Chapter 6: Understanding key cost
relationships
Following the feedback I
got for my ASS #1 and the for the KCQ’s for Chapter 1 & 3, I decided that when reading Chapter 6, I
will separate my thoughts and reflections into different paragraphs and subheadings,
based on the subchapters provided in the study guide. It makes the marker’s
life a little bit easier when reading the mess of my thoughts and maybe it will
help me to make a little bit more sense of all of it as well. My biggest fear
is that, when separating them in detail, I will start summarising everything
and not actually reflecting my personal thoughts and opinions. Nevertheless I
plan write my initial reflections down as I go, hoping that I’ll be able to
translate the thoughts of the author into mine. So let’s see how I understand
the ‘Understanding key cost relationships’…
Key Concepts, Questions & My Understandings of
Them
Introduction
After reading the paragraph, I felt like yeah, I get this, I got this, everything is quite self-explanatory. The product that the company provides to a customer has to have a bigger value to the customer than the price they pay for the product, and the money that the customer provides to the company for the product, well, has to be more valuable for the company than the product itself. Companies trade their products to customers for money – it just makes sense.. And evidently accounting has to have something to do with it – recording the transactions help the managers gain a better understanding of what is going on in the firm. Like we read in chapter 1 and 3, when firms wouldn’t enter their transactions to journals and ledgers, and provide financial statements, it would be impossible to keep track of what money came in and what money went out and when and for what. So it only makes sense that accounting has a big role in regards of the key cost relationships in the firm. I’m sure though, that it can’t be that easy. How, in particular does accounting do that? I’m sure that after reading the next 18 pages I will certainly find out, or at least try to.
Introduction
After reading the paragraph, I felt like yeah, I get this, I got this, everything is quite self-explanatory. The product that the company provides to a customer has to have a bigger value to the customer than the price they pay for the product, and the money that the customer provides to the company for the product, well, has to be more valuable for the company than the product itself. Companies trade their products to customers for money – it just makes sense.. And evidently accounting has to have something to do with it – recording the transactions help the managers gain a better understanding of what is going on in the firm. Like we read in chapter 1 and 3, when firms wouldn’t enter their transactions to journals and ledgers, and provide financial statements, it would be impossible to keep track of what money came in and what money went out and when and for what. So it only makes sense that accounting has a big role in regards of the key cost relationships in the firm. I’m sure though, that it can’t be that easy. How, in particular does accounting do that? I’m sure that after reading the next 18 pages I will certainly find out, or at least try to.
Cost objects
I have to be honest, when first starting to read about the costs and the relationships between the firm and the customer, I found that the juxtaposition of cleaning my room with attaching costs to cost objects only made sense – to tidy everything up you just separate all of them to different categories, to where they belong to! It was good though that right away the author burst my bubble and said it can’t be that superficial. I like how the author emphasised the fact that understanding the relationships of a firm’s costs to the firm’s activities is critical for managers, CRITICAL! Did I already say it was critical? It does make sense though, company’s costs are the company - if the costs get out of control the company goes out of business, hence the managers have to be aware of them in order to plan and organise for the future. For example – the firm I work at, I’ve helped with constructing the weekly payment schedules, and it does make sense – you have to be aware of how much, for example, superannuation you paid last quarter, so you know the approximate amount that you have to pay for this quarter. Evidently the amounts won’t be the same, but then you at least have an expectation of what the next number will be. I found it rather surprising though, that EVERY activity in a firm costs the firm something – even storing goods in a warehouse! After further thinking, it does make sense though, because storing goods in a warehouse takes up space and the company has to pay employees to do inventory and value the products and so on. I also found surprising that we understate the firm’s profit for the period when not including the revenue they will generate in the future (because they haven’t been sold yet) whilst deducting the costs of buying or manufacturing products. So we have to include the estimated benefits as well as costs when finding the firm’s profit for a period? How do you estimate an income? From previous sales? And the revenue and costs have to stay in the same time period, otherwise, when including last period’s revenue to a new period, we would overstate the firm’s profit for the last period. I would have never thought of it before, but when I think about it, it does make sense. How do they make it successfully work though? Oooooh… They put the costs of the products into an asset, they don’t include them as an expense but wait until they sell the products! Okay, so that makes a lot more sense. Instead of estimating future revenue, they just include the costs as assets and then when the product is actually sold, they get the revenue and expenses that both match in a period where they actually belong to – the period when the product was finally sold! I always thought I had a clear understanding of the term inventory – little did I know that inventory isn’t just some stock staying in a warehouse, but it can also be seen as asset – a future economic resource for the company.
I have to be honest, when first starting to read about the costs and the relationships between the firm and the customer, I found that the juxtaposition of cleaning my room with attaching costs to cost objects only made sense – to tidy everything up you just separate all of them to different categories, to where they belong to! It was good though that right away the author burst my bubble and said it can’t be that superficial. I like how the author emphasised the fact that understanding the relationships of a firm’s costs to the firm’s activities is critical for managers, CRITICAL! Did I already say it was critical? It does make sense though, company’s costs are the company - if the costs get out of control the company goes out of business, hence the managers have to be aware of them in order to plan and organise for the future. For example – the firm I work at, I’ve helped with constructing the weekly payment schedules, and it does make sense – you have to be aware of how much, for example, superannuation you paid last quarter, so you know the approximate amount that you have to pay for this quarter. Evidently the amounts won’t be the same, but then you at least have an expectation of what the next number will be. I found it rather surprising though, that EVERY activity in a firm costs the firm something – even storing goods in a warehouse! After further thinking, it does make sense though, because storing goods in a warehouse takes up space and the company has to pay employees to do inventory and value the products and so on. I also found surprising that we understate the firm’s profit for the period when not including the revenue they will generate in the future (because they haven’t been sold yet) whilst deducting the costs of buying or manufacturing products. So we have to include the estimated benefits as well as costs when finding the firm’s profit for a period? How do you estimate an income? From previous sales? And the revenue and costs have to stay in the same time period, otherwise, when including last period’s revenue to a new period, we would overstate the firm’s profit for the last period. I would have never thought of it before, but when I think about it, it does make sense. How do they make it successfully work though? Oooooh… They put the costs of the products into an asset, they don’t include them as an expense but wait until they sell the products! Okay, so that makes a lot more sense. Instead of estimating future revenue, they just include the costs as assets and then when the product is actually sold, they get the revenue and expenses that both match in a period where they actually belong to – the period when the product was finally sold! I always thought I had a clear understanding of the term inventory – little did I know that inventory isn’t just some stock staying in a warehouse, but it can also be seen as asset – a future economic resource for the company.
Cost of products
Of course there can’t be just ‘costs’, there has to be direct and indirect costs. Allocating direct costs to products is rather straightforward, but allocating indirect costs to products is obviously not that simple. Obviously. Why? Why can’t accounting just all be straightforward? There always has to be something to mess with our brains, always! Okay, so direct costs, are for example, salaries, because there is a clear link between the cost and the cost object – the salary and the company? I like the metaphor of fridge magnets naturally sticking to the door and the magnets that need to shoved onto the door with blue-tack! It creates such a clear picture that makes it hard not to understand the concept! It’s interesting that in some cases we’re able to identify direct and indirect costs of the product whilst it’s still being manufactured, however we can’t do that with everything - for example we can’t do it with chocolate. So when we can’t do that, we can calculate an average production cost across all the products being produced at that particular production process. So we just estimate. It’s also great that in addition to all the accounting theory, the author knows in detail how to make chocolate! An interesting read and also brings a lot more clarity to the cost side of it. So we don’t have to allocate costs to a specific product or groups of products, we can also allocate them to a manufacturing process? All in all, is job-costing attaching costs to the products while they are still being manufactured, and process-costing allocating costs to products by allocating them to a manufacturing process? In my head it makes sense, hopefully it’s correct. Oh joy, just when I started to make sense of all of it in my head, there’s more costs – product and period costs! So are product costs basically the same as direct costs – magnets easily attaching to the fridge, and are period costs same as indirect costs – needing the help of Blu-Tac to attach the magnets to the fridge??? Product costs are like assets, expecting to provide a future benefit to our firm, whilst period costs are just expenses, and do not contain any future benefits for the firm
Of course there can’t be just ‘costs’, there has to be direct and indirect costs. Allocating direct costs to products is rather straightforward, but allocating indirect costs to products is obviously not that simple. Obviously. Why? Why can’t accounting just all be straightforward? There always has to be something to mess with our brains, always! Okay, so direct costs, are for example, salaries, because there is a clear link between the cost and the cost object – the salary and the company? I like the metaphor of fridge magnets naturally sticking to the door and the magnets that need to shoved onto the door with blue-tack! It creates such a clear picture that makes it hard not to understand the concept! It’s interesting that in some cases we’re able to identify direct and indirect costs of the product whilst it’s still being manufactured, however we can’t do that with everything - for example we can’t do it with chocolate. So when we can’t do that, we can calculate an average production cost across all the products being produced at that particular production process. So we just estimate. It’s also great that in addition to all the accounting theory, the author knows in detail how to make chocolate! An interesting read and also brings a lot more clarity to the cost side of it. So we don’t have to allocate costs to a specific product or groups of products, we can also allocate them to a manufacturing process? All in all, is job-costing attaching costs to the products while they are still being manufactured, and process-costing allocating costs to products by allocating them to a manufacturing process? In my head it makes sense, hopefully it’s correct. Oh joy, just when I started to make sense of all of it in my head, there’s more costs – product and period costs! So are product costs basically the same as direct costs – magnets easily attaching to the fridge, and are period costs same as indirect costs – needing the help of Blu-Tac to attach the magnets to the fridge??? Product costs are like assets, expecting to provide a future benefit to our firm, whilst period costs are just expenses, and do not contain any future benefits for the firm
Apportioning indirect costs
It’s surprising to read that managers can use whatever accounting approach they wish to help them understand key cost relationships in their firm – I always thought that they need to follow specific regulations or standards in order to do that! It’s good though, because it gives them the freedom to choose the approach most comfortable to them in order to understand the business realities as well as possible. It is evident though, that when constructing financial reports for outside eyes, they need to follow rules and accounting standards – it saves money and also is easier to avoid confusion – what one manager thinks is right doesn’t necessarily have to match with another manager’s opinion. So many departments and so many costs! All the indirect costs are connected to the activities of EVERYONE in the firm. Obviously there aren’t just production departments, but also service departments who basically provide services to production departments, such as maintenance and quality control and so on.. The indirect costs need to be assigned to service departments and from there to production departments. Each of the departments have their own share of costs as well as the shared costs of other departments! How do we separate what each cost is for if there’s so many? There are two main approaches used to allocate indirect costs to products – functional-based and activity-based systems. As usual to accounting – there’s always two sides to it – ALWAYS! Functional-based costing system – using various functional relationships to approximate the actual relationship. So we separate the indirect costs to production departments and then in turn absorb these costs into specific products connected to the specific production department? The calculation got me a little bit confused – Total overheads of a production department divided by Level of Activity. How do we find the level of activity? Oh. It’s always good to keep reading.. We measure the volume of the products, for example kilograms for chocolate being worked on each stage of production or machine hours for different products. When thinking about different kinds of products and the way they need to be treated, there is still a lot estimating and approximations - all in all how accurate will all of it be? However, since it can take a whole year to know the costs for a full year it is crucial to estimate in order to know how much costs the company needs to absorb into products throughout the year. It is quite logical though, that the difference between the estimation and the actual costs are charged either into income of that period or into product costs, depending how accurate the estimation was and whether it was more or less than the actual overhead costs of that particular period. Hence it is crucial that the calculations and estimations of the overhead costs are as accurate as possible. It made me happy when I continued to read about Activity-based costing systems – a way to more accurately connect indirect costs to products, using a presumed functional relationship between cost centres and products. The system identifies the activities and then the activity is attached to each product until the product finishes using the activity. When trying to make sense of it in my head, I just see a factory and a chocolate going through different stages of the conveyor belts – different activities. When the chocolate moves on to another stage, packaging, for example, that can be seen as the next activity – the chocolate has moved on! Thanks accounting, you’ve made me sound like a crazy person. Nevertheless this is how it makes sense in my head (yes, thanks to the author there’s a fully-functioning chocolate factory in my head, trying to make sense how to connect indirect costs to products). It makes sense that it is usual for a firm to only allocate production costs. That’s why so many people, including me, don’t realise at first that actually EVERYTHING costs money in a firm, and not only the production part of a product. But because the production costs are more emphasised, it might make people to think that way.
How costs change
It seems to me, than an important ability that a manager must have, is the talent to predict the future. They have to consider future costs and revenues in order to pursue or discharge opportunities presented to the company. But only good fortune-telling skills won’t help them – they have to be able to understand how costs and revenue may change at different levels of sales or production. Fixed costs are the costs that firm has to pay and that can’t really be affected, for example salary of a full-time factory worker, whilst variable costs are changing constantly and are rarely the same, for example the costs of materials used for production. The quantity is different and the prices always change. If there’s more variable costs and that equals higher level of risk to a company, does that mean that more fixed costs equal lower level of risk to a company? Not necessarily. Firms have to be aware that high levels of fixed costs might make the customer to decline the sale. It only makes sense. For example – if I have to airline companies – one with fixed ticket prices, and other with ticked prices that are variable depending on time, luggage and so on, I most likely choose the second option because it’s more likely cheaper. Costs and level of activity in a firm are strongly connected. Costs are the results of firm’s activities, the results of a firm ‘doing things’. The relationship between fixed and variable costs and business activities help us calculate the profit at the end of the production, which in turn helps us understand the risks we are taking in our business – it helps us to look forward and decide whether risks are worth taking or not.
It seems to me, than an important ability that a manager must have, is the talent to predict the future. They have to consider future costs and revenues in order to pursue or discharge opportunities presented to the company. But only good fortune-telling skills won’t help them – they have to be able to understand how costs and revenue may change at different levels of sales or production. Fixed costs are the costs that firm has to pay and that can’t really be affected, for example salary of a full-time factory worker, whilst variable costs are changing constantly and are rarely the same, for example the costs of materials used for production. The quantity is different and the prices always change. If there’s more variable costs and that equals higher level of risk to a company, does that mean that more fixed costs equal lower level of risk to a company? Not necessarily. Firms have to be aware that high levels of fixed costs might make the customer to decline the sale. It only makes sense. For example – if I have to airline companies – one with fixed ticket prices, and other with ticked prices that are variable depending on time, luggage and so on, I most likely choose the second option because it’s more likely cheaper. Costs and level of activity in a firm are strongly connected. Costs are the results of firm’s activities, the results of a firm ‘doing things’. The relationship between fixed and variable costs and business activities help us calculate the profit at the end of the production, which in turn helps us understand the risks we are taking in our business – it helps us to look forward and decide whether risks are worth taking or not.
Conclusion
After reading this chapter I once again realised that there’s so much more to a firm than it might seem at first. There aren’t just costs – there’s direct costs and indirect costs, fixed and variable costs, there’s product costs and period costs, different departments of production and service, all influenced by diverse costs and a variety of systems to calculate the costs. And all of this is vital for managers to keep track of costs in their firms, to manage the costs, plan ahead and manage the risks in order to run a successful company.
After reading this chapter I once again realised that there’s so much more to a firm than it might seem at first. There aren’t just costs – there’s direct costs and indirect costs, fixed and variable costs, there’s product costs and period costs, different departments of production and service, all influenced by diverse costs and a variety of systems to calculate the costs. And all of this is vital for managers to keep track of costs in their firms, to manage the costs, plan ahead and manage the risks in order to run a successful company.
