11.3. Becoming More Familiar with Costs

The following sections explain important cost distinctions that managers should understand in making decisions and exercising control. Also, these cost distinctions help managers better appreciate the cost figures that accountants attach to products that are manufactured or purchased by the business.

Retailers (such as Wal-Mart or Costco) purchase products in a condition ready for sale to their customers — although the products have to be removed from shipping containers, and a retailer does a little work making the products presentable for sale and putting the products on display. Manufacturers don't have it so easy; their product costs have to be "manufactured" in the sense that the accountants have to accumulate various production costs and compute the cost per unit for every product manufactured. I focus on the special cost concerns of manufacturers in the upcoming section "Assembling the Product Cost of Manufacturers."

11.3.1. Direct versus indirect costs

You might say that the starting point for any sort of cost analysis, and particularly for accounting for the product costs of manufacturers, is to clearly distinguish between direct and indirect costs. Direct costs are easy to match with a process or product, whereas indirect costs are more distant and have to be allocated to a process or product. Here are more details:

• Direct costs: Can be clearly attributed to one product or product line, or one source of sales revenue, or one organizational unit of the business, or one specific operation in a process. An example of a direct cost in the book publishing industry is the cost of the paper that a book is printed on; this cost can be squarely attached to one particular phase of the book production process.

• Indirect costs: Are far removed from and cannot be naturally attached to specific products, organizational units, or activities. A book publisher's phone bill is a cost of doing business but can't be tied down to just one step in the book editorial and production process. The salary of the purchasing officer who selects the paper for all the books is another example of a cost that is indirect to the production of particular books.

  Each business must determine a method of allocating indirect costs to different products, sources of sales revenue, organizational units, and so on. Most allocation methods are far from perfect and, in the final analysis, end up being arbitrary to one degree or another. Business managers should always keep an eye on the allocation methods used for indirect costs and take the cost figures produced by these methods with a grain of salt. If I were called in as an expert witness in a court trial involving costs, the first thing I'd do is critically analyze the allocation methods used by the business for its indirect costs. If I were on the side of the defendant, I'd do my best to defend the allocation methods. If I were on the side of the plaintiff, I'd do my best to discredit the allocation methods — there are always grounds for criticism.

  
  

The cost of filling the gas tank as I drive from Denver to San Diego and back to consult with my coauthor and son, Tage, about the book we wrote together, Small Business Financial Management Kit For Dummies (Wiley), is a direct cost of making the trip. The annual auto license plate fee that I pay to the state of Colorado is an indirect cost of the trip, although it is a direct cost of having the car available during the year.

11.3.2. Fixed versus variable costs

If your business sells 100 more units of a certain item, some of your costs increase accordingly, but others don't budge one bit. This distinction between variable and fixed costs is crucial:

• Variable costs: Increase and decrease in proportion to changes in sales or production level. Variable costs generally remain the same per unit of product, or per unit of activity. Additional units manufactured or sold cause variable costs to increase in concert. Fewer units manufactured or sold result in variable costs going down in concert.

• Fixed costs: Remain the same over a relatively broad range of sales volume or production output. Fixed costs are like a dead weight on the business. Its total fixed costs for the period are a hurdle it must overcome by selling enough units at high enough margins per unit in order to avoid a loss and move into the profit zone. (Chapter 9 explains the break-even point, which is the level of sales needed to cover fixed costs for the period.)

Note: The distinction between variable and fixed costs is essential for understanding and analyzing profit behavior, which I explain in Chapter 9.

11.3.3. Relevant versus irrelevant costs

Not every cost is important to every decision a manager needs to make. Hence the distinction between relevant and irrelevant costs:

• Relevant costs: Costs that should be considered and included in your analysis when deciding on a future course of action. Relevant costs are future costs — costs that you would incur, or bring upon yourself, depending on which course of action you take. For example, say that you want to increase the number of books that your business produces next year in order to increase your sales revenue, but the cost of paper has just shot up. Should you take the cost of paper into consideration? Absolutely — that cost will affect your bottom-line profit and may negate any increase in sales volume that you experience (unless you increase the sales price). The cost of paper is a relevant cost.

• Irrelevant (or sunk) costs: Costs that should be disregarded when deciding on a future course of action; if brought into the analysis, these costs could cause you to make the wrong decision. An irrelevant cost is a vestige of the past — that money is gone. For this reason, irrelevant costs are also called sunk costs. For example, suppose that your supervisor tells you to expect a slew of new hires next week. All your staff members use computers now, but you have a bunch of typewriters gathering dust in the supply room. Should you consider the cost paid for those typewriters in your decision to buy computers for all the new hires? Absolutely not — that cost should have been written off and is no match for the cost you'd pay in productivity (and morale) for new employees who are forced to use typewriters.

Generally speaking, fixed costs are irrelevant when deciding on a future course of action, assuming that they're truly fixed and can't be increased or decreased over the short term. Most variable costs are relevant because they depend on which alternative is selected.

Although fixed costs themselves are usually irrelevant in decision making, these costs often indicate something about a business's capacity — how much building space it has, how many machine-hours are available for use, how many hours of labor can be worked, and so on. Managers have to figure out the best way to utilize these capacities. For example, suppose your retail business pays an annual building rent of $200,000, which is a fixed cost (unless the rental contract with the landlord has a rent escalation clause based on sales revenue). The rent, which gives the business the legal right to occupy the building, provides 15,000 square feet of retail and storage space. You should figure out which sales mix of products will generate the highest total margin — equal to total sales revenue less total variable costs of making the sales, including the costs of the goods sold and all variable costs driven by sales revenue and sales volume.

11.3.4. Actual, budgeted, and standard costs

The actual costs a business incurs may differ (though we hope not significantly) from its budgeted and standard costs:

• Actual costs: Historical costs, based on actual transactions and operations for the period just ended, or going back to earlier periods. Financial statement accounting is mainly (though not entirely) based on a business's actual transactions and operations; the basic approach to determining annual profit is to record the financial effects of actual transactions and allocate historical costs to the periods benefited by the costs.

• Budgeted costs: Future costs, for transactions and operations expected to take place over the coming period, based on forecasts and established goals. Fixed costs are budgeted differently than variable costs. For example, if sales volume is forecast to increase by 10 percent, variable costs will definitely increase accordingly, but fixed costs may or may not need to be increased to accommodate the volume increase. In Chapter 10, I explain the budgeting process and budgeted financial statements.

• Standard costs: Costs, primarily in the area of manufacturing, that are carefully engineered based on detailed analysis of operations and forecast costs for each component or step in an operation. Developing standard costs for variable production costs is relatively straightforward because most are direct costs. In contrast, most fixed costs are indirect, and standard costs for fixed costs are necessarily based on more arbitrary methods (see "Direct versus indirect costs," earlier in this chapter). Note: Some variable costs are indirect and have to be allocated to specific products in order to come up with a full (total) standard cost of the product.

11.3.5. Product versus period costs

Some costs are linked to particular products, and others are not:

• Product costs: Manufacturing costs attached directly or allocated to particular products. The cost is recorded in the inventory asset account and stays in that asset account until the product is sold, at which time the cost goes into the cost of goods sold expense account. (See Chapters 4 and 5 for more about these accounts; also, see Chapter 7 for alternative methods for selecting which product costs are first charged to the cost of goods sold expense.)

  For example, the cost of a new Ford Focus sitting on a car dealer's showroom floor is a product cost. The dealer keeps the cost in the inventory asset account until you buy the car, at which point the dealer charges the cost to the cost of goods sold expense.

  
  

• Period costs: Costs that are not attached to particular products. These costs do not spend time in the "waiting room" of inventory. Period costs are recorded as expenses immediately; unlike product costs, period costs don't pass through the inventory account first. Advertising costs, for example, are accounted for as period costs and recorded immediately in an expense account. Also, research and development costs are treated as period costs (with some exceptions).

Separating product costs and period costs is particularly important for manufacturing businesses, as you find out in the following section.