Chapter 3
Cost Management Concepts and Cost Behavior
Study Guide by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
ABKY Main Page
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
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.
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 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.
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.
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.
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 Perspective | Startup - Growth - Maturity - Decline - Abandon |
Production Perspective | Conception - Design - Development - Production - Logistical Support |
Customer or Consumption Perspective | Operations - Support - Disposal |
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Questions
1. What are some different uses of cost information? See item 5 in Chapter 1 Summary.
2. Why do different types of cost information need to be reported to support different managerial purposes and decisions? See item 6 in Chapter 1 Summary.
3. What is a cost object? See Terminology above.
4. How is it possible to distinguish direct costs from indirect cost? See Terminology above.
5. Explain the difference between flexible costs and capacity-related costs. See Terminology above.
6. Are flexible costs always direct? See Flexible resources and costs above.
7. Are capacity related costs always indirect costs? See Terminology above.
8. How are costs in a manufacturing firm classified for external reporting? See Terminology above.
9. Describe the difference between costs and expenses. See Expired and unexpired costs above.
10. What are the two principle categories into which manufacturing costs are classified? See Manufacturing costs above.
11. What are six categories of costs, classified by function, that are included in non-manufacturing costs for external reporting? See Non-manufacturing costs above.
12. Why do traditional cost accounting systems tend to analyze manufacturing costs in greater detail than they do other functional categories of costs? See the Matching concept above.
13. What are two broad purposes for which costs are used inside an organization?
14. Explain why you agree or disagree with the following statement: "An organization should have the most accurate and complete cost system possible." See Item 4 above.
15. What is an opportunity costs? See Terminology above.
16. What is the distinction between short run costs and long run costs? See Terminology above.
17. How has the composition of manufacturing costs changed in recent years? How has this change affected the design of cost accounting systems? See Item 5 above.
18. What are five categories of production activities? Explain the differences among them. See Item 6 above.
19. Why have customer-related costs attracted increasing attention in recent years?
20. What are the five stages in a typical product's life cycle? What is the cost focus in each stage? See Item 8 above.