# Cost concepts.

Generally we think about costs only as a consumer. How much will this item "cost" me? How much cash will I have to give up now or when that credit card bill comes in.

But the concept of cost is much more complex and is dependent on the circumstances involved. The cost to the purchaser of an automobile is different than the cost to the manufacturer. Understanding the various types of costs and their behavior is an important part of decision-making. This column will attempt to list some of these costs and to provide a brief explanation of their use.

Among the terms we hear most frequently are variable costs" and "fixed costs". A variable cost is one that varies in direct proportion to changes in output. For example, in manufacturing, the cost of materials is usually a variable cost. Each item manufactured requires a certain amount of material. Therefore, changes in the total cost of material depend on the number of items manufactured. The variable cost per unit remains constant.

Fixed costs will remain constant in total amount whether or not changes occur in the activity level. Management salaries, rents, insurance and depreciation are good examples of fixed costs. That's not to say these costs won't change; for example, rent may increase. However, the changes are not simply based on in the number of units manufactured.

These two costs are frequently used in budgeting and decision making. When the fixed costs and the variable costs per unit are known, an analysis can be made of total cost based on the number of units produced.

Total = Fixed + [Variable x Units Produced] Cost Cost Cost

This equation gives us a basic look at the cost relationships. There are usually more factors to consider in the total picture. These costs must be considered within the range of anticipated activity, the relevant range. Depending on the quantity manufactured, both variable cost per unit and overall fixed costs may change. The production of more units will require more material and may allow the manufacturer to negotiate a better price. On the other hand, the production of more units may increase fixed costs due to the need for more equipment or floor space. And to complicate matters more, some costs are mixed costs consisting of a basic fixed cost plus a variable rate. Telephone charges usually are made up of a basic monthly charge plus a variable rate depending on the number of calls made.

Costs can also be either direct or indirect costs with respect to a particular activity. If the cost is readily identified with the activity, it is defined as a direct cost. If the cost is not directly traceable to the activity, it is defined as indirect. The cost of a hinge used in the manufacture of a specific product is a direct cost. The cost of air-conditioning a factory in which several products are made is an indirect cost. Here again, we can complicate matters. A factory manager's salary can be direct or indirect depending on the circumstances. If only one product is manufactured under the manager's supervision, then the cost can be called a direct cost of the product. However, if he/she supervises the manufacture of several products, that salary is indirect as related to the specific product. Indirect costs are sometimes called common costs and can be allocated to the products in a variety of ways.

Another type of cost is a sunk cost. These are usually unavoidable costs which have already been committed and cannot be changed. The cost of rent under a building lease is a sunk cost. If a retail store is considering changing its image and some of the products sold, rental costs need not be considered in the decision making process. These costs will not vary as a result of changes made.

Costs that must be considered in the decision making process are differential costs and opportunity costs. A differential cost is the difference between options. As an example, consider a retail store that has outgrown its current space. Management is considering two alternatives; leasing warehouse space across town or leasing the adjacent property. The warehouse space can be leased at a much lower price than the adjacent property. However, there would be an additional cost of trucking the merchandise to the store. Management will evaluate the differential cost between the two alternatives in order to make a decision. An opportunity cost is a different way of looking at a differential cost. An opportunity cost is the amount lost by not choosing a certain alternative. A corporation decides to develop a plot of land near a beach community. After extensive study, they determine that the two best uses of the land are as a water sports park or as a miniature golf course. They estimate that the annual income of the water sports park will be \$400,000 and the annual income of the golf course will be \$275,000. In choosing the water sports park, the opportunity cost is \$275,000, the cost of the next best alternative. Essentially, the corporation gave up the \$275,000 to get \$400,000.

Finally, a manager must consider controllable cons. If he/she has jurisdiction over the decision making process with respect to a cost, the cost is controllable. Obviously, if the manager is not authorized to incur or change the cost, it is noncontrollable with respect to the manager.

Controllable costs for a department manager would be salaries, and supplies within the department. Noncontrollable costs could be cleaning and maintenance of the equipment, particularly if these costs are contracted out for the entire plant. In turn however, these costs will be the responsibility of another manager and will be his/her controllable costs.

Costs have many attributes and behave in a variety of ways. It is essential to understand what drives a cost and how to use costs in decision planning and budgeting.
COPYRIGHT 1992 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.