Lecturer: PhD.

Nguyen Thi Hong Tham

Phone number: 0916.126.019
Email: [email protected]
 ASSESSMENT

Participation Assessment: 10%

Mid-term exam: 20%
Group presentation: 20%
Final-term Assessment: 50%

McGraw-Hill/Irwin Copyright © 2015 by the McGraw-Hill Companies, Inc. All rights reserved.
COST MANAGEMENT

* Chapter 3: Basic Cost Management Concepts

* Chapter 4: Job Costing

* Chapter 7: Cost Allocation: Departments, Joint Products, and By-Products

McGraw-Hill/Irwin Copyright © 2015 by the McGraw-Hill Companies, Inc. All rights reserved.
COST MANAGEMENT

* Chapter 8: Cost Estimation

* Chapter 11: Decision Making with a Strategic Emphasis

* Chapter 18: Strategic Performance Measurement: Cost

Centers, Profit Centers, and the Balanced Scorecard

McGraw-Hill/Irwin Copyright © 2015 by the McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Three

Basic Cost Management Concepts

 Learning Objectives

• Recognize the strategic role of basic cost

management concepts.
• Explain the cost driver concepts at the activity,
volume, structural, and executional levels.
• Explain the cost concepts used in product and
service costing.
• Demonstrate how costs flow through the accounts
and prepare and interpret an income statement for
both a manufacturing and a merchandising company.

3-6
 Basic Definitions
• A cost is incurred when a resource is used
for some purpose

• Costs are assembled into meaningful

groups called cost pools (e.g., by type of
cost or source)

3-7
 More Basic Definitions

• Any factor that has the effect of changing

the level of total cost is called a cost
driver

• A cost object is any product, service,

customer, activity, or organizational unit
to which costs are assigned for some
management purpose
3-8
 Cost Assignment

Cost assignment is the process of assigning costs

to cost pools or from cost pools to cost objects
– Direct costs can be conveniently and economically
traced to a cost pool or a cost object
– Indirect costs cannot be traced conveniently or
economically to a cost pool or a cost object
– Cost allocation is the assignment of indirect costs to
cost pools and cost objects through the use of cost
drivers
– These cost drivers are often called allocation bases

3-9
 Cost Assignment: General Principles
Resource Cost
Costs Pools Cost
Electric Objects
Motor
Materials Assembl Dishwash
Handling y er

Supervision
Washin
Packing Packin g
Materials g Machin
e
Final
Inspection
3-10
 Direct and Indirect Product:
Costs for a Manufacturer (1 of 3)
• Direct material costs = cost of materials that
can be readily traced to outputs = purchase
price of materials + freight – purchase discounts
+ reasonable allowance for scrap and defective
units

• Indirect material costs = cost of materials

that cannot be readily or economically traced to
outputs (e.g., rags, lubricants, and small tools)

3-11
 Direct and Indirect Product Costs:
Costs for a Manufacturer (2 of 3)
• Direct labor costs = labor that can be readily
traced to outputs = wages paid plus a reasonable
allowance for nonproductive time (e.g., coffee
breaks or personal time)

• Indirect labor costs = labor costs that cannot

be readily or economically traced to outputs (i.e.,
they are manufacturing support costs).
Examples include supervision, quality control,
and inspection
3-12
 Direct and Indirect Product Costs:
Costs for a Manufacturer (3 of 3)
• Indirect costs for the manufacturer, including indirect
materials, indirect labor, and other indirect items are
often combined in a cost pool referred to as overhead (or
factory overhead, or indirect manufacturing costs)

• The three main types of costs, direct materials, direct

labor, and overhead, are sometimes condensed even
further:
Direct materials + Direct labor = Prime costs
Direct labor + Overhead = Conversion costs

3-13
 Cost Drivers

• Cost drivers provide two roles for the

management accountant
– Assigning costs to cost objects
– Explaining cost behavior, i.e., how total cost
changes as the cost driver changes
• Four types of cost drivers:
– Activity-based
– Volume-based
– Structural
– Executional

3-14
 Cost Drivers (continued)
• Activity-based cost (ABC) drivers are developed
at a detailed level of operations using activity
analysis–a cost driver is determined for each activity
• Volume-based cost drivers are developed at an
aggregate level and relate to the amount produced
or quantity of service provided:
– The relationship between the cost driver and total
cost is approximately linear within a relatively
short range of output

3-15
Volume-Based Cost Drivers: Classification by Behavior

• Variable cost is the change in total cost

associated with each change in quantity of a
selected cost driver
• Fixed cost is the portion of total cost that does
not change with changes in quantity of the
selected cost driver
• Mixed cost is used to refer to a total cost figure
that includes both a fixed and variable
component
• Step cost varies with the change in cost driver
3-16
Linear Approximation and Relevant
Range
Total
Cost

3,500 3,600
Units of the Cost Driver
3-17
 Fixed Costs – Exhibit 3.8

Total
Cost

Total Fixed Cost

$6,600

$6,500

$3,000
3,500 3,600
Units of the Cost
Driver 3-18
 Total Costs – Exhibit 3.8

Total
Total Cost
Cost

6,600
Total Variable
Cost
6,500
Total Fixed Cost

3,000
3,500 3,600
Units of the Cost
Driver 3-19
 Total Cost and Unit Cost

Fixed cost Variable cost

Total $100,0 $100,0 $80,00 $160,0
00 00 0 00
Units
of 10,000 20,000 10,000 20,000
output
Per $10 $5 $8 $8
unit
Total cost ÷ Units of Total cost ÷ Units of
output output

3-20
 Structural versus Executional Drivers

• Structural cost drivers facilitate strategic decision

making because they involve plans and decisions that
have long-term effects
– Scale, experience, technology, and complexity are
considered in hopes of improving competitive position

• Executional cost drivers facilitate operational

decision making by focusing on short-term effects
– Workforce involvement, design of the production
process, and supplier relationships are examples of
operational decisions
3-21
 Product and Service Costing Concepts

• Product costs include only the costs necessary to

complete the product at the manufacturing step in
the value chain (manufacturing) or to purchase and
transport the product to the location of sale
(merchandising)

• Period costs (also called non-product costs)

include all other costs incurred by the firm in
managing or selling the product (costs outside the
manufacturing step of the value chain)

3-22
Manufacturing versus Merchandising
Exhibit 3.13

Note the movement

of costs through the
multiple inventory
accounts for a
manufacturing firm
before arriving at
Cost of Goods
Sold.

3-23
Inventory and Related Expense Accounts
Exhibit 3.14

Both types of firms

have a Cost of
Good Sold account.
The difference is
that the value for a
manufacturing firm
is derived from the
costs incurred in
the production
process as
opposed to simply
using the amount
paid to a third party
for the completed
inventory.

3-24
 Qualitative Attributes of
Cost Information
– Accuracy (impacted by internal accounting
controls)
– Timeliness (often involves sacrificing in the
other two areas)
– Cost and value of information (the cost of
information is affected by desired accuracy,
timeliness, and level of aggregation and
should not outweigh the associated benefits)

3-25
 Chapter Summary (1 of 2)
• Cost assignment: the tracing of direct or
allocation of indirect costs to cost pools
using cost drivers.

• Four types of cost behavior (and cost

drivers):
– Activity-based;
– Volume-based;
• Variable cost
• Fixed cost
• Mixed cost
• Step cost
– Structural;
– Executional.
3-26
 Chapter Summary (2 of 2)

• Product and service costing focuses on differentiating

product costs from period costs.

• Manufacturing and merchandising firms both have a Cost of

Goods Sold amount.

• Costs flow through three inventory accounts in a

manufacturing firm(materials inventory, work-in-process
inventory, and finished goods inventory); merchandising
firms have one inventory account (inventory held for sale).
3-27
Chapter Four

Job Costing
 Learning Objectives (1 of 2)

• Explain the types of costing systems.

• Explain the strategic role of costing.

• Explain the flow of costs in a job

costing system.

• Explain the application of factory

overhead costs in a job costing system.

4-29
 Learning Objectives (2 of 2)

• Calculate underapplied and overapplied

overhead and show how it is accounted for.
• Apply job costing to a service industry.
• Explain an operation costing system.
• Explain how to handle spoilage, rework, and
scrap in a job costing system (appendix).

4-30
 Why Costing Systems?

• Costing accuracy is critical to a firm’s

success
• Costing systems help management
estimate costs and accurately charge
customers
• An accurate costing system can provide a
competitive advantage

4-31
Developing a Costing System (1 of 5)

• Product costing is the process of

accumulating, classifying, and assigning direct
materials, direct labor, and factory overhead
costs to cost objects, which most commonly
are products, services, or projects:
– Direct costs are traced to a cost object (e.g., a job)
– Indirect costs are allocated to a cost object (using
one or more cost-allocation bases/cost drivers)

4-32
Developing a Costing System (2 of 5)

• When developing a product-costing

system, there are three choices that
must be made:
– Cost accumulation method (i.e., job or process
costing)
– Cost measurement method (i.e., actual, normal,
or standard costing)
– Overhead assignment method (i.e., volume-
based or activity-based)
4-33
Developing a Costing System (3 of 5)

A firm’s choice of costing system

depends upon the
• firm’s industry and product or service
• firm’s strategy and management
information needs, and
• costs and benefits of acquiring, designing,
modifying, and operating a particular
system
4-34
Developing a Costing System (4 of 5)
Cost accumulation: Job or Process Costing?
– In a job costing system, all manufacturing costs
incurred are assigned to jobs
• This type of system is appropriate when cost can be
readily identified with specific customers, jobs, or
projects
• Often found in small or medium firms that produce
customized products and in professional services firms
– Process costing is often found in firms that
produce one or a few homogeneous products
through continuous mass production

4-35
Developing a Costing System (5 of 5)

The examples below show how certain industries

tend to favor a particular cost accumulation
method:
Construction, printing, special
equipment manufacturing,
Job
shipbuilding, medical services, custom
Costing
furniture manufacturers, advertising
agencies, accounting firms, etc.
Chemical industry, bottling companies,
Process plastics, food products, paper products,
cement manufacturing, brick 4-36
 Cost Measurement: Actual

An actual costing system uses actual costs

incurred as the measure of product cost. It is
rarely used because
• Unit costs fluctuate significantly, thereby increasing
the possibility of error in pricing, adding/dropping
product lines, and executing performance
evaluations
• Factory overhead costs are only known at or after
the end of the period (thus, cost information is not
available on a timely basis)

4-37
 Cost Measurement: Normal

A normal costing system uses actual costs

for direct materials and direct labor but
normal costs for factory overhead:
• Involves estimating a portion of overhead to be
assigned to each product as it is produced
providing a timely estimate of cost
• Choice of an appropriate denominator activity
level for allocating fixed overhead costs is a key
consideration

4-38
 Cost Measurement: Standard

A standard costing system uses standard

costs for all cost elements, direct and
indirect:
• Standard costs are costs a firm should attain
under relatively efficient operating conditions
• Standard costing systems provide a basis for
cost control, performance evaluation, and
process improvement

4-39
Developing a Costing System ꟷ
Summary

4-40
Overhead assignment under normal costing:
Volume-based or activity-based? (1 of 2)

Volume-based costing systems allocate

overhead using a volume-based cost driver,
such as units produced, direct labor-hours,
direct labor costs, or machine-hours
• This approach relies heavily on the
assumption that overhead cost incurrence is
related to output volume
4-41
Overhead assignment under normal costing:
Volume-based or activity-based? (2 of 2)

Activity-based costing (ABC) systems allocate

factory overhead to products using a cause-and-
effect criterion with multiple cost drivers, both
volume-based and non-volume-based
• This system allocates factory overhead more
accurately based on resource consumption and
activity consumption cost drivers
4-42
 The Strategic Role of Product
Costing
To be competitive a firm needs accurate
cost information for:
– Product pricing decisions
– Product profitability analysis
– Customer profitability analysis
– Evaluation of management performance
– Refinement of strategic goals

4-43
 Job Costing System

Accumulates costs and assigns them to specific

jobs, customers, projects, clients, or contracts
– The basic supporting document is the job-
cost sheet, which records and summarizes
the costs of direct materials, direct labor, and
factory overhead for a particular job
– A job cost sheet is started when the
production or processing of a job begins

4-44
Example Job Cost Sheet

4-45
 Job Costing

– As a job goes through the production process,

all costs for the job are accumulated on the job-
cost sheet
– Upon its completion, overhead is allocated to
the job
All the costs that appear on the job-cost sheet are recorded
in the Work-in-Process (WIP) Inventory account

– The total of all the active job cost sheets should

equal the cost of the ending WIP Inventory

4-46
Cost Flows – Direct and Indirect Materials

– First recorded in Materials Inventory

– A bill of materials, a listing similar to a recipe, is used to decide the materials

needed for a particular project

– A request is made with a materials requisition for the supplies needed for a job

– Upon issuance to production, the cost of the materials is then transferred to

WIP Inventory

– The materials requisitions are used to record the direct material costs on the
job-cost sheets

– Indirect materials, when issued to production, are taken out of Materials

Inventory, but these costs are recorded to Factory Overhead rather than WIP
Inventory

4-47
Bill of Materials

4-48
Materials Requisition

4-49
 Cost Flows – Direct and Indirect Labor

– Costs are recorded to the job-cost sheet from time tickets,

which show the amount of time an employee worked on
each job, the pay rate, and the total labor cost chargeable to
each job

– Time cards are also used for this purpose

– Indirect labor, such as supervisors’ and warehouse clerks’

salaries, is recorded as Factory Overhead while Direct Labor
is added to the WIP Inventory

Note: recording and assignment of time worked may be done

electronically 4-50
 Cost Flows – Factory Overhead
Overhead application is the process of allocating
overhead costs to individual jobs
– There are three approaches to allocating overhead:
actual, normal, and standard costing (standard
costing is covered in Chapters 14 and 15)
• Under the actual application method, overhead costs
are tracked for each job and are transferred to WIP and
Finished Goods Inventory in the exact amounts incurred

• Under the normal application method, overhead costs

are applied to various jobs using a predetermined
factory overhead rate

4-51
Application of Factory Overhead (1 of
5)
The predetermined factory overhead
rate is an estimated factory overhead rate
used to apply factory overhead cost to a
job
– The amount of overhead assigned to a
job using this rate is called factory
overhead applied

4-52
Application of Factory Overhead (2 of 5)
The predetermined factory overhead rate is obtained using a
four-step process:
❶ Estimate total factory overhead costs for the operating
period, usually a year. (May be referred to as the numerator
value.)

❷ Select the appropriate cost driver(s) that will be used to apply

factory overhead costs.

❸ Estimate the total amount or activity level of the chosen cost

drivers for the operating period. (May be referred to as the
“denominator activity level”.)

❹ Divide the estimated factory overhead costs by the estimated

amount of the chosen cost driver(s) to obtain the
predetermined overhead rate.
4-53
Plantwide versus Departmental Rates

• When production departments are similar

with respect to the amount of overhead
and cost driver usage, a plantwide rate is
appropriate
• When departments differ significantly in
the amount of overhead cost and driver
usage departmental rates are more
appropriate
4-54
Application of Factory Overhead (3 of
5)
The predetermined factory overhead (OH) rate used
to apply overhead to jobs is determined before the
period begins.
Estimated factory
overhead
OH Rate amounttotal
for the year of
Estimated amount
= cost
Some Possible Costdriver for the year
Drivers:
1. direct labor-hours The OH rate can
2. machine-hours be
3. number of set-ups calculated on a
4. number of orders plantwide or a
5. manufacturing cycle- departmental
time basis.
4-55
Application of Factory Overhead (4 of
5)

Estimated factory
overhead
OH Rate amounttotal
for the year of
Estimated amount
= cost
driver for the year
Overhead applied = OH Rate × Actual
activity
Based on estimates, Actual amount of the
and determined allocation base, such as
before the period direct labor-hours,
begins incurred during the period

4-56
 Application of Factory Overhead (5 of 5)

The factory overhead applied to jobs during a period is

rarely exactly equal to actual factory overhead costs
incurred during that period:
– Overapplied overhead exists when factory overhead applied >
actual factory overhead
– Underapplied overhead exists if factory overhead applied <
actual factory overhead
– If the predetermined factory overhead rate is reasonably
accurate (i.e., both the numerator and denominator in the OH
rate are estimated with precision), these differences should be
small
4-57
 Factory Overhead Account

The factory overhead account is a

temporary account and, as such, must be

closed at the end of the year.

4-58
 Disposition of Underapplied and
Overapplied Factory Overhead
Two treatments are possible:
– Adjust the Cost of Goods Sold account , that is,
the difference is simply added to (when
underapplied) or subtracted from (when
overapplied) the Cost of Goods Sold account
– Adjust the production costs of the period (i.e.,
prorate the difference to the ending balances of
Work in Process Inventory, Finished Goods
Inventory, and the Cost of Goods Sold accounts

4-59
 Potential Errors In Overhead Application
• Aggregation error

– An example is the use of an aggregate rate, such as a

plantwide rate rather than a departmental rate

• Specification error

– Arises when the wrong cost driver is used, for example

when a labor hours driver should be used rather than a
machine hour driver

• Measurement error

– Arises from estimation and calculation error

4-60
Job Costing in Service Industries
Job costing is used extensively in service industries such as
advertising agencies, construction companies, hospitals,
accounting firms, and law firms
– The cost object is often a client, contract, or project rather than a
job, but the approach is the same
– The major difference between manufacturing and service
industries is the use of direct materials--service industries may
use little or no direct materials
• The main focus of a service industry’s costing system is
direct labor
– The OH rate is usually based on direct labor cost
4-61
 Operation Costing
A hybrid costing system that uses job costing to assign direct
material costs to jobs and a processing “departmental” approach
to assign “conversion costs” to products or services:
– Common in manufacturing companies whose conversion activities are
similar across several product lines, but whose direct materials vary
significantly
– Direct material costs are traced directly to jobs while conversion costs
(direct labor and factory overhead) are traced to departments and then to
jobs
– Common in the following industries: clothing, food processing, textiles,
shoes, furniture, metalworking, jewelry, and electronic equipment

4-62
 Chapter Summary (1 of 7)
• When developing a product costing
system, there are three choices that must
be made:
– Cost accumulation method (i.e., job or
process costing);
– Cost measurement method (i.e., actual,
normal, or standard costs);
– Overhead assignment method (i.e., volume-
based or activity-based).
4-63
 Chapter Summary (2 of 7)

• A firm’s competitive strategy should

guide its choice of a cost system to fit
the firm’s competitive environment.
• Job costing is a product costing
system that accumulates costs and
assigns them to specific jobs,
customers, projects, or contracts.
4-64
 Chapter Summary (3 of 7)

• Job costing uses several accounts to control

product cost flows:
– Materials Inventory for recording direct material
costs;
– Work-in-Process Inventory for recording the use of
direct labor and direct materials and the application
of factory overhead;
– Factory Overhead to track the actual overhead and
the application of overhead to jobs;
– Finished Goods Inventory to track completed goods.

4-65
 Chapter Summary (4 of 7)
• A predetermined factory overhead rate is
used to apply factory overhead cost to
specific jobs. This process of determining
the predetermined rate has four steps:
1. Estimating the factory overhead costs;
2. Selecting an appropriate cost driver;
3. Estimating the quantity of the chosen cost
driver;
4. Dividing the estimated cost by the estimated
amount of the chosen driver.
4-66
 Chapter Summary (5 of 7)
• At the end of the period the Factory Overhead
account should be closed out to zero (i.e., over- or
under-applied overhead must be disposed of), using
one of two methods:
– Close the over/underapplied overhead entirely to the Cost
of Goods Sold account.
– Allocate (prorate) the over/underapplied overhead to the
Work-in-Process, Finished Goods, and Cost of Goods Sold
accounts.

4-67
 Chapter Summary (6 of 7)

• The three potential errors in

overhead application are
aggregation errors, specification
errors, and measurement errors.
• Service industries use job costing
with a focus on direct labor.

4-68
 Chapter Summary (7 of 7)

• Operation costing is a hybrid costing

system that uses job costing to
assign direct material costs to jobs
and a processing “departmental”
approach to assign conversion costs
(direct labor and factory overhead)
to products or services.
4-69
 Appendix: Spoilage, Rework, and
Scrap in Job Costing (1 of 4)
Spoilage refers to the unacceptable units
that are discarded or sold for disposal
value. Spoilage can be
– Normal spoilage – meaning it occurs under normal
operating conditions
• Job specific
• Common
– Abnormal spoilage - an excess over the amount of
normal spoilage expected under normal operating
conditions

4-70
Appendix: Spoilage, Rework, and
Scrap in Job Costing (2 of 4)
– The cost of job-specific normal spoilage
becomes part of the cost of that job
– The cost of common normal spoilage is
included as part of Factory Overhead
cost
– The cost of abnormal spoilage is treated
as a “Loss from Abnormal Spoilage”

4-71
 Appendix: Spoilage, Rework, and
Scrap in Job Costing (3 of 4)
Rework units are units produced that are be
reworked into good units that can be sold in
regular channels
– For normal defective units for a specific job, rework
costs are charged (debited) to Work in Process Inventory
– For normal defective units common to all jobs, rework
costs are charged (debited) to Factory Overhead
– For abnormal units, charge the costs to a “Loss from
Abnormal Rework” account

4-72
Appendix: Spoilage, Rework, and
Scrap in Job Costing (4 of 4)
Scrap is the material left over
from the manufacture of the
product; it has little or no value
– For scrap from a specific job, scrap is
charged to the WIP Inventory account
– For scrap common to all jobs, scrap is
charged to the Factory Overhead
account

4-73
 Chapter Seven

Cost Allocation: Departments,

Joint Products, and By-Products
 Learning Objectives (1 of 2)
• Identify the strategic role and objectives of
cost allocation.

• Explain the ethical issues of cost allocation.

• Use the three phases of departmental cost

allocation.

• Explain the implementation issues of the

different departmental cost allocation
methods.
7-75
 Learning Objectives (2 of 2)

• Explain the use of cost allocation in service

firms.
• Use the three joint product costing
methods.
• Use the four by-product costing methods
(appendix).

7-76
Production and Service Departments

• A production department (sometimes

called an operating department) is a unit
of the manufacturing company that is
involved directly in producing the
company’s product or service;
• A service department is a unit of the
organization that performs one or more
support tasks for production departments
7-77
 Two types of joint costs covered

• Costs of production departments and

service departments shared by two
or more different products
• Joint manufacturing costs for
products that are not separately
identifiable until some later point in
the manufacturing process
7-78
 The Strategic Role of Cost Allocation

1. Determine accurate departmental and product costs as

a basis for the evaluation of the cost efficiency of
departments and the profitability of different products,
financial reporting, and tax compliance.

2. Motivate managers to exert a high level of effort to

achieve the goals of top management.

3. Provide the right incentive for managers to make

decisions that are consistent with the goals of top
management.

4. Fairly determine the rewards earned by the managers

for their effort and skill and for the effectiveness of
7-79
their decision-making.
 Cost Allocation Bases
– The most clear and unbiased basis for
cost allocation exists when a cause-
and-effect relationship can be
determined, such as the relationship
between machine breakdowns and
maintenance costs
– Other alternatives exist in the
absence of cause-and-effect
relationships, such as ability-to-bear
7-80
 Ethical Issues in Cost Allocation (1 of 2)

• An ethical issue arises when costs are allocated

to products or services that are produced for
both a competitive market and a public or
governmental entity – there is the incentive to
shift costs from competitive products to cost-
plus-based products, since cost-plus pricing can
increase revenue and profits
• An equity or fair share issue arises when a
governmental unit reimburses the costs of a
private institution or when it provides a service
to the public for a fee; the choice of cost
allocation method can be biased because it will
affect revenue and profit
7-81
 Ethical Issues in Cost Allocation (2 of 2)

• A third ethical issue is the effect 0f the

chosen allocation method on the costs of the
products sold to or from foreign subsidiaries
• By choosing an allocation method that has
the effect of increasing the costs of products
purchased in high-tax countries or in
countries where the firm does not have
favorable tax treatment, the firm can reduce
its overall tax liability
7-82
Overhead Allocation: Three General Approaches

Three general approaches for allocating

overhead costs to products:
– The volume-based approach allocates overhead
from a single cost pool (chapter 4)

– The departmental approach allocates overhead

to production departments, and then from
production departments to products (chapter 7)

– The activity-based approach allocates overhead

to production activities, and then from production
activities to products (chapter 5)
7-83
 The Departmental Approach

The departmental approach classifies

manufacturing departments into production
and service departments

This approach involves three phases:

❶ Trace all direct costs and allocate indirect costs to the

production departments and service departments
❷ Allocate the service department costs to the
production departments
❸ Allocate production department costs to products
7-84
The Three Phases of Departmental
Cost Allocation

7-85
 Departmental Approach Example
Beary Company manufactures two products and
has two production departments (P-1 and P-2)
and two service departments (S-1 and S-2).
Beary uses labor-hours (DLH) to allocate indirect
labor costs and machine-hours (MH) to allocate
indirect materials costs.

Not Traceable

7-86
Departmental Approach: Phase 1

7-87
 Departmental Approach:
Phase 2
Phase 2, allocation of service department costs:
whether, and to what extent, reciprocal cost
flows are recognized?
Three methods are used to allocate service
department costs:
– The direct method
– The step method
– The reciprocal method

7-88
Phase 2: Direct Method

7-89
Phase 3: Direct Method

7-90
 Phase 1: Step Method
Phase 1 of the Step Method is the same as
Phase 1 of the Direct Method, as shown
below:

7-91
 Phase 2: Step Method

Note: In this example, service department 1 (S-1) is

allocated first; the approach would be done in a similar
manner if S-2 goes first.
7-92
Phase 3: Step Method

7-93
 Phase 1: Reciprocal Method
Phase 1 of the Reciprocal Method is the
same as Phase 1 of the Direct Method,
as shown below:

7-94
Phase 2: Reciprocal Method (1 of 2)

7-95
Phase 2: Reciprocal Method (2 of 2)

7-96
Phase 3: Reciprocal Method

7-97
 Key Implementation Issues
• Choosing the most accurate method is important
– Wide variations can occur in the product allocation amounts

• Watch for Disincentive Effects when Allocation Base is

Unrelated to Usage or Allocation is Based on Actual Usage
1. Allocation Base Unrelated to Usage: In this case there is an
incentive for a user to increase usage since the user does not
pay fully for the increased usage; all users share the cost of the
increased usage. The outcome is unfair and costly
2. Allocation Base is Actual Usage: In this case a change in one
user’s activity will affect the costs shared by other users; a
decline in use by one user will increase the cost allocated to
others. The outcome is unfair and demotivating.

7-98
 Solving the Disincentive Problem

• Two ways to deal with these two

disincentives:
– Use dual allocation, which separates
variable and fixed costs and traces the
variable costs directly to the departments
that caused the cost
– Using budgeted amounts rather than
actual amounts makes the allocation of
fixed costs more predictable and less
7-99
 An Additional Disincentive Problem

Allocated costs can exceed external

purchase cost
– Occasionally the cost allocated to a
department for a product or service
exceeds the cost of purchasing that item
from an outside supplier, giving the
purchaser the incorrect incentive to
purchase outside the company. A
solution is to allocate the common cost
on the basis of outside purchase price 7-
100
 Service Industry Cost Allocation
• The concepts of allocation relate to
service and not-for-profit
organization that incur joint costs.
• Exhibit 7.14 offers an example

7-
101
 Joint Product Costing (1 of 3)

• Some manufacturing plants yield more than

one product from a common resource input;
this is called a joint production process

• Joint products are products from a joint

production process that have relatively
substantial sales values

• Products whose total sales values are minor

in comparison to the sales value of the joint
products are classified as by-products
7-
102
 Joint Product Costing (2 of 3)
• Joint products and by-products start their
manufacturing life as part of the same raw material,
so up until a certain point, no distinction can be made
between the products
– By-products differ from joint products in that the sales
value of the by-product is minor in comparison to that of
the joint products
• The point in a joint production process at which
individual products can be identified for the first time
is called the split-off point
• Joint costs include all manufacturing costs incurred
prior to the split-off point
7-
103
 Joint Product Costing (3 of 3)

• Costs incurred after the split-off point are

called separable processing costs

• Four methods are commonly used to allocate

joint product costs
– Physical measures
– Sales values of the products at split-off
– Net realizable values (NRV) of the products
– Constant Gross Margin Percentage Method

7-
104
Method 1: Allocation Based on Physical Measures

• The physical measure method uses a

physical measure of output such as pounds,
gallons, or units to allocate the joint costs to
joint products
– The greater the output (however
measured), the greater the share of joint
costs allocated to the product
• This method is also called the average cost
method when units of output are used in the
costing procedure
7-
105
The Physical Measure Method: Example (1 of 2)
Assume Johnson Seafood produces tuna filets and
canned tuna for distribution to restaurants and
supermarkets:

7-
106
 The Physical Measure
Method: Example (2 of 2)

7-
107
The Physical Measure Method: Summary

Advantages Disadvantages
❶ Easy to use ❶ Ignores the revenue-
producing capability of
individual products

❷ The criterion for the ❷ Each product can have its

allocation of the joint own unique physical
costs is objective measure

7-
108
 Method 2: Sales Value at
Split-off Method
• The sales value at split-off method
allocates joint costs to joint products
on the basis of their relative sales
values at the split-off point
• This method can only be used when
joint products can be sold at the
split-off point
7-
109
 Sales Value at Split-off Point Method: Example

Using the same example as for the physical measure

method, the sales value at split-off point method
produces the following results, where price per unit is
the price at the split-off point

7-
110
 Sales Values at Split-off Point
Method: Summary

Advantages Disadvantages

❶ Easy to calculate ❶ Market prices for some

industries change constantly

❷ Costs are allocated ❷ Sales price at split-off

according to the might not be available
individual product’s because additional
revenue processing is necessary for
sale

7-
111
 Method 3: The Net Realizable Value
(NRV) Method
• The Net Realizable Value (NRV) method can be
used when joint products cannot be sold at split-off

• The net realizable value (NRV) of a product is the

product’s estimated sales value at the split-off point

• NRV is determined by subtracting additional

processing and selling costs beyond the split-off point
from the estimated ultimate sales value of the product

7-
112
 The Net Realizable Value (NRV)
Method: Example (1 of 2)
Assume Johnson Seafood in the above
example also produces cat food from
the raw, unprocessed tuna

7-
113
The Net Realizable Value (NRV)
Method: Example (2 of 2)

$4,400 cat food = $5,250 -

$850 7-
114
Decision to Sell Before or After Additional Processing

• At the split-off point, it is often necessary to decide

whether to:
– Sell the product as is (at the split-off point), or
– Add additional costs to improve the product and sell it later
for a higher price

• The correct decision is to compare the potential

additional cost with the increase in sales value
from the split-off point to the sales value after
additional processing
• If the increase in sales value is less than the
additional cost, then sell at split-off point
7-
115
Method 4: Constant Gross Margin Percentage Method

• The constant gross margin

percentage method is used when it is
desired to have each joint product, after
joint cost allocation and separable costs,
to have the same gross margin
percentage
• The outcome is that each joint product
will be equally profitable as measured
by the gross margin percentage
7-
116
 By-Product Costing
• Four Methods: Two based on assets, two based on revenues:

• Asset Recognition Methods:

– Net Realizable Value (NRV) Method
– Other Income at Production Point Method

• Revenue Methods:
– Other Income at Selling Point Method
– Manufacturing Cost Reduction at Selling Point Method

• The main difference between these methods is the former

grouping records by-product produced as inventory at NRV,
while the latter grouping recognizes by-product revenue in
the period sold
7-
117
 Chapter Summary (1 of 6)

• Cost allocation is strategically important in

determining accurate departmental and
product costs, for evaluating the cost efficiency
of departments, and for assessing the
profitability of different products.
• Ethical issues arise when costs are allocated
to products or services:
– What method is being used to allocate the
costs?
– Is the market competitive or on a cost-plus 7-
118
 Chapter Summary (2 of 6)
There are three methods of overhead allocation:
– The volume-based approach allocates overhead
costs from a single cost pool, directly to
products and services;
– The departmental approach allocates
overhead to production departments, and then
from production departments to products;
– The activity-based approach allocates overhead
to production activities, and then from
production activities to products.
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119
 Chapter Summary (3 of 6)
This chapter focused on the departmental
approach, which has three phases:
– Assign total overhead costs to production and
service departments by tracing direct
overhead costs to production and service
departments and by allocating common
(joint) overhead costs to service and
production departments;
– Allocate service department costs to
production departments (using either the
7-
120
 Chapter Summary (4 of 6)
• Methods Used for Departmental Cost
Allocation:
– Direct Method (ignores reciprocal service
between service departments;
– Step Method (assigns reciprocal service
costs in steps);
– Reciprocal Method (accounts for all
reciprocal service between service
departments).
7-
121
 Chapter Summary (5 of 6)
• Joint production processes - two different types
of output:
– Joint products
– By-products
• Two types of costs associated with a joint
production process:
– Joint costs
– Separable processing costs
• Four methods commonly used to allocate joint
costs:
– Physical Measure
– Sales values at the split-off point
– Relative NRVs (estimated sales values at the split- 7-
122
 Chapter Summary (6 of 6)

There are four by-product costing alternatives:

• Asset Recognition Methods (benefits recognized
in period of production):
• Net Realizable Value (NRV) Method
• Other Income at Production Point Method

• Revenue Methods (benefits recognized in period

of sale):
• Other Income at Selling Point Method
• Manufacturing Cost Reduction at Selling Point
7-
123
Chapter Eight

Cost Estimation
 Learning Objectives
• Explain the strategic role of cost estimation.
• Apply the six steps of cost estimation.
• Use the high-low and regression analysis
methods of cost estimation.
• Explain the implementation issues of the
cost estimation methods.
• Use learning curves in cost estimation when
learning is present (appendix).
8-
125
 Strategic Role of Cost Estimation
Cost estimation
• is the development of a well-defined
relationship between a cost object and
its cost drivers for the purpose of
predicting the cost
• helps identify the key cost drivers for a
cost object
• supports planning, decision making, and
control 8-
126
 Steps in Cost Estimation (1 of 2)
There are six steps in the cost estimation
process:
❶ Define the Cost Object

❷ Determine the Cost Drivers

– The most important step: specification of underlying

causal factors of a cost

❸ Collect Consistent and Accurate Data

– Consistent means that the data are calculated on the
same accounting basis and all transactions are
recorded in the proper period
– Accuracy refers to the reliability of the data 8-
127
 Steps in Cost Estimation (2 of 2)
❹ Graph the Data
– To identify unusual patterns, possible
nonlinearities, and any outlier observations
❺ Select and Employ the Estimation Method
- the high-low method
- linear regression
❻ Assess the Accuracy of the Cost Estimate
– One measure of the accuracy of the estimation
method is the mean absolute percentage error
(MAPE)
– Regression analysis is generally regarded as more
accurate than the high-low method 8-
128
 Cost Estimation: Example (1 of 3)
Bill Garcia, a management accountant, wants
to estimate future maintenance costs for a
large manufacturing company; recent monthly
cost data are as follows:

8-
129
 Cost Estimation: Example (2 of 3)
Garcia would like to estimate an underlying cost function
for maintenance costs using the high-low method.
Garcia feels there is an economic relationship between
maintenance cost and monthly operating hours (the cost
driver), so he collects the following monthly observations:

January February March April May June July

Total operating hours 3,451 3,325 3,383 3,615 3,423 3,410 3,500

Maintenance costs ($) 22,843 22,510 22,706 23,032 22,413 22,935 23,175

8-
130
 Cost Estimation: Example (3 of 3)
Another graph is created to incorporate the new
data:

8-
131
 The High-Low Method (1 of 5)
The high-low method uses algebra to determine a
unique estimation line between representative high
and low points in the data
– This method provides a unique cost line through
a set of data points
– The high-low equation is as follows:

Where Y = the value of the estimated cost

a = the intercept, a fixed quantity for the value of Y
when X = 0
b = the slope of the line (unit variable cost)
X = the cost driver, the number of operating hours
8-
132
 The High-Low Method (2 of 5)
• Using the graph of operating hours versus
maintenance cost, Garcia picks two data points,
one representative of the lower points and one
representative of the higher points (these points
are often, but not necessarily, the highest and
lowest points in the data set)

• Let us assume that Garcia picks from the data set

February (low point) and April (high point)

• The next step is to calculate the equation of the line

connecting these two points 8-
133
 The High-Low Method (3 of 5)

b = Unit variable cost = $522 ÷ 290 hours = $1.80/hour

a = Fixed cost = Total cost − Estimated variable cost

Estimated cost function:

Total cost = Fixed cost + Variable cost

While the high point was used to estimate the fixed costs, the data from the low point
could have also been used
8-
134
 The High-Low Method (4 of 5)
For values of the cost driver (operating hours) within the
“relevant range” of approximately 3,325 to 3,615 hours, the
preceding equation can be used to estimate monthly
maintenance costs. For example, for the month of August:

8-
135
 The High-Low Method (5 of 5)

Pros:
– Requires the study of a graph of the
data to identify outliers and nonlinearity
Cons:
– Relies on only two points, and the
selection of those two points requires
judgment (that is, it discards most of
the data)
8-
136
 Regression Analysis (1 of 7)
Regression analysis is a statistical method
for obtaining the unique cost-estimating
equation by minimizing, for a set of data points,
the sum of the squares of the estimation errors:
An error is the distance measured from the
regression line to one of the data point
– Since errors are squared, this method of cost-
estimation is sometimes referred to as least-
squares linear regression

8-
137
 Regression Analysis (2 of 7)
Regression analysis involves two types of
variables:
– The dependent variable is the cost to be estimated
– The independent variable (or variables) is the cost
driver(s) used to estimate cost:
• When one cost driver is used, the regression model
is referred to as a simple regression model
• When two or more cost drivers are used, the
regression model is referred to as a multiple
regression model

8-
138
 Regression Analysis (3 of 7)
A simple linear regression model
(equation) is as follows:

8-
139
 Regression Analysis (4 of 7)
To illustrate a simple, linear regression cost-
estimation model, the following table contains
three months of data on supplies expense and
production levels (normally 12 or more points will
be involved):
Month Supplies Expense (Y) Production Level (X)
1 $250 50 units
2 310 100 units
3 325 150 units
4 ? 125 units

8-
140
 Regression Analysis (5 of 7)
Here is what the regression line and the data
look like:
400
Regression Line
350
Supplies Expense (Y)

300

250

Mean of the dependent

200
variable, supplies expense

50 100 150
Units of Output (X)
8-
141
 Regression Analysis (6 of 7)
The data from Exhibits 8.3a and 8.3b are used
in the example below. The regression estimation
line is obtained usually from a computer
software application such as Excel (see Exhibit
8.8
Thein text for model
estimation an example):
is:
Y = a + (b x X) + e
And the regression solution from Excel is:
a = $220 and b = $0.75
So, for X = 125 units for month 4:
Y = $220 + $0.75 🞪 125 units
Y = $313.75 = Estimated Cost, Month 4
8-
142
 Regression Analysis (7 of 7)

Pros:
– Objective, statistically precise method of estimating
future costs
– Provides quantitative measures of its precision
(accuracy of the estimate) and reliability (the
statistical validity of the regression); see next slide…

Cons:
– Can be influenced strongly by “outlier” data points
resulting in a line that is not representative of all the
data 8-
143
 Regression Analysis: Measuring
Reliability and Precision (1 of 6)
Reliability: whether the regression reflects
actual relationships among the variables,
as measured by:
• R-squared, also known as the coefficient of
determination
• The t-value
• The p-value
Precision: the accuracy of the estimates
from the regression analysis, as measured
by:
• The standard error of the estimate (SE)

8-
144
 Regression Analysis: Measuring
Reliability and Precision (2 of 6)
R-squared
– A number between zero and one that describes the
explanatory power of the regression (the degree to
which the change in Y can be explained by changes
in X)
– A relative measure of “goodness-of-fit” (i.e., the
percentage change in Y that can be explained by
changes in X)
– The maximum value for R-squared is 1.00 (i.e.,
100%)

8-
145
 Regression Analysis: Measuring
Reliability and Precision (3 of 6)
t-value
– A measure of the statistical reliability of each
independent variable in the cost function: does the
independent variable have a valid, stable, relationship
with dependent variable?
– Variables with a low t-value should be evaluated and
possibly removed to improve cost estimation
– In a multiple-regression model, low t-values signal the
possibility of multicollinearity, meaning two or more
independent variables may be highly correlated with each
other; removal of one or more of these variables may be
8-
146
 Regression Analysis: Measuring
Reliability and Precision (4 of 6)

Standard error of the estimate (SE)

– A measure of the precision/accuracy of the

regression’s estimate

– A regression with high precision will have

an SE value that is relatively small
compared to the average value of the
dependent variable.
8-
147
 Regression Analysis: Measuring
Reliability and Precision (5 of 6)
Standard error of the estimate (SE)
– Can be used to establish confidence intervals for
cost estimation:

• The range of +/- one SE around an estimate

provides a confidence range of 67%; the
unknown true value of the estimate should fall
within this range of the amount predicted by the
regression equation
• The range of +/- two x SE around an estimate is
interpreted as above except the confidence is 8-
148
 Regression Analysis: Measuring
Reliability and Precision (6 of 6)
p-values

– Measures the risk that the true value of

a given cost coefficient is zero; low p-
values imply rejection of the assumption
of a relationship between the dependent
and independent variables. Normally, p-
values of 5% or less are expected in
useable regression models.
8-
149
Regression Analysis: Example (1 of 4)
Continuing with the Garcia example,
regression (using Excel) produces the
following output:

8-
150
Regression Analysis: Example (2 of 4)
Garcia reviews the results of his analysis:

– R-squared is less than 0.50, which is lower than

desired
– However, the SE is approximately 1% of the mean
of the dependent variable, which is good
– The t-value on the estimated coefficient is slightly
more than 2, which implies a low probability that
there is no relationship between monthly
maintenance costs and changes in units of output

8-
151
Regression Analysis: Example (3 of 4)

But why is R squared relatively low?

– Jan notices that the month of May’s
maintenance costs are unusually low
compared to the other months and decides to
use a dummy variable to potentially capture
seasonal effects (therefore, she assigns a value
of one for May and a value of zero for the
other months)
– After this addition to the model, the
quantitative measures all improve: apparently,
the seasonal fluctuation was distorting the 8-
152
Regression Analysis: Example (4 of 4)
These are the results after inclusion of the dummy variable:

8-
153
 The Five Steps of Strategic Decision Making for
Harrah’s Casino: An Application of Regression
1. Determine the strategic issues surrounding the
problem. Harrah’s strategy is based on customer
service and customer loyalty.
2. Identify the alternative actions. Dealing with customer
“pain points,” the amount of loss when they leave the
casino.
3. Obtain information and conduct analyses of the
alternatives. Use regression analysis to predict when
each customer may be reaching the pain point.
4. Based on strategy and analysis, choose and
implement the desired alternative. Use the prediction
model to intervene when a customer is reaching the pain
point. 8-
154
 Time-Series and
Cross-Sectional Regression
• Time Series Regression: the most common
type of regression analysis in cost
management, it is used to predict future
amounts, based on prior periods’ data

• Cross-Sectional Regression: used to predict

costs for a given cost object, based on costs of
related cost objects, where the data for the
regression is taken from the same period of
time
8-
155
Time-Series and Cross-Sectional Regression Illustrated

Time-series Regression:
Time-series regression is based on data for 2018-2021, to predict
2022 costs

Department 2018 2019 2020 2021 2022

Time Series
1 Prediction

Cross-Sectional
5 Prediction

Cross-sectional
Regression

Cross-sectional regression is based on data for departments 1-4, to predict dept. 5 costs in
8-
2021 156
 Cost Estimation Implementation: Nonlinearity

There are three main issues: trend & seasonality,

outliers, and data shift:
– Trend and Seasonality: most cost and operating data
have some trend or seasonality, which means the cost
estimation is not linear; solution: transform the
variables, use a trend variable, or a dummy variable
– Outliers: when a data point or points are far from the
others, the data should be reviewed and the point
removed or the model revised
– Data shift can be the result of an unusual business
condition that causes a shift to the data; often fixed
with a dummy variable.
8-
157
 Learning Curve Analysis
• Learning Curve Analysis applies when an
activity has a certain labor component and
repetition of the same activity or operation
makes the labor more proficient; the task
over time is completed more quickly with
the same or higher level of quality
• A cost whose amount is influenced by
learning is an example of nonlinear cost
behavior
8-
158
 Learning Curve Analysis (2 of 5)

Learning curve analysis is a systematic

method for estimating costs when learning
is present:

– The learning rate, obtained by reviewing

historical data, is the percentage by which
average time (or total time) falls from previous
levels as output doubles

– A learning rate ranges from one (no learning) to

0.5 (best possible)
8-
159
 Learning Curve Analysis (3 of 5)
Below is the general equation used in
learning-curve analysis:

Note: Y/a is the learning rate

8-
160
 Learning Curve Analysis (4 of 5)
Learning curve analysis is useful in:
• life-cycle planning,
• cost-volume-profit analysis,
• budgeting production levels and labor
needs,
• make-or-buy decisions,
• capital budgeting,
• preparing bids for production contracts,
• developing standard product costs, and
• management control, among other
applications…
8-
161
 Learning Curve Analysis (5 of 5)
Learning curve analysis has three inherent
limitations:
❶ The approach is for labor-intensive contexts that
involve repetitive tasks such as long production runs
or repetitive operations, and this is becoming less
common in organizations of all types
❷ The learning rate is assumed to be constant, as
output doubles
❸ A carefully estimated learning curve might be
unreliable because the observed change in
productivity in the data used to fit the model was 8-
162
 Chapter Summary (1 of 2)
• Accurate cost estimates are a critical starting
point for strategic cost management.
• There are six steps in the cost estimation
process: (1) define the cost object, (2) determine
the cost drivers, (3) collect consistent and
accurate data, (4) graph the data, (5) select and
employ a cost-estimation method, and (6) assess
the accuracy of the cost estimates.
• Two cost-estimation methods are discussed in
this chapter: the high-low method and regression
analysis. 8-
163
 Chapter Summary (2 of 2)
• Quantitative measures are available to judge the
precision and reliability of regression analysis;
these measures include: R-squared, SE, t-values,
and p-values.
• There are three main issues to consider when
assessing the potential linearity of an estimation
model: trend & seasonality, outliers, and data
shift.
• Learning curve analysis is a systematic method
for estimating costs when learning is present;
learning curve models represent a particular 8-
164
 Chapter
Eleven

Decision Making with a Strategic Emphasis

 Learning Objectives (1 of 3)
• Define the decision-making process and
identify the types of cost information
relevant for decision making.

• Use relevant cost analysis and strategic

analysis to make special-order decisions.

• Use relevant cost analysis and strategic

analysis in the make-vs.-buy and lease-vs.-
buy decisions.
11-166
 Learning Objectives (2 of 3)
• Use relevant cost analysis and strategic
analysis in the decision to sell before or after
additional processing.

• Use relevant cost analysis and strategic

analysis in the decision to keep or drop
products or services.

• Use relevant cost analysis and strategic

analysis to evaluate service offerings of not-
for-profit organizations. 11-167
 Learning Objectives (3 of 3)

• Use relevant cost analysis and strategic

analysis to perform a constrained
optimization (i.e., short-term product-mix)
analysis.
• Discuss behavioral, implementation, ethical,
and legal issues in decision making.
• Set up and solve in Excel a simple product-
mix problem (appendix).
11-168
 Five Steps in the Decision-
Making Process

*Relevant information includes both quantitative (including financial) information as well as qualitative
information.

11-169
 Relevant Cost Analysis
• A relevant cost is a future cost that differs
between/among decision alternatives
– Both characteristics must be present for a cost to be relevant
– Relevant costs can be variable or fixed, but variable costs are
generally relevant while fixed costs are not
– Relevant cost analysis and total cost analysis produce the
same results
– Relevant costs are also referred to as avoidable costs

• A sunk cost is a cost that has been incurred in the past

or committed for the future and is therefore irrelevant
for decision-making
11-170
Relevant and Irrelevant Costs: The Car
Purchase Decision (Exhibit 11.2)

11-171
Equipment-Replacement Decision: An Example (1 of
2)
Which costs are not relevant to the decision to
keep an old machine or replace it with a new,
more efficient one?
•• Original
Original cost
cost of
of old
old machine,
machine, $4,200
$4,200
•• Current
Current book
book value
value ofof old
old machine,
machine, $2,100
$2,100
•• Purchase
Purchase price
price of
of aa new
new machine,
machine, $7,000
$7,000
•• New
New machine
machine will
will have
have zero
zero salvage
salvage value
value
•• Repairs
Repairs to
to old
old machine
machine would
would be
be $3,500
$3,500 and
and would
would
allow
allow one
one more
more year
year of
of productivity
productivity
•• Power
Power for
for either
either machine
machine is
is expected
expected to
to be
be $2.50/hour
$2.50/hour
•• New
New machine
machine will
will reduce
reduce labor
labor costs
costs by
by $0.50/hour
$0.50/hour
•• Expected
Expected level
level of
of output
output for
for next
next year
year is
is 2,000
2,000 units
units
11-172
Equipment-Replacement Decision: An Example (2 of 2)

Relevant versus Irrelevant

Costs:
•• Original
Original cost
cost of
of old
old machine,
machine, $4,200
$4,200
•• Current
Current book
book value
value ofof old
old machine,
machine, $2,100
$2,100
•• Purchase
Purchase price
price of
of aa new
new machine,
machine, $7,000
$7,000
•• New
New machine
machine will
will have
have zero
zero salvage
salvage value
value
•• Repairs
Repairs to
to old
old machine
machine would
would be
be $3,500
$3,500 and
and
would
would allow
allow one
one more
more year
year of
of productivity
productivity
•• Power
Power for
for either
either machine
machine is
is expected
expected to
to be
be
$2.50/hour
$2.50/hour
•• New
New machine
machine will
will reduce
reduce labor
labor costs
costs by
by
$0.50/hour
$0.50/hour 11-173
 Equipment Replacement Decision: Differential
Analysis (Exhibit 11.3)

Relevant Difference:
Relevant
Costs: Replace Minus
Costs: Repair
Replace Repair

Variable costs:

Labor (2,000 × $10, $9.50) $20,000 $19,000 $(1,000)

Fixed costs:

Old machine repair cost 3,500 (3,500)

Cost of new machine 7,000 7,000

Total costs $23,500 $26,000 $ 2,500

11-174
 Equipment Replacement Decision:
Total Cost Analysis (Exhibit 11.4)
Difference:
Total Costs: Total Costs:
Replace Minus
Repair Replace
Repair

Variable costs:
Labor $20,000 $19,000 $(1,000)
Power 5,000 5,000 0
Fixed costs:
Old machine:
Depreciation 2,100 2,100 0
Repair cost 3,500 (3,500)
Cost of new machine 7,000 7,000
Total costs $30,600 $33,100 $ 2,500

11-175
 Relevant Cost Analysis:
Additional Considerations (1 of 2)
• Batch-level cost drivers should be considered in
relevant cost analysis
– For example, if setup on one machine takes longer
and requires more skilled labor than the other
machine, these factors should be included in the
analysis
• Opportunity costs, the benefit lost when one chosen
option precludes the benefits from an alternative
option, should also be considered in the analysis of
alternative options
– For example, addition of a new product could cause 11-176
Relevant Cost Analysis: Additional Considerations (2 of 2)

• Depreciation is not included in relevant cost analysis except

when considering tax implications
• Time value of money is relevant when deciding among
alternatives with cash flows over two or more years (this topic
is covered in Chapter 12 of the text)
• Importance of qualitative factors:
– Differences in quality
– Functionality
– Timeliness of delivery
– Reliability in shipping
– After-sale service level
11-177
 Strategic Analysis
Strategic information keeps the decision maker’s
attention focused on the firm’s strategic goals
– By only identifying relevant costs, the decision maker
might fail to link the decision to the firm’s strategy

– For example, while it may be advantageous to

outsource production of a part based on cost figures,
this decision might be a poor strategic move if the
firm’s competitive position depends on product
reliability that can be maintained only by
manufacturing that part internally

11-178
 Relevant Cost Analysis versus Strategic Analysis (Exhibit 11.6)

Relevant Cost
Analysis Strategic Analysis
Short-term focus Long-term focus
Not necessarily linked Linked to the firm's
to strategy strategy
Product-cost focus Customer focus
Integrative; considers
Focused on individual all customer-related
product or decision factors
situation
11-179
 Relevant Cost Analysis and Strategic
Analysis in Decision Making
This decision framework can be used to address
common management decisions such as:
– The special-order decision
– The make-vs.-lease and make-vs.-buy decision
– The decision to sell a product before or after
additional processing
– The short-term product-mix (or service-mix)
decision
– Profitability analysis (i.e., whether to keep or
drop products or services) 11-180
 The Special-Order Decision:
Tommy T-Shirt Inc. (TTS)

• A special-order decision occurs when a firm has a

one-time opportunity to sell a specified quantity of
its product or service; these orders are generally
non-recurring
• The first step in the decision process is to consider
the relevant costs (an example follows):
TTS, Inc., normally charges $9.00 per T-shirt,
but Alpha Beta Gamma has offered to pay
$6.50 for each of 1,000 T-shirts. What are the
relevant costs in determining whether this
offer should be accepted? 11-181
 The Special-Order Decision:
TTS (Exhibit 11.7)

Batch-Level Costs: Batch-Level Costs: Facilities-Level

Cost Element Costs per Unit Per Batch Fixed Batch Costs (all fixed)
Shirt $3.25
Ink 0.95
Operating labor 0.85
Subtotal $5.05
Setup $130 $29,000
Inspection 30 9,000
Materials
40 7,000
handling
Subtotal $200 $45,000
Machine-related $315,000
Other 90,000
Total $5.05 $200 $45,000 $405,000

11-182
 The Special-Order Decision:
TTS (Summary)
Total Cost-Estimation Equation = $5.05 per unit + $200
per batch + $450,000

TTS
BUT, costs that Fixed Facilities-Level
Costs
are not relevant Setup $ 29,000
to the decision Inspection 9,000

total $450,000 Materials handling 7,000

(fixed, facilities- Machine-related 315,000

level costs) Other 90,000

$ 450,000
11-183
 The Special-Order Decision:
TTS (Exhibit 11.8)
Relevant Relevant Cost for One
Unit Costs Batch of 1,000 Units
Unit-level costs
Unprinted shirt $3.25 $3,250
Ink and other supplies 0.95 950
Machine time (operator labor) 0.85 850
Total unit-level costs $5.05 $5,050
Batch-level costs (that vary with the number of
batches)
Setup 130
Inspection 30
Materials handling 40
Total ($200/batch; $0.20/unit) $0.20 $200
Total relevant costs $5.25 $5,250 11-184
 The Special-Order Decision: TTS (Analysis)

Analysis of the net contribution looks favorable:

Sales 1,000 units @ $6.50 $6,500

Relevant costs 1,000 units @ $5.25 5,250
Net Contribution 1,000 units @ $1.25 $1,250

If TTS has excess capacity, based only on a

short-term profitability analysis, the offer
should be accepted because it will add
$1,250 (i.e., 1,000 shirts × $1.25 per shirt)
to the company’s pre-tax operating income.
11-185
 The Special-Order Decision:
TTS (Strategic Considerations)
BUT...to make an informed decision, TTS must also
consider the strategic factors in this decision
– Is TTS producing at or near full capacity?
• In this case, the answer is no
• If TTS were producing at or near capacity, it would have to consider
opportunity costs
– Is this order really a one-time special order?

• Special-order decisions are meant for infrequent situations, and if

done on a regular basis, can erode profitability

– The credit history of the buyer, any potential complexities in the

design that might cause problems

– How might the special-order price affect the long-term price

11-186
 Make-vs.-Buy Decision:
Blue Tone Manufacturing (Blue Tone)

Decision context: which parts to make

internally and which parts to purchase from
an outside supplier?
– The relevant cost analysis proceeds much
like that of a special-order decision (an
example
Blue Tone follows):
is currently manufacturing the
Blue Tone is currently manufacturing the
mouthpiece for its clarinet, but has the
option to buy
this item from a supplier. Fixed overhead
costs will not change whether or not Blue
Tone
chooses to make or to buy the mouthpiece.

mouthpiece for its clarinet, but has the

option to buy
this item from a supplier. Fixed overhead
costs will not change whether or not Blue
Tone
chooses to make or to buy the mouthpiece. 11-187
 Make-vs.-Buy Decision:
Blue Tone (Relevant Cost Analysis)
Cost to buy the mouthpiece $ 24.00
Cost to manufacture, per unit:
Materials $ 16.00
Labor 4.50
Variable overhead 1.00
Total variable costs 21.50
Fixed overhead 6.00
Total cost to manufacture $ 27.50
Total relevant costs 21.50
Per-unit savings from continuing to make $ 2.50
11-188
 Make-vs.-Buy Example:
Blue Tone (Strategic Factors)

The preceding relevant cost analysis

indicates that manufacturing the part is
more cost effective, but Blue Tone must also
consider strategic factors, such as the
quality of the part, reliability of the
supplier, and potential alternative uses of
plant capacity, before making a final
decision. 11-189
 Lease-vs.-Purchase (Buy) Decision:
Quick Copy Inc. (Quick Copy)
Let’s say the decision is not whether to
make or buy an item for the firm, but
whether to lease or purchase (buy) that
item (an example follows):
Quick Copy is considering an upgrade to the latest
model copier that is not available for lease but must
be purchased for $160,000. The purchased copier is
useful for one year, after which it could be sold back
to the manufacturer for $40,000. In addition, the new
machine has a required annual service contract of
$20,000. Should Quick Copy purchase the new copier
or renew its lease on its old copier? 11-190
Lease-vs.-Purchase: Quick Copy (Exhibit 11.10)

Lease Purchase

Annual lease $ 40,000 N/A

Charge per copy 0.02 N/A

Purchase cost N/A $ 160,000

Annual service contract N/A 20,000

Value at end of period N/A 40,000

Expected number of copies per year 6,000,000 6,000,000

The first step in this analysis is to use CVP

analysis to calculate the indifference
point . . . 11-191
Lease-vs.-Purchase: Quick Copy (Indifference Point)

Indifference point = annual volume

level where
Annual lease cost = Annual purchase cost
Annual lease cost = Annual purchase
cost
Annual fee + Per-copy charge = Net purchase
cost + Service contract
$40,000 + ($0.02 × Q) = ($160,000 −
$40,000) + $20,000
Q = $100,000 ÷ $0.02
= 5,000,000 copies per
year

Annual lease cost = Annual purchase

cost
Annual fee + Per-copy charge = Net purchase
cost + Service contract
$40,000 + ($0.02 × Q) = ($160,000 −
$40,000) + $20,000
Q = $100,000 ÷ $0.02
11-192
Lease-vs.-Purchase: Quick Copy (Other Strategic Factors)
The indifference point, 5,000,000
copies per year, is lower than the
expected annual machine usage of
6,000,000 copies. So, Quick Copy
should purchase the machine if
strategic factors, such as quality of the
copy, reliability of the machine, and
benefits and features of the service
contract, are favorable.

The indifference point, 5,000,000

copies per year, is lower than the
expected annual machine usage of
6,000,000 copies. So, Quick Copy
should purchase the machine if
strategic factors, such as quality of the
copy, reliability of the machine, and
benefits and features of the service 11-193
Lease-vs.-Purchase: Quick Copy (Exhibit 11.11)

Annual
Cost Cost to lease
copier

$140,000
Net cost to purchase copier (after
$40,000 trade-in) + Service contract

# of copies per
year
Q = 5,000,000
11-194
Decisions to Sell Before or After Additional Processing:
Foundational Concepts/Terms
• Joint production process

• Split-off point

• Joint production costs

• Separable processing costs

• Joint production process

• Split-off point

• Joint production costs

• Separable processing costs

11-195
 Sell Before or After Additional Processing:
TTS (Cost Analysis)
Decision: whether to sell a product or
service before an intermediate
processing step or to add further
processing and then sell the product or
TTS has suffered an equipment malfunction
causing 400 T-shirts not to be acceptable. The
shirts can be sold as-is for $4.50 each or run
through the printing process again. The cost of
running the T-shirts through the printer a
second time is variable cost of $1.80 per shirt
and the cost of one setup.

service for a higher price?

TTS has suffered an equipment malfunction
causing 400 T-shirts not to be acceptable. The
shirts can be sold as-is for $4.50 each or run
through the printing process again. The cost of
running the T-shirts through the printer a
second time is variable cost of $1.80 per shirt
and the cost of one setup. 11-196
 Sell Before or After Additional Processing:
TTS (Exhibit 11.12)

Sell to Discount
Reprint Store
Revenue (400 @ $9.00) $ 3,600

(400 @$4.50) $ 1,800

Relevant costs: (@$1.80 variable + setup)

Ink ($0.95 per unit) 380

Labor ($0.85 per unit) 340

Setup, inspection, handling per batch 200

Total relevant costs 920 -

Incremental contribution margin $ 2,680 $ 1,800

Net advantage to reprint $2,680 ‒ $1,800 = $ 880

11-197
 Sell Before or After Additional Processing:
TTS (Strategic Considerations)
• W ill th e s a le a ff e c t th e s a le o f T-s h irts in re ta il
s to re s ?

• W ill th e cost of p a c k in g , d e liv e ry, and s a le s

c o m m is s io n s d iff e r fo r th e tw o ty p e s o f s a le s ?

• W ill th e le s s e r-q u a lity o f th e s e T-s h irts a ff e c t th e

c o m p a n y ’s c o m p e titiv e p o s itio n in th e lo n g ru n ?

• W o u ld it b e s tra te g ic a lly b e tte r in th e lo n g -te rm to

fi n d and e lim in a te th e c a u s e o f th e p ro b le m to
re d u c e th e p o s s ib ility o f d e fe c ts in th e fu tu re ?

• Will the sale affect the sale of T-shirts in retail

stores?

• Will the cost of packing, delivery, and sales

commissions differ for the two types of sales?

• Will the lesser-quality of these T-shirts affect the

company’s competitive position in the long run?

• Would it be strategically better in the long-term to

find and eliminate the cause of the problem to
reduce the possibility of defects in the future?
11-198
Product- (or Service-) Line Profitability Analysis: Windbreakers

Profitability analysis addresses issues such as:

– Which product lines are most profitable?
– Are the products priced properly?
– Which products should be promoted and advertised
more aggressively?
– Which product-line managers should be rewarded?
An example follows:
W in d b re a k e rs m a n u fa c tu re s th re e ja c k e ts .
M a n a g e m e n t is c o n c e rn e d a b o u t th e lo w p ro fi ta b ility o f
th e “G a le ” ja c k e t a n d is th in k in g a b o u t d ro p p in g th e
p ro d u c t. If th e ja c k e t is d ro p p e d , th e re w ill b e n o
c h a n g e in to ta l fi x e d c o s ts fo r th e c o m in g y e a r.

Windbreakers manufactures three jackets.

Management is concerned about the low profitability of
the “Gale” jacket and is thinking about dropping the
product. If the jacket is dropped, there will be no
change in total fixed costs for the coming year. 11-199
 Product Line Profitability Analysis ─ Keep or Drop a
Product Line: Windbreakers (Exhibit 11.13)
Calm Windy Gale Total

Units sold last year 25,000 18,750 3,750 47,500

Revenue $750,000 $600,000 $150,000

Price $ 30.00 $ 32.00 $ 40.00

Relevant costs

Unit variable cost 24.00 24.00 36.00

Unit contribution margin $ 6.00 $ 8.00 $ 4.00

Nonrelevant (i.e., allocated) fixed costs 3.60 3.60 3.60 $171,000

Operating profit per unit $ 2.40 $ 4.40 $ 0.40

Question faced by Windbreakers’ management: Should

the Gale product line be dropped?
11-200
Product Line Profitability Analysis ─ Contribution Income
Statements: Windbreakers (Exhibits 11.14 & 11.15)
Gale Dropped Calm Windy Total
Sales $750,000 $600,000 $1,350,000
Relevant costs
Variable cost ($24 ea) 600,000 450,000 1,050,000
Contribution margin $150,000 $150,000 $ 300,000
Nonrelevant costs
Fixed cost (unavoidable) 171,000
Operating profit without Gale $ 129,000
Gale Retained Calm Windy Gale Total
Sales $750,000 $600,000 $150,000 $1,500,000
Relevant costs
Variable cost ($24, $24, $36) 600,000 450,000 135,000 1,185,000
Contribution margin $150,000 $150,000 $ 15,000 $ 315,000
Nonrelevant costs
Fixed cost (unavoidable) 171,000
11-201
Operating profit with Gale $ 144,000
 Product Line Profitability Analysis ─ Keep or Drop the Gale
Product Line: Windbreakers (Other Strategic Factors)
As shown on the previous slide, the
company is $15,000 ($144,000 −
$129,000) better off retaining rather
than deleting the Gale jacket.

Windbreakers should also consider

strategic factors in this decision, such
as whether dropping one product line
would affect sales of another and
whether employee morale would be
affected by the decision.

As shown on the previous slide, the

company is $15,000 ($144,000 −
$129,000) better off retaining rather
than deleting the Gale jacket.

Windbreakers should also consider

strategic factors in this decision, such
as whether dropping one product line
would affect sales of another and 11-202
F u rth e r in v e s tig a tio n re v e le d th a t $ 6 0 ,0 0 0 o f th e
$ 1 7 1 ,0 0 0 o f fi x e d c o s ts a re a d v e rtis in g c o s ts s p e n t
d ire c tly o n in d iv id u a l p ro d u c t lin e s , m a k in g th e m
p o te n tia lly a v o id a b le c o s ts . T h e b re a k d o w n is a s
fo llo w s :

• $ 2 5 ,0 0 0 w a s fo r C a lm

• $ 1 5 ,0 0 0 fo r W in d y

• $ 2 0 ,0 0 0 fo r G a le

If a p ro d u c t is d ro p p e d , th e a d v e rtis in g w o u ld g o
a w a y.

Profitability Analysis ─ Keep or Drop the Gale

Product Line: Windbreakers (New Data)

Further investigation reveled that $60,000 of the

$171,000 of fixed costs are advertising costs spent
directly on individual product lines, making them
potentially avoidable costs. The breakdown is as
follows:

• $25,000 was for Calm

• $15,000 for Windy

• $20,000 for Gale

If a product is dropped, the advertising would go 11-203

 Contribution Income Statement Profitability Analysis ─ Including Traceable
(i.e., avoidable) Advertising Costs: Windbreakers (Exhibit 11.16A)

Calm Windy Gale Total

Sales $750,000 $600,000 $150,000 $1,500,000

Relevant costs

Variable cost ($24, $24, $36 per unit) 600,000 450,000 135,000 1,185,000

Contribution margin $150,000 $150,000 $ 15,000 $ 315,000

Other relevant costs (traceable)

Advertising 25,000 15,000 20,000 60,000

Contribution after all relevant costs $125,000 $135,000 $ (5,000) $ 255,000

Nonrelevant costs (non traceable)

Fixed cost (unavoidable portion) $ 111,000

Operating profit $ 144,000

11-204
 Contribution Income Statement Profitability Analysis ─
Dropping Gale and Related Traceable Advertising Costs:
Windbreakers (Exhibit 11.16B)
Calm Windy Total

Sales $750,000 $600,000 $1,350,000

Relevant costs

Variable cost ($24, $24 per unit) 600,000 450,000 1,050,000

Contribution margin $150,000 $150,000 $ 300,000

Other relevant costs (traceable)

Advertising 25,000 15,000 40,000

Contribution after all relevant costs $125,000 $135,000 $ 260,000

Nonrelevant costs (non traceable)

Fixed cost (unavoidable portion) $ 111,000

Operating profit $ 149,000

11-205
The previous slides show that the total
contribution margin for Gale is now a negative
$5,000, providing a potential $5,000 increase in
operating profit by dropping Gale because of
the expected $20,000 savings in avoidable
advertising costs.
Note that the numbers show Gale could be
profitable without advertising. Management
may choose to forgo the advertising for Gale
and assess the impact on sales from the loss of
advertising.

Profitability Analysis ─ Keep or Drop the Gale Product

Line with Avoidable Fixed Costs: Windbreakers

The previous slides show that the total

contribution margin for Gale is now a negative
$5,000, providing a potential $5,000 increase in
operating profit by dropping Gale because of
the expected $20,000 savings in avoidable
advertising costs.

Note that the numbers show Gale could be

profitable without advertising. Management
may choose to forgo the advertising for Gale
and assess the impact on sales from the loss of 11-206
 Profitability Analysis ─ Service Offerings of Not-for-Profit
Organizations: Triangle Women’s Center (TWC) (Exhibit 11.17)
Relevant cost analysis is often used by service and
NFP firms to determine the desirability of new
services: for example, TWC’s new service will
require $9,400 additional funding:

11-207
 Profitability Analysis ─ Strategic Analysis:
• Can TWC
personnel for
recruit

planned new service?

appropriate
implementing the

• Are there liability issues that need to

be addressed?
• Are there other, more productive,
uses for the resources (space, etc.)
that would be devoted to the new
service?
• Would funding for the new service be
available on a continuing basis?
TWC (Strategic Considerations)
• Can TWC recruit appropriate
personnel for implementing the
planned new service?
• Are there liability issues that need to
be addressed?
• Are there other, more productive,
uses for the resources (space, etc.)
that would be devoted to the new
service?
• Would funding for the new service be 11-208
 Short-Term Product-Mix Decision: Windbreakers
How to make best use out of existing
resources? That is, how to choose the best
short-term product mix?
Continuing with the Windbreakers’ example,
T h e W in d y a n d G a le ja c k e ts a re m a n u fa c tu re d in th e
sam e p la n t— b o th

is
re s o u rc e ).
one
re q u ire

m o n th ).

p ro d u c tio n
an

The
a u to m a te d

b e ru n u p to 2 0 h o u rs p e r d a y, 5 d a y s p e r w e e k
(1 ,2 0 0 h o u rs per dem and

c o n s tra in t or
s e w in g
m a c h in e fo r a s s e m b ly. T h e re a re 3 m a c h in e s th a t c a n

fo r b o th
ja c k e ts e x c e e d s th e c a p a c ity o f th e 3 m a c h in e s (i.e .,
th e re lim itin g

assume one production constraint:

The Windy and Gale jackets are manufactured in the
same plant—both require an automated sewing
machine for assembly. There are 3 machines that can
be run up to 20 hours per day, 5 days per week
(1,200 hours per month). The demand for both
jackets exceeds the capacity of the 3 machines (i.e.,
there is one production constraint or limiting
11-209
 Short-Term Product Mix Decision with One Production
Constraint: Windbreakers (Exhibit 11.18)

The goal is to maximize contribution margin,

subject to the production resource constraint. For
this, we need to determine each product’s
contribution margin per unit of the scare resource:
Windy Gale
Contribution margin per unit $8 $4
Sewing time per jacket 3 min. 2 min.
Number of jackets produced per hour 20 30
Contribution margin per machine hour $ 160 $120
Maximum production for each product, given
the 1,200-hour constraint:
(1,200 hours × 20 jackets per hour) 24,000
(1,200 hours × 30 jackets per hour) 36,000 11-210
Production & Sales Possibilities with One Production Constraint
─ The Sewing Machine: Windbreakers (Exhibit 11.19)

Monthly
Sales, Gale
36,000
– Production constraint for
sewing machine. All
possible sales mixes are
represented on this line.

24,000
Slope = -36,000 ÷ 24,000 =
-3/2
Intercept = 36,000

– Monthly
Slope = -36,000 ÷ 24,000 = Sales, Windy
-3/2
Intercept = 36,000
11-211
 Short-term Product-Mix Decision with One
Production Constraint: Windbreakers

Production of Windy is favored over production of

Gale ($48,000 = $192,000 − $144,000). When
there is one constraint, one of the products will be
favored over the others. 11-212
 Short-term Product-Mix Decision with Two
Production Constraints: Windbreakers

In the presence of two or more production

constraints, determining the best sales mix
becomes more complicated, but the principle
is the same.
Continuing with the are
Windbreakers’
inspected andexample:
T he com pleted jackets are inspected and labels are
added before packaging. Forty w orkers are required
for this operation. E ach of the 40 w orkers w orks 35
productive hours per w eek. T hus, 5,600 hours (40
w orkers x 35 hours/w eek x 4 w eeks/m onth) are
available per m onth for inspecting and packaging.

The completed jackets labels are

added before packaging. Forty workers are required
for this operation. Each of the 40 workers works 35
productive hours per week. Thus, 5,600 hours (40
workers x 35 hours/week x 4 weeks/month) are
available per month for inspecting and packaging. 11-213
 Short-term Product-Mix Decision with Two
Production Constraints: Windbreakers (Exhibit 11.20)

With two constraints, the results are as follows:

11-214
Production & Sales Possibilities (Feasible Area) with Two
Production Constraints: Windbreakers (Exhibit 11.21)

11-215
Summary Analysis of Corner-Point ─ Windy/Gale: Windbreakers

Corner Point Windy Gale Contribution Margin

#1 0 0 $0

#2 0 36,000 144,000

#3 22,400 0 179,200

#4 20,800 4,800 $185,600

11-216
 Behavioral and Implementation Issues (1 of 2)

• Managers must be sure to keep the firm’s

strategic objectives in the forefront in any
decision situation to avoid focusing solely
on short-term gains

• Predatory pricing occurs when a company

has set prices below average variable cost
with a plan to raise prices later to recover
losses from these lower prices
11-217
 Behavioral and Implementation Issues (2 of 2)

• Management’s goal should be to maximize contribution

margin while minimizing fixed costs

– Relevant cost analysis focuses on variable costs, appearing to

ignore fixed costs

– If upper-level management focuses too heavily on variable

costs, lower-level management may feel pressure to replace
variable costs with fixed costs at the firm’s expense

• Managers must be careful not to include irrelevant, sunk

costs in their decision making

– When fixed costs are shown as cost per unit, many managers
tend to improperly classify them as relevant
11-218
Appendix: Linear Programming & the Product-Mix Decision

• The short-term product/service-mix problem is a subset of what

are called “constrained optimization” problems
– The Solver routine in Excel can be used to solve linear
constrained optimization problems
• Of particular interest is the Sensitivity Report that can be
generated by Excel in addition to an optimal solution (e.g., optimum
short-term product mix):
– Allowable increase and decrease for each coefficient in the
objective function, for which indicated solution still holds
– Shadow price = opportunity cost of not having enough
resource(s) = maximum amount the organization would pay
per unit of the scare resource
– Allowable range of resource values over which indicated
shadow prices are valid. 11-219
 Chapter Summary (1 of 3)
• A relevant cost is a future cost that differs
between decision alternatives:
– relevant costs are also called “avoidable” costs
– relevant costs = out-of-pocket costs + opportunity
costs

• It is important to consider strategic factors

when performing a relevant cost analysis:

– Focusing solely on short-term profits could

potentially lead to long-term losses
11-220
 Chapter Summary (2 of 3)

This decision framework in this

chapter was applied to four common
management decisions:
– The special-order decision
– The make-vs.-lease and make-vs.-buy decision
– The decision to sell or process further decision
– Profitability analysis (e.g., product-line profitability,
and product/service-mix decisions)
11-221
 Chapter Summary (3 of 3)
• Relevant cost analysis changes significantly with two or
more products and limited resources:
– Under conditions of one or more production
constraints, the goal is to find the most profitable
sales mix
– For decision-making purposes, product profitability
must be expressed in terms of contribution margin
per unit of the scare resource(s)
• Managers must be careful to encourage maximization of
contribution margin and reduction of fixed costs.
• Irrelevant, sunk costs must not be included in a relevant
cost analysis. 11-222
 Chapter Eighteen

Strategic Performance Measurement: Cost Centers,

Profit Centers, and the Balanced Scorecard
 Learning Objectives
• Identify the objectives of management control.
• Identify the types of management control systems and
understand factors that affect the design of
management control systems.
• Explain the objectives and applications of strategic
performance measurement for cost centers, revenue
centers, and profit centers.
• Explain the role of variable costing and full costing in
evaluating profit centers.
• Explain the role of the balanced scorecard in
strategic performance measurement.
Performance Measurement and Control (1 of 2)

• Performance measurement is the

process by which managers at all levels
gain information about the performance
of tasks within the firm and judge that
performance against pre-established
criteria as set out in budgets, plans, and
goals
• Management control refers to the
evaluation by upper-level managers of the
performance of mid-level managers
Performance Measurement and Control (2 of 2)

• Operational control means the evaluation of

operating-level employees by mid-level
managers
• Management control focuses on higher-level
managers and long-term strategic issues,
while operational control focuses on detailed
short-term performance
• Operational control is a management-by-
exception approach while management
control is more consistent with the
management-by-objectives approach
Organization Chart─Operational and
Management Control: (Exhibit 18.1)
Chief
Executive
Financial
Management

Management
Control
Marketing Operations
Management Management

Region
Region AA Region
Region BB Plant
Plant AA Plant
Plant BB

Operational
Control
Employee
Employee Employee
Employee Employee
Employee Employee
Employee
11 22 33 44
 Management-by-Objectives
• In a management-by-objectives approach, top
management assigns a set of responsibilities
to each mid-level manager depending on the
functional area involved and the scope of
authority of the mid-level manager
• Areas of responsibility are often called
strategic business units (SBUs)
• An SBU consists of a well-defined set of
controllable operating activities over which
the SBU manager is responsible
 Objectives of Management Control

• Motivate managers to exert a high level of effort

to achieve the goals set by top management
• Provide the right incentives for managers to
make decisions consistent with the goals set by
top management (that is, to align managers’
efforts with strategic goals)
• Determine fair rewards to be earned by
managers for their efforts and skill and the
effectiveness of their decision making
 Achieving Management Control Objectives

• A common mechanism for achieving these multiple

objectives is to develop an employment contract
between the manager and top management
• A contract promotes goal congruence: the contract
specifies the manager’s desired behaviors and the
compensation to be awarded for achieving specific
outcomes by using these behaviors
• Contracts can be written or unwritten, explicit or
implied
 Employment Contracts (1 of 3)

• An economic model, the

principal-agent model, describes
the key elements that a contract
must have to achieve the desired
objectives
 Employment Contracts (2 of 3)

• There are three important aspects of management

performance that affect the contracting relationship:
controllability, risk aversion, and lack of information
asymmetry
– Managers operate in an environment that is influenced by factors
beyond the manager’s control; there is some degree of uncertainty
– Uncertainty exposes the manager to risk, so the manager’s
tolerance for risk (i.e., risk preferences) needs to be considered

– Many efforts and decisions made by the manager are not

observable to top management, and the manager often possesses
information not accessible to top management
 Employment Contracts (3 of 3)

Because of uncertainty, risk, and the lack of

observability, three principles should be followed in
the preparation of an employment contract:
– Alignment: the contract should be designed to align the
incentives of managers with the goals of top management
– Controllability: wherever possible, known uncontrollable
factors should be excluded from the contract
– Risk-sharing: managers are often more risk-averse than
top management or the firm’s owners. Therefore, it can
be mutually beneficial to introduce risk-sharing into the
contract, often by way of both fixed and variable
components of compensation.
The Principal-Agent Model: (Exhibit 18.2)

Manager
 Designing Management Control Systems

There are four questions management must ask

when developing a management control system:
– Who is interested in evaluating the organization’s
performance (owners, directors, creditors, employees,
etc.)?
– What is being evaluated (an individual, team, or SBU)?
– When is the performance evaluation to be conducted,
and should it be based on the master budget (resource
inputs –ex ante) or the flexible budget (outputs of the
manager’s effort–ex post)?
– Should the system be formal or informal?
Systems for Management Control: Exhibit 18.4
 Strategic Performance Measurement (1 of 2)

• Strategic performance measurement is a system

used by top management to evaluate SBU managers
• Before designing strategic performance
measurement systems, top managers determine
when delegation of responsibility is desirable

– A firm is decentralized if it has chosen to delegate a

significant amount of responsibility to SBU managers
– A centralized firm reserves much of the decision-
making at the top-management level
 Strategic Performance Measurement (2 of 2)

• Centralized firms provide more control and the

expertise of top management can be effectively
utilized
• Decentralized firms are able to make more timely
decisions at the operational level; top
management lacks the necessary local knowledge
• Decentralized firms are often more motivating for
managers, are an excellent environment for
training future top-level managers, and can be a
better basis for performance evaluations
 Types of SBUs (1 of 2)

• Cost Centers are a firm’s production or support

departments that are charged with the responsibility of
providing the best quality product or service at the lowest
cost (examples: a plant’s data-processing department, and
its shipping and receiving department)
• Revenue Centers focus on the selling function and are
defined either by product line or by geographic area
• Profit Centers are created when an SBU both generates
revenues and incurs the major portion of the cost for
producing these revenues
• Investment Centers include assets employed by the SBU
 Types of SBUs (2 of 2)

The choice of a profit, cost, or revenue center

depends on the nature of the production and
selling environment in the firm:
– Products that have little need for coordination
between the manufacturing and selling functions
are good candidates for cost and revenue centers
– For products that require close coordination
between these functions, profit centers would be
the preferred option
 Cost Centers (1 of 2)
• Direct manufacturing and manufacturing
support departments are often evaluated as cost
centers since these managers have significant direct
control over costs but little control over revenues or
decision-making for investment in facilities
• Several strategic issues arise when
implementing cost centers:
– Cost shifting occurs when a department replaces
its controllable costs with noncontrollable costs
(e.g., variable costs to fixed costs)

(continued…)
 Cost Centers (2 of 2)

– Many performance-measurement systems focus

excessively on short-term cost figures, neglecting
long-term strategic issues

– The majority of cost centers have some amount of

budgetary slack, which is the difference between
budgeted and expected performance

– Budgetary slack can be good as it reduces risk

aversion, but too much slack can result in reduced
employee effort and (as indicated in Chapter 10)
can complicate the planning process
 Two Methods of Implementing Cost Centers for
Production and Support Departments: (Exhibit 18.6)
 Implementing Cost Centers in
General and Administrative Departments

These departments have the same two

methods to choose from, but the proper
choice may change over time:
– For example, if cost reduction is a key
objective, the human resources
department might be treated as an
engineered cost center
– Later, it might be changed to a
discretionary cost center to motivate
managers to focus on the achievement of
Step‐Cost Administrative Support Costs─Discretionary‐Cost
versus Engineered‐Cost: (Exhibit 18.7)

Cost behavior
in
administrative
support
centers
is often a
step cost
 Cost Centers:
Implementation Considerations (1 of 2)

• Many firms are choosing to outsource

manufacturing, customer service, engineering,
and other services
• When using a cost center, how should the firm
allocate the jointly incurred costs of service
departments to the departments using the
service?
– An allocation method should be chosen based on
its ability to motivate managers, encourage goal
congruence, and provide a basis for fair evaluation
of the managers’ performance
 Cost Centers:
Implementation Considerations (2 of 2)

– Dual allocation is a cost allocation method

that separates fixed and variable costs;
variable costs are directly traced to user
departments, and fixed costs are allocated
on some logical basis
– Indirect costs should be traced to cost
centers using activity-based costing (ABC)
 Revenue Centers
• Management commonly uses revenue drivers
in evaluating the performance of revenue
centers
• Revenue drivers in manufacturing firms are
the factors that affect sales volume, such as
price changes, promotions, discounts,
customer service, changes in product
features, delivery dates, and other value-
added factors
• Revenue drivers in service firms focus on the
 Marketing Departments

The marketing departments can be

either a revenue or a cost center:
– The revenue center responsibility stems from
the fact that the marketing department
manages the revenue-generating process and
produces revenue reports for evaluation
– This department can also be a cost center as it
incurs two types of costs, order-getting
(advertising and promotion) and order-filling
(warehousing, packing, and shipping) costs
 Profit Centers
• The profit center manager’s goal is to earn
profits
• Three strategic issues cause firms to choose
profit centers rather than cost or revenue
centers:
– Profit centers provide the incentive for the
desired coordination among marketing,
production, and support functions
– Profit centers motivate service department
managers to consider their product as marketable
to outside customers
Two Different Strategic Contexts─Cost Leadership,
Differentiation, and SBUs: (Exhibit 18.8)
 Contribution Income Statement
• A common form of profit center evaluation is the
contribution income statement, which is based on
the contribution margin developed for each profit
center and for each relevant group of profit centers
• Detail of the statement varies based on
management’s needs
• Contribution by Profit Center (CPC)
measures all costs traceable to, and therefore
controllable by, the individual profit center,
including traceable fixed costs
Controllable and Noncontrollable Fixed Costs

Fixed costs can be either controllable or

noncontrollable from the perspective of
each profit center:
– Controllable fixed costs are fixed costs that the
profit center manager can influence in
approximately a year or less, such as
advertising, data processing, and management
consulting expenses
– Noncontrollable fixed costs are those that are
not controllable within a year’s time, such as
depreciation and taxes
 Profit Center Performance Measurement

• Subtracting controllable fixed costs from the

contribution margin results in the center’s
controllable margin
• The contribution margin income statement can
also be used to help determine whether a profit
center should be dropped or retained
• One complication in the preparation of this
statement is that some costs that are not
traceable at a detailed level are traceable at a
higher level
 Contribution Income Statement─Example:
Machine Tools Inc. (Exhibit 18.9) (1 of 3)
(000s omitted)

The Contribution Income Statement shows the CPC for

both Divisions is positive, and when Division B is
partitioned into its three product lines, Products 1 and 2
are shown as profitable, while Product 3 has a CPC loss
of $70.
 Contribution Income Statement─Example:
Machine Tools Inc. (Exhibit 18.9) (2 of 3)

• Positive values of CPC mean that the profit center

(division or product line) is covering all of its traceable
costs, both variable and fixed; since a portion of the fixed
costs are not controllable (but traceable), CPC is a useful
measure of the economic performance of the profit center
and a useful measure of the long-term performance of the
manager.
• The CPC of the unit, because it includes non-controllable
fixed costs, represents the long-term (up to several years)
profitability of the unit (dropping product 3 would save
$70,000 in the long-term)
 Contribution Income Statement─Example:
Machine Tools Inc. (Exhibit 18.9) (3 of 3)

• To evaluate the short-term, controllable performance

of the manager, controllable margin is preferred
since it excludes noncontrollable fixed costs.
• To assess whether a profit center should be retained
or deleted, the value of the contribution margin, if
positive, shows the short-term loss of dropping the
unit (dropping product 3 means a loss of $50,000)
• The controllable margin, if positive, shows the longer-
term (approximately a year) effect on total firm
profits of dropping the unit (dropping product three
means a loss of $50,000)
 Variable Costing vs. Full Costing

• The use of the contribution income statement is often

called variable costing because it separates variable
and fixed costs
• Full costing is the conventional costing system that
includes fixed manufacturing cost as part of product
cost
• Full costing, also called absorption costing, is
required by GAAP for financial reporting and by the
IRS for computing taxable income
• Full costing satisfies the matching principle while
variable costing meets the three objectives of
 Variable Costing
• The reasons for using variable costing include
better planning and decision making (Chapters 9-
11), and also improved performance measurement:
– Although net income determined using full costing is
affected by changes in inventory levels, net income using
variable costing is not affected -- under variable costing,
fixed manufacturing costs are treated as period costs, not
product (inventoriable) costs
• The following example compares the two costing
methods over two periods, one with increasing
inventory and the other with decreasing inventory
Variable vs. Full Costing─Example: Inventory
(Exhibit 18.10A, Panel 1) decreased
by 40 units
Inventory
increased
by 40 units

$4,000 ÷ 100 units = $40 fixed manufacturing

cost per unit
Variable vs. Full Costing─Example: (Exhibit 18.10A, Panel 2)

Difference in
Ending Inventory
$2,800 - $1,200 =
$1,600

Difference in
Income
$300 – ($1,300) =
$1,600
Variable vs. Full Costing─Example: (Exhibit 18.10B)

Difference in
Beginning
Inventory
$2,800 - $1,200 =
$1,600

Difference in
Income
$2,300 - $3,900 =
$1,600
 Variable vs. Full Costing: Summary Analysis
• Full costing net income exceeds variable costing net income
by the amount of fixed cost in the inventory change when
inventory increases, and variable costing net income is
higher than full costing net income when inventory
decreases
– A useful rule for calculating the income difference:
Difference in income = Change in inventory × Fixed
manufacturing cost per unit
• Variable costing is not affected by the change in inventory
because all fixed costs are deducted from income in the
period in which they occur; fixed costs are not included in
inventory so that changes in inventory levels do not affect
net income
– Variable costing is a more useful measure for evaluating
The Contribution Income Statement and Value Streams

• In applications of lean accounting, products and

services are collected into groups called value
streams.
• The value stream income statement shows the
contribution of each of the organization’s value
streams in much the same way as the
contribution income statement; each value
stream is a profit center.
• A unique feature of the value stream income
statement is that it shows separately the gain (or
loss) associated with an increase (or decrease) in
 Strategic Performance Measurement and the
Balanced Scorecard (BSC) (1 of 2)

• The BSC measures SBU performance in four

key perspectives:
– Financial performance
– Customer satisfaction
– Internal processes
– Learning and innovation
• Cost, revenue, and profit centers focus on the
financial dimension
Strategic Performance Measurement and
the Balanced Scorecard (BSC) (2 of 2)
• The BSC is an important performance
measurement method because it aligns
manager’s performance with the
organization’s strategic goals – financial,
customer, internal process, and learning and
innovation.
• The BSC is particularly important in difficult
economic times, when traditional profit-based
measures may be distorted and difficult to
benchmark against established benchmarks such
The Balanced Scorecard (BSC): Implementation
Issues (1 of 3)
There are implementation issues when using the BSC
in performance measurement:
– BSC measures are often difficult to compare across
SBUs, and are used only to compare the unit to prior
periods
– The BSC is often used in evaluation but less often in
compensation, and the two need to be linked
– Validation is needed of the links between measures that
are assumed to improve performance and actual
performance
– Managers must provide information on the strategic
 The Balanced Scorecard (BSC):
Implementation Issues (2 of 3)

– Many large firms have installed

enterprise resource planning systems
(ERPs) to collect BSC information, but
firms lacking such a system may have
trouble collecting the necessary data
– The nonfinancial information used in the
BSC is not subject to control or audit
and may be unreliable or inaccurate
The Balanced Scorecard (BSC):
Implementation Issues (3 of 3)
– Nonfinancial information is often
prepared on a weekly or daily basis
while performance reviews are
generally conducted quarterly or
annually
– Concern arises related to the timeliness
and reliability of nonfinancial data
prepared by external sources
 Managements Control in Service Firms and Not-
for-Profit Organizations

• Service firms and not-for-profit organizations

commonly use cost centers and/or profit centers
• Cost centers are used when the manager’s
critical mission is to control costs
• Profit centers are preferred when the department
manager must manage both costs and revenues,
or alternatively (in a not-for-profit), manage costs
without exceeding budgeted revenues
 Chapter Summary (1 of 6)
• There are formal, informal, team, and individual
management control systems.

• The objectives of management control are to:

– Motivate managers to exert a high level of effort to achieve

the goals set by top management
– Provide the right incentives for managers to make decisions
consistent with the goals set by top management (i.e., to
align managers’ efforts with the desired strategic goals)
– Determine fairly the rewards earned by managers for their
efforts and skill and the effectiveness of their decision
making
 Chapter Summary (2 of 6)

• Strategic performance measurement is a system

used by top management to evaluate SBU
managers.
• Before designing strategic performance
measurement systems, top managers determine
when delegation of responsibility is desirable:
– A firm is decentralized if it has chosen to delegate a
significant amount of responsibility to SBU
managers
– A centralized firm reserves much of the decision
making at the top management level
 Chapter Summary (3 of 6)
• There are four types of SBUs:
– Cost Centers are a firm’s production or support Centers
that provide the best quality product or service at the
lowest cost
– Revenue Centers focus on the selling function and are
defined either by product line or by geographic area
– Profit Centers: when an SBU both generates revenues
and incurs the major portion of the cost for producing
these revenues, it is a profit center
– Investment Centers include assets employed by the
center as well as profits in the performance measurement
 Chapter Summary (4 of 6)

• A key feature of the BSC is that it links

manager’s performance to the strategy of the
organization.
• The BSC measures SBU performance in four
key perspectives:
– Customer satisfaction
– Financial performance
– Internal processes
– Learning and innovation
 Chapter Summary (5 of 6)

• The contribution income statement

(variable costing) has an important role in
performance evaluation because it
distinguishes controllable and non-
controllable costs and because it is not
subject to the “inventory effect” of full
costing. Given the inventory effect of full
costing, profits increase when inventory
increases, and vice-versa, since inventory
cost includes applied fixed overhead.
 Chapter Summary (6 of 6)

• Many countries use international financial

reporting standards (IFRS), which
simplifies the comparison of financial
performance for divisions in other
countries.
• Value stream accounting, from lean
accounting (chapter 11), is a useful tool
for performance evaluation, in particular
because it specifically identifies the
 Management Control…
a Challenging Topic

Additional topics include:

• Investment centers (chapter 19) and
• Compensation (chapter 20)
THANK YOU SO MUCH