Accounting management deal with the requirements to assess and estimate fixed costs and variable costs. A fixed cost is a cost that remains the same in total as activity usage increases or decreases while a variable cost is a cost that changes in direct proportion to changes in activity output. In economics, it is usually assumed that fixed costs and variable costs are known however in practical assesment requires consideration of
- Time horizon.
- Resource usage.
- Activity output measurement.
In the long run, according to economics, all costs are variable and only at least one cost fixed in the short run. The length of the short run may differ from one cost to another cost. For practical purposes, the firm treats direct materials as variable even though the amount of direct materials already purchased is fixed. In some settings, companies have the ability to hire and lay off its labor, concerning with direct labor in short time intervals, it is fewed as a variable cost. In other cases, circumstances prohibit laying off labor for short term drops in production. In such conditions where lay offs impossible in the short run even when there have been permanent changes in the need for labors, direct labor could be treated as a fixed cost rather than a variable cost.
The same observation can be made for other forms of labor. For example, salaries of moulding production line, supervisors are difficult to adjust as the activity output fluctuates. It could take months, a year or two years to determine whether a drop in production is permanent. According to this situation, this labor cost is seen as a fixed cost rather than a variable cost.
The length of the short run or the long run period depends on management judgment and the purpose of cost is being estimated. Submitting a bid on one time for a special order which span only a month can be used to create a bid and produce the order. Other types of decisions such as product discontinuance or product mix decisions will affect a much longer period of time. In this case the costs including product design and product development, marketing development and marketing penetration that must be considered are long run variable costs.
Short run costs often do not reflect all the costs such as design, produce, market, distribute and support a product.
The ability or capacity to perform activities that must be acquired called Activity Capacity. How much the capacity is needed depends on the level of performance required for each activity. The efficient level of activity performance is called Practical Capacity or Practical Capacity Resources.
Resources are needed to enable activities to be performed. Resources such as capital, labor, energy and materials are simple economic inputs that are consumed in performing activities. Resource Spending is the cost of acquiring capacity to perform an activity.
Resource Usage is the amount of activity capacity used in producing the activity output. Resource usage is equivalent to activity usage. Unused Capacity is the difference between the acquired capacity and the actual activity usage. The relationship between resource spending and resource usage to be used to define variable cost and fixed cost behavior.
Resources supplied in two ways
- As used and needed
- In advance of usage
Resources supplied as used and needed
Those resources are required from outside sources where the terms of acquisition do not require any long term commitment for any given amount. The firm is free to buy only the quantity of needed or in other words the quantity of supplied equals with the quantity demanded. No unused activity capacity because resource usage equals with resource supplied. For examples materials and energy.
Resources supplied in advance of usage
Those resources acquired by the use of either an explicit or implicit contract to obtain a given quantity of resources, regardless of whether the quantity of the resource is fully used or not. Resources supplied in advance may exceed the demand for their usage. In here, unused capacity is possible. For examples equipment and supervision.
Since the cost of the resources supplied as needed equals with the cost of resources used, the total cost of the resource increases as demand for the resource increases. Generally, we treat the cost of resources supplied as needed as a variable cost. In a manufacturing with Just In Time (JIT) environment, materials are acquired and used as needed for production activities. As the units produced increase, the usage and cost of raw materials would increase proportionately because “units produced” as the activity driver. Similarly, a machining activity will use more power as more machine hours are used, thus the cost of power will increase with an increase in machine hours. Resource supply and usage are measured by an activity driver.
Many resources are acquired before the actual demands for the resource are realized. Organizations acquire many multiperiod service capacities by paying cash up in front or by entering into an explicit contract that requires periodic cash payments. Buying or leasing building and equipment as examples of advance resource acquisition. The annual expense associated with the actual usage of the resources can be defined as fixed expenses. This committed fixed expenses costs incurred provide long term activity capacity.
Organizations that acquire resources in advance through implicit contracts usually with its salaried and hourly employees. The organization will maintain employment levels even though there may be temporary downturns in the quantity of activity used. This expense associated with this category of resources is independent of the quantity used, at least in the short run. Short, the amount of resource expense remains unchanged even though the quantity used may vary in the short run. Resource spending for this category corresponds to discretionary fixed expenses because the costs incurred for the acquisition of short term activity capacity.
Suppose a company hires five receiving clerks for $150,000 to supply the capacity of processing 18000 receiving orders. The activities of receiving orders involve in bringing purchased materials into the plant, include inspecting work, unpacking, creating a receiving order to match to the invoice and moving the materials to the storeroom. Receiving orders is the driver used to measure the receiving activity’s capacity and usage. None of the five receiving clerks would expect to be laid off if only 6000 receiving orders were actually processed unless the downturn in demand is viewed as permanent.
Nowadays, many companies are turning to contingent employment to handle variation in demand for labor services. Suppose the drop is permanent or an activity has too much capacity, resource spending will not be reduced until we reduce the capacity.
The activity based resource can improve on managerial control and decision making. Operational control systems have to pay more attention to control resource usage and spending. If sufficient unused activity capacity does not exist then resource spending must increase, similarly if activity management brings excess activity capacity, managers have to consider what is to be done with the excess capacity, managers must find ways to reduce resource usage. Eliminating excess capacity could decrease resource spending and improve overall profits. Using the excess capacity to increase products produced and sold could increase revenues without increasing in resource spending.
The activity based resource usage allows managers to calculate the changes in resource supply and demand resulting from such decisions as
Make or buy a part
- Accept or reject special orders
Keep or drop product lines.
This model increases the power of traditional management accounting decision making because most of decision making models depend on knowledge of cost behavior.
Activity output measurement
Describing cost behavior as variable costs and fixed costs, requires measurement of activity output however that activity output is measured by activity drivers. Therefore we must determine the underlying activities and associated drivers that measure activity capacity and usage. To understand cost activity relationship leads to determination of measurement of activity output or activity driver. For examples material handling output measured by number of moves, shipping goods output measured by units sold, laundering hospital bedding output measured by pounds of laundry. Choice of driver not only to the particular firm but also to the particular activity or cost being measured.
Activity drivers explain changes in activity costs by measuring changes in activity usage or output. There are two categories of activity drivers
- Unit level drivers
- Nonunit level drivers
Unit Level Drivers, explain changes in cost as units produced change. For examples pounds of direct materials and kilowatt hours used to run production machinery. Direct labor hours are examples of unit based activity drivers.
Nonunit Level Drivers, explain changes in costs as factors other than units change. Examples of nonunit based cost driver such as setups costs, work orders, engineering change orders, inspection hours, material moves. There are three kinds of nonunit level drivers
- Batch level
- Product level
- Facility level
Batch Level Costs tends to vary as the number of batches changes, Product Level Costs tends to change as number of different products changes, Facility Level Costs tends to stay constant and can be viewed as fixed costs at least for the short run.
In a traditional management accounting system, cost behavior is assumed to be described by unit based drivers only however in a contemporary management accounting system both unit and nonunit based drivers are used.
Managerial judgment is critically important in determining cost behavior. Many managers simply use their experience and past observation of cost relationships to determine fixed and variable costs. Some managers assign particular activity costs to the fixed and variable category, they ignore the possibility of mixed costs. Management should do well to make sure that each cost is predominantly fixed or variable and that decisions being made are not sensitive to errors in classifying costs.
The advantage of using managerial judgment to separate fixed and variable costs is its simplicity. In situations in which the manager has a deep understanding of the firm and its cost patterns, this kind of method (managerial judgment) can give good results. However, if the manager does not have a good judgment, errors will occur. Therefore, it is important to consider the experience of the manager to minimize or avoid the potential for errors and the effects have on related decisions.
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