Management Accounting

and the
Business Environment

Objectives of Management
Accounting
Providing managers with information for
decision making and planning.
Assisting managers in directing and
controlling operational activities.
Assisting managers in motivating
employees toward the organizations
goals.
Measuring the performance of subunits,
managers, and other employees within
the organization.
2

Comparison of Financial and

Managerial Accounting

The Business Environment

What issues are important in business management?

Cost management.

Revenue (or yield) management.

Quality and risk management.

Regulatory and legal environment.

Others?

Changes in practices often require new or modified

accounting practices or systems to measure the
appropriate variables.

Strategic Cost Management

Strategic cost management (Shank and
Govindarajan) - the process though which a
sophisticated understanding of an
organizations cost structure is developed and
used in the search for sustainable competitive
advantage.
From an accounting standpoint, strategic cost
management is an analytic framework that
relates meaningful accounting information to an
organizations business strategy.
5

Three Key Themes

Value chain analysis - How do we organize
our thinking about cost management?
Strategic positioning - What role does cost
management play in the firm?
Cost driver analysis - What causes our
costs?

Activities The Unit of Analysis in Modern

Cost Management
Activity at the most basic level, a unit of
work (e.g., seating customers, taking orders,
preparing food, delivering food to customer).
Activity drivers what causes activities to be
performed. Examples of activity cost drivers
include: number of meals served, number of
employees in the service area, number of
cooks, training needed for new employees,
any activity that influences cost.
7

Value Chain Analysis

The value chain for any firm in any business is the linked
set of value-creating activities all the way from basic raw
material sources for component suppliers through to the
ultimate end-use product delivered into the final
customers hands.
The value-chain focus of management today is largely
internal to the firm (its purchases, its processes, its
functions, its products, its customers). This perspective is
too narrow if considered in a strategic context.
Strategic/competitive advantage is gained through
managing the entire value chain from raw material
supplier to the end user.
8

Strategy and the Value Chain

Two generic strategies for achieving competitive advantage:
Low-price leadership.
Product differentiation.
Whichever strategy is selected, value chain analysis can help a firm
focus on its chosen strategy and achieve competitive advantage.
The industry value chain is composed of all the value-creating
activities within the industry, beginning with the basic raw material
and ending with delivery of the product to the final consumer.
A companys internal value chain consists of all of the physically and
technologically distinct activities within the company that add value
to the product.

Internal Value Chain Analysis

What activities within the firm create competitive
advantage? How can those activities be managed to
improve competitive advantage?
Steps in evaluating the internal value chain:
Identify value chain activities.
Determine which of the value chain activities are
strategic.
Trace costs to value chain activities.
Use the activity-cost information to manage the
strategic value chain activities better than other
companies in the industry.

10

Industry Value Chain Analysis

What are the firms relative strengths within the industry?
How can the firm best take advantage of these
strengths?
The industry value stream considers activities both
upstream and downstream from the firm.
Analysis of the financial returns available at each link in
the industry value chain may reveal opportunities for
exploitation. The analysis could also provide useful
information as to whether the firm should continue with
its existing strategy, reconfigure its value chain, or even
exit the business.
11

Strategic Positioning
The role of cost analysis in the firm depends on how the
firm chooses to compete (lower costs versus superior
products).
Example: How important are standard costs in assessing
performance?
Cost leadership - Very important.
Differentiation - Not as important.
Example: How important is marketing cost analysis?
Cost leadership - Not very important.
Differentiation - Critically important.
12

Cost Driver Analysis

Costs are caused (or driven) by many factors that are
interrelated in complex ways.
Understanding costs implies understanding the
interplay between cost drivers in any given situation.
Traditional management accounting - costs are solely
a function of output volume.
But output volume is often a poor way to explain cost
behavior.

13

What Drives A Firms Cost Position?

Five strategic choices by the firm regarding its underlying
economic structure drive its cost position for a given
product:

Scale - How big an investment to make in manufacturing, in

R&D, and in marketing resources.
Scope - Degree of vertical integration.
Experience - How many times in the past the firm has already
done what it is doing again.
Technology - What process technologies are used at each step
of the firms value chain.
Complexity - How wide a line of products or services to offer to
customers.

These represent structural cost drivers.

14

What Factors Allow A Firm to Execute

Successfully?
These are called organizational drivers. More is always better.
The list of basic organizational drivers:
Work force involvement (participation).
Total quality management (beliefs and achievement
regarding product and process quality).
Capacity utilization (given the scale choices on facility
construction).
Plant layout efficiency (the relative efficiency of the layout).
Product configuration (the effectiveness of the design or
formulation).
Exploiting linkages with suppliers and/or customers.

15

Key Ideas Regarding Cost Drivers

For strategic analysis, volume is usually not the most
useful way to explain cost behavior.
In a strategic sense, it is more useful to explain cost
position in terms of the structural choices and
organizational skills that shape the firms competitive
position.
Not all the strategic drivers are equally important all the
time, but some (more than one) of them are likely very
important in every case.
For each cost driver, there is a particular cost analysis
framework that is critical to understanding the positioning
of the firm.
16

Cost Terms, Concepts

and Classifications

17

Costs Versus Expenses

Cost - a resource sacrificed or forgone to
achieve a specific objective.
Expense - a cost that has been charged against
revenue in an accounting period (an expired
cost).

18

Economic Characteristics of Costs

Opportunity cost - the potential benefit given up when the
choice of one action precludes selection of a different action.
Out-of-pocket cost (outlay cost) - a cost incurred that
requires the expenditure of cash or other assets (or the
incurrence of liabilities).
Marginal cost - the extra (or incremental) cost incurred in
producing one additional unit of output.
Average cost - the total cost of producing a particular
quantity of output, divided by the number of units of output
produced.
Sunk cost - a cost that was incurred in the past and cannot
be altered by any current or future decision.
Differential cost - the difference in a cost item under two
decision alternatives.

19

Types of Organizations and Cost

Measures
Service organizations - provide customers with an
intangible product. Usually maintain no inventories.
Interested in measuring cost of services billed or provided.
Merchandising organizations - organizations that sell their
customers a tangible product. These firms maintain
inventories of the product they sell, but they do not
manufacture the product. Interested in measuring cost of
goods sold plus the cost of ending inventory.
Manufacturing organizations - these firms manufacture
goods for sale rather than simply purchasing them.
Interested in measuring cost of goods sold, cost of goods
manufactured, and costs of ending inventories.
20

Controllable and Uncontrollable

Costs
Controllable cost - a cost is controllable if a manager
is in a position to exert control over the level of the
cost or to significantly influence the level of the cost.
Uncontrollable cost - a cost is uncontrollable if a
manager is not in a position to exert control over the
level of the cost or to significantly influence the level
of the cost.
Costs may be uncontrollable in the short run but are
usually controllable in the long run.

21

Direct versus Indirect Costs

Cost object - any activity or item for which a separate measurement of cost is
desired.
Direct cost - a cost that can be traced to a given cost object in an economically
feasible manner.
Indirect cost - a cost that cannot be traced to a given cost object in an
economically feasible manner.
Economically feasible means that the benefit of tracing the cost (greater
accuracy) outweighs the cost of doing so.
Costs are assigned to cost objects by tracing (direct costs) and by allocation
(indirect costs).
A cost may be direct with respect to one cost object but indirect with respect to
another.

22

Additional Cost Terms

Manufacturing costs - Three basic categories.
Direct materials.
Direct labor.
All other costs associated with the manufacture of the
product (also called indirect manufacturing costs,
manufacturing overhead, factory overhead, factory burden).
Manufacturing costs are also known as inventoriable costs or
product costs. Under full absorption costing, these costs are
inventoried (treated as an asset) until the product is sold.
Prime costs = Direct materials used + direct labor.
Conversion costs = Direct labor + factory overhead.

23

Product Costs versus Period Costs

Costs that are not directly related to the manufacture
of a product are called period costs, since they are
expensed in the period they are incurred.
These costs consist of general and administrative
costs, research and development costs, and/or
marketing and selling costs.
These costs are never treated as part of
inventoriable costs.
Manufacturing costs = inventoriable (or product)
costs. Nonmanufacturing costs = period costs.
24

Flow of Costs in Manufacturing Firms

A manufacturing firm converts raw (direct) materials into a salable
product.
When purchased, materials (both direct and indirect) are charged to the
Materials Inventory account, and a liability created (Accounts Payable).
When placed in production, the cost of direct materials used are
transferred to Work in Process Inventory and out of Materials Inventory.
Other manufacturing costs are also charged to Work in Process Inventory.
When completed, the manufacturing costs associated with the product
are transferred to Finished Goods Inventory and out of Work in Process
Inventory.
When finished goods are sold, the costs of the product sold are charged
to Cost of Goods Sold (Finished Goods Inventory).

25

Flow of Costs in A Merchandising

Firm
Goods are purchased from suppliers and resold.
Purchases are charged to Merchandise
Inventory and a liability created (Accounts
Payable).
When goods are sold, Cost of Goods Sold is
charged with the total costs of the units sold,
while Merchandise Inventory is reduced by the
same amount.
26

Basic Inventory Equations

Beg. Matl. Inv. + Purchases End. Matl. Inv. = Matl.
Used.
Beg. WIP Inv. + Curr. Mfg. Costs End. WIP Inv. =
COGM.
Beg. FG Inv. + COGM End. FG Inv. = COGS.
where: COGM = Cost of Goods Manufactured,

COGS = Cost of Goods Sold,

WIP = Work in Process, and
FG = Finished Goods.
27

Cost Drivers
Cost driver - any factor whose change causes a
change in the total cost of a related cost object;
more simply, any factor that causes costs.
We assume a causal relation exists between the use
of the cost driver and the incurrence of the cost.
Cost drivers can be financial (e.g., direct materials
costs) or nonfinancial (e.g., number of equipment
setups, number of transactions processed).
Costs are often categorized based on their behavior
relative to a cost driver.
28

Cost Behavior -- Variable Versus Fixed

Costs
A fixed cost is a cost that does not change in total given
changes in the level of the cost driver.
A variable cost is a cost that changes in total in direct
proportion to changes in the level of the cost driver.
We also encounter mixed costs (or semivariable costs) which
are costs that have both fixed and variable components.
Step (or step-variable) costs are costs which change in steps
as the cost driver changes.
Each of these behaviors may be valid only over a relevant
range.

29

Unit Fixed and Variable Costs

Unit cost = average cost per unit.
For product costing purposes, we unitize fixed
costs. This makes fixed costs appear to be
variable.
For decision making purposes, unit fixed costs are
often misleading because the cost is not variable.
It is fixed in total. In addition, the per-unit amount
changes for each level of the denominator.
We usually assume that the variable cost per unit
is constant within the relevant range.
30

Other Cost Terms

Full cost - the sum of all costs of manufacturing and selling
a unit of product (including fixed and variable costs).
Full absorption cost - all variable and fixed manufacturing
costs are inventoried; used to compute the value of
inventory under GAAP.
Variable costing - only variable manufacturing costs are
inventoried.
Gross margin = Revenue COGS.
Contribution margin = Revenue Variable costs.

31

Costs of Quality
The costs of quality are the costs that would be
eliminated if all workers were perfect in their jobs.
Every dollar and labor hour not used making scrap can
be used for making better products on time or improving
existing products or processes.
Some survey evidence suggests that poor quality leads
to losses of up to 20% to 30% of gross sales.
Costs of quality can be subdivided into the costs of
conformance and the costs of nonconformance.
32

Costs of Conformance
Costs of Conformance - the costs necessary to achieve
quality products; in most firms, these costs run to 3% to 4%
of sales; can be categorized into prevention costs and
appraisal costs.
Prevention costs are associated with preventing defects
before they happen. Examples include costs of process
design, product design, employee quality training, supplier
programs, quality improvement projects, machine
inspections, inbound material inspection.
Appraisal costs include measuring, evaluating, or auditing
products to assure conformance to standards. Examples
include field testing, intermediate and end-of-process
inspections, supplies for the activities.
33

Costs of Nonconformance
Costs of Nonconformance - the expenditures incurred when
operations go awry; can go as high as 20% of sales; can be
categorized as internal failure and external failure costs.
Internal failure costs are incurred before the product is
shipped. Examples include costs of scrap, rework, reinspection, opportunity cost of machine downtime.
External failure costs are incurred after the product is
shipped. They arise from product failure at the customer
level. Examples include the costs of processing customer
complaints, customer returns, warranty claims, product
recalls, product liability, marketing costs, and opportunity
costs of lost sales and reduced contribution margin.
34

Summary of Cost Concepts

For purposes of valuing inventories and measuring income,
costs are classified as either product costs or period costs.
For purposes of predicting cost behavior, costs are classified
as either variable or fixed.
For purposes of assigning costs to cost objects, costs are
classified as either direct or indirect.
For purposes of making decisions, the following cost
distinctions are important:
Differential costs and revenues.
Opportunity cost.
Marginal cost.
Sunk costs.
For evaluating performance, costs are classified as
controllable or non-controllable.
For purposes of managing costs of quality, quality costs are
classified as either costs of conformance or costs of
nonconformance.
35

Summary of Cost Flow Equations

Materials Inventory Equation:
Beg. Matls. Inventory + Purchases = Materials used
+ End. Matls. Inventory
Work-in-Process (WIP) Inventory Equation:
Beg. WIP + Tot. Mfg. Costs Incurred = Cost of Goods Mfg. + End. WIP
Beg. WIP + (DM used + DL + MOH) = COGM + End. WIP
Beg. WIP + (DM used + DL + MOH) = Total mfg. costs to account for
Finished Goods (FG) Inventory Equation:
Beg. FG + Cost of Goods Mfg. = Cost of Goods Sold + End. FG
Beg. FG + COGM = COGS + End. FG
Beg. FG + COGM = Cost of goods available for sale (COGAS)

36

Cost Behavior: Analysis and Use

37

Motivation for Understanding Cost

Behavior
Understanding how costs behaved in the past informs us
as to their likely behavior in the future, thus allowing us to
predict costs.
Decision making involves choosing between alternatives.
Managers need to know the costs that are likely to be
incurred for each alternative. Examples:

How much overhead should be allocated to this cost object?

How much will costs increase if sales increase by 10 percent?
What will costs be if the firm introduces a new product?
How much should the firm bid on a prospective job?

The link to firm value?

More accurate costs => Better decisions => Increased firm
value

38

Cost Behavior
Cost category In Total
Per Unit
Variable
Total variable cost
Variable cost per unit
changes as the activity
remains the same over wide
level changes
ranges of the activity
Fixed
Total fixed cost remains
Fixed cost per
unit
constant even when the
decreases when the
activity level changes
activity level increases
Total costs = Fixed costs + Variable costs
= F + VX
where V is the variable cost per unit of the activity, and X is the
volume of the activity in appropriate units.

39

Types of Fixed Costs

Committed fixed costs - relate to the investment in facilities,
equipment, and the basic organizational structure of the
firm. Examples include depreciation of buildings and
equipment, taxes on real estate, insurance, etc.
Discretionary fixed costs - usually arise from annual
decisions by management to spend in certain fixed cost
areas. Examples include advertising, research and
development, public relations, etc.
The trend in many companies is toward more fixed costs
relative to variable costs, primarily through investments in
automation and technology. This has led to an increase in
the demand for knowledge workers needed to operate the
machinery or technology.
40

The Relevant Range

The relevant range is defined as the activity range
within which a cost projection may be valid.
Within the relevant range, both unit variable costs
(V ) and total fixed costs (F ) remain essentially
unchanged.
The relevant range includes the upper and lower
limits of past activity for which data are available.
However, outside the relevant range, the general
cost equation we estimate may not be valid.

41

Methods of Estimating Costs

Methods include:

Engineering estimates.
Account analysis.
Scattergraphs and high-low analyses.
Statistical methods.

Each approach focuses on estimating cost

functions that separate a mixed (or semivariable)
cost into its fixed and variable components.

42

Engineering Estimates
Cost estimates are based on measurement and pricing of the
work involved.
Direct labor:
- Analyze the kind of work performed.
- Estimate the time required for each labor skill for each unit.
- Use local wage rates to obtain labor costs per unit.
Direct material:
- Material required for each unit is obtained from engineering
drawings and specification sheets.
- Material prices are determined from vendor bids.
Overhead costs are obtained in a similar fashion - a detailed
step-by-step analysis of the work involved.
43

Advantages/Disadvantages of Engineering
Estimates
Advantages:
- Detailed analysis results in better knowledge of the
entire process.
- Data from prior activities is not required, so it can be
used to estimate costs of new activities/products.
Disadvantages:
- Detailed analysis is time-consuming (thus costly).
- Engineering expertise is usually required.

44

Account Analysis
Cost estimates are based on a review of
each account making up the total cost
being analyzed.
The objective of the analysis is to relate
costs and activities in the form of the
general cost equation.

45

Account Analysis - Procedure

Identify each cost category as fixed or variable.
Sum the fixed costs, yielding F.
Sum the variable costs, yielding VX.
Divide the total variable costs (VX ) by the total
number of units of the activity (X ) to obtain the
variable cost per unit (V ).
The result is a specific cost equation that can be used
to forecast total costs at other levels of activity:
Total costs = F + VX.
46

Account Analysis - Example

Total
Account
Costs
Indirect labor
$
450
Indirect materials
Depreciation
1,000
Property taxes
200
Insurance
300
Utilities
400
Maintenance
600
Totals
$ 3,650

Overhead Costs for 1,000 Units

Variable
Fixed
Costs
Costs
$ 450
$
700
700
1,000
200
300
350
50
500
100
$ 2,000
$ 1,650

47

Account Analysis - Example

To compute variable cost per unit:
V = Total variable costs / level of activity
= ($2,000 / 1,000 units) = $2.00 per unit.
Fixed costs are as identified in the analysis:
F = $ 1,650.
The cost equation relating overhead costs to units of output
is:
Overhead costs = $ 1,650 + $2.00/unit (Number of units)
Estimate the total overhead cost for 1,400 units of output:
Overhead costs = $ 1,650 + $2.00/unit (1,400 units)
= $ 1,650 + $2,800 = $ 4,450.
48

Advantages/Disadvantages of Account
Analysis
Advantages:
Applied properly, the approach is a reasonable means
of estimating the cost function.
Takes advantage of the experience and judgment of
managers and accountants who are familiar with
company operations and the way costs react to
changes in activity levels.
Disadvantages:
The person estimating the cost function may not be
objective and may misclassify costs as fixed and
variable.
Accounting and managerial expertise are required.
49

Scattergraph (Visual Fit) Method

The scattergraph is a very useful approach to analyzing
costs.

Steps in estimating the cost function:

Plot the data points on a graph (total cost versus

activity) that includes the origin (zero total costs, zero
activity).
Draw a line through the plotted data points so that
about equal numbers of points fall above and below the
line.
Extend the line to Total Cost axis. The point at which
the line intersects the Total Cost axis is F.
The slope of the drawn line is V. The slope is computed
as (Change in cost/Change in units of activity).
50

High-Low Method
Similar to the scattergraph method.
Rather than eyeballing the line, two points in the scatterplot
are chosen and a straight line drawn to connect them.
The two points should be representative of the cost and
activity relationships over the range of activity for which the
estimation is made. These are usually the highest and lowest
levels of the activity (not the cost).
Slope of line = V = (Costhigh Costlow) / (Unitshigh Unitslow).
Intercept of line = F = Costhigh V x (Unitshigh), or
= Costlow V x (Unitslow).

51

High-Low Method - Example

A firm recorded the following production activity and
maintenance costs for two months:
Units
Cost
High activity level
9,000
$9,700
Low activity level
5,000
$6,100
Change
4,000
$3,600
Using this information, compute:
- Variable cost per unit,
- Fixed costs, and
- The cost equation relating maintenance costs to
production.
52

High-Low Method - Example

Unit variable cost = $3,600 / 4,000 units = $0.90/unit.
Fixed costs (using
= $9,700
= $9,700
Fixed costs (using
= $6,100
= $6,100

the highest activity level)

(9,000 units)($0.90/unit)
$8,100 = $1,600.
the lowest activity level)
(5,000 units)($0.90/unit)
$4,500 = $1,600.

The cost equation is:

Maintenance costs = $1,600 + $0.90/unit x (Number of
units)

53

Advantages/Disadvantages of
High/Low and Scattergraph Methods
Advantages:
- Plotting cost/activity data is useful in assessing
associations
and possible structural changes.
- Involve relatively simple calculations.
- Easy methods to apply.
Disadvantages:
- Inherently subjective in application.
- Model parameter estimates do not use all of the data.
- No statistical means of assessing model fit.

54

Regression Analysis
Regression analysis is a statistical procedure that is
used to estimate the parameters of a model that
can be used for forecasting purposes.
The general cost equation estimated is still:
Total costs = F + VX.
In the context of regression analysis, we call total
costs the dependent variable and we call X the
independent variable. The dependent variable is
whatever we are attempting to estimate or forecast.
55

Measures of Goodness of Fit

Correlation coefficient - a measure of the linear
association between variables such as costs and
activities. The correlation coefficient, r, is bounded by 1
and +1. A correlation of +1 indicates a perfect positive
association between two variables, while a correlation of
1 indicates a perfect negative association. A correlation
of 0 indicates no association between two variables.
Coefficient of determination - the square of the
correlation coefficient, called R2, is interpreted as the
proportion of variability in the dependent variable that is
explained by its linear association with the independent
variable. R2 is bounded by 0 and 1; the closer that R2 is
to 1, the closer the data points are to the fitted
regression line.

56

Advantages of Regression Analysis

Unlike the high-low method, all data are used in
computing parameter estimates.
The approach yields a model that represents the
best possible fit.
Statistical information generated can be used to
assess the strength of the association between
costs and activity levels and to forecast future
costs given some anticipated level of the activity.
The approach can be generalized to incorporate
more than one cost driver in explaining total costs.
57

Regression Method Cautions

A logical relationship must be established between the
variables.
Entering numbers into the analysis that have no
logical relationship will result in meaningless
estimates.
Linear regression assumes that a linear model
describes the data.
An apparently strong relationship may be due to
another variable that is not included in the model.
Data points that vary significantly from the regression
line (outliers) draw the regression line away from the
majority of data points.
58

Regression Method Cautions (continued)

The intercept term should be used with caution
as an estimate of fixed costs, since the
intercept is likely to be outside the relevant
range of observations (it occurs at an activity
level of zero).
The regression line may be a poor predictor of
future costs if (1) cost-activity relationships
have changed, or (2) costs themselves have
changed independently of activity changes.

59

Which Cost Estimation Method Is

Best?
No single method is best for all situations.
Better results are often obtained by use of several
of the methods. For example:
Engineering estimates and account analysis
may lead to the establishment of logical, causal
relationships between variables.
A scattergraph plot will lead to a better
understanding of the relationship and may
reveal outlier data points.
Regression provides the best equation for the
data points and yields statistical measures of fit.
60

Multiple Regression
We can extend the simple regression model (i.e., one
independent variable) to include multiple cost drivers
(i.e., multiple independent variables).
The resulting model can be specified as:
TC = F + V1X1 + V2X2 + . . . + VkXk.
where TC = total costs, and the rest of the variables have
the same meanings as in the simple model.
In concept, we will apply this general model to the
activity-based accounting model we will cover later:
TC = F + VuXu + VbXb + VpXp.
The subscripts (u, b, and p) indicate various categories of
cost drivers.
61

Cost-Volume-Profit (C-V-P)
Relationships

62

Cost-Volume-Profit Relationships
Cost-Volume-Profit (C-V-P) Analysis - the study of the
interrelationships between costs and volume and how
they impact profit.
Surveys suggest that over 50 percent of responding firms
use some form of C-V-P analysis.
Useful in answering such questions as:
How will revenues and costs be affected if we sell
1,000 more units? If we raise or lower our selling
prices? If we cut fixed costs by 20 percent?
How many units must we sell in order to break even?
How might changes in product mix affect our profits?
63

Assumptions
Linear C-V-P analysis assumes that . . .
Revenues change proportionately with volume.
Total variable costs change proportionately with volume.
Fixed costs do not change at all with volume.
Product mix is constant.
All output is sold (equivalently, there is no net change in
inventory levels).

64

C-V-P Analysis as a Planning and Analysis

Tool
C-V-P analysis arises from manipulation of the
fundamental equation: Profit = TR TC, where TR =
total revenues, TC = total expenses.
Next, define P = selling price per unit, V = variable cost
per unit, X = number of units sold, F = total fixed costs, t
= tax rate, OI = operating (pre-tax) income, and NI = net
income. Further, assume that output volume is the only
cost driver.
Note that, since OI = TR TC, then:
(1 t)(TR TC) = (1 t) OI = NI.

65

C-V-P Models
Using the previous assumptions and definitions, we
can derive the following equivalent expressions:
Equation approach to C-V-P Model:
(1 t) [(P V) X F ] = NI.
Contribution approach to C-V-P Model:
X = {F + [NI /(1 t)]} / (P V).
The term (P V) is called contribution margin per
unit (or CM/unit).

66

C-V-P Analysis and Different Cost

Structures
An organizations cost structure is represented
by the relative proportions of fixed and variable
costs to total costs.
Cost structures differ dramatically across
industries (e.g., grocery stores versus heavy
manufacturers; legal services firms versus urban
hospitals).
An organizations cost structure has a significant
effect on the sensitivity of its profits to changes
in volume.
67

Operating Leverage
The extent to which a firms cost structure is made up of
fixed costs is called operating leverage.
Everything else being equal, the higher a firms operating
leverage, the higher its break-even point.
Higher leverage is associated with more rapidly increasing
losses if demand is less than that required to break even.
Higher leverage is associated with more rapidly increasing
profits after reaching the break-even point.
Firms with lower (higher) leverage tend to have greater
(lower) flexibility in reacting to changes in demand.
68

Relevant Costs for Decision Making

69

Information Relevance and Decision

Making
A decision involves a choice between two or more
alternatives.
Information is relevant if it is pertinent to a
decision problem.
Information that is pertinent to a decision
problem must also be accurate (or precise).
Information that is relevant and accurate is of
little use if it is not timely, (i.e., available in time
to be used in making a decision).
70

Relevant Costs
Relevant cost - a cost that differs between
alternatives.
Relevant cost or benefit information:
Has some bearing on the future.
Is different across competing alternatives.
Use of relevant costs and benefits in decision making:
Eliminate costs and benefits that do not differ
between alternatives.
Use the remaining costs and benefits that do differ
across alternatives in making the decision.
71

Types of Costs to Consider

Sunk costs.
Opportunity costs.
Future costs that do not differ across
alternatives.
Out-of-pocket costs (or outlay costs).
Allocated fixed costs.
Avoidable versus unavoidable costs.

72

Sunk Costs
Sunk Costs - costs which have already been
incurred and cannot be changed by any
current or future action. This implies that sunk
costs are irrelevant in decision making.
Examples: Book value of equipment, cost of
inventory on hand.
Both of these items represent costs that
were incurred at some time in the past;
write-offs of these amounts are irrelevant
unless they affect cash flows.
73

Opportunity Costs
An opportunity cost is the potential benefit
given up when the choice of one action
precludes choosing a different option.
Opportunity costs tend to be overlooked or
underestimated, but are usually extremely
important in making a decision. Typically,
opportunity costs are as important as (and
sometimes more important than) initial out-ofpocket costs in the decision.
74

Allocated Fixed Costs

Allocated fixed costs can make a particular
product line or segment appear
unprofitable.
Yet dropping the line (or segment) could
result in lower earnings for the firm if (1)
the product line (or segment) is generating
positive contribution margin, and (2) the
allocated fixed costs are unavoidable.

75

Avoidable versus Unavoidable Costs

An avoidable cost is a cost that can be eliminated in
whole or in part by choosing one alternative over
another.
Future costs that do not differ across alternatives
would represent unavoidable costs, and, hence, they
would be irrelevant to any decision regarding the
alternatives.
By this criterion, a sunk cost is an unavoidable cost
and, therefore, it will never be a relevant cost in
decisions.
76

Analysis of Special Decisions

Accept or reject a special order.
Outsource a product or service (make or buy).
Add or drop a service, department, or product.

77

Accept or Reject A Special Order

Relevant factors in the decision to accept or reject a
special order:
Does excess capacity exist?
What are the differential revenues and differential
costs?
What effect would filling this order have on regular
sales volume and prices?
Decision rule: Everything else being equal, accept the
special order if the incremental revenues of accepting the
order exceed the incremental costs; otherwise, reject the
special order.

78

Outsourcing Decisions
Relevant factors in the decision to outsource a product or
service:
What are the relevant costs in producing the product or
providing the service?
How important is it to have control over quality and
availability?
What amount of productive capacity is foregone by
producing the product or service internally?
Decision rule: Everything else being equal, outsource the
product or service if the incremental benefit of outsourcing
exceeds the incremental benefit derived from sourcing
internally; otherwise, generate the product or service
internally.
79

Product Line Decisions

Relevant factors in the decision to continue or discontinue
a product line:
How will the discontinuance of a product line affect the
sales of the companys other products?
What alternative use might be made of the production
facilities now used to manufacture this product line?
How will the discontinuance of a product line affect the
profitability of the companys other products?
Decision rule: Everything else being equal, continue the
product line if earnings including the product line exceed
earnings excluding the product line; otherwise,
discontinue the product line.
80

Steps Involved In Evaluating A Product

Line
Identify the effect on overall sales of dropping the product line,
including possible reduced sales from complementary products,
or increased sales of other product lines.
Identify the relative reduction in variable costs, and the
corresponding change in contribution margin as a result of
dropping the product line.
Identify the relative reduction in fixed costs, if any, as a result of
dropping the product line.
Compute the difference in earnings between keeping or dropping
the product line. Then implement the decision rule as to
whether to keep or discontinue the product line.
81

Decisions Involving Limited

Resources
Given scarce resources, firms must choose which
products or orders to fill, and which ones to decline.
Decision rule: Given a constraint on output, produce
the product (or service) that maximizes the contribution
margin per unit of the constrained resource, everything
else being equal.

82

Pitfalls to Avoid
Sunk costs - These costs occurred in the past and cannot be
changed by any current or future course of action.
Unitized fixed costs - Fixed costs are unitized for product
costing purposes, thus appearing to be variable (and, hence,
avoidable if production were to cease). Fixed costs should
be considered in total rather than on a per-unit basis.
Allocated fixed costs - Allocated fixed costs may or may not
be avoidable even though the product or operating unit to
which the costs are allocated has been discontinued.
Opportunity costs - Opportunity costs are just as real and
important to making a correct decision as are out-of-pocket
costs.
83

Cost System Design:

Job Costing

84

Overview of Costing Systems

Costing systems provide the unit cost of
producing a product or service.
Costing systems provide different cost figures
as needed for different purposes:
Purpose Reported costs
Make or buy decision Incremental costs
Financial statements Full absorption costs
Long-term pricing
Full costs of all value chain
functions
85

Design of Costing Systems

Costing systems should have a decision
making focus in that they meet the
information needs of decision makers.
Cost information for managerial purposes
must meet the cost-benefit test. The
benefits of system improvements must
outweigh the costs of improvement.
Design of the cost system should not be
subordinated to the needs of the external
financial reporting function.
86

Characteristics of Job Costing

Systems
Costs are accumulated by job. If a job consists of a number of
identical units, the cost of an individual unit can then be
computed as sum of the costs of the job, divided by the
number of units produced.
There is a subsidiary account, or job cost record, for each job.
The costs of each inventory control account (e.g., WIP, FG)
equals the sum of the costs accumulated for each job in that
inventory.
Job-order costing is widely used in construction companies,
manufacturers, service providers, and nonprofit organizations.

87

Why Accumulate Costs by Job?

Managers can use their knowledge of the costs of
prior and current jobs to estimate the costs of
prospective jobs.
Managers can compare actual job costs to the
estimated (or budgeted) job costs in order to control
costs.
Since the actual costs of jobs sometime deviate from
estimated costs, managers can use job cost
information to renegotiate contracts with customers.

88

Attaching Costs to Jobs

1.

Identify the job requiring cost measurement.

2.

Identify the direct cost categories for the job.

3.

Identify the indirect cost pool(s) associated with the

job and an appropriate allocation base.

4.

Trace the direct costs to the jobs.

5.

Allocate the indirect costs to the job using the

chosen allocation base.
89

Cost Tracing versus Cost Allocation

Direct costs are traced to the specific job.
Indirect costs are allocated to the specific job.
Costs are allocated to jobs because jobs
consume costly resources that cannot be traced
in an economically feasible manner.

90

Methods of Assigning Costs to Jobs

Actual costing - a costing method that assigns direct
costs and indirect costs to jobs based on the actual
costs incurred.
Normal costing - a costing method that assigns direct
costs to jobs based on actual costs incurred, and
assigns indirect costs to jobs using a predetermined
overhead rate.
Standard costing - a costing method that assigns
both direct and indirect costs to jobs using
predetermined or budgeted rates.
91

Why Use Predetermined Overhead

Rates?
Predetermined rates have certain advantages over actual
rates:
They reduce variability inherent in actual overhead
rates.

Managers do not have to wait until the end of an

accounting period to get job cost reports.

They require managers to engage in planning.

They set performance expectations.

Any resulting variances are attention-directors.

92

Computing/Using Predetermined Overhead

Rates
Identify the indirect costs to be allocated.
Estimate the amount of these costs expected to be incurred
during the period, based on the estimated level of operations.
Select an appropriate cost allocation base.
Estimate the level of the allocation base expected to be
consumed, based on the estimated level of operations.
Compute the predetermined overhead (OH) rate:
OH Rate = Est. annual OH costs/Est. level of allocation base.
During the period, measure the actual amount of the
allocation base consumed by a given job.
Allocate overhead by multiplying the predetermined rate by
the actual amount of the allocation base consumed by the
job.

93

Accounting for Allocated (Applied) Overhead

Allocation (or application) of overhead is
accounted for independently of the incurrence
of overhead.
The Inventory account is debited for the
allocated overhead and the Overhead account
is credited with the amount of the
allocation.
If actual overhead during the period is greater
(less) than applied or allocated overhead, this
gives rise to an overhead variance.
94

Over- or Underapplied Overhead

The Overhead account is a temporary account
and is closed out at the end of the accounting
period.
The difference between the actual overhead
incurred and the amount allocated to jobs
represents the over/under applied overhead or
the overhead variance.
Large overhead variances are candidates for
investigation, as they may indicate that a
process is out of control.
95

Causes of Overhead Variances

An overhead variance will occur whenever total
actual overhead incurred differs from the total
amount of overhead allocated to jobs.
This condition will occur for one or both of the
following reasons:
Actual total overhead cost differed from expected
total overhead cost (the numerator reason).
Actual amount of allocation base used differed
from the budgeted amount used to compute the
rate (the denominator reason).

96

Activity-Based Costing

97

Identifying Activities
Activity - any event that causes the consumption of overhead resources.

Activities can be generally be classified into five broad classes:

Unit-level activity - activities performed each time a unit is produced.
Batch-level activity - activities performed each time a batch is handled
or processed, regardless of how many units are in the batch.
Product-level activity - activities that relate to specific products and
typically must be carried out regardless of how many batches are run or
units of product are produced or sold.
Customer-level activity - activities that relate to specific customers and
include activities that are not tied to any specific product.
Organization-sustaining activity - activities that are carried out
regardless of which customers are served, which products are produced,
how many batches are run, or how many units are made.

98

Cost Distortions/Inaccuracy with Volume-Based

Systems
Volume-based costing system - A product costing system in
which costs are assigned to products or services on the basis
of a single activity base that is closely related to volume
(e.g., direct labor hours, number of units, machine hours).
Distortions in reported costs may arise if:
A relatively large proportion of indirect costs incurred
relate to non-unit-level activities (i.e., batch-level,
product-level, customer-level or organization sustaininglevel).
The individual products or services make differing
demands on firm resources through their use of activities
(i.e., products or services are diverse).

99

Activity-Based Costing
Activity-based costing (ABC) system - A product costing system in
which costs are assigned to products or services on the basis of their
consumption of an organizations fundamental activities.
Activity-based costing is designed to provide managers with cost
information for strategic and other decisions that potentially affect
capacity and, therefore, fixed costs.
ABC systems are usually supplemental to the firms formal cost system
(which computes product costs for external reporting purposes).
The linkage between resources and costs:
Products/services
resources

Activities

Firm

100

Steps in Implementing Activity-Based

Costing
1. Identify and define activities and activity pools.
2. Whenever possible, directly trace costs to activities and cost
objects.
3. Assign costs to activity cost pools.
4. Calculate activity rates.
5. Assign costs to cost objects using the activity rates and activity
measures.
6. Prepare management reports.

101

Baxendale and Dornbusch:

Activity-Based Costing for a Hospice
ABC can be applied to a service organization as well as a
manufacturing firm, including not-for-profit groups.
The issue faced by Hospice of Central Kentucky was properly
measuring the costs of providing hospice care, conditional on the
degree of acuity faced by patients.
The underlying assumption: Higher acuity involves greater
consumption of hospice resources.
The result of the analysis and cost system modifications was that
higher acuity patient-days are assigned higher costs.
This helped the hospice justify higher reimbursement rates from
health care insurance programs for patients making greater
demands on hospice resources.
102

Customer Profitability Analysis

Customer profitability analysis is a manifestation of the responsibility
accounting concept. Customers are held responsible for the costs
and revenues they generate for the firm.
Revenues and costs caused by each customer are assessed using
activity analysis.
Customers may be broadly categorized into two classes:
High cost-to-serve.
Low cost-to-serve.
Profitability analysis generally helps firms in identifying high and low
cost-to-serve customers.
Customer profitability reports typically indicate that only a relatively
few of a firms customers generate most of its profits.
103

Activity-Based Management
Porters concept of the value chain motivates
implementation of activity-based management
(ABM).
An organization is a causal chain of activities that
add profit or customer value through the
transformation of inputs into delivered services or
products.
The strategic organizational design issue is
configuring an organizations value chain effectively
and efficiently.
104

Activity-Based Management
Activity-based cost management - Key objectives:
To measure the cost of the resources consumed in
performing the organizations significant activities.
To identify and eliminate non-value-added costs.
These are the costs of activities that can be
eliminated with no deterioration of product quality,
performance, or perceived value.
To determine the efficiency and effectiveness of all
major activities performed in the enterprise.
To identify and evaluate new activities that can
improve the future performance of the organization.

105

Value-Added vs. Non-Value-Added

Activities
Two types of value-added activities:
- Activities that add value to the customer.
- Activities essential for the proper functioning of the
enterprise.
Non-value-added activities are activities that can be
reduced or eliminated without decreasing the
enterprises ability to compete and meet customer
demands.

106

Resources Supplied Versus Resources

Used
Resources supplied to an activity are the expenditures or
amounts spent on the activity.
Resources used in an activity are measured by the cost (activity)
driver rate multiplied by the volume of the cost driver consumed.
The difference between resources used and resources supplied is
called unused resource capacity.
Activity-based management involves looking for ways to reduce
unused resource capacity.
Unused resource capacity occurs because managers commit to
supply a certain level of resources before they are actually used.

107

Unused Resource Capacity in

Activities
Recall the five levels of activities: unit-level, batch-level, product-level,
customer-level and organization-sustaining activities.
Where do firms have the greatest flexibility in reducing unused resource
capacity?
The greatest gains are usually made in the batch-level, product-level, and
customer-level activities.
Unit-level activities have to be performed once for every output, so
resources are supplied as they are used. Therefore, there is little unused
capacity.
Organization-sustaining activities represent long-term, committed costs.
There is typically unused capacity here unless the firm is operating at full
capacity. Control over these costs is exercised through capital budgeting
or other long-term commitments.

108

Process View (ABM) versus Cost Assignment View

(ABC)

109

Service Department Costing

Operating department those departments or units where the
central purposes of the organization are carried out; i.e., those
departments that carry out operating activities.
Service department those departments that do not engage in
operating activities. These departments support or provide
services to the operating departments.
Service department costs are generally considered to be part of
the cost of the final product or service.
Since products or services directly consume only operating
activities, this requires service department costs to be allocated
to operating departments.
110

Service Department Costing

Allocation rates of service department costs become
transfer prices for services. Consuming departments
thus purchase services at a unit price equal to the
allocation rate.
Regarding practice, some firms choose not to allocate
costs in order to encourage the use of the service
resource.
However, other firms allocate some portion of the costs
of the service resource (often the fixed portion) to reflect
the cost of the capacity provided. Paying a certain
amount, regardless of usage, may encourage usage of
the resource.

111

Methods for Allocating Service Department

Costs
Direct method no recognition of reciprocal (or
interdepartmental) services.
Step method partial recognition of reciprocal
services.
Reciprocal method full recognition of
reciprocal services.

112

Pricing Policy

113

Pricing Policy
Pricing policy is generally informed using one of
two basic approaches:

Cost-based pricing.
Market-based pricing.

Although infrequently used, an economicsbased framework would lead to price

adjustments culminating with the marginal
revenue of one additional unit sold exactly
equaling the marginal cost of that unit.

114

Cost-Based Pricing
Cost-based pricing assumes that:

Costs are known and available, and

Customers are, in general, price-takers in the market.

Cost-based pricing is rational in the sense that

revenues must exceed costs for long-run viability.
Cost-based pricing takes cost as the starting
point, and these costs are marked up to arrive
at a selling price. Regarding the cost base,
practice is diverse.
115

Cost-Based Pricing
Possible cost bases include:

Direct costs (materials, labor).

Total variable costs.
Full manufacturing costs.
Total value chain costs.

In general, the markup percentage must

be sufficiently large in order to cover any
costs not included in the cost base, plus
any profit expectations.
116

Cost-Based Pricing
The general expression for computing
the markup ratio is given by:
(Costs not included in the cost base + Desired profit) /
Cost base

This initial selling price would then be

computed as:
Initial price = Cost base + (Cost base x Markup ratio)

117

Cost-Based Pricing
Potential problems with cost-based pricing:

The approach requires accurate cost assignment.

All costs must be known to make appropriate markup
decisions.
It assumes payers are, generally, price-takers in the
market.
In a competitive market, cost-based approaches may
increase the time and cost of bring a new product to market.

These criticisms have led many organizations to

move toward more market-based approaches in
setting prices.

118

Target-Costing
Target-costing starts with determining what
customers are willing to pay for a product or service
(the target price).
The target cost is defined when a target profit is
subtracted from the target price.
Whether the organization can produce the product
or service at the target cost is the issue that
management must address.
The target cost is generally achieved by the
decisions made in the product development phase.
119

Target-Costing
Steps in target costing:

Determine customer wants, needs and price sensitivities.

Establish planned selling price.
Determine target cost (= Selling price desired profit).
Using the target cost constraint, task key employees and
trusted suppliers to:
Design the product.
Determine production procedures.
Determine necessary raw materials.

Repeat the previous step until the target cost is achieved.

Manufacture the product.
Sell the product.

120

Budgeting and Profit Planning

121

What is a Budget?
A budget is a detailed plan for the acquisition and use of
financial and other resources over a specified period of
time. Good budgeting practice should provide for both
planning and control.
Planning - developing objectives and preparing various
budgets to achieve these objectives.
Control - the steps taken by management to increase the
likelihood that the objectives set down at the planning
stage are attained, and to ensure that all parts of the
organization function in a manner consistent with
organizational policies.

122

Responsibility Accounting
Responsibility accounting is based on the notion
that managers should be held responsible for
those (and only those) cost/revenue items that the
manager can control to a significant extent.
However, while some costs may be uncontrollable,
a manager may still be able to mitigate the
incurrence of the cost through appropriate actions.
From a control point of view, someone in the
organization must take ownership for each
budget item or else no one will be responsible.
123

The Master Budget

Master budget - a financial plan of an organization for the
coming year or other planning period. It generally culminates in
a cash budget, a budgeted income statement, and a budgeted
balance sheet.
The master budget is also called the static budget.
The master budget reflects managements best guess as to the
sales levels, production and cost levels, income, and cash flows
anticipated for the coming year.
Developing a master budget is a dynamic process that ties
together goals, plans, decision making, and performance
evaluation.
124

The Master Budget and Strategic

Planning
Organization
goals

Long-range
strategic plan

Individual goals
and values

Anticipated
conditions

Individual
beliefs

Master
budget
Strategic
evaluation

Actual period
results

Performance
evaluation
125

Purposes of Budgeting Systems

Budgeting system - procedures used to develop
a budget.
Budgeting systems have five major purposes:
Planning.
Facilitating communication and coordination.
Allocating resources.
Controlling profit and operations.
Evaluating performance and providing
incentives.
126

Advantages and Disadvantages of

Budgeting
Advantages:
forces managers to plan.
provides performance benchmarks.
promotes communication and coordination.
Disadvantages:
consumes a good deal of time.
may lead to a short-term focus and gaming behavior.
managers may simply extrapolate current trends.
may lead to the impression that functional areas are
independent.
may promote a slash and burn mentality in tough times.

127

Performance Evaluation
Performance evaluation requires a benchmark or standard
for comparison.
Budgeted performance may be a better criterion than past
performance as a benchmark.
Past performance:
may hide inefficiencies.
may not reflect changes in opportunities in the external
business environment.
However, budgets induce additional problems, primarily in
the area of effects on human behavior (e.g., budget
administration may induce budget bias or budgetary
slack).
128

Promoting Coordination and

Communication
Coordination is the meshing and balancing of all factors of
production or service so that the organization achieves its
objectives.
The budget process forces departments with different
incentives and goals to communicate and work together
toward achieving the goals of the firm as a whole.
Communication is getting those objectives understood and
accepted by all parties.
Individual operating units and departments are thus
informed about where they fit in the overall scheme of the
firm and what is expected of each.
Coordination and communication allow managers to make
better judgments about the necessary resource allocations
within their departments.
129

Steps in Preparing the Budget

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.

Sales/revenue budget.
Ending inventory budget.
Production budget.
Materials requirements (in units and dollars) budget.
Labor costs budget.
Overhead costs budget.
Cost of sales budget.
Marketing and administrative costs budget.
Budgeted income statement.
Capital budget.
Cash budget.
Budgeted balance sheet.
Budgeted statement of cash flows.

130

Sales Budget
The sales budget is the basis for all other budget
components.
Units to be sold are a function of the forecasted selling
price.
The budget requires a forecast of sales, typically involving
sales staff and market research. Various statistical
techniques may also be used. Sales may be forecasted in
units and in dollars.
Budgeted revenues can be computed as:
Forecasted sales (in units) x Forecasted selling price.
131

Ending Inventory and Production

Budgets
We use the following relationship to forecast production
requirements:
Required
Budgeted
Budgeted
Budgeted
production
=
sales in +
ending in beginning
in units
units
inventory
inventory
Three estimates required to forecast production:
Budgeted sales in units.
Budgeted ending inventory.
Budgeted beginning inventory.
Estimated units in beginning and ending inventories based
on inventory policies and/or market conditions.
132

Materials
We use the following relationship to forecast
material purchase requirements:
Required
purchases
in units

Materials
Budgeted
to be used in +
ending
production
inventory

Budgeted
beginning
inventory

Beginning and ending inventory levels are

estimated using some inventory model, while
production requirements are based on an estimated
amount per unit.
Multiplication of each component by the forecasted
cost per unit converts these amounts to dollars.
133

Labor and Overhead Budgets

Amounts of labor and overhead expected to be consumed
are based on the production budget.
These amounts are also used to forecast staffing levels.
Overhead estimates tie back to estimated capital
budgeting expenditures for capacity.
Costs may be broken out into fixed and variable
components.
If activity-based costing is used for budgeting purposes,
levels of activities are forecasted based on anticipated
production, and overhead is estimated for each activity.
134

Cost of Sales Budget

Computation requires estimates of beginning and
ending levels of work-in-process and finished goods
inventories.
If WIP levels are assumed to be constant, the
calculation reduces to:
Estimated
Cost
=
of Sales

Estimated
Budgeted
Budgeted
production + cost of beginning cost of ending
costs
inventory
inventory

Estimated production costs consist of estimated

materials costs, labor costs, and overhead costs
from the previous budgeted amounts.
135

Marketing and Administrative Costs

The budgeting objective is to estimate the
amount of marketing and administrative costs
required to:
Operate the organization at its projected level
of sales and production.
Achieve long-term company goals.
These estimates are often based on prior period
expenditures or planned expenditures, but
adjusted for inflation, changes in operations, etc.

136

Budgeted Income Statement

The budgeted income statement is easily generated
using information from the previous budgets.
To complete the computation of net income, an
estimate must be made of tax expense.
The computed net income is then incorporated into
the calculation of budgeted retained earnings, while
estimates of ending materials, work in process and
finished goods inventories are incorporated into
budgeted assets.

137

Cash Budget
We now need to incorporate the sales cycle in forecasting cash
requirements:
Cash => Inventory => Sales => Accts. Recv. => Cash
Cash budget - a statement of cash on hand at the start of the budget
period, expected cash receipts, expected cash disbursements, and
the resulting cash balance at the end of the period.
Cash disbursements - amounts required to pay for purchases,
operating expenses, taxes, interest, dividends, etc.
Cash receipts - collections from accounts receivable, cash sales, sales
of assets, borrowing, issuing stock, etc.
The cash budget requires that all revenues, costs, expenses, and
other transactions be examined in terms of their effects on cash.
138

Budgeted Balance Sheet

Budgeted balance sheet - a statement of budgeted financial
position.
The ending balance in a given account equals the beginning
balance plus any estimated change.
The cash budget provides the ending cash balance on the balance
sheet.
The ending inventories for materials and finished goods are
reported on the balance sheet.
Ending accounts receivable/accounts payable are derived from the
cash budget.
The budgeted statement of cash flows explains the difference
between estimated cash at the beginning of the period and that at
the end of the period. The change in cash is explained as arising
from operating activities, investing activities, and financing
activities.
139

How the Budget Pieces Fit Together

Production
budget
Required materials,
labor and overhead
budgets

Sales forecast

Budgeted cost
of sales

Marketing and
admin. budget
Budgeted
income
statement

Cash budget
Budgeted balance
sheet

140

Flexible Budgets
Budgets are usually used to evaluate
performance after the fact, using a process
known as variance analysis.
Since some costs are variable with respect to
output and some are fixed, changes in output
will automatically lead to increases/decreases
in costs absent any input from managers.
Since static budgets reflect planned output
rather than actual output, they are not a good
basis of comparison to actual costs.

141

Flexible Budgets
In order to use the budget as a control tool (i.e., to evaluate
cost and revenue performance at the end of the period),
budgets usually require revisions to reflect actual output
during the period rather than planned output.
A flexible budget is designed to facilitate these revisions, as
the budget is prepared with full consideration of variable
costs, fixed costs, and the associated cost-volume relations.
Flexible budgets tell managers what costs should have
been given the actual level of output. This makes for a
more equitable basis for comparison with actual costs, and
makes variances easier to interpret.

142

Standard Costs,
Performance Reports, and
the Balanced Scorecard

143

Standard Costs
Definition: Standard costs are benchmarks for the cost of
a product, process, or subcomponent.
Used for Planning and Decision Making:
Standards can be better predictors of future costs
than actual past costs.
Can be used in product pricing, bidding, and
outsourcing decisions.
Used for Controlling Operations:
Set performance expectations.
Variances from standards get attention of managers.
144

Setting and Revising Standards

Setting standards depends on specialized
knowledge:

Price (or rate) standards derived from economic forecasts.

Quantity (or efficiency) standards derived from engineering
studies.

Choosing between tight and loose standards:

Tight standards motivate higher performance.

Loose standards allow more discretion.

Standards are usually set once a year:

Frequent revision would reduce incentives to control costs.

145

Purpose of Variances
Variances measure the difference between
actual and standard costs:

Favorable (F) variance, if actual < standard.

Unfavorable (U) variance, if actual > standard.

Controlling operations:

Variances alert managers to deviations from plan.

Performance rewards may be based on
minimizing variances.

146

Variance Computation
Symbols: A = Actual; S = Standard; P = Price; Q = Quantity
Total Variance
Standard Cost

Actual Cost

Total Variance =
(AQ AP)

(SQ SP)
= (AQ AP) (SP AQ) + (SP AQ) (SQ SP)
= [(AQ AP) (SP AQ)] + [(SP AQ) (SQ SP)]
= [ AQ (AP SP) ] + [ (AQ SQ) SP ]
=
Price Variance
+
Quantity Variance
Total Variance
Quantity Variance

Price Variance

147

Direct Labor Variances

Symbols: AQ = Actual quantity of hours used; SQ = Standard
quantity of hours allowed; SP = Standard wage rate per hour; AP
= Actual wage rate.
Total
Total
actual
standard
cost
cost
AQ AP
AQ SP
SQ SP
|________________________|______________________|
AQ (AP SP)
(AQ SQ) SP
Rate variance Efficiency variance
|_______________________________________________|
(AQ AP) (SQ SP)
Total labor variance
Note: Total standard cost equals the cost allowed for the actual
output achieved.

148

Interpreting Direct Labor Variances

Large variances in either direction indicate performance is not
as planned, due to poor planning, poor management, poor
standards, or random fluctuation.
Unfavorable rate variance:

Could indicate overtime had to be paid, depending on how

overtime is accounted for.
Workers were not available at lower rates.

Unfavorable wage variance with favorable efficiency variance:

Higher-paid workers performed work more efficiently.

Favorable wage variance with unfavorable efficiency variance:

Lower-paid workers performed work less efficiently.

149

Direct Material Variances

Total actual
Actual Purchases
cost
at standard cost
AQ AP
AQ SP
|______________________________|
AQ (AP SP)
Price variance
Actual Usage at
Total standard
standard cost
cost
AQ SP
SQ SP
|_______________________________|
(AQ SQ) SP
Quantity variance
Price variance recognized at time materials are purchased.
Quantity (efficiency) variance recognized at time materials are used.

150

Interpreting Direct Material

Variances
Large variances in either direction indicate performance is not as planned, due
to poor planning, poor management, poor standards, or random fluctuation.
Price and Quantity variances:

Unfavorable: Material purchased for more than planned prices; could also
indicate material had to be rush/special-ordered, due to late requisitioning
by production. More material used than expected.

Favorable: Material purchased for less than planned prices; could indicate
lower quality material purchased or excess quantities purchased (quantity
breaks). Less material used than expected

Unfavorable price variance with favorable quantity variance:

Higher-quality material resulted in less waste and scrap; may also result in
a favorable labor efficiency variance.
Favorable price variance with unfavorable quantity variance:

Lower-quality material resulted in more waste and scrap; may also result
in an unfavorable labor efficiency variance.

151

Advantages of Standard Costing

Provide the basis for sensible cost comparisons.
Enables managers to employ management by
exception.
Provide a means of performance evaluation.
Provide motivation for employees to achieve
standards.
Result in more stable product costs if used in
product costing.
May result in cost savings in maintaining
inventory records.
152

Potential Disadvantages of Standard

Costing in Modern Production Settings
Information may be too aggregated and too delayed to be
useful in controlling things that matter.
Information may be aggregated over multiple product lines or
production batches.
Requires a stable production process to be cost-effective.
Shorter product life cycles lead to quickly outdated standards.
Variance analyses tend to lead to a primary focus on cost
minimization, rather than on value maximization.

153

Incentive Effects of Standard

Costing
Incentives for both Purchasing and
Production to build inventories.
Externalities imposed on the firm through
the actions of Purchasing and/or Production.
Disincentives to cooperate.
Incentives to engage in satisficing (i.e., do
only what is necessary to meet the
standard).
154

Earnings as a Summary Performance

Measure
Earnings represent the changes in the net assets of the
firm (exclusive of owner activity). Accounting rules require
that some assets remain unrecognized because of the
difficulty of placing a reliable financial value on them.
Example of unreported assets:
New product pipelines.
Process capabilities and flexibility.
Customer relationships.
Employee skills, expertise and motivation.
Databases and other forms of information technology.
Earnings measure changes in the above unrecognized
assets poorly.

155

Earnings as a Summary Performance

Measure
Further, reported earnings always lag actual performance,
leading to the criticism that earnings are not timely.
This suggests that reported earnings is not an adequate
summary performance measure, and is not a sufficient
statistic.
A line of accounting research has documented that a
fixation on financial performance measures may lead to
dysfunctional behavior on the part of managers (e.g.,
disinvestment, reduced spending on quality and R&D,
earnings manipulation).
Instead, the performance measurement system needs to
measure and report relevant measures in addition to
earnings that employees can use to inform and guide
value-relevant actions.
156

The Balanced Scorecard

More firms are using a portfolio of measures to assess
performance.
Kaplan and Norton (1992) have advocated a balanced
scorecard approach to performance measurement that
they argue (1) provides managers with a fast but
comprehensive view of the business, and (2)
communicates to managers the measures to which
they need to attend.
The scorecard consists of (1) financial measures to
summarize the results of actions already taken, and (2)
operational measures that are the drivers of future
performance.
157

Strategic Dimensions of The

Scorecard
The balanced scorecard is a way to clarify,
simplify, and then operationalize the vision at
the top of the organization.
In other words, the scorecard presents a
prescriptive view of the organization.
Perspectives of concern:
Innovation, learning and growth perspective.
Internal business perspective.
Customer perspective.
Financial perspective.
158

Innovation, Learning and Growth

Perspective:
Can We Continue To Improve And Create
Value?

Intense global competition requires that firms

make continual improvements to their existing
products and processes and have the ability to
introduce entirely new products with expanded
capabilities.
A companys ability to innovate, improve, and
learn ties directly to the companys value.

159

Internal Business Processes

Perspective:
What Must We Excel At?
Excellent customer performance derives from processes,
decisions, and actions occurring throughout the
organization.
The internal measures should stem from the processes
that have the greatest impact on customer satisfaction.
These are factors that affect:
Cycle time.
Quality.
Employee skills.
Productivity.
Firms should also attempt to identify and measure their
core competencies, which are the critical technologies
needed to ensure continued market leadership.
160

Customer Perspective:
How Do Our Customers See Us?
Customer concerns fall into four basic
categories:
Time.
Quality.
Performance and service.
Cost.
Firms should articulate goals for each of these
factors, and then translate these goals into
specific measures.
161

Financial Perspective:
How Do Our Share/Stakeholders See
Us?
Financial performance measures indicate whether the companys
strategy, implementation, and execution are contributing to
bottom-line improvement.
Typical financial goals have to do with:
Profitability.
Growth.
Shareholder wealth.
Financial goals have been criticized for various reasons (reflect
historical costs, conservatism, assets not reflected on the
balance sheet, etc.).
But improved operating performance does not automatically
translate into financial success; therefore, attention to financial
goals is necessary.
162

The Balanced Scorecard and Firm Strategy

(Kaplan and Atkinson, 1998)
A strategy is a set of hypotheses about cause and effect.
The measurement system should make the relationships
(hypotheses) between objectives (and measures) in the
various perspectives explicit so they can be measured
and validated.
The chain of cause and effect should pervade all four
perspectives of a balanced scorecard.
A properly designed balanced scorecard should tell the
story of the business units strategy.

163

An Example
Financial:

Return on employed capital

Customer:

Customer loyalty
On-time delivery

Internal business:

Process quality

Learning and growth:

Process cycle time

Employee skills and training

164

Segment Reporting
and Decentralization

165

Decentralization
Decentralization - a form of organization in which sub-unit
managers are given authority to make substantive
decisions.
Micro-level decentralization - a work group of five shop
workers making various quality decisions.
Macro-level decentralization - a stand-alone division of a
firm making product or capital budgeting decisions.
Firms choose to decentralize operations because of
information asymmetries between top managers and local
managers.
166

Advantages of Decentralization
Top management is freed to concentrate on strategic and
other high-level issues.
Lower level managers have greater and better
information, which leads to greater responsiveness to
local needs and quicker and better decision making.
Increases motivation and job satisfaction.
Aids management development and learning.
Sharpens the focus of managers and aids in performance
evaluation.

167

Disadvantages of Decentralization
Lower-level managers may pursue goals that are
incongruent with the goals of the organization as
a whole.
Activities may be uncoordinated among lowerlevel managers.
Communication among divisions may be hindered.
Lower-level managers may not see the big
picture and may have less loyalty toward the
organization as a whole.

168

Responsibility Accounting
Characteristics of responsibility centers are:
The knowledge held the centers managers is difficult
to acquire, maintain, or analyze at higher levels.
The duties that a particular individual in an
organization is expected to perform are specified for
each center.
Types of responsibility centers:
Cost center.
Profit center.
Investment center.

169

Segmented Reporting
Effective decentralization requires segmented
reporting.
A segment is a subunit of an organization for
which performance measures (e.g., revenues,
costs, expenses, profit) are needed.
However, the concept of segmented reporting
can be extended to the customer level as well
(e.g., customer profitability analysis).
170

Segmented Reporting (continued)

Consider a healthcare setting. Management
reports requested from the accounting system
can include analyses of, among other things:

The
The
The
The

profitability
profitability
profitability
profitability

of
of
of
of

individual
individual
individual
individual

patients.
physicians.
payer/insurance groups.
departments.

These reports can be useful both from revenuemanagement and cost-management

perspectives.
171

Segmented Reporting (continued)

Proper cost assignment (tracking and allocation) is critical
to proper segment reporting.
A traceable fixed cost of a responsibility center is a fixed
cost that is incurred because of the existence of the
segment.
If the responsibility center were eliminated, the
traceable fixed cost would disappear.
A common fixed cost is a fixed cost that supports the
operations of more than one segment but is not traceable
in whole or in part to any one segment.
If the responsibility center were eliminated, there would
be no change in a true common fixed cost.
172

Investment Centers
Given that managers have decision rights over
the activities and net assets of the subunit of
the firm, performance measurement should
address the efficiency and effectiveness of
managers stewardship over those net assets.
Performance measurement for investment
centers:
Return on investment (ROI).
Residual income (RI).
Economic value added (EVA).
173

Return on Investment
Return on investment (ROI) for an investment center =
Accounting net income / Total investment in that investment
center

Interest and tax expense can be ignored at the divisional

level if capital structure, financing and tax decisions are
made at the corporate level.
DuPont formula separates ROI into two components:
ROI = Sales (or Asset) turnover x
Profit Margin
ROI = (Sales / Total Investment) x (Net Income / Total
Sales)
ROI increases with smaller investments and larger profit
margins.
174

Residual Income
Residual income (RI) =
Accounting income of investment center
(Required rate of return x Capital invested in that center).

RI is determined with financial accounting

measurements of net income and capital.
Each investment center could be assigned a
different required rate of return depending on its
risk.
RI can be increased by increasing income or
decreasing investment.
175

Transfer Pricing
Transfer Price - the internal price (or cost allocation)
charged by one segment of a firm for a product or service
supplied to another segment of the same firm.
Examples of transfer prices:
Internal charge paid by final assembly division for
components produced by other divisions.
Service fees to operating departments for
telecommunications, maintenance, and services by
support services departments.
Cost allocations for central administrative services
(general overhead allocation).

176

Transfer Pricing for International

Taxation
When products or services of a multinational firm are
transferred between segments located in countries with
different tax rates, the firm attempts to set a transfer price that
minimizes total income tax liability.
Segment in higher tax country (or jurisdiction): Reduce taxable
income in that country by charging high prices on imports and
low prices on exports.
Segment in lower tax country (or jurisdiction): Increase taxable
income in that country by charging low prices on imports and
high prices on exports.
Government tax regulators try to reduce tax shifting through
transfer pricing manipulation.

177

Capital Budgeting Decisions

178

Capital Budgeting/Investment
Alternatives
Opportunity cost of capital: The benefits of investing capital
in one investment alternative that are foregone when that
capital is invested in some other alternative.
When expected cash flows occur in different time periods, the
opportunity cost of capital becomes relevant to our decision.
Capital budgeting: The analysis of investment alternatives
involving cash flows received or paid over time.
Capital budgeting is used for decisions about replacing
equipment, leasing or buying equipment, and plant
acquisitions.
179

Time Value of Money

Basic Concept: A dollar received today is worth more than a
dollar received tomorrow (everything else being equal),
because you could invest the dollar today and have your
dollar plus interest tomorrow.
Example:
Value at end
Investment Alternative:
of one year
a. Invest $1,000 in bank account earning 5 percent per year
$1,050
b. Invest $1,000 in project returning $1,000 in one year
$1,000

Alternative B foregoes the $50 of interest that could have

been earned from the bank account. The opportunity cost
of selecting alternative B is $1,050.
180

Present Value Concept

Since investment decisions are being made now at the
beginning of the investment period, all future cash flows
must be converted to their equivalent dollars now.
Beginning-of-year dollars (1Interest rate)= End-of-year
dollars.
End-of-year dollars (1Interest rate)= Beginning-of-year
dollars.

181

Interest Rate Mathematics

Define:

FV = Future Value
PV = Present Value
r = Interest rate per period (usually per year)
n = Periods from now (usually years)

Then:
Future Value of a single flow:

FV = PV (1 + r)n

Present Value of a single flow: PV = FV(1 + r)n

= [1(1 + r)n] FV
Discount factor = 1 (1 + r)n

182

Interest Rate Mathematics

Present value of a perpetuity (a stream of equal
periodic payments for infinite periods):
PV = FV r
Present value of an annuity (a stream of equal
periodic payments for a fixed number of years):
PV = FVr ) [ 1 (1 (1 + r)n)]}

183

Net Present Value Basics

1. Identify after-tax cash flows for each period.
2. Determine discount rate.
3. Multiply the cash flow by the appropriate
present-value factor (single or annuity) for each
cash flow. PV factor is 1.0 for cash
invested/received now.
4. Sum of the present values of all cash flows = net
present value (NPV).
5. If NPV 0, then accept project.
6. If NPV < 0, then reject project.
NPV is also known as discounted cash flow (DCF).
184

Capital Budgeting Basics

1. Discount after-tax cash flows, not accounting earnings.
Cash can be invested and earn interest. Accounting earnings include
accruals that estimate future cash flows.
2. Include working capital requirements.
Consider cash needed for additional inventory and accounts
receivable.
3. Include opportunity costs but not sunk costs.
Sunk costs are not relevant to decisions about future alternatives.
4. Exclude financing costs.
The costs of financing the project are implicitly included when future
cash flows are discounted. If the project has a positive NPV, then its
cash flows yield a return in excess of the firms cost of capital.
185

After-Tax Cash Flows

Determine cash flows after taxes. Revenues and
expenses are reduced by income tax effects.
On its income tax return, a firm cannot fully deduct the
cost of a capital investment in the year purchased.
Instead, firms depreciate the investment over several
years at the rate allowed by the tax law.
TimeCash flow
Beginning of project Cash to acquire assets
Future years Depreciation deduction on tax
return reduces future tax
payments (depreciation tax shield)
186

Alternative Capital Budgeting

Methods
Methods that consider the time value of money:
Net present value (NPV) method.
Internal rate of return (IRR) method.
Methods that do not consider the time value of
money:
Payback method.
Accounting rate of return on investment.

187

Alternative: Payback Method

Payback Period: The time required until cash inflows from a
project equal the initial cash investment.
Rank projects by payback and accept those with shortest
payback period.
Advantages of payback method:
Simple to explain and compute.
Disadvantages of payback method:
Ignores time value of money (when is cash received within
payback period).
Ignores cash flows beyond end of payback period.

188

Alternative: Accounting Rate of

Return
Accounting rate of return defined as:
Average annual accounting income from project

Average annual investment in the project

= Accounting Rate of Return on investment
Advantages of Accounting Rate of Return method:
Simple to explain and compute using financial statements.
Consistent with performance measures in common use in
divisional settings.
Disadvantages of Accounting Rate of Return method:
Ignores time value of money.
Accounting income is usually not equal to cash flow.

189

Alternative: Internal Rate of Return

(IRR)
Internal rate of return (IRR) is the interest (discount) rate that equates
the present value of future cash inflows to the present value of the
cash outflows.
With a single cash flow, PV = FV (1 + irr), or irr = (FV PV) 1
Comparison of IRR and NPV methods:
Both consider time value of cash flows.
IRR indicates relative return on investment.
NPV indicates magnitude of investments return.
IRR can yield multiple rates of return.
IRR assumes all cash flows reinvested at projects constant IRR.
NPV assumes all cash flows reinvested with the specified discount
rate.
190