Question

I want you to think about why different types of costs and their measurement matter. You learned about different cost behaviors, types, and structures - but why is that important? Think about why managers and business owners care about cost behavior. What kind of business problems require detailed knowledge of how costs behave. Use an example from your own (work) experience or think of a real-world business scenario to illustrate your stance.

Answer 1

Why different types of costs and their measurement matter?

Measurement of costs accurately remains a challenging topic as they can be measured accurately only after they have been incurred (after the budgeting period), but then that will be too late. However some of these costs can be estimated fairly accurately at the beginning such as variable costs once we make an assumption about activity levels or production volumes. Out of fixed costs, costs which are committed can be also estimated accurately thus leaving problems only with estimating the discretionary costs.

But problems just don’t end there. Even if we are able to estimate or measure these costs on overall basis, there are other challenges:

• Management might be interested in knowing costs specific to a product, job, and order or project thus necessitating need to know these specific costing methods.
• Not every unit of production will be sold in that budgeting period. How the total cost of allocation should be absorbed between costs of goods sold and inventory?
• If a process gives way to multiple products, how costs should be allocated to each one of them.
• How the by-product(s) should be treated as far as costing is concerned.
• Management needs to develop an understanding of the nature and types of cost drivers and the casual relationship that exists between cost drivers and costs incurred
• Management needs to know what costs are controllable and which ones are not?

----------------------------

What kind of business problems require detailed knowledge of how costs behave. Use an example from your own (work) experience or think of a real-world business scenario to illustrate your stance

Businesses where detailed knowledge of costs behaviour is required:

• Businesses that produce smaller number of specific, customised products - in such case managers will like to know the unit cost
• Businesses involved in multiple products: Management needs to know the exact behaviour of the costs to identify which products are more profitable and which ones are lesser. So, manager where to invest and divest in future.
• Business that undertake multiple activities to complete one order: Here there is a need to understand activity based costing to reduce redundancies and lower cost.
• Businesses that are involved into multiple processes to get the output (say for example: oil & gas): here knowledge of process costing is required
• Businesses producing joint products through a common assembly line: Knowledge regarding specific and common costs is required.\
• Businesses producing by products: Complex costing techniques are required.

A cost object can be completed through a series of activities. In order to measure costs of these objects, a cost pool is created where all the costs associated with cost the object are accumulated. These costs are then assigned to different activities required to complete the cost object.

An example from my life: (Note: the name of the products have been morphed to prevent identity)

My company processes input A to manufacture two joint products, X and Y. It purchases 1,000 units of A for $ 30,000. Processing costs are $ 10,000 and results in 700 units of X and 300 units of Y. The selling price for X is $ 200 per unit and $ 100 per unit for Y. Both X and Y require a further processing charge of $ 15,000 and $ 5,000 respectively. We were struggling to allocate the cost between X and Y based on gross margin method and assess how much would be the gross margin for X and Y?

We approached the problem in following steps:

• Sales value of X = (700 units) x $ 200 / unit = $ 140,000
• Sales value of Y = (300 units) x $ 100 / unit = $ 30,000
• Total sales value = $ 170,000
• Total joint costs = $ 30,000 + $ 10,000 = $ 40,000
• Total separable costs = $ 15,000 + $ 5,000 = $ 20,000
• Total Gross Profit = Total sales value – total joint costs – total separable costs = $ 170,000 – $ 40,000 – $ 20,000 = $ 110,000
• Gross Margin % = $ 110,000/ $ 170,000 = 64.71%
• X's Gross Margin = $ 140,000 x 64.71% = $ 90,588 = Sales of X – X’s share of the joint costs – X’s separable cost = $ 140,000 – X’s share of the joint costs – $ 15,000
• X’s share of the joint costs = $ 140,000 – $ 15,000 – $ 90,588 = $ 34,411
• Y’s Gross Margin = $ 30,000 x 64.71% = $ 19,412 = $ 30,000 – Y’s share of the joint costs – 5,000
• Y's share of the joint costs = $ 30,000 – $ 5,000 –$ 19,412 = $ 5,588