CHAPTER FOUR UNDERSTANDING COSTS
CHAPTER FOUR UNDERSTANDING COSTS
As managers work on the preparation of plans, one of the critical requirements is a good understanding of costs. The better managers understand costs, the more accurate their plans will be. Furthermore, a solid understanding of costs will improve a manager's ability to make effective decisions.
Costs, however, are complicated. Many cost terms are widely used but are not well understood. Direct costs, indirect costs, average costs, fixed costs, variable costs, and marginal costs are concepts that managers should understand. This chapter provides definitions of these and other key terms.
After defining costs, this chapter considers how costs change as volume changes. The relationship between costs and volume has a dramatic impact on the profits or losses incurred by an organization. An understanding of this relationship can be instrumental in decision-making. As part of the planning process, organizations must decide whether it makes sense to expand or contract volume or whether to add or eliminate services. Issues such as these require sophisticated thinking to optimize the results for both the organization and its clientele. Managers must learn which costs are relevant for evaluating these decisions.
Learning Objectives
Learning Objectives
The learning objectives of this chapter are to define cost terms, including direct costs, indirect costs, average costs, fixed costs, variable costs, marginal costs, relevant range, mixed costs, and step-fixed costs;
discuss the behavior of costs with a focus on the impact of changes in the volume of services provided;
discuss outsourcing decisions using marginal cost analysis;
explain break-even analysis and provide an example of the technique;
extend the use of break-even analysis to situations with multiple products or services; discuss the managerial implications of break-even analysis;
define and discuss the concept of margin of safety;
introduce the concept of cost measurement;
discuss cost allocation, including the selection of the base for allocation, approaches for allocation from mission centers to service centers, and allocation to units of service; and introduce and explain activity-based costing.
The chapter then examines a decision method called break-even analysis, a technique that assists the manager in determining what volume of activity is required for a program or service to become financially self-sufficient. Although many not-for-profit organizations are willing to undertake projects that lose money, the organization's survival depends on managers knowing when that will happen and how much money projects will probably make or lose. An awareness of likely losses will give managers critical information. They can then respond by finding other profitable activities that will make up for the losses or by trying to obtain grants or donations to subsidize specific services.
The chapter concludes with a discussion of cost measurement. The measurement of costs is complicated by the fact that some responsibility centers provide services to other centers. To determine the costs of products or services provided by the organization, it is necessary to allocate all the costs of the organization to the centers that produce the organization's products or services. In addition to addressing cost allocation, this section also discusses activity-based costing, a technique designed to improve the accuracy of cost measurements.