2.

1 Definition of Managerial (Management) Accounting

 Management accounting is the sourcing, analysis, communication and use of decision-relevant financial and non-financial
information to generate and preserve value for organisations.
- [CIMA: Chartered Institute of Management Accountants (UK)]

 Management accounting is a profession that involves partnering in management decision making, devising planning and
performance management systems, and providing expertise in financial reporting and control to assist management in the
formulation and implementation of an organization’s strategy
- [IMA: Institute of Management Accountants (USA)]

 Management accounting measures, analyzes, and reports financial and nonfinancial information that helps managers make
decisions to fulfill the goals of an organization. Managers use management accounting information to develop, communicate,
and implement strategy. They also use management accounting information to coordinate product design, production, and
marketing decisions and to evaluate performance. Management accounting information and reports do not have to follow set
principles or rules. The key questions are always (1) how will this information help managers do their jobs better, and (2) do
the benefits of producing this information exceed the costs?
- Cost Accounting A Managerial Emphasis 14e - Horngren, Datar & Rajan

2.2 Differences between Financial and Managerial Accounting

Accounting Information System

 Consists interrelated manual and computer parts
 Uses processes such as collecting, recording, summarizing, analyzing, and managing data to transform inputs into information
provided to users
 Two major systems
o The financial accounting information system
 Produces outputs for external users
 Follows rules and conventions set by the SEC and FASB
 Provides outputs such as financial statements
o The cost management accounting information system
 Produces outputs for internal users
 Provides information for three broad objectives
 Cost services, products, and other objects
 Planning and control
 Decision making
 Criteria and formats are set internally
 Two sub-systems
 Cost Accounting Information System
o Assigns costs to individual products and services
o Assists external financial reporting
o Conforms to the rules and conventions set by the SEC and the FASB
 Operational Control Information System
o Provides accurate and timely feedback
o Improves profit by increasing customer value

Financial Accounting Management Accounting

Communicate organization’s financial position
Purpose of Help managers make decisions to fulfill an
to investors, banks, regulators, and other
information organization’s goals
outside parties
External users
Primary (Intended) Internal parties
(investors, creditors, banks, regulators, &
users (Managers of the organization)
suppliers)
Future-oriented
Past-oriented
Type of Information Non-financial; Current and prospective
Financial; Historical
(projection)
Format Based on standards Based on management needs
Rules of Financial statements must be prepared in Internal measures and reports do not have to
measurement and accordance with GAAP and be certified by follow GAAP but are based on cost-benefit
reporting external, independent auditors analysis
Underlying
Principles Precision/ Accuracy Timeliness/ Relevance
(More focus on)
Focus of the report Organization as a whole Segments of the organization

 Management accounting differs from financial accounting primarily in its targeted users.
o Management accounting information is intended for internal users, whereas financial accounting information is
directed toward external users.
  Management accounting is not bound by the externally imposed rules of financial reporting.
 Management accounting provides more detail than financial accounting, and it tends to be broader and multidisciplinary.

Cost accounting
 Provides information for management accounting and financial accounting.
 For example, calculating the cost of a product is a cost accounting function that answers financial accounting’s inventory-
valuation needs and management accounting’s decision-making needs (such as deciding how to price products and choosing
which products to promote).

2.3 Controllership vs. Treasurership

 Controller / Chief Accounting Officer

(CONTROLLERSHIP)  Treasurer (TREASURERSHIP)
o Supervises all accounting departments o Responsible for the finance function
(ACCOUNTING FUNCTION) (FINANCE FUNCTION)
o Participates in planning, controlling, and o Provision of Capital
decision-making activities o Cash management and short-term financing
o Reporting and interpreting o Investments
o Evaluating and consulting o Credits and Collections
o Responsible for both internal and external o Insurance
accounting requirements o Investor and Bank relations
o Financial reporting, Tax reporting, Budgeting, o Risk management
Internal Auditing
o Protection of Assets
Both functions/positions are on the same level under VP for Finance or Chief Financial Officer (CFO)

***** Line and Staff Positions

 Line positions:
o positions that have direct responsibility for
the basic objectives of an organization
o Line management, such as production,
marketing, and distribution management, is
directly responsible for attaining the goals of
the organization (If the objective is to earn
profit).
 Staff positions:
o positions that are supportive in nature and
have only indirect responsibility for an
organization’s basic objectives
o Staff management, such as management
accountants and information technology and
human-resources management, provides
advice, support, and assistance to line
management

Note: If we talk to about a particular department then the head of that unit is a line function. Head of the unit is a line manager
because they directly achieve the objectives of the organization; BUT if whole organization, other VPs are part of indirectly
achieving the goals of the company.

2.4 Role of Management Accountant

 Planning:
o a detailed formulation of future actions to achieve a particular end
o requires setting objectives and identifying methods to achieve those objectives/setting goals
 Controlling:
o leading and organizing
o a managerial activity of monitoring a plan’s implementation and taking corrective action
o achieved with the use of feedback
 Continuous improvement
o relentless pursuit of improvement in the delivery of value to customer
o required to remain competitive or to establish a competitive advantage
o monitoring the operations of the business and gaining feedback to continuously improve the operations of the
business
 Decision making
o process of choosing among competing alternatives
o participate and become a partner in decision-making; BUT management accountant will NOT make decisions, they
are there to provide suggestions but decisions are still up to the management
*** In other textbooks:
 Scorekeeping – gather information
 Attention Directing – direct management to more critical areas
 Problem Solving – be able to solve problems and make certain improvements in the future

Factors Affecting Cost Management

 Advances in Manufacturing Environment
• Theory of constraints: method used to continuously improve manufacturing activities and nonmanufacturing activities
• Just-in-time manufacturing: strives to produce a product only when it is needed and only in the quantities demanded
• Lean manufacturing: a persistent pursuit and eliminates waste that simultaneously embodies respect for people
 • Computer-integrated manufacturing: an automation of the manufacturing environment allowing firms to reduce
inventory, increase productive capacity, improve quality and service, decrease processing time, and increase output
 Customer Orientation
• Deliver value to the customer
• Value chain: the set of activities required to design, develop, produce, market, and deliver products and services to
customers
• Satisfy internal customers
 New Product Development
• High proportion of production costs are involved during the development and design stage of new products
• Cost management procedures
• Target costing: encourages managers to assess the overall cost impact of product designs over the product’s
life cycle
• Activity-based management: identifies the activities produced at each stage of the development process and
assesses their costs
 Total Quality Management
• Continuous improvement and elimination of waste are the two foundation principles
• Objectives: producing products and services that actually perform according to specifications and with little waste
 Time as a Competitive Element
• Crucial element in all phases of the value chain
• Decrease in non-value-added time increases quality
 Efficiency
• Improving efficiency is a vital concern
• Cost is a critical measure of efficiency

2.5 Standards of Ethical Conduct for Management Accountants

Statement of Ethical Professional Practice: Institute of Management Accountants (IMA)

Members of IMA shall behave ethically. A commitment to ethical professional practice includes overarching principles that express our
values, and standards that guide our conduct.

PRINCIPLES
IMA’s overarching ethical principles include: Honesty, Fairness, Objectivity, and Responsibility. Members shall act in accordance with
these principles and shall encourage others within their organizations to adhere to them.

STANDARDS
A member’s failure to comply with the following standards may result in disciplinary action.

I. COMPETENCE
1. Maintain an appropriate level of professional expertise by continually developing knowledge and skills.
2. Perform professional duties in accordance with relevant laws, regulations, and technical standards.
3. Provide decision support information and recommendations that are accurate, clear, concise, and timely.
4. Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or
successful performance of an activity.

II. CONFIDENTIALITY
1. Keep information confidential except when disclosure is authorized or legally required.
2. Inform all relevant parties regarding appropriate use of confidential information. Monitor subordinates’ activities to ensure
compliance.
3. Refrain from using confidential information for unethical or illegal advantage.

III. INTEGRITY
1. Mitigate actual conflicts of interest, regularly communicate with business associates to avoid apparent conflicts of interest.
Advise all parties of any potential conflicts.
2. Refrain from engaging in any conduct that would prejudice carrying out duties ethically.
3. Abstain from engaging in or supporting any activity that might discredit the profession.
4. Contribute to a positive ethical culture and place integrity of the profession above personal interests.(Additional)

IV. CREDIBILITY
1. Communicate information fairly and objectively.
2. Disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of the
reports, analyses, or recommendations.
3. Disclose delays or deficiencies in information, timeliness, processing, or internal controls in conformance with organization
policy and/or applicable law.
4. Communicate professional limitations or other constraints that would preclude responsible judgment or successful
performance of an activity. (Additional)

RESOLUTION OF ETHICAL CONFLICT

In applying the Standards of Ethical Professional Practice, the member may encounter problems identifying unethical behavior or
resolving an ethical conflict.

When faced with ethical issues, the member should follow his organization’s established policies on the resolution of such conflict. If
these policies do not resolve the ethical conflict, the member should consider the following courses of action:

1. The resolution process could include a discussion with the member’s immediate supervisor. If the supervisor appears to be
involved, the issue could be presented to the next level of management.
- Discuss the issue with your immediate supervisor except when it appears that the supervisor is involved. In that case,
present the issue to the next level. If you cannot achieve a satisfactory resolution, submit the issue to the next
management level. If your immediate superior is the chief executive officer or equivalent, the acceptable reviewing
authority may be a group such as the audit committee, executive committee, board of directors, board of trustees, or
owners. Contact with levels above the immediate superior should be initiated only with your superior’s knowledge,
assuming he or she is not involved. Communication of such problems to authorities or individuals not employed or
engaged by the organization is not considered appropriate, unless you believe there is a clear violation of the law.

2. Clarify relevant ethical issues by initiating a confidential discussion with an IMA Ethics Counselor or other impartial advisor to
obtain a better understanding of possible courses of action. IMA offers an anonymous helpline that the member may call to
request how key elements of the IMA Statement of Ethical Professional Practice could be applied to the ethical issue.

3. The member should consider consulting his or her own attorney to learn of any legal obligations, rights, and risks concerning
the issue.

If resolution efforts are not successful, the member may wish to consider disassociating from the organization.

3.1 Review of Cost Concepts and Classifications

 Cost: cash or cash equivalent value sacrificed for goods and services that are expected to bring a current or future benefit
 Expenses: expired costs that are deducted from revenues
 Loss: cost that expires without producing any revenue benefit
 Assets: unexpired costs and appear on the balance sheet
 Cost Objects
1. Things for which costs are measured and assigned
2. Includes products, customers, departments, projects, activities, etc.
 Traceability: ability to assign cost directly to a cost object
 Methods of Tracing
1. Direct tracing: process of identifying and assigning costs to a cost object that are specifically or physically
associated with the cost object
2. Driver tracing: use of drivers to assign costs to cost objects
 Drivers are factors that cause changes in resource usage, activity usage, costs, and revenues
 Assigning Indirect Costs
1. Indirect costs cannot be traced to cost objects
2. Assignment of indirect cost is called allocation

 COST CLASSIFICATION
1. According to GAAP
 Product Cost / Inventoriable / Cost of Sales / Manufacturing Cost
 Direct materials: materials traceable to the goods or services being produced
o Example: the cost of wood in furniture
 Direct labor: labor that is traceable to the goods or services being produced
o Example: wages of assembly-line workers
 Overhead: production costs other than direct materials and direct labor
o Example: plant depreciation, utilities, property taxes, indirect materials, indirect labor, etc.
 Prime cost = Direct materials + Direct labor
 Conversion cost = Direct labor + Manufacturing Overhead
 Period Cost / Non-Inventoriable / Operating Expenses / Non-Manufacturing Cost
 Marketing (selling) / (distribution) costs: costs necessary to market and distribute a product or
service
o Example: advertising, storage costs, and freight out
 Administrative costs: costs that cannot be reasonably assigned to either marketing or production
 o Example: salaries, legal fee, and research and development
2. According to Traceability to Cost Object
 Direct Cost
 economically feasible to be traced to the product
 Direct Materials and Direct labor
 Indirect Cost
 not economically feasible to be traced to the product
 Manufacturing Overhead (MOH)
* More costs become direct as you expand the cost object
 Three methods of cost assignment:
o Direct tracing—physical observation, most accurate
o Driver tracing—more expensive, more accurate than allocation
o Allocation—least accurate, easiest to apply
3. According to Inventory
 Raw Materials
 can be direct or indirect
 Work in Process
 Finished Goods
4. According to Cost Behaviour
 Fixed Costs
 In total, does not change with changes in activity level within a relevant range
 Per unit, changes inversely with changes in activity level
 Variable Costs
 In total, change directly with changes in activity level within a relevant range
 Per unit, constant
 Step – Costs
 Step-Fixed Cost
 Step-Variable Cost
 Mixed Costs
 Have both fixed and variable costs component
 Y = Fixed cost + Total variable cost
Y = F + VX
Where
Y = Total cost (Usually a mixed cost)

Income Statement: Manufacturing Firm

• Income statement prepared for external parties follows the standard format
• Referred to as absorption-costing income or full-costing income because all manufacturing costs are fully assigned to the
product
• Expenses are separated according to function and then deducted from revenues to arrive at operating income
• Two major functional categories of expense are cost of goods sold and operating expenses
• Cost of goods manufactured: represents the total manufacturing cost of goods completed during the
current period
• Only costs assigned to goods completed are the manufacturing costs of direct materials, direct
labor, and overhead
• Details of this cost assignment are given in a supporting schedule, called the
statement of cost of goods manufactured
• + Direct materials
+ Direct labor
+ Manufacturing overhead costs
+ Beginning WIP inventory
- Ending WIP inventory
= Cost of goods manufactured

• Cost of goods sold: manufacturing cost of the units that were sold during the period
• + Beginning finished goods inventory
+ Cost of goods manufactured
- Ending finished goods inventory
= Cost of goods sold

Traditional Cost Management Systems

• Traditional Cost Accounting
 • Assumes that all costs can be classified as fixed or variable with respect to changes in the units or volume
• Uses only unit-based activity drivers to assign costs
• Traditional Cost Control
• Assigns costs to organizational units
• Holds the organizational unit manager responsible for controlling the assigned costs
• Traces costs to individuals who are responsible for costs
Activity-Based Cost Management Systems
• Activity-Based Cost Accounting
• Emphasizes tracing over allocation
• Uses both unit- and non-unit-based activity
drivers
• Activity-Based Cost Control
• Focuses on accountability for activities
rather than costs
• Activity- based management (ABM)
focuses on improving customer value

3.2 Cost Behavior and Cost Estimation

 Cost Behavior
o The term used to describe whether a cost changes when the level of output changes
o Fixed costs do not change as output changes
o Variable costs increase in total with an increase in output and decrease in total with a decrease in output
 Cost Objects
o An item for which managers want cost information
o For manufacturing or merchandising firms, it is usually the tangible product
o For service firms, it is usually the service provided
 Measures of Output
o Activity drivers explain changes in activity costs by measuring changes in activity output (usage)
o The two general categories of activity drivers
 Unit-level drivers
 Non-unit-level drivers
 Fixed costs are costs that in total are constant within the relevant range as the level of the activity driver varies
o Even though fixed costs may change, this does not make them variable.
o They are fixed at a new higher (or lower) rate.
o
 Variable costs are costs that in total vary in direct proportion to changes in an activity driver
o The total cost of direct materials for each level of production varies, but the unit cost stays the same
 Mixed Costs
o Have both fixed and variable costs component
o Y = Fixed cost + Total variable cost
Y = F + VX
Where
Y = Total cost (Usually a mixed cost)

 Resources
o Economic elements that enable one to perform activities
o When a firm acquires the resources needed to perform an activity, it obtains activity capacity
o Practical capacity is the activity level where the activity is performed efficiently
o Flexible Resources
 Supplied as needed and used
 Quantity of resource supplied equals quantity demanded
 No unused capacity
o Committed Resources
 Supplied in advance of usage
 A given quantity is obtained, whether or not that full amount is used
 Unused capacity is possible
 Step-Costs Behavior
o Some cost functions may be discontinuous.
o Known as step costs (or semi-fixed).
o A step cost function displays a constant level of cost for a range of output and then jumps
to a higher level (or step) of cost at some point, where it remains for a similar range of
output.
o Step-variable Costs
 Follow a step-cost behavior with narrow steps
 Items that display a step-cost behavior must be purchased in chunks.
  The width of the step defines the range of activity output for which a particular quantity of the resource must
be acquired.
o Step-fixed Costs
 Follow a step-cost function
 Exceed the relevant range, and the costs increase “one step”
 Step cost with wide steps are more characteristic of fixed costs.
 Example: A company may have to lease production machinery.
 If the machine can only produce 1,000 units and the company grows, they will
have to lease additional machines for each 1,000 units of production needed
 Resulting in the wide steps shown in the following graph.

 Activities and Mixed Cost Behavior
o Many activities have characteristics of both flexible and committed resources
o For example, a power department acquires long-term capacity for supplying power by investing in a building and
equipment
o It also acquires fuel to produce power on an as-needed basis
 Need for Cost Separation
o Sometimes it is easy to spot the variable and fixed portion of a costv
o Other times it is not; thus there is a need for a method to separate costs into their fixed and variable components
o Only through a formal effort to separate costs can all costs be classified into the appropriate cost behavior
categories.
o If mixed costs are a very small percentage of total costs, formal cost separation may be more trouble than it’s worth.
o Mixed costs could be assigned to either the fixed or variable cost category without much concern for the classification
error or its effect on decision making.
o Alternatively, the total mixed cost could be divided between the two cost categories. (This is rarely done and not a
good option.)
o Typically, mixed costs for many firms are large enough to call for separation.

Methods of Determining Cost Behavior (Cost Estimation)

o The best cost estimators are individuals who thoroughly understand the process, the cost drivers, and the degree of variability
between the driver, the activity, and the cost.
JUDGEMENT BASED-METHODS
 Industrial Engineering Method
o A forward-looking method of determining, through physical observation and analysis, just what activities, in what
amounts, are needed to complete a process
o Time and motion studies may be used in conjunction with this method. Industrial engineers may literally stand behind
production workers with a stop watch to determine precisely how many minutes it takes to produce a unit of product.
o Once completed, the engineering studies are very precise. They are expensive to implement, however, and seldom
updated once they are done.
o This method is most frequently used for manufacturing processes where there is a direct link between materials and
labor inputs with the output. An advantage of engineering methods is that they can be applied to new processes and
designs. Industrial engineers determine the amount of each direct material needed and the amount of labor time
each process will take. Then accountants and purchasing specialists can apply the appropriate unit costs. While this
method is useful in determining the cost of manufactured items, where the process stays the same from unit to unit, it
is less useful in services where different customers or circumstances may require varying amounts of time and types
of service.
 Account Analysis Method
o Used to estimate costs by classifying accounts in the general ledger as fixed, variable, or mixed
o Take out all historical records and analyze the trend to a particular cost
o Commonly partnered with conference method
 Conference Method
o Gather a group of cross-functional managers and they decide whether a particular cost is fixed, variable or mixed
based on their judgment
o More reliable info, takes more time

QUANTITATIVE METHODS FOR SEPARATING MIXED COSTS INTO FIXED AND VARIABLE COMPONENTS
 Each method requires the simplifying assumption of a linear cost relationship.
 Y = F + VX or Y = A + BX
Where,
Y = Total cost (the dependent variable)
F = Fixed cost (the intercept parameter) A
V = Variable cost per unit (the slope parameter) B
X = Measure of output (the independent variable)

 High-Low Method o The high-low method is method of

o Given two points, the slope and the intercept separating mixed costs into fixed and
can be determined.
 variable components by using just the high
and low data points.
o The high point is defined as the point with
the highest output or driver level. The low
point is defined as the point with the lowest
output or driver level. Note that the high and
low points are determined by the
independent variable, not the dependent
(typically cost) variable.
o Advantages:
 Objective
 Simple to calculate
o Disadvantages
 The high and low points may be
“outliers”
 Other pairs of points may clearly be
more representative
o Steps:
 Calculate the variable rate (V) or
(A)  Slope
 (total costs @ highest
activity – total costs @
lowest activity) / (highest
activity – lowest activity)
 Calculate fixed costs (F) or (B)
using the variable rate
 Write the cost formula and
substitute only the highest
or data point
 Develop the cost formula (Y = F +
VX or Y = A + BX )
 Scatterplot Method / Scattergraph / Visual Fit
o Uses all data points
o The scattergraph method is a way to see the
cost relationship by plotting the data points
on a graph.
o Uses a scattergraph to visually assess the
relationship between cost and output
 Intercept is fixed cost
 Slope is variable rate
o Advantages
 Allows for visual inspection of the
data
 Identifies nonlinearity, outliers, and
shifts in the cost relationship
o Disadvantages – it is subjective
It is subjective
o The first step is to plot the data points. (Use
all data points)
o Inspect the scattergraph to see if it reveals
one or more points (outliers) that do not
seem to fit the pattern of behavior.
 This might justify their elimination
and perhaps lead to a better
estimate of the underlying cost
function.
o Use scattergraph to visually fit a line to the
data points on the graph
 Draw the line of best fit – line that
minimizes square deviations)
o The manager or cost analyst will choose the
line that appears to fit the points the best.
 Least Squares Regression Model
 Also uses all data points
 R2 = coefficient of determination
 Method of least squares (regression) is a
statistical way to find the best-fitting line
through a set of data points.
 One advantage is that for a given set of data,
it will always produce the same cost formula.
 Eliminates the disadvantage of
scatterplot
 The best-fitting line is the one in which the
data points are closer to the line than to any
other line.
 Line Deviations
 The regression line better describes
the pattern of the data than other
possible lines.
 Results because the squared
deviations between the regression
line and each data point are, in
total, smaller than the sum of the
squared deviations of the data
points and any other line.
 The least squares statistical
formulas can find the one line with
the smallest sum of squared
deviations or the line which
minimizes the cost prediction errors
or differences between predicted
costs (i.e., on the regression line)
and actual costs (i.e., the actual
data points).

Comparison of Models
 Knowing how costs
change in relation to
changes in output is
essential to planning,
controlling, and decision
making.
 Each of the methods for
separating mixed costs
into fixed and variable
components help
managers understand
cost behavior and
consequently make good
business decisions
Reliability of Cost Formulas

 Hypothesis test of cost parameters

o Hypothesis Test of Cost Parameters
o The “t Stat” tests the hypothesis that the parameters are different from zero
o The “P-value” is the level of significance achieved
o Generally, a P-value of 0.05 or less is needed for significance
 Goodness of fit
o Goodness of Fit Measures
 The coefficient of determination, or R2, shows the percentage of variability in the dependent variable
explained by the independent variable
 Since R2 is the percentage of variability explained, it always has a value between 0 and 1.00
 Typically, the Adjusted R Square is used because this value has been adjusted for the number of variables
included in the equation
 Coefficient of Correlation
 It is the square root of the coefficient of determination when there is one independent variable
 Range between −1 and +1
 The higher the magnitude, the greater the correlation
 A coefficient of correlation value close to zero indicates no correlation
 Confidence intervals
o Confidence Intervals
Y f ± tS e
o This is the formula for calculating the desired level of confidence
o Yf is the predicted cost for a given level of activity
o t is the t distribution (get this from the table in your book
o Se is the standard error shown in the regression output

 Regression routines provide information on goodness of fit.

 Goodness of fit tells us how well the independent variable predicts the dependent variable.
 The percentage of variability in the dependent variable explained by an independent variable (in this case, a measure of
activity output) is called the coefficient of determination (R2)
 The higher the percentage of cost variability explained, the better job the independent variable does of explaining the
dependent variable.
 Since R2 is the percentage of variability explained, it always has a value between 0 and 1.00.

Multiple Regression
• Whenever least squares is used to fit an equation involving two or more independent variables, the method is called multiple
regression
• In the case of two explanatory variables, the linear equation is expanded to include the additional variable
Y = F + V1X1 + V2X2
where
X1 = Number of moves
X2 = Number of pounds moved
 • Adding another independent variable might increase the explanatory power of our model
• Performing the regression is very similar to simple regression
• Input the data – make sure the two independent variables are side by side.
• Follow the same directions, but select both independent variable columns for the “input X range”

Managerial Judgement
 Managerial judgment is critically important in determining cost behavior and is by far the most widely used method in practice.
 Many managers simply use their experience and past observation of cost relationships to determine fixed and variable costs.
 This method may take a number of forms.
 Some managers simply assign some costs to the fixed category and others to the variable category and ignore the
possibility of mixed costs.
 Other managers may identify mixed costs and divide these into fixed and variable components.
 Management may use experience and judgment to refine statistical estimation results.
 The experienced manager might ‘‘eyeball’’ the data and throw out several points as being highly unusual or revise the results
of estimation account for projected changes in cost structure or technology.
 The advantage of using managerial judgment to separate fixed and variable costs is its simplicity.
 In situations in which the manager has a deep understanding of the firm and its cost patterns, this method can give good
results.
 However, if the manager does not have good judgment, errors will occur.
 There are ethical implications to the use of managerial judgment.
 Managers use their knowledge of fixed and variable costs to make important decisions, such as whether to switch suppliers,
expand or contract production, or lay off workers.
 These decisions affect the lives of workers, suppliers, and customers.
 Ethical managers will make sure that they have the best information possible when making these decisions.

Learning Curve and Non-Linear Cost Behavior

o A number of cost behavior patterns do not follow a linear pattern.
o Learning Curve – a graphical representation that shows a decrease in direct labor (cost/time) as employees perform tasks
repetitively.
o The learning curve shows how labor hours per unit decreases as units produced increases

o Experience Curve – much broader than learning curve (can be apply to any task)
o The experience curve relates cost to increased efficiency – the more you perform a task the lower the cost is of doing
it

2 forms of learning curve model:

1. Cumulative Average-Time Learning Curve (Wrights Model)
 States that the cumulative average time per unit decreases by a constant percentage , or learning rate, each time the
cumulative quantity of units produced doubles.
 The learning rate is expressed as a percent, and it gives the percentage of time needed to make the next unit, based
on the time it took to make the previous unit.
 The learning rate is determined through experience and must be between 50 and 100 percent. A 50 percent learning
rate would eventually result in no labor time per unit—an absurd result. A 100 percent learning rate implies no
learning (since the amount of decrease is zero). An 80 percent learning curve is often used to illustrate this model,
possibly because the original learning curve work with the aircraft industry found an 80 percent learning curve.
Cornerstone 3.8 shows how to calculate the amount of time needed for producing successive units given an 80
percent learning rate and 100 direct labor hours for the first unit.
Let’s take a closer look at the time for the last unit in Exhibit 3.16. See how the time it takes to complete the last unit drops
from the first unit (1,000 hours) to the sixteenth unit (just 280.6 hours). This learning helps companies realize efficiencies as
more and more units are completed. Accountants can use this information in budgeting and preparing bids, as they realize that
the time for the first unit of a new type of job will not be equal to the time it takes to complete the last unit. Cost goes down.
Accountants can also use this information to advise managers on the need to keep experienced employees rather than having
excessive turnover. The turnover requires more training and does not give the company the benefit of the experienced
employee’s ability to do the job more quickly and competently.
 Exhibit 3.17 shows the graph of both the cumulative average time per unit (the bottom line) and the cumulative total hours
required (top line). We can see that the time per unit decreases as output increases, but that it decreases at a decreasing rate.
We also see that the total labor hours increase as output increases, but they increase at a decreasing rate. Again, the
implication for costing is that average cost will decrease as more experience is gained.

2. Incremental Unit-Time Learning Curve (Crawford’s Model)

 The incremental unit-time learning curve model decreases by a constant percentage each time the cumulative
quantity of units produced doubles.
 The same general assumptions for the learning curve hold; however, the learning rate is assumed to apply to the last
unit produced, not to the cumulative average of all units to date. For an 80 percent learning rate, the cumulative
average-time learning model assumes that the cumulative average time for every unit produced is just 80 percent of
the amount for the previous output level. Thus, when we look at the time to produce two units, the average time for
each of the units is assumed to be 80 percent of the time for the first unit. However, the incremental unit-time learning
model assumes that only the last (incremental) unit experiences the decrease in time, so the second unit takes 80
hours, but the first still takes 100 hours. Thus, the total time is 180 (100 + 80) hours. Further explanation of the
incremental unit-time learning curve will be left for more advanced courses.
 The use of the learning curve concepts permits management to be more accurate in budgeting and performance
evaluation for processes in which learning occurs. While the learning curve was originally developed for
manufacturing processes, it can also apply in service industries. For example, insurance companies develop new
policies and methods of selling policies. There is a learning component to each new policy as employees discover
glitches that were unexpected in the development process and then learn how to fix those glitches and become more
efficient.
 Of course, it is important to note that the learning rate can differ for each process. Management must estimate the
rate, usually on the basis of discussion with engineering and production personnel and past experience.


SUMMARY OF LEARNING OBJECTIVES

1. Define and describe fixed, variable, and mixed costs.

• Variable costs change in total as activity usage changes.
• Usually, variable costs increase in direct proportion to increases in activity output.
• Fixed costs do not change in total as activity output changes.
• Mixed costs have both a variable and a fixed component.

2. Explain the use of resources and activities and their relationship to cost behavior.
• Flexible resources are acquired as used and needed.
• Flexible resources have no excess capacity for these resources.
• They are usually considered to be variable costs.
• Committed resources are acquired in advance of usage.
• May have excess capacity
• Frequently considered fixed
• Step costs are acquired in lumpy amounts.
• Narrow steps approximated by a variable cost function
• Wide steps approximated as fixed

3. Explain how several methods of cost estimation can be used.

• The industrial engineering method uses physical observation and analysis to determine what activities in what
amounts are needed to complete a process.
• Time and motion studies may be used.
• Typically expensive and seldom updated
 • Account analysis requires the accountant to classify accounts as either fixed or variable.
• Frequently used in practice
• Gives good results if accounts are primarily fixed costs or variable costs
• Average account values and average driver values are used to calculate fixed costs and variable rates.

4. Separate mixed costs into their fixed and variable components using the high-low method, the scatterplot method, and
the method of least squares.
• High-low method uses the high and the low data points to form a straight line.
• Slope is variable rate.
• Intercept is fixed cost.
• Advantages: objective and easy
• Disadvantage: nonrepresentative high or low point leads to misestimated cost function
• Scatterplot method plots data—two points chosen to determine a line.
• Intercept is fixed cost.
• Slope is variable rate.
• Advantages: identify nonlinearity, outliers, shifts in the cost relationship
• Disadvantage: subjectivity
• OLS (regression) produces a best-fitting line.

5. Evaluate the reliability of the cost formula.

• Coefficient of correlation shows degree to which two variables move together.
• Perfect positive correlation is 1.0.
• Perfect negative correlation is −1.0.
• Coefficient of determination (R2) shows amount of cost variability explained by driver.
• 0 <= R2 <= 1.0
• Often multiplied by 100 and used as percent
• Standard error of estimate used to build a prediction interval for cost.

6. Explain how multiple regression can be used to assess cost behavior.

• Has two or more independent variables
• Useful when dependent variable is affected by more than one independent variable

7. Define the learning curve, and discuss its impact on cost behavior.
• Nonlinear relationship between labor hours and output
• Doubling of output requires less than a doubling of labor time.
• Cumulative average-time learning curve assumes the cumulative average time per unit decreases by a constant
percentage, or learning rate, each time the cumulative quantity of units produced doubles.
• Incremental unit-time learning curve assumes the incremental unit time decreases by a constant percentage each
time the cumulative quantity of units produced doubles.

8. Discuss the use of managerial judgment in determining cost behavior.

• Used alone or in conjunction with the high-low, scatterplot, or least-squares methods
• Experienced managers use knowledge of cost and activity-level relationships to:
• Identify outliers
• Understand structural shifts
• Adjust parameters due to anticipated changing conditions
Profit Planning System or Product Costing System/ Inventory Costing Method
3.3 Absorption and Variable Costing

3.3.1 Absorption costing (Full Costing)

 Absorption costing assigns all manufacturing costs to the product.
 Direct materials, direct labor, variable overhead, and fixed overhead define the cost of a product.
 Under this method, fixed overhead is assigned to the product through the use of a predetermined fixed overhead rate and is
not expensed until the product is sold.
 Fixed overhead is an inventoriable cost.

3.3.2 Variable costing (Direct Costing/ Marginal Costing)

 Variable costing stresses the difference between fixed and variable manufacturing costs.
 Variable costing assigns only variable manufacturing costs to the product; these costs include direct materials, direct labor,
and variable overhead.
 Fixed overhead is treated as a period expense and is excluded from the product cost.
 Under variable costing, fixed overhead of a period is seen as expiring that period and is charged in total against the revenues
of the period.

3.3.3. Throughput costing (Super-Variable Costing)

 An extreme form of variable costing in which only direct material costs are included as inventoriable costs.
 Throughput costing treats all costs except direct materials as costs of the period in which they are incurred.
 Throughput costing results in a lower amount of manufacturing costs being inventoried than either variable or absorption
costing.
 Throughput margin equals revenues minus all direct material cost of the goods sold.
 Advocates of throughput costing say it provides less incentive to produce for inventory than either variable costing or,
especially, absorption costing. Throughput costing is a more recent phenomenon in comparison with variable costing and
absorption costing and has avid supporters, but so far it has not been widely adopted.

Absorption Costing Variable Costing Throughput Costing

Format of Traditional (Functional) Contribution Contribution

Income Format Format Format
Statement  Based on GAAP  Based on Cost  Based on Cost
Behavior Behavior
Sales
Less: COGS Sales Sales
Gross Profit Less: V COGS Less: DM
OpEx Manufacturing Margin Throughput Margin
Net Operating Income Less: V OpEx Less: DL
Contribution Margin V MOH
Less: FC F MOH
Net Operating Income V OpEx
M OpEx

DM
DM
Product Cost DL DM
DL
Computation V MOH
VMOH
F MOH

DL
F MOH
V DistributionEx V MOH
Period Cost V DistributionEx
V AdminEx F MOH
Computation V AdminEx
F DistributionEx V DistributionEx
F DistributionEx
F AdminEx. V AdminEx
F AdminEx.
F DistributionEx
F AdminEx.

 The only difference between the two approaches is the treatment of fixed factory overhead\
 As a result, the unit product cost under absorption costing is always greater than the unit product cost under variable costing.
 Because unit product costs are the basis for cost of goods sold, the variable and absorption-costing methods can lead to
different operating income figures.
 The difference arises because of the amount of fixed
overhead recognized as an expense under the two
methods.

 The relationship between variable-costing income and

absorption-costing income changes as the relationship between production and sales changes. 
 The evaluation of managers is often tied to the profitability of the units that they control.
 If income performance is expected to reflect managerial performance, then managers have the right to expect the following:
o As sales revenue increases from one period to the next, all other things being equal, income should increase.
o As sales revenue decreases from one period to the next, all other things being equal, income should decrease.
 As sales revenue remains unchanged from one period to the next, all other things being equal, income should remain
unchanged.
 Variable costing ensures that the above relationships hold; however, absorption costing may not.
 When absorption costing is used, managers can increase current operating income by producing more units for inventory.
Producing for inventory absorbs more fixed manufacturing costs into inventory and reduces costs expensed in the period.
Critics of absorption costing label this manipulation of income as the major negative consequence of treating fixed
manufacturing costs as inventoriable costs.

3.3.4 Reconciliation of income

** Fixed manufacturing costs in ending inventory are deferred to a future period under absorption costing.

Formula 3: (Based from formula 1)

Absorption-Costing Operating Income

Fixed MOH Released from inventory
(Fixed MOH Deferred in inventory)
Variable Costing Operating Income