Wednesday, August 10, 2011

Common Cost Accounting Terms Used In Cost Based Negotiations:

In my book I spend several chapters on cost. One chapter explains all the different costs that can exist in a procurement relationship. Another chapter discusses negotiating cost. If you are going to do cost based negotiations you need to be able to speak the language and understand what all of the cost accounting terms mean. Since negotiating cost is one of the key portions of negotiations I wanted to share a list of the most common cost terms.

Actual cost is the actual expenditure for labor and material.

Allocated cost Is the cost of supporting departments that may not be directly attributable to the product or service. Allocated cost is shared by a formula.

Administrative expenses are usually allocated on the basis of total cost of products (i.e. labor plus materials plus manufacturing overhead).

Budgeted cost is based on a budgeted amount that is carried in the estimate.

Capital assets are items that must be depreciated over defined depreciation schedule.

Cost analysis is the review and evaluation of a supplier’s proposed cost or pricing data to determine what the cost should be, assuming reasonable economy of scale and efficiency.

Costs are expenditures for material, labor, and burden (expenses) incurred in the production and sale of an item or service.

Contingencies are not costs, they are reserves (when accounted for) or allowances (when built into the prices) to cover events or situations that may occur, such as possible increases in material prices, lower yields, higher labor costs, or delays in the schedule. When the contingencies occur they result in cost. If the contingency called for never occurs and they were treated as an allowance, they become an addition to the suppliers profit.

Direct costs are those costs that have been incurred and which can be directly traced to a given product or service. Direct costs can be charged directly to that of a given order, job or product or service. The most important direct costs are labor and materials.

Direct labor is the cost of all labor performed upon the product which changes the shape, form, or nature of the materials that are used in the product or service and includes: wages, fringe benefits, payroll taxes, bonuses, and other compensation.

Direct material is the cost of raw materials, purchased parts, and subcontracted manufacturing or services that become part of the manufactured product or service.

Expenses are purchases that may be expensed in the year purchased.

Fixed costs are not affected by production quantity or volume-period costs. Examples of fixed costs are depreciation, rent, and executive salaries.

Incremental costs are the costs to produce more of a unit or product, labor, material, etc. This is an important way to view costs particularly in the pricing of changes in work, material or scope or changes in production quantity or volume. Only the incremental costs should be relevant.

Indirect costs are those that do not result from the manufacture of a specific unit or lot or performance of the service, so that they cannot be charged directly, but must be allocated or apportioned to that product or service by some method of approximation.

Manufacturing or production overhead is indirect expense incurred in the manufacturing, conversion, or service delivery process. Manufacturing or production overhead expenses include Indirect labor, maintenance and operating supplies, and fixed or period charges (i.e. expenses not affected by quantity or volume of production) Among manufacturers, indirect labor would broken down into sub-categories such as production foremen, group leaders, clerks, and production material handlers, quality control and process engineering, procurement, materials and production control, including scheduling, receiving, and warehousing, industrial engineering, supervision, cost accounting and industrial relations. Non-labor expenses in manufacturing overhead include maintenance materials: spare parts, operating and repair materials, work performed by outside maintenance and repair contractors. Operating expenses such as building maintenance, depreciation, all perils insurance, taxes, fuel and non-production fuels and electricity, non-capital equipment and tools. Overhead costs also include expendables, office supplies, postage, rentals, non-production travel, depreciation and amortization, dues, memberships, obsolescence of raw material, and auto expenses.

Material acquisition rate would be a charge applied to the materials cost to cover the associated overhead and expenses that may not be directly attributable to the item. It’s an allocation of costs against each purchase expressed as a percentage of the direct material cost.

Non-manufacturing overhead includes all other indirect costs, such as selling administrative, engineering costs, research and development expenses, sales commissions, travel expenses, advertising, insurance on finished goods, taxes on finished goods, officer's salaries, office personnel salaries office stationery legal and accounting expenses, office supplies, telephone and related expenses, losses on bad accounts, contributions, etc.

Opportunity cost refers to profit that will lost from not taking a particular action.

Overhead costs are indirect costs that cannot be charged directly to a unit of product or service. They may be accounted for in one general account, or may be broken down and allocated against a more direct accountable function or department using an activity measure such as direct labor hours, machine hours or units produced. The approach used for assigning overhead can be extremely important as they can be used to unreasonably burden the cost of a product. Overhead cost and overhead rates can also be actual, expected or budgeted. Suppliers may have manufacturing or production overhead, selling and administrative overhead, and engineering overhead.

Period cost is a cost recognized in the period in which they occur.

Profit is not a cost. Profit is the return on the supplier’s investment for risk-taking, the use of their capital, and for managing production and operating performance. Suppliers profit goals may be calculated different basis depending on the Supplier:
Profit on Sale - Gross margin (GM),
Profit before taxes (PBT)
Profit as a rate of return on assets (ROA)
Rate of return on investment (ROI)
Profit as a percentage of cost
Profit through over-absorption or over-recovery of cost

Product costs are costs assigned to the product produced.

Relevant costs are costs that differ with alternatives.

Reserves are contingent costs that are accounted for to cover the cost of obligations that may occur in the future. For example many companies that offer warranties against defects will establish warranty reserves that are considered part of the cost of the product at the time of sale. Those reserves are used to pay for future warranty costs incurred.

Semi Variable. Semi-variable costs are a combination of variable and fixed. A certain portion is fixed and another portion varies based on the level of production.

Set up or tear down costs are associated with setting up the equipment for production and tearing down the equipment after production has been done. Set up and tear down costs are usually established in standard labor hours to perform the tasks and then should be allocated or spread over the production run.

Standard cost is a predetermined measure of cost based upon time and motion study, past costs and production experience, expected costs, theoretical costs or some combination thereof. Cost accounting systems may employ either actual or standard cost data.

Start up costs can be a hybrid between the variable cost and fixed costs of overhead, which result from a particular activity:
Special engineering from design or production.
Special Tooling - tools, dies fixtures.
Special set up costs such as purchase and installation of special machinery.
Rearrangement of physical manufacturing plant.
Loss of use of facilities during set-up.
Training costs for employees to implement / use new process.
Start-up costs may be accounted for in standard overhead accounts, but as the Buyer you would want them to be segregated. This is to avoid their being treated as recurring costs, rather than one-time or non-recurring expenses. You want to pay for the start up costs once, and not be paying for it over and over as part of some overhead rate.

Sunk cost refers to costs that are already incurred.

Unit costs are costs of a unit of product as incurred cumulatively through the production and/or distribution cycle or delivery of the service.

Variable cost. The cost will vary directly with production quantity or volume. Common variable costs are direct labor and direct materials.

Variances normally apply when standard cost approaches are used. Variances represent the difference between the actual costs you incur versus the standard cost. Variances may be favorable positive where the actual cost is less than the standard cost. A negative variance occurs when the actual cost is more than the standard cost. Suppliers track product cost variances or overhead variances. Buyer’s track purchase price variances.

All costs may be actual, budgeted or standard.