Perspectives on Various Issues of Interest

Impact investing: a new way to fund cures for cancer

Impact investing: a new way to fund cures for cancer "Impact investing can help business-savvy, socially conscious individuals and organizations fuel the future of precision medicine," writes @HBSExecEd https://t.co/gRX02AGoW1 via @statnews

— Case Foundation (@CaseFoundation) February 27, 2019

Nature is a powerful genetic resource

From natural ingredients like marula oil & African sandalwood in cosmetics & perfume to plant-based medicine, nature is a powerful genetic resource. Our case studies 🔎 🌿 innovations in 27 countries which benefit the whole world: https://t.co/F98IBDYcVJ #NewDealForNature pic.twitter.com/H43DKG29up

— UN Development (@UNDP) February 17, 2019

Some Cost Concepts for Operations and Supply Chain Management

Awareness of some fundamental cost concepts enable operations and supply chain managers to deliver higher value to their organizations. However, in most cases there seem to be a lack of understanding (and interest) in these concepts. In this post I present some information that would hopefully help in bridging the knowledge gap.

Manufacturing costs are usually grouped into three main categories: direct materials, direct labor, and manufacturing overhead. These costs are incurred to make a product. Direct materials are raw materials that become an integral part of the finished product and that can be physically and conveniently traced to it. Examples include the aircraft engines on a Boeing 777, the Intel processing chip in a personal computer, the blank video cassette in a pre-recorded video, and a radio in an automobile. Direct labor consists of that portion of labor cost that can be easily traced to a product. Direct labor is sometimes referred to as “touch labor”since it consists of the costs of workers who “touch”the product as it is being made. Manufacturing overhead includes all manufacturing costs except direct materials and direct labor. These costs cannot be easily traced to specific units produced (also called indirect manufacturing cost, factory overhead, and factory burden).  Manufacturing overhead includes indirect materials that are part of the finished product, but that cannot be easily traced to it and indirect labor costs that cannot be physically or conveniently traced to the creation of products. Other examples of manufacturing overhead include: maintenance and repairs on production equipment, heat and light, property taxes, depreciation and insurance on manufacturing facilities, and salaries for supervisors, janitors, and security guards.

A manufacturing company incurs many other costs in addition to manufacturing costs. For financial reporting purposes, most of these other costs are typically classified as selling costs and administrative costs. These costs are also called selling, general and administrative costs, or SG&A. Selling and administrative costs are incurred in both manufacturing and merchandising firms. Selling costs include all costs necessary to secure customer orders and get the finished product into the hands of the customer. These costs are also referred to as order-getting and order-filling costs. Administrative costs include all executive, organizational, and clerical costs associated with the general management of an organization that are not classified as production or marketing costs.

Costs can also be classified as product or period costs. Product costs include all the costs that are involved in acquiring or making a product.  In the case of manufactured goods, it includes direct materials, direct labor, and manufacturing overhead. Consistent with the matching principle, product costs are recognized as expenses when the products are sold. This can result in a delay of one or more periods between the time in which the cost is incurred and when it appears as an expense on the income statement. Product costs are also known as inventoriable costs. According to the usual interpretation of Generally Accepted Accounting Principles (GAAP), all manufacturing costs are treated as product costs. Period costs include all selling and administrative costs. These costs are expensed on the income statement in the period incurred. All selling and administrative costs are typically considered to be period costs. The usual rules of accrual accounting apply to period costs. For example, administrative salary costs are “incurred” when they are earned by the employees and not necessarily when they are paid to employees.

Prime cost consists of direct materials plus direct labor. Conversion cost consists of direct labor plus manufacturing overhead.

The flow of costs in a manufacturing company can be represented as follows:

Raw materials are purchased and placed into raw materials inventory. Next, raw materials are requisitioned out of raw materials inventory into work in process.  Direct labor and manufacturing overhead are charged directly to work in process inventory. When a firm completes the product, the product and its costs are transferred out of work in process inventory into finished goods. All raw materials, work in process and unsold finished goods at the end of the period are shown as inventoriable costs in the asset section of the balance sheet. As finished goods are sold, their costs are transferred to cost of goods sold on the income statement. Selling and administrative expenses are not involved in making the product; therefore, they are treated as period costs and reported in the income statement for the period the cost is incurred.

Within the income statement, merchandising companies calculate cost of goods sold as Beginning Merchandise Inventory plus Purchases minusEnding Merchandise Inventory. However, for manufacturing companies, the cost of goods sold for a period is not simply the manufacturing costs incurred during the period. They calculate cost of goods sold as Beginning Finished Goods Inventory plus Cost of Goods Manufactured minusEnding Finished Goods Inventory.  For a manufacturing company, some of the cost of goods sold may be for units completed in a previous period. And some of the units completed in the current period may not have been sold and will still be on the balance sheet as an asset. The cost of goods sold is computed with the aid of a schedule of costs of goods manufactured, which takes into account changes in inventories. The schedule of cost of goods manufactured is not ordinarily included in external financial reports, but must be compiled by accountants within the company in order to arrive at the cost of goods sold. 

Cost changes in response to changes in activities:

Managers often need to be able to predict how costs will change in response to changes in activity. The activity might be the output of goods or services or it might be some measure of activity, internal to the company, such as the number of purchase orders processed during a period. Cost behavior refers to how a cost will react to changes in the level of activity within the relevant range.  The most commonly used classifications of cost behavior are variable and fixed costs. The total of just about any cost will change if there is a big enough change in activity. It is therefore important to consider the “relevant range.” Some refer to the relevant range as the range of activity within which the company usually operates. Whereas others refer to the relevant range as the range of activity within which the assumptions about variable and fixed costs are valid. The latter definition highlights the notion that fixed costs can change if the level of activity changes enough.

A variable cost varies in direct proportion to changes in the level of activity. Although variable costs change in total as the activity level rises and falls, variable cost per unit is constant. A fixed cost is constant within the relevant range. In other words, fixed costs do not change for changes in activity that fall within the “relevant range.” When expressed on a per unit basis, a fixed cost is inversely related to activity—the per unit cost decreases when activity rises and increases when activity falls.

A cost object is anything for which cost data are desired including products, customers, jobs, organizational subunits, etc.  For purposes of assigning costs to cost objects, costs are classified two ways:

• Direct costs are costs that can be easily and conveniently traced to a unit of product or other cost object. Examples of direct costs are direct material and direct labor.
• Indirect costs are costs that cannot be easily and conveniently traced to a unit of product or other cost object. An example of an indirect cost is manufacturing overhead. Common costs are indirect costs incurred to support a number of cost objects.  These costs cannot be traced to any individual cost object.

It is important to realize that every decision involves a choice between at least two alternatives. The goal of making decisions is to identify those costs that are either relevant or irrelevant to the decision. Costs and benefits that differ between alternatives are relevant to the decision.  All other costs and benefits are irrelevant and can and should be ignored. To make decisions, it is essential to have a grasp on three concepts:  Differential costs, opportunity cost, and sunk cost.

Differential costs (or incremental costs) is a difference in cost between any two alternatives.  A difference in revenue between two alternatives is called differential revenue. Differential costs can be either fixed or variable.

An opportunity cost is the potential benefit that is given up when one alternative is selected over another. These costs are not usually entered into the accounting records of an organization, but must be explicitly considered in all decisions.

A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Since sunk costs cannot be changed, they cannot be differential costs; therefore, sunk costs should be ignored in decision making.  

Interview with the Director of Supply Chain - WFP

“When you move 4 million tons of food a year, food quality is what keeps you awake at night — especially because half of the people who receive it are children,” says Jakob.
Read this interview with WFP's Director of Supply Chain 👉 https://t.co/PY03VfV6ta pic.twitter.com/z6ts5koJNI

— World Food Programme (@WFP) February 3, 2019