CHAPTER 17

Chapter 17 - Full Costs and Their Uses

CHAPTER 17

FULL COSTS AND THEIR USES

Changes from the Twelfth Edition

All changes to Chapter 16 were minor.

Approach

This chapter introduces the general concept of cost and describes, in a preliminary way, methods of recording costs in an accounting system. Some of the problems that many students seem to have are:

1. Students think that there is such a thing as "the" cost. They don't realize that the measurement of cost always relates to some specific cost object, and that what is an item of cost for one cost object may not be at all relevant for another cost object. As one way of overcoming this misconception, we have emphasized the idea of "cost object" from the outset.

2. Students think in terms of product costs. This is because in financial accounting the students' principal contact with "cost" was in connection with measuring inventory cost and cost of goods sold. They, therefore, fail to appreciate that products (literally "goods") are only one of a number of possible cost objects. They think, for example, that direct material and direct labor are always relevant costs, and that the word "direct" means that the material and labor are directly associated with the product, whereas for certain cost objects (e.g., advertising), direct material and direct labor are inappropriate terms. Furthermore, an item of cost may be direct to a certain cost object, such as the cost of a department or responsibility center, even though the item is indirect with respect to a product manufactured in that responsibility center. It is true that we do focus on product costs in Chapters 17 and 18, but the definitions and statements are made broad enough so that they can be used without modification when other cost objects are discussed.

3. Students think that the definitions are applied more precisely in practice than actually is the case. They tend to regard an item of cost as being direct labor only if they can visualize the worker as physically touching the product, for example. We do not attempt to describe the wide diversity that exists in actual practice because this diversity tends to confuse beginning students. The point is that students should not be overly concerned about drawing a fine line between direct and indirect costs, or between manufacturing and non-manufacturing costs.

We have decided not to stress the idea that cost is a "sacrifice," which is central to many definitions of cost. The word "sacrifice" implies something bad, something to be avoided, whereas a company gladly incurs a cost when it believes it will receive revenue or some other benefit by doing so. We think it more meaningful to students to think of cost as measuring the use of resources. They should visualize the resources themselves(the physical material, the hours of labor service(and think of costs as being monetary measures of how much of these resources were used for a given cost object.

In general, we think it desirable to use the word "product" as referring either to a good or to a service; that is, products are the sum of goods and services. We cannot do this uniformly, however, because the term "product cost" is in widespread use, whereas in the above terminology it really should be "goods cost." (This is a small point, but it can create confusion if not properly handled. The author of this paragraph did not comprehend the distinctions made above until many years after he had completed his first course in cost accounting.)The description of the cost flow through a pen factory is a central part of the pedagogy. Students should be able to explain each line on the flowchart and each of the related journal entries.

We have tried to avoid the twin dangers of, on the one hand, being critical of cost accounting because it does not yield costs that are entirely "true" or "accurate" and, on the other hand, creating the impression that cost accounting does in fact provide true and accurate costs. Students tend to go too far toward one or the other of these extremes, and it is difficult for them (as well as for many managers) to take the appropriate middle ground. This middle ground, we believe, is that although it is impossible to measure the costs of a cost object with absolute accuracy whenever indirect costs exist, it is nevertheless possible to measure costs with sufficient accuracy so that they are useful to management for many purposes. Managements would not continue to spend large amounts of money in the operation of cost accounting systems if they did not believe that the results were worthwhile.

In recent years, full-cost pricing is being given an increasing amount of attention, for a number of reasons the growth of cost-reimbursement pricing in hospitals and in government relationships of various types, the fact that some foreign producers have been found to have sold goods in the U.S. at less than full cost, and the growth in the understanding that business has a social responsibility to set "fair" prices, that is, prices that do not produce extraordinarily high profits.

Students who have been exposed to economics should also realize that contribution pricing is not slighted. As the text states, this topic is discussed in depth in Chapter 26, where it belongs, and in this discussion a distinction is drawn between situations in which full-cost pricing is appropriate and situations in which contribution pricing is appropriate. Of course, if students have not been exposed to a course in economics of the type implied above, then this problem will not even arise.

It is desirable that the relationship between profit and assets employed be emphasized. This relationship was introduced in Chapter 13, and it will come up several times in later chapters in this book. It is not an easy relationship to grasp (especially the relationship between profit percentage, asset turnover, and return on investment), but once the student understands it, he or she has a model that explains how the parts of a business, and decisions on these parts, relate to one another. Since the general public (including newspaper stories and television news programs) tends to think of profits as a percentage of sales, it is not easy to get students to think in terms of the broader and more valid concept of return on investment.

Any discussion of pricing necessarily includes a discussion of profit. Some students are emotionally antagonized by the basic concept of profit; they confuse "profit" and "profiteering," or they have the impression that business extracts an unconscionable amount of profit from the consumer. If they are to understand what normal pricing practices actually are, they must overcome this emotional block. It is hoped that the reiteration of the point that a business must earn a reasonable return on its investment if it is to survive may help in overcoming this block.

Cases

Delaney Motors raises the general issue of what is cost? and enables a discussion of the possible uses of full cost information.

Lipman Bottle Company deals with the use of cost data in product pricing decisions.

Shelter Partnership, Inc., allows students to see the multiple purposes for which cost accounting is used in a nonprofit organization and to consider whether additional cost accuracy is desirable.

Problems

Problem 17-1: Martin Company

(000s omitted)Raw Materials Inventory

Balance, Sept. 1

80Issued for use

100

Purchases

55To balance

35

135135

Balance, October 1

35

Work in Process Inventory

Balance, Sept. 1

95Goods manufactured

210

Direct material

100To balance

120

Direct labor

60330

Overhead

75

330

Balance, October 1

120

Finished Goods Inventory

Balance, Sept. 1

65Cost of sales

235

Goods manufactured

210To balance

40

275275

Balance, October 1

40

Cost of Sales

235

Problem 17-2: Burtis Company

Calculation of normal selling price for 20x3 assuming continued use of full cost:

20x2Increase20x3

Direct material

$ 4.00$ .48*$ 4.48

Direct labor

7.00 .84* 7.84

Indirect manufacturing

4.80 .60 5.40

Selling and administrative

3.50 .00 3.50

Total full cost

19.30 1.92 21.22

Profit (10%)

1.93 .19 2.12

Selling price

$21.23$2.11$23.34

*12 percent increase for direct material (.12 x $4.00 = $.48) and for direct labor (.12 x $7.00 = $.84)

$6,000 increase with volume of 10,000 units = increase of $.60 per unit.

Problem 17-3: Micha Smitha. Fee per hour =

= $60.00 per hour

b.Revenue, 100 hours @ $60

$6,000

Costs

5,700

Profit

$ 300

Problem 17-4: Valade Company

a. Calculation of selling prices:

TotalCompanyProduct___J___Product___K___

Direct manufacturing cost

$ 700,000$400,000$300,000

Indirect manufacturing cost

280,000160,000120,000

Selling and administrative cost

140,000 80,000 60,000

Full cost

1,120,000640,000480,000

Desired profit*

280,000 160,000 120,000

Sales revenue

$1,400,000$800,000$600,000

Divide by units

10,000 10,000

Selling price per unit

$80.00$60.00

*The desired profit of 280,000 for the company as a whole is 25 percent of the companys full cost. Therefore, a 25 percent profit margin percentage is applied to the full cost of each product to obtain the selling price.

The profit percentage is equal to:

(Desired profit + Selling and administrative cost) Full production cost. For Product A it equals ($160,000 + 80,000)/560,000 = 42.86% which is the same as for product K = ($120,000 + $60,000)/$420,000 = 42.86% b.TotalCompanyProduct___A___Product___B___

Sales revenue*

$1,248,000$384,000$864,000

Full cost+

1,040,000 320,000 720,000

Profit

$ 208,000$ 64,000$144,000

*Sales Revenue

A: 5,000 units @ $76.80 = $384,000

B: 15,000 units @ $57.60 = $864,000

+Full Cost

A: (5,000) = $320,000

B: (15,000 units) = $720,000

c. Profit margin pricing results in product prices containing identical profit percentages. However, the product with the higher price will yield the higher total dollar profit. Therefore, a shift in product mix toward lower price items will reduce total dollar profits for the company as a whole.

CasesCase 17-1: Delaney Motors*Note: This case is unchanged from the Twelfth Edition. Approach

This introductory case is a vehicle for discussing the allocation of costs without the complications and calculations that are found in later cases. It can be used to make the following points:

There is no perfect way of allocating indirect costs to cost objects. Nevertheless, some methods are better than others.

The underlying concept is to allocate on the basis of causation.

Full costs (i.e., direct costs plus an equitable share of indirect costs) may be useful:

a. For examining the profitability of a segment. Does it "carry its own weight"(recover its share of costs plus a profit?

b. For comparing the profitability of a segment with that of similar segments in other companies.

c. In arriving at selling prices.

d. In motivating managers by providing the basis for bonus calculations.

However, full costs are not necessarily worth the effort of collecting them for any of these purposes. Also, they can be misleading and misused unless their limitations are understood.

Analysis of Allocation MethodsQuestion 1 suggests that attention should first be focused on the rationale used by the consultant in arriving at the allocations. (Some instructors may prefer to take the reverse approach: first, discuss the possible usefulness of the costs, and then discuss the techniques used.)

The objective here is to allocate all indirect costs to the body shop. In many companies, general and administrative expense (such as the owner's salary and legal and auditing) would not be allocated at all. Full allocation is helpful in judging whether the body shop is profitable after recovering its fair share of all costs. It also is desirable in improving the basis of comparison with other dealers. Unless all costs are allocated, comparisons may be distorted because of differences in practices as to what costs are classified as general and administrative. (There are some indications of this diversity in the case.)

Semivariable costs are allocated on the basis of number of employees. This is a surrogate for direct labor hours, which would have been used if available. Probably, the number of employees is an indication of the relative amount of effort required by management, and hence is satisfactory.

The alternatives of revenue dollars or gross margin dollars are less satisfactory. They tend to be based on the criterion of "ability to pay," which defeats the purpose of the allocation. (If allocated on the basis of revenue, the relative profitability of each segment would be the same as if there were no allocations at all.) The criterion should be causation.

The label semivariable is probably not accurate. These are probably fixed. They are unlikely to vary at all with changes in volume in a given dealership, within reasonable volume ranges. They are discretionary costs, but that is not the same as semivariable.

The real distinction is between "occupancy costs" (here labeled "fixed costs") and other indirect costs. This distinction is useful because occupancy costs (depreciation and other costs related to the building and equipment) are reasonably allocated on the basis of square footage, or something similar.

In this situation, the distinction between the two types of costs turns out to be unimportant because both types charge about the same percentage of costs to the body shop (21.79% in one case and 20% in the other).

The Volkswagen method of using a "value factor" to weight the amount of occupancy costs charged is an interesting topic to debate. If the guiding criterion is causation, it is doubtful that the value factor reflects causation. More likely, it does the opposite: the body shop probably has more equipment and, therefore, should have a higher weight than the used car department.

The danger exists that the discussion will get bogged down in the details of various allocation methods. Students should leave this topic with the general impressions given at the beginning: no method is perfect, and it is not worthwhile to argue about fine points. However, some methods are better than others.

Use of the Information

To introduce this part of the discussion, it might be useful to ask "Why should Mr. Delaney worry? If the body shop were closed down, the company would lose the gross profit of $91,107, and obviously he doesn't want to do this."A counter-argument is that every segment of the company ideally should contribute a share of the profits. If a segment operates at a loss, it is at least cause for concern. The main result of the analysis was that it did lead to questions and a reexamination of possibilities for improving profitability, questions that might not even be raised in the absence of such an analysis. Theoretically, managers should continually be studying ways of improving profitability. In practice, managers have a limited amount of time and need some guidance in deciding where to focus attention.)

The comparison with other dealers shows that the majority of dealers (as indicated by the median, No. 6) have a body shop that earns a profit after all costs have been allocated. This raises the question: If they can do it, why can't Delaney?

One line of investigation is the possibility of raising selling prices. This is feasible only if Delaney's prices do not get out of line with competition. Thus, the idea of finding out what competitors charge is important. The fact that Delaney has a lower gross profit percentage than other dealers (29.7% vs. 30.0% for No. 6 and 30.6% for No. 3) indicates that there may be a little room for improvement here, but not very much.

The more likely cause of the situation is volume. Note that the allocated costs No. 6 and No. 3 are not proportionately greater than Delaney or No. 9, but that No. 6 and No. 3 have much larger volume. Are there ways of increasing volume, for example, by advertising? Or does the low volume indicate a lack of customer satisfaction, and if so, is there a way of improving this?

If time permits, a discussion of the basis for the body shop manager's bonus may be interesting. If based on profitability as calculated in the exhibit, the manager may not understand the rationale for the allocations and may therefore not accept the fairness of the bonus calculations. There are indications that if a bonus is paid at all, it might be based on the controllable profit, which is, it appears, approximately the same as the gross profit. However, it may be premature to raise the bonus question in this case.

Conclusion

Assuming that Mr. Delaney can't find ways of making the body shop profitable, should he discontinue it? The argument that he would then have more time to devote to the profitable segments seems of dubious merit, especially in view of the size of the contribution that would be lost. In any event, the numbers that are relevant to such a decision are the differential costs and revenues, not the full costs. (This is a good opportunity to emphasize again the idea of different costs for different purposes.) The advantage of being able to offer customers a body shop is also relevant.

Students can easily pick holes in the numbers. They are admittedly crude. However, the calculations were made from the existing system and did not require new data collection. The study was therefore quite inexpensive, a few hours at most. If not taken as being too precise, the results may provide some useful food for thought to Mr. Delaney, focusing attention on an area in which profit improvement is possible. If taken too seriously, however, they can lead to an unwise action; that is, the numbers taken by themselves certainly do not indicate that the body shop should be closed or leased.

Case 17-2: Lipman Bottle Company*Note: This case is unchanged from the Twelfth Edition. Please see the printed Instructors Resource Guide for the Harvard Teaching Notes.Case 17-3: Shelter Partnership, Inc.*Note: This case is unchanged from the Twelfth Edition.Approach

This case was written to illustrate the use of cost information and cost systems in a nonprofit setting. The case is particularly interesting because managers at Shelter Partnership were actively considering whether the possible undercosting of one of the organization's major elements (Shelter Resource Bank) might be adversely affecting their fundraising.

Suggested Assignment Questions

Suggested questions appear at the end of the case.

Case Analysis

A. What is the main purpose of cost information at Shelter Partnership?

The class should discuss three purposes:

1. Product costing. Managers should know the costs of the different services the organization provides. If the costs of a particular service are judged to exceed value, that particular service can be discontinued.

For example, the Salvation Army managers analyzed the costs of their organization's various programs. They decided to discontinue pick-up service of donated goods at private residences. The cost of doing so was greater than the value of the goods received. Instead, they decided to use donation centers in major traffic areas (which gave them economies of scale).

Students should understand, however, that use of cost information for product costing purposes is limited in Shelter Partnership because this is not a client-supported organization. Most of the revenues come from donations, not sales or service fees, and costing has little to do with pricing.

2. Fund raising. Cost estimates help determine the level of fundraising necessary to support Shelter Partnership's activities. (Note that some students question Ruth Schwartz's assumption that higher costs facilitate fund raising.)

3. Sourcing decisions. Managers can make decisions as to whether to have the organization provide its own services or contract them to outsiders (make or buy).

Cost control purposes seem not to be greatly served by the cost system. Shelter Partnership did not have reliable cost standards, so actuals vs. standards comparisons were not possible. However, some actuals vs. history comparisons were useful.B. The Shelter Partnership cost system:

C.Shelter Partnership provides four products or services:

a. technical(fund raising and distribution

b. program development(conferences, publicity

c. public policy support(research studies, educational programs

d. Resource Bank

But Ms. Schwartz does not express interest in tracing costs to the individual services, with the exception of the Resource Bank.

D. Is a single-stage cost system appropriate? Why or why not?

The students can quickly identify the cost pools and recognize how the costs are distributed across the difference services. There are three main categories of cost pools: (1) personnel (which includes salaries, benefits, and payroll tax expenses); (2) other operating costs; and (3) independent contractor costs.Some students will develop systems that add a "first-stage" allocation to the system, in which expenditures from the budget line items are pooled according to a common cost driver. Then they calculate burden rates for each cost pool and assign costs through a second stage allocation down to the cost object (service or program) level. Their cost drivers are commonly labor dollars of the ''personnel pool," and floor space for the "other operating costs" pool, etc. The students will argue that their scheme will make the costs of the various cost objects more "accurate." It is impossible to reach consensus on that, but most students will agree with Ms. Schwartz that Shelter Partnership has no particular need for this level of sophistication.

It would be time-consuming and therefore costly, to identify the activities performed and to attach costs to each of these activities, thereby constructing a true activity-based (2-stage) cost system. The benefits would probably not exceed the costs.

E. How many cost centers should Shelter Partnership identify?

Shelter Partnership uses nine cost centers. There are two personnel cost centers because different categories of people are allocated in different proportions to the Resource Bank. The costs of the donations distribution and solicitation managers and warehouse staff are allocated 100% to the Resource Bank. The costs of the administrative personnel (associate director, development director, office managers, and receptionists) are allocated 50% to the Resource Bank and 50% to the other three services.

Students will question why no personnel costs related to the executive director and program manager are allocated to the Resource Bank. They will also question whether it is desirable to make salary information essentially public by incorporating them into the allocations.

Shelter Partnership uses four costs centers for the other operating costs:

a. Warehouse expenses (100% assigned to the Resource Bank).

b. Office rent, office expenditures, postage, photocopying, printing, telephone, insurance, local travel, community training/board education, training and education, and equipment (50% assigned to the Resource Bank);

c. Nonlocal travel, newsletters, and publications (one-third assigned to Resource Bank);

d. (Not mentioned in text) Professional fees (assigned on a project-by-project basis).

Three cost centers are used for the independent contractor costs:

a. Trucking and warehouse temporary labor costs (traced 100% to the Resource Bank);

b. Accountant expense (50% assigned to Resource Bank):

c. Development consultant (which were zero in 1990) and the temporary consultant (0% to Resource Bank).

Are these enough cost centers? Too many? The discussion should refer back to the purposes of the cost information (Question 1).

F. Are Ruth Schwartz's estimates accurate enough?This is a difficult question to answer, but it gets students thinking in the right direction. The students realize that Ruth could interview her staff and get better estimates as to how they direct their time toward the four services the organization provides. They also realize that, for the personnel and independent contractor expenses, the allocation bases (which map directly into the percentages) are labor hours, measured with respect to some "actual capacity" estimate of total labor time available for all four services.

Ask the students what happens if, for example, the associate director quits and nobody else is hired to replace him/her'? It is clear that the percentages would have to be recalculated because both the numerator and denominator are changing. If the change is temporary, the use of standard percentages seems appropriate.

The allocation basis used for the four cost centers related to other expenses (such as office and expenditures) is not clear. Students can propose alternative allocation bases for each, on which the percentages might have been based. Some students, of course, will propose that Shelter Partnership do a study to better understand the purposes served by each of these various categories of expenses.

G. Is accuracy (or truth) the desired goal for Shelter Partnership's cost system?

For internal decision making purposes, approximation of the real costs is probably desirable. However, in communications to outside parties, Ms. Schwartz suggests that Shelter Partnership might want to overstate the costs of the Resource Bank, or at least recognize the full costs of the Bank. She thinks that higher costs will make the Bank appear more substantial and will be more likely to attract the attention of foundations.

If accuracy is not the goal of the cost system, why should management even be concerned with truth? Why not just assign almost every cost possible to the Resource Bank? This, of course, raises a number of legal and ethical issues.

But if Ms. Schwartz's argument that higher costs will attract foundation attention is correct, then she should have the cost system reflect the full costs of the Resource Bank. She should fully value the donation of space from the General Services Administration and she should assign the bulk of the insurance costs to the warehouse. Students will see that assignments like these make cost accounting more an art than a science.

Some students may raise the counter argument that Ms. Schwartz also has incentives to understate the costs of the Bank, to make it look more efficient. Where are the controls on the organization's internal accounting (cost) systems?

H. What do you think of Shelter Partnership's budgeting system?

At some point in the class, some attention can be usefully directed toward Shelter Partnership's budgeting system. Budgeting plays (or should play) key roles for Shelter Partnership. It might be used for resource planning and allocation purposes, and it might serve cost control roles.

The case does not provide much information about Shelter Partnership's budgeting system, but Exhibit I shows that the organization has a budget and that it appears to be only an aggregated, line-item budget. The organization would probably benefit from using program budgeting, instead of their line-item-based system. And where should standards come from for efficiency (actuals vs. standard) comparisons?I. Should the Resource Bank be tracked and evaluated as a cost center or a revenue center?

It could be done either way. If the Bank is considered a profit center, a value will have to be imputed to the donations.

All other services

Subjective estimates of proportion of resources consumed

Indirect costs

trace

Service

Resource Bank

Cost

Direct bank costs:

warehouse and donations people

warehouse costs

*This Teaching Note was prepared by Robert N. Anthony. Copyright by the President and Fellows of Harvard College. Harvard Business School Teaching Note 5-183-091.

*This Teaching Note was prepared by Michael J. Sandretto. Copyright by the President and Fellows of Harvard College. Harvard Business School Teaching Note 5-182-201.

*This teaching note was prepared by Kenneth A. Merchant. Copyright 1998 by Kenneth A. Merchant.

These games are apparently relatively common. See, for example, R. Khalaf, "The Accounting Games Charities Play," Forbes (October 26, 1992), pp. 252-254.

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