Understanding Activity Costs and the Rate of Output
The operation of an organization can be divided into activities. These activities are tasks performed by the organization to help achieve its goals.
Activities are units of work within the organization that are the subject of cost-benefit analysis Opens in new window.
- designing products,
- purchasing materials,
- hiring employees,
- making product parts, and
- responding to customer queries.
Specific activities that add to customer value are identified as the value chain Opens in new window of an organization.
By adopting an appropriate strategy for customer value and activities linked to this strategy, customer preferences can be met and organizational value created.
An organization must decide whether to engage in a particular activity and how to engage in it. For example, an organization must decide whether to advertise a certain product in print media, on the Internet, or not at all.
Making planning decisions with respect to activities requires knowledge about their benefits and costs Opens in new window. In this post, we examine the cost characteristics of activities.
Activities use a variety of resources and are, therefore, costly to perform. In general, the cost of the activity is related to the intensity of the performance of the activity.
For example, surveying 60 customers is more costly than surveying 10. The relation between activity costs and the rate of output of the activity (e.g., the number of customers surveyed) can be described by stages.
These stages include the cost of initiating activities, the cost of activities at normal rates, and the cost of activities when exceeding capacity.
While our focus is on the rate of output, we illustrates additional ways to capture activity costs.
Costs of Initiating ActivitiesCertain costs must be incurred before activities can begin.
These start-up costs may include the purchase of materials, machines and facilities, the hiring of employees, and designing and planning the activity.
For example, a typical activity performed by an organization is the payment of wages to employees.
- The activity must be designed to record hours worked, determine deductions, and distribute paychecks.
- Employees in the payroll department must be hired and trained.
- Equipment must be purchased.
These start-up efforts must occur even if the organization only has a few employees to pay. Therefore, the cost per payroll check issued could be very high, if only a few are issued.
In summary, the cost per output of an activity is generally quite high for the first few units of output.
Costs of Activities at Normal Rates
Once the activity is designed, sufficient equipment has been purchased, training is complete, and employees have learned to perform the activity, an activity achieves a normal rate of operation.
In the example of the payroll activity, considerable costs are incurred to initiate the activity.
But once several payroll checks have been processed and issued, considerable learning has taken place. At that point, further checks most likely can be issued more efficiently. The cost per additional check probably would be relatively small.
Cost of Activities When Exceeding Capacity
The normal rate of an activity is not constrained by the size of the facility, equipment, or employees.Capacity is a measure of the constraints on activities.
Capacity constraints include the physical size of the facility, the number of machine hours available, and employee time.
Additional costs arise because limitations in facility size cause congestion.
Extra equipment might have to be purchased, or existing equipment might become over-used and additional maintenance costs incurred.
Lost sales arise as customers who are not willing to wait go elsewhere. Also, employees might have to be paid overtime.
An organization can increase capacity for an activity, but the cost of buying a new facility or hiring and training a new set of employees might be high, especially if the firm must do it quickly.
Therefore, the cost of additional output when exceeding capacity is greater than under normal operations.
Graphical Analysis of Activity Costs and the Rate of Output
The common characteristics of how costs change with increased output of an activity during a period of time are graphed in Figure I.
|Figure I | A non-linear cost curve|
The curve represents total cost of the activity at different rates of output.
- The total activity costs might rise sharply at low rats of output (point A) because of start-up costs.
- Activity costs then increase moderately when normal operating rates are achieved (point B).
- When output rates near capacity (point C), total costs begin to rise sharply again due to congestion and other capacity-related costs.
Marginal and Average Costs
The marginal cost of an activity is the cost of producing one more unit of output, given the existing rate of output.
- Themarginal cost of the activity is the slope of the total cost curve in Figure I at each rate of output; the steeper the slope, the higher the marginal cost.
- The marginal cost is highest at very low output rates (point A) and output rates near capacity (point C).
- The marginal cost is lowest at normal operations (point B) between these extreme rates of output.
The marginal cost is useful in making decisions about small changes in output rates of activities.
Given a particular rate of output, the marginal cost represents the cost of another unit of activity output or the cost of savings of one less unit of activity output.
In the case of the payroll activity, the marginal cost would be the cost of issuing one more payroll check (or the cost savings of issuing one less check), given a specified level of payroll checks being issued.
The average cost per unit of activity is calculated by dividing the total activity costs by the number of units of output.
- For the pattern of total costs in Figure I, the average cost per unit is very high at low levels of output but declines as output increases.
- The average cost per unit only increases as output nears capacity.
The average cost per unit is commonly calculated by organizations. For example, a firm might calculate the average cost of issuing a payroll check by summing all the costs related to payroll and dividing by the number of checks issued.
This figure does not reflect the cost of issuing additional payroll checks, as it includes the initial start-up costs, which will not be incurred again if additional ones are issued. Therefore, the average cost should not be used in decisions to make small adjustments to the rate of output.
Beech Canoe Refinishing specializes in the refurbishment of upscale custom-made canoes. The company estimates the following total costs for refurbishing canoes in one month:
|Number of Canoes||Total Cost|
- What is the marginal and average cost for each level of output of the refurbishing activity?
- The company is currently refurbishing 80 canoes per month. A small resort would like to bring in 10 canoes for refurbishing this month. The resort is willing to spend $90,000 for the refurbishing job. Should Beech accept this additional job?
|Number of units||Total Cost||Marginal Cost||Average Cost|
2. The company should not accept the offer because the marginal cost of refurbishing 10 additional canoes is $100,000. The average cost of $52,222 should not be used for this decision.