Chapter 11 - Costing - Basic Concepts


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Introduction

In this chapter we look at some of the basics of costing, particularly:

The main message is that costing, for all its apparent precision in its use of hard numbers, incorporates many assumptions and conventions. Any report or estimate of costs can be manipulated to advance or to disadvantage particular arguments.

When we look at supply and costing in Chapter 14 we bring in the issue of price, and see how supply responds to externally determined price. This is not the same as pricing, which is an activity undertaken by entities which have some control on the price they set (covered in Chapters 14 and 15). For an entity with no control on price, a price-taker, supply depends on the interaction of cost and price.

 

Why We Need to Know Costs

A key question in managerial decision-making is often: "How much does X cost?". We may want to know, for example:

What is the least-cost means of achieving a given outcome; should we do a task 'in house' or should we contract it out? Should we run our own fleet of office cars, or should we rent them from a private firm who will attend to their replacement, maintenance and repair? This is an exercise in cost-effectiveness analysis, covered in Chapters 8 to 10.

Whether the resources we are putting into a task are commensurate with the value of outcome from the task. Often the purpose of costing is to raise cost awareness in the organization. What does it cost to put in four hours' research and writing to answer a letter?

What to charge for use of resources when we are operating on cost recovery: how much should we charge for research done for another organization? How much should we charge for giving advice to clients? (We should bear in mind, however, that pricing and costing are quite separate activities. There are commercial and public policy reasons for setting prices above or below cost.)

What is the lowest-cost scale of operation before scale diseconomies start to outweigh scale economies? What is the best size for our schools and hospitals? Should we have many small hospitals or a few large ones?

Whether our activities are profitable; what are the most profitable activities to continue and expand; what are the loss activities to discontinue?

This last-mentioned type of decision is central to production decisions in multi-product firms, and tends to dominate costing texts. In the public sector, however, the manager usually has little discretion on whether to expand or discontinue a product or service.

With the exception of this last issue, the public sector generally faces the same costing issues as the private sector. In addition the public sector faces some costing issues of its own. The main ones are:

budgetary allocations to fund public services; how much should we allocate to each public hospital? Should we reimburse hospitals for actual costs they incur (historical cost), or should we fund them on a standard cost basis - that is, some estimate on what their costs should be if they use sound practice? If on a standard cost basis, will we fund them on their catchment population, the number of patients, the number of occupied-bed-days, the number of patients with specific conditions? What are the incentives in the different systems?

budgetary allocations (or relief from dividend requirements) to government business enterprises to compensate them for the cost of meeting community service obligations (CSOs) - mandated services which a commercially-oriented operator would not provide. Telstra, for example, provides phone lines at a standard price, regardless of location, services for people with disabilities, public phones and other services which would not be commercially viable but the provision of which are mandated by the government. State governments provide substantial CSOs in transport. In 1999-00 the NSW Government outlaid $177 million for CSOs for the State Transit Authority, the operator of metropolitan buses and ferries. Those CSOs amounted to 40 percent of the Authority's revenue. What is a fair method of costing these CSOs?

justice and efficiency in price-controlled markets. The Commonwealth sets many prices in health care, including medical practitioner fees, prices for pharmaceuticals and services of pharmacists. The NSW Government has a Government Pricing Tribunal which has a charter to determine maximum prices for services provided by government monopolies. In determining prices the Tribunal may use as reference "the cost of providing the service concerned". Included in such cost the Tribunal may consider "an appropriate rate of return on public sector assets" - normal profit in economists' terms.

cost-based interventions markets for private goods. In the fifties and sixties industries would be granted tariff protection on the basis of what it cost them to make and sell their products. What was the cost on which the tariff should be set? What did it cost to make a Chesty Bonds T Shirt or an AWA radio?

CSO BoxNone of these questions, in management or in policy, has an unambiguous answer. Costing is imprecise, and the answer we get to any costing question will depend on the assumptions we use. Usually the first question we should ask is: "Why do we want to know?", for cost models relevant to one purpose will not necessarily be relevant to another.

 

Key Concepts in Costing

These are the key concepts of costing:

Opportunity cost - defined as the value of this resource in its next most productive use. This is a central concept in costing, and, while having a solid theoretical basis, can give rise to some tremendous difficulties in measurement. Consideration of some opportunity cost issues will help to clarify the concept and to illustrate some of the issues in opportunity costing:

Coal - In the Hunter Valley New South Wales has high quality black coal which could be sold to commercial customers. Victorian brown coal from the Yallourn Valley has a good calorific content, but is not able to be transported because it is subject to spontaneous ignition; the power stations in he Yallourn Valley are adjacent to the coalfields. To electricity producers Hunter Valley coal therefore has a much higher opportunity cost therefore than Victorian coal.

A thousand cases of Chardonnay, bought for $240 a case, before fashion turned towards Riesling and Sauvignon Blanc.

A former army stores depot, no longer needed?

Your own time during a normal busy working day, or your own time while you are waiting at an airport for a delayed flight?

$20 000 in banknotes Aunt Clarabelle has in a sock under her bed?

A highly trained fighter pilot, with no other special skills?

5000 surplus nuclear warheads?

 

Perspective of the decision maker - the cost you see depends on where you stand.

Government finance departments often have an obsession with costs which pass though the budget, but little concern for other costs, a point picked up in Chapters 8 and 9 when we looked at the difference between economic and financial evaluation. If the Commonwealth Government were to propose spending more money in the health care budget, through buying hospital services from the private sector, the Department of Finance would be likely to take a narrow budgetary view, and point out the effects on budgetary outlays. Other government departments are likely to take a broader view, and look at the effect on aggregate health care costs, public and private sector. How much does this save people in terms of insurance premiums? What efficiency gains can we expect?

One argument for financial devolution is that brings home to the local manager costs which he or she might otherwise overlook. In most organizations payments for superannuation and workers' compensation insurance are made centrally. They are then onwards debited to particular cost centers.

Also under 'perspective' is the issue of external costs.

 

External costs – costs which are real, but which do not enter the decision maker’s accounts.

The most common cases of external costs or externalities relate to pollution. The cost of the open fire in my living room is more than what I pay for building my fireplace and buying wood; there is also the cost, to the community, of the added pollution. It may be very economical for a city on the Murray river to discharge its effluent into the river, but it is a cost borne by Adelaide residents.

These are examples of negative externalities. There are also positive externalities, which relate to benefits which do not enter the decision maker’s accounts but confer benefits on others. A new university will probably enhance local property values. Our decision to have a guard patrol our office after hours will have security benefits for other tenants in our building. There are external benefits in connection to many utilities; my decision to be connected to sewerage and a telephone line carries benefits for other members of society.

 

Transfers - a shift of resources from one party to another, but with no change in those resources.

Again the perspective of the decision-maker is important. A decision to sell Qantas will be seen by economists as involving no change in resources; all that's happened is that there has been a shift around on the right hand side of the balance sheet. The new owners will have incurred a cost, however, in purchasing the company. It will be a cost to them, but not to the economy.

The notion of transfers as defined by economists, should not be confused with the closely related notion of transfer payments, which are financial transactions within an entity. For example one division in a government department may charge another division for use of its staff. On the department's books this payment will cancel itself out, and will not make a call on any financial resources, but it could still represent a call on real resources.

In Canberra many years ago, when the Postmaster General's (Telecom) was a government department, and STD calls were new and expensive, Canberra public servants used to make liberal use of their phones for personal calls. The justification was that the cost simply represented a transfer payment between the department and the PMG, but no real cost to the public purse. This argument was valid at the margin, but the service was so heavily used that the PMG had to invest in a new exchange. Once this capacity limitation was reached it was no longer simply a transfer payment; real resources were involved.


Sunk costs - costs previously incurred.

Conventional economic wisdom says that costs previously incurred are not relevant to the decision to continue incurring costs. The accountants' aphorism is: "let bygones be bygones".

Imagine we are building a sports stadium, which will yield net annual benefits of $1.2 million. The quote is $15.0 million, so the stadium's return will be 8.0 percent - just within our government's cut off criterion of 7.5 percent. After the project is started and $4.0 million is spent, it becomes obvious that the sub-surface geology is very different from what was revealed in initial drilling, and that the site will require an extra $3.0 million on drainage and piling. That means the project will cost a total of $18.0 million, and its return will drop to 6.7 percent. Should we proceed or should we abandon the project?

The answer is obvious; such reasoning has brought us some expensive projects, however. Understatement of a project's cost is a common means of manipulation called wedging, used most effectively by New York's Director of Public Works Moses fifty years ago to build some of that city's extravagant projects.(1) There are many examples of wedged projects in Australia - at Bennelong Point in Sydney and Bruce in Canberra to name two examples.

 

Profit - a concept with different meanings in accounting and economics.

Accountants define profit as the difference between revenue and expense. To economists, however, a normal profit (that is, a return on capital) is a normal cost of running a business. An economist's definition is the difference between revenues received from the sale of goods and the value of inputs, which includes the opportunity cost of capital, so that profits are economic profits.(2) In short, the return which assets would normally make, which would be some mixture of interest, capital gain and dividends, is part of the economic cost of the business. It is an example of opportunity cost - what would these assets make elsewhere?

This concept is built into the NSW Pricing Tribunal Act, which refers to the "agency's economic cost of production". Profits above that level, economists call economic profits. A more colloquial term for economic profit is 'rip off'. For example, if a firm's return on equity was 25 percent in an industry where the norm was 13 percent, 12 percent would be economic profit, with the base 13 percent being economic cost.

 

Cost and Volume Relationships

In general, for any enterprise, costs vary with the level of output. The more we produce the more cost we incur.

There are two ways we can think about costs:

  1. we can look at total costs over a given period. This is the way accountants usually look at costs. It is the way we might do an annual household budget for running a car. It is the way an electricity authority would prepare a cash budget.
  2. we can look at unit costs. This is the way costs are usually presented in economics texts. It is the way we might set a traveling allowance rate for our employees using their own cars. It is the way a price regulator may set a cost-based price for an electricity authority, developed by examining generating costs per KwH.

Both total and unit costs will be dependent on volume, and, because we live in a world in which there are both economists and accountants, and in which there is a need for both types of information, we consider both types of costs here.

 

Total Cost Concepts

Accountants preparing financial returns, managers preparing budgets, and taxation authorities collecting company tax, are concerned with total costs.

The most basic cause of output dependence is because some costs do not vary with output, while some others do. These are known as:

Fixed costs or total fixed costs (TFC) - those costs which do not vary with the volume of output.

Variable costs or total variable costs (TVC) - those costs which do vary with the volume of output.

Total costs (TC) - the sum of TFC and TVC.

Avoidable costs - costs associated with a discrete block of output.

This last concept of avoidable costs requires some explanation. It is an attempt to answer the question "what would we save if we did not produce X", where X is a discrete block of output. What would a university save if it closed a school? What would the State Rail Authority save if it closed the Yass Railway Station?

 

Unit Cost Concepts

An alternative way of looking at costs is to look at costs per unit. Economists and others concerned with efficiency, taxation authorities looking at sales tax, tend to be concerned with unit costs.

The main costs are:

Average fixed cost (AFC) - the fixed cost divided by the level of output.

It represents the way fixed costs are spread over each unit produced, and as production increases fixed cost per unit decreases.

Average variable cost (AVC) - the variable costs divided by the level of output.

This tends to be constant, or close to constant, across various levels of output, possibly rising as diseconomies of scale are reached.

Average total cost (ATC) - the sum of AFC and AVC.

At high levels of output the ATC comes close to the AVC. (Mathematically it is asymptotic to the AVC.)

Marginal cost (MC) - is the additional cost incurred by the production of one additional unit. (In many cases this is the same as AVC.)

Cost volume relationship

These four concepts are similar to their counterparts in the total model, in that they take total costs and divide them by output.

The concept of marginal cost needs some explanation. Once we get away from simple linear models it is no longer the same as average variable cost, for, in many enterprises, variable costs actually change as production levels are changed. Marginal costs often follow a U shape as output increases - initially falling, then rising.

To illustrate this point we could think of a small print shop, with four offset machines, each with a capacity of two million pages a year.

To buy inks, photographic plates and papers in small quantities is expensive. There are scale economies in purchasing. Good discounts cannot be obtained until the print room is turning over at least three million pages a year.

But there are also diseconomies of scale. The most efficient machine is modern with a low operating cost. The next most efficient is a little older. The other two machines are museum pieces, but are kept for very busy periods. In fact, before swinging these into production the printer prefers to use overtime on the newer machines, but that incurs a labor cost penalty.

We can see how a combination of scale economies and scale diseconomies are at work. The cost curves - MC, ATC, AVC are shown on the graph. (In the interest of keeping the diagram uncluttered AFC is not shown.)

Note the relationship between the AVC and MC curves. They start together, for the MC and the AVC of the first unit of output are identical. As the marginal cost falls, so too does the AVC, but at a slower rate; therefore the AVC curve remains above the MC curve. In other words the marginal is pulling down the average. To use a sporting analogy, if the Sri Lanka cricket team started on 12 runs an over, but slowly dropped to 6 runs an over, then their average would be above 6 but less than 12.

As the marginal cost curve turns up, it catches up with the average, and crosses the AVC curve at its lowest point. To continue the cricket analogy, imagine Sri Lanka now lifts its game. So long as the marginal rate (runs in this over) are below the average so far, the average will keep falling. Once, however, the marginal run rate passes the average so far, the average starts rising.

We look at these in more detail in the next chapter, when we work through some practical examples.

 

Costs and Time Frame

The costs described above hold only over a given period of time. Accountants and economists point out that over the very short term all costs are fixed and over the long term all costs are variable. For example, over a very short period (an hour or so) an electricity generating authority cannot vary its costs much, especially when using thermal stations. Over a very long period the authority can decide on different technologies (gas, hydro, nuclear) etc, and will have an optimum technology and scale for each projected level of output. In the medium term, however, the fixed/variable cost breakdown provides us with useful models.

In this regard it is interesting to note that traditionally economists and accountants considered labor, especially factory labor, to be a variable cost. If you didn't produce and sell, you didn't have to pay wages. Labor could be retrenched and re-hired as market conditions demanded. Machinery, on the other hand, was a fixed cost, as were the salaries of managers and others who did not work on the factory floor. A class system, supported by a set of assumptions about the fungibility of labour, tended to become built into accounting systems. We should use judgement in costing, and not fall back on dated convention. Labor, especially skilled labor, may be a fixed cost, while machinery, if we can lease it, may be a variable cost.

Scale Economies

Downward sloping unit cost curves reflect economies of scale, which exist in many industries. They are usually easy to model. For a school, for example, the number of support and administrative staff will rise more slowly than the number of students. If we need one cleaner for a school with 300 students, we will probably not need three for a school of 900, and we will still need only one principal.

Scale economies and diseconomies

Diseconomies of scale are less easily measured in any accounting or economic model. Our example of the print room above shows certain easily-traced diseconomies of scale, but there are many others. As an organization gets bigger the tasks of coordination and communication get more complex. In a large school, supervision of troublesome children becomes more difficult. Fewer parents are likely to contribute voluntary resources to a large, impersonal institution (an example of the free rider problem). Staff may find they're spending more time looking for others, or walking from classroom to classroom. These diseconomies of scale are real and costly, but are often hard to measure.


Unit costs

Many manuals on performance management refer to the concept of unit cost. This is one of the crudest forms of costing - a division of total costs by the number of units produced. It takes on account of fixed and variable components of costs, and often the "units" are far from homogeneous. We would expect a small school in the country to have higher costs per student than a large urban school, because of scale diseconomies. We would not consider it reasonable to use a cost indicator such "$ per arrest" if one police unit was concerned with homicide while another was concerned with marijuana offences. Yet the term "unit cost" has a strong following among the disciples of performance management.

 

Multi Product Costing - Overhead Allocation

Single product establishments are the exception rather than the norm. Most establishments produce more than one product. Big manufacturing firms may produce hundreds of different products; government mega departments are responsible for many different programs. Even a water supply authority may have different 'products' - water delivered in large but irregular quantities to industrial customers, and water produced in regular predictable quantities to domestic customers. The problem in such establishments is that many costs cannot be traced to particular products. It may be too expensive to trace costs (e.g. tracing electricity use to every machine) or it may be conceptually impossible (e.g. tracing fire protection to particular products).

Frequently in private industry management wants to know what each product 'costs'. Is each product pulling its weight? Politicians will want to know the costs of various program elements; what does it cost to process each Medicare payment, for example? Often a set of costs developed for one purpose, say inventory valuation for tax purposes, are used, wrongly, for decision-making purposes. Inventory valuation is an important issue. There is an incentive to value it low, so that profit is reduced and thus tax is reduced; there may be an incentive to value it high so that a high profit may be reported, leading to a high dividend payout and thus a high share price. Multinational firms have an incentive to report their highest costs in countries with the highest taxation rates. For those reasons there are conventions in costing, particularly inventory valuation, but these 'costs' may not be suitable for decision-making purposes.

 

The Origins of Costing

Costing conventions come from manufacturing and are applied, often with little change, to other industries. There are many variants, but they are mostly based on building costs up from the factory floor, a "bottom up" approach. Materials and direct labor (people who actually manipulate the items) are traditionally the main elements of direct cost - that is, costs incurred in the factory which are variable with respect to volume and traceable to particular products. (Some costs, such as electricity and wear on fork lift trucks, may be variable but not practically traceable to particular products.) Therefore direct costs, while being variable, are lower than truly variable costs, because there will be some costs which do vary with volume but which cannot be traced.

The figure below shows the combination of these concepts of traceability and variability. Conventional costing systems use the direct costs as a base and count all other costs as overheads. By implication all overheads are fixed (even though costs in the bottom right corner are really variable). Another term for non-traceable costs is joint costs - that is costs shared between products.

Cost allocation

Overheads are lumped into two classifications, depending on where they occur, in the factory or in administration. To direct costs are added other factory costs, often called manufacturing or factory overheads, to give a factory cost. This is used to value inventory. Out of these costs must come sufficient contribution to cover managerial overheads, which are assumed all to be all fixed.

 

Standard Cost Systems

Often factories implement a standard cost system, standard costs being essentially a normative cost which managers should reach. For example, a hub cap may have a standard direct cost of $5.14, being $3.58 of materials, plus 0.05 hours of labor at a standard rate of $31.20 an hour, coming to $1.56. These would all be measured carefully by work study engineers, using precise measures of standard material use, and standard production time measured with stopwatches or micromotion studies. If the work team works a bit harder, under the incentive of piece work, and produces more hub caps, there is a credit to the factory account; if there is steel wastage there is a debit.

These debits and credits, or variances, are the prime instrument of cost control - in accordance with the philosophy of management by exception. In some factories almost the entire computing capacity of the firm may be devoted to production of variance reports, and weekly meetings, up to half a day, may try to trace the reasons for the variances. There are attempts to shift blame ("We didn't waste steel, purchasing is to blame for buying from a lousy supplier, and we had to waste ten percent of it - debit it to their variance account") or to claim credit, and often there is little attempt to fix the problems, or to track the real causes for the positive variances. And, of course, no-one looks at the time wasted in these managerial squabbles; these are all 'managerial overheads', which are not controlled on a day to day basis.

Factory indirect costs (and sometimes managerial overheads) are assigned to products in a variety of ways. Usually assignment is on the basis of direct cost - all products have an X% loading to absorb overheads, and this loading is called an absorption factor. Sometimes other systems are used - value-added (mainly factory direct labor), volume of a key input, even floor area devoted to inventory).

These "bottom up" systems have an air of precision and objectivity, and they are still widely used. Indeed, the power of modern computing has made for more elaborate standard cost systems. But they are getting increasingly out of touch with reality. First, as labor is replaced with machinery, a lower and lower proportion of costs can be traced as 'labor' costs. Second, as people work more in work teams, the whole Taylorist notion of measuring individuals' standard times is becoming irrelevant; in fact, more and more people in the factory are doing work which was once classified as factory overheads. Third, large cost increases have been in the area of managerial overheads and it is hard for middle managers to appreciate that they are, perhaps, adding little value. Yet many firms are persisting with systems which were developed in different times, when spans of supervision were wide, when there were many workers and few bosses, and when most tangible value-added came from the factory floor. And government departments and business enterprises often take on cost systems, developed in manufacturing, in another era, with little modification.

The implication in "bottom up" costing systems is that overheads are non-controllable; the systems focus attention away from managerial costs. This may not appear rational, but it is a reminder that costing systems are designed in those areas of an enterprise classified as "overheads".

Costing Reform

There are various attempts at costing reform. One which is often claimed as a new development (actually it was used at least twenty-five years ago in Australia) is activity based costing, whereby, rather than relying on standard formulae, the cost analyst tries to find the most accurate cost drivers. This may require activity recording, activity costing, and attempts to link these activities to particular products. Another is to use statistical techniques, to find, empirically, how certain not easily traced costs vary with the level of production of different products, using a technique called multivariate analysis. Japanese firms, for example, tend not to use complex standard cost systems; cost and efficiency awareness is built in more as a corporate culture, and, while they do pay great attention to cost measurement, it is used more for product and process design rather than as a basis for day-to-day control.

The main barrier to costing reform is perhaps that there are many people within organizations who don't really relish the sort of exposure and accountability which costing reform would bring.

 

By-products

Particular mention should be made of by-products. You cannot produce butter without producing skim milk. You cannot supply navigation aids for regular public transport aircraft without producing them for light aircraft (a point to which we'll return when we look at public goods). Sometimes the 'product' and 'by product' switch. When the Snowy Scheme was established hydro electricity was a by-product of the main product which was an assured supply of irrigation water. At times the hydro electricity has been the more valuable product, and, naturally, fruit growers would like to argue that their water is only marginal to electricity production, which should absorb the overheads of the scheme.


Notes

General References

Any good management accounting text will provide standard definitions and concepts.

J Fred Bingham and Eugene F Bingham Managerial Finance (Holt Rinehart and Winston 1962)

Charles Horngren and Gary Sundem Introduction to Management Accounting (Prentice Hall 1990)

H Thomas Kaplan and Robert S Kaplan Relevance Lost - The Rise and Fall of Management Accounting (Harvard Business School Press 1987)

Specific References

1. Robert A Caro The Power Broker - Robert Moses and the Fall of New York (Alfred A Knopf 1974)

2. R G Lipsey et al Economics (Harper and Row 1984)