Chapter 5

Cost: The Price of Value Creation

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc. 2008

Learning Objectives
Describe the relationship between cost and value. Understand how costs affect the three profitability measures. Describe why costs are important in operations. State the dangers of using average costs. Explain why it is important to be able to assign operations costs. Explain the concepts of tracing and allocating costs. Define the components of product cost. Describe how cost reduction relates to productivity improvement. Explain the concepts of standards and variances. Compute usage, price, and total variances. Understand the difference between total cost and cost per unit. Conduct a breakeven analysis.
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Cost versus Price

Cost Cost A scarce resource given up in order to obtain a current or future benefit.

Tieiness Price Amount of money a seller agrees to accept in return for something, like a product or service.

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Paying for Value

Cost includes all resource outlays over the life of the product or service
The cost is not necessarily monetary Increasing cost detracts from value Cost includes all resource outlays over the life of the product or service. While most value attributes enhance value, cost is almost always viewed as an overriding negative factor.

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Price vs. Total Cost: Customer Perspective Non-Price dimensions of Cost

Shipping/Distribution Repairs and maintenance Related expenditures (insurance, supplies, etc.)

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Price vs. Total Cost: Customer Perspective

Non-financial costs
Quality, flexibility, response time

Non-financial costs are difficult to include in decision-making

They are difficult to quantify In tradeoffs, quantifiable measures often win

Firms struggle to incorporate non-monetary costs (and benefits) into decision-making

Ignoring them implicitly says they are zero The balanced scorecard (coming later) is an approach to include nonfinancial issues.

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Profitability and Cost

Net income is in the numerator of Profit Margin, Return on Assets, and Return on Equity Net Income = Net Sales - Cost of Goods Sold
Selling and Administrative Costs Depreciation- Interest Paid Taxes

Reduced Costs

Higher Net Income

Greater Profitability
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Types of Costs
Expected costs: Forecasted payments for future benefits. Actual costs: Past payments for currently owned resources. Out-of-pocket costs: Cash payments made for resources. Product costs: Costs of resources used to make products. Period costs: Costs of resources used in nonproduction elements of a business. Total costs: Costs of all resources obtained in a particular period.
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Average Costs
Can be Great for comparing current costs to historic. Can be Great for making comparisons with competitors. Can be Dangerous because there is no average product or average customer. Can be Dangerous because they can lead to ignoring important details.
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Costs and the Value Chain

The Value Chain is a model of the way processes are linked together.
It identifies all of the parts of the supply chain that add value. All value is added through processes, but all costs are not.

What is missing?
Administrative support functions like accounting, legal services, computer services, personnel functions, etc.

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Costs and the Value Chain

All activities directly and indirectly generate costs.
An activity must generate more value than cost, or it should be eliminated

Most businesses have a pretty good understanding of total costs (i.e., they know how much they spent last year)

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Assigning Operations Costs

Direct (value chain) and indirect cost generators need to be assigned and analyzed Resource Cost: What the business spent on a particular resource

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Assigning Operations Costs

Cost object: an item for which costs are measured or assigned.

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Assigning Operations Costs

Direct Tracing: Costs (e.g., direct labor & materials) are physically associated with a cost object For example: direct labor or direct materials Or the link may be made by observation

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Assigning Operations Costs

Direct Tracing example:
A product requires eight hours of labor to assemble It uses $1,000 in materials Labor costs are $100 per hour
Product Cost = $1,000 + (8 * $100) = $1,800 for direct labor and material

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Assigning Operations Costs

Driver Tracing A resource (cost) driver is used to provide the link between the cost and the cost object
Resource drivers measure demands placed on resources by activities and are used to assign costs of resources to activities

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Assigning Operations Costs

Activity drivers: Measure demands that cost objects place on activities
Activity Drivers are used to assign the costs of associated activities to cost objects

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Assigning Operations Costs

Driver Tracing example:
A company spends $50,000/month on Human Resources 80% of HR time is spent hiring and training direct labor personnel The plant consumes a total of 1600 direct labor hours/month (10 people * 40 hours/week * 4 weeks) Use Direct Labor hours as Activity Driver = $25 per hour ($40,000/1600 direct labor hours) Recall: 8 hours of direct labor per product = 8 * $25 = $200 in HR cost Product Cost = $1,800 for direct labor and material $200 for HR costs $2,000 total cost
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Components of Product Cost

Production costs: associated with actual production. Nonproduction costs: associated with selling and administration. Direct materials: materials that can be traced directly to the good or service being produced. Direct labor: labor that can be traced directly to the good or service being produced. Overhead: all other nondirect costs.
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Putting Cost Information to Work for Operations: Standards and Variances

Standards
Are what should happen in terms of . . .
Quantity (output or usage per unit of time) Price (price per unit)

Actuals
What actually got used in production
May be more or less than standard

Variance Analysis
The comparison of standards to actuals in order to assess operating performance
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Putting Cost Information to Work for Operations: Standards and Variances

Example:
Company produced units at a total cost of $23.14 per batch Their standards tell them it should only have cost them $18.00 per batch What went wrong?
Did they pay too much for material?? Or use too much material??
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Variance Analysis Materials Example 1

Required information:
Standard usage rate (standard quantity): how much do you expect to use of the resource?
Example: 15 ounces per 50-gallon batch

Standard price: How much do you expect to pay for the resource?
Example: $1.20 per ounce

Actual usage rate (actual quantity): how much did you actually use of the resource?
Example: 16.3 ounces per 50-gallon batch

Actual price: how much did you actually pay for the resource?
Example: $1.42 per ounce
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Variance Analysis Materials Example 1

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Variance Analysis Materials Example 2

Same Standards
Standard Quantity - 15 ounces per 50-gallon batch Standard Price - $1.20 per ounce

New Actual Usage Assumptions

Actual Quantity 12 ounces per 50-gallon batch Actual Price - $1.50 per ounce

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Variance Analysis Materials Example 2

What is the Total Variance?
(Actual Quant * Actual Price) (Standard Quant * Standard Price) (12 * $1.50) (15 * $1.20) = $18.00 - $18.00 $0.00

What is the Price Variance?

(Actual Quant * Actual Price) (Actual Quant * Standard Price) (12 * $1.50) (12 * $1.20) = $18.00 - $14.40 Overage of $3.60 per 50-gallon batch on price

What is the Usage Variance?

(Actual Quant * Standard Price) (Standard Quant. * Standard Price) (12 * $1.20) (15 * $1.20) = $14.40 - $18.00 Underage of $3.60 per 50-gallon batch on materials
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Variance Analysis Materials Example 3

Same Standards
Standard Quantity - 15 ounces per 50-gallon batch Standard Price - $1.20 per ounce

New Actual Usage Assumptions

Actual Quantity 12 ounces per 50-gallon batch Actual Price - $1.40 per ounce

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Variance Analysis Materials Example 3

What is the Total Variance?
(Actual Quant * Actual Price) (Standard Quant * Standard Price) (12 * $1.40) (15 * $1.20) = $16.80 - $18.00 Underage of $1.20 per 50-gallon batch

What is the Price Variance?

(Actual Quant * Actual Price) (Actual Quant * Standard Price) (12 * $1.40) (12 * $1.20) = $16.80 - $14.40 Overage of $2.40 per 50-gallon batch on price

What is the Usage Variance?

(Actual Quant * Standard Price) (Standard Quant. * Standard Price) (12 * $1.20) (15 * $1.20) = $14.40 - $18.00 Underage of $3.60 per 50-gallon batch on materials
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Variance Analysis
Helps in determining where things did not go according to plan. Can be used for many kinds of resources, including
Materials Labor Overhead

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Variance Analysis
When and how to update standards can be a big decision
Line managers may not want to update quantity standards if they are getting better (sandbagging)

Detecting the variance is the first step, understanding them can be much more complicated
Are negative price variations due to poor practices or just generally rising prices?

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Breakeven Analysis
Breakeven analysis is an analytical process that compares the fixed and variable costs of alternatives in order to identify the best alternative for a given volume of output.
Fixed costs are costs that are not affected by volume. Variable costs are costs that increase or decrease as units produced increase or decrease.

The total cost curves are assumed to be linear and can be created by using the basic formula for a line: y = a + bn Where y is the total cost for producing n units, a is the fixed cost, and b is the variable cost per unit.
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Breakeven Analysis Example

Three alternatives:

Insert Exhibit 5.7

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Breakeven Analysis

Insert Exhibit 5.8

WEEZL is the low-cost alternative for volumes below 230,508.

Market Probe is the low-cost alternative for volumes between 230,508 and 387,097

Prophecy is the low-cost alternative for volumes greater than 387,097

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Nonfinancial Costs
Some resources are difficult to quantify. Examples: quality, flexibility, response time, etc. In tradeoffs, quantifiable measures often win. Balanced scorecard is an approach to include nonfinancial issues.

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The Balanced Scorecard

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