ACCTF 533, Section 1: Module 1: Costs and Cost Allocation: Lecture 2: Cost Drivers and Cost Allocation Cost Drivers and Cost Allocation Cost Drivers and Cost Allocation: Now that we have a basic understanding of cost concepts and terminology, we can move to cost management. Managing costs is typically done by focusing on management of the activities being performed, rather than on the products or services directly. Cost Management To forecast and manage costs Key business activities performed Resources consumed in performing these activities Costs of the resources used Cost drivers In order to forecast and manage costs, the following need to be identified: What key business activities is the entity performing? What resources are consumed in performing these activities? What are the costs of the resources used? And what are the cost drivers? Value Chain Analysis Michael Porter, 1985, The Competitive Advantage To create product or provide service o Set of activities (business functions) o Value adding/non-value adding Identify and focus on value-added activities Competitive advantage 1
To identify key business activities performed, the organization will ideally have conducted a value chain analysis. The value chain concept was originated by Michael Porter in his book The Competitive Advantage in 1985. The basic idea is that the organization conducts a series of activities (or a set of business functions) in creating a product or providing a service. Not all activities or functions, however, add value. The organization will perform best if it is able to identify and focus on improving the value-added activities. This will enable the organization to maintain a competitive advantage in the marketplace. Resource Costs and Cost Drivers National Pizza Chain Value Chain Function Resource Cost Possible Cost Drivers Research & development Salaries of food scientists # of new product ideas Design Ingredient costs Complexity of new products Production Wages for hourly employees Labor hours Marketing Advertising costs # of ads, size of ads (inches, minutes) Distribution Delivery costs, e.g. fuel # of deliveries, distance Customer service Salaries of customer service personnel # of requests, # of complaints Once the key business activities are identified, then the resources consumed in performing each activity can be identified. The next steps are to identify the costs of the resources and the cost drivers for those costs. Here are some examples of resource costs and possible cost drivers for common value chain functions for a national pizza restaurant chain: For the value chain function of research and development we have as a possible resource cost salaries of food scientists. The cost driver: number of new product ideas. For design, we have a resource cost of ingredients, and the possible cost driver: complexity of new products. For the value chain function of production, how about wages for hourly employees, and the cost driver here would be labor hours. In marketing, as a resource cost we have advertising, and possible cost drivers for advertising: number of ads or size of ads in perhaps inches or minutes. 2
For distribution, we have delivery costs, for example, fuel costs, and possible cost drivers are the number of deliveries or the distance. The final area, customer service, we have salaries of customer service personnel, and the cost drivers: number of requests or number of complaints. The Problems with Cost Drivers More than one cost driver Not always visible Not always counted [Pictures Shown] Figuring out the resources consumed and the cost of those resources generally doesn t cause a problem. What does cause a problem is identifying the cost driver. Remember that a cost driver is a factor that causes activity costs to change. An activity can have more than one cost driver. For example, think about a dressmaking shop and the activity of making a dress and the resource cost of the labor required. The labor costs are driven by: the type of fabric, how much of the dress is machine sewn, the complexity of the design, and the amount of detail to be added, for example, beading or embroidery. You have to be able to determine what is driving the activity or process. It is often something visible only when you review the process step by step, for example, by looking at a flowchart or a process map. As another example think about the Purchasing function. If you looked only at the general ledger summary of costs for the Purchasing division, you would see payroll, rent, utilities, office supplies all of the normal operating expenses for an administrative division. What you won t see is purchase orders. Yet purchase orders drive the Purchasing function. Cost Allocation [Picture of a Printer] Cost driver = Direct labor $ Overhead Costs Amount Indirect materials $25,000 Indirect labor $10,000 Manufacturing equipment depreciation $175,000 3
Factor costs, e.g. rent, utilities $95,000 Total cost $305,000 Expected DL$ $12,200 Total cost $305,000 / Expected DL$ 12,200 $25 per DL$ Why do we care about cost drivers? Because they are used to allocate resource costs. Let s look at an example. Suppose that Hewlett Packard has a factory in which it manufactures 10 different types of printers. The cost of each printer consists of direct materials, direct labor, and manufacturing overhead. HP has decided to lump all overhead costs together in a single pool and to allocate the overhead costs to each product based on direct labor dollars. First, let s look at the cost allocation. All of the overhead costs are added up. We have $25,000 in indirect materials, $10,000 in indirect labor, $175,000 in depreciation on manufacturing equipment, and factory costs like rent and utilities of $95,000. The grand total is $305,000. We divide that by the expected Direct Labor Cost of $12,200 because we have decided to use Direct Labor dollars as our cost driver. Our overhead rate is $25 per Direct Labor $. Cost Drivers Allocate Costs Printer 101 Cost Amount Direct materials $13.90 Direct labor 1.10 Overhead ($35 per DL$) 27.50 Total cost $42.50 As a result, Printer 101 has the following costs: Direct materials $13.90, Direct labor $1.10, Overhead (which, again, is being allocated based on Direct Labor dollars): the overhead cost is $27.50. So the total cost of printer 101 is $42.50. Based on these numbers, HP must price the printer above $42.50 if it wants to sell the printer at a profit. Notice, however, the very small amount of cost for direct labor. Because of heavy automation of the manufacturing process, direct labor has become a smaller and smaller portion of product cost for HP. In fact, HP reported that direct labor had dropped to only 3% of the total manufacturing 4
costs. And the bulk of the cost was now appearing in overhead as that is where the cost of the manufacturing equipment is included. Does it make sense to continue using direct labor dollars as the cost driver? Implications of Cost Choices In past, common drivers volume, time Today, closer look at cost drivers and cost allocation methods Each choice has different implications Each choice will change behavior In the past, the most common drivers were volume or time, for example, number of pieces produced or labor hours worked. These were used because of ease of application and ready availability of the information that was needed. Today, however, organizations actively working to manage and control costs have found themselves taking a closer look at cost drivers and cost allocation methods. There are many more choices for cost drivers AND each choice has different implications cost distribution is different, different measurement problems arise. Even more critical, the choice of a cost allocation method and cost driver will change behavior and the behavioral changes may not be exactly what were expected. 5