ELEMENTS OF COST

The elements of cost most discussed are material, labor and equipment ... but they are only part of the cost. There are very substantial costs associated with research and development, creation, design and engineering, marketing, distribution and rewarding capital.

Cost accounting is boring

Yes ... cost accounting is boring if it is defined as simply the recording of the basis data. But cost accounting is exciting when it helps to understand the behavior of costs, and all the factors that influence these costs. Boredom is usually some reflection of the individual, more than it is cost accounting per se.

Materials, labor and equipment are the elements that go into most production activities ... and determine costs. These items also determine the behavior of costs and how costs can be improved. The interaction of these three elements can be optimized with respect to cost, and there is a large body of literature that helps decision makers optimize cost.

Optimizing cost may have a secondary impact on quality and value. This is one reason to talk of optimizing cost rather than minimizing cost.

Organizations like the IMF and the World Bank refer to “economic classifications”. In the corporate environment the phrase “elements of cost” were also used. What they are called matters less than understanding what they are and how they behave.

Working with other languages

The idea that the semantics of word meaning is important gets minimized when the work is being done in a foreign language. I have worked a lot in English ... my native tongue, and in French, which I have studied over many years. The differences in the meaning of the language, and the understanding of the underlying concepts gets interesting ... but much more interesting when the language is quite different from my native language. Try explaining the concepts in Lao, or Russian, or Arabic! At the limit it is only the big concepts that move from language to language and culture to culture.

Materials .. a critical element of most economic activity.

The availability of material has been a driver and a constraint on economic progress.

Iron and steel industry

Pulp and paper industry

Electricity generation

Construction

Consumer products

Automobiles, trucks and buses

South Korea

I have always held the view that man industries owed their success to the easy availability of all the required raw materials for production. This was true in all industries, but very much a constraint for the automobile industry. Over the years automobiles have used more and more plastics ... engineered materials ... and until the 1980s these were not available in South Korea. When Dow Chemical started production of this type of material the groundwork was in place for international standard cars from South Korea.

Labor ... potentially both a contributor to production and a beneficiary of production. Labor is an important element of cost, also a source of creativity, imagination and productivity, and also the reason for industry and pursuit of happiness. In classical economics people were producers and people were also consumers ... more recently people have been both, and sometimes referred to as “prosumers”. The trend for people to be in all aspects of the economic pot is continuing.

Location of industry – labor

Labor is an important cost in most products ... not all. It can be minimized in some products by moving the production to a “low wage” country ... and further reduced when the low wages are linked with good productivity and good quality.

This is good news for the company doing the manufacturing ... costs are reduced and profits increased ... but is it to everyones advantage. While there are jobs gained in one place ... are there offsetting jobs lost in another place? Maybe ... but not necessarily. The analysis needs to be done carefully.

What other impacts are there? Are workers' rights respected ... do they exist at all? If the ONLY driver is enterprise profit, then labor is likely to be exploited ... if the driver is a more inclusive set of socio-economic progress metrics, there may be very valuable worker benefits and progress.

Labor – labor

Labor is an important cost in most products ... not all. It can be minimized in some products by moving the production to a “low wage” country ... and further reduced when the low wages are linked with good productivity and good quality.

This is good news for the company doing the manufacturing ... costs are reduced and profits increased ... but is it to everyones advantage. While there are jobs gained in one place ... are there offsetting jobs lost in another place? Maybe ... but not necessarily. The analysis needs to be done carefully.

What other impacts are there? Are workers' rights respected ... do they exist at all? If the ONLY driver is enterprise profit, then labor is likely to be exploited ... if the driver is a more inclusive set of socio-economic progress metrics, there may be very valuable worker benefits and progress.

Applied common sense

Estimating costs

Figuring out how much somethings costs starts out as a theoretical exercise ... but it can be done very accurately when people know what they are doing.

People who work in any area ought to know what things cost ... if they don't, then there is something wrong. Good people will also know something about the behavior of cost ... that is how costs vary depending on the prevailing conditions. Unit cost tends to go down as volume increases ... but then will increase if the production requires overtime pay or weekend pay ... or if there are shortages of raw materials that require higher cost procurement. Good people know this stuff ... and a good cost system lets these details into the analysis so that good decisions can be made.

Estimating Costs

One of the most effective measures of organizational competence is the ability to estimate costs and get it right. The World Bank is reported to have had 300% cost overruns on the rebuilding of its headquarters building in Washington ... and the IMF had a similar experience. What does this tell you about two key organizations in the international relief and development sector

Bureaucrats have no concept of cost behavior - I

I have never found a bureaucrat that had anything but the most simplistic view of costs and cost behavior. One of my pet peeved is the idea that costs are low when they are under budget ... especially when I have listened in on the budget process and know how the numbers were negotiated.

Bureaucrats have no concept of cost behavior - II

This is typical. A colleague sat in at a high level UN audit meeting and heard the explanation that a big project ... actually a computer installation and upgrade ... had not cost anything because all the staff were on salary (and if I remember right this was maybe 50 people for 2 years!).

Integrated cost accounting

The idea of integrated cost accounting was to make it possible to discipline cost analysis within the double entry framework of accountancy. This was important when analysis was manual and not easy to check in detail ... less important now that computer spreadsheets and relational databases are everywhere.

There is increasing evidence that since this discipline was discontinued, the understanding of operational cost behavior has deteriorated and instead some system that is quite superficial and dangerous. I cannot pretend to understand how some of the accounting works.

Fixed and variable costs

One of the simple classifications is between fixed costs and variable costs. The corporate business that has success is usually one where there is a good understanding of how all cost behave and optimizes accordingly.

Making fixed cost variable

Part of my success in the corporate world was my simple view that fixed costs were, in fact, variable and a big job of management was to change them so that they were optimized.

Getting to change fixed into variable meant changing established ways of doing things ... changing to different ways of thinking. Outsiders would do it very quickly in an acquisition setting ... we wanted to do it as insiders and have a positive outcome for the company. My job was to help make it happen ... and do it in weeks or months and not years.

Making variable costs fixed

My impression, early in my career was that more senior people had deep legal training than had accounting or technical training and big decisions were made with very limited understanding of cost behavior. This sometimes translated into an unwillingness to have fixed costs ... even though this would end up reducing the unit cost and increasing profit. There was some risk ... but that is what gives enterprise the ability to drive progress.

Most of the Board of Aerosol Techniques were in this mindset ... and also too many at Gulton Industries. This was a serious problem at Gulton, an early pioneer of microelectronics which completely failed to enter the second phase of circuit integration because of the high fixed costs of the required production and testing gear and disappeared from contention.

When costs are thought of as being fixed and variable, and revenues are thought of as being directly related to quantities, in a profitable activity, there is a mathematical point where revenues equal the sum of fixed and variable costs. This is known as the breakeven point.

The idea of a beakeven point is useful, albeit simplistic since the assumptions about linearity are rarely realistic in a real situation.

Students are taught the basics of a breakeven analysis ... with the simple breakdown of costs between fixed and variable costs ... and a revenue that increases linearly with volume.

There is nothing wrong with the concept ... but the simplified assumptions do not take into account much what happens in the real world.

There are much more complex changes going on that must be taken into consideration.

In a real situation the fixed costs tend to grow ... not in the same pattern as variable costs ... but they do grow. They tend to increase in steps ... but they do increase with scale.

In a well managed organization the fixed costs can be reduced ... can be made variable to some extent by good decision making and thoughtfulness.