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Chapter 3 - Basic Cost Management Concepts

CHAPTER 3: BASIC COST MANAGEMENT CONCEPTS


QUESTIONS
3-1

Cost assignment refers to the general case of assigning costs to cost pools or
cost objects. When there is a direct and traceable link between the cost and the
cost pool or cost object, then the management accountant traces that cost to the
cost pool or cost object. When there is an indirect link between the cost and the
cost pool or cost object, then the management accountant uses cost allocation.
Cost allocation uses cost drivers to assign the cost.

3-2

Direct costs can be physically identified with and/or traced to the cost object
because there is a direct causal link between them. Indirect costs cannot be
traced to each cost object. Direct costs for a manufactured product include the
materials (called direct materials) which are part of the product and the labor
(called direct labor) which is used to assemble the product. Indirect costs include
the machinery, plant and other labor necessary to manufacture the product, but
which is not directly traceable to the product, such as labor for inspection and
supervision.

3-3

All direct costs are variable by definition since they can be directly traced to the
cost object, and thus must vary with the cost driver.

3-4

All fixed costs must be indirect, since the increase in the cost driver or volume of
output does not affect the level of fixed cost.

3-5

A cost driver is any activity that has the effect of changing the level of total cost.

3-6

Variable costs are those for which total cost changes with each change in the
cost driver. Fixed costs are the portion of total cost which remains constant as
the cost driver changes.

3-7

A step-fixed cost varies with the cost driver, but in discrete steps. Costs remain
fixed over narrow ranges of the cost driver. However, total costs increase by a
constant amount at set intervals. Examples of step-fixed costs are the costs for
certain clerical tasks, order filling, and other administrative tasks. At specific
levels of the cost driver, an additional clerk must be added. Therefore, total costs
increase by a constant amount at these points.

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Chapter 3 - Basic Cost Management Concepts

3-8

The relevant range is the range of the cost driver for which total cost is
approximately linear. The relevant range is used to provide a useful range of
activity for the cost driver in which it can be assumed that variable costs will be
constant per unit of the cost driver. This is an assumption since the behavior of
actual costs is likely to be non-linear (see Exhibit 3-6) over the range of the cost
driver. The concept of the relevant range allows the management accountant to
use the concept of constant unit variable cost for a defined range of operations,
even though actual unit variable costs change over the entire range of the cost
driver.

3-9

Conversion costs are the sum of direct labor and overhead costs. Prime costs
are the sum of direct materials and direct labor.

3-10 Average cost can be misleading unless the activity level (denominator) is known.
Because average cost includes a fixed cost component, it will be different at each
possible activity level. The term average cost is meaningless if the denominator
is unknown. An increase in volume does not increase total cost by the amount of
the increase in volume multiplied by total unit cost; total cost increases by the
increase in volume multiplied by the unit variable cost.
3-11

Total variable costs increase as the cost driver increases.


Total fixed costs remain constant as the cost driver increases.
Average variable costs remain constant as the cost driver increases.
Average fixed costs decrease as the cost driver increases.

3-12 Unit cost is the additional cost that is incurred as the cost driver increases by one
unit.
3-13 Product costs are costs which are capitalized as assets, or inventoried. They are
referred to as manufacturing costs in manufacturing firms and merchandise
inventory in merchandising firms. Period costs are expensed as they are
incurred because there is no expectation that they will provide any future benefit
to the firm. Since period costs are not directly or indirectly related to the
production process, they are sometimes called non-manufacturing costs.
3-14 Cost of goods manufactured is the cost of the units produced this period and
transferred into finished good inventory. Cost of goods sold is the cost of the
units sold this period. Cost of goods sold will differ from cost of goods
manufactured because of changes in finished goods inventory. If finished goods
inventory is very nearly the same from the beginning to the end of the period,
then cost of goods sold and cost of goods manufactured will be very nearly the
same.

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Chapter 3 - Basic Cost Management Concepts

3-15 The types of inventory in manufacturing firms are:


1. materials inventory
2. work-in-process inventory
3. finished products inventory
3-16 Both accuracy and timeliness are important attributes of cost information.
Accuracy is important because effective planning and decision making require
accurate cost information. The same is true for effective decision making.
3-17 Executional cost drivers include employee empowerment, design of the
production process or work place, and management of supplier relationships.
3-18 Structural cost drivers include scale, experience, technology, and complexity
3-19 Indirect materials include items used in the production process that are not
included in the product itself; rags and small tools, lubricant for the machines,
etc.
3-20

Indirect labor includes labor that is used in the manufacturing process but cannot
be traced to each product as it is produced; indirect labor includes supervision,
inspection (by batch, because inspection of each and every product would be a
variable cost), training, etc.

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Chapter 3 - Basic Cost Management Concepts

BRIEF EXERCISES
3-21

The answer depends on what you consider the cost object.


Suppose we
consider the flight as the cost object, then the variable costs should include fuel
and the flight team, and any meals or other products provided to passengers on
the flight. If the object is the individual passenger, then the list of variable costs
is shorter, since fewer costs are actually caused by the addition of another
passenger perhaps only beverages. While the cost of the aircraft and most
airline staff would be clearly fixed costs for either type of cost object, some types
of airline staff, such as baggage handlers and gate attendants might be variable
with the flight.

3-22 We start with the cost object, which in this case could be the item of merchandise
sold. Then the variable costs are the cost of merchandise and the selling costs
for the cashiers and restocking. For a large discount retailer, most other costs
will be driven by the number of hours open each week, and the variety of
merchandise handled.
For other types of retailers (not discounters), sales
commissions might be an applicable variable cost.
3-23 The cost object for a movie theater could be the number of films being shown, or
the number of screens. The cost of renting the movie from the film producer is
the main cost. The key driver of revenue (not cost) is the number of ticket
holders for ticket revenue and also revenue from sales of food and beverages.
Some costs will also be driven by the number of ticket holders, such as the cost
of food and beverages. The cost of staff is likely to be a step cost, which
depends on the expected number of ticket holders for each different day in the
week, and time of day. Other facilities costs are likely to be fixed for the number
of ticket holders, or number of films being shown.
3-24

The cost object here is more readily identified the beer product, whether
measured in individual bottles or larger quantities. The variable costs will be
significant here, including the ingredients that go into the brewing of beer. Other
costs for the brewery are likely to be fixed for this cost object, but there are
important activity costs which will vary with, for example, the number of
customers/distributors (delivery and account management costs), the number of
different types of beer, or the complexity of the brewing process for the brewery
(a brewery that specializes in the more expensive beers require more costly
ingredients, processing time, and different packaging).

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Chapter 3 - Basic Cost Management Concepts

3-25 Here it is plausible to consider the individual lesson as the cost object. Variable
costs would include that portion of the trainers pay which is based on each
lesson (the salary portion of the trainers pay would be fixed for this cost object).
Other variable costs could include any materials that are used for each lesson,
and perhaps the travel cost to each client, if the company reimburses the trainers
for miles traveled.
3-26 $200 + $13,400 -$400 = $13,200
3-27 $2.6 + $10 = $12.6 million
3-28 $66,000 + $98,000 +($22,000 - $1,000) - $2,000 = $183,000
3-29 $400,000 + $1,600,000 - $200,000 = $1,800,000 cost of goods sold
3-30 Period cost includes interest, advertising, and office expense: $4,000 + $2,500 +
$14,000 = $20,500

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Chapter 3 - Basic Cost Management Concepts

EXERCISES
3-31 Fares and Fees in the Airline Industry (15 min)
Very much like the consumer products industry (Procter & Gamble as an
example) introduced at the start of the chapter, the airline industry is
characterized by a high degree of complexity in pricing both fares and
fees.
1.

It is likely most will argue that the airline industry is a cost leadership
industry. Most passengers look for the lowest price ticket and see
very little difference between airlines in terms of quality, reliability, or
service. On the other hand, airlines would very much like to build a
brand loyalty by providing certain free services and customer
service. Whether this will work is a good question for class
discussion. One point that should arise in the discussion is to
determine whether the airline business is a commodity business.
Can a customer differentiate the different carriers?
Another issue is the airlines desire for more control over the
purchasing of tickets. Could this approach help them develop a
brand, or simply add to the complexity and frustration of the
consumer? On the other hand, some travel analysts have
questioned the impartiality of the available Web sites passengers use
to purchase tickets; arguments of this nature could drive the
development of new search engines and away from airlines that did
not participate in trusted, independent Web search sites. If the
number of Web sites increases, as some in the travel industry expect,
then it is likely to place more price pressure on the airlines and
reinforce the commodity view of the industry.

2. The complexity of fees and fares presents a challenge for the


consumer, and an opportunity for search sites such as Expedia to
assist passengers in getting the flight they want at the lowest price.
From the airlines point of view, the complexity presents an
opportunity for revenue growth (fees for various services such as
checked baggage, priority seating, etc.). Does the additional
complexity increase the operating costs of the airline?

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Chapter 3 - Basic Cost Management Concepts

3-31 (continued -1)


It is likely that the additional complexity in fares and fees will affect
the airlines costs for the cost of additional time and materials in
processing fee payments and in assisting customers. Of course, the
additional fees are very likely to cover these additional costs.
Source: Jad Mouawad and Claire Cain Miller, Search for Low
Airfares Gets More Competitive, The New York Times, February
10, 2011; Gary Stoler, Fee-fi-fo-fum, Airline Charges Leave Some
Travelers Numb, USA Today, September 20, 2011, p B1.
For a contrasting view, see, Loizos Hereacleous and Jochen
Wirtz, Singapore Airlines Balancing Act, Harvard Business Review,
July-August 2010, pp. 145-149. The authors argue that Singapore
Airlines simultaneously competes on cost leadership and
differentiation. The authors further argue that this competition is
common in Asian airlines. The authors call this a dual strategy.

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Chapter 3 - Basic Cost Management Concepts

3-32 Complexity of Operations and the Effect on Cost (15 min)


The observations made by the consultant show that the manufacturer was
incurring large costs in operations, distribution, and administration due to
the high level of complexity in its products. Maintaining relationships with
10 vendors for a single item contributed to high purchasing and stocking
costs. Similarly, most of the firms volume was made up of products with
five color combinations, with the result that manufacturing, warehousing,
shipping and selling costs were high relative to fewer color combinations.
Also, the high product variety required smaller batch production and more
frequent set-ups, which caused increased manufacturing costs. Also, the
variety of different customers, prices, and promotional programs created
increased manufacturing, shipping and customer service costs as well as
increased costs in accounting for the customers invoices and account
balances.
The solution? Reduce complexity. This was done by reducing the
number of customers; the low value customers were reviewed and some
were not continued. Also, a process of review was developed for the
introduction of new products or new variations on existing products, to
ensure the likely profitability of the new product. Further, the complexity of
equipment set-ups was reduced so that the firm could meet the customers
demands for smaller batch sizes without increasing overall costs. The
result of the program was that overall profit margins improved. The firm
had found a way to deal with the cost consequences of its strategic
initiative.
Also, the firm adopted new cost management practices that included
new non-financial measures such as set-up time and frequency, percent of
orders shipped on time, percent of orders on just-in-time, and number of
vendors for the top 20 commodity raw materials items. In addition, the firm
began to calculate and regularly review customer profitability, by type of
market and customer size.

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Chapter 3 - Basic Cost Management Concepts

Based on information in: Barry Berman, Products, Products Everywhere,


The Wall Street Journal, August 23, 2010, p R8; Managing Complexity
Through Performance Measurement, by Frank A. J. Gonsalves and Robert
G. Eiler, Management Accounting, August 1996, pp 34-39.
3-33 Classification of Costs (10 min)
Parts 1 and 2:
1. Print machine setup costs: activity; product
2. Cost of complexity; the number and variety of products: structural;
product
3. Training costs for new staff: structural or executional; product
4. Ink: volume; product
5. Customer service costs: activity; period
6. Paper: volume; product
7. Redesign of the print process to improve efficiency: executional;
product
8. Machine operation labor: volume; product
9. Order taking: activity; period
10. Purchasing and stocking paper and other supplies activity;
product

3. The ink could have a harmful environmental impact. The company


could choose to use environmentally friendly ink, or dispose of the
harmful ink in a proper manner. All waste paper should be properly
recycled.
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Chapter 3 - Basic Cost Management Concepts

3-34 Classification of Costs (10 min)


1. period
2. product and indirect
3. product and indirect
4. product and direct
5. period (the answer is correct, but note that delivery of materials
would be included in inventory cost of the materials if the
purchaser paid for delivery)
6. period
7. product and direct
8. period
9. product and indirect (could be direct if electricity is metered and
measured for each product)
10. period
11. period
12. product and indirect
13. period
14. period

3-35 Classification of Costs (10 min)


1. direct and variable
2. indirect and fixed
3. indirect and variable
4. indirect and fixed
5. direct and variable
6. indirect and fixed
7. indirect and variable
8. direct and variable
9. indirect and fixed
10. indirect and fixed

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

3-36 Classification of Costs (10 min)


1. direct
2. indirect
3. direct
4. indirect
5. direct
6. indirect
7. indirect
8. direct
9. indirect
10. indirect
3-37 Activity Levels and Cost Drivers (10 Min)

Cost Object
1 product line or
customer
2 product line or
customer
3 product line
4 product line
5 customer order
6 customer order
7 customer order
8 customer order
9 each customer
10 customer order
11 not allocated
12

not allocated

Cost Driver
trace to product line, or each custom order
requiring design
trace to product line, or each custom order
requiring testing
product line
number of purchase orders
trace directly to customer
trace directly to customer
trace directly to customer
trace directly to customer
trace directly to customer
trace directly to customer
cannot be traced to product or customer; must be
allocated using some reasonable method, for
example, number of units produced
cannot be traced to product or customer; must be
allocated using some reasonable method, for
example, the number of units produced
3-11

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Chapter 3 - Basic Cost Management Concepts

3-38 Application of the Direct Cost Concept in the Fashion Industry


(15 min)
It is always possible, by definition, to trace direct materials and direct labor
costs to each unit produced. In some cases, as this one, the most
practical approach is to trace the materials and labor costs directly to the
batch. This is convenient both for cost management and pricing, since
the batch is often for a single customer. This is a preview of job costing,
which is the topic of the following chapter, chapter 4.

3-39 Direct Manufacturing Labor: Fixed or Variable? (10 min)


The effect of the policy on cost is that labor expense, while fixed in total
expenditure, is in reality a variable expense. Labor is flexible and can be
moved from job to job or plant to plant as demand dictates; that is, labor
cost at the plant level fluctuates with demand at each plant, while total labor
cost at the firm stays fixed. Thus, instead of incurring a fixed cost for labor,
the companys total labor costs are flexible and vary with demand, as parttime labor is added when needed.
Source: Clara Asbury, In the Workplace, Jobs Morph to Suit Rapid Pace
of Change, The Wall Street Journal, March 22, 2002, p1.

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Chapter 3 - Basic Cost Management Concepts

3-40 Average and Total Costs (15 min)


1. Total cost:
$ 1,500 (fixed cost of space rental)
+ 1,500 (variable cost of refreshments = $15 x 100)
$ 3,000
Average cost: $3,000/100 people = $30.00 per person
2. Total cost:
$ 1,500 (fixed cost of space rental)
+ 3,000 (variable cost of refreshments = $15 x 200)
$ 4,500
Average cost: $4,500/200 people = $22.50 per person
3. Average costs decrease as attendance increases because the
fixed cost component to total costs is now spread over 100 extra
people.
Fixed cost per person: $1,500/100 people = $15
$1,500/200
= $ 7.50
Decrease in fixed cost per person
$ 7.50
Average cost for 100 people
- Decrease per person in fixed costs
Average cost for 200 people

$30.00
7.50
$ 22.50

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Chapter 3 - Basic Cost Management Concepts

3-41 Cost Classification for Dance Studio (15 min)


1. While a variety of possible cost objects are possible for the dance
studio, the most reasonable choice is the studio since managements
goal is to analyze the profitability of the studios.
2. Studios as the cost object
1. a,c
2. a,c
3. a,c
4. a,c
5. a,c
6. b,c
7. a,c
8. a,d
Or,
Lessons as the cost object
1. a,d
2. b,d
3. b,d
4. b,d
5. b,d
6. b,d
7. b,d
8. b,d

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Chapter 3 - Basic Cost Management Concepts

3-42 Relevant Range (20 min)


This exercise is intended to develop the students appreciation of the
complexities in cost determination and the importance of considering
foreign exchange effects when doing business abroad.
1. The volume-based costs include:
a. Fixed costs: administrative costs of management in Austin and
Paris and the 16 marketing and customer service locations
b. Variable costs: the royalties paid for the images sold, the cost
of computer operations personnel, the purchase of small
servers as needed
c. Step costs: purchase of larger computer servers as needed
when demand increases, facilities costs including lease or
depreciation expense, insurance, maintenance, security, etc.

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Chapter 3 - Basic Cost Management Concepts

2. The relevant range is applicable for PGI because PGIs operations


centers must grow as demand increases. This means higher
variable costs due to the cost of adding small computer servers and
the cost of hiring additional staff, etc. Note that the cost of the
additional staff would be variable costs, but the cost of adding
capacity additional large servers and new administrative staff
would be a step cost, increasing unit costs. So PGIs total costs
increase in a non-linear, upward-sloping manner over wide ranges of
demand. The relevant range is used to determine the level of unit
variable cost and total fixed cost for a limited range of activity a
range in which there is no need for additional servers or hiring costs,
etc.
3-42 (continued -1)
3. The growth of the company globally means that the company will be
more exposed to the effects of foreign currency fluctuations. For
example, a falling dollar relative to the Euro will lower the effective
cost of PGIs U.S.-based services to European customers, thereby
potentially increasing demand in Europe. Also, the translation of the
European earnings in Euros to PGIs financial statement will mean
foreign currency gains, as the Euro earnings are worth more with the
falling dollar. The changes in the currency exchange rates can
potentially and perhaps significantly affect the companys earnings in
two ways: increased sales and foreign currency exchange gains.
The reverse would be true if the dollar were to appreciate relative to
the Euro. The same currency issues apply should the companys
business continue to grow in China. In this case, the currency effect
is likely to be smaller, since the Chinese currency has not changed
much relative to the dollar in recent years.

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Chapter 3 - Basic Cost Management Concepts

3-43 Fixed, Variable and Mixed Costs (10 min)


Department A
Department B
Department C
Department D
Department E

fixed
variable
mixed
mixed
variable

3-44 Fixed, Variable and Mixed Costs (10 min)


Department A
Department B
Department C
Department D
Department E

mixed
mixed
fixed
variable
variable

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Chapter 3 - Basic Cost Management Concepts

3-45 Strategy; Variable and Fixed Costs (20 min)


1. The variable costs for Zipcar would be the same as for any car
owner gasoline (customers do not pay for gas, but instead a simple
hourly rate) and upkeep. The fixed cost are the largest part of total
cost, the cost of the car, insurance, and the parking spot, among
others.
2. The key challenge facing Zipcar is the entrance of competitors such
as Hertz and Enterprise car rental agencies. Zipcar has no barrier
to entry, and is vulnerable to new competition.
A good question for class discussion: How will Zipcar be able to
compete effectively against the larger companies? Is the Zipcar
concept a commodity which can be copied and used by the other
companies, or are there some features and services that can make
Zipcar unique and differentiated? One idea would be to stress that
the company uses very small cars to achieve both convenience (in
large cities) and a green advantage (by Zipcars estimate, each car
it adds to its fleet keeps up to 20 cars off the road). Another
approach might be to emphasize its initiative in the business and its
environmental contribution over the last 10 years, ideas that might
have traction with those customers who want to make a statement
about their commitment to the environment.
Since fixed costs are a key component of total costs for the
company, the ability of the company to grow at a fast rate is critical. A
larger company, with more members and more usage of its vehicles,
would be able to more easily cover those fixed costs. As shown in
Exhibit 3.11, average fixed costs fall as output increases.
Another challenge for Zipcar is the rising cost of gasoline.
Because of the short rental periods, it is not practical to have
customers refuel the car, and the flat hourly rate is appropriate and
convenient. But this also exposes Zipcar to fluctuations in gas prices
which must be covered by that fixed hourly rate.
Source: The Business of Sharing, The Economist, October 14, 2010;
Adam Aston, Growth Galore, but Profits are Zip, Business Week,
September 8, 2008, p 62. Also: Mark Clothier, In The Race for the Carless, Can Hertz Outrun Zipcar? Bloomberg Businessweek, April 2, 2012,
pp. 23-24.
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Chapter 3 - Basic Cost Management Concepts

3-46 Interpreting Average Cost (15 min)


This question is based on a report by Paul Raeburn, Hybrid Cars: Less
Fuel but More Costs, Business Week, April 15, 2002, p 107. See also
information on the history of gas prices from January 2000 to the present at
the U.S. Department of Energy website:
http://tonto.eia.doe.gov/oog/info/gdu/gaspump.html
CAF standards have remained at 27.5 mpg since 2002 but have been
increased by 2007 legislation which required 35 mpg by the year 2020. In
May 2009, the Obama admiration pushed the 35MPG target back to 2012,
and in August 2011 legislation was passed that required 54.5 mpg by 2025.
The urgency of energy sustainability, oil independence from non-domestic
supplies, and climate change have substantially increased the efforts to
improve vehicle efficiency and reduce vehicle emissions.
The rapid increase of gasoline prices in 2004-2011 should enhance the
interest in the issue discussed. The costs shown for each gallon of
gasoline saved look much better in 2011 than in 2002 when the article was
written; in 2002 the price of gas averaged $1.30, about 30% of the 2011
price. The cost justification for higher fuel efficiency of the full hybrid
would not pass in 2002 (cost of $1.80 per gallon when the price of gas was
$1.30), but would surely pass the test in summer 2011, with the price of gas
just short of $4.00 per gallon.
The main point of this exercise is to have the students understand that the
determination of an average cost, as in this report, requires a specification
of the level of activity, or output, that drives costs. This is the reason the
concept of average cost is often misunderstood and misused in practice.
For example, since in this case total cost per gallon of gas depends
on both variable costs (gasoline) and fixed costs (vehicle cost), the
determination of an average cost requires an assumption of activity level.
While variable costs (the price of gasoline) are constant per unit, for the
number of gallons purchased, theaverage per-gallon fixed costof
purchasing the vehicle will depend on the number of miles traveled. Car
owners who travel relatively few miles will have large average fixed costs in
contrast to road warriors with many miles traveled.
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Chapter 3 - Basic Cost Management Concepts

3-46 (continued -1)


The Business Week report does a good job in this regard by reporting
that the assumed activity was 12,000 miles per year for 12 years. This
gives the reader a way to interpret the findings; those who drive more than
this amount can expect lower cost for each gallon of gas saved from
improvements in the vehicle, while those who drive fewer miles can expect
higher costs than those reported.
Instructors can start this exercise by asking the class how average
cost is determined in this case. The key idea to bring out is that average
fixed cost is determined by some pre-determined activity level.
CAF Standards links:
http://www.nhtsa.gov/fuel-economy

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

3-47 Interpreting Average Cost (15 min)


This question is based upon the following: Vincent Ryan, Treasury:
Bigger is Better, CFO.com, November 9, 2010; How Does Your Finance
Department Measure Up?Journal of Accountancy, January 1997, pp50-51.
The main point of this exercise, as for 3-46 above, is to help the student
understand the importance of taking activity levels into account when
interpreting average cost information.
The two articles show, as represented by the information presented in the
exercise, that average fixed costs decline with higher levels of activity.
Larger companies, with higher levels of transaction volume, will have
higher total fixed costs, but average fixed costs should be lower due to
economies of scale. Looked at another way, if a given firm were to grow,
and its volume of transactions grew as well, then average fixed costs (or in
this case the ratio of total accounting costs to total revenue) would have to
fall. Average fixed cost would continue to fall with increasing numbers of
transactions, until the firm felt it necessary to increase capacity in the
accounting department, thereby increasing fixed costs.
Thus, the data presented is as we would expect larger firms will have
lower average costs. We would not expect otherwise. Average fixed
costs should be lower for the larger firms.

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

3-48 Average Cost (15 min)


The percentage increase in total variable manufacturing cost, averaging
both labor and fuel costs, is 7.5% for Company A and 6% for Company B.
The increase is higher for Company A because it has a higher percent of
fuel costs which have risen faster than labor costs.
Calculations:
7.5% =(.5 x 5%) + (.5 x 10%)
6% = (.8 x 5%) + (.2 x 10%)
The calculations for percentage change shown above hold irrespective of
the underlying amounts, as long as the amounts are positive. The example
below illustrates:

This example illustrates that two companies that may have the same total
variable costs, and facing the same changes in materials or labor costs, will
be affected differently if the mix of variable costs are not the same for the
two companies.
This example is sometimes called the fallacy of averages. The takeaway is that averages should be interpreted carefully, and in particular, the
management accountant should always consider the components of cost
which make up that average, as in the example above.

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

3-48 (continued -1)


Here is another example. The recession in the early 1980s caused an
increase in unemployment for workers at all educational levels. Also, in
the great recession, during 2009, the unemployment rates were higher for
all educational levels than in 1983. However, the overall unemployment
rate in 2009 (10.2%) was lower than the overall unemployment rate in
1983(10.8%). Why? The reason for this apparently confusing result is
that the group with the highest educational attainment and lowest
unemployment rates in both recessions was a larger percentage of the total
employed in 2009 relative to 1983. Since more 2009 workers were in the
highly educated group than in 1983, and this groups unemployment rate
was lower (in both periods), the effect was to bring down the overall
unemployment rate in 2009 relative to 1983.
Source: Carl Bialik, When Combined Data Reveal the Flaw of Averages,
The Wall Street Journal, December 9, 2009, p A21.

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Chapter 3 - Basic Cost Management Concepts

3-49 Classification of Costs; Customer Profitability Analysis (15 min)


1.
Direct (D) or
Indirect(I)
1. Staff salaries
D
2. Rent on office and work space used
I
by the company
3. Licenses and fees
I
4. Supplies; grooming supplies, and
D
related items
5. Medications
D
6. Legal fees
I*
7. Accounting services provided partI
time by practicing accountant
8. Pet food
D
9. Utilities for office and work space;
I
electricity and water
10. Fire insurance for office and work
I
space and its contents
11. Liability insurance for the company
I
business
*It may be possible to trace some portions of legal fees to specific customers, so that
the cost would be direct and not indirect

2. Pet Partner could use the information to identify costs that are
traceable to each customer (the direct costs) and determine over a
period of a month (or year) whether the direct costs traced to the
customer are less than or greater than the revenues from the
customer, that is, to determine if the customer is profitable or not. A
much more thorough means of determining customer profitability
analysis is covered in chapter 5, together with activity-based costing.

3-24
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

3-50 Classification of Costs (15 min)


Parts 1 and 2
Fixed(F) or
Variable (V)

Product (P) or
Period (PD)

1. Food costs including pizza dough,


olive oil, tomato sauce, etc.
2. Salaries for drivers
3. Salaries for telephone operators
4. Salaries for cooks
5. Insurance for drivers
6. Utilities; water and electricity

N*
N*
N*
F
V

7. Advertising
8. Discount coupons
9. Food handling licenses,
inspections, and fees
10. Accounting and payroll services
11. Cooking supplies
12. Cleaning supplies
13. Mortgage payments
14. Insurance on facilities

F
V
F

PD
PD
P
P
P/PD (allocated to kitchen
and other space)
PD
PD
P

F
V
V
F
F

PD
P
P
PD
PD

*Note for Class Discussion: these costs are fixed unless Papas manager
schedules drivers, operators, and cooks so as to eliminate slack time, in
which case the cost of the drivers, operators, and cooks could be
considered variable costs
3. There are a number of possible answers. Inefficiency and waste in
the use of utilities or food products could be considered an
environmental issue. Also, cleaning supplies should be
environmentally-friendly and/or disposed of properly.

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

3-51 Classification of Costs (15 Min)


Parts 1 and 2

1.Technicians
2.Parts
3.Purchase of oil and tires
4.Supplies
5.Tools
6.Rental of each location
7.Advertising
8. Utilities
9.Licenses and fees
10.Employee training*
11.Security service
12. Software for sales and reports
13. Disposal of waste oil and used
tires

Fixed(F) or
Variable (V)

Product (P)
Period (PD)

F
V
V
V
F
F
F
F
F
F
F
F
V

P
P
P
P
P
PD
PD
PD
PD
P
PD
PD
PD

Employee training is considered a product cost because it is related to


direct labor of the technicians.
3. The disposal of waste oil and used tires is the critical environmental
issue for Speedy Auto Service. Both the waste oil and used tires,
which would accumulate in significant quantities for this type of
business, should be disposed of in an environmentally appropriate
manner.

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

PROBLEMS
3-52 Executional Cost Drivers: Internet Retailer (20 min)
The example of an internet retailer such as Bikes.com is a good
example of the type of firm that must pay close attention to
executional cost drivers. The reason is that its success depends on
customer service prompt response to customer requests, and
prompt and accurate filling of customer orders. Customer loyalty is a
key success factor for a firm such as this, and loyalty comes from
superior customer service in all its dimensions. Amazon.com
introduced the successful internet retailing business model, and has
built a successful business on the basis of customer loyalty. This is
the approach Bikes.com needs to follow and this means execution,
execution, execution. The fall off in sales growth could be an
indication of problems in customer sales returns, that is customer
satisfaction and loyalty. Bikes.com can review sales records to
investigate.
Specific executional steps that Bikes.com can take include
looking for possible improvements in the purchase and stocking of
merchandise and the shipping of customer orders the upstream and
downstream activities that must work smoothly to get the orders to
the customers quickly and accurately. Also, Bikes.com should
consider the work flow in the company. Can it be streamlined? Are
there non-value-adding activities that can be eliminated? What are
the bottlenecks, if any, that slow the process of accurately filling a
customers order? Also, are employees aware of the importance of
executional issues? Are the employees working together to achieve
the required speed and accuracy necessary for the firms success?
Executional cost drivers are important to Bikes.com in two
ways. First, these are the executional issues which the firm must
achieve in a superior way in order to compete effectively in internet
retailing. And second, effective attention to the cost drivers and
effective cost management can lower the costs of operation and
speed the arrival of profits.

3-27
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

3-53 Structural Cost Drivers (25 min)


Case A: A key structural issue for Food Fare is complexity. As the
menu has changed, so will costs and service. More complexity
means higher food purchasing costs, higher operating costs, and
more complex operations. This will require new types of training for
employees and perhaps additional employees. Moreover, it will be a
challenge for Food Fare to continue to provide the speed of service
that was possible with the shorter menu. The change will require
careful attention to operations and to cost management issues for the
firm to continue to be profitable. Employee training and new uses of
technology to streamline the process of order taking and order filling
are likely to be necessary. Scale might also be an important issue in
this case how large must each restaurant become, and how many
restaurants must the chain have in order to justify the increased
purchasing and stocking costs, and the new training and technology
costs?
Case B: A key issue in this case is the speed with which Gilman can
provide customer service. The speed of service provides value to the
customer and also increases profitability. In order to increase the
speed of service, Gilman needs effective communication and
coordination among the service teams. This is probably being
accomplished now by cell phone. Gilman can research new and
more effective ways to accomplish this, perhaps using hand-held
internet access devices, iphones, or other modem-equipped devices.
The advantage of computer-based access is that computer-based
tools can be used in the scheduling and assignment of the service
teams. Additionally, the computer can be used by each service team
to quickly determine the availability of parts in the firms warehouse or
in other service vehicles, thereby allowing faster service time. Also,
the computer can be used to develop real-time analyses of customer
demand and profitability in order to better understand which
services and which types of customers are most profitable.

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

3-53 (continued -1)


Is it in installation or service, Brand X or Brand Y, residential or
commercial, etc.? Scale is also an important cost driver for Gilman.
To serve the large area it now serves, there should be a careful
strategic analysis to get the right balance between order getting costs
(advertising and promotion to obtain new customers) plus the costs of
maintaining the truck fleet and service teams versus the opportunity
to provide additional services to existing customers.

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

3-54 Cost of Goods Manufactured and Sold (30 min)

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

3-55 Cost of Goods Manufactured and Sold (30 min)

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

3-56 Cost of Goods Manufactured and Sold (30 min)

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

3-57 Cost of Goods Manufactured and Sold (30 min)

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

3-58 Cost of Good Manufactured and Income Statement (40 min)


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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

3-35
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

3-58(continued -1)

3-36
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.