cost behaviour-2

ACCOUNTS-601 MBA Fall Semester - 2009

Cost Behaviour: A study on various costs and their perception

A survey on basic Manufacturing Costs and how they a considered differently due to various management

accounting practices

Study By

Hashim Hilal - 3261

Yousif Ameen

Mai Alkhalifa – 1700

Hussain

Project: Cost Behaviour: A study on various costs and their perception

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INTRODUCTION

The following is a project survey, based on the initial research done by the National Association of Accountants (NAA), Tokyo Affiliate. They surveyed the various Costs involved in the manufacturing industry and analyzed their behavior as Fixed, Variable and Semi variable cost.

After the survey, NAA released their study results in 1988 entitled “Management Accounting in the Advanced Management Surrounding – Comparative Study on Survey in Japan and U.S.A”.

A total of 257 American companies and 40 Japanese manufacturing companies responded to questionnaire related to their management accounting practices. The companies were asked whether they considered certain costs as Variable, Semivariable or Fixed.

It was noticed that there was a big difference in the management accounting practices between US companies and their counterpart Japanese Manufacturing firms.

This study looks into these various Manufacturing Costs and analysis their behavior. At first these variables are separately studied and come up with logical reasoning if they should be considered as Fixed, Variable or Semivariable. Then a small survey is done on GCC Companies to see where they stand on , in juxtaposition to Western (US) and Far Eastern (Japan) manufacturing industries.

What Costs need to be considered as fixed, variable or semivariable, by looking at their benefits and positive impact on accounting practices? If US companies consider them as fixed then what is the benefit as such, and if Japanese companies consider some as variable costs, then what is the benefit of considering them as such, or consider a majority of them as Semi variable cost.


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Review of Fixed, Variable and Semi-Variable Costs

It is important to know how costs behave in response to a change in activity base i.e number of units produced, number of direct labor hours etc. As the activity level rises and falls, a particular cost may rise or fall as well – or it may remain

FIXED COSTS BEHAVIOUR

A Fixed cost remains constant regardless of the change in the level of activity. No matter how many units are manufactured, this type cost remains the same. The total cost per unit decrease with the increase in number of units. This behavior is shown in graph above.

In management accounting, fixed costs are defined as expenses that do not change in proportion to the activity of a business, within the relevant period. For example, a retailer must pay rent and utility bills irrespective of sales, thus they are Time dependent and not per unit production dependent.

Advantage of Considering Costs as Fixed

The benefit of considering costs as fixed is that the per unit value decreases with the increase in number of units manufactured. This goes along with the fact of Economies of Scale


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Economies of scale is a long run concept and that is related to the size of production, the capacity of production. Purchasing (bulk buying of materials), Managing (increasing skill level of staff), Finance related (obtaining lower-interest charges when borrowing from banks), and Market related (spreading the cost of advertising over a greater range in media)

VARIABLE COST BEHAVIOUR

Variable costs behave in proportional fashion with the number of units produced (activity base). If the production doubles, then the Total Variable cost doubles. If the production is cut down in half, these costs are also reduced by 50%.

For example, a manufacturing firm pays for raw materials. When activity is decreased, less raw material is used, and so the spending for raw materials falls. When activity is increased, more raw material is used and spending therefore rises.

In retail the cost of goods is almost entirely a variable cost; this is not true of manufacturing where many fixed costs, such as depreciation, are included in the cost of goods.


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Advantage of Considering Costs as Variable

The company becomes more flexible in changing its production output. Flexibility is considered good for a s company as it can accommodate the fluctuation in the Market demand. Demand is cyclical in nature

The economic theory of business cycles says that the demand goes through ups and down over a period of time as shown below [3]

.

[Fig 2 The Business Cycle]


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SEMI VARIABLE COST BEHAVIOUR

Semi Variable costs are those that have both Variable and Fixed cost components. These are also known as Mixed costs.

The fixed cost element shall be a part of the cost that needs to be paid irrespective of the level of activity achieved by the entity. On the other hand the variable component of the cost is payable proportionate to the level of activity.

Examples of Semi Variable Costs: telephone bills. One must pay line rental and on top of that a price that depends on how heavy one is using the service. So it changes with output.

Cost of energy such as electricity is a good example as it is behaves in a semi variable manner. Energy has both the fixed and variable aspects, because electrical power is necessary for the basic operation of the business - this fixed component can be considered as a sunk cost that is foregone irrespective of production. As demand increases more energy is required to ramp up the production process. Therefore, the cost electricity can be viewed as semi variable.

Another example is Sales staff who are also are given sales commission. They get a fixed salary plus an additional compensation if they increase or achieve sales target.

Mathematical Form of Semi-variable Costs:

The simplest form of semi-variable cost representation is the Straight Line Approximation.

Y = a + bX

Where Y = total semi variable cost

a = The total fixed cost


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b = The variable cost per unit of activity

X = The level of activity

Advantage of Considering Costs as Semivariable

Even though semivarible cost is more complex when compared to Fixed or True Variable cost, but they do reflect the true cost behavior of a number of types of costs. Like phone bill, electricity or energy, Material handling Labor etc.

This gives a mathematical perspective to costs behavior, and in Advanced Management Accounting practices where more mathematical approach is used, Semi variable cost are ideally suited and give a clear picture of cost behavior.

Various examples of Mixed Cost Behaviors.


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THE STUDY DONE BY NAA (National Association of Accountants).

The National Association of Accountants is an Organization made up mostly of non-CPAs. It has made significant contributions over the years to the development of management accounting principles. It has created the Institute of Management Accounting, which offers a program leading to the Certificate in Management Accounting (CMA).

As mentioned in the Introduction section of this report, , NAA released their study results in 1988 entitled “Management Accounting in the Advanced Management Surrounding – Comparative Study on Survey in Japan and U.S.A”.

Costs Studied in the Survey

The following eight types of Costs associated with the Manufacturing Organizations. Were studied by NAA, Tokyo Affiliate office to determine how these costs are considered to be Treated as Fixed, Variable or Semivariable (Mixed)

1. Production Labor

2. Repairs & Maintenance

3. Production Support

4. Work-In-Progress carrying cost

5. Material Handling Labor

6. Energy

7. Taxes and Insurance

8. Building Occupancy

It was noted that there is a big difference in the realization of cost behavior between US and Japanese companies, as the West and Far East have different ways of looking at things.

The results of the study are summarized in the chart below:


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[Fig 1. The results on cost behavior study done by NAA]


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EXPLANATION OF EACH TYPE OF MANUFACTURING RELATED COSTS

1. Production Labor

Work directly involved in making the product. Examples of direct labor costs are the wages of assembly workers on an assembly line and the wages of a machine tool operator in a machine shop. [4]

2. Repairs & Maintenance

One universal measurement of maintenance performance, and perhaps the measure that matters most in the end, is the cost of maintenance. Unfortunately maintenance costs are often used to compare maintenance performance between companies or between plants within the same company. Equally unfortunately, there is no standard for measuring maintenance costs. Each company, usually each plant within a company and often each department within a plant develop their own definition of "maintenance costs".

If you are in the process of defining maintenance costs, or believe that your definition needs updating, the following table may be of help.

Type of cost (materials and labor) Recommended cost category

Preventive maintenance Maintenance

Corrective maintenance (repair or replacement of failed components)

Maintenance (unless its a capital replacement)

Lubrication (a specific PM task) Maintenance (In some plants this is a Production cost)

Contracted preventive and corrective maintenance

Maintenance

"Maintenance" work done by Production employees. This can included cleaning, inspections, replacement of "production"

Production - but remember to take these costs into account when making comparisons


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http://www.idcon.com/preventive-maintenance.htm

http://www.idcon.com/maintenance-definition-C.htm


components (e.g. filter media, etc) and perhaps some lubrication.

"Non-working" maintenance labor (e.g. maintenance safety meetings, waiting time, etc)

Maintenance

Maintenance supervision, planning and administration

Maintenance

Non-capital plant improvements. This includes both process and reliability improvements

Probably maintenance, however its a good idea to include an "improvement" category in Work Order codes to allow improvement costs to be identified

Capital improvements and replacements Capital (but remember that the definition of "capital" also varies widely)

Disposal of obsolete and surplus stock and inventory adjustments (where inventory is working capital)

A special expense account, separate from other costs and not in the maintenance budget

A clear definition is important so that cost trends can be identified, which is the "comparison" that is of the greatest value. The definition becomes critical if costs are used as part of an incentive, for example, where maintenance is contracted to an outside company. [5]

3. Production Support

Production Support is the team of professionals that manage an organization’s ERP (Enterprise Resource Planning) System. They form the IT backbone of any manufacturing organization and their primary role is to receive Incidents & Requests from end users, analyzing these and either responding to the end user with a solution or escalating it to the other IT teams. These teams may include Developers, System Engineers and Database Administrators.

Based on their nature of work, and where most of the IT systems are capable of handling a large number of transactions automatically; these may not be severely affected by a change in production demand. Thus, they can be considered to be fairly fixed cost.


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In multinational manufacturing organizations , where there are production centres are present in many regions (for example P&G, Unilever etc); they have a central networked MIS (IT) system, in their case a global increase or decrease in their product demands, will need a scalable Production Support Staff, where they may increase or decrease with a corresponding change in Demand.

Thus production support can be considered as a Semivariable cost, especially for multinational manufacturing firms; where the fixed cost part is the core IT staff, and variable is the temporary staff hired to compensate for the fluctuation in global demand.

4. Work-In-Progress carrying cost

WIP generally describes inventory that is currently being processed in an operation, or inventory that has been processed through one operation and are awaiting another operation. WIP is actually an inventory account that represents the value of materials, labor, and overhead that has been issued to manufacturing but has not yet produced a stockable item. Depending on how your accounting and inventory systems are set up, it may also include components picked for production usage or finished products awaiting final inspection. [6]

WIP carrying cost by its very nature , has mostly been considered as a Variable Cost as it is directly affected by the level of Production.

5. Material Handling Labor

The techniques employed to move, transport, store, and distribute materials, with or without the aid of mechanical equipment.

This cost is mainly a variable one where a change in production will result in more or less Material Handling Labor. In organizations where production is budgeted i.e. they fix their production capacity for one year, and then this can be considered a fixed cost.


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6. Energy

Energy Cost is mainly the cost of Electricity in most modern day Manufacturing Organizations. However, in some large scale manufacturing organizations (like Steel Mill, Foundry etc) do use other sources of energy (like Crude Oil, Coal etc).

However, majority of the organizations use sophisticated Electronic & Electrical Control systems for producing goods, so Electrical Energy is the most common type of energy consumed in Organizations today.

Energy provided by Electrical companies is a Semivariable cost, as there is a fixed minimum charge and a linear variable when consumption increases above a certain kWh (Kilo Watt Hour), and charges are increased accordingly.

Energy costs, heating and cooling, for example are at times non linear, and rise & fall based on seasonality and not only on levels of production. So, it is best to consider them as Semivariable with fixed part associated with Production and Variable Part associated with Seasonal change.

7. Taxes and Insurance

Taxes are the cost imposed by the government and are usually given as a Percentage of Sales (and not a fixed dollar value). This means that if Production Increases and Sales increases, then the Taxes also increase and vice versa. So Taxes can mainly be considered as Variable. If in case that the companies are not performing well and do not show Profit, then a fixed minimum charge is applied.

Insurance is usually applied as a fixed amount to be covered for plant & equipment (and labor). These are fixed amount to be for one year period, every year, so its behavior is mainly fixed. Combining Taxes and Insurance under one category will lead to Semivariable cost behavior.


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8. Building Occupancy

This is usually considered a fixed capacity, and as the production capacity increases the company may wish to increase the size of its facility. For example, the rent on a building will not change until the lease runs out or is re-negotiated, irrespective of the level of business activity within that building.

THE SURVEY FOR COST BEHAVOUR

A survey was done on 20 individuals from 20 different companies based in Bahrain, to know their perception on cost behavior.

The form ACCT-A1, was made and distributed. The objective was to know, how Middle Eastern companies judged cost behavior, for the same types of costs identified by NAA; and see that difference to Middle East as compared to West & Far East. Bahrain is the ideal country to represent Middle East.

In a region experiencing an oil boom, Bahrain has the fastest growing economy in the Arab world, the United Nations Economic and Social Commission for Western Asia found in January 2006.Bahrain also has the freest economy in the Middle East according to the 2006 Index of Economic Freedom published by the Heritage Foundation/Wall Street Journal, and is twenty-fifth freest overall in the world.

In 2008, Bahrain was named the world’s fastest growing financial centre by the City of London’s Global Financial Centres Index. Bahrain’s banking and financial services sector, particularly Islamic banking, have benefited from the regional boom. In Bahrain, petroleum production and processing account for about 60% of export receipts, 60% of government revenues, and 30% of GDP.[7]


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SURVEY QUESTIONAIRE FOR IDENTIFICATION OF COSTS

Name: ______________________________________

Company: ___________________________________

Position: ____________________________________

Cost Type Fixed Variable Semivariable

Production Labor

Repairs & Maintenance

Production Support

WIP Carrying Cost

Material Handling Labor

Energy

Taxes & Insurance

Building Occupancy

Form ACCT-A1: Survey Questionnaire for Cost Behavior Identification


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SURVEY QUESTIONAIRE RESULTS IDENTIFICATION OF COSTS

Cost Type Fixed Variable Semivariable

Production Labor 12 7 1

Repairs & Maintenance 11 3 6

Production Support 8 7 5

WIP Carrying Cost 10 3 7

Material Handling Labor

13 1 6

Energy 3 3 14

Taxes & Insurance 10 5 5

Building Occupancy 18 0 2

Total 85 29 46


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Source: Survey Questionnaire for Cost Behavior Identification

CONCLUSION

The results onbtained from the survey, are summarized in graphs below:

[Fig 2. The results on cost behavior Survey of 20 companies in Bahrain]

As observed from the chart, the tendency is mainly to consdier Production Labor, Repairs, Material Handling Labor , Taxes and Insurance as Fixed costs; whereas a majority of


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others to be Semivariable cost; as one way or another, the cost are impacted by the change in Production, although they carry certain fixed cost component.

[Fig 3. Overall Percentage of Cost Behavior Classification]

With the advancement of ERP systems, it will be possible to enter a cost behavour fucntion (like Linear, Log Linear, Step Variable etc) mathematically in the ERP software; then a true cost behaviour will be reflected and treated in that manner.


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[Fig 4. Majority of Costs Behavior Classification]

For the overall summary, most of the people consider to treat costs as Fixed, simply becasue it is easier for them to prepare budget, and easier to calculate as compared to variable of semivariable cost.

This study ends with a note , that it is important to indentify cost behaviour and treat them as such, to avoid any unwanted losses.

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References:

[1] Website: http://en.wikipedia.org/wiki/Compustat

[2] Website: http://highered.mcgraw-hill.com/sites/0073526703/student_view0/chapter5/text_exhibits.html#

[3] Website: http://www.thebluecollarinvestor.com/blog/recession-a-normal-part-of-the-business-cycle/

[4] Website: http://www.answers.com/topic/direct-labor

[5] Website: http://www.idcon.com/reliability-tips-77.htm

[6] Website: http://www.inventoryops.com/dictionary.htm

[7] Website: http://en.wikipedia.org/wiki/Bahrain#Economy


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http://en.wikipedia.org/wiki/Bahrain#Economy

http://www.inventoryops.com/dictionary.htm

http://www.idcon.com/reliability-tips-77.htm

http://www.answers.com/topic/direct-labor

http://www.thebluecollarinvestor.com/blog/recession-a-normal-part-of-the-business-cycle/

http://www.thebluecollarinvestor.com/blog/recession-a-normal-part-of-the-business-cycle/

http://en.wikipedia.org/wiki/Compustat

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