the concept of cost- benefit analysis, how cost structures differ today, the activity cost hierarchy, and life cycle cost. They also provide an example to illustrate the concept of relevant cost. 2. MANAGEMENT ACCOUNTING TERMINOLOGY More Specific Definition Cost or other Term Definition or Example Cost Sacrifice The price of any resource. Cost object Any segment or element A product, service, project, for which cost activity, department, information is desired. division, etc. Direct cost Cost used by a single cost A cost that would be object. eliminated if the cost object is eliminated. A supervisor's salary is a direct cost to the production department he or she is in charge of or managing. Indirect cost Cost that is common or A production supervisor's shared by more than one salary is an indirect cost to cost object. the products produced within his or her department.
  2. 2. Flexible resource Resources that generate Direct material. cost in proportion to the amount used. Flexible cost Cost of flexible resources. Direct material costs, i.e., Always direct costs. Cost cost of materials or that vary in proportion to components that go into or the amount used. become the product. Capacity related Resources purchased in Resources that generate resource advance. Committed cost based on the amount resources. acquired rather than the amount used. Buildings and equipment. Capacity related cost Cost that are based on the Can be direct or indirect, amount acquired rather but are fixed in the short than the amount used. run. Depreciation on buildings and equipment. Variable cost This term is not defined Direct material. in Chapter 3, but it is a cost that changes or varies with changes in the activity level. See Chapter 5, p. 182. Fixed cost A cost that does not Capacity related cost. See change or vary with page 83. Straight line changes in the activity depreciation, a supervisor's level. salary, property taxes. Matching concept I don't think matching is Accrual accounting where defined in this chapter, benefits (revenues) are but it is the idea of matched with the costs bringing cost and benefits (expenses) associated with together on the income generating the benefits. statement in the same time period. Expired cost A cost associated with an An expense such as cost of object who's benefits have goods sold. been obtained or recorded. Unexpired cost An asset. Inventory until sold, buildings, equipment.
  3. 3. Expense An expired cost. See Cost of goods sold. above. Asset An unexpired cost. An Inventory, book value or object with expected undepreciated cost of future benefits. buildings and equipment. Product cost Costs associated with Direct manufacturing costs producing a product that such as direct materials and are capitalized in the direct labor, as well as inventory, i.e., become indirect manufacturing assets until the products costs usually referred to as are sold. factory overhead. Inventory cost Product costs. See above. See cell above. Manufacturing cost Cost associated with the Includes direct material, production of products. direct labor (direct Factory costs. These are manufacturing costs) and unexpired costs (assets) indirect manufacturing until the products are costs also referred to as sold, then are charged off factory overhead and as expense, i.e., cost of factory burden. goods sold Non-manufacturing cost Cost not associated with Distribution, selling, the production of marketing, customer products, but with some service, research and other function such as development. See page 77. administration or distribution. Treated as period costs by GAAP. Period cost Cost that are expensed in Non-manufacturing costs the period in which according to GAAP. See incurred. above. Incremental cost Cost of one more item, Cost of one more passenger unit or customer. on an airline. Full cost Direct plus indirect cost. GAAP product costs is Variable plus a share of considered full costs the fixed costs. although this is misleading because it does not include non-manufacturing costs.
  4. 4. Historical cost Recorded costs. Any costs that are recorded Sometimes referred to as such as labor costs, actual cost, but this is materials costs, misleading because the depreciation etc. For cost recorded depends on example, accounting the accounting alternative alternatives for chosen. depreciation include straight line and several accelerated methods. Future cost Estimated costs. Budgeted costs. Average cost Usually refers to the mean The unit cost of a product of a category of costs. that flows through a production process. Implicit cost Unstated and unrecorded Opportunity costs. cost. Opportunity cost Benefit foregone by not The income or interest on accepting or pursuing the an alternative investment. next best alternative. The opportunity cost of owning anything is what you could have obtained with the money. Short run ABKY define this as the Usually thought of as a time period where a year in accounting, but this decision maker cannot is just a ball park number adjust capacity. See page and depends on the type of 83. resource involved. The short run for an inter-state highway, or factory building is longer than a year and for a resource like fork lift trucks, it would be much shorter than a year. Long run The opposite of the above See the cell above. where capacity can be increased or decreased. Short run cost ABKY define these as Direct material. flexible costs. See page 83.
  5. 5. Long run cost These can be flexible or Depreciation on plant and capacity related according equipment. to ABKY. Discretionary cost Can be increased or Advertising, employee decreased at the training, research & discretion of the decision development, preventive maker. Not committed. maintenance. Business level or Capacity related cost. Buildings and equipment. sustaining cost Activity cost Cost associated with Unit level, batch level, different types, or levels product level, customer of activities. level and business level. See below and exhibit 3-7 on page 93. Unit level cost Cost of an activity that is Direct material required for required or performed a unit of product. each time a unit of product or service is produced or provided. Batch level cost Cost of an activity that is Setting up the production required or performed line to produce a batch of each time a batch of product X. Also inspecting products or services is the batch, moving the batch produced. etc. Product level cost Cost of an activity that is Product engineering. required or performed to support a specific product. Customer level cost Cost of an activity that is Sales calls, installation of a required or performed to product and technical support a specific support. customer. Business (or facility) Cost associated with Maintenance, level cost maintaining the business housekeeping, and and facilities. administrative functions. Relevant cost Cost that will be different The cost that will be when two or more different if a product is alternatives are involved. dropped. See note below
  6. 6. Also called differential related to the example on cost. pages 93-96. Life cycle cost Cost associated with the Cost of product: various stages of a 1. Development and product's life cycle. See design. page 98. 2. Introduction. 3. Production. 4. Distribution. 5. Post sales service. 6. Product take back. 7. Abandonment. 3. WHY GAAP USES A FUNCTIONAL APPROACH TO COST This section relates to why costs are separated into manufacturing and non- manufacturing categories. On page 79 ABKY say the answer to this question is not clear, but it is probably related to idea that different people are responsible for different functions. Other explanations are related to the matching concept (i.e., why manufacturing costs are charged to the inventory and non- manufacturing costs are charged to expense) and include the following. 1) The benefits associated with many of the non-manufacturing activities are received in the period in which the activities are performed and the costs are incurred, e.g., most distribution, selling, and after sale service. 2) The amount and timing of receipt of the benefits from other non- manufacturing activities are too difficult to estimate, even though future benefits are expected, e.g., advertising and research and development. 4. COST BENEFIT ANALYSIS There is a short discussion on pages 79 and 80 related to the cost-benefit tradeoff for cost information. The idea is to develop the expected value of different alternatives. Determining the expected value of an alternative is calculated by multiplying the expected result by an estimate of the probability of the result. This topic extends well beyond the scope of this textbook, but the
  7. 7. point is that information is not costless. A decision to capture a new type of information, or develop or improve an information system, always involves costs. The question is always whether the expected benefits will exceed the expected costs. 5. COST STRUCTURES TODAY In the section on pages 88 and 89, the authors discuss why the old cost allocation systems that allocate indirect cost based on a production volume related measurement such as direct labor cost now produce inaccurate or distorted product costs. There are a number of reasons for this but in general, capacity related costs now represent a much larger proportion of total manufacturing costs than in the past, and direct labor costs represent a much smaller proportion. There is also a lot more automation and a lot more product diversity than in the past. Many indirect costs, or support costs, do not vary in proportion to production volume. The ABKY example of an electric company shows that meter reading and billing costs do not vary with the volume of electricity produced and sold. When these costs are allocated to the various classes of customers based on the volume of electricity (i.e., the conventional costing shown in Exhibit 3-6), industrial and commercial customers are overcharged and apartments and homes are significantly undercharged. The electric company is actually losing money on Apartment customers as shown in Exhibit 3-5. 6. THE ACTIVITY COST HIERARCHY The cost hierarchy is included in the table above and discussed on pages 90-93 in the text. The implications of separating cost into activity cost pools is illustrated fairly well in Exhibit 3-7. Cost are separated into different cost categories based on whether they are related to units, batches, specific products, specific customers, or facilities. This allows the cost in each category to be traced to cost objects in different ways, instead of combining all indirect cost into a single cost pool and treating them as unit level or unit related costs. The main idea is to avoid the cost distortions mentioned above. This is the activity based cost approach that is illustrated in Chapter 5. 7. RELEVANT COST EXAMPLE
  8. 8. There is a somewhat involved example on pages 93-96 designed to show that the cost of acquiring resources is very different from the cost of using resources. The example involves three products and the decision of whether or not to drop product 3. The illustration shows that all of the costs, except the $2,400 cost of plastic, are capacity related costs and will not change if product 3 is dropped. In the short run, the only relevant cost for this decision are those costs that will be different. ABKY cover relevant costing in more depth in Chapter 6. 8. LIFE CYCLE STAGES Different authors define the stages of the product life cycle in different ways. ABKY define these stages as: Product development & planning Introduction Growth Maturity Decline & abandonment. Some authors indicate that the stages are different depending on the perspective as indicated in the table below. As ABKY point out on page 98, there are many types of product related costs and these costs occur unevenly over a product's life cycle. All costs need to be considered in product related decisions, not just the current costs of production and distribution. Also, products need to be evaluated differently at different stages of their life cycle. Mature products support products in the design and development stages. A company's strategy changes from growth and market share in the early stages to profits and cash flow in the later stages of the life cycle. The PLC concept is closely related to the value chain concept and recognizes that everyone along the value chain is important including society as a whole. For more specifics on the product life cycle concept click on the link below the table. Perspective Product Life Cycle Stages Marketing or Sales Startup Growth Maturity Decline Abandon Perspective Production Perspective Conception Design Development Production Logis tical Support Customer or Consumption Operations Support Disposal Perspective Project Management is the acquired knowledge and skills applied using a formal set of tools and techniques to initiate, plan, execute, monitor, control and close projects.
  9. 9. In today's economy, all business lines have incorporated Project Management as an integral part of their operational practices. Project Management has helped businesses to accompalish their pre-defined objectives within the defined time limits. Project Management has facilitated all business sectors to make profitable decisions as well as operationalize strategies to bring their projects to completion. Project Management has brought profitability to various Business Lines in numerous ways. Few of the important ones have been summarized below. Project Management has provided:  A clear project framework for achieving project specific goals and business goals.  An emphasis on phased development i.e. regular and measurable progress.  A systematic approach to resolving high-risk factors associated with an objective.  A focus on team thus inculcating the concept of teamwork and skill specialization – delegating tasks to team members selected for their skills that correspond to the requirements of the project, leading to specialized input into the development process.  A built-in mechanism for assessing the feasibility of a proposed project – assessing requirements and matching available resources to those requirements.  A process for involving all concerned parties into project execution, ensuring that the end product perfectly matches the requirements and thus avoiding last minute glitches.  A measure for incorporating Quality Assurance within the project life cycle thus producing Quality Outputs. The above list is by no means exhaustive, but it gives very accurate picture of what value add Effective Project Management can do to the business and its projects. To get a better understanding on what Project Management is, lets us now have a look on the various Project Management Objectives. Project Management Objectives  Coordinate the various interrelated processes of the project.  Ensure project includes all the work required, and only the work required, to complete the project successfully.  Ensure that the project is completed on time and within budget.  Ensure that the project will satisfy the needs for which it was undertaken.  Ensure the most effective use of the people involved with the project.  Promote effective communication between the projects team members and key stakeholders.  Ensure that project risks are identified, analyzed, and responded.
  10. 10. In practice, Project Management follows a Phased Approach for Project Excution and have a standard defined Project Life Cycle. Teamwork and Quality Assurance are few important inherent characteristics of successful Project Management. Cost Management Cost management is one of the fundamental and yet most challenging tasks for a project manager. 7 Things You Need to Know About Development Project Estimations Whether you are a project manager planning for a smooth implementation of a plan or a project sponsor on whose decisions a project depends, you cannot escape from the fact that project estimation is essential to its success. In the first place, there are three basic requirements that a project must satisfy: schedule, budget, and quality. The need to work within these essential project boundaries poses a huge challenge to everyone in the central management team. Estimating: Part 3 In this last article of the series, I'll cover a potpourri of other estimating topics including the key outcome of estimating, converting effort estimates into budgets, dealing with poorly defined work, and what to do when management thinks it should cost less or take less time. Estimating: Part 2 This is the second of three articles on estimating. It may seem obvious, but the first requirement for developing an estimate is to know what you are estimating. For now, let's assume that you have been asked to estimate how much effort (how much of your time) is likely to be required to paint your bedroom. Although this is a fairly small activity, it is still one with a significant amount of uncertainty. Effort Estimating: A Primer Estimating is a forbidding topic for some. I've even heard intelligent, experienced project managers assert that it is "impossible" to estimate the work on their project. I think that these people just don't understand estimating. I think that these people may be confusing estimating (making informed assessments of uncertain events) with extra sensory
  11. 11. perception (making exact predictions of uncertain events). Or in some cases, they may be trying to prepare budgets or prices in the absence of estimates. 5 Ways to Finesse Budget Discussions for New Client Projects Do you have difficulty engaging in budget discussions for new projects, particularly during initial client meetings when it can be tempting to make promises that will be challenging to carry out? If so, you're not alone! This article explores five ways to help you gracefully avoid backing yourself into a corner. Make or Break: Why Accurate Cost Estimation Is Key The accuracy of your cost estimation process can make or break project success. Learn the strategies that will help you gain control of this key area and ensure future project profitability! One of the greatest challenges for a project leader is to successfully deliver on all aspects of a project both according to the client's specifications and within the allotted budget. 3 Main Benefits of Project Baselining When you have finished planning your project, and you have all the scheduled dates, hours, and costs (and charges if applicable) agreed, why is it a good idea to store those values? We explore the reasons. Project Cost Management How do we know what a project will cost? We really don't, until the project is complete. I sound more like a car mechanic than a project manager, but the truth is, and this may sting just a little, we can't know the final project cost until the project is complete because we can't accurately predict the future. What we can do is create an estimate. 12 Tips for Accurate Project Estimating Projects typically involve many dynamic aspects, yet they're often constrained by finite conditions. These contradictory forces make it very difficult to determine with pinpoint accuracy the time and effort required. By using a set of proactive estimating techniques to scope, plan, and constrain your project conditions, you can dramatically improve your estimating practices, reduce and mitigate risks, and increase your project success rate. Estimating Project Costs
  12. 12. Estimating is the process of forecasting a future result in terms of cost, based upon information available at the time. Many techniques, books and software packages exist to help with estimating project costs. A few basic rules will also help ensure that an accurate and realistic estimate is produced. Monte Carlo Simulation in MS Excel The Monte Carlo method is based on the generation of multiple trials to determine the expected value of a random variable. There are a number of commercial packages that run Monte Carlo simulation; however a basic spreadsheet program (such as Microsoft Excel) can be used to run a simulation. Forecasting Support Costs Did you know that maintenance accounts for 50% to 80% of the overall product cost? Well, it does! And while most project managers are fairly good at sizing new product features, many are terrible at estimating the effort required to support a product once it becomes generally available. As a result, maintenance projects are inadequately staffed, companies can't respond to customer requests in a timely manner, and products never reach payback. Cost Benefit Analysis The cost benefit analysis is based on the comparison of a base case and one or more alternatives. For each case all the cash flows over a period of time are identified and organised into a spreadsheet. The bottom line is the net cash flow after tax. This series of cash flows can be converted to a present value (NPV) by using an appropriate discount rate.