Inventory Costs and Factors – Production and Operations Management
Whatever the basis, the inventory cost is essential part of the decision-making process in a company. However, a distinction needs to be made between the inventory cost for accounting purposes and the cost for managerial decision-making. Financial accounting is focused on satisfying the statutory requirements of a company in terms of the profits and losses incurred by the company being made public, which is quite different from costing for internal decision-making. Although Cost Accounting fills much of the latter requirements, it is still not totally decision-oriented.
DISTINCTION BETWEEN FIXED AND VARIABLE COSTS
Fixed inventory costs refer to those costs which do not change in respect to the volume of output or in the level of activity as an example, the rent paid for office buildings or the amount of allocated depreciation of machinery in the company, remains static without any influence of the output. Sometimes, the term, ‘overhead’ denotes it , in financial accounting systems. This leads to confusion with the fixed cost. In fact, ‘over- heads’ could be either fixed or variable. Fixed inventory costs point to the no variation in costs against any decision to change the output quantity.
For example, a factory producing one lakhs units instead of 75,000 units per year, the fixed cost would remain the same for both outputs The decision as to whether a inventory cost is fixed or not fixed is related to the question of whether the output should be increased or not. The distinctions between the costs are according to the question to be answered.
The costs which are affected with production output is called as variable costs. If there is an increase in the output of the production from 75,000 units to 1,00,000 units, variable costs also will increase. For exam ple, the raw material needed will vary and cost of of the raw materials is a variable cost. Similarly, more labour hours are to be spent in making the finished product in more quantity; and therefore, the labour-hours are also a variable cost.
If the production capacity in the earlier example were to be increased to 1,50,000 per year, then the plant capacity would be inadequate and therefore, more machinery would have had to be procured increasing the fixed cost. This means for a range of 75,000 to 1,00,000 units per annum the fixed costs were ‘X’, whereas for the range from 1,00,000 to 1,50,000 the fixed cost could have been X plus another Y. Many people would like to term such cost-behaviour as semi-fixed; but, the concept of semi-fixed and semi-variable costs is only notional. The fixed or the variable nature of the costs refers to a particular decision situation.
The electricity, steam, and water consumed in a plant could be treated as a fixed cost provided there is no such decision regarding the output level being made. But when the decision regarding increasing or decreasing the output is to be made, such costs can partially vary with respect to the level of activity. Although illumination load might remain the same, the load on the machinery will increase. Although the basic heating facilities for the plant will have to be provided, additional steam input might be required to heat or to dry or to process the raw material. Even the inventory cost of supplies such as cottonwool, grease, etc. may be variable to some extent for this decision. A decision has to be weighed in terms of its impact on the variable components of cost. Therefore, the cost for one decision cannot be treated as being the same for another kind of a decision.
Fixed Costs, F = Rs. 10, 00,000
Variable Costs, V = Rs. 10 per unit
Revenue, R = Rs. 15 per unit
Total costs, T. for a volume of output = (Fixed Cost + Variable Cost for that volume of output) Break-Even Point (or Break-Even Volume of Output), BEP, is where the Total Revenue and Total Costs are equal.
BEP = F/(R-v)
The fixed cost was taken to be Rs. 10,00,000 over the span of output pertaining to the decision. Similarly, the variable cost of Rs. 10 per unit was considered not to vary (per unit) over the span of the decision being taken. One has to note that the variable costs do not always remain the same in terms of their incremental value. The variable cost might increase (per unit) at a certain rate during a certain range of production and at another rate during another range of production. Similarly, as was said earlier, the fixed cost could be different for different ranges of production activity. If one takes these into account, the Break-Even Analysis will be more accurate.
It is possible that even two break-even points may emerge. These will be the boundaries within which the production level has to be confined in order to make a profit. Thus, break-even need not necessarily be one particular level of activity; but, depending upon the behaviour of the variable and fixed costs one can have multiple breakeven points showing the desired output volume ranges for profitability.
OPPORTUNITY COSTS AND THEIR USE
The opportunity cost refers to the gain made by deciding the best of the available alternative opportunities and not loosing on the benefit of the decision. For example, an amount of Rs. 10,000 kept at home against being a deposit in a bank, the decision to keep the money at home has an opportunity cost of the 4% bank interest which you would have earned on Rs. 10,000. Conversely, the opportunity cost of money at home equals zero as, no interest is earned.
SUNK COSTS
It refers to the costs which are of no use for future.
DIRECT AND INDIRECT COSTS
The word direct’ refers to the traceability of a cost-factor to a product. The power consumption in a plant producing a number of products cannot be traced or directed to a particular product a part of the power consumption is a variable cost, yet it is not a direct cost. In fact, it is an indirect cost.
OVERHEADS
It includes both the fixed and the variable components. Such a distinction may be extremely crucial for a management decision to either increase or decrease the level of activity in the organisation. Overheads are allocated to different products as per different basis.
CONTROLLABLE AND NON-CONTROLLABLE COSTS
There are various instances when certain departmental or divisional managers have to explain for cost-variances over which they have little or no control. Distinction between the controllable and non-controllable cost ensures more effective and responsible accounting.
RELEVANT COSTS AS DIFFERENT FROM ACCOUNTING COSTS
Accounting costs are usually past-oriented and report the status of the income or profit-and- loss during a given period, whereas cost data are needed to help the manager in his choice of a future course of action.
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