Prof. Dr. Thomas Loy
Management Accounting &
Information Systems
Management Accounting and Decision Making
Summer Term 2023
© Folie/Fotos: Universität Bremen
Structure
Structure (1/2)
1. Managerial Accounting, the Business Organization and Professional
Ethics
2. Introduction to Cost Behavior and Cost-Volume-Profit Relationships
3. Measurement of Cost Behavior
4. Cost Management Systems and Activity-Based Costing
5. Relevant Information for Decision Making with a Focus on Operational
Decisions
6. Management Control Systems and Responsibility Accounting
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
2
Structure
Structure (2/2)
7. Management Control in Decentralized Organizations
8. Capital Budgeting
9. Cost Allocation
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
3
Structure
Main Text
US Edition
International Edition
Links to the respective pages in the book are presented like this:
Literature:
Horngren, C.T./Sundem, G. L./Burgstahler, D./Schatzberg J.:
Introduction to Management Accounting (2014), pp. 2-35.
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
4
Structure
Where we are
1. Managerial Accounting, the Business Organization and Professional
Ethics
2. Introduction to Cost Behavior and Cost-Volume-Profit Relationships
3. Measurement of Cost Behavior
4. Cost Management Systems and Activity-Based Costing
5. Relevant Information for Decision Making with a Focus on Operational
Decisions
6. Management Control Systems and Responsibility Accounting
Literature:
Horngren, C.T./Sundem, G. L./Burgstahler, D./Schatzberg J.:
Introduction to Management Accounting (2014), pp. 2-35.
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
5
Structure
Where we are
1. Managerial Accounting, the Business Organization and Professional
Ethics
1.1
1.2
1.3
1.4
1.5
1.6
Necessity of Accounting for Decision Makers/Managers
Roles of Accounting Information
Budget and Performance Reports
Cost-Benefit and Behavioral Considerations
The Value Chain
Current Trends in Management Accounting
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1.1 Necessity of Accounting for Decision Makers/Managers
Overview
▪ Accounting information is used in decision making for planning
and control.
▪ Planning describes how the organization will achieve its
objectives.
▪ Control is the process of implementing plans and evaluating if
objectives are achieved.
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1.1 Necessity of Accounting for Decision Makers/Managers
Users of Accounting Information
▪ Management Accounting:
Process of identifying, measuring, accumulating, analyzing,
preparing, interpreting, and communicating information
→ Used by Managers
▪ Financial Accounting:
Develops information for external decision makers:
→ Used by Stockholders, Suppliers, Banks, Government
Authorities
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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1.2 Roles of Accounting Information
Accounting Information System
Accounting Information System:
▪ Formal mechanism for gathering, organizing, and communicating
information about an organization’s activities.
▪ In order to reduce costs and complexity, many organizations use
a general-purpose accounting system that attempts to meet the
needs of both external and internal users.
▪ However, there are important differences between management
accounting information and financial accounting information.
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Prof. Dr. Thomas Loy
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1.2 Roles of Accounting Information
Roles of Accounting Information
▪ Scorekeeping:
▪ Evaluate organizational performance
▪ Attention Directing:
▪ Compare actual results to expected
▪ Problem Solving:
▪ Assess possible courses of action
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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1.2 Roles of Accounting Information
Planning and Control
Accounting information helps managers plan and control the
organization’s operations.
▪ Planning: Setting objectives and outlining how the objectives will
be obtained.
▪ Control: Implementing plans and using feedback to evaluate the
attainment of objectives.
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Prof. Dr. Thomas Loy
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1.2 Roles of Accounting Information
Nature of Planning and Control
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 7.
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Prof. Dr. Thomas Loy
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1.3 Budget and Performance Reports
Overview
▪ Budget:
 quantitative expression of a plan of action
▪ Performance reports:
 compare actual results with budgeted amounts
 provide feedback by comparing results with plans
 highlight variances
▪ Variances:
 deviations from plans
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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1.3 Budget and Performance Reports
Performance Reports
Mayfair Starbucks Store, March 31, 20X1
Sales
Less:
Ingredients
Store labor
Other labor
Utilities, etc.
Total expenses
Operating income
Budget
$50,000
Actual
$50,000
Variance
0
22,000
12,000
6,000
4,500
$44,500
$ 5,500
24,500
11,600
6,050
4,500
$46,650
$ 3,350
$2,500 U
400 F
50 U
0
$2,150 U
$2,150 U
U = Unfavorable – actual exceeds budget
F = Favorable – actual is less than budget
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Prof. Dr. Thomas Loy
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1.3 Budget and Performance Reports
Influences on Accounting Systems
▪ Generally accepted accounting principles (GAAP), IFRS or local
accounting standards
▪ Foreign Corrupt Practices Act
▪ Sarbanes-Oxley Act
 Internal controls
 Internal auditors
 Management audits
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1.4 Cost-Benefit and Behavioral Considerations
Overview
▪ Cost-benefit balance:
Weighing estimated costs against probable benefits, the primary
consideration in choosing among accounting systems and
methods.
→ The system must provide accurate, timely budgets and
performance reports in a form useful to managers.
▪ Behavioral implications:
The accounting system’s effect on the behavior, specifically the
decisions, of managers.
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Prof. Dr. Thomas Loy
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1.4 Cost-Benefit and Behavioral Considerations
Product Life Cycle
Product life cycle refers to the various stages through which a
product passes:
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 10.
Management Accounting and Decision Making
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1.5 The Value Chain
Overview
Research and
Development
Product
Service, or
Process
Design
Customer
Service
Customer
Focus
Distribution
Production
Marketing
Based on: Horngren et al.: Introduction to Management Accounting (2014), p. 11.
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1.5 The Value Chain
Accounting’s Position in the Organization
Management accountant’s role as consultant:
▪ Collects and compiles information
▪ Prepares standardized reports
▪ Interprets and analyzes information
▪ Is involved in decision making
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Prof. Dr. Thomas Loy
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1.5 The Value Chain
Controller and Treasurer Function
Chief Financial Officer (CFO)
Controller Functions
▪
▪
▪
▪
▪
▪
▪
Planning for control
Reporting and interpreting
Evaluating and consulting
Tax administration
Government reporting
Protection of assets
Economic appraisal
Treasurer Functions
▪
▪
▪
▪
▪
▪
▪
▪
Provision of capital
Investor relations
Short-term financing
Banking and custody
Credits and collections
Investments
Risk management
(insurance)
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1.6 Current Trends in Management Accounting
Overview (1/2)
Adaption to changes:
▪ Shifting from a manufacturing-based to a service-based economy
▪ Increased global competition
▪ Advances in technology
▪ Changes in business processes
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1.6 Current Trends in Management Accounting
Overview (2/2)
▪ The service sector now accounts for more than (almost) 80%
(70%) of the employment in the United States (Germany).
▪ In major cities (New York City, London, Berlin) the service sector
accounts for approx. 90% of employment and GNP (Gross
National Product).
▪ Common characteristics of service organizations:
 Labor is a major component of costs.
 Output is usually difficult to measure.
 Service organizations cannot store their major inputs and outputs.
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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1.6 Current Trends in Management Accounting
Major Influences on Management Accounting
▪ Advances in technology:
 E-commerce
 Enterprise resource planning (ERP)
 B2C and B2B
▪ Business process reengineering:




Just-in-time (JIT) philosophy
Lean manufacturing
Computer-integrated manufacturing
Six sigma
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Prof. Dr. Thomas Loy
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Structure
Where we are
1. Managerial Accounting, the Business Organization and Professional
Ethics
2. Introduction to Cost Behavior and Cost-Volume-Profit Relationships
3. Measurement of Cost Behavior
4. Cost Management Systems and Activity-Based Costing
5. Relevant Information for Decision Making with a Focus on Operational
Decisions
6. Management Control Systems and Responsibility Accounting
Literature:
Horngren, C.T./Sundem, G. L./Burgstahler, D./Schatzberg J.:
Introduction to Management Accounting (2014), pp. 36-85.
Management Accounting and Decision Making
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Structure
Where we are
2. Introduction to Cost Behavior and Cost-Volume-Profit Relationships
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
Cost Drivers and Cost Behavior
Variable and Fixed Cost Behavior
Step- and Mixed-Cost Behavior Patterns
Cost-volume-profit (CVP) analysis
Break-Even Point
Target Net Profit
Contribution Margin and Gross Margin
Sales Mix Analysis
Impact of Income Taxes
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2.1 Cost Drivers and Cost Behavior
Overview
▪ Cost drivers are measures of activities that require the use of
resources and thereby cause costs.
▪ Cost behavior is how the activities of an organization affect its
costs.
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 38.
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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2.1 Cost Drivers and Cost Behavior
Reminder: Value Chain
Research and
Development
Product
Service, or
Process
Design
Customer
Service
Customer
Focus
Distribution
Production
Marketing
Based on: Horngren et al.: Introduction to Management Accounting (2014), p. 11.
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2.1 Cost Drivers and Cost Behavior
Value Chain Functions, Costs, and Cost Drivers (1/3)
▪
▪
▪
▪
▪
Value Chain Function And
Example Cost Drivers
Resource Costs
Research and Development
Salaries of sales personnel ▪ Number of new product
Costs of market surveys
proposals
Salaries of product and
process engineers
Design of products, services, and processes
Salaries of product and
▪ Number of engineering
process engineers
hours
Costs of computer-aided
▪ Number of distinct parts
design equipment used to
per product
develop prototype of
product for testing
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2.1 Cost Drivers and Cost Behavior
Value Chain Functions, Costs, and Cost Drivers (2/3)
▪
▪
▪
▪
▪
Value Chain Function And
Example Cost Drivers
Resource Costs
Production
Labor wages
▪ Labor hours
Supervisory salaries
▪ Number of people
Maintenance wages
supervised
Depreciation of plant and
▪ Number of mechanic hours
machinery supplies
▪ Number of machines hours
Energy cost
▪ Kilowatt hours
Marketing
▪ Costs of advertisments
▪ Salaries of marketing
personnel, travel costs,
entertainment costs
▪ Number of advertisments
▪ Sales dollars
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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2.1 Cost Drivers and Cost Behavior
Value Chain Functions, Costs, and Cost Drivers (3/3)
Value Chain Function And
Example Cost Drivers
Resource Costs
Distribution
▪ Wages of shipping
▪ Labor hours
personnel
▪ Weight of items delivered
▪ Transportation costs
including depreciation of
vehicles and fuel
Customer service
▪ Salaries of service
personnel
▪ Costs of supplies, travel
▪ Hours spent servicing
products
▪ Number of service calls
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Prof. Dr. Thomas Loy
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2.2 Variable and Fixed Cost Behavior
Overview
Variable costs:
▪ A cost that changes in direct proportion to changes in the costdriver level.
▪ Think of variable costs on a per-unit basis.
▪ The per-unit variable cost remains unchanged regardless of
changes in the cost-driver.
Fixed costs:
▪ A cost that is not affected by changes in the cost-driver level.
▪ Think of fixed costs on a total-cost basis.
▪ Total fixed costs remain unchanged regardless of changes in the
cost-driver.
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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2.2 Variable and Fixed Cost Behavior
Cost Behavior: Further Considerations
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 39.
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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2.2 Variable and Fixed Cost Behavior
Cost Behavior: Further Considerations
▪ Cost behavior depends on the decision context, the
circumstances surrounding the decision for which the cost will be
used.
▪ Cost behavior also depends on management decisions —
management choices determine cost behavior.
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Prof. Dr. Thomas Loy
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2.2 Variable and Fixed Cost Behavior
Relevant Range
▪ The relevant range is the limit of cost-driver activity level within
which a specific relationship between costs and the cost driver is
valid.
▪ Even within the relevant range, a fixed cost remains fixed only
over a given period of time — usually the budget period.
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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2.2 Variable and Fixed Cost Behavior
Fixed Costs and Relevant Range
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 42.
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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2.3 Step- and Mixed-Cost Behavior Patterns
Overview
▪ Step cost:
A cost that changes abruptly at different intervals of activity because
the resources and their costs come in indivisible chunks.
▪ Mixed Cost:
A cost that contains elements of both fixed- and variable-cost behavior
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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2.3 Step- and Mixed-Cost Behavior Patterns
Step-Cost Behavior
Step cost treated as fixed cost
Step cost treated as variable cost
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 43.
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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2.4 Cost-volume-profit (CVP) analysis
Overview
▪ Managers trying to evaluate the effects of changes in volume of
goods or services produced might be interested in upward
changes such as increased sales expected from increases in
promotion or advertising.
▪ Managers might be interested in downward changes such as
decreased sales expected due to a new competitor entering the
market or due to a decline in economic conditions.
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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2.4 Cost-volume-profit (CVP) analysis
CVP Scenario
Cost-volume-profit (CVP) analysis is the study of the effects of
output volume on revenue (sales), expenses (costs), and net income
(net profit).
Per Unit
Selling price
Variable cost of each item
Selling price less variable cost
Monthly fixed expenses:
Rent
Wages for replenishing and
servicing
Other fixed expenses
Total fixed expenses per month
$1.50
$1.20
$ .30
Percentage of
Sales
100%
80%
20%
$3,000
$13,500
$1,500
$18,000
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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2.4 Cost-volume-profit (CVP) analysis
Cost-Volume-Profit Graph
Based on: Horngren et al.: Introduction to Management Accounting (2014), p. 46.
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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2.5 Break-Even Point
Overview
The break-even point is the level of sales at which revenue equals
expenses and net income is zero.
Sales
- Variable expenses
- Fixed expenses
Zero net income (Break-Even Point)
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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2.5 Break-Even Point
Contribution Margin Method
Contribution margin
Per Unit in $
Selling price
Variable costs
Contribution margin
$1.50
$1.20
$.30
Contribution margin ratio
Per Unit in %
Selling price
Variable costs
Contribution margin
100%
80%
20%
$18,000 fixed costs ÷ $.30 = 60,000 units (Break-Even)
60,000 units × $1.50 (Sales Price)
$18,000 fixed costs ÷ 20%
(Contribution-margin percentage)
= $90,000 in sales to break even
= $90,000 in sales to break even
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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2.5 Break-Even Point
Equation Method
Let N = number of units to be sold to break even.
Sales – Expenses(Variable) – Expenses(Fixed) = net income
$1.50N – $1.20N – $18,000 = 0
$.30N = $18,000
N = $18,000 ÷ $.30
N = 60,000 Units
Let S = sales in dollars needed to break even.
S – .80S – $18,000 = 0
.20S = $18,000
S = $18,000 ÷ .20
S = $90,000
Shortcut formulas:
Break-even
=
fixed expenses = $18,000 = 60,000
volume in units unit contribution margin
.30
Break-even
=
fixed expenses = $18,000 = $90,000
volume in sales contribution margin ratio
.2
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Prof. Dr. Thomas Loy
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2.5 Break-Even Point
Overview
Managers use CVP analysis to determine the total sales, in units and
dollars, needed to reach a target net profit.
Target Sales
- Variable expenses
- Fixed expenses
Target Net Income
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2.6 Target Net Profit
Example (1/2)
𝐓𝐚𝐫𝐠𝐞𝐭 𝐬𝐚𝐥𝐞𝐬 𝐯𝐨𝐥𝐮𝐦𝐞 𝐢𝐧 𝐮𝐧𝐢𝐭𝐬
(𝐅𝐢𝐱𝐞𝐝 𝐞𝐱𝐩𝐞𝐧𝐬𝐞𝐬 + 𝐓𝐚𝐫𝐠𝐞𝐭 𝐧𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞)
=
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐦𝐚𝐫𝐠𝐢𝐧 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭
Contribution margin
Per Unit in $
Selling price:
Variable costs:
Contribution margin per unit:
Target Net Profit:
$1.50
$1.20
$ .30
$1,440
($18,000 + $1,440) ÷ $.30 = 64,800 units
Target sales dollars = sales price × sales volume in units
Target sales dollars = $1.50 × 64,800 units = $97,200.
Management Accounting and Decision Making
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2.6 Target Net Profit
Example (1/2)
𝐓𝐚𝐫𝐠𝐞𝐭 𝐬𝐚𝐥𝐞𝐬 𝐯𝐨𝐥𝐮𝐦𝐞 𝐢𝐧 𝐝𝐨𝐥𝐥𝐚𝐫𝐬
(𝐅𝐢𝐱𝐞𝐝 𝐞𝐱𝐩𝐞𝐧𝐬𝐞𝐬 + 𝐓𝐚𝐫𝐠𝐞𝐭 𝐧𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞)
=
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐦𝐚𝐫𝐠𝐢𝐧 𝐫𝐚𝐭𝐢𝐨
Contribution margin ratio
Per Unit in %
Selling price:
Variable costs:
Contribution margin per unit:
100%
80%
20%
Sales volume in dollars:
18,000 + $1,440 = $97,200
.20
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2.6 Target Net Profit
Nonprofit Application (1/2)
Suppose a city has a $100,000 lump-sum budget appropriation
to conduct a counseling program.
Variable costs per prescription
are $400 per patient per day.
Fixed costs are $60,000 in the
relevant range of 50 to 150 patients.
If the city spends the entire budget appropriation, how many
patients can it serve in a year?
Sales = expenses (Variable) + expenses (Fixed)
$100,000 = $400N + $60,000
$400N = $100,000 – $60,000
N = $40,000 ÷ $400
N = 100 patients
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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2.6 Target Net Profit
Nonprofit Application (2/2)
If the city cuts the total budget appropriation by 10%, how
many patients can it serve in a year?
Budget after 10% Cut
$100,000 × (1 - .1) = $90,000
Sales = expenses (Variable) + expenses (Fixed)
$90,000 = $400N + $60,000
$400N = $90,000 – $60,000
N = $30,000 ÷ $400
N = 75 patients
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Prof. Dr. Thomas Loy
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2.6 Target Net Profit
Operating Leverage
▪ Low leveraged firms have lower fixed costs and higher variable
costs. Changes in sales volume will have a smaller effect on net
income.
▪ Margin of safety = planned unit sales – break-even sales.
▪ How far can sales fall below the planned level before losses
occur?
▪ Operating leverage: A firm’s ratio of fixed costs to variable costs.
▪ Highly leveraged firms have high fixed costs and low variable
costs. A small change in sales volume results in a large change in
net income.
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2.7 Contribution Margin and Gross Margin
Overview
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 58.
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2.7 Contribution Margin and Gross Margin
Example (1/2)
Sales price – Cost of goods sold = Gross margin
Sales price - all variable expenses =
Contribution margin
Selling price
Variable costs (acquisition cost, i.e. COGS)
Per Unit
$1.50
$1.20
$ .30
→ Contribution margin and gross margin are equal
(as there are no fixed cost in this example)
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2.7 Contribution Margin and Gross Margin
Example (2/2)
Suppose the firm paid a commission of $.12 per unit sold.
Contribution Margin
Per Unit
Sales
$1.50
Acquisition cost of unit sold
$1.20
Commission
Total variable expense
Contribution margin
Gross margin
Gross Margin
Per Unit
$1.50
$1.20
$.12
$1.32
$.18
$.30
→ Contribution margin and gross margin differ as the commission is a
fixed expense paid per unit sold
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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2.8 Sales Mix Analysis
Overview
▪ Sales mix is the relative proportions or combinations of quantities
of products that comprise total sales.
▪ If the proportions of the mix change, the cost-volume-profit
relationships also change.
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2.8 Sales Mix Analysis
Example (1/5)
Ramos Company Example
Data
Gross
Variable expenses
Contribution margins
Sales in units
Sales
Variable expenses
Contribution margins
Fixed expenses
Net income
Wallets (W)
$8
$7
$1
Key Kases (K)
$5
$3
$2
W
K
Total
300,000
$2,400,000
$2,100,000
$300,000
75,000
$375,000
$225,000
$150,000
375,000
$2,775,000
$2,325,000
$450,000
$180,000
$270,000
Management Accounting and Decision Making
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2.8 Sales Mix Analysis
Example (2/5)
Let K = number of units of K to break even, and 4K = number
of units of W to break even.
Break-even point for a constant sales mix of 4 units of W for
every unit of K.
sales – expense(variable) – expense(fixed) = zero net income
[$8(4K) + $5(K)] – [$7(4K) + $3(K)] – $180,000 = 0
32K + 5K - 28K - 3K - 180,000 = 0
6K = 180,000
K = 30,000
W = 4K = 120,000
30,000K + 120,000W = 150,000 total units (K + W).
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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2.8 Sales Mix Analysis
Example (3/5)
If the company sells only key cases:
Break-Even Point =
fixed expenses
contribution margin per unit
=
$180,000
$2
=
90,000 key cases
If the company sells only wallets:
Break-Even Point =
fixed expenses
contribution margin per unit
=
$180,000
$1
=
180,000 wallets
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2.8 Sales Mix Analysis
Example (4/5)
▪ Suppose total sales were equal to the budget (plan) of 375,000
units.
▪ However, Ramos sold only 50,000 key cases and 325,000 wallets.
What is net income?
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Prof. Dr. Thomas Loy
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2.8 Sales Mix Analysis
Example (5/5)
Ramos Company Example
Data
Gross
Variable expenses
Contribution margins
Sales in units
Sales
Variable expenses
Contribution margins
Fixed expenses
Net income
Wallets (W)
$8
$7
$1
Key Kases (K)
$5
$3
$2
W
K
Total
325,000
$2,600,000
$2,275,000
$325,000
50,000
$250,000
$150,000
$100,000
375,000
$2,850,000
$2,425,000
$425,000
$180,000
$245,000
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
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2.9 Impact of Income Taxes
Overview
▪ Income taxes do not affect the break-even point. There is no
income tax at a level of zero income.
▪ Income taxes affect the calculation of the volume required to
achieve a specified after-tax target profit.
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2.9 Impact of Income Taxes
Example (1/2)
Suppose that a company earns $1,440 before Taxes and pays
income tax at a rate of 40%.
Suppose the target net income after taxes was $864
Target income before taxes
= Target after-tax net income
(1 – tax rate)
Target income before taxes
=
$864
= $1,440
(1 – 0.40)
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2.9 Impact of Income Taxes
Example (2/2)
Target sales - Variable expenses - Fixed expenses
= Target after-tax net income ÷ (1 – tax rate)
$1.50N - $1.20N - $18,000 = $864 ÷ (1 – 0.40)
$.30N = $18,000 + ($864/.6)
$.18N = $10,800 + $864 = $11,664
N = $11,664/$.18
N = 64,800 units
Suppose target net income after taxes was $1,440
$1.50N - $1.20N - $18,000 = $1,440 ÷ (1 – 0.40)
$.30N = $18,000 + ($1,440/.6)
$.18N = $10,800 + $1,440 = $12,240
N = $12,240/$.18
N = 68,000 units
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Structure
Where we are
1. Managerial Accounting, the Business Organization and Professional
Ethics
2. Introduction to Cost Behavior and Cost-Volume-Profit Relationships
3. Measurement of Cost Behavior
4. Cost Management Systems and Activity-Based Costing
5. Relevant Information for Decision Making with a Focus on Operational
Decisions
6. Management Control Systems and Responsibility Accounting
Literature:
Horngren, C.T./Sundem, G. L./Burgstahler, D./Schatzberg J.:
Introduction to Management Accounting (2014), pp. 86-121.
Management Accounting and Decision Making
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62
Structure
Where we are
3. Measurement of Cost Behavior
3.1
3.2
3.3
3.4
3.5
Cost Drivers and Cost Behavior
Management’s Influence on Cost Behavior
Cost Functions
Choice of Cost Drivers: Activity Analysis
Methods of Measuring Cost Functions
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3.1 Cost Drivers and Cost Behavior
Overview
▪ Accountants and managers often assume that cost behavior is
linear over some relevant range of activity or cost-driver levels.
▪ We can graph linear-cost behavior with a straight line because we
assume each cost to be either fixed or variable.
▪ Recall that the relevant range specifies the interval of cost-driver
activity within which a specific relationship between a cost and
its driver will be valid.
▪ Managers usually define the relevant range based on their
previous experience operating the organization at different levels
of activity.
Management Accounting and Decision Making
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3.1 Cost Drivers and Cost Behavior
Graph
Costs are assumed to be fixed or variable within the relevant range
of activity
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 88.
Management Accounting and Decision Making
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65
3.1 Cost Drivers and Cost Behavior
„Sticky Cost“
•
There has been considerable interest in the accounting literature in
understanding determinants and differences in the degree of cost stickiness
Cost
„Sticky“ cost
Proportional
development of cost
„Anti-Sticky“ cost
Salest+1
Salest
Salest+1
Activity
•
Three broad categories of firm-level determinants (Banker et al. 2017):
(1) Adjustment costs, (2) Managerial optimism, and (3) Managerial opportunism
•
Country-level determinants: E.g., employment protection laws (Banker et al. 2013),
legal systems (Calleja et al. 2006), culture (Kitching et al. 2016) or generalized trust
(Hartlieb et al. 2020)
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3.2 Management’s Influence on Cost Behavior
Overview
▪ Product and service decisions and the value chain
▪ Capacity
▪ Technology
▪ Policies to create incentives to control costs
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3.2 Management’s Influence on Cost Behavior
The Value Chain
▪ Managers influence cost behavior throughout the value chain through
their choices of:
 process and product design
 quality levels
 product features
 distribution channels, etc.
▪ Each decision contributes to the organization’s performance.
▪ Managers must consider the costs and benefits of each decision.
Management Accounting and Decision Making
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3.2 Management’s Influence on Cost Behavior
Capacity Decisions
What are capacity costs?
They are the fixed costs of being able to achieve a desired level of
production or to provide a desired level of service while maintaining
product or service attributes.
Management Accounting and Decision Making
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3.2 Management’s Influence on Cost Behavior
Committed Fixed Costs
▪ Committed fixed costs arise from the possession of facilities,
equipment, and the basic organization of the firm.
▪ Examples:
 Lease payments
 Property taxes
 Salaries of key personnel
Management Accounting and Decision Making
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70
3.2 Management’s Influence on Cost Behavior
Discretionary Fixed Costs
▪ Discretionary fixed costs are costs fixed at certain levels only
because management decided that these levels of cost should be
incurred to meet the organization’s goals.
▪ These discretionary fixed costs have no obvious relationship to
levels of output activity but are determined as part of the
periodic planning process.
▪ Each planning period, management will determine how much to
spend on discretionary items. These costs then become fixed
until the next planning period.
Management Accounting and Decision Making
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71
3.2 Management’s Influence on Cost Behavior
Examples of Commited and Discretionary Fixed Costs (1/2)
Fixed Costs
Planned
Amounts
Advertising and promotion
Depreciation
Employee training
Management salaries
Mortgage payment
Property taxes
Research and development
$50,000
$400,000
$100,000
$800,000
$250,000
$600,000
$1,500,000
Total
$3,700,000
Management Accounting and Decision Making
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3.2 Management’s Influence on Cost Behavior
Examples of Commited and Discretionary Fixed Costs (2/2)
Fixed Costs
Committed
Depreciation
Mortgage payment
Property taxes
Total committed
Planned Amounts
$400,000
$250,000
$600,000
$1,250,000
Discretionary (potential savings)
Advertising and promotion
Employee training
Management salaries
Research and development
Total discretionary
$50,000
$100,000
$800,000
$1,500,000
$2,450,000
Total committed and discretionary
$3,700,000
Management Accounting and Decision Making
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73
3.2 Management’s Influence on Cost Behavior
Technology Decisions
▪ Choosing the type of technology an organization will use to
produce products or deliver services is a critical decision for
management.
▪ Choice of technology (e-commerce versus in-store or mail-order
sales) positions the organization to meet its current goals and to
respond to changes in the environment.
▪ The use of high-technology methods rather than labor usually
means a much greater (committed) fixed-cost component to the
total cost.
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
74
3.2 Management’s Influence on Cost Behavior
Cost-Control Incentives
▪ Managers use their knowledge of cost behavior to set cost
expectations.
▪ Employees may receive rewards that are tied to meeting these
expectations.
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75
3.3 Cost Functions
Overview (1/2)
▪ Managers will use cost functions often as a planning and control
tool.
▪ Planning and controlling the activities of an organization require
useful and accurate estimates of future fixed and variable costs.
▪ Cost measurement involves estimating or predicting costs as a
function of appropriate cost drivers.
Management Accounting and Decision Making
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76
3.3 Cost Functions
Overview (2/2)
Understanding relationships between costs and their cost drivers
allows managers to:
 Make better operating, marketing, and production decisions
 Plan and evaluate actions
 Determine appropriate costs for short-run and long-run decisions.
▪ The first step in estimating or predicting costs is measuring cost
behavior as a function of appropriate cost drivers.
▪ The second step is to use these cost measures to estimate future
costs at expected levels of cost-driver activity.
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3.3 Cost Functions
Cost Function Equation
▪ Let:
Y = Total cost
F = Fixed cost
V = Variable cost per unit
X = Cost-driver activity in number of units
▪ The mixed-cost function is called a linear-cost function.
Mixed-cost function:
Y = F + VX
Y = $10,000 + $5.00X
Management Accounting and Decision Making
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78
3.3 Cost Functions
Developing Cost Functions
▪ Plausibility:
The cost function must be believable.
▪ Reliability:
A cost function’s estimates of costs at actual levels of activity must
reliably conform with actually observed costs.
Management Accounting and Decision Making
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79
3.4 Choice of Cost Drivers: Activity Analysis
Overview
▪ Choosing a cost function starts with choosing cost drivers.
▪ Managers use activity analysis to identify appropriate cost
drivers.
▪ Activity analysis directs management accountants to the
appropriate cost drivers for each cost.
Management Accounting and Decision Making
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80
3.4 Choice of Cost Drivers: Activity Analysis
Example (1/3)
▪ Northwestern Computers makes two products: Mozart-Plus and
Powerdrive.
▪ In the past, most of the support costs were twice as much as
labor costs.
▪ Recently, Northwestern Comp. has upgraded the production
function, which has increased support costs and reduced labor
cost.
Management Accounting and Decision Making
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3.4 Choice of Cost Drivers: Activity Analysis
Example (2/3)
Using the old cost driver, labor cost, the prediction of support
costs would be:
Labor cost
Support cost:
2 × Direct labor cost
Mozart-Plus
$8.50
Powerdrive
$130.00
$17.00
$260.00
Management Accounting and Decision Making
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82
3.4 Choice of Cost Drivers: Activity Analysis
Example (3/3)
Using a more appropriate cost driver,
in this case the number of components added to products,
companies can predict support costs more accurately:
Mozart-Plus
Support cost at $20
per component
$20 × 5 components
$20 × 9 components
Difference in predicted
support cost
Powerdrive
$100.00
$180.00
$ 83.00
higher
$ 80.00
lower
→ Managers will make better decisions with this more accurate
information.
Management Accounting and Decision Making
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83
3.5 Methods of Measuring Cost Functions
Overview
1.
Engineering
Analysis
5.
Least-Squares
Regression
2.
Measuring
Methods
Account
Analysis
4.
3.
Visual-Fit
Analysis
High-Low
Analysis
Management Accounting and Decision Making
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84
1.
3.5 Methods of Measuring Cost Functions
Engineering Analysis
Engineering
Analysis
5.
Least-Squares
Regression
2.
Measuring
Methods
Account
Analysis
4.
3.
Visual-Fit
Analysis
High-Low
Analysis
▪ Engineering analysis measures cost behavior according to what
costs should be, not by what costs have been.
▪ Engineering analysis entails a systematic review of materials,
supplies, labor, support services, and facilities needed for
products and services.
Management Accounting and Decision Making
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85
1.
3.5 Methods of Measuring Cost Functions
Engineering
Analysis
Account Analysis (1/2)
5.
Least-Squares
Regression
2.
Measuring
Methods
Account
Analysis
4.
3.
Visual-Fit
Analysis
High-Low
Analysis
The simplest method of account analysis selects a plausible cost
driver and classifies each account as a variable or fixed cost.
Parkview Medical Center
Monthly cost
Supervisor’s salary and benefits
Hourly workers’ wages and benefits
Equipment depreciation and rentals
Equipment repairs
Cleaning supplies
Total maintenance costs
Amount
Fixed
$3,800
$14,674
$5,873
$5,604
$7,472
$37,423
$3,800
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
Variable
$14,674
$5,873
$9,673
$5,604
$7,472
$27,750
86
1.
3.5 Methods of Measuring Cost Functions
Account Analysis (2/2)
Engineering
Analysis
5.
Least-Squares
Regression
2.
Measuring
Methods
Account
Analysis
4.
3.
Visual-Fit
Analysis
High-Low
Analysis
Division of Variable-Cost by Cost Driver:
Cost Driver: 3,700 patient-days
Fixed cost per month = $9,673
Variable cost per patient-day
= $27,750 ÷ 3,700
= $7.50 per patient-day
Resulting Mixed Cost Function:
Y = $9,673 + ($7.50 × patient-days)
Management Accounting and Decision Making
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87
1.
3.5 Methods of Measuring Cost Functions
High-Low Analysis (1/4)
Engineering
Analysis
5.
Least-Squares
Regression
▪ Plot historical data points on a graph.
2.
Measuring
Methods
Account
Analysis
4.
3.
Visual-Fit
Analysis
High-Low
Analysis
▪ Focus on the highest- and lowest-activity points.
High month: April
Maintenance cost: $47,000
Number of patient-days: 4,900
Low month: September
Maintenance cost: $17,000
Number of patient-days: 1,200
Management Accounting and Decision Making
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88
1.
3.5 Methods of Measuring Cost Functions
High-Low Analysis (2/4)
Engineering
Analysis
5.
Least-Squares
Regression
2.
Measuring
Methods
Account
Analysis
4.
3.
Visual-Fit
Analysis
High-Low
Analysis
The point at which the line intersects the Y axis is the intercept, F, or
estimate of Fixed Costs, and the slope of the line measures the variable
cost.
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 98.
Management Accounting and Decision Making
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89
1.
3.5 Methods of Measuring Cost Functions
Engineering
Analysis
High-Low Analysis (3/4)
5.
Least-Squares
Regression
2.
Measuring
Methods
Account
Analysis
4.
3.
Visual-Fit
Analysis
High-Low
Analysis
What is the variable cost (V)?
Using algebra to solve for variable and fixed costs.
Variable costs = Change in costs
Change in activity
V = ($47,000 – $17,000) ÷ (4,900 – 1,200)
= $30,000 ÷ 3,700 = $8.1081
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
90
1.
3.5 Methods of Measuring Cost Functions
Engineering
Analysis
High-Low Analysis (4/4)
5.
Least-Squares
Regression
What is the fixed cost (F)?
2.
Measuring
Methods
Account
Analysis
4.
3.
Visual-Fit
Analysis
High-Low
Analysis
F = Total mixed cost – total variable cost
At X (high): F = $47,000 - ($8.1081 × 4,900 patient-days)
= $47,000 – $39,730
= $7,270 a month
F = Total mixed cost – total variable cost
At X (low): F = $17,000 - ($8.1081 × 1,200 patient-days)
= $17,000 – $9,729.72
= $7,270 a month
Cost function measured by high-low method:
Y = $7,270 per month + ($8.1081 × patient-days)
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
91
1.
3.5 Methods of Measuring Cost Functions
Visual-Fit Analysis
Engineering
Analysis
5.
Least-Squares
Regression
2.
Measuring
Methods
Account
Analysis
4.
3.
Visual-Fit
Analysis
High-Low
Analysis
In the visual-fit analysis, the cost analyst visually fits a straight line
through a plot of all of the available data, not just between the high
point and the low point, making it more reliable than the high-low
method.
Management Accounting and Decision Making
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92
1.
3.5 Methods of Measuring Cost Functions
Least-Squares Regression Method (1/2)
Engineering
Analysis
5.
Least-Squares
Regression
▪ Similar to Visual-Fit Analysis
2.
Measuring
Methods
Account
Analysis
4.
3.
Visual-Fit
Analysis
High-Low
Analysis
▪ Regression analysis measures a cost function more objectively by
using statistics to fit a cost function to all the data
▪ Regression analysis measures cost behavior more reliably than
other cost measurement methods
Management Accounting and Decision Making
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93
1.
3.5 Methods of Measuring Cost Functions
Engineering
Analysis
Least-Squares Regression Method (2/2)
5.
Least-Squares
Regression
2.
Measuring
Methods
Account
Analysis
4.
3.
Visual-Fit
Analysis
High-Low
Analysis
Y = $9,329 + ($6.951 × patient-days)
Source: Horngren et al.: Introduction to Management Accounting (2014), p.100.
Management Accounting and Decision Making
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94
Structure
Where we are
1. Managerial Accounting, the Business Organization and Professional
Ethics
2. Introduction to Cost Behavior and Cost-Volume-Profit Relationships
3. Measurement of Cost Behavior
4. Cost Management Systems and Activity-Based Costing
5. Relevant Information for Decision Making with a Focus on Operational
Decisions
6. Management Control Systems and Responsibility Accounting
Literature:
Horngren, C.T./Sundem, G. L./Burgstahler, D./Schatzberg J.:
Introduction to Management Accounting (2014), pp. 122-179.
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
95
Structure
Where we are
4. Cost Management Systems and Activity-Based Costing
4.1
4.2
4.3
4.4
4.5
4.6
4.7
4.8
Cost Management System
Cost Accounting System
Cost Allocation
Categories of Manufacturing Costs
Financial Statement Presentation
Types of Costing Systems
Activity-Based Management
Design of an Activity-Based Cost Accounting System
Management Accounting and Decision Making
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96
4.1 Cost Management System
Overview
▪ A cost management system (CMS) is a collection of tools and
techniques that identifies how management’s decisions affect
costs.
▪ The primary purposes of a cost management system are:
 To provide cost information for strategic management decisions and
operational control and
 For measures of inventory value and cost of goods sold (COGS) for
financial reporting.
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97
4.1 Cost Management System
Cost
▪ A cost is a sacrifice or giving up of resources for a particular
purpose.
▪ Costs are frequently measured by the monetary units that must
be paid for goods and services.
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4.1 Cost Management System
Cost Object
▪ A cost object (objective) is anything for which a separate
measurement of costs is desired.
▪ Examples:





Customers
Service
Departments
Orders
Products
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4.2 Cost Accounting System
Overview (1/2)
Two Processes
▪ Cost accumulation:
Collecting costs by some “natural” classification such as materials or
labor
▪ Cost assignment:
Tracing costs to one or more cost objectives
Management Accounting and Decision Making
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100
4.2 Cost Accounting System
Overview (2/2)
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 125.
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101
4.3 Cost Allocation
Overview (1/3)
▪ Direct costs can be identified specifically and exclusively with a
given cost objective in an economically feasible way
▪ Indirect costs cannot be identified specifically and exclusively
with a given cost objective in an economically feasible way
▪ Cost allocation assigns indirect costs to cost objects, in
proportion to the cost object’s use of a particular cost-allocation
base
Management Accounting and Decision Making
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102
4.3 Cost Allocation
Overview (2/3)
▪ An ideal cost-allocation base would measure how much of the
particular cost is caused by the cost objective
▪ Note the similarity of this definition to that of a cost driver—an
output measure that causes costs; therefore, most allocation
bases are cost drivers
▪ Cost allocations support a company’s CMS that provides cost
measurements for strategic decision making, operational control,
and external reporting
Management Accounting and Decision Making
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103
4.3 Cost Allocation
Overview (3/3)
Four purposes of cost allocation:
▪ Predict economic effects of strategic and operational control
decisions
▪ Provide desired motivation and feedback for (employee)
performance evaluation
▪ Compute income and asset valuations for financial reporting
▪ Justify costs or obtain reimbursement
Management Accounting and Decision Making
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104
4.3 Cost Allocation
Cost Pool
▪ Individual costs allocated to cost objects using a single costallocation base
▪ Step-by-Step:
1. Accumulate indirect costs for a period of time
2. Select an allocation base for each cost pool, preferably a cost
driver, that is, a measure that causes the costs in the cost pool
3. Measure the units of the cost-allocation base used for each cost
object and compute the total units used for all cost objects
4. Multiply the percentage by the total costs in the cost pool to
determine the cost allocated to each cost object
Management Accounting and Decision Making
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105
4.3 Cost Allocation
Cost Assignment
Direct costs are physically traced to a cost object. Indirect costs are
allocated using a cost-allocation base.
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 128.
Management Accounting and Decision Making
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106
4.3 Cost Allocation
Unallocated Costs
▪ Some costs lack an identifiable relationship to a cost object; often
it is best to leave such costs unallocated
▪ An unallocated cost for one company may be an allocated cost or
even a direct cost for another
▪ These unallocated costs are recorded but not assigned to any
cost object
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
107
4.4 Categories of Manufacturing Costs
Overview
▪ Manufacturing operations transform raw materials, the basic
materials from which a product is made, into other goods
through the use of labor and factory facilities
▪ In manufacturing companies, products are frequently the cost
object
▪ Manufacturing companies classify production costs as either:
(1) direct material,
(2) direct labor, or
(3) indirect production costs
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
108
4.4 Categories of Manufacturing Costs
Manufacturing Companies
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 133.
Management Accounting and Decision Making
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109
4.4 Categories of Manufacturing Costs
Direct Material Costs
▪ Direct materials include the acquisition costs of all materials that
a company identifies as a part of the manufactured goods
▪ These costs are identified in an economically feasible way
Management Accounting and Decision Making
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110
4.4 Categories of Manufacturing Costs
Direct Labor Costs
▪ Direct Labor costs include the wages of all labor that can be
traced specifically and exclusively to the manufactured goods in
an economically feasible way
▪ In highly automated factories with a flexible workforce, there
may not be any direct-labor costs because all workers may spend
time overseeing numerous products, making it economically
infeasible to physically trace any labor cost directly to specified
products
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
111
4.4 Categories of Manufacturing Costs
Indirect Production Costs (Manufacturing Overhead)
▪ Manufacturing overhead includes all costs associated with the
production process that the company cannot trace to the
manufactured goods in an economically feasible way
▪ Depreciation, property taxes, supplies, and insurance are
examples of indirect costs of production. Minor items, such as
tacks or glue, and many labor costs, such as janitors and forklift
operators, are considered indirect labor costs and economically
infeasible to trace
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
112
4.4 Categories of Manufacturing Costs
Product Costs
▪ Product costs are costs identified with goods produced or
purchased for resale
▪ These costs first become part of the inventory on hand,
sometimes called inventoriable costs
▪ Inventoriable costs become expenses in the form of cost of goods
sold (COGS) only when the inventory is sold (s. slide 121)
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
113
4.4 Categories of Manufacturing Costs
Period Costs
▪ Period costs are deducted as expenses during the current period
without going through an inventory stage
▪ These costs are accumulated by departments, such as R&D,
advertising, and sales; most of these costs are reported as
Selling, General and Administrative (SG&A) expenses
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
114
4.5 Financial Statement Presentation
Merchandise Companies‘ Costs
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 133.
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
115
4.5 Financial Statement Presentation
Current Asset Sections of Balance Sheets
Manufacturer
Retailer or Wholesaler
Cash
Receivables
Subtotal
$4,000
$25,000
$29,000
Cash
Receivables
Subtotal
$4,000
$25,000
$29,000
Finished goods
Work in process
Raw materials
Total inventories
Other current assets
Total current assets
$32,000
$22,000
$23,000
$77,000
$1,000
$107,000
Merchandise inventory
Other current assets
Total current assets
$77,000
$1,000
$107,000
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
116
4.5 Financial Statement Presentation
Income Statement Presentation of Costs for a Manufacturer
The manufacturer’s cost of goods produced and then sold is usually
composed of the three major categories of cost:
▪ Direct (raw) materials
▪ Direct labor
▪ Indirect manufacturing
Additionally, manufacturers show selling, general and administrative
(SG&A) expenses on the income statement; SG&A are period costs
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
117
4.5 Financial Statement Presentation
Income Statement Presentation of Costs for a Retailer
The merchandiser’s cost of goods sold is usually composed of the
purchase cost of items, including freight-in, that are acquired and
then resold.
Again, also retailers show SG&A expenses on their income
statements.
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
118
4.5 Financial Statement Presentation
Cost of Goods Sold Section of Income Statements
Manufacturer
Retailer or Wholesaler
Beginning finished goods
inventory
$4,000
Cost of goods manufactured:
Direct materials $20,000
Direct labor
$12,000
Indirect production $8,000 $40,000
Cost of goods available
for sale
$44,000
Less: Ending finished goods $8,000
Cost of goods sold (COGS) $36,000
Beginning merchandise
inventory
Purchases
Cost of goods available
for sale
Less: Ending merchandise
inventory
Cost of goods sold (COGS)
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
$4,000
$40,000
$44,000
$8,000
$36,000
119
4.6 Types of Costing Systems
Overview
▪ There are many different cost accounting systems, but most of
the important features of these systems can be described in
terms of two general types—traditional and activity-based cost
accounting systems.
▪ Companies adopt cost accounting systems that are consistent
with their management philosophies and their production and
operating technologies. Changes in philosophies or technologies
often prompt corresponding changes in cost accounting systems.
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
120
4.6 Types of Costing Systems
Traditional Costing System
Cell phone casings (Pen casings) require 500 (10%) vs. 4,500 (90%) direct labor hours
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 138.
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
121
4.6 Types of Costing Systems
ABC System
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 139.
Management Accounting and Decision Making
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122
4.7 Activity-Based Management
Overview (1/2)
▪ Activity-Based Management (ABM) is using the output of an
activity-based cost accounting system to aid strategic decision
making and to improve operational control
▪ A value-added cost is the cost of an activity that cannot be
eliminated without affecting a product’s value to the customer
▪ Nonvalue-added costs are costs that can be eliminated without
affecting a product’s value to the customer
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4.7 Activity-Based Management
Overview (2/2)
▪ Benchmarking is the continuous process of comparing products,
services, and activities to the best industry standards
▪ Benchmarks can come from within the organization, from
competing organizations, or from other organizations having
similar processes
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4.7 Activity-Based Management
Benefits of Activity-Based Costing and Management Systems
Companies adopt ABC systems to:
▪ set an optimal product mix
▪ estimate profit margins of new products
▪ determine consumption of shared resources
▪ keep pace with new product techniques
▪ keep pace with technological changes
▪ decrease costs associated with bad decisions
▪ take advantage of reduced cost of ABC
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4.8 Design of an Activity-Based Cost Accounting System
Overview
Determine the Key Components of the Activity-Based Cost
Accounting System:
▪ Cost objectives
▪ Key activities
▪ Resources
▪ Related cost drivers
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4.8 Design of an Activity-Based Cost Accounting System
Design of a Traditional Costing System
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 145.
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4.8 Design of an Activity-Based Cost Accounting System
Step 1
Determine the Key Components of the Activity-Based Cost
Accounting System:
Key Activity
Corresponding Cost Driver
Account billing
Bill verification
Account inquiry
Correspondence
Other activities
Number of printed pages
Number of accounts verified
Number of inquiries
Number of letters
Number of printed pages
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4.8 Design of an Activity-Based Cost Accounting System
Step 2
Determine relationships among cost objectives, activities, and
resources:
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 148.
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4.8 Design of an Activity-Based Cost Accounting System
Step 3
Collect relevant data concerning costs and the physical flow of the
cost-driver units among resources and activities:
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 149.
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4.8 Design of an Activity-Based Cost Accounting System
Step 4
Calculate and interpret the new activity-based information:
▪ Determine the traceable costs for each of the activity cost pools
▪ Determine the activity-based cost per account for each customer
class
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4.8 Design of an Activity-Based Cost Accounting System
Strategic Decisions, Operational Cost Control, and ABM
▪ Outsourcing
▪ Reducing operating costs
▪ Identifying nonvalue-added activities
▪ Improving both strategic and operational decisions
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4.8 Design of an Activity-Based Cost Accounting System
Example (1/3)
▪ Number of Cost Driver Units for the Billing Department (example
from slide 130)
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 149.
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4.8 Design of an Activity-Based Cost Accounting System
Example (2/3)
▪ Total traceable costs for the 5 activity cost pools:
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 150.
Management Accounting and Decision Making
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134
4.8 Design of an Activity-Based Cost Accounting System
Two-Stage Cost Allocation for Billing Department Operations
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 149.
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4.8 Design of an Activity-Based Cost Accounting System
Example (3/3)
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 151.
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Structure
Where we are
1. Managerial Accounting, the Business Organization and Professional
Ethics
2. Introduction to Cost Behavior and Cost-Volume-Profit Relationships
3. Measurement of Cost Behavior
4. Cost Management Systems and Activity-Based Costing
5. Relevant Information for Decision Making with a Focus on Operational
Decisions
6. Management Control Systems and Responsibility Accounting
Literature:
Horngren, C.T./Sundem, G. L./Burgstahler, D./Schatzberg J.:
Introduction to Management Accounting (2014), pp. 226-269.
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Structure
Where we are
5. Relevant Information for Decision Making with a Focus on Operational
Decisions
5.1
5.2
5.3
5.4
5.5
5.6
5.7
5.8
Opportunity, Outlay, and Differential Costs and Analysis
Make-or-Buy Decisions
Deletion or Addition of Products, Services, or Departments
Optimal Use of Limited Resources
Joint Product Costs
Equipment Replacement
Irrelevant or Misspecified Costs
Decision Making and Performance Evaluation
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5.1 Opportunity, Outlay, and Differential Costs and Analysis
Overview (1/3)
▪ Differential cost is the difference in total cost between two
alternatives.
▪ Differential revenue is the difference in total revenue between
two alternatives.
▪ A differential analysis is a decision process that compares
differential revenues and costs of alternatives.
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5.1 Opportunity, Outlay, and Differential Costs and Analysis
Overview (2/3)
▪ Incremental costs are additional costs or reduced benefits
generated by the proposed alternative.
▪ Incremental benefits are the additional revenues or reduced
costs generated by the proposed alternative.
▪ Analyzing the differential costs between the existing situation
and a proposed alternative is an incremental analysis.
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5.1 Opportunity, Outlay, and Differential Costs and Analysis
Overview (3/3)
▪ An outlay cost requires a cash disbursement.
▪ If there are many alternative uses of resources, an incremental
analysis can become cumbersome. Opportunity costs may be a
viable option.
▪ An opportunity cost is the maximum available benefit forgone
(or passed up) by using a resource that a company already owns
or that it has already committed to purchase for a particular
purpose.
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5.1 Opportunity, Outlay, and Differential Costs and Analysis
Example (1/4)
Nantucket Nectars has a machine for which it paid $100,000 and it is
sitting idle.
Nantucket Nectars has three alternatives:
1. Increase production of Peach juice
2. Sell the machine
3. Introduce and produce a new drink: Papaya Mango
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5.1 Opportunity, Outlay, and Differential Costs and Analysis
Example (2/4)
▪ Introducing Papaya Mango entails two types of costs, outlay costs
and opportunity costs.
▪ Outlay costs include costs for items such as materials and labor.
▪ Opportunity cost is the maximum available benefit forgone (or
passed up) by using such a resource for a particular purpose
instead of the best alternative use.
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5.1 Opportunity, Outlay, and Differential Costs and Analysis
Example (3/4)
1. Peach Juice Contribution margin is $60,000.
2. Sell machine for $50,000.
3. Produce Papaya Mango juice with projected sales of $500,000.
Suppose Nantucket Nectars will have total sales over the life cycle of
“Papaya Mango 100% Juice” of $500,000. The production and
marketing costs (outlay costs), excluding the cost of the machine,
are $400,000.
→ What is the net financial benefit from producing the Papaya
Mango?
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5.1 Opportunity, Outlay, and Differential Costs and Analysis
Example (4/4)
Revenues
Costs:
Outlay costs
Financial benefit before opportunity costs
Opportunity cost of machine
Net financial benefit
$500,000
$400,000
$100,000
$60,000
$40,000
→ Nantucket Nectars will gain $40,000 more financial benefit
using the machine to make Papaya Mango than it would make
using it for the next most profitable alternative.
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5.2 Make-or-Buy Decisions
Overview
▪ Managers often must decide whether to produce a product or
service within the firm or purchase it from an outside supplier.
▪ Purchasing products or services from an outside supplier is
sometimes referred to as outsourcing.
▪ Managers apply relevant cost analysis to a variety of outsourcing
decisions.
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5.2 Make-or-Buy Decisions
Example (1/3)
Nantucket Nectars Company’s Cost of Making 12-ounce Bottles
Direct material
Direct labor
Variable factory overhead
Fixed factory overhead
Total costs
$60,000
$20,000
$40,000
$80,000
$200,000
$.06
$.02
$.04
$.08
$.20
Another manufacturer offers to sell Nantucket Nectars the bottles
for $.18.
Should Nantucket Nectars make or buy the bottles?
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5.2 Make-or-Buy Decisions
Example (2/3)
▪ Perhaps Nantucket Nectars will eliminate $50,000 of fixed costs if
the company buys the bottles instead of making them. For
example, the company may be able to release a supervisor with a
$50,000 salary.
▪ If the company buys the bottles, $50,000 of fixed overhead would
be eliminated.
Should Nantucket make or buy the bottles?
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5.2 Make-or-Buy Decisions
Example (3/3)
Make
Purchase cost
Direct material
Direct labor
Variable overhead
Fixed OH avoided by
not making
Total relevant costs
Difference in favor
of making
Buy
Total
Per Bottle
$60,000
$20,000
$40,000
$.06
$.02
$.04
$50,000
$170,000
$.05
$.17
$10,000
$.01
Total
$180,000
0
$180,000
Per Bottle
$.18
0
$.18
*Note that unavoidable fixed costs of $80,000 – $50,000 = $30,000 are irrelevant.
These would also arise if the company buys (such as property taxes, insurance, etc.)
Thus, the irrelevant costs per unit are $.08 – $.05 = $.03.
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5.2 Make-or-Buy Decisions
Make or Buy and the Use of Facilities (1/2)
▪ Suppose Nantucket can use the released facilities in other
manufacturing activities to produce a contribution to profits of
$55,000, or can rent them out for $25,000.
→ What are the alternatives?
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5.2 Make-or-Buy Decisions
Make or Buy and the Use of Facilities (2/2)
Amounts in Thousands
Make
Rent revenue
Contribution from
other products
Variable cost of bottles
Net relevant costs
Buy and
Buy and use
leave Buy and facilities
facilities rent out for other
idle
facilities products
$ —
$ —
$ 25
$ —
$ —
$(170)
$(170)
$ —
$(180)
$(180)
$ —
$(180)
$(155)
$ 55
$(180)
$(125)
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5.3 Deletion or Addition of Products, Services, or Departments
Overview
▪ Often, existing businesses will want to expand or contract their
operations to improve profitability.
▪ Decisions to add or to drop products or whether to add or to
drop departments will use the same analysis: Examining all the
relevant costs and revenues.
▪ Relevant information plays an important role in decisions about
adding or deleting products, services, or departments.
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5.3 Deletion or Addition of Products, Services, or Departments
Avoidable and Unavoidable Costs
▪ Avoidable costs are costs that will not continue if an ongoing
operation is changed or deleted. Most avoidable costs are
variable, but some fixed costs may also be avoidable.
▪ Unavoidable costs are costs that continue even if an operation is
halted. Most unavoidable costs are fixed.
▪ Common costs are costs of facilities and services that are shared
by (multiple) users.
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5.3 Deletion or Addition of Products, Services, or Departments
Department Store Example (1/7)
Consider a department store that has three major departments:
▪ Groceries (food)
▪ General merchandise (non-food)
▪ Drugs
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5.3 Deletion or Addition of Products, Services, or Departments
Department Store Example (2/7)
*Amounts in Thousands
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 234.
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5.3 Deletion or Addition of Products, Services, or Departments
Department Store Example (3/7)
▪ Assume that the only alternatives to be considered are dropping
or continuing the grocery department, which has consistently
shown an operating loss.
▪ Assume further that the total assets invested would be
unaffected by the decision.
▪ The vacated space would be idle and the unavoidable costs
would continue.
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5.3 Deletion or Addition of Products, Services, or Departments
Department Store Example (4/7)
*Amounts in Thousands
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 235.
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5.3 Deletion or Addition of Products, Services, or Departments
Department Store Example (5/7)
▪ Assume that the store could use the space made available by the
dropping of groceries to expand the general merchandise
department.
▪ This will increase sales by $500,000, generate a 30% contribution
margin, and have avoidable fixed costs of $70,000.
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5.3 Deletion or Addition of Products, Services, or Departments
Department Store Example (6/7)
*Amounts in Thousands
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 235.
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5.3 Deletion or Addition of Products, Services, or Departments
Department Store Example (7/7)
▪ Nonfinancial information can influence decisions to add or delete
products or departments, too.
▪ When deciding to delete a product or to close a plant, there are
ethical considerations.
▪ How will the decision affect:
 Employees?
 Customers?
 Community?
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5.4 Optimal Use of Limited Resources
Overview
▪ A limiting factor or scarce resource restricts or constrains the
production or sale of a product or service.
▪ Limiting factors include labor hours and machine hours that limit
production (and hence sales) in manufacturing firms and square
feet of floor space or cubic meters of display space that limit
sales in department stores.
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5.4 Optimal Use of Limited Resources
Nike Example (1/4)
▪ Nike produces the Air Court tennis shoe and the Air Max running
shoe. Assume that one factory is the only facility that produces
the shoes, and Nike managers must decide how many shoes of
each type to produce.
▪ Machine time is the measure of capacity in this factory, and there
is a maximum of 10,000 hours of machine time. The factory can
produce 10 pairs of Air Court shoes or 5 pairs of Air Max shoes in
1 hour of machine time.
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5.4 Optimal Use of Limited Resources
Nike Example (2/4)
Which is more profitable?
Air Court
Selling price per pair
Variable costs per pair
Contribution margin per pair
Contribution margin ratio
$80
$60
$20
25%
Air Max
$120
$84
$36
30%
→ If the limiting factor is demand, that is, pairs of shoes, the more
profitable product is Air Max.
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5.4 Optimal Use of Limited Resources
Nike Example (3/4)
▪ Suppose that demand for either shoe would exceed the plant’s
capacity. Now, capacity is the limiting factor.
▪ Which is more profitable?
→ If the limiting factor is capacity, the more profitable product is Air
Court.
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5.4 Optimal Use of Limited Resources
Nike Example (4/4)
Air Court:
Contribution margin per pair ($20) × 10 pairs/hour × 10,000 hours
= $2,000,000 contribution
Air Max:
Contribution margin per pair ($36) × 5 pairs/hour × 10,000 hours
= $1,800,000 contribution
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5.4 Optimal Use of Limited Resources
Retail Store (1/2)
▪ In retail stores, the limiting factor is often floor space. The focus
is on products taking up less space or on using the space for
shorter periods of time.
▪ Retail stores seek faster inventory turnover (the number of times
the average inventory is sold per year).
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5.4 Optimal Use of Limited Resources
Retail Store (2/2)
Faster inventory turnover makes the same product a more profitable
use of space in a discount store.
Regular
Department
Store
Retail Price
Costs of merchandise and other variable costs
Contribution to profit per unit
Units sold per year
Total contribution to profit, assuming the
same space allotment in both stores
Discount
Department
Store
$4.00
$3.00
$1.00 (25%)
10,000
$3.50
$3.00
$.50 (14%)
22,000
$10,000
$11,000
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5.5 Joint Product Costs
Overview (1/2)
▪ Joint products have relatively significant sales values.
▪ They are not separately identifiable as individual products until
their split-off point.
▪ The split-off point is that juncture of manufacturing where the
joint products become individually identifiable.
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5.5 Joint Product Costs
Overview (2/2)
▪ Separable costs are any costs beyond the split-off point.
▪ Joint costs are the costs of manufacturing joint products before
the split-off point.
▪ Examples of joint products include chemicals, lumber, flour, and
the products of petroleum refining.
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5.5 Joint Product Costs
Example (1/2)
▪ Suppose Dow Chemical Company produces two chemical
products, X and Y, as a result of a particular joint process.
▪ The joint processing cost is $100,000.
▪ Both products are sold to the petroleum industry to be used as
ingredients of gasoline.
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5.5 Joint Product Costs
Example (2/2)
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 238.
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5.5 Joint Product Costs
Illustration of Sell or Process Further (1/2)
▪ Suppose the 500,000 liters of Y can be processed further and sold
to the plastics industry as product YA.
▪ The additional processing cost would be $.08 per liter for
manufacturing and distribution, a total of $40,000.
▪ The net sales price of YA would be $.16 per liter, a total of
$80,000.
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5.5 Joint Product Costs
Illustration of Sell or Process Further (2/2)
Sell at
Split-off
as Y
Revenues
Separable costs
beyond split-off
at $.08
Income effects
Process
Further and
Sell as YA
Difference
$30,000
$80,000
$50,000
–
$30,000
$40,000
$40,000
$40,000
$10,000
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5.6 Equipment Replacement
Overview
The book value of equipment is not a relevant consideration in
deciding whether to replace the equipment.
Why?
→ Because it is a past, not a future cost.
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5.6 Equipment Replacement
Book Value of Old Equipment (1/2)
▪ Depreciation is the periodic allocation of the cost of equipment.
▪ Accumulated depreciation is the sum of all depreciation charged
to past periods.
▪ The equipment’s book value (or net book value) is the original
cost less accumulated depreciation.
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5.6 Equipment Replacement
Book Value of Old Equipment (2/2)
▪ Suppose a $10,000 machine with a 10-year life span has
depreciation of $1,000 per year.
▪ What is the book value at the end of 6 years?
Original cost
Accumulated depreciation (6 × $1,000)
Book value
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
$10,000
$6,000
$4,000
176
5.6 Equipment Replacement
Keep or Replace the Old Machine?
Old Machine
Original cost
Useful life in years
Current age in years
Useful life remaining in years
Accumulated depreciation
Book value
Disposal value (in cash) now
Disposal value in 4 years
Annual cash operating costs
Replacement Machine
$10,000
10
6
4
$6,000
$4,000
$2,500
0
$5,000
Management Accounting and Decision Making
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$8,000
4
0
4
0
N/A
N/A
0
$3,000
177
5.6 Equipment Replacement
Relevance of Equipment Data (1/2)
▪ A sunk cost is a cost already incurred and is irrelevant to the
decision-making process.
▪ 4 commonly encountered items:




Book value of old equipment
Disposal value of old equipment
Gain or loss on disposal
Cost of new equipment
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5.6 Equipment Replacement
Relevance of Equipment Data (2/2)
▪ The book value of old equipment is irrelevant because it is a past
(historical) cost. Therefore, depreciation on old equipment is
irrelevant.
▪ The disposal value of old equipment is relevant because it is an
expected future inflow that usually differs among alternatives.
▪ The cost of new equipment is relevant because it is an expected
future outflow that will differ among alternatives.
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5.6 Equipment Replacement
Gain or Loss on Disposal
▪ This is the difference between book value and disposal value.
▪ It is a meaningless combination of irrelevant (book value) and
relevant items (disposal value).
▪ It is best to think of each separately.
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180
5.6 Equipment Replacement
Cost Comparison
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 241.
Management Accounting and Decision Making
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181
5.7 Irrelevant or Misspecified Costs
Overview
The ability to recognize irrelevant costs is important to decision
makers.
▪ Cost of obsolete inventory
▪ Book value of old equipment
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5.7 Irrelevant or Misspecified Costs
1st Example (1/2)
▪ Suppose General Dynamics has 100 obsolete aircraft parts in its
inventory.
▪ The original manufacturing cost of these parts was $100,000.
▪ General Dynamics can repurpose (remachine) the parts for
$30,000 and then sell them for $50,000, or scrap them for
$5,000.
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5.7 Irrelevant or Misspecified Costs
1st Example (2/2)
Expected future revenue
Expected future costs
Relevant excess of
revenue over costs
Accumulated historical
inventory cost*
Net loss on project
Remachine
$50,000
$30,000
Scrap
$5,000
$0
Difference
$45,000
$30,000
$20,000
$5,000
$15,000
$100,000
$(80,000)
$100,000
$(95,000)
$0
$15,000
* Irrelevant because it is unaffected by the decision.
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5.7 Irrelevant or Misspecified Costs
Possible Errors
There are two major ways to go wrong when using unit costs in
decision making:
1. including irrelevant costs
2. comparing unit costs not computed on the same volume basis
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5.7 Irrelevant or Misspecified Costs
2nd Example (1/4)
Assume that a new $100,000 machine with a five-year useful life
can produce 100,000 units per year at a variable cost of $1 per unit,
as opposed to a variable cost per unit of $1.50 with an old machine
(which is fully written-off).
Is the new machine a worthwhile acquisition?
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5.7 Irrelevant or Misspecified Costs
2nd Example (2/4)
Units
Variable cost
Straight-line depreciation
Unit relevant costs
Old Machine
100,000
$150,000
$0
$1.50
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
New Machine
100,000
$100,000
$20,000
$1.20
187
5.7 Irrelevant or Misspecified Costs
2nd Example (3/4)
▪ It appears that the new machine will reduce costs by $.30 per
unit.
▪ However, if the expected volume is only 30,000 units per year,
the unit costs change in favor of the old machine.
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5.7 Irrelevant or Misspecified Costs
2nd Example (4/4)
Units
Variable costs
Straight-line depreciation
Total relevant costs
Unit relevant costs
Old Machine
30,000
$45,000
0
$45,000
$1.50
Management Accounting and Decision Making
Prof. Dr. Thomas Loy
New Machine
30,000
$30,000
$20,000
$50,000
$1.6667
189
5.8 Decision Making and Performance Evaluation
Overview
▪ To motivate managers to make the right choice, the method used
to evaluate performance should be consistent with the decision
model.
▪ Consider the replacement decision where replacing a machine
has a $2,500 advantage over keeping it (s. slide 181).
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5.8 Decision Making and Performance Evaluation
Example (1/2)
Year 1
Cash operating
costs
Depreciation
Loss on disposal
($4,000 – $2,500)
Total charges
against revenue
Keep
Replace
Years 2, 3, and 4
Keep
Replace
$5,000
$1,000
$3,000
$2,000
$5,000
$1,000
$3,000
$2,000
$0
$1,500
$0
$0
$6,000
$6,500
$6,000
$5,000
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5.8 Decision Making and Performance Evaluation
Example (2/2)
▪ Performance is often measured by accounting income, consider
the accounting income in the first year after replacement
compared with that in years 2, 3, and 4.
▪ If the machine is kept rather than replaced, first-year costs will be
$500 lower ($6,500 – $6,000), and first-year income will be $500
higher.
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Structure
Where we are
1. Managerial Accounting, the Business Organization and Professional
Ethics
2. Introduction to Cost Behavior and Cost-Volume-Profit Relationships
3. Measurement of Cost Behavior
4. Cost Management Systems and Activity-Based Costing
5. Relevant Information for Decision Making with a Focus on Operational
Decisions
6. Management Control Systems and Responsibility Accounting
Literature:
Horngren, C.T./Sundem, G. L./Burgstahler, D./Schatzberg J.:
Introduction to Management Accounting (2014), pp. 352-389.
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Structure
Where we are
6. Management Control Systems and Responsibility Accounting
6.1
6.2
6.3
6.4
6.5
Management Control Systems
Evaluating Performance
Developing Performance Measures
Responsibility Centers
Performance Measures
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6.1 Management Control Systems
Overview
Management Control System:
An integrated set of techniques for gathering and using information
to make planning and control decisions, for motivating employee
behavior, and for evaluating performance. It also facilitates
forecasting and budgeting.
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6.1 Management Control Systems
Planning and Control
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 354.
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6.1 Management Control Systems
Key Success Factors
▪ Key Success Factors are characteristics or attributes that
managers must achieve in order to drive the organization toward
its goals.
▪ Goals provide a long-term framework around which an
organization will form its comprehensive plan for positioning
itself in the market.
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6.1 Management Control Systems
Translating Goals and Objectives into Performance Measures
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 355.
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6.2 Evaluating Performance
Goal Congruence, Managerial Effort and Motivation
▪ Good management control systems foster goal congruence and
managerial effort.
▪ Goal congruence is achieved when employees, working in their own
perceived best interests, make decisions that help meet the overall
goals of the organization.
▪ To be effective, goal congruence must be accompanied by managerial
effort.
▪ Managerial effort is exertion toward a goal or objective, including all
conscious actions (such as supervising, planning, and thinking) that
result in more efficiency and effectiveness.
▪ Motivation is a drive toward some selected goal:
✓ It creates effort.
✓ It creates action toward that goal.
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6.3 Developing Performance Measures
Overview
▪ Effective performance measurement requires multiple
performance measures, both financial and nonfinancial.
▪ Effective performance measures will:
1. Reflect key actions and activities that relate to the organization’s
goals
2. Be affected by actions of managers and employees
3. Be readily understood by employees
4. Be reasonably objective and easily measured
5. Be used consistently and regularly to evaluate and reward
6. Balance long-term and short-term concerns
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6.3 Developing Performance Measures
Financial Measures of Performance
▪ Financial measures are often lagging indicators that arrive too
late:
 Operating Budgets
 Profit Targets
 Profit Targets
▪ Often the effects of poor nonfinancial performance do not show
up in the financial measures until considerable ground has been
lost.
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6.3 Developing Performance Measures
Nonfinancial Measures of Performance
▪ Nonfinancial measures often motivate employees toward
achieving important performance goals.
▪ AT&T Universal Card Services uses 18 Performance measures for
its customer inquiries process.
▪ These measures include average speed of answer, abandon rate,
and application processing time.
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6.3 Developing Performance Measures
Monitoring and Reporting Results
▪ Feedback and learning are at the center of the management
control system.
▪ At all points in the planning and control process, it is vital that
effective communication exists among all levels of management
and employees.
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6.3 Developing Performance Measures
A Successful Organization and Measures of Achievement
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 358.
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6.3 Developing Performance Measures
Controllability & Measurement of Financial Performance (1/2)
Management Control System (MCS)
Controllable events
Uncontrollable events
Controllable costs
Uncontrollable costs
▪ An uncontrollable cost is any cost that cannot be affected by the
management of a responsibility center within a given time span.
▪ Controllable costs include all costs that a manager’s decisions
and actions can influence.
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6.4 Responsibility Centers
Overview
▪ A responsibility center is a set of activities assigned to a
manager, a group of managers, or other employees.
▪ System designers apply responsibility accounting to identify what
part of the organization has responsibility for each action.
▪ We identify a range of possible responsibility centers:
 Cost centers
 Profit centers
 Investment Centers
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6.4 Responsibility Centers
Cost Centers
▪ In a cost center, managers are responsible for costs only. A cost
center may encompass an entire department, or a department
may contain several cost centers.
▪ The determination of the number of cost centers depends on
cost-benefit considerations—do the benefits exceed the higher
costs of reporting?
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6.4 Responsibility Centers
Profit Centers
▪ Profit-center managers are responsible for controlling revenues
as well as costs—that is, profitability.
▪ Profit centers also exist in nonprofit organizations, despite the
name, (though it might not be referred to as such) when a
responsibility center receives revenues for its services.
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6.4 Responsibility Centers
Investment Centers
▪ An investment center adds responsibility for investment to
profit-center responsibilities. Investment center success depends
on both income and invested capital, measured by relating
income generated to the value of the capital employed.
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6.4 Responsibility Centers
Contribution Margin
▪ The contribution margin is especially helpful for predicting the
impact on income of short-run changes in activity volume.
▪ Managers may quickly calculate any expected changes in income
by multiplying increases in dollar sales by the contribution margin
ratio.
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6.4 Responsibility Centers
Contribution Controllable by Segment Managers
▪ Managers help explain the total segment contribution, but they
are responsible only for the controllable contribution.
▪ Controllable fixed costs are deducted from the contribution
margin to obtain the contribution controllable by segment
managers.
▪ Controllable costs are usually discretionary fixed costs such as
local advertising and some salaries, but not the manager’s salary.
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6.5 Performance Measures
Overview
Many organizations, in recent years, have developed an awareness
of the importance of controlling aspects of nonfinancial
performance measures:
1.
Quality Control
Nonfinancial
Performance Measures
3.
2.
Productivity
Cycle Time
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6.5 Performance Measures
1.
Quality Control
Quality Control
Nonfinancial
Performance Measures
3.
2.
Productivity
Cycle Time
▪ Quality control is the effort to ensure that products and services
perform to customer requirements.
▪ The traditional approach to controlling quality in the U. S. was to
inspect products after completing them and reject or rework
those that failed the inspections.
▪ Because testing is expensive, companies often inspected only a
sample of products.
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6.5 Performance Measures
1.
Quality Control
Cost of Quality Report
Four categories of quality costs:
Nonfinancial
Performance Measures
3.
2.
Productivity
Cycle Time
▪ Prevention costs are the costs incurred to prevent the production
of defective products or delivery of substandard services.
▪ Appraisal costs are the costs incurred to identify defective
products or services.
▪ Internal failure costs are the costs of defective components and
final products or services that are scrapped or reworked.
▪ External failure costs are the costs caused by delivery of
defective products or services to customers, such as field repairs,
returns, and warranty expenses.
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6.5 Performance Measures
1.
Quality Control
Total Quality Management (TQM)
Nonfinancial
Performance Measures
3.
2.
Productivity
Cycle Time
▪ Total quality management (TQM) focuses on prevention of
defects and on achievement of customer satisfaction.
▪ The TQM approach assumes an organization minimizes the cost
of quality when it achieves high quality levels.
▪ TQM is the application of quality principles to all the
organization’s efforts to satisfy customers.
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6.5 Performance Measures
1.
Quality Control
Quality-Control Chart (1/2)
Nonfinancial
Performance Measures
3.
2.
Productivity
Cycle Time
▪ The quality-control chart is a statistical plot of measures of
various product dimensions or attributes.
▪ This plot helps detect process deviations before the process
generates defects.
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6.5 Performance Measures
1.
Quality Control
Quality-Control Chart (2/2)
Nonfinancial
Performance Measures
3.
2.
Productivity
Cycle Time
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 368.
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6.5 Performance Measures
1.
Quality Control
Six Sigma
Nonfinancial
Performance Measures
3.
2.
Productivity
Cycle Time
▪ Six Sigma is a continuous process-improvement effort designed
to reduce costs by improving quality.
▪ It has broadened into a general process to define and measure a
process, analyze it, and improve it to minimize errors.
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6.5 Performance Measures
1.
Quality Control
Control of Cycle Time
Nonfinancial
Performance Measures
3.
2.
Productivity
Cycle Time
▪ Cycle time, or throughput time, is the time taken to complete a
product or service, or any of the components of a product or
service.
▪ The longer a product or service is in process, the more costs it
consumes.
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6.5 Performance Measures
1.
Quality Control
Control of Productivity (1/2)
Nonfinancial
Performance Measures
3.
2.
Productivity
Cycle Time
▪ Productivity is a measure of outputs divided by inputs.
𝐎𝐮𝐭𝐩𝐮𝐭𝐬
𝐏𝐫𝐨𝐝𝐮𝐜𝐭𝐢𝐯𝐢𝐭𝐲 =
𝐈𝐧𝐩𝐮𝐭𝐬
▪ Productivity measures vary widely according to the type of
resource with which management is concerned.
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6.5 Performance Measures
1.
Quality Control
Control of Productivity (2/2)
Nonfinancial
Performance Measures
3.
2.
Productivity
Cycle Time
▪ How should outputs and inputs be measured?
▪ Labor-intensive organizations are concerned with increasing the
productivity of labor, so labor-based measures are appropriate.
▪ Highly automated companies focus on machine use and
productivity of capital investments, so capacity-based measures
are available.
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6.5 Performance Measures
1.
Quality Control
Measures of Productivity
Nonfinancial
Performance Measures
3.
2.
Productivity
Cycle Time
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 369.
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Structure
Where we are
7. Management Control in Decentralized Organizations
8. Capital Budgeting
9. Cost Allocation
Literature:
Horngren, C.T./Sundem, G. L./Burgstahler, D./Schatzberg J.:
Introduction to Management Accounting (2014), pp. 390-433.
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Structure
Where we are
7. Management Control in Decentralized Organizations
7.1
7.2
7.3
7.4
7.5
Decentralization
Responsibility Centers and Decentralization
Performance Metrics and Management Controls
Measures of Profitability
Transfer Prices
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7.1 Decentralization
Overview
▪ The delegation of freedom to make decisions is called
decentralization.
▪ The process by which decision making is concentrated within a
particular location or group is called centralization.
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7.1 Decentralization
Costs and Benefits (1/2)
Benefits of decentralization:
▪ Lower-level managers have the best information concerning local
conditions
▪ It promotes management skills which, in turn, helps ensure
leadership continuity
▪ Managers enjoy higher status from being independent and thus
are better motivated
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7.1 Decentralization
Costs and Benefits (2/2)
(Potential) costs of decentralization:
▪ Managers may make decisions that are not in the organization’s
best interests
▪ Managers also tend to duplicate services that might be less
expensive if centralized
▪ Costs of accumulating and processing information frequently rise
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7.1 Decentralization
Middle Ground
▪ Many companies find that decentralization works best in part of
the company, while centralization works better in other parts.
▪ Decentralization is most successful when an organization’s
segments are relatively independent of one another.
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7.1 Decentralization
Segment Autonomy
▪ If management has decided in favor of heavy decentralization,
segment autonomy, the delegation of decision-making power to
managers of segments of an organization, is also crucial.
▪ For decentralization to work, autonomy must be real, not just “lip
service.” Top managers must be willing to abide by decisions
made by segment managers in most circumstances.
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7.2 Responsibility Centers and Decentralization
Overview (1/2)
Design of a management control system should consider two
separate dimensions of control:
1. Responsibilities
2. Autonomy
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7.2 Responsibility Centers and Decentralization
Overview (2/2)
Profit centers
Cost centers
▪ Will a profit center or a cost center better solve the problems of goal
congruence and management effort?
▪ In designing accounting control systems, top managers must consider
the system’s impact on behavior desired by the organization.
▪ The management control system should be designed to achieve the
best possible alignment between local manager decisions and the
actions central management seeks.
▪ For example, a plant may seem to be a “natural” cost center because
the plant manager has no influence over decisions concerning the
marketing of its products.
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7.3 Performance Metrics and Management Controls
Overview
▪ Linking rewards to responsibility-center performance metrics
affects incentives and risk.
▪ Incentives are the rewards, both implicit and explicit, for
managerial effort and actions.
▪ A performance metric is a specific measure of management
accomplishment.
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7.3 Performance Metrics and Management Controls
Motivation, Performance, and Rewards
Incentives
Performance-based rewards that
enhance managerial effort toward
organizational goals.
Motivational
Criteria
Rewards
▪ You get what you measure!
▪ Therefore, accounting measures, which provide relatively objective
evaluations of performance, are important.
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7.3 Performance Metrics and Management Controls
Management Control System Design
The design of a management control system affects the actions of
managers. It specifies how outcomes translate into unit performance metrics and into both explicit and implicit rewards.
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 394.
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7.3 Performance Metrics and Management Controls
Agency Theory (1/2)
▪ Agency theory provides a model to analyze relationships where
one party (the principal) delegates decision-making authority to
another party (the agent).
▪ Agency theory is useful to analyze situations where there is
imperfect alignment between the principal’s and agent’s
1. Information and
2. Objectives.
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7.3 Performance Metrics and Management Controls
Agency Theory (2/2)
▪ Agency theory deals with contracting between an organization
and the managers that it hires to make decisions on its behalf.
▪ 3 Factors:
 Incentive(s)
 Risk(s)
 Cost of measuring performance
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7.4 Measures of Profitability
Overview
▪ Measures of income are readily available from the financial
reporting system at any level of the organization for which a
company can identify revenues and expenses.
▪ Accountants can easily customize income measures such as
income before interest and taxes (EBIT) or earnings before
interest, taxes, depreciation, and amortization (EBITDA).
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7.4 Measures of Profitability
Return on Investment
▪ A more comprehensive measure of profitability that takes into
account the investment required to generate income is the return
on investment (ROI).
Income
ROI =
Invested Capital
Income
Revenue
ROI =
∗
Revenue Invested Capital
ROI = Return on Sales ∗ Capital Turnover
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7.4 Measures of Profitability
Valuation of Assets (1/3)
▪ Should values be based on gross book value (original cost) or net
book value (original cost less accumulated depreciation)?
▪ Practice is overwhelmingly in favor of using net book value based
on historical cost.
▪ Most companies use net book value in calculating their
investment base.
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7.4 Measures of Profitability
Valuation of Assets (2/3)
▪ Asset values: beginning, ending, or average
▪ If investment does not change throughout the year, it will not
matter whether assets are measured at the beginning, the end,
or average for the year.
▪ If investment changes throughout the year, we should measure
invested capital as an average for the period.
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7.4 Measures of Profitability
Valuation of Assets (3/3)
▪ Why the measurement of the invested capital as an average if
there are changes in investment?
→ Because income is a flow of resources over a period of time, and
a company should measure the effect of the flow on the average
amount invested.
▪ The most accurate measures of average investment take into
account the amount invested month-by-month, or even day-byday.
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7.4 Measures of Profitability
Economic Profit (Residual Income)
▪ Economic Profit, also called Residual Income (RI), is defined as
net operating profit after-tax (NOPAT) less a capital charge.
▪ Net operating profit after-tax (NOPAT) is income before interest
expense but after tax.
▪ Capital charge is the cost of capital multiplied by the average
invested capital.
▪ Economic Profit tells you how much a company’s after-tax
operating income exceeds the cost of capital employed to
generate that income.
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7.4 Measures of Profitability
Economic Value Added (EVA)
Economic Value added (EVA) =
adjusted NOPAT – (weighted average cost of capital ×
adjusted average invested capital)
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7.5 Transfer Prices
Overview
▪ The price that one segment charges another segment of the
same organization for a product or service is a transfer price.
▪ When one segment of a company produces and sells an item to
another segment, a transfer price is required.
▪ The transfer price is revenue to the producing company and cost
to the acquiring segment.
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7.5 Transfer Prices
Purpose of Transfer Pricing
▪ A company wants profitability metrics that reward the segment
manager for decisions that increase both a segment’s profitability
and the profitability of the entire company.
▪ Transfer prices should guide managers to make the best possible
decisions regarding whether to buy or sell products inside or
outside of the company.
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7.5 Transfer Prices
General Rule
Transfer price = Outlay cost + Opportunity cost
▪ Outlay costs require a cash disbursement. They are essentially
the additional amount the producing segment must pay to
produce the product or service.
▪ Opportunity cost is the contribution to profit that the producing
segment forgoes by transferring the item internally.
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7.5 Transfer Prices
Transfer-Pricing Systems
▪ Transfer-pricing systems have multiple goals. The general rule
provides a good benchmark by which to judge transfer pricing
systems.
▪ Popular transfer-pricing systems:
1. Market-Based Transfer Prices
2. Cost-Based Transfer Prices
a. Variable-Cost
b. Full-Cost (possibly plus profit)
3. Negotiated transfer prices
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7.5 Transfer Prices
Market-Based Transfer Prices
▪ Common Maxim: If a market price exists, use it.
▪ If there is a competitive market for the product or service being
transferred internally, using the market price as a transfer price
will generally lead to goal congruence because the market price
equals the variable cost plus opportunity cost.
▪ Sometimes market prices are not always available for items
transferred internally.
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7.5 Transfer Prices
Cost-Based Transfer Prices
▪ When market prices don’t exist, companies resort to cost-based
transfer prices.
▪ Cost-based transfer prices are easy to understand and use.
▪ BUT Cost-based transfer prices can lead to dysfunctional
decisions - decisions in conflict with the company’s goals.
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7.5 Transfer Prices
Cost-Based Transfer Prices (Variable-Cost)
▪ This transfer pricing system is most appropriate when the selling
division forgoes no opportunity when it transfers the item
internally.
▪ Variable-cost transfer prices cause dysfunctional decisions when
the selling segment has significant opportunity costs.
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7.5 Transfer Prices
Cost-Based Transfer Prices (Full-Cost)
▪ This transfer pricing system includes not only variable cost but
also an allocation of fixed costs (and, if included, the profit markup.) It is implicitly assumed that the allocation is a good
approximation of the opportunity cost.
▪ Dysfunctional decisions arise with full-cost transfer prices when
the selling segment has opportunity costs that differ significantly
from the allocation of fixed costs and profit.
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7.5 Transfer Prices
Negotiated Transfer Prices
▪ Companies heavily committed to segment autonomy often allow
managers to negotiate transfer prices.
▪ Open negotiation allows the managers to make optimal
decisions.
▪ Critics of negotiated prices focus on the time and effort spent
negotiating, an activity that adds nothing directly to the profits of
the company.
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7.5 Transfer Prices
Overview Multinational Transfer Pricing (1/2)
▪ Multinational companies use transfer pricing to minimize their
worldwide taxes, duties, and tariffs.
▪ Divisions in a high-income-tax-rate country produce components
for another division in a low-income-tax-rate country. A low
transfer price would allow the company to recognize most of the
profit in the low-income-tax-rate country, thereby minimizing
taxes.
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7.5 Transfer Prices
Overview Multinational Transfer Pricing (2/2)
▪ Tax authorities also recognize the incentive to set transfer prices
to minimize taxes and import duties. Therefore, most countries
have restrictions on allowable transfer prices.
▪ U.S. multinationals must follow an Internal Revenue Code rule
specifying that transfers be priced at “arm’s-length” market
values, or at the price one division would pay another if they
were independent companies.
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7.5 Transfer Prices
Example (1/2)
A high-end running shoe produced by an Irish Nike division with a
12% income tax rate.
It is transferred to a division in Germany with a 40% income tax rate.
An import duty equal to 20% of the price of the item is imposed by
Germany.
Full unit cost is $100, and variable cost is $60 (either transfer price
could be chosen).
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7.5 Transfer Prices
Example (2/2)
Income of the Irish division is $40 higher:
12% × $40 = ($4.80) higher taxes
Income of the German division is $40 lower:
40% × $40 = $16 lower taxes
Import duty paid by German division:
20% × $40 = ($8)
Net savings = $3.20
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Structure
Where we are
7. Management Control in Decentralized Organizations
8. Capital Budgeting
9. Cost Allocation
Literature:
Horngren, C.T./Sundem, G. L./Burgstahler, D./Schatzberg J.:
Introduction to Management Accounting (2014), pp. 434-479.
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Structure
Where we are
8. Capital Budgeting
8.1
8.2
8.3
8.4
8.5
8.6
8.7
Capital Budgeting
Sensitivity Analysis
Comparison of Two Projects
Relevant Cash Flows for Net Present Values (NPV)
Income Taxes and Capital Budgeting
Gains or Losses on Disposal
Other Models for Analyzing Long-Range Decisions
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8.1 Capital Budgeting
Overview
Capital budgeting describes the long-term planning for making and
financing major long-term projects.
1. Identify potential investments.
2. Choose an investment.
3. Follow-up or “post audit.”
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8.1 Capital Budgeting
Discounted-Cash-Flow Models
▪ Discounted-Cash-Flow (DCF) Models focus on a project’s cash
inflows and outflows while taking into account the time value of
money.
▪ They compare the value of today’s cash outflows with the value
of the future cash inflows.
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8.1 Capital Budgeting
Net Present Value Model
▪ The net-present-value (NPV) method computes the present
value of all expected future cash flows using a minimum desired
rate of return.
▪ The minimum desired rate of return depends on the risk-the
higher the risk, the higher the rate.
▪ The required rate of return (also called hurdle rate or discount
rate) is the minimum desired rate of return based on the firm’s
cost of capital.
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8.1 Capital Budgeting
Applying the NPV Method
1. Identify the amount and timing of relevant expected cash
inflows and outflows.
2. Find the present value of each expected cash inflow or outflow.
3. Sum the individual present values.
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8.1 Capital Budgeting
NPV Example (1/2)
Original investment (cash outflow): $5,827
Useful life: 4 years
Annual income generated from the
investment (cash inflow): $2,000
Minimum desired rate of return: 10%
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8.1 Capital Budgeting
NPV Example (2/2)
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 436.
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8.1 Capital Budgeting
Assumptions of the NPV Model
Two Major Assumptions
▪ World of certainty:
Predicted cash flows occur at times specified.
▪ There are perfect capital markets:
Money can be borrowed or loaned at the same interest rate.
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8.1 Capital Budgeting
Decision Rules
▪ Managers determine the sum of the present values of all
expected cash flows from the project.
▪ If the sum of the present values is positive, the project is
desirable.
▪ If the sum of the present values is negative, the project is
unattractive.
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8.1 Capital Budgeting
Internal Rate of Return Model
▪ The Internal Rate of Return Model (IRR) determines the interest
rate at which the NPV equals zero.
▪ If IRR > minimum desired rate of return, then NPV > 0 and accept
the project.
▪ If IRR < minimum desired rate of return, then NPV < 0 and reject
the project.
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8.2 Sensitivity Analysis
Overview
▪ Sensitivity analysis shows the financial consequences that would
occur if actual cash inflows and outflows differ from those
expected.
▪ Managers often use sensitivity analysis to deal with uncertainty,
to answer the what-if questions.
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8.2 Sensitivity Analysis
Example (1/2)
▪ Suppose that a manager knows that the actual cash inflows in the
previous example could fall below the predicted level of $2,000.
▪ How far below $2,000 must the annual cash inflow drop before
the NPV becomes negative?
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8.2 Sensitivity Analysis
Example (2/2)
Follow-up example from Slide 264 (solvable only with annuity table
method or e.g. Microsoft Excel):
(3.1699 × Cash flow) – $5,827 = 0
Cash flow = $5,827 ÷ 3.1699 = $1,838
If the annual cash flow is less than $1,838, the NPV is negative, and
the project should be rejected.
Annual cash inflows can drop only $2,000 – $1,838 = $162 or 8.1%
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8.3 Comparison of Two Projects
Overview
Two common methods for comparing alternatives are:
▪ Total project approach
▪ Differential approach
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8.3 Comparison of Two Projects
Total Project Approach
▪ The Total Project Approach computes the total impact on cash
flows for each alternative and then converts these total cash
flows to their present values.
▪ The alternative with the largest NPV of total cash flows is best.
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8.3 Comparison of Two Projects
Differential Approach
▪ The Differential Approach computes the differences in cash flows
between alternatives and then converts these differences to their
present values.
▪ This method cannot be used to compare more than two
alternatives.
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8.4 Relevant Cash Flows for NPV
Overview
Three types of inflows and outflows should be considered when the
relevant cash flows are arrayed:
1. Initial cash inflows and outflows at time zero
2. Future disposal values
3. Operating cash flows
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8.4 Relevant Cash Flows for NPV
Operating Cash Flows
▪ The only relevant cash flows are those that will differ among
alternatives.
▪ Fixed overhead can be ignored.
▪ A reduction in cash outflow is treated the same as a cash inflow.
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8.5 Income Taxes and Capital Budgeting
Overview
▪ Another type of cash flow that must be considered when making
capital-budgeting decisions is after-tax cash flows.
▪ In capital budgeting, the relevant tax rate is the marginal income
tax rate.
▪ This is the tax rate paid on incremental taxable income.
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8.5 Income Taxes and Capital Budgeting
Effects of Depreciation Deductions (1/3)
▪ Depreciation expense is a noncash expense and is ignored for
capital budgeting, except that it is an expense for tax purposes
and will provide a cash inflow from income tax savings.
▪ Organizations that pay income taxes usually keep two sets of
books one set that follows the rules for financial reporting and
one that follows the tax rules, a practice that is not illegal or
immoral – it is necessary.
▪ Sometimes (or for some assets) tax authorities allow accelerated
depreciation.
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8.5 Income Taxes and Capital Budgeting
Effects of Depreciation Deductions (2/3)
Assume the following:
Cash inflow from operations: $60,000
Tax rate: 40%
What is the after-tax inflow from operations?
$60,000 × (1 – tax rate) = $60,000 × .6 = $36,000
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8.5 Income Taxes and Capital Budgeting
Effects of Depreciation Deductions (3/3)
What is the after-tax effect of $25,000 depreciation expenses?
$25,000 × 40% = $10,000 tax savings
The depreciation deduction reduces taxes, and thereby increases cash
flows, by $10,000 annually.
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8.6 Gains or Losses on Disposal
Overview (1/3)
▪ The disposal of equipment for cash can also affect income taxes.
▪ Suppose a piece of equipment with a useful life of 5 years,
purchased for $125,000, is sold at the end of year 3 after taking
three years of straight-line depreciation.
What is the book value?
$125,000 – (3 × $25,000) = $50,000
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8.6 Gains or Losses on Disposal
Overview (2/3)
▪ If the equipment is sold for $50,000 (book value), there is no gain
or loss and, hence, no tax effect.
▪ If it is sold for more than $50,000, there is a gain on disposal and
an additional tax payment.
▪ If it is sold for less than $50,000, there is a loss on disposal and
tax savings.
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8.6 Gains or Losses on Disposal
Overview (3/3)
Assume that the equipment is sold for $70,000 and the tax rate is
40%.
What is the tax expense associated with the sale?
($70,000 – $50,000) = 20,000 × 40% = $8,000
What is the net cash inflow from the sale?
$70,000 – $8,000 = $62,000
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8.6 Gains or Losses on Disposal
Cash Flow Effects of Disposal of Equipment
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 451.
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8.7 Other Models for Analyzing Long-Range Decisions
Payback Time
▪ Payback time, or payback period, is the time it will take to
recoup, in the form of cash inflows from operations, the initial
dollars invested in a project.
initial amount invested
𝐏𝐚𝐲𝐛𝐚𝐜𝐤 𝐓𝐢𝐦𝐞(𝐏) =
equal annual incremental
cash flow from operations
𝐈
𝐏=
𝐎
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8.7 Other Models for Analyzing Long-Range Decisions
Payback Time Example
▪ Assume that $12,000 is spent for a forklift with an estimated
useful life of 4 years.
▪ Annual savings of $4,000 in cash outflows are expected from
operations.
What is the payback period?
P = $12,000 ÷ $4,000 = 3 years
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8.7 Other Models for Analyzing Long-Range Decisions
Accounting Rate-of-Return Model
The accounting rate-of-return (ARR) model expresses a project’s
return as the increase in expected average annual operating income
divided by the required initial investment.
ARR =
ARR =
increase in expected average
annual operating income
initial required investment
average annual incremental net cash inflow from operations
− average incremental annual depreciation
initial required investment
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8.7 Other Models for Analyzing Long-Range Decisions
Example
▪ Assume the following (s. example from Slide 263):
▪ Investment is $5,827.
▪ Useful life is four years.
▪ Estimated disposal value is zero.
▪ Expected annual cash inflow from operations is $2,000.
Annual depreciation = (cost – disposal value)/useful life
Annual depreciation = ($5,827 – 0)/4 = $1,456.75
ARR = ($2,000 – $1457) ÷ $5,827 = 9.3%
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Structure
Where we are
7. Management Control in Decentralized Organizations
8. Capital Budgeting
9. Cost Allocation
Literature:
Horngren, C.T./Sundem, G. L./Burgstahler, D./Schatzberg J.:
Introduction to Management Accounting (2014), pp. 480-531.
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Structure
Where we are
9. Cost Allocation
9.1
9.2
9.3
9.4
9.5
9.6
9.7
General Framework for Cost Allocation
Allocation of Service Department Costs
Direct and Step-Down Methods
Traditional Approach
Allocation of Customer Costs
Allocation of Central Costs
Allocation of Joint Costs
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9.1 General Framework for Cost Allocation
Overview (1/4)
▪ Cost allocation methods comprise an important part of a
company’s cost accounting system to determine the cost of a
product, service, customer, or other cost object.
▪ Less than half of most companies’ operating costs can be traced
directly to products and services.
▪ The rest of a company’s costs must be allocated using a costallocation base or left unallocated.
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9.1 General Framework for Cost Allocation
Overview (2/4)
▪ After developing a general framework for cost allocation,
companies assign costs to cost objectives.
▪ There are four types of cost objectives:
1.
2.
3.
4.
service departments,
producing departments,
products/services, and
customers.
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9.1 General Framework for Cost Allocation
General Framework for Cost Allocation
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 482.
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9.1 General Framework for Cost Allocation
Overview (3/4)
▪ The cost accounting system first accumulates costs and assigns
them to organizational units, which are also called departments.
▪ There are two types of departments:
1. producing departments, where employees work on the
organization’s products or services, and
2. service departments, which exist only to support other
departments or customers.
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9.1 General Framework for Cost Allocation
Overview (4/4)
▪ Direct costs can be physically traced to each department.
▪ Indirect costs must be allocated.
▪ Many companies develop allocation methods to assign service
department costs to the producing departments.
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9.2 Allocation of Service Department Costs
Overview
1. Allocate variable- and fixed-cost pools separately.
2. Establish the cost allocation procedures in advance.
3. Evaluate performance using budgets for each production and
service department.
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9.2 Allocation of Service Department Costs
Service Department Example (1/2)
University computer department serves two major users:
▪ School of Business
▪ School of Engineering
→ Allocate the cost of the computer onto both schools.
Suppose there are two major purposes for the allocation:
▪ Predicting economic effects of the use of the computer.
▪ Motivating departments and individuals to use its capabilities
more fully.
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9.2 Allocation of Service Department Costs
Service Department Example (2/2)
▪ The primary activity performed is computer processing.
▪ Resources consumed:
1.
2.
3.
4.
5.
6.
Processing time
Operator time
Consulting time
Energy
Materials
Building space
▪ The budget formula for the forthcoming year is $100,000
monthly fixed cost plus $200 variable cost per hour of computer
time used.
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9.2 Allocation of Service Department Costs
Variable-Cost Pool (1/2)
▪ The cost driver for the variable-cost pool is actual hours of
computer time used.
▪ Variable costs should be allocated as follows:
Cost-allocation rate per hour × Actual hours of computer time
used
▪ Consider the allocation of variable costs to a department that
uses 500 hours of computer time.
▪ 500 hours × $200 = $100,000
▪ Suppose inefficiencies in the computer department caused the
variable costs to be $120,000 instead of $100,000.
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9.2 Allocation of Service Department Costs
Variable-Cost Pool (2/2)
▪ A good cost-allocation scheme would allocate only the $100,000
to the consuming department and would let the $20,000 remain
as an unallocated unfavorable budget variance of the computer
department.
▪ This scheme holds computer department managers responsible
for the $20,000 and reduces the resentment of user managers.
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9.2 Allocation of Service Department Costs
Fixed-Cost Pool (1/3)
▪ Allocation of fixed costs will be based on the long-run capacity
available to the user, regardless of actual usage from month to
month.
▪ Long-range planning regarding the expected required overall
level of service, not short-run fluctuations in actual usage, affects
the level of fixed costs.
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9.2 Allocation of Service Department Costs
Fixed-Cost Pool (2/3)
▪ Suppose the deans had originally predicted the long-run average
monthly usage as follows:
▪ School of Business: 210 hours
▪ School of Engineering: 490 hours
How is the fixed-cost pool allocated?
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 482.
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9.2 Allocation of Service Department Costs
Fixed-Cost Pool (3/3)
▪ A major strength of using capacity available rather than capacity
used to allocate budgeted fixed costs is that actual usage by user
departments does not affect the short-run allocations to other
departments.
▪ Such a budgeted lump-sum approach is more likely to have the
desired motivational effects with respect to the ordering of
services in both the short run and the long run.
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9.3 Direct and Step-Down Methods
Overview
▪ Service departments often support other service departments in addition to
production departments.
▪ There are two popular methods for allocating service department costs: (1)
The direct method and (2) the step-down method
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 487.
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9.3 Direct and Step-Down Methods
Direct Methods (1/2)
▪ The direct method ignores other service departments when any given
service department’s costs are allocated to the producing departments.
▪ Example (1/2):
 Facilities management cost = $1,260,000
 The direct method allocates these costs to the processing and assembly
departments based on the relative square footage occupied by each of the
two departments.
Total square footage in both producing departments =
+ 3,000 = 18,000
15,000
Facilities management cost allocated to processing department = (15,000
÷ 18000) × $1,260,000 = $1,050,000
Facilities management cost allocated to assembly department = (3,000 ÷
18,000) × $1,260,000 = $210,000
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9.3 Direct and Step-Down Methods
Direct Methods (2/2)
Example (2/2):
The direct method allocates human resources department costs to
the producing departments on the basis of the relative number of
employees in the producing departments.
▪ Human Resources costs = $240,000
▪ Total employees in producing departments = 16 + 64 = 80
▪ Human resources costs allocated to processing department =
(16 ÷ 80) × $240,000 = $48,000
▪ Human resources costs allocated to assembly department =
(64 ÷ 80) × $240,000 = $192,000
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9.3 Direct and Step-Down Methods
Step-Down Methods (1/2)
▪ The step-down method recognizes that some service
departments support the activities in other service departments
as well as those in production departments.
▪ To apply the step-down method, choose the sequence in which
to allocate service department costs.
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9.3 Direct and Step-Down Methods
Step-Down Methods (2/2)
▪ Example:
We choose to allocate facilities management department costs first,
then we allocate human resources cost.
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 488.
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9.3 Direct and Step-Down Methods
Service Department Costs Allocation: Summary
Direct versus Step-Down Method
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 489.
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9.4 Traditional Approach
Overview (1/3)
1. Divide the costs in each producing department in:
 Direct costs
 Indirect costs
2. Assign direct costs to the appropriate products, services, or
customers.
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9.4 Traditional Approach
Overview (2/3)
3. Select one or more cost pools and related cost drivers in each
production department.
Indirect departmental costs
Cost Pool
Cost Pool
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9.4 Traditional Approach
Overview (3/3)
4. Allocate costs to Products
Cost Pool
Product A
Product B
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9.4 Traditional Approach
Traditional Approach and Step-Down Method
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 491.
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9.4 Traditional Approach
Activity-Based Costing (ABC) (1/2)
1. Determine the key components of the system and the
relationships among them.
2. Collect relevant data concerning costs and the physical flow of
the cost-allocation base units among resources and activities.
3. Calculate and interpret the new ABC information.
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9.4 Traditional Approach
Activity-Based Costing (ABC) (2/2)
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 496.
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9.5 Allocation of Customer Costs
Overview (1/3)
Customer profitability depends on the costs incurred to fulfill
customer orders and to provide other customer services such as
order changes, returns, and expedited scheduling or delivery.
Customer Type 1
Customer Type 2
1. Buys a mix of products with 1. Buys a mix of products with
high gross margins
lower gross margins
2. Low cost-to-serve %
2. High cost-to-serve %
3. High profitability
3. Low profitability
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9.5 Allocation of Customer Costs
Overview (2/3)
Exemplary Customer Profiles
Customer Type 1
Low Cost to Serve
1. Large order quantity
2. Few order changes
3. Little pre- and post-sales
support
4. Regular scheduling
5. Standard delivery
6. Few returns
Customer Type 2
High Cost to Serve
1. Small order quantity
2. Many order changes
3. Large amounts of pre- and
post-sales support
4. Expedited scheduling
5. Special delivery
6. Frequent returns
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9.5 Allocation of Customer Costs
Overview (3/3)
Customer profitability depends on more than gross margin, it is a
function of customer gross margin and cost to serve.
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 498.
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9.5 Allocation of Customer Costs
Example (1/6)
▪ Assume Cedar City Distributors (CCD) distributes products to
retail outlets.
▪ The products are classified into just two product groups – apparel
and sports gear.
▪ CCD has two types of customers:
 Small store
 Large store
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9.5 Allocation of Customer Costs
Example (2/6)
▪ CCD uses a simple cost accounting system to calculate both
product and customer profitability.
▪ The only direct costs are costs of the purchase of apparel and
sports gear products.
▪ Indirect costs are allocated to the product groups using a single
indirect cost pool for all indirect costs with “pounds of product”
as the allocation base.
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9.5 Allocation of Customer Costs
Example (3/6)
▪ To determine customer profitability:
1. Calculate profit margin per case for each product
2. Use the product mix ordered by each customer to calculate
profitability
• Small stores’ product mix is 75% apparel.
• Large stores’ product mix is 50% apparel.
• Small store customers are expected to have the larger
profit margin percentage.
• But, the refined cost-allocation system shows large stores
are the most profitable customers.
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9.5 Allocation of Customer Costs
Example (4/6)
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 500.
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9.5 Allocation of Customer Costs
Example (5/6)
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 500.
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9.5 Allocation of Customer Costs
Example (6/6)
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 500.
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9.5 Allocation of Customer Costs
Allocation of Costs-to-Serve (1/2)
▪ Might number of customer orders be a more plausible costallocation base?
▪ Include cost of order processing and customer service activities in
a separate cost pool and allocate on a number of order basis.
▪ Gives managers more insight into operations, and a tool to
measure and manage customer profitability.
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9.5 Allocation of Customer Costs
Allocation of Costs-to-Serve (2/2)
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 503.
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9.6 Allocation of Central Costs
Overview (1/2)
▪ Many managers believe it is desirable to fully allocate all costs to
the revenue-producing parts of the organization.
▪ If a company allocates central support costs, it is important to
allocate them in a way that managers accept as “fair.”
▪ Some companies find measures that managers believe are fair,
such as usage, either actual or estimated.
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9.6 Allocation of Central Costs
Overview (2/2)
Often used cost-allocation bases for central costs:
▪ Revenue
▪ Total assets
▪ Cost of goods sold
▪ Total cost of each division
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9.6 Allocation of Central Costs
Use of Budgeted Sales for Allocation
▪ If management allocates the costs of central services based on
sales, it should use budgeted sales rather than actual sales.
▪ The method has the advantage that the fortunes of other
departments will not affect the costs allocated to a given
department.
▪ It has the disadvantage of providing an incentive for the
department to under-predict their own sales.
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9.7 Allocation of Joint Costs
Overview (1/2)
▪ Companies allocate joint product costs to products for inventory
valuation purposes and income determination.
▪ Two conventional ways of allocating joint costs to products are
widely used:
 Physical Units
 Relative Sales Values
▪ Joint costs include all inputs of material, labor, and overhead
costs that are incurred before the split-off point.
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9.7 Allocation of Joint Costs
Overview (2/2)
▪ The physical-units method requires a common physical unit for
measuring the output of each product.
▪ The joint costs are allocated based on each product’s percentage
of the total physical units produced.
▪ Allocation of joint costs should not affect decisions about the
individual products.
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9.7 Allocation of Joint Costs
Physical-Units Method
▪ Dow Chemical produces two chemicals, X and Y. Joint cost is
$100,000. X sells for $.09 per liter and Y for $.06 per liter.
▪ Two-thirds of the liters produced are chemical X; allocate twothirds of the joint cost to X. One-third of the liters are chemical Y;
allocate one-third of the cost to Y.
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 508.
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9.7 Allocation of Joint Costs
Relative-Sales-Value Method
▪ If a common physical unit is lacking, many companies use the
relative-sales-value method for allocating joint costs.
▪ Weighting is based on the sales values of the individual products
at the split-off point.
Source: Horngren et al.: Introduction to Management Accounting (2014), p. 508.
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9.7 Allocation of Joint Costs
By-Product Costs
▪ By-product costs are not individually identifiable until
manufacturing reaches a split-off point.
▪ By-product costs have a relatively insignificant sales value in
comparison with other products emerging at split-off.
▪ Allocate only separable costs to by-products. Allocate all joint
costs to the main products.
▪ Deduct revenues from by-products, less their separable costs,
from the main products cost.
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The End
Thank you for your attention!
Good luck for your preparation as well as your exams!
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