©The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin

Chapter 5

Cost: The Price of Value Creation

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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

Tieiness

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

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 non-financial 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

Reduce

d Costs

Higher NetIncome

GreaterProfitability

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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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• 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)

Costs and the Value Chain

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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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• 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

Assigning Operations Costs

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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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• 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

Assigning Operations Costs

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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 + bnWhere 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

Insert Exhibit 5.7

Three alternatives:

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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