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How and Why Unit Cost Change
A quick guide to why actual results are often different from planned results.
Management Accounting Analysis
The financial management pathway to understanding what happened.
Using Unit Cost at Various Levels
A brief description of how unit cost information can be used.
The Benefits of Unit Cost Management
What managers gain from using unit cost management
Changes in quantity of output
 The unit cost goal, the planning target, is based on the estimated volume of output or workload expected. If actual output is different from expected output, actual unit cost may be different from the unit cost goal. A change in unit cost as a result of changes in output (workload) can be seen in Figure 4. In Figure 4, the actual output is less than the estimated output and the resultant unit cost is higher than the unit cost goal. The actual unit cost can be higher or lower than the unit cost goal, depending on where on the average total cost curve the unit cost goal is located.
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Figure 4 displays the
relationship between
quantity and unit cost
as they relate to fixed,
variable and total
costs. |
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 Managers should be concerned with how sensitive their unit cost goal is to changes in production volume. When the current level of production is low compared to production capacity, increases in output tend to reduce unit cost. This can be seen in Figure 5, where, as output increases from output point A to output point B, unit cost falls. When production levels are high, as represented at the output level at point C, increases in output may increase unit cost as a result of taking costly measures such as paying overtime premiums or renting additional facilities. Movement from output point C to D illustrates this change. For many processes, there is a range of output over which the unit cost is relatively insensitive to changes in output. This is depicted in Figure 5 as the flat area of the curve, between output points B and G which, for illustration purposes, also have the same unit cost. |
Figure 5 demonstrates
the unit cost sensi-
tivity to changes in
output levels. |
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Changes in productivity
 Productivity can change for a variety of reasons. These include changes in the basic production process (e.g., substituting machines for labor), specialized education or training for employees and changing the technology employed in the production process (e.g., using newer computers).
When productivity improves, we can produce the same output with less resources, and thus less cost. When this occurs, we are changing our cost function and lowering costs at all levels of production or output as illustrated in Figure 6. Changing technology to produce output should be done with the goal of improving productivity and lowering total cost.
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Figure 6 compares
the effect of a change
in productivity which
lowers unit cost at
every level. |
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| Changes in input costs
Inputs to the production process are goods and services producers purchase to create output. A change in the purchase price of one or more inputs can also change the unit cost. Situations such as material quantity discounts could lower variable costs while paying overtime for labor costs could raise unit costs. Any change in total cost when workload remains constant will clearly cause a change in unit cost. Changes in the cost of inputs can lead managers to substitute lower-cost inputs for higher-cost inputs. For example, if an industrial activity has a variety of material technically acceptable for a certain job, managers choose the lowest-cost material, assuming all are equally available. |
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Management Accounting Analysis
Using the unit cost goal as a benchmark or measure against actual unit cost enables managers to perform variance analysis. Variance analysis is a managerial accounting method used to determine the difference or variance between actual operating results (actual unit cost) and expected results (unit cost goal). This analysis helps management understand where and why differences occurred. In conducting variance analysis, different aspects of actual unit cost (input costs, quantity of output and productivity) are compared with the unit cost goal (the "should cost" target - expected input costs, planned output and planned productivity). The variances between the actual unit cost and unit cost goal may be the result of any or all of the factors described in the previous section.
In any case, properly executed, variance analysis provides management the information necessary to target production processes in need of management attention. If, for example, less output is produced and the actual unit cost exceeds the unit cost goal, management will need to evaluate the following: why workload is not materializing; whether or not workload will increase later in the year; how costs can be contained in order to meet the goal; or if an adjustment to the unit cost goal can be supported and is necessary. |
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Using Unit Cost at Various Levels
Because unit cost requires that we identify outputs and assign all costs to those outputs, it is a useful management tool at all levels of the DoD. At each level, the focus on total cost provides useful information for comparisons of alternatives. It helps us to make the decisions necessary at each level to ensure that we use our resources efficiently and effectively.
USD (Comptroller) and Component Level
Unit cost provides a consistent managerial framework for comparing dissimilar operations. It allows senior leaders to assess, on one dimension, how well an organization has met corporate expectations. Unit cost also enables senior leaders and analysts to determine the total cost of each of the various outputs produced. It helps managers consider whether resources should be shifted from production of one output to the production of another.
Unit cost also provides an indicator of performance among producers of similar output. It is not, however, the only measure of performance. Other measures of performance, such as quality and timeliness, are equally important.
Management headquarters level
At the management headquarters level, unit cost provides those responsible for overall management of a support function the ability to view total cost as it relates to total work accomplished, across individual activities. The distributed unit cost goal provides a financial benchmark for a support area manager to evaluate subordinate activities' performance. The unit cost methodology provides a consistent method of analyzing activity performance over time and among producers of similar output.
Provider/Producer or activity level
At the producer level, unit cost encourages managers to focus on both the total cost of producing the activity's output and the production process. This focus on cost and process encourages consideration of alternate methods of production and provides consistently defined benchmarks for the local activity over time. Unit cost provides activity level managers with better cost visibility by helping to identify costs and cost drivers as they relate to output. Once an activity is aware of what an output costs, managers will be able to make more informed decisions and can better determine how to reduce and eliminate costs and cost drivers. |
Varience analysis is
an investigation of the
differences between
the actual unit cost
and the unit cost
goal. Variance
analysis helps man-
agers understand
"what happened." |
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| Cost drivers are factors that cause changes in the cost of an output. To the extent management can control cost drivers, they should be evaluated to determine whether or not they add value to an output or result in improved customer support. With the ability to identify cost drivers through unit cost, an organization can minimize or eliminate costs and ultimately reduce the total cost and cost per unit of output. For example, one of an organization's outputs may be employees paid. In reviewing the cost per employee paid, management may identify significant labor and postal costs associated with mailing checks. Action could be taken to reduce these costs by electronically transferring the funds directly to an employee's personal financial institution in lieu of mailing checks to employees. In this case, one cost driver is the postage for checks mailed. Moving to electronic transfer of funds might result in reducing the cost per employee paid, by reducing the cost driver, postage. |
Cost drivers are
factors that cause
changes in the cost of
an output. |
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| Unit cost also provides managers the flexibility to make cost trade-off decisions between elements of operations cost. Managers are freed from compartmentalized funding (e.g., set amounts for travel or supplies) and are allowed to make trade-offs between these types of costs as work requirements demand. For instance, if the purchase of one personal computer would improve work methods and would reduce personnel requirements, a manager operating under unit cost may have the authority and flexibility to make that trade-off decision.
Managers actively and routinely compare actual results with the unit cost goal (i.e., conduct variance analysis) and use other nonfinancial benchmarks to help target areas needing management attention. Proper use of the unit cost methodology provides additional information for managers to evaluate operating results and reward performance. Monthly comparisons between actual unit costs and unit cost goals enable managers to understand the results of monthly operations and trends over time. End-of-year results indicate if the activity's management completed the mission within financial expectations and provide a measure of organization and management performance. |
Unit cost gives man-
agers the flexibility to
make trade-off
decisions. |
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A powerful local management approach in using unit cost goal information is to make each subordinate part of an activity (e.g., branches, departments or divisions) responsible for its share of the unit cost for each output. To do this, activity managers must implement a local process to break the unit cost goal to the lowest level (e.g., work centers) that incur costs producing an output. If unit cost information is provided and used in this manner, work center supervisors and employees have a better understanding of their contribution to the actual unit cost and can actively review their processes with the goal of controlling their costs while improving performance. This is the essence of dynamic interactive management and employee empowerment. This approach requires active management support and the resources to develop and use local information systems capable of accomplishing this task. True benefits come about only from long term usage.
Tools that can help process examination include business process reengineering and activity-based cost management. These tools help managers better understand the production process of a support organization, and in particular help management better manage processes.
The use of unit cost to manage can highlight possible inefficient use of scarce resources and motivate the search for alternative methods of production. For example, contracting out a part of the production process that organically is classified as a fixed cost, but as a contracted function becomes variable, might be one solution that adds managerial flexibility. |
Local Management
can make each subor-
dinate part of an
organization respon-
sible and accountable
for its share of the
unit cost for each
output. |
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The Benefits of Unit Cost Management
Executives and managers who integrate unit cost principles into their workplace culture will improve decision making capabilities by having better, more meaningful information available. The unit cost approach has the advantage of encouraging employees at all levels to look at all costs in terms of the output of the business. Using unit cost principles will not solve the problems of managing an organization or function nor is it a substitute for sound management or leadership. Rather, unit cost is a powerful tool useful in the management process.
Employing unit cost principles moves DoD toward modern business practices, better meeting today's work place challenges. This means encouraging employees to reengineer business practices and production processes, thus giving employees a stake in the success of the "corporation." Engaged employees take responsibility and ownership of their actions and become more aware of the long term consequences of today's decisions. |
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Benefits
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Provides a capability to
determine total production
costs traced to outputs.
Assists in targeting areas
needing management
attention.
Encourages the consideration
of alternative methods of
production.
Highlights operational
efficiency.
Provides financial
benchmarks for activity
performance.
Provides more information
to measure and reward
performanace.
Provides a common
managerial framework
among support activities. |
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