Many people have a very simplistic, if not naïve, view of what cost means. This is probably because many people only think of their cost as the price they see in stores. The reality is that cost can take many views depending on the perspective and information needs of the user. Consider the soup can below.
Most people think of the cost of the soup can as the price stamped on the bar code and think that cost is a very simple concept. They are confusing the price they pay and while this is the cost to them it is only one way to look at the cost of the soup can.
What is the Manufacturer’s Cost Perspective?
From the manufacturer’s perspective the cost of the soup can looks quite different. The manufacturer is concerned with the purchase cost of cans, labels, tomatoes and all other ingredients that go into making soup. There are also worker salaries and the costs of equipment to process, cook, fill, and label the cans. There is also marketing and distribution cost to consider and the cost of the factory itself.
To determine the cost of producing a can of soup the producer must consider all the costs of the operation. If the producer has only one product this is easier (at least annually) because the external accounting systems of the company capture all cost and it is all for tomato soup.
However, it is very likely that the producer makes numerous types of soup and maybe even other types of canned goods. It is far beyond the scope of external reporting to determine the cost of each type of soup. This is where cost accounting or managerial costing becomes necessary. It can be a complex problem to determine what portion of each cost element is related to tomato soup production.
Consider the portion of the factory that does the canning process. It is supplied cooked soup, un-sealed cans, and can tops. It puts the he soup in the, places the can lid on top and seals the edges so they won’t leak.
Determining the cost of canning each product means determining the cost of each of these cost elements and then distributing that cost among all the products produced in the canning department. Some cost elements are more difficult to determine. Consider the factory’s rent.
We undoubtedly know the total rent bill for the factory, but must somehow determine how much is related to the canning department. Once we do then it would have to be further distributed among the various soups produced. This is called a two stage allocation process. (See blogs on allocation.)
Why Would the Manufacturer Want to Know the Cost?
Knowing the cost must provide some benefit to the manufacturer that offsets the cost of the cost accounting effort. There are several potential benefits. One is that the manufacturer might want to know the cost of a can of soup before setting the price given to its grocery store customer.
If the producer just matches the price of a competitor he still needs to know the cost in order to know if the product is generating a profit or is being sold at a loss! A product that is losing profit is not a good thing if the company is to continue in business. On the other hand, too much profit might provide a “price umbrella” that would encourage competitor companies to enter the business.
Another reason for knowing cost is managing the performance of the operations. Managers at various levels are given targets for cost and their performance is judged on how they do. One way to think about this is as a process control. If costs are going up perhaps there is a problem somewhere that needs to be identified and corrected to remain competitive. If costs are going down perhaps there is an improvement that could be applied elsewhere.
Consider Cost Issues in Other Parts of the Supply Chain
The grocery store has a completely different perspective of the cost of soup. The grocer buys boxes of the cans and must consider inventory holding costs and the labor of stocking shelves and checkout. There may also be costs of obsolescence if sell-buy date is passed. The grocer will also include cost of the store rent, utilities, insurance etc.
The farmer has costs too. He must buy seeds, prepare the field, plant, weed, water, and harvest. The cans also have a supply chain that starts with digging ore, smelting, refining, casting, rolling, and forming. The paper supplier also has a supply chain reaching all the way back to harvesting trees. Even the energy used to boil soup has a supply chain.
Each node in every supply chain has a perspective on the cost of a can of soup.