Theme: Analysis of the cost of the product and the factors influencing its change Plans: Introduction

Product cost analysis. Its principles and features.

Cost – this is the set of all resources, including raw materials, energy, machinery, equipment, buildings, training and remuneration of personnel, patents, technology and other costs expended in the production and sale of a product expressed in monetary terms. That is a large number of components resources, and ever-changing purchase prices for them, as well as the daily improvement of technology and the emergence on the market of new competitors, forcing managers to seek new ways of development.
The cost to material and labor are the direct costs while the factory overheads are the indirect costs, all of which are required to create a finished good ready to sell from raw material. As per GAAP and IFRS, the product costs are required to get capitalized as inventory in the balance sheet and should not be expensed in the statements of profit and loss because the expenditures to such costs generate benefits and value for future periods also.
The raw materials that get transformed into a finished good by applying direct labor and factory overheads are referred to as direct material in cost accounting. Direct materials are those raw materials that can be easily identified and measured. For example, an automobile manufacturing company typically requires plastic and metal to create a car. The amount of these resources can be easily counted or kept a record. However, manufacturing a car also requires lubricants like oils and grease. Still, it is very difficult or insignificant to trace the low value of grease used in a particular vehicle hence referred to as indirect costs.
Direct labors are the employees or the labor force that gets directly involved in producing or manufacturing finished goods from raw material. The direct labor costs are the salaries, wages, and benefits that are being paid to these labor forces against their services. For example, the workers in an assembly line of an automobile factory that weld the metal, fix the screw apply oil and grease, and assembles pieces of metals and plastic into a car are direct labors. A particular employee to be classified as direct labor, it must be directly associated with a specific job. E.g., a secretary at a large automobile manufacturing company has to perform a variety of roles as and when required. Thus it gets difficult to quantify the amount of benefits created to assemble a car. Hence it is not direct labor.
The indirect expense related to manufacturing a finished product that cannot be directly traced is referred to as the factory or manufacturing overheads. In other words, overheads are that cost that is neither direct material nor direct labor. That is why overheads are referred to as an indirect cost that includes indirect labor and material costs.

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  Indirect Material – The materials that get used in the manufacturing process but cannot be traced directly as a raw material are the indirect material. E.g., grease, oil, welding rods, glue, tape, cleaning supplies, etc. are all indirect materials. It is difficult as well as not cost-effective to determine the exact expense of indirect materials applied upon a single unit of a product.
  
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  Indirect Labor – The workers or employees that are required for the smooth functioning of the production process but do not get directly involved in creating a finished product are referred to as indirect materials. E.g., quality assurance teams, security guards, supervisors, etc. in the manufacturing premise are classified as the indirect labor force, and the associated costs in the form of their salaries, wages, and other benefits are considered to be the indirect labor cost.
  
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  Other Overheads – The factory overheads that falls under neither of the above two categories of factory overheads can be classified as other factory overheads. E.g., electricity expenses cannot be classified as material or labor. Similarly, costs like factory and equipment depreciation, insurance costs, property taxes on factory premises, factory rent or lease, the cost to utilities. The expenses that are not related to manufacturing a finished product or are incurred outside of the production facility should not be considered as product costs, for example, selling, general and administrative expenses. These costs generally get expensed to the income statement as and when they incurred and did not get capitalized into the value of inventory.
  

As noted earlier, more and more organizations are shifting their attention away from price management and toward cost management. In so doing, there may be opportunities to reduce costs that are not available when the discussion focuses only on price. In cost analysis, the supply manager performs a detailed analysis of the different elements of costs shown earlier in Exhibit 11.6 and identifies what is driving the different elements.

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   Cost-Based Pricing Models
   
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   Cost Markup Pricing Model
   

In this model, the supplier simply takes its estimate of costs and adds a markup percentage to obtain the desired profit. This markup percentage could be added to the product cost only (usually direct materials plus direct labor plus production overhead), in which case the markup would have to provide for profit, plus all other indirect costs of operating the business. Whether they realize it or not, purchasers impact price at the time they set the specifications for the product or service. Specifying products or services requiring custom design and tooling affects a seller’s price, which is one of the reasons purchasers try to specify industry-standard parts whenever possible. Cost (and hence price) becomes higher as firms increase the value-added requirements for an item through design, tooling, or engineering requirements. Purchasers should specify industry-accepted standard parts for as much of their component requirements as possible and rely on customized items when they provide a competitive product advantage or help differentiate a product in the marketplace.
The ability to perform a cost analysis is a direct function of the quality and availability of information. If a purchaser and seller maintain a distant relationship, cost data will be more difficult to identify due to the lack of support from the seller. An obvious approach that can help in obtaining necessary cost data is to require a detailed production cost breakdown when a seller submits a purchase quotation. The reliability of self-reported cost data must be considered. Another approach or option involves the joint sharing of cost information. A cross-functional team composed of engineers and manufacturing personnel from both companies may meet to identify potential areas of the supplier’s process (or the purchaser’s requirements) that can potentially reduce costs. One of the benefits of developing closer relations with key suppliers is the increased visibility of sup- plier cost data. The following section details some techniques that focus on cost.
Often suppliers will not be forthcoming in sharing cost data. In these situations, the purchaser must resort to a different type of analytical approach called “reverse price analysis”. A seller’s cost structure affects price because, in the long run, the seller must price at a level that covers all variable costs of production, contributes to some portion of fixed costs, and contributes to some level of profit. As discussed later in the chapter, many suppliers are reluctant to share internal cost information. This information, however, is valuable to a purchaser, particularly when evaluating whether a supplier’s price is justifiable and reasonable. In the absence of specific cost data, a supplier’s overall cost structure must be estimated using a cost analysis meaning that if the supplier is assigning costs in an appropriate manner.
Information about a specific product or product line is often difficult to identify. A purchaser may have to use internal engineering estimates about what it costs to produce an item, rely on historical experience and judgment to estimate costs, or review public financial documents to identify key cost data about the seller. The latter approach works best with publicly traded small suppliers producing limited product lines. Financial documents allow estimation of a supplier’s overall cost structure. The drawback is that these documents do not provide much information about a specific breakdown of cost by product or product line. Also, if a supplier is a privately held company, cost data become difficult to obtain or estimate. Despite these difficulties, there are tools available that can be used to estimate a supplier’s cost using some publicly available information. When evaluating a supplier’s costs, the major determinants of a supplier’s total cost structure must be taken into consideration. Let’s assume a supply management manager is buying a product or service for the first time without experience of what fair pricing might be. Because they do not have the tools at hand, or because they are too busy, many purchasers’ usual technique is to go with their gut feel or to evaluate competitive bids. It may be worth the time and effort, however, to perform some additional research using data from an income statement or from Internet sites. In doing so, the purchaser may perform a reverse price analysis— which essentially means breaking down the price into its components of material, labor, overhead, and profit.
Process capability. The purchaser should also consider if projected volume requirements match a supplier’s process capability. It may be inefficient to source smaller lot sizes with a supplier that requires long runs to minimize costs. On the other hand, suppliers specializing in smaller batches cannot efficiently accommodate volumes requiring longer production runs. A supplier’s production processes should match a purchaser’s production requirements. Supply management should also evaluate production processes to determine if they are state-of-the-art or rely on outdated technology. Production and process capability influences operating efficiencies, quality, and the overall cost structure of a seller.
• Learning-curve effect. Learning-curve analysis indicates whether a seller can lower its cost as a result of the repetitive production of an item.
• The supplier’s workforce. A supplier’s labor force affects the cost structure. Issues such as unionized versus nonunionized, motivated versus unmotivated, and the quality awareness and commitment of employees all combine to add another component to the cost structure. When visiting a supplier’s facility, representatives from the purchaser should take the time to talk with employees about quality and other work-related items. Meeting with employees provides valuable insight about a supplier’s operation. In recent years, the cost of labor in the workforce has gone up dramatically.
• Management capability. Management affects costs by directing the workforce in the most efficient manner, committing resources for longer-term productivity improvements, defining a firm’s quality requirements, managing technology, and assigning financial resources in an optimal manner. Management efficiency and capability have both a tangible and intangible impact on a firm’s cost structure. In the end, every cost component is a direct result of management action taken at some point in time.
• Supply management efficiency. How well suppliers purchase their goods and services has a direct impact on purchase price. Suppliers face many of the same uncertainties and forces in their supply markets that purchasers face. Supplier visits and evaluations should evaluate the tools and techniques suppliers use to meet their material requirements.
Firms perform break-even analysis at different organizational levels. At the highest levels, top management uses this technique as a strategic planning tool. For example, an automobile manufacturer can use the tool to estimate expected profit or loss over a range of automobile sales. If the analysis indicates that the break-even point in units has risen over previous estimates, cost-cutting strategies can be put in place. Divisions or business units can use the technique to estimate the break-even point for a new prod- uct line.
Break-even analysis requires the purchaser to identify the important costs and revenues associated with a product or product line. Graphing the data presents a visual representation of the expected loss or profit at various production levels. Cost equations also express the expected relationship between cost, volume, and profit. When using break- even analysis, certain common assumptions are typically used:

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  Fixed costs remain constant over the period and volumes considered.
  
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  Variable costs fluctuate in a linear fashion, although this may not always be the case.
  
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  Revenues vary directly with volume. This is represented graphically by an upward-sloping total revenue line beginning at the origin.
  
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  The fixed and variable costs include the semivariable costs. Thus no semivariable cost line exists.
  
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  Break-even analysis considers total costs rather than average costs. However, the technique often uses the average selling price for an item to calculate the total revenue line.
  
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  Significant joint costs among departments or products limits the use of this technique if these costs cannot be reasonably apportioned among users. If shared costs cannot be apportioned, then break-even analysis is best suited for the entire operation versus individual departments, products, or product lines.
  
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  This technique considers only quantitative factors. If qualitative factors are important, management must consider these before making any decisions based on the break-even analysis.
  

Cost analysis was designed to build a fence around human creative acts that prevent futuristic thinking in terms of rapid growth into the future. Rapid growth - in fact even growth without austerity cannot be achieved within the confines of the Empire that created this “valid” rendition of the principals the British financial system operates . It is a debt system based on accumulating money, gold, or papers of ownership looted from the general population, into it’s vaults computer banks with out providing the funds for the physical necessities of people, and coming generations. 
Material costs can often be estimated by consulting with internal engineers. Using an estimate of required material, as well as external information on current pricing of these materials as shown in the previous section, a rough estimate can be made of the amount of material in the product.
Resource consumption analysis requires a thorough understanding of the resource consumption patterns within the processes carried out by different types of organizations. The information supplied by this kind of analysis is included in decisional models for resource consumption optimization. Traditionally resource consumption was covered by two different concepts: expenses and costs. Whereas expense analysis area is relatively well covered by multiple researches and a sound methodology, cost analysis was rather lightly considered and made use of in national business literature. Certainly the main difficulty related to cost analysis is represented by the great variety of costing methods and systems used in different enterprises, so that cost analysis is required to by customized to the content of informational output generated by each costing method.
Cost analysis represents a process undertaken each time when there occurs a cost deviation from its projected value, or when it is required a cost optimization, even if the level of costs does not exceed the budgeted one. The primary information source for cost analysis is cost accounting, as well as 2160 other types of information of internal or external origin. Taking into account that the costing system represents, in most cases, an adaptation of a certain theoretical costing method to the specificities of a real enterprise, or a cross combination between two or more costing methods, the cost analysis is differentiated based on costing system informational outputs content and characteristics. Also, the goal of cost analysis – resource consumption efficiency improvement regarding internal value creating processes, in other words – identification of durable cost reduction solutions, are influenced by the specifics of enterprise’s activity as well as other factors. All these assumptions lead to the conclusion that cost analysis could not represent a homogeneous approach, so that application of methodology needs to be adapted to the actual conditions of the enterprise which costs are being analyzed.
The structure of cost analysis methodology contains 4 distinct stages:
1) Isolation of object that is undergoing analysis
2) Acquisition of information required to carry out the analysis
3) Processing of the available information
4) Identification of cost efficiency improvement solutions.
Cost analysis is currently a somewhat controversial set of methods in program evaluation. One reason for the controversy is that these terms cover a wide range of methods, but are often used interchangeably. At the most basic level, cost allocation is simply part of good program budgeting and accounting practices, which allow managers to determine the true cost of providing a given unit of service. At the most ambitious level, well-publicized cost-benefit studies of early intervention programs have claimed to show substantial long-term social gains for participants and cost savings for the public. Because these studies have been widely cited and credited with convincing legislators to increase their support for early childhood programs, some practitioners advocate making more use of cost-benefit analysis in evaluating social programs. Others have cautioned that good cost-benefit or cost-effectiveness studies are complex, require very sophisticated technical skills and training in methodology and in principles of economics, and should not be undertaken lightly. Whatever position you take in this controversy, it is a good idea for program evaluators to have some understanding of the concepts involved, because the cost and effort involved in producing change is a concern in most impact evaluations .
Common costs are treated as cost of processes they reflect, relative to which they have a direct relationship. Some other cost elements cannot be calculated relative to a certain process, so that there are no measurement means (heating costs, lighting, general water consumption , these being allocated to processes by some allocation criteria. Overhead costs are structured in three parts: indirect manufacturing costs, general administration costs and marketing costs. Indirect manufacturing costs and marketing costs are in turn of two types: variable and fixed. In case of indirect variable standard costs there could be determined different level of costs for different degrees of manufacturing capacity usage, determining common standard costs ratios. On the other 2164 hand, indirect fixed costs make part of a common cost ratio and transform into proportional costs, even if such an approach is not real. In order to carry out the analysis, standard direct costs do no present any interest because usually these reflect a level close to optimal one or even the optimal itself. The only unsolved problem is related to the indirect costs – overhead, especially to its fixed components. In order to further deepen the analysis, indirect costs are approached separately by their fixed and variable components.
There are three types of cost – analysis in evaluation:
Cost allocation, cost-effectiveness analysis, and cost-benefit analysis represent a continuum of types of cost analysis which can have a place in program evaluation. They range from fairly simple program-level methods to highly technical and specialized methods. However, all have specialized and technical aspects. If you are not already familiar with these methods and the language used, you should plan to work with a consultant or read some more in-depth texts (see some suggested references at the end of this discussion) before deciding to attempt them.
Cost allocation is a simpler concept than either cost-benefit analysis or cost-effectiveness analysis. At the program or agency level, it basically means setting up budgeting and accounting systems in a way that allows program managers to determine a unit cost or cost per unit of service. This information is primarily a management tool. However, if the units measured are also outcomes of interest to evaluators, cost allocation provides some of the basic information needed to conduct more ambitious cost analyses such as cost-benefit analysis or cost-effectiveness analysis. For example, for evaluation purposes, you might want to know the average cost per child of providing an after-school tutoring program, including the costs of staff salaries, snacks, and other overhead costs.
Besides budget information, being able to determine unit costs means that you need to be collecting the right kind of information about clients and outcomes. In many agencies, the information recorded in service records is based on reporting requirements, which are not always in a form that is useful for evaluation. If staff in a prenatal clinic simply report the number of clients served by gender, for example, you might know only that 157 females were served in March. For an evaluation, however, you might want to be able to break down that number in different ways. For example, do young first-time mothers usually require more visits than older women? Do single mothers or women with several children miss more appointments? Is transportation to appointments more of a problem for women who live in rural areas? Are any client characteristics commonly related to important outcomes such as birth weight of the the baby? Deciding how to collect enough client and service data to give useful information, without overburdening staff with unnecessary paperwork requirements, requires a lot of planning. Larger agencies often hire experts to design data systems, which are called MIS or management-and-information-systems. If you are working for an existing agency, your ability to separate out unit costs for services or outcomes may depend on the systems that are already in place for budgeting, accounting, and collecting service data. However, if you are in a position to influence these functions, or need to supplement an existing system, there are a number of texts that discuss the pros and cons of different ways of budgeting, accounting, and designing MIS or management-and-information-systems.
Most often, cost-effectiveness and cost-benefit studies are conducted at a level that involves more than just a local program. Sometimes they also involve following up over a long period of time, to look at the long-term impact of interventions. They are often used by policy analysts and legislators to make broad policy decisions, so they might look at a large federal program, or compare several smaller pilot programs that take different approaches to solving the same social problem. People often use the terms interchangeably, but there are important differences between them.
Analysis of cost of production, works, services provides an opportunity to identify how efficiently resources are used in the production process, storage and marketing, as well as to give a correct assessment of company's profitability and its sustainability in a competitive environment. The research of the composition of production costs allows to identify the main directions of material and monetary flows in the enterprise, which should be given special attention. And generating tables and graphs of the cost structure for a few years to characterize the dynamics of the movement of certain items of expenditure. Perform analysis of production costs for example in industrial production include the following cost items:

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  Material costs;
  
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  Fuel and energy;
  
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  The cost of staff wages and royalties;
  
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  The costs of maintenance and operation of the equipment;
  
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  Production (workshop) costs;
  
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  Overhead expenses
  
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  Production of the marriage;
  
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  Other costs.
  

Depending on the specifics of the company, the cost structure may change to include additional categories of basic expenses. To explore changes in indicators of the cost in time compiled tables and graphs that use accounting data for several years, and also planned indicators of production costs. First analyzes the indicator of the total cost and its structure, as well as increased costs in the costs per ruble of output. They give an idea about the General state of efficiency and intensity of use material, financial and human resources of the enterprise and the priorities for further research costs. An inevitable part of a project business case and a cost-benefit analysis are certain success measures. While the set of indicators needs to be in line with the organization’s requirements, there are in fact a number of very common indicators that are introduced below. These success measures allow project managers to conduct a balanced cost-benefit analysis that covers different aspects such as profitability, liquidity and riskiness of project options. At the same time, these indicators are comparatively simple to calculate and easy to understand in the course of stakeholder communication. For more in-depth study of the changes in the set of indicators ,cost and creation cost with the organization’s requirements, are
indicators of the cost of individual product. It also discusses the cost structure, their level of influence on the formation of the profit of the individual product and of the enterprise as a whole. Next is the calculation of deviations of actual values from planned cost, the reasons of the overspending in individual line items, identify the causes of defects and other non-production losses, developing a plan to reduce production costs.
In this age of computer technology we can not forget about the use of mathematical models in the study of Economics. Correlation analysis will identify the causal relationship of cost changes with various factors that directly or indirectly affect production. Here can take into account such factors as labor costs of staff as a whole or by categories, power, capital to labour ratio, the cost of new technologies.
With the increase in the size of the firm, the economies of scale also increase and as a result the cost of per unit production comes down. There is a positive relation between the cost and the output, as the output increases the cost also increases and vice-versa. Likewise, the price of inputs is directly related to the price, as the input price increases the cost of production also increases. But however, the technology is inversely related to the cost, i.e. with an improved technology the cost of production decreases.
Thus, the cost analysis is pivotal in business decision-making as the cost incurred in the input and output is to be carefully understood before planning the production capacity of the firm. A cost-product analysis is an economic evaluation of investment alternatives and project options with respect to their profitability and liquidity effects. It can also consider non-financial and qualitative aspects which however may or may not be reflected in the forecast of cost and benefits.
Besides forecasting investments, cost and benefits over an individually defined time horizon, a cost-benefit analysis usually involves a number of indicators. These measures aggregate forecasts and assumptions into catchy numbers that can be used for comparison and communication purposes.
Discounting cash flows, determining the amortization time, and calculating return rates are the most common approaches for calculating key performance indicators of a forecast in a cost-benefit analysis. We will cover these approaches in detail in the next section.
There are several reasons for using a cost-product analysis. The most obvious one is to determine the expected financial returns and profitability of an investment or a project. Subsequently, different options can be compared with each other based on cost-benefit analyses. This can be the basis for decision-making and the selection of the alternative or option to go for source. This is a typical step before project initiation and often part of a project business case. The initial cost-benefit analysis results also serve as a baseline for the measurement of success in an ongoing project. Thus, they help project managers, sponsors and other stakeholders to measure, monitor and manage the value a project is creating against the original expectation.
Although the cost-product analysis is not an original risk management technique, its results can be used to assess and consider certain risks of a project. An example is a benefit-cost ratio greater than the closer it gets to 1, the higher the risk that even small deviations from the forecasted benefits lead to a loss-producing project.
On the other side, discounted cash flow-based approaches can be calculated using a risk-adjusted discount rate. This allows taking inherent risk into account when net present values or benefit-cost ratios are calculated.