Management Accounting
and the
Business Environment
1
Objectives of Management Accounting
Providing managers with information for
decision making and planning.
Assisting managers in directing and controlling
operational activities.
Assisting managers in motivating employees
toward the organization’s goals.
Measuring the performance of subunits,
managers, and other employees within the
organization.
2
Comparison of Financial and Managerial
Accounting
Financial Accounting
Managerial Accounting
External persons who
make financial decisions
Managers who plan for
and control an organization
Historical perspective
Future emphasis
3. Verifiability
versus relevance
Emphasis on
verifiability
Emphasis on relevance
for planning and control
4. Precision versus
timeliness
Emphasis on
precision
Emphasis on
timeliness
5. Subject
Primary focus is on
the whole organization
Focuses on segments
of an organization
6. GAAP
Must follow GAAP
and prescribed formats
Need not follow GAAP
or any prescribed format
Mandatory for
external reports
Not
Mandatory
1. Users
2. Time focus
7. Requirement
3
The Business Environment
What issues are important in business management?
 Cost management.




Revenue (or yield) management.
Quality and risk management.
Regulatory and legal environment.
Others?
Changes in practices often require new or modified accounting
practices or systems to measure the appropriate variables.
4
Strategic Cost Management
Strategic cost management (Shank and Govindarajan)
- the process though which a sophisticated
understanding of an organization’s cost structure is
developed and used in the search for sustainable
competitive advantage.
From an accounting standpoint, strategic cost
management is an analytic framework that relates
meaningful accounting information to an
organization’s business strategy.
5
Three Key Themes
Value chain analysis - How do we organize our
thinking about cost management?
Strategic positioning - What role does cost
management play in the firm?
Cost driver analysis - What causes our costs?
6
Activities – The Unit of Analysis in Modern Cost
Management
Activity – at the most basic level, a unit of work
(e.g., seating customers, taking orders, preparing
food, delivering food to customer).
Activity drivers – what causes activities to be
performed. Examples of activity cost drivers
include: number of meals served, number of
employees in the service area, number of cooks,
training needed for new employees, any activity
that influences cost.
7
Value Chain Analysis
The value chain for any firm in any business is the linked set of
value-creating activities all the way from basic raw material
sources for component suppliers through to the ultimate end-use
product delivered into the final customers’ hands.
The value-chain focus of management today is largely internal to
the firm (its purchases, its processes, its functions, its products,
its customers). This perspective is too narrow if considered in a
strategic context.
Strategic/competitive advantage is gained through managing the
entire value chain from raw material supplier to the end user.
8
Strategy and the Value Chain
Two generic strategies for achieving competitive advantage:
 Low-price leadership.
 Product differentiation.
Whichever strategy is selected, value chain analysis can help a firm focus
on its chosen strategy and achieve competitive advantage.
The industry value chain is composed of all the value-creating activities
within the industry, beginning with the basic raw material and ending
with delivery of the product to the final consumer.
A company’s internal value chain consists of all of the physically and
technologically distinct activities within the company that add value to
the product.
9
Internal Value Chain Analysis
What activities within the firm create competitive advantage?
How can those activities be managed to improve competitive
advantage?
Steps in evaluating the internal value chain:
 Identify value chain activities.
 Determine which of the value chain activities are strategic.
 Trace costs to value chain activities.
 Use the activity-cost information to manage the strategic
value chain activities better than other companies in the
industry.
10
Industry Value Chain Analysis
What are the firm’s relative strengths within the industry? How
can the firm best take advantage of these strengths?
The industry value stream considers activities both upstream and
downstream from the firm.
Analysis of the financial returns available at each link in the
industry value chain may reveal opportunities for exploitation.
The analysis could also provide useful information as to whether
the firm should continue with its existing strategy, reconfigure its
value chain, or even exit the business.
11
Strategic Positioning
The role of cost analysis in the firm depends on how the firm
chooses to compete (lower costs versus superior products).
Example: How important are standard costs in assessing
performance?
 Cost leadership - Very important.
 Differentiation - Not as important.
Example: How important is marketing cost analysis?
 Cost leadership - Not very important.
 Differentiation - Critically important.
12
Cost Driver Analysis
Costs are caused (or driven) by many factors that are
interrelated in complex ways.
Understanding costs implies understanding the interplay
between cost drivers in any given situation.
Traditional management accounting - costs are solely a
function of output volume.
But output volume is often a poor way to explain cost
behavior.
13
What Drives A Firm’s Cost Position?
Five strategic choices by the firm regarding its underlying
economic structure drive its cost position for a given product:





Scale - How big an investment to make in manufacturing, in R&D,
and in marketing resources.
Scope - Degree of vertical integration.
Experience - How many times in the past the firm has already done
what it is doing again.
Technology - What process technologies are used at each step of the
firm’s value chain.
Complexity - How wide a line of products or services to offer to
customers.
These represent structural cost drivers.
14
What Factors Allow A Firm to Execute Successfully?
These are called organizational drivers. More is always better.
The list of basic organizational drivers:
 Work force involvement (participation).
 Total quality management (beliefs and achievement regarding
product and process quality).
 Capacity utilization (given the scale choices on facility
construction).
 Plant layout efficiency (the relative efficiency of the layout).
 Product configuration (the effectiveness of the design or
formulation).
 Exploiting linkages with suppliers and/or customers.
15
Key Ideas Regarding Cost Drivers
For strategic analysis, volume is usually not the most useful way
to explain cost behavior.
In a strategic sense, it is more useful to explain cost position in
terms of the structural choices and organizational skills that
shape the firm’s competitive position.
Not all the strategic drivers are equally important all the time, but
some (more than one) of them are likely very important in every
case.
For each cost driver, there is a particular cost analysis framework
that is critical to understanding the positioning of the firm.
16
Cost Terms, Concepts
and Classifications
17
Costs Versus Expenses
Cost - a resource sacrificed or forgone to achieve a
specific objective.
Expense - a cost that has been charged against
revenue in an accounting period (an expired cost).
18
Economic Characteristics of Costs
Opportunity cost - the potential benefit given up when the choice
of one action precludes selection of a different action.
Out-of-pocket cost (outlay cost) - a cost incurred that requires
the expenditure of cash or other assets (or the incurrence of
liabilities).
Marginal cost - the extra (or incremental) cost incurred in
producing one additional unit of output.
Average cost - the total cost of producing a particular quantity of
output, divided by the number of units of output produced.
Sunk cost - a cost that was incurred in the past and cannot be
altered by any current or future decision.
Differential cost - the difference in a cost item under two decision
alternatives.
19
Types of Organizations and Cost Measures
Service organizations - provide customers with an intangible
product. Usually maintain no inventories. Interested in
measuring cost of services billed or provided.
Merchandising organizations - organizations that sell their
customers a tangible product. These firms maintain inventories
of the product they sell, but they do not manufacture the
product. Interested in measuring cost of goods sold plus the cost
of ending inventory.
Manufacturing organizations - these firms manufacture goods for
sale rather than simply purchasing them. Interested in
measuring cost of goods sold, cost of goods manufactured, and
costs of ending inventories.
20
Controllable and Uncontrollable Costs
Controllable cost - a cost is controllable if a manager is
in a position to exert control over the level of the cost
or to significantly influence the level of the cost.
Uncontrollable cost - a cost is uncontrollable if a
manager is not in a position to exert control over the
level of the cost or to significantly influence the level
of the cost.
Costs may be uncontrollable in the short run but are
usually controllable in the long run.
21
Direct versus Indirect Costs
Cost object - any activity or item for which a separate measurement of
cost is desired.
Direct cost - a cost that can be traced to a given cost object in an
economically feasible manner.
Indirect cost - a cost that cannot be traced to a given cost object in an
economically feasible manner.
Economically feasible means that the benefit of tracing the cost (greater
accuracy) outweighs the cost of doing so.
Costs are assigned to cost objects by tracing (direct costs) and by
allocation (indirect costs).
A cost may be direct with respect to one cost object but indirect with
respect to another.
22
Additional Cost Terms
Manufacturing costs - Three basic categories.
 Direct materials.
 Direct labor.
 All other costs associated with the manufacture of the product
(also called indirect manufacturing costs, manufacturing
overhead, factory overhead, factory burden).
 Manufacturing costs are also known as inventoriable costs or
product costs. Under full absorption costing, these costs are
inventoried (treated as an asset) until the product is sold.
Prime costs = Direct materials used + direct labor.
Conversion costs = Direct labor + factory overhead.
23
Product Costs versus Period Costs
Costs that are not directly related to the manufacture
of a product are called period costs, since they are
expensed in the period they are incurred.
These costs consist of general and administrative
costs, research and development costs, and/or
marketing and selling costs.
These costs are never treated as part of inventoriable
costs.
Manufacturing costs = inventoriable (or product)
costs. Nonmanufacturing costs = period costs.
24
Flow of Costs in Manufacturing Firms
A manufacturing firm converts raw (direct) materials into a salable
product.
When purchased, materials (both direct and indirect) are charged to the
Materials Inventory account, and a liability created (Accounts Payable).
When placed in production, the cost of direct materials used are
transferred to Work in Process Inventory and out of Materials Inventory.
Other manufacturing costs are also charged to Work in Process
Inventory.
When completed, the manufacturing costs associated with the product
are transferred to Finished Goods Inventory and out of Work in Process
Inventory.
When finished goods are sold, the costs of the product sold are charged
to Cost of Goods Sold (Finished Goods Inventory).
25
Flow of Costs in A Merchandising Firm
Goods are purchased from suppliers and resold.
Purchases are charged to Merchandise Inventory and
a liability created (Accounts Payable).
When goods are sold, Cost of Goods Sold is charged
with the total costs of the units sold, while
Merchandise Inventory is reduced by the same
amount.
26
Basic Inventory Equations
Beg. Matl. Inv. + Purchases − End. Matl. Inv. = Matl. Used.
Beg. WIP Inv. + Curr. Mfg. Costs − End. WIP Inv. = COGM.
Beg. FG Inv. + COGM − End. FG Inv. = COGS.
where: COGM = Cost of Goods Manufactured,
COGS = Cost of Goods Sold,
WIP = Work in Process, and
FG = Finished Goods.
27
Cost Drivers
Cost driver - any factor whose change causes a
change in the total cost of a related cost object; more
simply, any factor that causes costs.
We assume a causal relation exists between the use of
the cost driver and the incurrence of the cost.
Cost drivers can be financial (e.g., direct materials
costs) or nonfinancial (e.g., number of equipment
setups, number of transactions processed).
Costs are often categorized based on their behavior
relative to a cost driver.
28
Cost Behavior -- Variable Versus Fixed Costs
A fixed cost is a cost that does not change in total given changes
in the level of the cost driver.
A variable cost is a cost that changes in total in direct proportion
to changes in the level of the cost driver.
We also encounter mixed costs (or semivariable costs) which are
costs that have both fixed and variable components.
Step (or step-variable) costs are costs which change in steps as
the cost driver changes.
Each of these behaviors may be valid only over a relevant range.
29
Unit Fixed and Variable Costs
Unit cost = average cost per unit.
For product costing purposes, we “unitize” fixed costs.
This makes fixed costs appear to be variable.
For decision making purposes, unit fixed costs are
often misleading because the cost is not variable. It is
fixed in total. In addition, the per-unit amount
changes for each level of the denominator.
We usually assume that the variable cost per unit is
constant within the relevant range.
30
Other Cost Terms
Full cost - the sum of all costs of manufacturing and selling a unit
of product (including fixed and variable costs).
Full absorption cost - all variable and fixed manufacturing costs
are inventoried; used to compute the value of inventory under
GAAP.
Variable costing - only variable manufacturing costs are
inventoried.
Gross margin = Revenue − COGS.
Contribution margin = Revenue − Variable costs.
31
Costs of Quality
The costs of quality are the costs that would be eliminated if all
workers were perfect in their jobs.
Every dollar and labor hour not used making scrap can be used
for making better products on time or improving existing
products or processes.
Some survey evidence suggests that poor quality leads to losses
of up to 20% to 30% of gross sales.
Costs of quality can be subdivided into the costs of conformance
and the costs of nonconformance.
32
Costs of Conformance
Costs of Conformance - the costs necessary to achieve quality
products; in most firms, these costs run to 3% to 4% of sales;
can be categorized into prevention costs and appraisal costs.
Prevention costs are associated with preventing defects before
they happen. Examples include costs of process design, product
design, employee quality training, supplier programs, quality
improvement projects, machine inspections, inbound material
inspection.
Appraisal costs include measuring, evaluating, or auditing
products to assure conformance to standards. Examples include
field testing, intermediate and end-of-process inspections,
supplies for the activities.
33
Costs of Nonconformance
Costs of Nonconformance - the expenditures incurred when
operations go awry; can go as high as 20% of sales; can be
categorized as internal failure and external failure costs.
Internal failure costs are incurred before the product is shipped.
Examples include costs of scrap, rework, re-inspection,
opportunity cost of machine downtime.
External failure costs are incurred after the product is shipped.
They arise from product failure at the customer level. Examples
include the costs of processing customer complaints, customer
returns, warranty claims, product recalls, product liability,
marketing costs, and opportunity costs of lost sales and reduced
contribution margin.
34
Summary of Cost Concepts
For purposes of valuing inventories and measuring income, costs are
classified as either product costs or period costs.
For purposes of predicting cost behavior, costs are classified as
either variable or fixed.
For purposes of assigning costs to cost objects, costs are classified
as either direct or indirect.
For purposes of making decisions, the following cost distinctions are
important:
 Differential costs and revenues.
 Opportunity cost.
 Marginal cost.
 Sunk costs.
For evaluating performance, costs are classified as controllable or
non-controllable.
For purposes of managing costs of quality, quality costs are
classified as either costs of conformance or costs of
nonconformance.
35
Summary of Cost Flow Equations
Materials Inventory Equation:
Beg. Matls. Inventory + Purchases = Materials used
+ End. Matls. Inventory
Work-in-Process (WIP) Inventory Equation:
Beg. WIP + Tot. Mfg. Costs Incurred = Cost of Goods Mfg. + End. WIP
Beg. WIP + (DM used + DL + MOH) = COGM + End. WIP
Beg. WIP + (DM used + DL + MOH) = Total mfg. costs to account for
Finished Goods (FG) Inventory Equation:
Beg. FG + Cost of Goods Mfg. = Cost of Goods Sold + End. FG
Beg. FG + COGM = COGS + End. FG
Beg. FG + COGM = Cost of goods available for sale (COGAS)
36
Cost Behavior: Analysis and Use
37
Motivation for Understanding Cost Behavior
Understanding how costs behaved in the past informs us as to
their likely behavior in the future, thus allowing us to predict
costs.
Decision making involves choosing between alternatives.
Managers need to know the costs that are likely to be incurred
for each alternative. Examples:




How much overhead should be allocated to this cost object?
How much will costs increase if sales increase by 10 percent?
What will costs be if the firm introduces a new product?
How much should the firm bid on a prospective job?
The link to firm value?
More accurate costs => Better decisions => Increased firm value
38
Cost Behavior
Cost category
In Total
Variable
Total variable cost
changes as the activity
level changes
Total fixed cost remains
constant even when the
activity level changes
Fixed
Per Unit
Variable cost per unit
remains the same over wide
ranges of the activity
Fixed cost per unit
decreases when the
activity level increases
Total costs = Fixed costs + Variable costs
= F + VX
where V is the variable cost per unit of the activity, and X is the volume of
the activity in appropriate units.
39
Types of Fixed Costs
Committed fixed costs - relate to the investment in facilities,
equipment, and the basic organizational structure of the firm.
Examples include depreciation of buildings and equipment, taxes on
real estate, insurance, etc.
Discretionary fixed costs - usually arise from annual decisions by
management to spend in certain fixed cost areas. Examples include
advertising, research and development, public relations, etc.
The trend in many companies is toward more fixed costs relative to
variable costs, primarily through investments in automation and
technology. This has led to an increase in the demand for
knowledge workers needed to operate the machinery or technology.
40
The Relevant Range
The relevant range is defined as the activity range
within which a cost projection may be valid.
Within the relevant range, both unit variable costs (V )
and total fixed costs (F ) remain essentially
unchanged.
The relevant range includes the upper and lower limits
of past activity for which data are available.
However, outside the relevant range, the general cost
equation we estimate may not be valid.
41
Methods of Estimating Costs
Methods include:




Engineering estimates.
Account analysis.
Scattergraphs and high-low analyses.
Statistical methods.
Each approach focuses on estimating cost functions that
separate a mixed (or semivariable) cost into its fixed and
variable components.
42
Engineering Estimates
Cost estimates are based on measurement and pricing of the
work involved.
Direct labor:
- Analyze the kind of work performed.
- Estimate the time required for each labor skill for each unit.
- Use local wage rates to obtain labor costs per unit.
Direct material:
- Material required for each unit is obtained from engineering
drawings and specification sheets.
- Material prices are determined from vendor bids.
Overhead costs are obtained in a similar fashion - a detailed
step-by-step analysis of the work involved.
43
Advantages/Disadvantages of Engineering Estimates
Advantages:
- Detailed analysis results in better knowledge of the
entire process.
- Data from prior activities is not required, so it can be
used to estimate costs of new activities/products.
Disadvantages:
- Detailed analysis is time-consuming (thus costly).
- Engineering expertise is usually required.
44
Account Analysis
Cost estimates are based on a review of each
account making up the total cost being
analyzed.
The objective of the analysis is to relate costs
and activities in the form of the general cost
equation.
45
Account Analysis - Procedure
Identify each cost category as fixed or variable.
Sum the fixed costs, yielding F.
Sum the variable costs, yielding VX.
Divide the total variable costs (VX ) by the total number of
units of the activity (X ) to obtain the variable cost per unit
(V ).
The result is a specific cost equation that can be used to
forecast total costs at other levels of activity:
Total costs = F + VX.
46
Account Analysis - Example
Total
Account
Costs
Indirect labor
$
450
Indirect materials
700
Depreciation
1,000
Property taxes
200
Insurance
300
Utilities
400
Maintenance
600
Totals
$ 3,650
Overhead Costs for 1,000 Units
Variable
Fixed
Costs
Costs
$ 450
$
700
1,000
200
300
350
50
500
100
$ 2,000
$ 1,650
47
Account Analysis - Example
To compute variable cost per unit:
V = Total variable costs / level of activity
= ($2,000 / 1,000 units) = $2.00 per unit.
Fixed costs are as identified in the analysis:
F = $ 1,650.
The cost equation relating overhead costs to units of output is:
Overhead costs = $ 1,650 + $2.00/unit (Number of units)
Estimate the total overhead cost for 1,400 units of output:
Overhead costs = $ 1,650 + $2.00/unit (1,400 units)
= $ 1,650 + $2,800 = $ 4,450.
48
Advantages/Disadvantages of Account Analysis
Advantages:
 Applied properly, the approach is a reasonable means of
estimating the cost function.
 Takes advantage of the experience and judgment of
managers and accountants who are familiar with company
operations and the way costs react to changes in activity
levels.
Disadvantages:
 The person estimating the cost function may not be objective
and may misclassify costs as fixed and variable.
 Accounting and managerial expertise are required.
49
Scattergraph (Visual Fit) Method
The scattergraph is a very useful approach to analyzing
costs.
Steps in estimating the cost function:




Plot the data points on a graph (total cost versus activity)
that includes the origin (zero total costs, zero activity).
Draw a line through the plotted data points so that about
equal numbers of points fall above and below the line.
Extend the line to Total Cost axis. The point at which the
line intersects the Total Cost axis is F.
The slope of the drawn line is V. The slope is computed as
(Change in cost/Change in units of activity).
50
High-Low Method
Similar to the scattergraph method.
Rather than “eyeballing” the line, two points in the scatterplot are
chosen and a straight line drawn to connect them.
The two points should be representative of the cost and activity
relationships over the range of activity for which the estimation is
made. These are usually the highest and lowest levels of the activity
(not the cost).
Slope of line = V = (Costhigh − Costlow) / (Unitshigh − Unitslow).
Intercept of line = F = Costhigh − V x (Unitshigh), or
= Costlow − V x (Unitslow).
51
High-Low Method - Example
A firm recorded the following production activity and
maintenance costs for two months:
Units
Cost
High activity level
9,000
$9,700
Low activity level
5,000
$6,100
Change
4,000
$3,600
Using this information, compute:
- Variable cost per unit,
- Fixed costs, and
- The cost equation relating maintenance costs to production.
52
High-Low Method - Example
Unit variable cost = $3,600 / 4,000 units = $0.90/unit.
Fixed costs (using the highest activity level)
= $9,700 − (9,000 units)($0.90/unit)
= $9,700 − $8,100 = $1,600.
Fixed costs (using the lowest activity level)
= $6,100 − (5,000 units)($0.90/unit)
= $6,100 − $4,500 = $1,600.
The cost equation is:
Maintenance costs = $1,600 + $0.90/unit x (Number of units)
53
Advantages/Disadvantages of
High/Low and Scattergraph Methods
Advantages:
- Plotting cost/activity data is useful in assessing associations
and possible structural changes.
- Involve relatively simple calculations.
- Easy methods to apply.
Disadvantages:
- Inherently subjective in application.
- Model parameter estimates do not use all of the data.
- No statistical means of assessing model “fit.”
54
Regression Analysis
Regression analysis is a statistical procedure that is used to
estimate the parameters of a model that can be used for
forecasting purposes.
The general cost equation estimated is still:
Total costs = F + VX.
In the context of regression analysis, we call total costs the
dependent variable and we call X the independent variable.
The dependent variable is whatever we are attempting to
estimate or forecast.
55
Measures of Goodness of “Fit”
Correlation coefficient - a measure of the linear association
between variables such as costs and activities. The correlation
coefficient, r, is bounded by −1 and +1. A correlation of +1
indicates a perfect positive association between two variables,
while a correlation of −1 indicates a perfect negative association.
A correlation of 0 indicates no association between two variables.
Coefficient of determination - the square of the correlation
coefficient, called R2, is interpreted as the proportion of variability
in the dependent variable that is explained by its linear
association with the independent variable. R2 is bounded by 0
and 1; the closer that R2 is to 1, the closer the data points are to
the fitted regression line.
56
Advantages of Regression Analysis
Unlike the high-low method, all data are used in
computing parameter estimates.
The approach yields a model that represents the
“best” possible fit.
Statistical information generated can be used to
assess the strength of the association between costs
and activity levels and to forecast future costs given
some anticipated level of the activity.
The approach can be generalized to incorporate more
than one cost driver in explaining total costs.
57
Regression Method Cautions
A logical relationship must be established between the
variables.
 Entering numbers into the analysis that have no logical
relationship will result in meaningless estimates.
 Linear regression assumes that a linear model
describes the data.
 An apparently strong relationship may be due to
another variable that is not included in the model.
Data points that vary significantly from the regression line
(outliers) draw the regression line away from the majority
of data points.
58
Regression Method Cautions (continued)
The intercept term should be used with caution as an
estimate of fixed costs, since the intercept is likely to
be outside the relevant range of observations (it
occurs at an activity level of zero).
The regression line may be a poor predictor of future
costs if (1) cost-activity relationships have changed, or
(2) costs themselves have changed independently of
activity changes.
59
Which Cost Estimation Method Is Best?
No single method is best for all situations.
Better results are often obtained by use of several of
the methods. For example:
 Engineering estimates and account analysis may
lead to the establishment of logical, causal
relationships between variables.
 A scattergraph plot will lead to a better
understanding of the relationship and may reveal
outlier data points.
 Regression provides the “best” equation for the
data points and yields statistical measures of fit.
60
Multiple Regression
We can extend the simple regression model (i.e., one
independent variable) to include multiple cost drivers (i.e.,
multiple independent variables).
The resulting model can be specified as:
TC = F + V1X1 + V2X2 + . . . + VkXk.
where TC = total costs, and the rest of the variables have the
same meanings as in the simple model.
In concept, we will apply this general model to the activitybased accounting model we will cover later:
TC = F + VuXu + VbXb + VpXp.
The subscripts (u, b, and p) indicate various categories of cost
drivers.
61
Cost-Volume-Profit (C-V-P)
Relationships
62
Cost-Volume-Profit Relationships
Cost-Volume-Profit (C-V-P) Analysis - the study of the
interrelationships between costs and volume and how they
impact profit.
Surveys suggest that over 50 percent of responding firms use
some form of C-V-P analysis.
Useful in answering such questions as:
• How will revenues and costs be affected if we sell 1,000 more
units? If we raise or lower our selling prices? If we cut fixed
costs by 20 percent?
• How many units must we sell in order to break even?
• How might changes in product mix affect our profits?
63
Assumptions
Linear C-V-P analysis assumes that . . .
Revenues change proportionately with volume.
Total variable costs change proportionately with volume.
Fixed costs do not change at all with volume.
Product mix is constant.
All output is sold (equivalently, there is no net change in
inventory levels).
64
C-V-P Analysis as a Planning and Analysis Tool
C-V-P analysis arises from manipulation of the fundamental
equation: Profit = TR − TC, where TR = total revenues, TC
= total expenses.
Next, define P = selling price per unit, V = variable cost per unit,
X = number of units sold, F = total fixed costs, t = tax rate, OI =
operating (pre-tax) income, and NI = net income. Further,
assume that output volume is the only cost driver.
Note that, since OI = TR − TC, then:
(1 − t)(TR − TC) = (1 − t) OI = NI.
65
C-V-P Models
Using the previous assumptions and definitions, we
can derive the following equivalent expressions:
Equation approach to C-V-P Model:
(1 − t) [(P − V) X − F ] = NI.
Contribution approach to C-V-P Model:
X = {F + [NI /(1 − t)]} / (P − V).
The term (P − V) is called contribution margin per
unit (or CM/unit).
66
C-V-P Analysis and Different Cost Structures
An organization’s cost structure is represented by the
relative proportions of fixed and variable costs to total
costs.
Cost structures differ dramatically across industries
(e.g., grocery stores versus heavy manufacturers;
legal services firms versus urban hospitals).
An organization’s cost structure has a significant effect
on the sensitivity of its profits to changes in volume.
67
Operating Leverage
The extent to which a firm’s cost structure is made up of fixed
costs is called operating leverage.
Everything else being equal, the higher a firm’s operating
leverage, the higher its break-even point.
Higher leverage is associated with more rapidly increasing
losses if demand is less than that required to break even.
Higher leverage is associated with more rapidly increasing
profits after reaching the break-even point.
Firms with lower (higher) leverage tend to have greater
(lower) flexibility in reacting to changes in demand.
68
Relevant Costs for Decision Making
69
Information Relevance and Decision Making
A decision involves a choice between two or more
alternatives.
Information is relevant if it is pertinent to a decision
problem.
Information that is pertinent to a decision problem
must also be accurate (or precise).
Information that is relevant and accurate is of little
use if it is not timely, (i.e., available in time to be used
in making a decision).
70
Relevant Costs
Relevant cost - a cost that differs between alternatives.
Relevant cost or benefit information:
 Has some bearing on the future.
 Is different across competing alternatives.
Use of relevant costs and benefits in decision making:
 Eliminate costs and benefits that do not differ
between alternatives.
 Use the remaining costs and benefits that do differ
across alternatives in making the decision.
71
Types of Costs to Consider
Sunk costs.
Opportunity costs.
Future costs that do not differ across
alternatives.
Out-of-pocket costs (or outlay costs).
Allocated fixed costs.
Avoidable versus unavoidable costs.
72
Sunk Costs
Sunk Costs - costs which have already been incurred
and cannot be changed by any current or future
action. This implies that sunk costs are irrelevant in
decision making.
Examples: Book value of equipment, cost of
inventory on hand.
 Both of these items represent costs that were
incurred at some time in the past; write-offs of
these amounts are irrelevant unless they affect
cash flows.
73
Opportunity Costs
An opportunity cost is the potential benefit given up
when the choice of one action precludes choosing a
different option.
Opportunity costs tend to be overlooked or
underestimated, but are usually extremely important
in making a decision. Typically, opportunity costs
are as important as (and sometimes more important
than) initial out-of-pocket costs in the decision.
74
Allocated Fixed Costs
Allocated fixed costs can make a particular
product line or segment appear unprofitable.
Yet dropping the line (or segment) could result
in lower earnings for the firm if (1) the product
line (or segment) is generating positive
contribution margin, and (2) the allocated
fixed costs are unavoidable.
75
Avoidable versus Unavoidable Costs
An avoidable cost is a cost that can be eliminated in
whole or in part by choosing one alternative over
another.
Future costs that do not differ across alternatives would
represent unavoidable costs, and, hence, they would be
irrelevant to any decision regarding the alternatives.
By this criterion, a sunk cost is an unavoidable cost and,
therefore, it will never be a relevant cost in decisions.
76
Analysis of Special Decisions
Accept or reject a special order.
Outsource a product or service (make or buy).
Add or drop a service, department, or product.
77
Accept or Reject A Special Order
Relevant factors in the decision to accept or reject a special
order:
 Does excess capacity exist?
 What are the differential revenues and differential costs?
 What effect would filling this order have on regular sales
volume and prices?
Decision rule: Everything else being equal, accept the special
order if the incremental revenues of accepting the order exceed
the incremental costs; otherwise, reject the special order.
78
Outsourcing Decisions
Relevant factors in the decision to outsource a product or service:
 What are the relevant costs in producing the product or
providing the service?
 How important is it to have control over quality and
availability?
 What amount of productive capacity is foregone by producing
the product or service internally?
Decision rule: Everything else being equal, outsource the
product or service if the incremental benefit of outsourcing
exceeds the incremental benefit derived from sourcing internally;
otherwise, generate the product or service internally.
79
Product Line Decisions
Relevant factors in the decision to continue or discontinue a
product line:
 How will the discontinuance of a product line affect the sales
of the company’s other products?
 What alternative use might be made of the production
facilities now used to manufacture this product line?
 How will the discontinuance of a product line affect the
profitability of the company’s other products?
Decision rule: Everything else being equal, continue the product
line if earnings including the product line exceed earnings
excluding the product line; otherwise, discontinue the product
line.
80
Steps Involved In Evaluating A Product Line
Identify the effect on overall sales of dropping the product line, including
possible reduced sales from complementary products, or increased sales
of other product lines.
Identify the relative reduction in variable costs, and the corresponding
change in contribution margin as a result of dropping the product line.
Identify the relative reduction in fixed costs, if any, as a result of
dropping the product line.
Compute the difference in earnings between keeping or dropping the
product line. Then implement the decision rule as to whether to keep or
discontinue the product line.
81
Decisions Involving Limited Resources
Given scarce resources, firms must choose which products or
orders to fill, and which ones to decline.
Decision rule: Given a constraint on output, produce the
product (or service) that maximizes the contribution margin per
unit of the constrained resource, everything else being equal.
82
Pitfalls to Avoid
Sunk costs - These costs occurred in the past and cannot be
changed by any current or future course of action.
Unitized fixed costs - Fixed costs are unitized for product costing
purposes, thus appearing to be variable (and, hence, avoidable if
production were to cease). Fixed costs should be considered in
total rather than on a per-unit basis.
Allocated fixed costs - Allocated fixed costs may or may not be
avoidable even though the product or operating unit to which the
costs are allocated has been discontinued.
Opportunity costs - Opportunity costs are just as real and
important to making a correct decision as are out-of-pocket
costs.
83
Cost System Design:
Job Costing
84
Overview of Costing Systems
Costing systems provide the unit cost of producing a
product or service.
Costing systems provide different cost figures as
needed for different purposes:
Purpose
Reported costs
Make or buy decision
Incremental costs
Financial statements
Full absorption costs
Long-term pricing
Full costs of all value chain
functions
85
Design of Costing Systems
Costing systems should have a decision making
focus in that they meet the information needs of
decision makers.
Cost information for managerial purposes must
meet the cost-benefit test. The benefits of system
improvements must outweigh the costs of
improvement.
Design of the cost system should not be
subordinated to the needs of the external financial
reporting function.
86
Characteristics of Job Costing Systems
Costs are accumulated by job. If a job consists of a number of
identical units, the cost of an individual unit can then be
computed as sum of the costs of the job, divided by the number
of units produced.
There is a subsidiary account, or job cost record, for each job.
The costs of each inventory control account (e.g., WIP, FG)
equals the sum of the costs accumulated for each job in that
inventory.
Job-order costing is widely used in construction companies,
manufacturers, service providers, and nonprofit organizations.
87
Why Accumulate Costs by Job?
Managers can use their knowledge of the costs of
prior and current jobs to estimate the costs of
prospective jobs.
Managers can compare actual job costs to the
estimated (or budgeted) job costs in order to control
costs.
Since the actual costs of jobs sometime deviate from
estimated costs, managers can use job cost
information to renegotiate contracts with customers.
88
Attaching Costs to Jobs
1.
Identify the job requiring cost measurement.
2.
Identify the direct cost categories for the job.
3.
Identify the indirect cost pool(s) associated with the job
and an appropriate allocation base.
4.
Trace the direct costs to the jobs.
5.
Allocate the indirect costs to the job using the chosen
allocation base.
89
Cost Tracing versus Cost Allocation
Direct costs are traced to the specific job.
Indirect costs are allocated to the specific job.
Costs are allocated to jobs because jobs consume
costly resources that cannot be traced in an
economically feasible manner.
90
Methods of Assigning Costs to Jobs
Actual costing - a costing method that assigns direct costs
and indirect costs to jobs based on the actual costs
incurred.
Normal costing - a costing method that assigns direct costs
to jobs based on actual costs incurred, and assigns indirect
costs to jobs using a predetermined overhead rate.
Standard costing - a costing method that assigns both
direct and indirect costs to jobs using predetermined or
budgeted rates.
91
Why Use Predetermined Overhead Rates?
Predetermined rates have certain advantages over actual rates:
 They reduce variability inherent in actual overhead rates.

Managers do not have to wait until the end of an accounting
period to get job cost reports.

They require managers to engage in planning.

They set performance expectations.

Any resulting variances are attention-directors.
92
Computing/Using Predetermined Overhead Rates
Identify the indirect costs to be allocated.
Estimate the amount of these costs expected to be incurred
during the period, based on the estimated level of operations.
Select an appropriate cost allocation base.
Estimate the level of the allocation base expected to be
consumed, based on the estimated level of operations.
Compute the predetermined overhead (OH) rate:
OH Rate = Est. annual OH costs/Est. level of allocation base.
During the period, measure the actual amount of the allocation
base consumed by a given job.
Allocate overhead by multiplying the predetermined rate by the
actual amount of the allocation base consumed by the job.
93
Accounting for Allocated (Applied) Overhead
Allocation (or application) of overhead is
accounted for independently of the incurrence
of overhead.
The Inventory account is “debited” for the
allocated overhead and the Overhead account
is “credited” with the amount of the allocation.
If actual overhead during the period is greater
(less) than applied or allocated overhead, this
gives rise to an overhead variance.
94
Over- or Underapplied Overhead
The Overhead account is a temporary account and is
closed out at the end of the accounting period.
The difference between the actual overhead incurred
and the amount allocated to jobs represents the
over/under applied overhead or the overhead
variance.
Large overhead variances are candidates for
investigation, as they may indicate that a process is
out of control.
95
Causes of Overhead Variances
An overhead variance will occur whenever total actual
overhead incurred differs from the total amount of
overhead allocated to jobs.
This condition will occur for one or both of the following
reasons:
 Actual total overhead cost differed from expected
total overhead cost (the numerator reason).
 Actual amount of allocation base used differed from
the budgeted amount used to compute the rate (the
denominator reason).
96
Activity-Based Costing
97
Identifying Activities
Activity - any event that causes the consumption of overhead resources.
Activities can be generally be classified into five broad classes:
 Unit-level activity - activities performed each time a unit is produced.
 Batch-level activity - activities performed each time a batch is handled or
processed, regardless of how many units are in the batch.
 Product-level activity - activities that relate to specific products and
typically must be carried out regardless of how many batches are run or
units of product are produced or sold.
 Customer-level activity - activities that relate to specific customers and
include activities that are not tied to any specific product.
 Organization-sustaining activity - activities that are carried out regardless
of which customers are served, which products are produced, how many
batches are run, or how many units are made.
98
Cost Distortions/Inaccuracy with Volume-Based Systems
Volume-based costing system - A product costing system in
which costs are assigned to products or services on the basis of a
single activity base that is closely related to volume (e.g., direct
labor hours, number of units, machine hours).
Distortions in reported costs may arise if:
 A relatively large proportion of indirect costs incurred relate to
non-unit-level activities (i.e., batch-level, product-level,
customer-level or organization sustaining-level).
 The individual products or services make differing demands
on firm resources through their use of activities (i.e., products
or services are diverse).
99
Activity-Based Costing
Activity-based costing (ABC) system - A product costing system in which
costs are assigned to products or services on the basis of their
consumption of an organization’s fundamental activities.
Activity-based costing is designed to provide managers with cost
information for strategic and other decisions that potentially affect
capacity and, therefore, “fixed” costs.
ABC systems are usually supplemental to the firm’s formal cost system
(which computes product costs for external reporting purposes).
The linkage between resources and costs:
Products/services
Activities
Firm resources
100
Steps in Implementing Activity-Based Costing
1. Identify and define activities and activity pools.
2. Whenever possible, directly trace costs to activities and cost objects.
3. Assign costs to activity cost pools.
4. Calculate activity rates.
5. Assign costs to cost objects using the activity rates and activity
measures.
6. Prepare management reports.
101
Baxendale and Dornbusch:
Activity-Based Costing for a Hospice
ABC can be applied to a service organization as well as a manufacturing
firm, including not-for-profit groups.
The issue faced by Hospice of Central Kentucky was properly measuring
the costs of providing hospice care, conditional on the degree of acuity
faced by patients.
The underlying assumption: Higher acuity involves greater consumption
of hospice resources.
The result of the analysis and cost system modifications was that higher
acuity patient-days are assigned higher costs.
This helped the hospice justify higher reimbursement rates from health
care insurance programs for patients making greater demands on
hospice resources.
102
Customer Profitability Analysis
Customer profitability analysis is a manifestation of the responsibility
accounting concept. Customers are “held responsible” for the costs and
revenues they generate for the firm.
Revenues and costs caused by each customer are assessed using activity
analysis.
Customers may be broadly categorized into two classes:
 High cost-to-serve.
 Low cost-to-serve.
Profitability analysis generally helps firms in identifying high and low
cost-to-serve customers.
Customer profitability reports typically indicate that only a relatively few
of a firm’s customers generate most of its profits.
103
Activity-Based Management
Porter’s concept of the value chain motivates
implementation of activity-based management (ABM).
An organization is a causal chain of activities that add
profit or customer value through the transformation of
inputs into delivered services or products.
The strategic organizational design issue is configuring
an organization’s value chain effectively and
efficiently.
104
Activity-Based Management
Activity-based cost management - Key objectives:
 To measure the cost of the resources consumed in
performing the organization’s significant activities.
 To identify and eliminate non-value-added costs. These
are the costs of activities that can be eliminated with no
deterioration of product quality, performance, or
perceived value.
 To determine the efficiency and effectiveness of all
major activities performed in the enterprise.
 To identify and evaluate new activities that can improve
the future performance of the organization.
105
Value-Added vs. Non-Value-Added Activities
Two types of value-added activities:
- Activities that add value to the customer.
- Activities essential for the proper functioning of the
enterprise.
Non-value-added activities are activities that can be reduced or
eliminated without decreasing the enterprise’s ability to compete
and meet customer demands.
106
Resources Supplied Versus Resources Used
Resources supplied to an activity are the expenditures or
amounts spent on the activity.
Resources used in an activity are measured by the cost (activity)
driver rate multiplied by the volume of the cost driver consumed.
The difference between resources used and resources supplied is
called unused resource capacity.
Activity-based management involves looking for ways to reduce
unused resource capacity.
Unused resource capacity occurs because managers commit to
supply a certain level of resources before they are actually used.
107
Unused Resource Capacity in Activities
Recall the five levels of activities: unit-level, batch-level, product-level,
customer-level and organization-sustaining activities.
Where do firms have the greatest flexibility in reducing unused resource
capacity?
The greatest gains are usually made in the batch-level, product-level,
and customer-level activities.
Unit-level activities have to be performed once for every output, so
resources are supplied as they are used. Therefore, there is little
unused capacity.
Organization-sustaining activities represent long-term, committed costs.
There is typically unused capacity here unless the firm is operating at full
capacity. Control over these costs is exercised through capital budgeting
or other long-term commitments.
108
Process View (ABM) versus Cost Assignment View (ABC)
Resource Costs
Assignment of resource costs
to activity cost pools
Activity Analysis
Root
Causes
Activity
Triggers
Activity Evaluation
Activities
Performance
Measures
Assignment of activity costs
to cost objects
Cost Objects
109
Service Department Costing
Operating department – those departments or units where the central
purposes of the organization are carried out; i.e., those departments
that carry out operating activities.
Service department – those departments that do not engage in
operating activities. These departments support or provide services to
the operating departments.
Service department costs are generally considered to be part of the cost
of the final product or service.
Since products or services directly consume only operating activities, this
requires service department costs to be allocated to operating
departments.
110
Service Department Costing
Allocation rates of service department costs become “transfer
prices” for services. Consuming departments thus “purchase”
services at a unit price equal to the allocation rate.
Regarding practice, some firms choose not to allocate costs in
order to encourage the use of the service resource.
However, other firms allocate some portion of the costs of the
service resource (often the fixed portion) to reflect the cost of the
capacity provided. Paying a certain amount, regardless of usage,
may encourage usage of the resource.
111
Methods for Allocating Service Department Costs
Direct method – no recognition of reciprocal (or
interdepartmental) services.
Step method – partial recognition of reciprocal
services.
Reciprocal method – full recognition of reciprocal
services.
112
Pricing Policy
113
Pricing Policy
Pricing policy is generally informed using one of two
basic approaches:


Cost-based pricing.
Market-based pricing.
Although infrequently used, an economics-based
framework would lead to price adjustments
culminating with the marginal revenue of one
additional unit sold exactly equaling the marginal cost
of that unit.
114
Cost-Based Pricing
Cost-based pricing assumes that:


Costs are known and available, and
Customers are, in general, “price-takers” in the market.
Cost-based pricing is “rational” in the sense that
revenues must exceed costs for long-run viability.
Cost-based pricing takes cost as the starting point,
and these costs are “marked up” to arrive at a selling
price. Regarding the cost base, practice is diverse.
115
Cost-Based Pricing
Possible cost bases include:




Direct costs (materials, labor).
Total variable costs.
Full manufacturing costs.
Total value chain costs.
In general, the markup percentage must be
sufficiently large in order to cover any costs
not included in the cost base, plus any profit
expectations.
116
Cost-Based Pricing
The general expression for computing the
markup ratio is given by:
(Costs not included in the cost base + Desired profit) / Cost base
This initial selling price would then be
computed as:
Initial price = Cost base + (Cost base x Markup ratio)
117
Cost-Based Pricing
Potential problems with cost-based pricing:




The approach requires accurate cost assignment.
All costs must be known to make appropriate markup
decisions.
It assumes payers are, generally, “price-takers” in the market.
In a competitive market, cost-based approaches may increase
the time and cost of bring a new product to market.
These criticisms have led many organizations to move
toward more market-based approaches in setting
prices.
118
Target-Costing
Target-costing starts with determining what customers are
willing to pay for a product or service (the target price).
The target cost is defined when a target profit is subtracted
from the target price.
Whether the organization can produce the product or
service at the target cost is the issue that management
must address.
The target cost is generally achieved by the decisions made
in the product development phase.
119
Target-Costing
Steps in target costing:




Determine customer wants, needs and price sensitivities.
Establish planned selling price.
Determine target cost (= Selling price – desired profit).
Using the target cost constraint, task key employees and
trusted suppliers to:
 Design the product.
 Determine production procedures.
 Determine necessary raw materials.



Repeat the previous step until the target cost is achieved.
Manufacture the product.
Sell the product.
120
Budgeting and Profit Planning
121
What is a Budget?
A budget is a detailed plan for the acquisition and use of
financial and other resources over a specified period of time.
Good budgeting practice should provide for both planning and
control.
Planning - developing objectives and preparing various budgets
to achieve these objectives.
Control - the steps taken by management to increase the
likelihood that the objectives set down at the planning stage are
attained, and to ensure that all parts of the organization function
in a manner consistent with organizational policies.
122
Responsibility Accounting
Responsibility accounting is based on the notion that
managers should be held responsible for those (and
only those) cost/revenue items that the manager can
control to a significant extent.
However, while some costs may be uncontrollable, a
manager may still be able to mitigate the incurrence of
the cost through appropriate actions.
From a control point of view, someone in the
organization must “take ownership” for each budget
item or else no one will be responsible.
123
The Master Budget
Master budget - a financial plan of an organization for the coming
year or other planning period. It generally culminates in a cash
budget, a budgeted income statement, and a budgeted balance
sheet.
The master budget is also called the static budget.
The master budget reflects management’s best guess as to the sales
levels, production and cost levels, income, and cash flows
anticipated for the coming year.
Developing a master budget is a dynamic process that ties together
goals, plans, decision making, and performance evaluation.
124
The Master Budget and Strategic Planning
Organization
goals
Long-range
strategic plan
Individual goals
and values
Anticipated
conditions
Individual
beliefs
Master
budget
Strategic
evaluation
Actual period
results
Performance
evaluation
125
Purposes of Budgeting Systems
Budgeting system - procedures used to develop a
budget.
Budgeting systems have five major purposes:
 Planning.
 Facilitating communication and coordination.
 Allocating resources.
 Controlling profit and operations.
 Evaluating performance and providing incentives.
126
Advantages and Disadvantages of
Budgeting
Advantages:
 forces managers to plan.
 provides performance benchmarks.
 promotes communication and coordination.
Disadvantages:
 consumes a good deal of time.
 may lead to a short-term focus and “gaming” behavior.
 managers may simply extrapolate current trends.
 may lead to the impression that functional areas are
independent.
 may promote a “slash and burn” mentality in tough times.
127
Performance Evaluation
Performance evaluation requires a benchmark or standard for
comparison.
Budgeted performance may be a better criterion than past
performance as a benchmark.
Past performance:
 may hide inefficiencies.
 may not reflect changes in opportunities in the external
business environment.
However, budgets induce additional problems, primarily in the
area of effects on human behavior (e.g., budget administration
may induce budget bias or budgetary “slack”).
128
Promoting Coordination and Communication
Coordination is the meshing and balancing of all factors of
production or service so that the organization achieves its
objectives.
 The budget process forces departments with different
incentives and goals to communicate and work together
toward achieving the goals of the firm as a whole.
Communication is getting those objectives understood and
accepted by all parties.
 Individual operating units and departments are thus informed
about where they fit in the overall scheme of the firm and
what is expected of each.
Coordination and communication allow managers to make better
judgments about the necessary resource allocations within their
departments.
129
Steps in Preparing the Budget
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
Sales/revenue budget.
Ending inventory budget.
Production budget.
Materials requirements (in units and dollars) budget.
Labor costs budget.
Overhead costs budget.
Cost of sales budget.
Marketing and administrative costs budget.
Budgeted income statement.
Capital budget.
Cash budget.
Budgeted balance sheet.
Budgeted statement of cash flows.
130
Sales Budget
The sales budget is the basis for all other budget components.
Units to be sold are a function of the forecasted selling price.
The budget requires a forecast of sales, typically involving sales
staff and market research. Various statistical techniques may
also be used. Sales may be forecasted in units and in dollars.
Budgeted revenues can be computed as:
Forecasted sales (in units) x Forecasted selling price.
131
Ending Inventory and Production Budgets
We use the following relationship to forecast production
requirements:
Required
Budgeted
Budgeted
Budgeted
production
=
sales in +
ending – in beginning
in units
units
inventory
inventory
Three estimates required to forecast production:
 Budgeted sales in units.
 Budgeted ending inventory.
 Budgeted beginning inventory.
Estimated units in beginning and ending inventories based on
inventory policies and/or market conditions.
132
Materials
We use the following relationship to forecast material
purchase requirements:
Required
purchases
in units
=
Materials
Budgeted
to be used in +
ending
production
inventory
–
Budgeted
beginning
inventory
Beginning and ending inventory levels are estimated
using some inventory model, while production
requirements are based on an estimated amount per
unit.
Multiplication of each component by the forecasted cost
per unit converts these amounts to dollars.
133
Labor and Overhead Budgets
Amounts of labor and overhead expected to be consumed are
based on the production budget.
These amounts are also used to forecast staffing levels.
Overhead estimates tie back to estimated capital budgeting
expenditures for capacity.
Costs may be broken out into fixed and variable components.
If activity-based costing is used for budgeting purposes, levels
of activities are forecasted based on anticipated production,
and overhead is estimated for each activity.
134
Cost of Sales Budget
Computation requires estimates of beginning and
ending levels of work-in-process and finished goods
inventories.
If WIP levels are assumed to be constant, the
calculation reduces to:
Estimated
Cost
=
of Sales
Estimated
Budgeted
Budgeted
production + cost of beginning – cost of ending
costs
inventory
inventory
Estimated production costs consist of estimated
materials costs, labor costs, and overhead costs from
the previous budgeted amounts.
135
Marketing and Administrative Costs
The budgeting objective is to estimate the amount of
marketing and administrative costs required to:
 Operate the organization at its projected level of
sales and production.
 Achieve long-term company goals.
These estimates are often based on prior period
expenditures or planned expenditures, but adjusted
for inflation, changes in operations, etc.
136
Budgeted Income Statement
The budgeted income statement is easily generated
using information from the previous budgets.
To complete the computation of net income, an
estimate must be made of tax expense.
The computed net income is then incorporated into
the calculation of budgeted retained earnings, while
estimates of ending materials, work in process and
finished goods inventories are incorporated into
budgeted assets.
137
Cash Budget
We now need to incorporate the sales cycle in forecasting cash
requirements:
Cash => Inventory => Sales => Accts. Recv. => Cash
Cash budget - a statement of cash on hand at the start of the budget
period, expected cash receipts, expected cash disbursements, and the
resulting cash balance at the end of the period.
Cash disbursements - amounts required to pay for purchases, operating
expenses, taxes, interest, dividends, etc.
Cash receipts - collections from accounts receivable, cash sales, sales of
assets, borrowing, issuing stock, etc.
The cash budget requires that all revenues, costs, expenses, and other
transactions be examined in terms of their effects on cash.
138
Budgeted Balance Sheet
Budgeted balance sheet - a statement of budgeted financial position.
The ending balance in a given account equals the beginning balance
plus any estimated change.
The cash budget provides the ending cash balance on the balance
sheet.
The ending inventories for materials and finished goods are reported
on the balance sheet.
Ending accounts receivable/accounts payable are derived from the
cash budget.
The budgeted statement of cash flows explains the difference
between estimated cash at the beginning of the period and that at
the end of the period. The change in cash is explained as arising
from operating activities, investing activities, and financing activities.
139
How the Budget Pieces Fit Together
Production
budget
Required materials,
labor and overhead
budgets
Sales forecast
Budgeted cost
of sales
Marketing and
admin. budget
Budgeted
income
statement
Cash budget
Budgeted balance
sheet
140
Flexible Budgets
Budgets are usually used to evaluate performance
after the fact, using a process known as variance
analysis.
Since some costs are variable with respect to output
and some are fixed, changes in output will
automatically lead to increases/decreases in costs
absent any input from managers.
Since static budgets reflect planned output rather than
actual output, they are not a good basis of comparison
to actual costs.
141
Flexible Budgets
In order to use the budget as a control tool (i.e., to evaluate cost
and revenue performance at the end of the period), budgets
usually require revisions to reflect actual output during the period
rather than planned output.
A flexible budget is designed to facilitate these revisions, as the
budget is prepared with full consideration of variable costs, fixed
costs, and the associated cost-volume relations.
Flexible budgets tell managers what costs should have been
given the actual level of output. This makes for a more equitable
basis for comparison with actual costs, and makes variances
easier to interpret.
142
Standard Costs,
Performance Reports, and
the Balanced Scorecard
143
Standard Costs
Definition: Standard costs are benchmarks for the cost of a
product, process, or subcomponent.
Used for Planning and Decision Making:
 Standards can be better predictors of future costs than actual
past costs.
 Can be used in product pricing, bidding, and outsourcing
decisions.
Used for Controlling Operations:
 Set performance expectations.
 Variances from standards get attention of managers.
144
Setting and Revising Standards
Setting standards depends on specialized knowledge:


Price (or rate) standards derived from economic forecasts.
Quantity (or efficiency) standards derived from engineering
studies.
Choosing between tight and loose standards:


Tight standards motivate higher performance.
Loose standards allow more discretion.
Standards are usually set once a year:

Frequent revision would reduce incentives to control costs.
145
Purpose of Variances
Variances measure the difference between actual
and standard costs:


Favorable (F) variance, if actual < standard.
Unfavorable (U) variance, if actual > standard.
Controlling operations:


Variances alert managers to deviations from plan.
Performance rewards may be based on minimizing
variances.
146
Variance Computation
Symbols: A = Actual; S = Standard; P = Price; Q = Quantity
Total Variance =
Actual Cost
−
Standard Cost
Total Variance =
(AQ  AP)
–
(SQ  SP)
= (AQ  AP) – (SP  AQ) + (SP  AQ) – (SQ  SP)
= [(AQ  AP) – (SP  AQ)] + [(SP  AQ) – (SQ  SP)]
= [ AQ  (AP – SP) ] + [ (AQ – SQ)  SP ]
=
Price Variance
+
Quantity Variance
Total Variance =
Price Variance
+
Quantity Variance
147
Direct Labor Variances
Symbols: AQ = Actual quantity of hours used; SQ = Standard quantity of
hours allowed; SP = Standard wage rate per hour; AP = Actual wage
rate.
Total
Total
actual
standard
cost
cost
AQ  AP
AQ  SP
SQ  SP
|________________________|______________________|
AQ  (AP – SP)
(AQ – SQ)  SP
Rate variance
Efficiency variance
|_______________________________________________|
(AQ  AP) - (SQ  SP)
Total labor variance
Note: Total standard cost equals the cost allowed for the actual output
achieved.
148
Interpreting Direct Labor Variances
Large variances in either direction indicate performance is not
as planned, due to poor planning, poor management, poor
standards, or random fluctuation.
Unfavorable rate variance:


Could indicate overtime had to be paid, depending on how
overtime is accounted for.
Workers were not available at lower rates.
Unfavorable wage variance with favorable efficiency variance:

Higher-paid workers performed work more efficiently.
Favorable wage variance with unfavorable efficiency variance:

Lower-paid workers performed work less efficiently.
149
Direct Material Variances
Total actual
Actual Purchases
cost
at standard cost
AQ  AP
AQ  SP
|______________________________|
AQ  (AP – SP)
Price variance
Actual Usage at
Total standard
standard cost
cost
AQ  SP
SQ  SP
|_______________________________|
(AQ – SQ)  SP
Quantity variance
Price variance recognized at time materials are purchased.
Quantity (efficiency) variance recognized at time materials are used.
150
Interpreting Direct Material Variances
Large variances in either direction indicate performance is not as planned, due to
poor planning, poor management, poor standards, or random fluctuation.
Price and Quantity variances:

Unfavorable: Material purchased for more than planned prices; could also
indicate material had to be rush/special-ordered, due to late requisitioning by
production. More material used than expected.

Favorable: Material purchased for less than planned prices; could indicate
lower quality material purchased or excess quantities purchased (quantity
breaks). Less material used than expected
Unfavorable price variance with favorable quantity variance:

Higher-quality material resulted in less waste and scrap; may also result in a
favorable labor efficiency variance.
Favorable price variance with unfavorable quantity variance:

Lower-quality material resulted in more waste and scrap; may also result in
an unfavorable labor efficiency variance.
151
Advantages of Standard Costing
Provide the basis for sensible cost comparisons.
Enables managers to employ management by
exception.
Provide a means of performance evaluation.
Provide motivation for employees to achieve
standards.
Result in more stable product costs if used in product
costing.
May result in cost savings in maintaining inventory
records.
152
Potential Disadvantages of Standard Costing in
Modern Production Settings
Information may be too aggregated and too delayed to be useful in
controlling things that matter.
Information may be aggregated over multiple product lines or production
batches.
Requires a stable production process to be cost-effective.
Shorter product life cycles lead to quickly outdated standards.
Variance analyses tend to lead to a primary focus on cost minimization,
rather than on value maximization.
153
Incentive Effects of Standard Costing
Incentives for both Purchasing and Production
to build inventories.
Externalities imposed on the firm through the
actions of Purchasing and/or Production.
Disincentives to cooperate.
Incentives to engage in satisficing (i.e., do
only what is necessary to “meet the
standard”).
154
Earnings as a Summary Performance Measure
Earnings represent the changes in the net assets of the firm
(exclusive of owner activity). Accounting rules require that some
assets remain unrecognized because of the difficulty of placing a
reliable financial value on them.
Example of unreported assets:
 New product pipelines.
 Process capabilities and flexibility.
 Customer relationships.
 Employee skills, expertise and motivation.
 Databases and other forms of information technology.
Earnings measure changes in the above unrecognized assets
poorly.
155
Earnings as a Summary Performance Measure
Further, reported earnings always lag actual performance,
leading to the criticism that earnings are not “timely.” This
suggests that reported earnings is not an adequate summary
performance measure, and is not a “sufficient” statistic.
A line of accounting research has documented that a “fixation” on
financial performance measures may lead to dysfunctional
behavior on the part of managers (e.g., disinvestment, reduced
spending on quality and R&D, earnings manipulation).
Instead, the performance measurement system needs to
measure and report relevant measures in addition to earnings
that employees can use to inform and guide value-relevant
actions.
156
The Balanced Scorecard
More firms are using a portfolio of measures to assess
performance.
Kaplan and Norton (1992) have advocated a “balanced
scorecard” approach to performance measurement that they
argue (1) provides managers with a fast but comprehensive
view of the business, and (2) communicates to managers the
measures to which they need to attend.
The scorecard consists of (1) financial measures to summarize
the results of actions already taken, and (2) operational
measures that are the drivers of future performance.
157
Strategic Dimensions of The Scorecard
The balanced scorecard is a way to clarify, simplify,
and then operationalize the vision at the top of the
organization.
In other words, the scorecard presents a prescriptive
view of the organization.
Perspectives of concern:
 Innovation, learning and growth perspective.
 Internal business perspective.
 Customer perspective.
 Financial perspective.
158
Innovation, Learning and Growth Perspective:
Can We Continue To Improve And Create Value?
Intense global competition requires that firms make
continual improvements to their existing products and
processes and have the ability to introduce entirely
new products with expanded capabilities.
A company’s ability to innovate, improve, and learn
ties directly to the company’s value.
159
Internal Business Processes Perspective:
What Must We Excel At?
Excellent customer performance derives from processes,
decisions, and actions occurring throughout the organization.
The internal measures should stem from the processes that have
the greatest impact on customer satisfaction. These are factors
that affect:
 Cycle time.
 Quality.
 Employee skills.
 Productivity.
Firms should also attempt to identify and measure their core
competencies, which are the critical technologies needed to
ensure continued market leadership.
160
Customer Perspective:
How Do Our Customers See Us?
Customer concerns fall into four basic categories:
 Time.
 Quality.
 Performance and service.
 Cost.
Firms should articulate goals for each of these factors,
and then translate these goals into specific measures.
161
Financial Perspective:
How Do Our Share/Stakeholders See Us?
Financial performance measures indicate whether the company’s
strategy, implementation, and execution are contributing to bottom-line
improvement.
Typical financial goals have to do with:
 Profitability.
 Growth.
 Shareholder wealth.
Financial goals have been criticized for various reasons (reflect historical
costs, conservatism, assets not reflected on the balance sheet, etc.).
But improved operating performance does not automatically translate
into financial success; therefore, attention to financial goals is necessary.
162
The Balanced Scorecard and Firm Strategy
(Kaplan and Atkinson, 1998)
A strategy is a set of hypotheses about cause and effect.
The measurement system should make the relationships
(hypotheses) between objectives (and measures) in the various
perspectives explicit so they can be measured and validated.
The chain of cause and effect should pervade all four
perspectives of a balanced scorecard.
A properly designed balanced scorecard should tell the story of
the business unit’s strategy.
163
An Example
Financial:
Customer:
Return on employed capital
Customer loyalty
On-time delivery
Internal business: Process quality
Learning and growth:
Process cycle time
Employee skills and training
164
Segment Reporting
and Decentralization
165
Decentralization
Decentralization - a form of organization in which sub-unit
managers are given authority to make substantive decisions.
Micro-level decentralization - a work group of five shop workers
making various quality decisions.
Macro-level decentralization - a stand-alone division of a firm
making product or capital budgeting decisions.
Firms choose to decentralize operations because of information
asymmetries between top managers and local managers.
166
Advantages of Decentralization
Top management is freed to concentrate on strategic and other
high-level issues.
Lower level managers have greater and better information, which
leads to greater responsiveness to local needs and quicker and
better decision making.
Increases motivation and job satisfaction.
Aids management development and learning.
Sharpens the focus of managers and aids in performance
evaluation.
167
Disadvantages of Decentralization
Lower-level managers may pursue goals that are
incongruent with the goals of the organization as a
whole.
Activities may be uncoordinated among lower-level
managers.
Communication among divisions may be hindered.
Lower-level managers may not see the “big picture”
and may have less loyalty toward the organization as
a whole.
168
Responsibility Accounting
Characteristics of responsibility centers are:
 The knowledge held the centers’ managers is difficult to
acquire, maintain, or analyze at higher levels.
 The duties that a particular individual in an organization
is expected to perform are specified for each center.
Types of responsibility centers:
 Cost center.
 Profit center.
 Investment center.
169
Segmented Reporting
Effective decentralization requires segmented
reporting.
A segment is a subunit of an organization for which
performance measures (e.g., revenues, costs,
expenses, profit) are needed.
However, the concept of segmented reporting can be
extended to the customer level as well (e.g., customer
profitability analysis).
170
Segmented Reporting (continued)
Consider a healthcare setting. Management reports
requested from the accounting system can include
analyses of, among other things:




The
The
The
The
profitability
profitability
profitability
profitability
of
of
of
of
individual
individual
individual
individual
patients.
physicians.
payer/insurance groups.
departments.
These reports can be useful both from revenuemanagement and cost-management perspectives.
171
Segmented Reporting (continued)
Proper cost assignment (tracking and allocation) is critical to
proper segment reporting.
A traceable fixed cost of a responsibility center is a fixed cost that
is incurred because of the existence of the segment.
 If the responsibility center were eliminated, the traceable
fixed cost would disappear.
A common fixed cost is a fixed cost that supports the operations
of more than one segment but is not traceable in whole or in part
to any one segment.
 If the responsibility center were eliminated, there would be no
change in a true common fixed cost.
172
Investment Centers
Given that managers have decision rights over the
activities and net assets of the subunit of the firm,
performance measurement should address the
efficiency and effectiveness of managers’ stewardship
over those net assets.
Performance measurement for investment centers:
 Return on investment (ROI).
 Residual income (RI).
 Economic value added (EVA).
173
Return on Investment
Return on investment (ROI) for an investment center =
Accounting net income / Total investment in that investment center
Interest and tax expense can be ignored at the divisional level if
capital structure, financing and tax decisions are made at the
corporate level.
DuPont formula separates ROI into two components:
ROI = Sales (or Asset) turnover
x
Profit Margin
ROI = (Sales / Total Investment) x (Net Income / Total Sales)
ROI increases with smaller investments and larger profit margins.
174
Residual Income
Residual income (RI) =
Accounting income of investment center
– (Required rate of return x Capital invested in that center).
RI is determined with financial accounting
measurements of net income and capital.
Each investment center could be assigned a different
required rate of return depending on its risk.
RI can be increased by increasing income or
decreasing investment.
175
Transfer Pricing
Transfer Price - the internal price (or cost allocation) charged by
one segment of a firm for a product or service supplied to
another segment of the same firm.
Examples of transfer prices:
 Internal charge paid by final assembly division for
components produced by other divisions.
 Service fees to operating departments for
telecommunications, maintenance, and services by support
services departments.
 Cost allocations for central administrative services (general
overhead allocation).
176
Transfer Pricing for International Taxation
When products or services of a multinational firm are transferred
between segments located in countries with different tax rates, the firm
attempts to set a transfer price that minimizes total income tax liability.
Segment in higher tax country (or jurisdiction): Reduce taxable income
in that country by charging high prices on imports and low prices on
exports.
Segment in lower tax country (or jurisdiction): Increase taxable income
in that country by charging low prices on imports and high prices on
exports.
Government tax regulators try to reduce tax shifting through transfer
pricing manipulation.
177
Capital Budgeting Decisions
178
Capital Budgeting/Investment Alternatives
Opportunity cost of capital: The benefits of investing capital in
one investment alternative that are foregone when that capital is
invested in some other alternative.
When expected cash flows occur in different time periods, the
opportunity cost of capital becomes relevant to our decision.
Capital budgeting: The analysis of investment alternatives
involving cash flows received or paid over time.
Capital budgeting is used for decisions about replacing
equipment, leasing or buying equipment, and plant acquisitions.
179
Time Value of Money
Basic Concept: A dollar received today is worth more than a dollar
received tomorrow (everything else being equal), because you could
invest the dollar today and have your dollar plus interest tomorrow.
Example:
Investment Alternative:
a. Invest $1,000 in bank account earning 5 percent per year
b. Invest $1,000 in project returning $1,000 in one year
Value at end
of one year
$1,050
$1,000
Alternative B foregoes the $50 of interest that could have been
earned from the bank account. The opportunity cost of selecting
alternative B is $1,050.
180
Present Value Concept
Since investment decisions are being made now at the beginning
of the investment period, all future cash flows must be converted
to their equivalent dollars now.
Beginning-of-year dollars  (1+Interest rate)= End-of-year dollars.
End-of-year dollars / (1+Interest rate)= Beginning-of-year dollars.
181
Interest Rate Mathematics
Define:
FV = Future Value
PV = Present Value
r = Interest rate per period (usually per year)
n = Periods from now (usually years)
Then:
 Future Value of a single flow:


FV = PV (1 + r)n
Present Value of a single flow: PV = FV / (1 + r)n
= [1 / (1 + r)n] FV
Discount factor = 1 / (1 + r)n
182
Interest Rate Mathematics
Present value of a perpetuity (a stream of equal periodic
payments for infinite periods):
 PV = FV / r
Present value of an annuity (a stream of equal periodic
payments for a fixed number of years):
 PV = FV {(1 / r )  [ 1 – (1/ (1 + r)n)]}
183
Net Present Value Basics
1. Identify after-tax cash flows for each period.
2. Determine discount rate.
3. Multiply the cash flow by the appropriate presentvalue factor (single or annuity) for each cash flow.
PV factor is 1.0 for cash invested/received now.
4. Sum of the present values of all cash flows = net
present value (NPV).
5. If NPV  0, then accept project.
6. If NPV < 0, then reject project.
NPV is also known as discounted cash flow (DCF).
184
Capital Budgeting Basics
1. Discount after-tax cash flows, not accounting earnings.
Cash can be invested and earn interest. Accounting earnings include
accruals that estimate future cash flows.
2. Include working capital requirements.
Consider cash needed for additional inventory and accounts receivable.
3. Include opportunity costs but not sunk costs.
Sunk costs are not relevant to decisions about future alternatives.
4. Exclude financing costs.
The costs of financing the project are implicitly included when future
cash flows are discounted. If the project has a positive NPV, then its
cash flows yield a return in excess of the firm’s cost of capital.
185
After-Tax Cash Flows
Determine cash flows after taxes. Revenues and expenses are
reduced by income tax effects.
On its income tax return, a firm cannot fully deduct the cost of a
capital investment in the year purchased. Instead, firms
depreciate the investment over several years at the rate allowed
by the tax law.
Time
Cash flow
Beginning of project
Cash to acquire assets
Future years
Depreciation deduction on tax
return reduces future tax
payments (depreciation tax shield)
186
Alternative Capital Budgeting Methods
Methods that consider the time value of money:
 Net present value (NPV) method.
 Internal rate of return (IRR) method.
Methods that do not consider the time value of
money:
 Payback method.
 Accounting rate of return on investment.
187
Alternative: Payback Method
Payback Period: The time required until cash inflows from a project
equal the initial cash investment.
Rank projects by payback and accept those with shortest payback
period.
Advantages of payback method:
 Simple to explain and compute.
Disadvantages of payback method:
 Ignores time value of money (when is cash received within payback
period).
 Ignores cash flows beyond end of payback period.
188
Alternative: Accounting Rate of Return
Accounting rate of return defined as:
Average annual accounting income from project
 Average annual investment in the project
= Accounting Rate of Return on investment
Advantages of Accounting Rate of Return method:
 Simple to explain and compute using financial statements.
 Consistent with performance measures in common use in divisional
settings.
Disadvantages of Accounting Rate of Return method:
 Ignores time value of money.
 Accounting income is usually not equal to cash flow.
189
Alternative: Internal Rate of Return (IRR)
Internal rate of return (IRR) is the interest (discount) rate that equates the
present value of future cash inflows to the present value of the cash
outflows.
With a single cash flow, PV = FV / (1 + irr), or irr = (FV / PV) - 1
Comparison of IRR and NPV methods:
 Both consider time value of cash flows.
 IRR indicates relative return on investment.
 NPV indicates magnitude of investment’s return.
 IRR can yield multiple rates of return.
 IRR assumes all cash flows reinvested at project’s constant IRR.
 NPV assumes all cash flows reinvested with the specified discount rate.
190