The question “What did it cost?” is an important one for managers to answer in many different organizational settings. Arriving at an answer can be much more difficult than it might first appear. Obviously, the question is rather easily answered if we are discussing the purchase of inputs (supplies, labor, and so on) for a production or service-delivery process. Even calculating the full cost of a unit produced—be it a mousetrap or a manicure—is relatively easy as long as the organization is producing goods or services that are completely homogeneous. Complications arise, however, when we introduce multiple goods and services into an organization, particularly when we use different kinds and amounts of resources to manufacture the goods or provide the services.
Additional complications arise when we move from the computation of full cost to the question of how costs will change under different decision-making scenarios. Indeed, one of the most significant concepts in cost accounting is the notion that different costs are used for different purposes. Full cost accounting does not address how costs will vary with changes in volume (or other factors, such as time). Yet information on cost behavior is important for several types of decisions that managers make on a fairly regular basis. Using full cost information as a basis for deciding which costs will change, or how costs will change under different scenarios, can lead managers to make decisions that are financially detrimental to the organization.
The first section of the note discusses full cost accounting, its uses, and the managerial choices that are involved in setting up a full-cost accounting system. The second section of the note, on differential cost accounting, first addresses the nature of costs. Once the various terms and concepts have been defined, we take up the subject of cost-volume-profit (CVP) analysis. We look at CVP analysis (sometimes called breakeven analysis) in its most basic form, and then examine a variety of special considerations that can serve to complicate it. Finally, the note discusses when differential costs should be used rather than full costs, and some of the complications in using them.
FULL COST ACCOUNTING
USES OF FULL COST INFORMATION
Information on the full cost of carrying out a particular endeavor has three basic uses: pricing, profitability assessments, and comparative analyses.
One of the basic functions of cost information is to assist management in setting prices. Clearly, cost information is not the only information management uses for this purpose, but it is an important ingredient in the decision-making process. Many firms are “price takers;” that is, they must accept whatever price prevails in their market. In these instances, prices are not based on costs but on the market. For other firms, especially market leaders, cost information is much more important to the pricing decision, although even these firms must consider other factors.
Some health insurance companies pay hospitals and other providers (such as nursing homes and home health agencies) on the basis of cost. Because many people believe that cost-based payments have contributed to the rising cost of health care, some insurers have shifted to fixed price arrangements, where the price usually is based on a patient’s diagnosis. In these situations, a healthcare provider becomes a price-taker, meaning that an accurate assessment of full costs is an important ingredient in management’s decision making.
Some firms price one product below full cost to increase its sales, which may lead to the sale of other products at prices set well above full cost. Hewlett-Packard, for example, may sell its printers below full cost in an effort to maximize printer sales. Once consumers have printers, they will purchase toner cartridges and paper, which is where the company earns most of its profits. Of course, if a firm is to deliberately price below full cost, it must have a good understanding of its costs. Thus cost information remains an important ingredient in price setting.
Firms that are price takers or that engage in cross-product subsidization, must calculate full costs if management is to know whether a particular product is profitable. There are a variety of actions that management might take if a product is not profitable on a full-cost basis, which we will examine later in the note. For the moment, it is sufficient to say that if a product’s price is not greater than its full cost, it is a “loss leader.” . . .