Key Cost Relationships

As I read the chapter I was beginning to see that understanding key cost relationships was created to understand the relationship of costs between that of a firm and its customers. A quote really stood out to me while reading this chapter, the one by Kazuo Inamori, ‘Too many people think only of their own profit. But business opportunity seldom knocks on the door of self-centred people. No customer ever goes to a store merely to please the storekeeper’. This just really highlighted to me that nobody will do anything unless it is a profit for them. I can understand what Martin meant when he wrote that ‘a firm’s relationship with its customer is one of exchanging values’. If a business does not see value is selling an item at a certain price, and does not see a profit, then it will not sell it at this price. Vice versa with customer’s. If a customer does not think the exchange of their money for a firm’s product of service is not of value to them, then they will not do it.

As I kept reading through the chapter, there were a few terms that stood out to me such as indirect and direct costs, and cost objects. I classify cost objects as an item in which costs are being measured separately. I can see that is a key concept that is used by managers when they manage the costs of their firm. I classify direct costs as, a cost that can be traced back to its cost object. It is a price that is associated with the production of goods or services. Whereas indirect costs are costs that are not directly associated with cost objects. Indirect costs are costs such as administration, personnel or security costs. This got me thinking about how I have always had an interest in knowing the costs associated within a business. I always like work out how many hours I would need to work, at my hourly rate, to be able to afford a product or service that I want. This would help me decide whether this item was actually worth it or not for me. But how do firm’s work out the price of a good or service, and what do they deem to be beneficial for them? I am keen to find out more.

The next key concept that really stood out to me was the functional-based and activity-based costing systems. I really enjoyed reading through this part and working out the differences between these two costing systems. I define a functional-based costing system as the total costs of all of the activities that are performed by a functional department. It also includes the costs associated with a work group or on an individual level. Fixed costs can be assigned to production overhead to output, on a per head/unit basis. An advantage of a functional-based costing system is that it can be more useful for short-term investors. It can be used to provide a big picture of company expenses, and it shows whether a business if good at managing its costs. Whereas a disadvantage of a functional-based costing system is that it can’t provide the insights that the activity-based costing system can for internal decisions made by management.

I define an activity-based costing system as it assigns costs based on activities performed within a business. It doesn’t add all of the costs that are incurred in individual departments. This costing system considers the time and space that is required for all of the tasks, as well as the number of units that are produced, to work out the cost-efficiency of different operations. I liked the following example, ‘Let’s figure out how much you are spending on utilities to create a product. To do this, you estimate that your total utility bill is $20,000 for the year. You determine that the cost driver impacting your utility bill is the number of direct labour hours worked. The number of direct labour hours worked totalled 1,000 hours for the year. Divide your total utility bill by your cost driver (the number of hours worked) to get your cost driver rate. Your overhead application is $20 ($20,000/1,000 hours). For this particular product, you used utilities for 3 hours. Multiply the hours by the cost driver rate of $20 to get $60’ (https://www.patriotsoftware.com/accounting/training/blog/activity-based-costing-small-business/ ).  I can see that an advantage of an activity-based costing system is that you can really analyse that profit or contribution from each different department, and it can help with product pricing. Whereas a disadvantage of this costing system is that it is much more time consuming compared to the financial-based costing system.

The next section that I found really beneficial was the difference between fixed and variable costs. My understanding of these costs is that a fixed cost stays the same, regardless of the amount of production that goes into something. Whereas a variable costs varies with the amount of production that goes into a product. This got me thinking about a company that manufactures anything. They would be watching to see if a product is popular with their customers, if it is, then they would produce more of that product. Vice versa, if a product is not popular with customers, then they wouldn’t produce much more of that product. That’s where a variable cost would come into play.

The final section that really stood out to me was contribution margins. I loved the example that Martin used and how he shows the maths calculations associated with the example. I always learn better when I can see an example in front of me, and if there is a description of how that equation was done. So a contribution margin shows the money that is generated for each of the business’ product sold, after taking away the costs associated. I am still not 100% on this section, but I know when I get stuck into my own company’s contribution margin, I will understand it a whole lot better.

After reading this chapter, I am feeling excited to continue on with the assignment, and put all of these terms into use when analysing my firms financial statements. I feel as if I need to practice working out the fixed and variable costs to understand them a bit more, as well as the contribution margin.