Oil and gas. Gas and oil. They make our cars go and they heat our homes. All in all, they’re pretty useful to have around, if we do say so ourselves. But oil and natural gas are finite resources—that means there’s only so much of them in the world. So oil and gas companies are always looking for the next great source of that ooey gooey nectar of industry, and those exploratory efforts can get expensive.
When cost accountants evaluate how much moolah these companies are spending on their exploratory efforts, one method they might use is called the “full-cost method.” This method basically takes every dollar spent, regardless of whether the effort was successful or not, adds it up, and capitalizes it. In other words, even if our latest geological survey of a potential oil field yields absolutely nothing, the costs associated with the survey are considered capital and not an expense. This can make our company look like it has a higher net income than it actually does. Which isn’t bad for us, because if our net income seems higher, we’re more likely to attract investors.
Which brings us to our next point: if we’re on the investor side of this whole situation, it would behoove us to do our homework if we’re considering buying into oil or gas. If we see that a company uses the full-cost method instead of the “successful efforts” method, which counts those failed ventures as expenses, we might want to dig a little deeper before we buy and make sure their financial picture is as rosy as it appears.
Related or Semi-related Video
Cost Accounting: What Are the Four Types...28 Views
And finance Allah Shmoop What are the four types of
costs Oh all right Well lots of things come in
fours legal's the horsemen of the Apocalypse and Stooges you
know don't forget ship Okay so in practical reality these
concepts actually matter how so Well think about your personal
budget The one you used to direct your day to
day expenses There are four universally accepted types of costs
for a regular person's budget rent Internet burritos and yes
video games Now think about a company As with your
budget well there are four types of costs that a
company has to consider the categories air well slightly different
though generally speaking of business has to keep in mind
these four kinds of expenses fixed variable semi variable and
step The categories correspond to how much the cost changes
When the amount of output changes you increase the amount
of stuff you make Well how much did that cost
change Not at all Well then it's a fixed cost
The cost changes proportionally with every increase in production Well
then that's a variable cost somewhere in between wealth And
that's semi variable or step Well you own a factory
that makes toothpicks for Gap tooth people made from exotic
hardwoods It's called the Dunaway Letterman Jack O Lantern company
Tough to fit on a mug but well you like
it You make one hundred thousand box of toothpicks a
month and you want to ratchet that number up to
one hundred twenty thousand boxes a twenty percent bump Well
how will the increased production effect costs Well the actual
cost will respond differently It depends on what category they
fit into Will all of the costs go up twenty
percent with this increase in production Yeah probably not Meaning
the company will scale You'll produce more and you'll have
higher profits So quick tour Here we go Fixed costs
don't change at all They stay the same no matter
how much you make that is fixed Like the toothpick
grinding floor the sawdust sucking system the factory building itself
fifty thousand units eighty thousand units a hundred thousand units
that fixed cost is all the same If you decided
to make eighteen million units Well then things would be
different But at this scale or this level it's all
fixed It's all the same The only big notable difference
is that the fixed costs and of the factory is
now amor ties over a larger number That is if
it cost twenty grand a month to rent that factory
and all the equipment in it If you made twenty
thousand toothpick boxes a month while the fixed cost per
box would be a buck if you made two hundred
thousand creep pick boxes in a month we'll then the
fixed cost per box would be a dime right That's
fixed It doesn't change month after month after month as
it Rikers and you basically save money when you have
big volume output Because the cost per fixed foot is
a flat variable costs are directly linked to the amount
of output Factories making and variable you know varies well
The increase in cost here is pro pie fortune All
make one more to thicken the variable cost increase accordingly
Why Well because you have to buy more raw wood
supplies to put through the system you have to run
the saws longer You have more sawdust to clean more
packing material to by someone Someone more Output demands more
input So think high brand fiber food something like that
okay Next semi variable costs have elements of fixed and
elements of variable costs Usually they have a fixed component
and a variable component like the electricity to run the
machine that puts the little plastic flew fi things at
the end of the toothpicks Turning it on takes a
certain amount of baseline electricity That part is fixed but
then running the machine takes a little extra electricity for
each flukey thing that gets installed That part is variable
so the cost of running the machine gets thrown into
the semi variable group A little bit fixed and a
little bit variable Got it Alright last category step costs
these increase in levels or scale The increase isn't proportional
as with variable cost but instead takes place in steps
like step cost might stay the same One output rises
from one hundred thousand to one hundred twenty thousand boxes
but then the one hundred twenty thousand and first item
causes the step cost to bump up The cost jumps
up in chunks and it stays the same for a
while But then a certain point moves it to a
higher level like you need a scale box Packer or
you need some other thing that handles ten thousand maur
twenty thousand fifty thousand more boxes because that's a whole
different scale set of demands than if you were just
packing a few hundred boxes You could do those manually
You don't need the high tech robots then to do
it right So it stayed same for a while as
a staff and then it reaches another production point and
then costs kind of zoom up well breaking down a
little more detail fixed Think Brent your toothpick factory cost
ten thousand month and rent It cost that much If
you meant no toothpicks it cost that much If you
make a thousand boxes of toothpicks and a cost that
much If you make one hundred thousand box of toothpicks
that rent is fixed it doesn't change To get the
most out of a fixed costs You want to make
his many things as possible As many Turbo Whittle five
thousand machines is you could fit into the factory Maximizing
volume production allows you to get the most out of
those fixed costs of rent per dollars spent Okay you
spent ten thousand dollars rent to make one toothpick while
that becomes a really expensive to pick right You have
to find someone to pay at least ten thousand dollars
for it plus all the other costs related to making
that one little wood sliver but make ten thousand or
one hundred thousand boxes of toothpicks and your rent expense
Well then is only a ten cents a box right
Next type variable The type of expense increases proportionally without
put raw material expense is a good example Each toothpick
needs so much African black wood or South American cedar
Yeah say you need three dollars worth of African black
wood to make ten boxes of toothpicks Still making one
box would cost thirty cents Making ten boxes will cost
three bucks and making one hundred thousand will cost thirty
grand and making one hundred thousand one boxes will cost
thirty thousand and three dollars of the African Blackwood stuff
right Because the same cost and no matter what volume
you order the cost goes up in what's called a
linear progression A straight line on a graph Labor can
also work this way but it depends on how you
pay your workers Pay them on a per piece basis
And it's completely variable Bob Splinter gets paid a penny
for every toothpick he makes He makes a thousand toothpicks
He gets a ten box He makes two thousand five
hundred twenty three toothpicks He gets twenty five dollars twenty
three cents It's completely variable but Bob joins the Toothpick
makers local one forty two Their contract calls for an
hourly wage twenty five dollars an hour Plus Bob is
guaranteed forty hours a week Well now his wages aren't
fixed at a grand A week there It doesn't matter
how many toothpicks he makes in an hour Bob gets
the same amount no matter what So if you can
get more efficient with production if you can figure out
how to make more per hour we'll then you Khun
Stretch the labor cost Mohr Just as with the rent
costs while you're proportional per unit cost will go down
the more you make in the same amount of time
on two semi variable elements of both fixed and variable
cost Think about the pay for a sales person with
a fixed salary of fifty grand a year to your
sales associate You also give them a bonus of two
dollars per ten boxes sold So each additional ten box
units sold carries a two dollars variable cost to you
related to commission But the salary is a fixed cost
It gets relatively less expensive per unit with each additional
sail Right You're going to pay fifty grand no matter
what if the sales person sells ten boxes in a
year Well the sales cost for that unit is fifty
thousand two dollars The full salary plus the two dollar
commission yet really expensive Yeah You just pay the salesperson
five thousand dollars in twenty cents for each box of
toothpicks they sold Yeah that was a bad deal If
they sell ten thousand boxes will Now the overall cost
is fifty two thousand for the year fifty grand in
salary and two grand for the total commission for those
thousand units Your paying Mohr on an absolute basis but
the per box amount is much better now You pay
just five twenty per box Okay so let's look at
the big winnings Compensation for one hundred thousand boxes sold
in a year Total cost goes up to seventy thousand
again Maurin Absolute basis Fifty thousand salary twenty thousand Commission
But now the per box costs just seventy cents Lastly
there's the step category Instead of a per unit commission
you offer your salespeople a bonus when they hit a
certain level If they sell a hundred thousand units they
get a twenty thousand dollar bonus So sales one through
ninety nine thousand nine hundred ninety nine while the sales
person earns fifty grand for the year on sale number
one hundred thousand They earned seventy thousand for the year
fifty grand in salary And you know the twenty grand
bonus that hundred thousand sail becomes very expensive for you
may be worth it to incentivize your sales force though
so you gotta think about that stuff But because of
the structure of strategy surrounding step costs are often different
than the other three categories Right Did you get that
big step function when they hit their next level of
bonus For each of the other categories it's better to
make output as high as possible Or in the case
of variable costs it's at least neutral Assume you sell
everything you make and that making tons of stuff doesn't
force prices down Well then given your ability to sell
everything and maintain pricing levels It's more profitable to make
a cz much as possible with fixed and semi variable
costs for each of those categories the per unit cost
goes down with each additional toothpick you make The per
unit cost of variable expenses states the same but it
doesn't cost any more at least on a relative basis
to make more So why not make more especially as
you're fixed and semi variable cost get relatively cheaper Is
output increases right Well step costs work differently as you've
seen there Khun B scenarios where it's more profitable to
not go to that next step and hopefully not have
to pay all those bonuses You Grinch In the case
of the sales bonus that hundred thousand unit comes with
a twenty thousand dollars sales price tag meaning that big
bump in commission to your sales force Well it might
be best just to make ninety nine thousand nine hundred
and nine boxes and call it a day But then
when the clock resets on the bonus well then you
start again at one sale Staff will not be happy
but well that one time you could save twenty grand
bonus and good luck with that That's not how the
real world works Is that bonus money worth a hostile
work environment create Yet Not for us to say You'll 00:09:30.462 --> [endTime] have Tio you know pick your own battles
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