Cost accounting and

control/
Strategic cost
management
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Chapter 1: Introduction to Cost Management
I. A Systems Framework
a. A system is a collection of connected components or a set of interrelated parts that
performs one or more processes to accomplish a specific objective.
 A systems framework affords a logical basis for the study of cost
management
 Each part of the system is critical for achievement of the overall objective
 A system uses processes to transform inputs into outputs that satisfy the
systems objective
b. An accounting information system consists of interrelated manual and computer
parts and uses processes such as collecting, classifying, summarizing, analyzing, and
managing data to provide information to users. Inputs to the accounting information
system are usually economic events. Its main goal is to give users information.

b.i. The financial accounting information system is primarily concerned with

producing
outputs (i.e. financial statements) for external users (e.g., investors,creditors,
government agencies, etc.).
 The nature of the inputs and the rules and conventions governing processes
are defined by the Securities and Exchange Commission (SEC) and the
Financial Accounting Standads Board (FASB).
 Outputs are financial statements such as the balance sheet, income statement,
and statement of cash flows for external users such as investors, creditors,
government agencies, and other outside users.
 Financial Accounting Information System is used for investment decisions,
stewardship evaluation, activity monitoring, and regulatory measures.
b.ii. The cost management information system is the process of organizing and
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managing a company’s budget.
 primarily concerned with producing outputs for internal users using inputs
and processes needed to satisfy management objectives, including:
b.ii.1. Costing services, products, and other objects of interest to management
b.ii.2. Planning and control (what should be done, why it should be done, how it
should be done, and how well it is being done)
b.ii.3. Decision-making
b.iii. Tracking information about the wide variety of activities that span the “value
chain” – the set of activities required to design, develop, produce, market,
deliver,and provide post-sales service for the products and services sold to
customers.
 In short, it must be designed to satisfy costing, controlling, and decision
making objectives.
 The costing and controlling objectives serve to define two major subsystems:
the cost accounting system and operational control system.
 Cost accounting system is used to allocate costs to specific goods
 Operational control sytem is designed to give managers an accurate
and timely feedback regarding how well they are planning an
controlling their activities. To determine which tasks should be
carried out and how successfully theya re done.
Managers use accounting information system to identify problems, solve problems, and
evaluate performance. It helps managers to carry out their roles of planning, controllig, and
decision making.
 Planning is the detailed formulation of action to achieve a particular end.
 Contorlling is the monitoring of a plan’s implementation.
 Decision making is choosing among competing altenatives.
The cost management system differs from the financial accounting system primarily in
its targeted users. Cost management information is inteded for internal usrs. Whereas
financial accounting information is directed toward external users.

II. Factors Affecting Cost Management

a. Global competition has increased the demand for accurate cost information which

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plays a vital role in reducing costs, improving productivity, and assessing product-
line
profitability.
b. Growth and deregulation increased competition in the service industry have added
to
the demand for relevant cost management information.
c. 3 major advances in information technology
c.i. Enterprise resource planning (ERP) software runs all the operations of a
company and provides access to real-time data from various functional areas of
the company (e.g. production, sales, marketing, and accounting).
c.ii. PCs, online analytic programs (OLAP), and decision-support systems
(DSS) are powerful tools used to analyze data generated by the ERP system.
c.iii. Electronic commerce (e-commerce) significantly reduces overhead. The
emergence of electronic data interchange (EDI) (i.e., the sharing of information
and exchange of purchasing and distribution documents via computer) and
supply chain management (the management of products and services from the
acquisition of raw materials through manufacturing, warehousing, distribution,
wholesaling and retailing) has increased the importance of costing out activities
in
the value chain and determining the cost to the company of different suppliers
and customers.
d. Several advances in manufacturing management have allowed firms to increase
quality, reduce inventories, eliminate waste and reduce costs.
d.i. The “Theory of Constraints” focuses attention on the activity
(manufacturing or
non-manufacturing) that is the most critical limiting factor (i.e., the constraint)
and
seeks to eliminate it.
d.ii. Just-in-time (JIT) manufacturing strives to produce a product only when it
is
needed and only in the quantities demanded by customers. Parts and materials
arrive just in time to be used in production, thereby reducing inventories to
much
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lower levels than those found in conventional systems.
d.iii. Lean manufacturing is the persistent pursuit and elimination of waste
(anything that does not add value to the end user customer. Lead time is
decreased, production processes are streamlined, and costs are decreased.
d.iv. Automation of the manufacturing environment allows firms to reduce
inventory, increase productive capacity, improve quality and service, decrease
processing time, increase output, and ultimately reduce costs.
e. Firms concentrate on delivering value to customers along the “value chain” (the set
of activities required to design, develop, produce, market, and deliver products and
services to customers), in order to establish a competitive advantage.
f. Total quality management is a philosophy in which managers strive to create an
environment that will enable organizations to produce defectfree products
andservices.
• Has replaced the acceptable quality attitudes of the past
o Continuous improvement and elimination of waste are the two foundation
principles
o Objectives: Producing products and services that actually perform according
to specifications and with little waste
g. Firms can reduce time to market by redesigning products and processes, be
eliminating wastes, and by eliminating non-value-added activities.
h. Firms can improve financial and non-financial measures of efficiency by analyzing
underlying activities and processes, by eliminating those that do not add value, and
enhancing those that do add value.

New Product Development

• High proportion of production costs is involved during the development and design
stage of new products
• Cost management procedures
– Target costing:
o Encourages managers to assess the overall cost impact of product designs
over the product’s life cycle
– Activity-based management:

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o Identifies the activities produced at each stage of the development process and
assesses their costs
Sustainable development
• Development that meets the needs of the present without compromising the ability
of future generations to meet their own needs
Time as a competitive element and Efficiency
• Time as a competitive element
o Crucial element in all phases of the value chain
o Decrease in non-value-added time increases quality
• Efficiency
o Improving efficiency is a vital concern
o Cost is a critical measure of efficiency

III. Role of the Management Accountant

 Managemeny accountant assists who are responsible for carrying out an
organization’s objectives.
a. Line positions have direct responsibility for the basic objectives of an organization.
They participate in activities that produce and sell their company’s product or
service.
b. Staff positions are supportive in nature and only have indirect responsibility for an
organization’s basic objectives.
c. The controller, the chief accounting officer, supervises all accounting departments.
The controller is often viewed as a member of the top management team and has
responsibility for both internal and external accounting, including internal audit, cost
accounting, financial reporting, accounting systems, budgeting, and taxes.
d. The treasurer is responsible for the finance function – raising capital and managing
cash, investments, and investor relations. The treasurer may also be in charge of
credit
and collections and insurance.
e. The cost and management accountant is responsible for generating financial
information required by the firm for internal and external reporting. This involves
responsibility for collecting, processing, and reporting information that will help
managers in their planning, controlling, continuos improvement and decision-making
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activities.
 Planning is the detailed formulation of future actions to achieve a particular
end. It involves setting goals and objectives and identifying methods to
achieve those objectives.
 Controlling involves monitoring a plan’s implementation and taking
corrective action as needed. Control is achieved with the use of feedback
(information that can be used to evaluate or correct steps that are currently
being taken to implement a plan).
e.ii.1. Accounting reports that provide feedback by comparing planned
(budgeted) data with actual data are called performance reports.
e.ii.2. Deviations from planned amounts that increase profits are labeled
“favorable variances.” / decrease profits are called “unfavorable
variances.”
 Decision-making is the process of choosing among competing alternatives.
 Continuous improvement has the goals of doing better than before and doing
better than competitors. It is defined as “the relentless pursuit of improvement
in the delivery of value to customers”
IV. Accounting and Ethical Conduct
a. Business ethics is the science of conduct for the work environment
a.i. Principles of personal ethical behavior include concern and respect for
others,
trustworthiness and honesty, fairness, doing good and preventing harm to
others.
a.ii. Ethical behavior for professionals (e.g. accountants) can be expanded to
include concepts such as objectivity, full disclosure, confidentiality, due
diligence, and avoiding conflicts of interest.
b. Studies find a positive correlation between ethical performance and economic
performance.
c. The Sarbanes-Oxley Act of 2002 (SOX) strongly encourages subject firms to
establish
a code of ethics for senior financial officers or explain why they do not have one.
d. The Institute of Management Accountants (IMA) has established ethical standards
for
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management accountants and has advised that “they shall not commit acts contrary to
these standards nor shall they condone the commission of such acts by others in their
organizations.” The code has five major divisions:
d.i. Competence
d.ii. Confidentiality
d.iii. Integrity
d.iv. Credibility
d.v. Resolution of ethical conflict
V. Certification
a. Three of the major certifications are:
a.i. Certified Management Accountant (CMA) was developed in 1974 by the
IMA to
establish management accounting as a recognized, professional discipline,
separate from the profession of public accounting.
a.ii. Certified Public Accountant (CPA) is the oldest certification in accounting.
Only
CPAs are permitted to serve as external auditors.
a.iii. Certified Internal Auditor (CIA) was established in 1974. Internal auditors
are
independent of the departments being audited however, they do report to the top
management of the company
Chapter 2: Basic Cost Management Concepts
I. Cost Assignment: Direct Tracing, Driver Tracing, and Allocation
 Cost is the cash or cash equivalent value sacrificed for goods and services that are
expected to bring a current or future benefit to the organization.
 Costs that are used up in the production of revenues (i.e. expired costs) are called
expenses.
 A loss is a cost that expires without producing any revenue benefit.
 An unexpired cost is classified as an asset and appears on the bs.
 A cost objects is any item for which costs are measured and assigned, and may include
products, customers, departments, projects, activities, etc.
 An activity is special kind of cost object. It is a basic unit of work performed with
an organization. Can also be defined as an aggregation of actions within an
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organization useful to managers for purposes of planning, controlling, and
decision-making.
 Assigning costs accurately to cost objects is crucial.
 The objective is to emasure and assign as accurately as possible the cost
of the resources used by a cost object.
 Distorted cost assignments can produce erroneous decisions and poor
evaluations.
 Traceability is the ability to assign a cost directly to a cost object in an economically
feasible way by means of a causal relationship.
 The more cost that can be traced to the object, the greater the accuracy
of the cost assignments.
 Direct costs are costs that can be traced easily and accurately to a cost object.
Direct costs are assigned through the use of direct tracing or driver tracing. Costs
can be assigned in an economically feasible way to trace easily. Costs can be
assigned using a causal relationship if costs are accurate.
 Indirect costs are costs that cannot be traced easily and accurately to a cost object.
Indirect costs are assigned to cost objects via allocation.
Methods of Assigning Cost to Cost objects
1. Direct tracing - the process of identifying and assigning costs to a cost object that are
specifically or physically associated with the cost object. It is the most precise.
a) Identifying costs can be accomplished by physical observation.
2. Driver tracing - use of drivers to assign costs to cost objects. It is very accurate if the
cause-and-effect relationship can be established.
a) Drivers uses cause-and-effect reasoning. They are factors that cause changes in
resource usage, activity usage, costs, and revenues.
3. Allocation is the assignment of indirect costs to cost object. Simple and inexpensive to
implement but least accurate cost assignment method.
a) Since no causal relationship exists in indirect costs, allocating it is based on
convenience or some assumed linkage.

II. Product and Service Costs

A. Two types of organizational outputs are:

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a) Tangible products – goods produced by converting raw materials into finished
products through the use of labor and capital inputs such as plant, land, and
machinery. Organizations that produce tangible products are called
manufacturing organizations.
b) Services – tasks or activities performed for a customer or an activity performed
by a customer using an organization’s products or facilities. Organizations that
produce intangible products are called service organizations.
i. Services differ from tangible products on four important dimensions:
1. Intangibility means that buyers of services cannot see, feel, hear, or
taste a service before it is bought.
2. Perishability means that services cannot be stored.
3. Inseparability means that producers of services and buyers of
services must be in direct contact for an exchange to take place.
4. Heterogeneity refers to the greater chances for variation in the
performance of services than in the productions of products.

III. Different Cost for Different Purposes

a. For pricing decisions, product mix decisions, and strategic profitability analysis, all
traceable costs along the value chain need to be assigned to the product.
b. For external financial reporting, FASB rules and conventions mandate that only
production costs be used in calculating product costs.
IV. Product Costs and External Financial Reporting

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Two categories of producing products

a. Production (also product or manufacturing) costs are those costs associated with
manufacturing goods or providing services. For external reporting purposes.
Production costs can be further classified:
i. Direct materials - traceable to the good or service being produced. Physical
observation can be used to measure the quantity consumed.
ii. Direct labor - traceable to the goods or services being produced. Physical
observation can be used to measure the quantity labor used to produce.
iii. Overhead - all production costs other than direct materials and direct labor.
In a manufacturing firm, overhead is also known as factory burden or
manufacturing overhead. Overhead may include:
1. Supplies – materials necessary for production that do not become part
of the finished product or are not used in providing a service.
2. Indirect materials – form an insignificant part of the final product
3. Indirect labor
4. Overtime for direct labor (only the overtime portion)
iv. Product costs remain on the balance sheet in an inventory account (raw
materials, work-in-process, or finished goods), and are expensed when the
product is sold or service is delivered.
v. Prime and Conversion Costs
1. Prime cost is the sum of direct materials cost and direct labor cost. Can
be traced directly.
2. Conversion cost is the sum of direct labor cost and overhead cost. In a
manufacturing firm, conversion cost can be interpreted as the cost of
converting raw materials into a finished product.
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b. Nonproduction (also nonmanufacturing) costs are those costs associated with the
functions of selling and administration. They cannot be reasonably estimated.
- Nonproduction costs are not inventoried and are called period costs. They are
expensed in the period in which they are incurred. Three categories are:
i.Reaserach and development costs - expenditures aimed at developing new
products and processes or at modifying existing products.
ii. Selling (or marketing) costs - costs necessary to market and distribute a
product or service and are often referred to as order-getting or order-filling
costs. Examples include: salaries and commissions of sales personnel,
advertising.
iii. All costs that cannot be reasonably assigned to production or
marketing(selling) are administrative costs. Examples include: top-executive
salaries, legal fees, printing and distributing the annual report, and general
accounting. Research and development is also part of administrative costs.

V. External Financial Statements

In preparing an income statement, production and nonproduction costs are separated.
The reason for the separation is that productions costs are product costs – costs that are
inventoried until the units are sold – and the nonproduction costs of marketing and
administration are viewed as period costs. Thus, production costs attached to the units sold
are recognized as an expense (cost of goods sold) on the income statement.
Nonproduction costs never appear on the balance sheet.
a. Income Statement: Manufacturing Firm
i. This income statement is frequently referred to as absorption costing or
full-costing income because ALL manufacturing costs (direct materials, direct
labor, and overhead) are fully assigned to the product.
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 Prepared for external parties
ii. Expenses are separated according to function and then deducted from
revenues to arrive at operating income. The two major functional categories of
expense are:
1. Operating expenses – Nonmanufacturing (selling and administrative)
expenses
2. Cost of goods sold – the cost of direct materials, direct labor, and
overhead attached to the units sold. The details of this assignment are
given in a supporting schedule, statement of cogmanufactured.
-The cost of goods manufactured represents the total manufacturing
costs of goods completed during the current period. Total
manufacturing costs of the period are added to the manufacturing
costs found in beginning work-in-process, which consists of partially
completed units as of the beginning of the period. The costs found in
ending work-in-process are then subtracted to arrive at the cost of
goods manufactured.
- Once the cost of goods manufactured is computed, it is added to
the costs of beginning finished goods to arrive at cost of goods
available for sale. The costs of ending finished goods are then
subtracted to arrive at cost of goods sold.
VI. Traditional and activity-based cost management systems
• Traditional-base/ functional-based cost accounting
o Assumes that all costs can be classified as fixed or variable with respect to
changes in the units or volume of product
o Uses only unit-based activity drivers to assign costs
• Traditional-base/ functional-based operation control system
o Assigns costs to organizational units
o Holds the organizational unit manager responsible for controlling the assigned
costs. Measured by comaring actual outcomes with budgeted outcomes.
o Traces costs to individuals who are responsible for costs.
o Overall max perf= individ max perf known as responsibility centers

Activity-based cost management systems

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• Activity-based cost (ABC) system
– Emphasizes tracing over allocation
– Drivers unrelated to the volume of product is called non-unit-based drivers
– Uses both unit- and non-unit-based activity drivers increases accuracy
• Activity-based operational control subsytem
– managing costs
– ABM focuses on accountability for activities rather than costs
– activity based costing dimension or cost view is the vertical dimension traces
the cost of overhead resources
– control dimension is te process view that identifies factors that cause an
activity’s cost, asses what work is done, and evaluates the work performed.

Choice of a cost management system

• Activity-based cost management system offers significant benefits that includes:
o Greater product costing accuracy o Enhanced strategic planning
o Improved decision making o Increased ability to manage activities
• Measurement costs: Costs associated with the measurements required by the
cosmanagement system
• Error costs: Costs associated with making poor decisions based on bad cost
information
Schedule of Cost of Goods Sold
(including Cost of Goods Manufactured)
Direct materials
Beginning inventory
Add: Purchases
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Materials available
Less: Ending inventory
Direct materials used in production
Direct labor
Manufacturing (factory) overhead
Total manufacturing costs
Add: Beginning work-in-process
Less: Ending work-in-process
Cost of Goods Manufactured
Add: Beginning finished goods
Cost of Goods Available for Sale
Less: Ending finished goods
Cost of Goods Sold
Income Statement
Sales
Less: Cost of Goods Sold
Gross margin
Less: Operating expenses
Selling expenses
Administrative expenses
Operating Income
b. Income Statement: Service Organization
b.i. Service firm has no finished goods, since service inventories cannot be
stored (perishability).
b.ii. However, it is possible to have work-in-process

Chapter 3: Cost Behavior

Cost behavior is used to describe whether a cost changes when the level of output changes.
a. Definitions
a.i. A cost object is any item about which managers want cost information.
a.ii. A fixed cost does not change as output changes.
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a.iii. A variable cost increases in total with an increase in output and decreases
in total with a decrease in output. (Variable costs change in direct proportion to
changes in the level of output.)
b. We must first determine the underlying activities and the associated drivers
(factors that cause changes in resource usage, activity usage, costs and revenues) that
measure the capacity of an activity and its output.
b.i. Activity drivers explain changes in activity costs by measuring changes in
activity output (usage.)
b.i.1. Unit-level drivers explain changes in cost as units produced change.
b.i.2. Non-unit-level drivers explain how costs change as factors other
than the number of units produced changes.
b.ii. In a traditional cost management system, cost behavior is assumed to be
described by unit-based drivers only.
b.iii. In an activity-based cost management system, both unit- and nonunit-
based drivers are used.
• JCM Audio Systems, Inc. produces speakers for home audio systems
• One department produces voice coils
• There are two production lines that can each make up to 100,000 voice coils per
year
• Production-line manager is paid $60,000 per year
• For production up to 100,000 units, only one manager is needed; above that (up to
200,000 units), two managers are needed

c. Fixed costs remain constant in total (within the relevant range) as the level of
associated driver varies.
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c.i. The relevant range is the range of activity over which the assumed cost
relationship is valid for the normal operations of the firm.
c.ii. Unit fixed costs change with changes in the level of activity. When activity
increases, fixed cost per unit (unit fixed cost) decreases. When activity
decreases, unit fixed cost increases. (Unit fixed cost varies inversely with changes in
the activity level.)
c.iii. Because fixed cost per unit changes with changes in the level of the driver,
it is easy to get the impression that total fixed costs vary with changes in activity.
DO NOT make this mistake. It is often safer to work with TOTAL fixed costs.
c.iv. Fixed costs can be represented on a graph as a horizontal line.

d. Variable costs are costs that vary in total in direct proportion to changes in the
activity driver.
d.i. Unit variable cost remains constant as changes in the activity level change.
d.ii. A linear relationship between variable costs and activity is implied.
d.iii. Variable costs can be represented on a graph as an upward sloping straight
line.

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e. Mixed costs have both a fixed and a variable component.

e.i. Total mixed cost: Y = F + VX, where F = total fixed cost, V = variable cost
per unit of activity driver, and X = activity driver
e.ii. Mixed costs can be represented on a graph by a line that intercepts the
vertical axis. The intercept corresponds to the fixed cost component, and the
slope of the line gives the variable cost per unit of activity driver.

f. Time Horizon
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f.i. According to economics, in the long run, all costs are variable.
f.ii. In the short run, at least one cost is fixed.
II. Resources, Activities, and Cost Behavior
a. Definitions
a.i. Resources are economic elements that enable one to perform activities
(tasks).
a.ii. Practical capacity is the amount of activity capacity that corresponds to the
level where the activity is performed efficiently.
a.iii. Unused capacity is the difference between the acquired capacity and the
actual amount of the activity capacity used.
a.iv. Activity Capacity is obtained when a firm acquires the resources needed to
perform an activity
b. Types of resources:
b.1 Flexible resources are supplied and used as needed.
b.i.i Quantity of resources supplied equals the quantity demanded.
b.i.ii. There is no unused capacity.
b.i.iii. The cost of a flexible resource is a variable cost.
b.2 Committed resources are supplied in advance of usage.
b.i.i An explicit or implicit contract is used to obtain a given quantity of
resource, regardless of whether that amount is fully used or not.
b.i.ii. Unused capacity is possible.
c. Step-costs (step-cost functions) display a constant level of cost for a range of
output and then jump to a higher level of cost at some point, where it remains for a
similar range of activity (output).

• Step-variable costs
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– Follow a step-cost behavior with narrow steps
• Step-fixed costs
– Follow a step-cost behavior with wide steps
– Activity rate: Average unit cost
▪ Obtained by dividing the resource expenditure by the activity’s practical capacity

• Relationship between resources supplied and resources used is given by either of the
following:
– Activity availability = Activity output + Unused capacity
– Cost of activity supplied = Cost of activity used + Cost of unused activity
EXHIBIT 3.7 - Step-fixed costs

Activities and Mixed Cost Behavior

• Activities have characteristics of both flexible and committed resources
– Example
▪ A power department acquires long-term capacity for supplying power by
investing in a building and equipment - Resources acquired in advance
▪ It acquires fuel to produce power as needed - Resources acquired as needed
• Need for cost separation
▪ Accounting records show only total cost and associated output of a mixed cost
item
– Total cost should be separated into fixed and variable components
III. Methods of Determining Cost Behavior
a. The industrial engineering method determines through physical observation and
analysis what activities and what amounts are need to complete a process.
a.i. Expensive to implement
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a.ii. Precise, but seldom updated
a.iii. Useful for manufactured items, but less useful for services where different
customers or circumstances may require varying amounts of time and types of
service.
b. The account analysis method classifies accounts in the general ledger as fixed,
variable, or mixed.
b.i. Often used in practice because it is simple and straightforward
b.ii. Accountant uses judgment and experience to classify accounts
IV. Quantitative Methods for Separating Mixed Costs into Fixed and Variable Components
a. Total (Mixed) Cost Formula
a.i. Equation for a straight line Y = F + VX
a.ii. Y = total cost (dependent variable – variable whose value depends on the
value of another variable)
a.iii. F = fixed cost (intercept parameter – the point at which the mixed cost line
intercepts the vertical (cost) axis)
a.iv. V = variable cost per unit (slope parameter – slope of the mixed cost line)
a.v. X = measure of output or activity level (independent variable – explains
changes in cost)
b. The High-Low Method preselects two points (high and low) that are used to
compute fixed cost (F) and variable cost per unit (V)
b.i. The high point is the point with the highest output or driver level.
b.ii. The low point is the point with the lowest output or driver level.
b.iii. NOTE: The high and low points are determined by the independent
variable (X), not the dependent variable (Y) or cost.
b.iv. V = (high cost – low cost) / (high activity – low activity)
b.v. F = total cost (Y) – (VX) (You may use either the high or low
cost/activity.)
b.vi. Advantages/Disadvantages of High-Low method
b.vi.1. Advantages – objective and simple
b.vi.2. Disadvantages – high or low points may be outliers, representing
atypical cost-activity relationships; other pairs of points may be more
representative

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c. Regression programs use the method of least squares to calculate the equation of a
line that best fits a series of multiple data points.
c.i. Regression gives the best linear unbiased estimates of the intercept and
slope for a set of data points. These can be used to find the fixed cost and
variable rate in a cost scenario, and can be used to predict cost for a given amount
of the independent variable.
Scatterplot Method
• Uses a scattergraph to visually assess the relationship between cost and output
– Intercept is fixed cost
– Slope is variable rate
• Assesses the validity of the assumed linear relationship
• Advantages
– Allows for visual inspection of the data
– Identifies nonlinearity, outliers, and shifts in the cost relationship
• Disadvantages
– Lacks objective criterion for choosing the best-fitting line
– Subjective in nature
• Anderson Company had the following 10 months of data on materials handling
cost and number of moves:

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Method of Least Squares

• Deviation: Difference between the predicted and actual costs
– Shown by the distance from the points marked in the scattergraph to the best-fitting line
• Measure of closeness is the sum of the squared deviations of the points from the line
– Smaller the measure, the better the line fits the points
EXHIBIT 3.10 - Deviations of Data from a Line

Using Regression Programs

• Enter the data
• Choose “Data Analysis” option from the “Tools” menu
– If not available, choose "Add-ins" and select "Analysis ToolPak" to add the data analysis
tools
• Click on “Regression”
• Click on “Input Y Range” and highlight the dependent variables column
• Click on “Input X Range” and highlight the independent variables column
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• Choose preferred location for output
• Click “OK”

Interpreting the results

– Under “Coefficients” in the bottom left of the output, find the intercept and the slope
– Write the equation
▪ Y = $12.39X + $854.50
– Use the equation to make a point estimate
▪ At a point of 350 moves, total cost is predicted
o Y = $12.39(350) + $854.50
o Y = $5,191

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V. Reliability of Cost Formulas

a. 3 statistical measures are used to assess the reliability of cost formulas
a.i. The hypothesis test of cost parameters indicates whether the parameters are
(significantly) different from zero
a.i.1. T statistic = coefficient / standard error
a.i.2. P-value is the level of significance achieved. Generally a P-value
of .05 or less is needed for significance.
a.ii. Goodness of fit measures the degree of association between cost and
activity output.
a.ii.1. The coefficient of determination (R2 ) is the percentage of
variability in the dependent variable that can be explained by the
independent variable.
a.ii.1.a. The higher the percentage the better.
a.ii.1.b. R2 always has a value between 0 and 1.00.
a.ii.2. The coefficient of correlation (r) is the square root of the coefficient
of determination (R2 ).
a.ii.2.a. Values can range from -1 to +1.
a.ii.2.b. If the coefficient of correlation is positive, then the two
variables move in the same direction and are positively correlated.
a.ii.2.c. If the coefficient of correlation is negative3, then the two
variable move in opposite directions and are negatively correlated.
a.ii.2.d. A correlation of +1/-1 indicates perfect positive/negative
correlation.
a.ii.2.e. A correlation of zero (0) indicates no correlation.

a.ii.3. The confidence interval is the range of possible values in which we

e xpect the true value to fall.
a.ii.3.a. The upper bound of the confidence interval is calculated by
adding the t-statistic x standard error to the predicted cost
a.ii.3.b. The lower bout of the confidence interval is calculated by
subtracting the t-statistic x standard error from the predicted cost
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Standard Errors
• Tell how tightly the data points cluster around the regression line
• Small standard error indicates that the regression line more closely approximates the data
– Larger standard error indicates the opposite
Multiple Regression
• Used whenever least squares is used to fit an equation involving two or more independent
variables
• Linear equation is expanded to include the additional variable when there are two
explanatory variables
Y = F + V1X1 + V2X2
– Where
▪ X1 = Number of moves
▪ X2 = Number of pounds moved
Multiple Regression
• Adding another independent variable might increase the explanatory power of our model
• Performing the regression is very similar to simple regression
– Input the data - Make sure the two independent variables are placed next to each
other
– Follow the same directions, but select both independent variable columns for the
“Input X Range”
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Interpreting the results

– Under “Coefficients” in the bottom left of the output find the intercept and the slope
– Write the equation
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▪ Y = $507.31 + $7.84X1 + $0.11X2
• Examine reliability of the new model
– Adjusted R Square is 99% - Significant improvement
VI. The Learning Curve and Nonlinear Cost Behavior
a. The learning curve shows that as we perform an action over and over, we improve,
and each additional performance takes less time than the preceding one.
-shows how labor hours per unit decreases as units produced increases.
b. The experience curve indicates that the more often a task is performed, the lower
will be the cost of doing it (i.e. efficiency is increased).
Incremental unit-time learning curve model
– Decreases by a constant percentage each time the cumulative quantity of units
produced doubles
• Cumulative average-time learning curve model

– States that the cumulative average time per unit decreases by a constant percentage,
or learning rate, each time the cumulative quantity of units produced doubles
▪ Learning rate: Gives the percentage of time needed to make the next unit,
based on the time it took to make the previous unit
o Expressed as a percent

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VII. Managerial Judgment

a. Many managers use their experience and past observation of cost relationships to
determine fixed and variable costs and often ignore the possibility of mixed costs.
b. It is important to consider the experience of the manager, the potential for error,
and the effect that error could have on related decisions.

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CHAPTER 1:Cost-Volume-Profit Analysis
2 approaches to find the breakeven point - Operating income and contribution margin
Variable cost - all cost that increase as more units are sold
- DM, DL, VOH, VS&A
Fixed costs - all fixed costs overhead and fixed selling and administrative expense
Contribution margin based income statement - useful tool for organizing the firms cost into
fixed and variable cost
- sales revenue- total variable costs
- total contribution margin equals fixed expenses
Net ncome operating income minus income taxes
Equations:
Variable product cost per unit = DM+DL+VOH
Selling expense per unit= price x percentage
Variable cost per unit = DM+DL+VOH+VSE
Contribution margin per unit= price - variable cost per unit
Contribution margin ratio= (price-variable cost per unit)/price
Total fixed expense= total fixed factory OH + total fixed selling and admin exp
Eqaution for a target profit in terms of units:
Target profit in units = (total fixed cost + target income) / (price - variable cost per
unit)
When target income is zero:
Break-even units= total fixed cost/(price - variable cost per unit)
Variable cost ratio - proportion of each sales dollar that must be used to cover variable cost
Contribution margin ratio - covers the fixed costs and provide profit
- it is the revenue remainingaftervariable costs are covered
- if total fixed costsequalthe conntribution margin, profit is zero.
Sales revenue approach equation
break-even sales = total fixed costs / contribution margin ratio
Target sales revenue = (total fixed cost + target profit) / contribution margin ratio
After tax profit
Operating income = net income / (1-tax rate)
Direct fixed expense - can be traced
Common fixed expenses - not traceable
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Sales mix - relative combination of products being sold by a firm
Profit- volume graph - portrays the relationship between profits and sales volume
- operating income (proft) is the dependent variable (vertical axis) and the number of
units is theindependent variable (horizontal axis)
Cost-volume profit graph - relationship among cost, volume, and profits
Assumptions of Cost-Volume-Profit Analysis
1. The analysis assumes a linear revenue and a linear cost function
2. The analysis assumes the price, total fixed costs, and unit variable costs can be
accurately identified and remain constant over the relevant range
3. The analysis assumes that what is produced is sold
4. For multiple-product analysis, the sales mix is assumed to be known
5. The selling prices and costs are assumed to be known with uncertainty
Margin of safety - units sold or expected to be sold or the revenue earned to be earned
above the break-even volume.
Equation: product units - break-even units
Operating leverage - use of fixed costs to extract higher percentage changes in profits as
sales activity changes
Degree of operating leverage - can be measured for a given leven of sales by taking the
ration of total contribution margin to profit
Equation : degree of operating leverage = total contribution margin/ profit
Sensitivity analysis - a what-if technique that examines the impact of changes in
underlying assumptions on an answer

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CHAPTER 2 : Pricing and Profitability Analysis

PRICE ELASTICITY OF DEMAND
- measured as % change in quantity divided by the % change in price.
- if demand is relatively elastic, a small percent change in price will lead to a greater
percent change in quantity demanded.
- price elastic : have many substitutes, not necessities, and take a relatively large
amount of customer income. Ex: movie tickets, restaurant meals, and automobiles
- price inelastic : few substitutes, are necessities, constitute a relatively small
percentage of consumer income. Ex: prescription drugs, electricity, and toothpicks
MARKET STRUCTURE
Market structure affects price, as well as the costs neceessary to support the price. The four
types of market structure differ according to the number of buyers and sellers, uniqueness
of the product, and the relative ease of entry.
Four types of Market Structure:
1. Perfect competition
- has many buyers and sellers, a homogenous product and easy entry into and exit
from the industry.
- cannot change a higher price than the market price because no one would buy.
2. Monopoly
- barriers to entry are so high that there is only one firm in the market and the product
is unique. This firm is a price setter.
3. Monopolistic competition
- characteristics of both monopoly and perfect competition.
4. Oligopoly
- characterized by few sellers and barriers to entry are high and usually cost related.
Market structure # of Barriers to Uniqueness Expenses related
firms entry

Perfect Many Very low Not unique No special expenses

competition

Monopolistic Many Low Some unique Advertising, coupons, costs of

differentiation

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Oligopoly Few High Fairly Costs of differentiation, advertising,
unique rebate, coupons

Monopoly One Very high Very unique Legal and lobbying expenditures

COST-BASED PRICING
Markup - is a percentage applied to base a cost; it includes desired profit and any costs not
included in the base cost
Equation:
Markup on COGS = (selling and administrative expenses + operating income) /
COGS
Price for new product = total cost x (1 + markup on COGS)
Markup on DM = (DL + Overhead + Selling and administrative expenses) / DM
Bid price = DM + (Markup on DM x DM)
TARGET COSTING AND PRICING
Target costing - sets the cost of a product or service based on the price (target price) that
customers are willing to pay.
Penetration pricing - pricing of a new product at a low initial price to build market share
quickly. It is not a predatory pricing and not meant to destroy competition.
Price skimming - a higher price is charged when a product or service is first introduced.
Price gouging - related to skimming and occurs when firms with market power price
products “too high”
Predatory pricing - practice of setting prices below cost for the purpose of injuring
competitors and eliminating competition.
Dumping - predatory pricing on the international market. Occurs when companies sell
below cost in other countries and domestic industry is injured
Price discrimination - a Robinson-Patman Act in 1936 that refers to charging of different
prices to different customers for same product.
- only manufacturers or suppliers are covered by the act; services and intangibles are
not included.
Absorption costing - assigns all manufacturing costs, direct materials, direct labor, variable
overhead, and a share of fixed overhead to each unit of product.
Equation :

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Unit product cost = DM+DL+VOH+FOH
Units in ending inventory = units beg inventory + units produced + units sold
Variable costing (direct costing) = assigns only unit level variable manufacturing costs and
it includes DM, DL, and VOH.
- FOH is treated as period cost and not inventoried and it is expensed in the period

CHANGES IN INVENTORY UNDER ABSORPTION AND VARIABLE COSTING

If Then
1. Production > sales Absorption-costing > variable costing
2. Production < sales Absorption-costing < variable costing
3. Production = sales Absorption-costing = variable costing
SALES PRICE AND SALES VOLUME VARIANCES
Equation:
Sales price variance = (actual price - expected price) x quantity sold
Sales volume variance = (Actual volume - expected volume) x expected price
Total (Overall) sales variance = sales price variance + sales volume variance
Contribution margin variance = actual CM - budgeted CM
Contribution margin volume variance = (actual quantity sold - bedgeted quantity
sold) x budgeted average unit CM
Budgeted average unit CM = total budgeted CM / total # of units all products to be
sold
Sales mix variance = [(product 1 actual units - product 1 budgeted units) x (product 1
budgeted CM - budgeted average unit CM)] + [(product 2 actual units - product
2 budgeted units) x (product 2 budgeted CM - budgeted average unit CM)]
MARKET SHARE AND MARKET SIZE VARIANCES
Market share - gives the proportion of industry sales accounted for by a company
Market size - total revenue for the industry
Equation:
Market share variance = [(actual market share percentage - budgeted market share
percentage) x actual industry sales in units] x budgeted average unit CM
Market size variance = [(actual industry sales in units - budgeted industry sales in
units) x budgeted market share percentage] x budgeted average unit CM

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Product life cycle - it helps the firm understand the different competitive pressures on a
product. The profit history of the product according to four stages: introduction,
growth, maturity, and decline.
Introduction - profits are low because the product gains market acceptance and investments

STEPS EXAMPLES
1. Define the problem What to do with small, ill-shaped apples
2. Identify the feasible accounts 1. Sell to pig farmers 4. Make pie filling
2. Sell bagged apples (feasible) 5. Continue dumping practice
3. Make applesauce (feasible)
3. Cost reduction Bagged alternative : Applesauce alternative:
A. Revenue: 1.30/bag (0.26 per A. Revenue: 0.78/can (0.65 per
pound) pound)
B. Cost 0.05 per pound Cost 0.40 per pound
4. Relevant costs vs benefits Revenue 0.26 0.65
Cost 0.05 0.40
Net benefit 0.21 0.25
Bagged: differentiation Applesauce: forward integration
5. Asset qualitative fators Bagged: differentiation strategy
Applesauce: discomfort with industrial value chain
6. Select best alternatives Bagging alternative because it is more profitable and more consistent

and learning may be high leading to higher expenses

Growth - increasing market acceptance and sales and bring down expenses and profit rises.
Maturity - profits are stabilized and revenues are relatively stable
Decline - revenues and profits decline.
CHAPTER 3 : Activity Resource Usage Model and Tactical Decision Making
Tactical decision making - consists of choosing among alternatives with an immediate or
limited end in view
Decision model - a set of procedures that will lead to a decision.
THE TACTICAL DECISION-MAKING PROCESS
Tactical cost analysis - use of relevant cost data to identify the alternative that provides the
greatest benefit to the organization.
Relevant costs (revenues) - future costs (revenue) that differ across alternatives
Sunk costs - when allocated for future periods it is called depreciation and are past costs
that are always irrelevant.
Tariff - a tax on imports levied by the federal government
Foreign trade zones (FTZs) - areas that are physically on US soil but considered to be
outside US commerce.
Activity resource usage model - focuses on the use of resources and has two categories

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A. Flexible resources - the resources demanded (used) equal the resources supplied. If the
demand for an activity changes across alternatives, then resource spending will change and
the cost of the activity is relevant to the decision
B.

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C. Committed resources - acquired in advance of usage through implicit contracting and
they are usually acquired in lumpy amounts. If a change in demand for the activity requires
a change in resource supply, then the activity cost will be relevant to the decision.
a) Change in cost can occur in (1) the demand for the resource exceeds the
supply (increase resource spending; (2) the demand for the resource drops
permanently and supply exceeds demand enough so that the capacity can
be reduced (decreases resource spending)
Category Relationships Relevancy
Flexible Supply = demand
A. Demand changes A. Relevant
B. Demand constant B. Not relevant
Committed Supply - demand = unused capacity
A. Demand increase < unused capacity A. Not relevant
B. Demand increase > unused capacity B. Relevant
C. Demand decrease (permanent)
1. Activity capacity reduced 1. Relevant
2. Activity capacity unchanged 2. Not relevant
MAKE OR BUY DECISION
Make-or-buy decision - a decision of whether to make or to buy components or services
used in making a product or providing a service
Outsourcing - refers to the move of a business function to another company
Activity cost formula = fixed cost + variable rate x amount of driver
Keep-or-drop decision - uses relevant cost analysis to determine whether a segment or line
of business should be kept or dropped.
Special order decision - focuses on whether a specially priced order should be accepted or
rejected
Sell or process further - all of the joint production costs are irrelevant

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CHAPTER 4 : Budgeting for Planning and Control
Budgets - quantitative plans for the future, stated in either physical or financial terms or
both
- method for translating the goals and strategies of an organization into operation
terms
Control - process of setting standards, receiving feedback on actual performance, and
taking corrective action. Used to compare actual outcomes with planned outcomes
Budget director - works under the direction of the budget committee and is a controller
Budget committee - responsible for reviewing the budget, providing policy guidelines and
budgetary goals, resolving differences that may arise, approving final budget and
monitoring actual performance.
- Ensures that budget is linked to the strategic plan of the organization.
Master budget - comprehensive financial plan for the year made up of various individual
departamental and acitivty budgets. Divided into two categories:
Operating budgets - concerned with income generating activities of a firm:
sales, production, and finished goods inventories. Its ultimate outcome is a
pro forma synonymous to budgeted and estimated
Financial budgets - inflows and outflows of cash and with financial position.
Prepared for one year period.
Continuous (rolling) budget - moving 12-month budget
Sales forecast - basis for all of the other operating budgets and most of the financial
budgets
Sales budget - projection approved by the budget committee that describes expected sales
for each product in units and dollars.
Production budget - describes how many units must be produced in order to meet sales
needs and satisfy ending inventory requirements
Units to be produced = unit sales +desired units in ending inventory - units in beg inv
Direct materials purchases budget - based on the amount of materials needed for
production and the inventories of direct materials
Purchases = expected usage +desired end inv of DM - beg inv of DM
Direct labor budget - total DL hours and DL cost needed for the number of units in the
production budget
Overhead budget - expected cost of all indirect manufacturing items
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Marketing expense budget - outlines planned expenditures for selling and distribution
activity
Administrative expense budget - consists of estimated expenditures for the overall
organization and operation of the company
Research and development expense budget - contains planned expenditures for a separate
department devoted to new product research and development
Capital expenditures budget - financial plan outlining the expected acquisition of long-term
assets and coevrs a number of years
Cash budget - detailed plan that shows all expected sources and uses of cash. Its five
sections are:
1. Total cash available - consists of beginning cash balance and expected cash receipts
2. Cash disbursements - lists all planned cash outlays for the period except for interest
payments on short term loans (appears in financing section). All expenses not
resulting in cash outlay are excluded.
3. Cash excess or deficiency - compares the cash available with the cash needed includes
the total cash disbursements plus the minimum cash balance required
4. Financing - consists of borrowings and repayments
5. Cash balance
The cash budget:
Beginning cash balance
+ cash receipts
Cash available
- cash disbursements
- minimum cash balance
Excess or deficiency of cash
- repayments
+ loans
+ minimum cash balance
Ending cash balance
SHORTCOMINGS OF THE TRADITIONAL MASTER BUDGET PROCESS
1. Departamental orientation - determines what resources it currently has and then adjust
those levels for the potential level of output
2. Static rathen than dynamic budgets - one developed for a single level of activity
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a) Incremental approach - can incorporate last year’s inefficiencies into current
budg
b) Zero base budgeting - an alternative approach that the prior year’s budget level
is not taken for granted. It requires extensive, in-depth analysis.
3. Results orientation
Two types of Flexible budget
1. Provides expected costs for a variety of activity levels
2. Provides budgeted costs for the actual level of activity

Variable budget - budgeted costs change bec of VC and referred to flexible budget
Flexible budget variances - by comparing budgeted costs for the actual level of activity
with actual costs for the same level
Efficiency - achieved when the business process is performed in the best possible way
Effectiveness - a manager achieves or exceeds the goals described by the static budget
Volume variances - any differences between flexible budget and static budget
Feature costing - assigns costs to activities and products based on the product’s features
Goal congruence - the alignment of managerial and organizational goals
Dysfunctional behavior - involves individual behavior that is in basic conflict with the
goals

Management by exception - selective investigation of significant variances allows

managers to focus only on areas that need attention
Incentives - means that are used to encourage managers to work toward achieving the
organization’s goals.
Participative budgeting - allows subordinate managers considerable say in how the budgets
are established
Budgetary shack - exists when a manager deliberately underestimates revenues or
overestimate costs
Pseudoparticipation - when top management assumes total control of the budgeting,
seeking only superficial participation from lower level managers.
Controllable costs - are costs whose level a manager can influence
Milking the firm or myopia - organizations make the mistake of using budget as their only
measure of managerial performance
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Myopic behavior - occurs when a manager takes actions that improve budgetary
performance in the short run but bring long run harm to the firm

CHAPTER 5 : Capital Investment

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