Different Meanings of Product Costs

Many cost terms used by organizations have ambiguous meanings. Consider the term product cost. A product cost is the sum of the costs assigned to a product for a specific situation, purpose, or question. Different situations may require or result in different measures of product cost, as the brackets on the value chain in Exhibit 2-11 illustrate:

• PRICING AND PRODUCT-MIX DECISIONS. For the purpose of making decisions about product mix, managers are usually interested in the overall (total) profitability of different products and, consequently, assign costs incurred in all business functions of the value chain to the different products. Similarly, managers typically make decisions about product pricing also based on product costs that include costs incurred in all business functions of the value chain.
• REIMBURSEMENT UNDER GOVERNMENT CONTRACTS. Government contracts often reimburse contractors based on the “cost of a product” plus a pre-specified margin of profit. A contract such as this is referred to as a “cost-plus” agreement. Cost-plus agreements are typically used for services and development contracts when it is not easy to predict the amount of money required to design, fabricate, and test items. Because these contracts transfer the risk of cost overruns to the government, agencies such as the Department of Defense and the Department of Energy provide detailed guidelines on the cost items they will allow (and disallow) when calculating the cost of a product. For example, many government agencies explicitly exclude marketing, distribution, and customer-service costs from product costs that qualify for reimbursement, and they may only reimburse R&D costs up to a point. These agencies want to reimburse contractors for only those costs most closely related to delivering products under the contract. The second bracket in Exhibit 2-11 shows how the product-cost calculations for a specific contract may allow for all design and production costs but only part of R&D costs.
• PREPARING FINANCIAL STATEMENTS FOR EXTERNAL REPORTING UNDER GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP). As we discussed in the previous two sections, under GAAP, only manufacturing costs can be assigned to inventories in the financial statements. For the purposes of calculating inventory costs, product costs include only inventoriable (production) costs.

As Exhibit 2-11 illustrates, product-cost measures range from a narrow set of costs for financial statements—a set that includes only production costs—to a broader set of costs for reimbursement under government contracts to a still broader set of costs for pricing and product-mix decisions.

This section focused on how different situations, purposes, and questions result in the inclusion or exclusion of the costs of different business functions of the value chain when calculating product costs. The same level of care in terms of clearly defining and understanding how costs are measured should be applied to each cost classification, or cost dimension, introduced in this chapter. Exhibit 2-12 summarizes the key cost classifications. Using the five-step process described in Chapter 1, think about how these different cost classifications help managers make decisions and evaluate performance.

1. IDENTIFY THE PROBLEM AND UNCERTAINTIES. Consider a decision about how much to price a product. This decision often depends on how much it costs to make the product.
2. OBTAIN INFORMATION. Managers identify the direct and indirect costs of a product in each business function. Managers also gather other information about customers, competitors, and the prices of competing products.
3. MAKE PREDICTIONS ABOUT THE FUTURE. Managers estimate what it will cost to make the product in the future. This requires managers to predict the quantity of the product they expect the company to sell as well as have an understanding of fixed and variable costs.
4. MAKE DECISIONS BY CHOOSING AMONG ALTERNATIVES.  Managers choose a price to charge based on a thorough understanding of costs and other information.
5. IMPLEMENT THE DECISION, EVALUATE PERFORMANCE, AND LEARN. Managers control costs and learn by comparing the actual total costs and unit costs against budgeted amounts.

The next section describes how the basic concepts introduced in this chapter lead to a framework for understanding cost accounting and cost management that can then be applied to the study of many topics such as strategy evaluation, quality, and investment decisions.