Cost Accounting

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Chapter 1 The Manager and Management Accounting
Financial accounting = focuses on reporting to external parties such as banks and suppliers. It measures
and records business transactions and provides financial statements that are based on generally
accepted accounting principles (GAAP).
Management accounting = measures, analyzes and report financial and nonfinancial information that
helps managers make decisions to fulfill the goals of an organization  to develop, communicate and
implement strategy
The key questions

1) How will this information help managers do their jobs better?
2) Do the benefits of producing this information exceed the costs?
Cost accounting = measures, analyzes and reports financial and nonfinancial information relating to the
costs of acquiring or using resources in an organization
Cost management = used to describe the approaches and activities of managers to use resources to
increase value to customers and to achieve organizational goals  information and accounting systems
themselves are not cost management
Strategy = describes how an organization will compete and the opportunities its managers should seek
and pursue
Strategic cost management = describes cost management that specifically focuses on strategic issues
Value chain analysis
1) Research and development (R&D)  generating and experimenting with ideas related to new
products, services or processes
2) Design of products and processes  detailed planning, engineering, and testing of products and
processes
3) Production  procuring, transporting and storing coordinating and assembling resources to
produce a product or deliver a service
4) Marketing  promoting and selling products or services to customers or prospective costumers
5) Distribution  processing orders and shipping products or services to customers
6) Customer service  providing after sales service to customers
In addition administrative function  includes functions such as accounting, human resource

management etc. that support the six primary business functions
CRM = customer relationship management
Supply chain = describes the flow of goods, services and information from the initial sources of materials
and services to the delivery of products to consumers
Key success factors  customers want companies to use the value chain and supply chain to deliver
ever improving levels of performance regarding the following;
 Cost and efficiency

 Quality
 Time (new-product development time and customer-response time)
 Innovation
Downloaded by Aurangzeb Chaudhary (zebch_61@hotmail.com)

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The five step decision making process

1) Identify the problem and uncertainties
2) Obtain information
3) Make predictions about the future
4) Make decisions by choosing among alternatives
5) Implement the decision, evaluate performance and learn
Planning = comprises selecting organization goals and strategies, predicting results under various
alternative ways of achieving those goals, deciding how to attain the desired goals and communicating
the goals and how to achieve them to the entire organization
Budget = the quantitative expression of a proposed plan of action by management and is and aid to
coordinating what needs to be done to execute that plan
Control = comprises taking actions that implement the planning decisions, deciding how to evaluate
performance and providing feedback and learning to help future decisions making
Learning = examining past performance and systematically exploring alternative ways to make better
informed decisions and plans in the future
Line management = such as production, marketing and distribution management is directly responsible
for attaining the goals of the organization
Staff management = such as management accountants and information technology, provides advice,
support and assistance to line management
Controller = the financial executive primarily responsible for management accounting and financial
accounting
Ethic points
Principles
Standards
Competence (bevoegdheid)
Confidentiality
Integrity (volledigheid)
Credibility (geloofwaardigheid)
Chapter 2 An Introduction to Cost Terms and Purpose
Actual cost = cost incurred

Budgeted cost = predicted or forecasted cost
Cost accumulation = the collection of cost data in some organized way by means of an accounting
system
Direct costs of a cost object = are related to the particular cost object and can be traced to it in an
economically feasible (cost-effective) way
Cost tracing = used to describe the assignment of direct costs to a particular cost object
Indirect costs of a cost object = related to the particular cost object but cannot be traced to it in an
economically feasible (cost-effective) way
Cost allocation = to describe the assignment of indirect costs to a particular cost object

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Factors affecting direct/indirect cost classifications
The materiality of cost in question = the smaller the amount of a cost (the more immaterial the cost is) the
less likely that it is economically feasible to trace that cost to a particular cost object
Available information-gathering technology = improvements in information-gathering technology make it

possible to consider more and more costs as direct costs (bar codes)
Design of operations = classifying a cost as direct is easier if a company’s facility is used exclusively for a
specific cost object
Variable cost = changes in total in proportion to changes in the related level of total activity or volume
Fixed cost = remains unchanged in total for a given time period, despite wide changes in the related level
of total activity or volume
Cost driver = a variable such as the level of activity or volume that causally affects costs over a given time
span
Relevant range = the band of normal activity level or volume in which there is a specific relationship
between the level of activity or volume and the cost in question
Unit cost / average cost = calculated by dividing total cost by the related number of units
Managers should think in terms of total costs rather than unit costs for many decisions
Cost of goods sold in the income statement + ending inventory in the balance sheet = total manufacturing
costs
Business sectors
Manufacturing sector companies = purchase materials and components and convert them into various
finished goods (Nokia)
Merchandising sector companies = purchase and then sell tangible products without changing their basic
form (retailing)
Service sector companies = provide services (intangible products) (law firms)
Types of inventory
Direct materials inventory = direct materials in stock and awaiting use in the manufacturing process
(computer chips)
Work-in-process inventory = goods partially worked on but not yet completed (cellular phones at various
stages of completion in the manufacturing process)
Finished goods inventory = goods completed but not yet sold (cellular phones)
Manufacturing costs
Direct material costs = are the acquisition costs of all materials that eventually become part of the cost
object and can be traced to the cost object in an economically feasible way
Direct manufacturing costs = include the compensation of all manufacturing labor that can be traced to
the cost object in an economically feasible way
Indirect manufacturing costs = all manufacturing costs that are related to the cost object but cannot be
traced to that cost object in an economically feasible way. (Supplies etc.)

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Inventoriable costs = all costs of a product that are considered as assets in the balance sheet when they
are incurred and that become cost of goods sold only when the product is sold
Cost of goods sold includes direct materials, direct manufacturing labor and manufacturing overhead
costs (indirect manufacturing costs)
Period costs = all costs in the income statement other than cost of goods sold
Example page 62
1) Direct material used  beginning inventory of direct materials + purchases of direct material –
ending inventory of direct materials = direct materials used
2) Total manufacturing costs  direct materials used + direct manufacturing labor + manufacturing
overhead costs = total manufacturing costs
3) Cost of goods manufactured  beginning work in process inventory + total manufacturing costs =
total manufacturing costs to account for – ending work in process inventory = costs of goods
manufactured
4) Cost of goods sold  beginning inventory of finished goods + cost of goods manufactured –
ending inventory of finished goods = cost of goods sold
5) Revenue – cost of goods sold = gross margin
Operating income = total revenues – cost of goods sold – operating costs
Prim costs = all direct manufacturing costs
Prime costs = direct material costs + direct manufacturing labor costs
Conversion costs = all manufacturing costs other than direct material costs
Conversion costs = direct manufacturing labor costs + manufacturing overhead costs
Overtime premium = the wage rate paid to workers in excess of their straight time wage rates 
considered to be part of indirect costs or overhead
Idle time = wages paid for unproductive time caused by lack of order, work delays, poor scheduling
(overhead costs)
Product costs
Product cost = the sum of the costs assigned to a product for a specific purpose
Pricing and product mix decisions = for the purpose of making decisions about pricing and which products
provide the most profits
Contracting with government agencies = often reimburse contractors on the basis of the cost of a product
plus a prespecified margin of profit
Preparing financial statements for external reporting under generally accepted accounting principles
(GAAP) = under GAAP only manufacturing costs can be assigned to inventories in the financial
statements

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Chapter 3 Cost-Volume-profit Analysis
Cost-volume-profit analysis = studies the behavior and relationship among these elements (revenues,
total costs, income) as changes occur in the units sold, the selling price, the variable cost per unit or the
fixed costs of a product
 Contribution margin = total revenues – total variable costs

 Contribution margin per unit = selling price – variable cost per unit
 Contribution margin = contribution margin per unit x number of units sold
 Contribution margin percentage (contribution margin ratio) = contribution margin per unit / selling
price
 Contribution margin = contribution margin percentage x revenues
Three ways expressing CVP relationships
1) The equation method

2) The contribution margin method
3) The graph method
The equation method and the contribution margin method are most useful when managers want to
determine operating income at few specific levels of sale. The graph method helps managers visualize
the relationship between units sold and operating income over a wide range of quantities of units sold
Equation method
[(selling price x quantity of units sold) – (variable cost per unit x quantity of units sold)] – fixed costs =
operating income
Contribution margin method
[(selling price – variable cost per unit) x (quantity of units sold)] – fixed costs = operating income
(contribution margin per unit x quantity of units sold) – fixed costs = operating income
Graph method

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1. Changes in the levels of revenues and costs arise only because of changes in the number of
product units sold. The number of units sold is the only revenue driver and the only cost driver.
Just as a cost driver is any factor that affects costs, a revenue driver is a variable such as volume
that causally affects revenues
2. Total costs can be separated into two components: a fixed component that does not vary with
units sold and a variable component that changes with respect to units sold
3. When represented graphically the behaviors of total revenues and total costs are linear in relation
to units sold within a relevant range (and time period)
4. Selling price, variable cost per unit and total fixed costs are known and constant
Breakeven point (BEP) = that quantity of output sold at which total revenues equal total costs
 Breakeven number of units = fixed costs / contribution margin per unit

 Breakeven revenues = breakeven number of units x selling price
 Breakeven revenues = fixed costs / contribution margin %
 Net income = operating income – income taxes
 Target net income = (target operating income) – (target operating income x tax rate)
 Target net income = (target operating income) x (1 – tax rate)
 Target operating income = target net income / 1 – tax rate
 Quantity of units required to be sold = Fixed costs + target operating income / contribution margin
per unit
Sensitivity analysis = is a what if technique that managers use to examine how an outcome will change if
the original predicted data are not achieved or if an underlying assumption changes
 Margin of safety = budgeted (or actual) revenues – breakeven revenues

 Margin of safety (in units) = budgeted (or actual) sales quantity – breakeven revenues
 Margin of safety percentage = margin of safety in dollars / budgeted (or actual) revenues
Operating leverage = describes the effects that fixed costs have on changes in operating income as
changes occur in units sold and contribution margin
High contribution margin  high proportion of fixed costs  small increases in sales lead to large
increases in operating income  small decreases in sales result in relatively large decreases in operating
income
 Degree of operating leverage = contribution margin / operating income
Sales mix = the quantities of various products that constitute total unit sales of a company
 Gross margin = revenues – cost of goods sold
Clear examples in chapter 3 about the formulas

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Chapter 4 Job costing
Cost pool = a grouping of individual indirect cost items
Cost allocation base = a systematic way to link an indirect cost or group of indirect costs to cost objects
 example operating costs of all metal cutting machines  indirect costs is 100 euro for 10 hours  the
cost allocation rate = 100 / 10 = 10 euro per machine hour, where machine hours is the cost allocation
base
Job costing system = the cost object is a unit or multiple units of a distinct product or service called a job.
The product or service is often a single unit. Because the products and services are distinct, job costing
systems accumulate costs separately for each product or service
Process costing system = the cost object is masses of identical or similar units of a product or service. In
each period, process costing systems divide the total costs of producing an identical or similar product or
service by the total number of units produced to obtain a per-unit cost. This per unit cost is the average
unit cost that applies to each of the identical or similar units produced in that period.
There are two reason for using longer periods to calculate indirect cost rates
1) The numerator reason (indirect cost pool)  the shorter the period, the greater the influence of
seasonal patterns on the amount of costs & non seasonal erratic costs = costs incurred in a
particular month that benefit operations during future months
2) The denominator reason (quantity of the cost allocation base)  to avoid spreading monthly fixed
indirect costs over fluctuating levels of monthly output and fluctuating quantities of the cost-
allocation base & annual period reduces the effect that the number of working days per month
has on unit costs
 Budgeting indirect cost rate = budgeted annual indirect costs / budgeted annual quantity of the
cost allocation base
 Overhead rate total = budgeting indirect cost rate (fixed) + variable overhead rate
Normal costing = a costing system that traces direct costs to a cost object by using the actual direct cost
rates times the actual quantities of the direct cost inputs and allocated indirect costs based on the
budgeted indirect cost rates times the actual quantities of the cost allocation base
7 Steps to assign costs to an individual job – normal costing
1) Identify the job that is the chosen job costing  job cost record/sheet = records and accumulates
all the costs assigned to a specific job starting when work begins
2) Identify the direct costs of the job  direct materials, direct manufacturing labor
3) Select the cost allocation bases to use for allocating indirect costs to the job  companies often
use multiple cost allocation bases
4) Identify the indirect costs associated with each cost allocation base  managers first identify cost
allocation bases and then identify the costs related to each cost allocation, since managers first
need to understand the cost driver
5) Compute the rate per unit of each cost allocation base used to allocate indirect costs to the job 
dividing budgeted total indirect costs in the pool (determine step 4) by the budgeted total quantity
of the cost allocation base (determine step 3)
6) Compute the indirect costs allocated to the job  actual quantity x budgeted indirect cost base
(step 5)
7) Compute the total cost of the job by adding all direct and indirect costs assigned to the job 
gross margin is bid a price for the job – the costs / bid a price for the job

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Actual costing  difference than normal costing, since actual costing uses actual indirect cost rates
calculated annually at the end of the year and normal costing uses budgeted indirect cost rates
Using budgeting indirect-cost rates and normal costing instead of actual costing has the advantage that
indirect costs can be assigned to individual jobs on an ongoing and timely basis, rather than only at the
end of the fiscal year when actual costs are known
Under allocated indirect costs = occur when the allocated amount of indirect costs in an accounting period
is less than the actual amount
Over allocated indirect costs = occur when the allocated amount of indirect costs in an accounting period
is greater than the actual amount
 Under allocated (over allocated) indirect costs = actual indirect costs incurred – indirect costs
allocated
Manufacturing overhead control = the record of the actual costs in all the individual overhead categories
Manufacturing overhead allocated = the record of the manufacturing overhead allocated to individual jobs
on the basis of the budgeted rate multiplied by actual direct manufacturing labor hours
Adjusted allocation rate approach = restates all overhead entries in the general ledger and subsidiary
ledger using actual costs rates rather than budgeted cost rates
The adjusted allocation rate approach yields the benefits of both the timeliness and convenience of
normal costing during the year and the allocation of actual manufacturing overhead costs at year end.
Proration = spread under allocated overhead or over allocated overhead among ending work in process
inventory, finished goods inventory and cost of goods sold
1) Calculate proportion for each account of the total amount

2) The over or under allocated amount times the proportion
3) Add or deduct that amount from the allocation of each account
Page 142 clear example
The proration approach only adjust the general ledger and not the subsidiary ledgers to actual
manufacturing overhead rates
Some companies use the proration approach but base it on the ending balances of work in process
control, finished goods control and cost of goods sold before proration.
For balance sheet and income statement reporting purposes, the write off to cost of goods sold is the
simplest approach for dealing with under or over allocated overhead
Service sector – Normal costing
Normal costing uses actual costs rates for all direct costs and budgeted cost rates only for indirect costs
1) Budgeted direct labor cost rate = budgeted total direct labor costs / budgeted total direct labor
hours
2) Budgeted indirect cost rate = budgeted total costs in indirect cost pool / budgeted total quantity of
cost allocation base (direct labor costs) = %
3) Calculate total costs  Direct labor cost = step 1 outcome x actual direct labor hours + indirect
costs allocated step 2 percentage x outcome direct labor cost

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Chapter 5 Activity Based Costing and Activity Based Management
Broad averaging can lead to undercosting or overcosting of products or services
Product undercosting = a product consumes a high level of resources but is reported to have a low cost
per unit
Product overcosting = a product consumes a low level of resources but is reported to have a high cost per
unit
Product cost cross subsidization = that if a company undercosts one of its products, it will overcost at
least one of its other products. Similarly, if a company overcosts one of its products, it will undercost at
least one of its other products. Product cost cross subsidization is very common in situations in which a
cost is uniformly spread – meaning it is broadly averaged – across multiple products without recognizing
the amount of resources consumed by each product
1) Design products and processes

2) Manufacture lenses
3) Distribute lenses
Simple costing system using a single indirect cost pool
1) Identify the products that are the chosen cost objects

2) Identify the direct costs of the products
3) Select the cost allocation bases to use for allocating indirect or overhead costs to the products
4) Identify the indirect costs associated with each cost allocation base
5) Compute the rate per unit of each cost allocation base  budgeted indirect cost rate = budgeted
total costs in indirect cost pool/ budgeted total quantity of cost-allocation base
6) Compute the indirect costs allocated to the products
7) Compute the total cost of the products by adding all direct and indirect costs assigned to the
products
Profit margin = operating income / revenues
Refined costing system = reduces the use of broad averages for assigning the cost of resources to cost
objects (such as jobs, products and services) and provides better measurements of the costs of indirect
resources used by different cost objects – no matter how differently various cost objects use indirect
resources
Reasons for refining a costing system
 Increase products diversity

 Increase in indirect costs
 Competition in product markets
Guidelines for refining a costing system
1) Direct cost tracing

2) Indirect cost pools  expand the number of indirect cost pools until each pool is more
homogeneous. All costs in a homogeneous cost pool have the same or a similar cause and effect
relationship with a single cost driver that is used as the cost allocation base
3) Cost allocation bases
Activity based costing = refines a costing system by identifying individual activities as the fundamental
cost objects (one of the best tools for refining a costing system)
Activity = an event, task or unit of work with a specified purpose.

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ABC systems identify activities in all functions of the value chain, calculate costs of individual activities
and assign costs to cost objects such as products and services on the basis of the mix of activities
needed to produce each product or service
Cost hierarchy = categorizes various activity cost pools on the basis of the different types of cost drivers,
or cost allocation bases or different degrees of difficulty in determining cause and effect relationships
ABC systems use a cost hierarchy with four levels
1) Output unit level costs  are the costs of activities performed on each individual unit of a product
or service (machine operations costs related to the activity of running the automated molding
machines are output unit level costs)
2) Batch level costs  are the costs of activities related to a group of units of a product or service
rather than each individual unit or product or service
3) Product sustaining costs (service sustaining costs)  the costs of activities undertaken to support
individual products or services regardless of the number of units or batches in which the units are
produced (design costs, cannot be avoided by producing fewer units or running fewer batches)
4) Facility sustaining costs  the costs of activities that cannot be traced to individual products or
services but that support the organization as a whole (general administration costs)
Allocating all costs to products or services becomes important when management wants to set selling
prices on the basis of an amount of cost that includes all costs
Implementing ABC
1) Identify the products that are the chosen cost objects

2) Identify the direct costs of the products
3) Select the activities and cost allocations bases to use for allocating indirect costs to the products
 split in activity, cost hierarchy category, total budgeted indirect costs, budgeted quantity of cost
allocation base, budgeted indirect cost rate, and cause and effect relationship between allocation
base and activity costs
4) Identify the indirect costs associated with each cost allocation base
5) Compute the rate per unit of each cost allocation base
6) Compute the indirect costs allocated to the products
7) Compute the total cost of the products by adding all direct and indirect costs assigned to the
products
Difference between ABC systems and simple costing system using a single indirect cost pool
 ABC systems trace more costs as direct costs

 ABC systems create homogeneous cost pools linked to different activities
 For each activity cost pool, ABC systems seek a cost allocation base that has a cause and effect
relationship with costs in the cost pool
Considerations to implement ABC systems
 Significant amounts of indirect costs are allocated using only one or two cost pools
 All or most indirect costs are identified as output unit level costs
 Products make diverse demands on resources because of differences in volume, process steps,
batch size or complexity
 Products that a company is well suited to make and sell show small profits. Whereas products
that a company is less suited to produce and sell show large profits
 Operations staff has substantial disagreement with the reported costs of manufacturing and
marketing products and services

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ABC systems  costly and need to be updated regularly
ABM decisions
 Pricing and product mix decisions  since more specific costs per unit per product
 Cost reduction and process improvement decisions
 Design decisions
 Planning and managing activities  at year end budgeted costs and actual costs are compared
to provide feedback on how well activities were managed and to make adjustments for
underallocated or overallocated indirect costs for each activity
Chapter 10 Determining how costs behave
Cost function = a mathematical description of how a cost changes with changes in the level of an activity
relating to that cost
Two assumptions when estimate cost function
1) Variations in the level of a single activity (the cost driver) explain the variations in the related total
costs
2) Cost behavior is approximated by a linear cost function within the relevant range
Example linear cost functions
 $5 per minute used. Total cost changes in proportion to the number of minutes used. No fixed
costs  y=$5X  $5 slope coefficient
 Total cost will be fixed at $100 per month regardless of the number of minutes used  y=100 
100 is also called constant/intercept  no variable costs only fixed
 $300 per month plus $2 per minute used  mixed cost (semi variable cost)  y=$300 + $2X 
both fixed and variable elements
y = a + bX
Nonlinear = the plot of the relationship on a graph is not a straight line
Cost estimation = measure a relationship based on data from past costs and the related level of an
activity
Cause and effect relationships
 A physical relationship between the level of activity and costs

 A contractual arrangement
 Knowledge of operations
Identify cost drivers on the basis of a long time horizon  cost may be fixed in the short run but hey are
usually variable and have a cost driver in the long run
Cost estimation methods
Industrial engineering method / work measurement method = estimates cost functions by analyzing the
relationship between inputs and outputs in physical terms  very time consuming
Conference method = estimates cost functions on the basis of analysis and opinions about costs and their
drivers gathered from various departments of a company  encourages interdepartmental cooperation,
however the emphasis on opinions rather than systematic estimations

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Account analysis method = estimates cost functions by classifying various cost accounts as variable,
fixed or mixed with respect to the identified level of activity  y = a + bX  supplementing the account
analysis method with the conference method improves credibility
Quantitative Analysis – Estimation of Cost Function
1) Choose the dependent variable

2) Identify the independent variable or cost driver  should be measureable and have an
economically plausible relationship with the dependent variable
3) Collect data on the dependent variable and the cost driver  time series data (pertain to the
same entity over successive past periods) or cross sectional data (pertain to different entities
during the same period)
4) Plot the data  graphical representation
5) Estimate the cost function  high low method or regression analysis
6) Evaluate the cost driver of the estimated cost function
High low method
It uses only the highest and lowest observed values of the cost driver within the relevant range and their
respective costs to estimate the slope coefficient and the constant of the cost function.
Slope coefficient b = Difference between costs associated with highest and lowest observations of the
cost driver / Difference between highest and lowest observations of the cost driver
Constant a = highest cost – (slope coefficient x highest cost driver)
Calculated for only the relevant range (don’t use this formula outside the relevant range)
Advantage = easy, quick and simple
Disadvantage = ignores information from all observations, only takes two observations into account
Regression analysis method
Is a statistical method that measures the average amount of change in the dependent variable associated
with a unit change in one or more independent variables
The least squares technique determines the regression line by minimizing the sum of the squared vertical
differences from the data points to the regression line
The vertical differences = residual term  measures the distance between actual cost and estimated cost
for each observation of the cost driver
Goodness of fit indicates the strength of the relationship between the cost driver and costs
b in the regression formula  indicates that the particular independent variable costs vary at that average
amount for every unit within the relevant range
More accurate than high low method since it uses information from all observations
Which cost driver? Both methods will not tell you, but you can use different cost drivers and test the
regression analysis and evaluate;
 Economic plausibility
 Goodness of fit
 Significance of independent variable  flat or slightly sloped regression line indicates a weak
relationship between the cost driver and costs

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Identifying the wrong drivers or misestimating cost functions can lead management to incorrect (and
costly) decisions along a variety of dimensions
ABC systems focus on individual activities  managers must identify a cost driver for each activity
Step cost function = the cost remains the same over various ranges of the level of activity, but the cost
increases by discrete amounts (increases in steps) as the level of activity increases from one range to the
next
Learning curve = a function that measures how labor hours per unit decline as units of production
increase, because workers are learning and becoming better at their jobs (nonlinearity)
Experience curve = a function that measures the decline in cost per unit in various business functions of
the value chain as the amount of these activities increases (marketing, distribution)
Cumulative average time learning model
Cumulative average time per unit declines by a constant percentage each time the cumulative quantity of
units produced doubles  example page 381
Incremental unit time learning model
Incremental time need to produce the last unit declines by a constant percentage each time the
cumulative quantity of units produced doubles  example 382
Difference is that the cumulative average time takes cumulative number of units x individual unit time and
the incremental unit time count the one up of the total time plus the individual unit time one down
Incremental predicts higher outcomes than the cumulative
Database requirements
 The database should contain numerous reliably measured observations of the cost driver and the
related costs
 The database should consider many values spanning a wide range for the cost driver
Occurring problems
 The time period for measuring the dependent variable does not match the period for measuring
the cost driver
 Fixed costs are allocated as if they are variable
 Inflation has affected costs, the cost driver, or both
 There is no homogeneous relationship between the cost driver and the individual cost items in the
dependent variable cost pool

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Chapter 15 Allocation of Support-Department costs, common costs and

revenues
Operating / production department = directly adds value to a product or service
Support / service department = provides services that assist other internal departments in the company
Two methods to allocate costs from the support department
Single-Rate Method
Makes no distinction between fixed and variable costs  it allocates costs in each cost pool to cost
objects (operating division) using the same rate per unit of a single allocation base
1) Fixed costs + total hours x budgeted variable cost per hour

2) Budgeted total rate per hour  total cost pool (1) / total hours
Advantages
 low cost to implement it

 conditioning the final allocations on the actual usage of central facilities rather than basing them
on forecast of expected demand, it offers the user divisions some operational control over the
charges they bear
Disadvantages
 it makes the allocated fixed costs of the support department appear as variable costs to the
operating divisions
Dual-Rate Method
Partitions the cost of each support department into two pools, a variable cost pool and a fixed cost pool
and allocates each pool using different cost allocation base
1) fixed costs per $ (total fixed costs / total hours) x budgeted hours
2) budgeted variable costs per $ x actual hours
Advantages
 it signals to division managers how variable costs and fixed costs behave differently
Examples pages 566-567  differs  single rate method allocates fixed costs of the support department
based on actual usage and dual-rate method allocates fixed costs based on budgeted usage
In both the methods we use budgeted rates to assign support department costs. An alternative approach
would involve using the actual rates based on the support costs realized during the period  less
common, since the level of uncertainty ti imposes on user divisions
User divisions do not pay for any costs or inefficiencies of the supplier department that cause actual rates
to exceed budgeted rates
Allocating costs of multiple support departments
Reciprocal support to each other (the supporting departments) as well as support the operating
departments  first allocate the costs of each support department using single-rate method or dual rate
method
Three methods  direct method, step down and reciprocal (examples page 572 – 578)

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Direct Method
It allocates each support department’s costs to operating departments only. The direct method does not
allocate support department costs to other support departments
1) calculate support department costs to operating department  total budgeted labor hours of the
operating departments (together) and then calculate the partial of one operating department
budgeted labor hour from the total to get a fracture
2) the fracture times the total budgeted overhead cost of the support department  this amount
goes the particular operation department
The benefit of the direct method is simplicity.
A disadvantage is that it ignores information about reciprocal services provided among support
departments and can therefore lead to inaccurate estimates of the cost of operating departments
Step down method
Also called the sequential allocation method  which allocates support department costs to other support
departments and to operating departments in a sequential manner that partially recognizes the mutual
services provided among all support departments
Same way as the direct method only also part to other support department  the part to assembly add to
the support department cost allocation  to allocate costs from that support department use the new total
costs to allocate the operating costs to the operating departments
Step down sequence begins with the support department that renders the highest percentage of its total
services to other support departments
Once a support department’s costs have been allocated no subsequent support department costs are
allocated back to it (once the higher ranked support department costs are allocated, it receives no further
allocation from lower ranked support departments)
Reciprocal method
Allocated support department costs to operating departments by fully recognizing the mutual services
provided among all support departments
1) calculate the same as step down method but then partial part % goes back to the higher ranked
support department (back and forward method until both support departments are zero)
Alternative way is to formulate and solve linear equations
1) Express support department costs and reciprocal relationships in the form of linear equations 
example PM = 6300000 + 0.1 IS and IS = 1452150 + 0.2 PM
2) Solve the set of linear equations to obtain the complete reciprocated costs of each support
department (substituting equation 1 into 2)  IS = 1452150 + [0.2($6300000 + 0.1 IS)]  solve
and outcome put in equation 1 and the two outcomes are the complete reciprocated costs or
artificial costs for the support departments
3) Allocate the complete reciprocated costs of each support department to all other departments
(both support departments and operating departments) on the basis of the usage percentages
(based on total units of service provided to all departments)
The reciprocal method fully recognizes all interrelationships among support departments as well as
relationships between support and operating departments

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The difference between complete reciprocated costs and budgeted costs for each support departments
reflects the costs allocated among support departments
Common costs
Common cost = a cost of operating a facility, activity or like cost object that is shared by two or more
users
The goal is to allocated common costs to each user in a reasonable way
Stand alone cost allocation method
Determines the weights for cost allocation by considering each user of the cost as a separate entity
Formula  amount of one user / total amount x total amount (page 579)
Incremental cost allocation method
Ranks the individual users of a cost object in the order of users most responsible for the common cost
and then uses this ranking to allocate cost among those users  first ranked user (primary user) is
allocated costs up to the costs of the primary user as a stand-alone user  second user (first incremental
party) is allocated the additional costs that arises from two users instead of only the primary user etc.
(page 580)
The difficulty with the method is that if a large common cost is involved, every user would prefer to be
viewed as the incremental party  use stand alone cost allocation method or Shapley value method
Shapley value method allocates to each employer the average of the costs allocated as the primary party
and as the incremental party
The USA government two main ways of contracts
1) The contractor is paid a set price without analysis of actual contract cost data
2) The contractor is paid after analysis of actual contract cost data  sometimes the contract will
state that the reimbursement amount is based on actual allowable costs plus a fixed fee (cost-
plus contract)
Allowable costs = a cost that the contract parties agree to include in the costs to be reimbursed
Bundling and revenue allocation
Revenue allocation occurs when revenues are related to a particular revenue object but cannot be traced
to it in an economically feasible (cost effective) way.
Revenue object = anything for which a separate measurement of revenue is desired (products,
customers, divisions)
Bundled product = a package of two or more products that is sold for a single price but whose individual
components may be sold as separate items at their own stand-alone prices (hotels offers weekend
package)  the bundled revenue must be allocated among the individual products in the bundle
The two main revenue allocation methods are the stand alone method and the incremental method
Stand-alone method
1) Selling prices  using the individual selling prices (ratio) x the revenue
2) Unit costs  using the costs of the individual products (ratio) x the revenue
3) Physical units  gives each product unit the same weight when allocating the revenue to
individual products (ratio) x revenue

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The selling prices method is the best, because the weights explicitly consider the prices customers are
willing to pay for the individual products. The physical units revenue allocation method is used when any
of the other methods cannot be used (when selling prices are unstable or units costs are difficult to
calculate for individual products)
Incremental revenue allocation method
Ranks individual products in a bundle according to criteria determined by management such as the
product in the bundle with the most sales and then uses this ranking to allocate bundled revenues to
individual products
First ranked product = primary product

Second ranked product = first incremental product
Third ranked product = second incremental product etc.
Page 585 examples
Because the stand-alone revenue allocation method does not require rankings of individual products in
the suite, this method is less likely to cause debates among product managers

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Chapter 6 Master Budget and Responsibility Accounting
Budget = the quantitative expression of a proposed plan of action by management for a specified period
and an aid to coordinate what needs to be done to implement that plan.
Strategic plans = long run budgets
Operating plan = short run budgets
Budgeting cycle
 Working together, managers and management accountants plan the performance of the company
as a whole and the performance of its subunits. Taking into account past performance and
anticipated changes in the future, managers at all levels reach a common understanding on what
is expected
 Senior managers give subordinate managers a frame of reference, a set of specific financial or
nonfinancial expectations against which actual results will be compared
 Management accountants help managers investigate variations from plans such as an
unexpected decline in sales. If necessary corrective action follows
 Managers and management accountants take into account market feedback, changed conditions
and their own experiences as they begin o make plans for the next period
Master budget = expresses managements operating and financial plans for a specified period and it
includes a set of budgeted financial statements
Operating decisions deal with how to best use the limited resources of an organization
Financing decisions deal with how to obtain the funds to acquire those resources
Budget do the following;
 Promote coordination and communication among subunits within the company

 Provide a framework for judging performance and facilitating learning
 Motivate managers and other employees
Limitations using past results  past results often incorporate past miscues and substandard
performance  and the future conditions can be expected to differ from the past
Rolling budget / continuous budget = a budget that is always available for a specified future period. It is
created by continually adding a month, quarter or year to the period that just ended
Preparing an operating budget  use the five step decision making process (chapter 1)
Operating Budget Calculations
1) Prepare the revenues budget  starting point for the operating budget  based on demand
2) Prepare the production budget (in units)  Budget production (units) = Budget sales (units) +
Target ending finished goods inventory (units) – Beginning finished goods inventory (units)
3) Prepare the direct material usage budget and direct material purchases budget  1) calculate
direct materials used in production  2) Purchases of direct materials = direct materials used in
production (1) + Target ending inventory of direct materials – Beginning inventory of direct
materials
4) Prepare the direct manufacturing labor costs budget  output units x direct manufacturing labor
hours per unit = total hours  total hours x hourly wage rate = total

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5) Prepare the manufacturing overhead costs budget  the costs of the support departments are
allocated as part of manufacturing operations overhead (first-stage cost allocation) and then the
indirect overhead costs with the applicable cost driver
6) Prepare the ending inventories budget  calculate all the parts of finished goods and then
calculate with the quantities (given) for the total ending inventory
7) Prepare the cost of goods sold budget  Use step 3 until 6 to calculate;
- Beginning finished goods inventory January 1 (given)

- Direct materials used (Step 3)
- Direct manufacturing labor (Step 4)
- Manufacturing overhead (Step 5)
- Cost of goods manufactured (Step 3 + 4 + 5)
- Cost of goods available for sale (Step 3 + 4 + 5 + 1)
- Deduct ending finished goods inventory, December 31 (step 6)
- Cost of goods sold (Cost of goods available for sale – step 6)
8) Prepare the nonmanufacturing costs budget  the departments such as product design,
marketing and distribution
9) Prepare the budget income statement  budgeting is a cross functional activity
- Revenues (step 1)
- Cost of goods sold (step 7)
- Gross margin (step 1 – step 7)
- Operating costs (step 8)
- Operating income (gross margin – operating costs)
Financial planning models = mathematical representations of the relationships among operating activities,
financing activities and other factors that affect the master budget
ERP = enterprise resource planning
If a scenario happens it will involves different aspects in the operating budget, such as decrease in selling
price reflects on revenue and marketing costs (sales commission)
When the success of a venture is highly dependent on attaining one or more targets, managers should
frequently update their budgets as uncertainty is resolved
Organization structure = an arrangement of lines of responsibility within the organization
Responsibility center = a part, segment or subunit of an organization whose manager is accountable for a
specified set of activities  the higher the mangers level, the broader the responsibility center and the
larger the number of his or her subordinates
Responsibility accounting = a system that measures the plans, budgets, actions and actual results of
each responsibility center
1) Cost center = the manager is accountable for costs only (maintenance department)
2) Revenue center = the manager is accountable for revenues only (sales department)
3) Profit center = the manager is accountable for revenues and costs (hotel manager)
4) Investment center = the manager is accountable for investments, revenues and costs (regional
manager)

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Budget Feedback
 Early warning  variances alert managers early to events not easily or immediately evident
 Performance evaluation  variances prompt managers to probe how well the company has
performed in implementing its strategies
 Evaluating strategy  variances sometimes signal to managers that their strategies are
ineffective
Controllability = the degree of influence that a specific manager has over costs, revenues or related items
for which he or she is responsible
Controllable cost = any cost that is primarily subject to the influence of a given responsibility center
manager for a given period
Controllability difficult  1) few costs are clearly under the sole influence of one manager 2) With a long
enough time span, all costs will come under somebody’s control
Responsibility accounting helps managers to first focus on whom they should ask to obtain information
and not on whom they should blame
Budgetary slack = describes the practice of underestimating budgeted revenues, or overestimating

budgeted costs, to make budgeted targets more easily achievable
Using external benchmark performance measures reduce a manager’s ability to set budget levels that are
easy to achieve or managers to involve themselves regularly in understanding what their subordinates are
doing
Kaizen budgeting (cost reduction) = explicitly incorporates continuous improvement anticipated during the
budget period into the budget numbers  these companies create a culture in which employee
suggestions are valued, recognized and rewarded
Multinational companies find budgeting a valuable tool when operating in very uncertain environments 
the purpose is the help managers throughout the organization to learn and to adapt their plans to the
changing conditions and to communicate and coordinate the actions that need to be taken throughout the
company
Chapter 7 Flexible budgets, direct cost variances and management control
Variance = the difference between actual results and expected performance (budgeted performance)
Variance analysis contributes in many ways to making the five step decision making process more
effective  allows managers to evaluate performance and learn by providing a framework for correctly
assessing current performance
Static budget variance = the difference between the actual result and the corresponding budgeted amount
in the static budget
Favorable variance = has the effect of increasing operating income relative to the budgeted amount (F)
Revenue F means actual revenues exceed budgeted revenues
Cost F means actual costs are less than budgeted costs
Unfavorable / adverse variance = has the effect of decreasing operating income relative to the budgeted
amount (U)

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Flexible budget = calculates budgeted revenues and budgeted costs based on the actual output in the
budget period
1) Identify the actual quantity of output

2) Calculate the flexible budget for revenues based on budgeted selling price and actual quantity of
output
3) Calculate the flexible budget for costs based on budgeted variable cost per output unit, actual
quantity of output and budgeted fixed costs
Level 1 = static budget variance

Level 2 = flexible budget variance and sale volume variance
Level 2 = individual line items of level 2 flexible budget variance  selling price variance, direct materials
variance, direct manufacturing variance, variable manufacturing overhead variance and fixed
manufacturing overhead
Level 3 = Direct materials price variance, direct materials efficiency variance, direct manufacturing labor
price variance and direct manufacturing labor efficiency
Level 1 reports the least detail; level 2 offers more information and so on.
Sales volume variance = the difference between a flexible budget amount and the corresponding static
budget amount
Flexible budget variance = the difference between an actual result and the corresponding flexible budget
amount
 Sales volume variance for operating income = flexible budget amount – static budget amount
 Sales volume variance for operating income = (budgeted contribution margin per unit) x (actual
units sold – static budget units sold)
The flexible budget variances are a better measure of operating performance than static budget variances
because they compare actual revenues to budgeted revenues and actual costs to budgeted costs for the
same output
 Flexible budget variance = actual result – flexible budget amount

 Flexible budget variance (selling price variance) = (actual selling price – budgeted selling price) x
actual units sold
Always think of variance analysis as providing suggestions for further investigation rather than as
establishing conclusive evidence of good or bad performance
Subdivide flexible budget variance for direct cost inputs into two more detailed variances (Level 3)
1) A price variance that reflects the difference between an actual input price and a budgeted input
price
2) An efficiency variance that reflects the difference between an actual input quantity and an
budgeted input quantity
Sources for budget input prices and budgeted input quantities
1) Actual input data form past periods  + represent quantities and prices that are real and past
data are available at low costs  - include inefficiencies and do not incorporate any changes
expected for the budget period
2) Data from other companies that have similar processes  + represent competitive benchmarks
from other companies  - data not available or may not be comparable to a particular company’s
situation

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3) Standards  a carefully determined price, cost or quantity that is used as a benchmark for
judging performance (per unit basis)  + exclude past inefficiencies and take into account
changes expected to occur in the budget period
Standard refers to many different things
 Standard cost per output unit for each variable direct cost input = standard input allowed for one
output unit x standard price per input unit
Price variance = the difference between actual price and budgeted price, multiplied by actual input
quantity  input price variance / rate variance
Efficiency variance = the difference between actual input quantity used and budgeted input quantity
allowed for actual output multiplied by budgeted price  usage variance
 Price variance = (actual price of input – budgeted price of input) x actual quantity of input
 Efficiency variance = (actual quantity of input used – budgeted quantity of input allowed for actual
output) x budgeted price of input
Chapter 7 focus on direct materials and direct manufacturing labor
Unfavorable variances = debits

Favorable variance = credits
Journal entries page 262
At the end of the fiscal year, the variances accounts are written off to cost of goods sold
Variances measure inefficiency or abnormal efficiency during the year they should be written off instead
of being prorated among inventories and cost of goods sold
ERP made it easy for firms to keep track of standard, average and actual costs for inventory items and to
make real time assessments of variances
Multiple causes of variances  Managers must not interpret variances in isolation of each other 
managers must attempt to understand the root causes of the variances
Two attributes of performance are commonly evaluated
1) Effectiveness  the degree to which a predetermined objective or target is met

2) Efficiency  the relative amount of inputs used to achieve a given output level
Managers should not automatically interpret a favorable variances as good news
The goal of variance analysis is for managers to understand why variances arise, to learn and to improve
future performance (performance evaluation, organization learning and continuous improvement)
Benchmarking = the continuous process of comparing the levels of performance in producing products
and services and executing activities against the best levels of performance in competing companies or in
companies having similar processes

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Chapter 11 Decision Making and Relevant Information
Decision model = a formal method of making a choice that often involves both quantitative and qualitative
analyses
Relevant costs = expected future costs  Relevant revenues = expected future revenues  that differ
among the alternative courses of action being considered
Relevant costs and relevant revenues must;
 Occur in the future

 Differ among the alternative courses of action
What difference will an action make?
Past costs / sunk costs = they are unavoidable and cannot be changed no matter what action is taken
Quantitative factors = are outcomes that are measured in numerical terms
Qualitative factors = are outcomes that are difficult to measure accurately in numerical terms (employee
moral)
This chapter considering decisions that affect output levels such as whether to introduce a new product or
to try to sell more units of an existing product
One time only special orders
Check only the relevant costs and revenues  for example marketing costs stays the same with
additional special orders  page 418 example
Two potential problems in relevant cost analysis;
 Managers must watch for incorrect general assumptions (such as all variable costs are relevant
and all fixed costs are irrelevant)
 Unit cost data can mislead decisions makers  when irrelevant costs are included  when the
same unit costs are used at different output levels
Make versus buy decisions
Outsourcing = purchasing goods and services from outside vendors
Insourcing = producing the same good or providing the same services within the organization
When calculating the make versus buy decisions  do not consider fixed costs, since they are required
for both.
Incremental cost = the additional total cost incurred for an activity  not fixed costs, since they always
occur
Differential cost = the difference in total cost between two alternatives
Strategic and qualitative factors affect outsourcing decisions  outsourcing is not without risks
(dependence on its suppliers, quality and delivery)  long run horizon
International outsourcing  important factor is the exchange rate risk

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How best to use available production capacity (example page 424 & 426)
1) Total alternatives approach to make or buy decisions (incremental costs and revenues)
2) Opportunity cost approach to make or buy decisions (incremental costs and revenues plus
opportunity cost)
Opportunity costs = the contribution to operating income that is forgone by not using a limited resource in
its next best alternative use  profit forgone from not making the product
Product mix decisions

Which products to sell and in what quantities  short run focus
Managers should choose the product with the highest contribution margin per unit of the constraining
resource (factor)
Customer mix decisions
 Relevant revenue and relevant cost analysis of dropping a customer
Save cost of goods sold etc.

Leave space and furniture handling equipment
Have no effect on fixed costs
 Relevant revenue and relevant cost analysis of adding a customer

 Relevant revenue and relevant cos analysis of closing or adding branch offices or segments
Past costs are irrelevant to decision making  a decision cannot change something that has already
happened
Replacement decisions
 Book value = irrelevant (past cost)

 Current disposal value of old machine = relevant because it is an expected future benefit that will
only occur if the machine is replaced
 Loss on disposal = irrelevant (should considered separately)
 Cost of new machine = relevant because it is an expected future cost that will only occur if the
machine is purchased
Chapter 12 Pricing Decisions and Cost Management
Three influences on demand and supply are customers, competitors and costs
Short run price decisions  one-time-only special order and adjusting product mix and output volume in a
competitive market
Long run price decisions  longer than a year and include pricing a product in a market where there is
some leeway in setting price
High short run prices  new products, new models or older products
Affect short run pricing
1) Many costs are irrelevant in short run pricing decisions such as marketing, distribution etc.
2) Short-run pricing is opportunistic. Prices are decreased when demand is weak and competition is
strong and increased when demand is strong and competition is weak
Relevant costs for long run pricing decisions include all future fixed and variable costs

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Long run price decisions

1) Market based (competitive markets)
2) Cost based, which is also called cost plus (no competitive markets)
Market based
Market based pricing starts with a target price (estimated price for a product or service that potential
customers are willing to pay  based on an understanding of customer’s perceived value for a product or
service and how competitors will price competing products or services)
Important;
1) Competition from lower cost producers is continually restraining prices

2) Products are on the market for shorter periods of time, leaving less time and opportunity to
recover from pricing mistakes, loss of market share and loss of profitability
3) Customers becoming more knowledgeable and incessantly demanding products of higher and
higher quality at lower and lower prices
Reverse engineering = disassembling and analyzing competitors’ products to determine product designs
and materials and to become acquainted with the technologies competitors use
Steps
1) Develop a product that satisfies the needs of potential customers

2) Choose a target price
3) Derive a target cost per unit by subtracting target operating income per unit from the target price
and compare with current full cos per unit
Target costs include all future costs, variable costs and costs that are fixed in the short run, because in
the long run a company’s prices and revenues must recover all its costs if it is to remain in business
4) Perform cost analysis

5) Perform value engineering to achieve target cost (value engineering = a systematic evaluation of
all aspects of the value chain, with the objective of reducing costs and achieving a quality level
that satisfies customers
Value engineering
Managers distinguish value added activities and costs from non-value added activities and costs
Value added cost = a cost that if eliminated, would reduce the actual or perceived value or utility
customers experience from using the product or service
Non-value added cost = a cost that if eliminated would not reduce the actual or perceived value or utility
customers gain from using the product or service
Gray area = supervision, production control, ordering, receiving, testing and inspection costs
Cost incurrence = describes when a resource is consumed to meet a specific objective
Locked-in costs / design costs = are costs that have not yet been incurred but based on decisions that
have already been made, will be incurred in the future

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Key steps value engineering
1) Understanding customer requirements, value added and non-value added costs

2) Anticipating how costs are locked in before they are incurred
3) Using cross functional teams to redesign products and processes to reduce costs while meeting
customer needs
Target costing efforts should always:
 Encourage employee participation and celebrate small improvements toward achieving the target
 Focus on the customer
 Pay attention to schedules
 Set cost cutting targets for all value chain functions to encourage a culture of teamwork and
cooperation
Cost plus pricing
Markup is added to the costs  markup component is flexible, depending on the behavior of customers
and competitors
 Target rate of return on investment = target annual operating income / invested capital
Invested capital = total assets (long term plus current assets)
Calculate target operating income per unit for the markup % (target operating income / cost of product per
unit)
The % target rate of return on investments expresses expected annual operating income as a percentage
of the investment
The % markup expresses operating income per unit as a percentage of the full product cost per unit
Managers includes both fixed and variable costs when calculating the cost per unit because:
 Full recovery of all costs of the product  in the long run the price of a product must exceed the
full cost of the product if a company is to remain in business
 Price stability  because it limits the ability and temptations of salesperson to cut prices  more
accurate forecasting and planning
 Simplicity
The eventual design and cost plus price must trade off cost, markup and customer reactions
Product life cycle = the time from initial R&D on a product to when customer service and support is no
longer offered for that product
Life cycle budgeting = managers estimate the revenues and business function costs across the entire
value chain from a product’s initial R&D to its final customer service and support
Features that make life cycle budgeting important
 The development period for F&D and design is long and costly
 Many costs are locked in at R&D and design stages, even if R&D and design costs themselves
are small
Customer life cycle costs = focus on the total costs incurred by a customer to acquire, use, maintain and
dispose of a product or service

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Price discrimination = the practice of charging different customers different prices for the same product or
service
Insensitivity of demand to price changes = demand inelasticity
Peak load pricing = the practice of charging a higher price for the same product or service when the
demand for the product or service approaches the physical limit of capacity to produce that product or
service
Predatory pricing = when it deliberately prices below its costs in an effort to drive competitors out of the
market and restrict supply and then raises prices rather than enlarge demand (not allowed by law)
Dumping = occurs when an non US company sells a product in the US at a price below the market value
in the country where it is produced and this lower price threatens the industry in the US (not allowed by
law)
Collusive pricing = occurs when companies in an industry conspire in their pricing and production
decisions to achieve a price above the competitive price and so restrain trade (not allowed by law)
Chapter 13 Strategy, Balanced Scorecard and Strategic Profitability Analysis

Strategy describes how an organization can create value for its customers while differentiating itself from
its competitors
Industry analysis focus on
 Competitors
 Potential entrants into the market
 Equivalent products
 Bargaining power of customers
 Bargaining power of input suppliers
Product differentiation = an organization’s ability to offer products or services perceived by its customers
to be superior and unique relative to the products or services of its competitors
Cost leadership = an organization’s ability to achieve lower costs relative to competitors through
productivity and efficiency improvements, elimination of waste and tight cost control
Improve quality  reduce defect rates and improve yields in its manufacturing process
Reengineering = the fundamental rethinking and redesign of business processes to achieve

improvements in critical measures of performance
Balance scorecard  used to track progress and manage the implementation of their strategies
Balance scorecard = translate an organization’s mission and strategy into a set of performance measures
that provides the framework for implementing its strategy.
The scorecard measures an organization’s performance from four perspectives
1) Financial  the profits and value created for shareholders

2) Customer  the success of the company in its target market
3) Internal business processes  the internal operations that create value for customers
- Innovation process  creating products that will meet the needs of customers
- Operations process  producing and delivering existing products and services that will meet the
needs of customers

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- Postsales service process  providing service and support to the customer after the sale of a
product or service
4) Learning and growth  the people and system capabilities that support operations
By balancing the mix of financial and nonfinancial measures, the balance scorecard broadens
management’s attention to short run and long run performance
Strategy map = a diagram that describes how an organization creates value by connecting strategic
objectives in explicit cause and effect relationship with each other in the four areas.
Strategic objectives, measures, initiatives, target performance and actual performance (columns balance
score card) per area
Companies use balanced scorecards to evaluate and reward managerial performance and to influence
managerial behavior
Well-designed balanced scorecard
 It tells the story of a company’s strategy, articulating a sequence of cause and effect relationships
 Helps to communicate the strategy to all members of the organization by translating the strategy
into a coherent and linked set of understandable and measurable operational targets
 Motivate managers to take actions that eventually result in improvements in financial performance
 Limits the number of measures, identifying only the most critical ones
 Highlights less than optimal tradeoffs that managers may make when they fail to consider
operational and financial measures together
Pitfalls
 Managers should not assume the cause and effect linkages are precise
 Managers should not seek improvements across all of the measures all of the time
 Managers should not use only objective measures
 Top management should not ignore nonfinancial measures when evaluating managers and other
employees
To evaluate the success of a strategy, managers and management accountants need to link strategy to
the sources of operating income increases
Strategic analysis of operating income
Comparing actual operating performance over two different periods
The change of operating income needs to be analyzed by three main factors; growth, price recovery,
productivity
Growth component = measures the change in operating income attributable solely to the change in the
quantity of output
 Revenue effect of growth = (actual units of output sold in 2011 – actual units of output sold in
2010) x selling price in 2010
 Cost effect of growth for variable costs = (units of input required to produce 2011 output in 2010 –
actual units of input used to produce 2010 output) x input price in 2010
 Units of input required to produce 2011 output in 2010 = direct materials 2010 x (units 2011 /
units 2010)
 Cost effect of growth for fixed costs = (actual units of capacity in 2010 because adequate
capacity exists to produce 2011 output in 2010 – actual unis of capacity in 2010) x price per unit
of capacity in 2010

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 Revenue effect of growth – cost effect of growth = change in operating income due to growth
Price recovery component = measures the change in operating income attributable solely to changes in
prices of inputs and outputs
 Revenue effect of price recovery = (selling price in 2011 – selling price in 2010) x actual units of
output sold in 2011
 Cost effect of price recovery for variable costs = (input price 2011 – input price 2010) x units of
input required to produce 2011 output in 2010
 Units of input required to produce 2011 output in 2010 = direct materials 2010 x (units 2011 /
units 2010)
 Cost effect of price recovery for fixed costs = (price per unit of capacity in 2011 – price per unit of
capacity in 2010) x actual units of capacity in 2010 because adequate capacity exists to produce
2011 output in 2010
 Revenue effect of price recovery – cost effect of price recovery = change in operating income due
to price recovery
Productivity component = measures the change in costs attributable to a change in the quantity of inputs
used in 2011 relative to the quantity of inputs that would have been used in 2010 to produce the 2011
output
 Cost effect of productivity for variable costs = (actual units of input used to produce 2011 output –
units of input required to produce 2011 output in 2010) x input price in 2011
 Cost effect of productivity for fixed costs = (actual units of capacity in 2011 – actual units of
capacity in 2010 because adequate capacity exists to produce 2011 output in 2010) x price per
unit of capacity in 2011
 Direct material costs + conversion costs = change in operating income due to productivity
Unused capacity = the amount of productive capacity available over and above the productive capacity
employed to meet consumer demand in the current period
Engineering costs = result from a cause and effect relationship between the cost driver (output) and the
resources used to produce that output
Discretionary costs = have two important features 1) they arise from periodic decisions regarding the
maximum amount to be incurred 2) they have no measurable cause and effect relationship between
output and resources used (marketing, R&D)
 Cost of unused capacity = cost of capacity at the beginning of the year – manufacturing
resources used during the year
Two options  eliminate unused capacity or grow output to utilize the unused capacity
Downsizing (rightsizing) = an integrated approach of configuring processes, products and people to

match costs to the activities that need to be performed to operate effectively and efficiently in the present
and future

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Chapter 14 Cost Allocation, Customer Profitability Analysis and Sales

Variance Analysis
Four criteria’s to guide cost allocation decisions
 Cause and effect

 Benefits received
 Fairness or equity
 Ability to bear
Assignment of costs to indirect cost pools  example page 528-532
Customer profit analysis = the reporting and assessment of revenues earned from customers and the
costs incurred to earn those revenues
Customer revenue analysis (cases sold x invoice price)
Price discount = the reduction in selling price below list selling price to encourage customers to purchase
more
Customer cost analysis
Customer cost hierarchy = categorizes costs related to customers into different cost pools on the basis of
different types of cost drivers, or cost allocation bases or different degrees of difficulty in determining
cause and effect or benefits received relationships
1) Customer output unit level costs  costs of activities to sell each unit to a customer
2) Customer batch level costs  costs of activities related to a group of units sold to a customer
3) Customer sustaining costs  costs of activities to support individual customer regardless of the
number of units or batches of product delivered to the customer
4) Distribution channel costs  costs of activities related to a particular distribution channel rather
than to each unit of product, each batch of product or specific customer
5) Corporate sustaining costs  costs of activities that cannot be traced to individual customers or
distribution channels
Customer profit analysis
Provide a useful tool for manager’s  ranks costumers based on customer level operating income
Columns  Retail customer code, customer level operating income, customer revenue, customer level
operating income divided by revenue, cumulative customer level operating income and cumulative
customer level operating income as a % of total customer level operating income
Presenting the results of customer profitability analysis  bar chart or plotting the contents (whale curve)
Whale curve = backward bending at the point where customers start to become unprofitable
Other considerations;
 Likelihood of customer retention  the more likely a customer will continue to do businesses with
a company, the more valuable the customer
 Potential for sales growth  the higher the likely growth of the customer’s industry and the
customer’s sale the more valuable the customer
 Long run customer profitability  this factor will be influenced by the first two factors and the cost
of customer support staff and special services required to retain customer accounts

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 Increases in overall demand from having well known customers  customers with established
reputations help generate sales from other customer through product endorsements
 Ability to learn from customers  customers who provide ideas about new products or ways to
improve existing products are especially valuable
Sales variances  comparing different markets with each other
Static budget variance = the difference between an actual result and the corresponding budgeted amount
in the static budget
Flexible budget variance = the difference between an actual result and the corresponding flexible budget
amount based on actual output level in the budget period
Sales volume variance = the different between a flexible budget amount and the corresponding static
budget amount
Actual results: Actual units of all Flexible budget: actual units of Static budget: budgeted units of
products sold x actual sales mix all products sold x actual sales all products sold x budgeted
x actual contribution margin per mix x budgeted contribution sales mix x budgeted
unit margin per unit contribution margin per unit
Sales mix variance = the difference between budgeted contribution margin for the actual sales mix and
budgeted contribution margin for the budgeted sales mix
Sales quantity variance = the difference between budgeted contribution margin based on actual units sold
of all products at the budgeted mix and contribution margin in the static budget (budgeted units of all
products to be sold) at the budgeted mix
Level 1 = static budget variance

Level 2 = Flexible budget variance and Sales volume variance
Level 3 = Sales mix variance and Sales quantity variance
Chapter 22 Management Control Systems, Transfer Pricing and Multinational

Considerations
Management control systems should be closely aligned with the organization’s strategies and goals
Goal congruence = when individuals and groups work toward achieving the organization’s goals 
managers working in their own best interest take actions that align with the overall goals of top
management
Effort = the extent to which managers strive or endeavor in order to achieve a goal
Decentralization = the freedom for managers at lower levels of the organization to make decisions
Autonomy = the degree of freedom to make decisions
Benefits decentralization
 Creates greater responsiveness to needs of a subunit’s customers suppliers and employees

 Leads to gains from faster decisions making by subunit managers  creates competitive
advantage
 Increases motivation of subunit managers
 Assists management development and learning
 Sharpens the focus of subunit managers, broadens the reach of top management

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Costs of decentralization
 Leads to suboptimal decisions making  incongruent decision making/dysfunctional decision

making = a decision’s benefit to one subunit is more than offset by the costs to the organization
as a whole
 Focuses manager’s attention on the subunit rather than the company as a whole
 Results in duplication of output
 Results in duplication of activities
The benefits of decentralization are generally greater when companies face uncertainties in their
environments
Multinational companies are often decentralized because centralized control of a company with subunits
around the world is often physically and practically impossible
Job rotation combined with decentralization helps develop manager’s abilities to operate in the global
environment
Decentralized organizations  uses transfer prices to coordinate the actions of the subunits and to
evaluate their performance
Transfer price = the price on subunit (department or division) charges for a product or service supplied to
another subunit of the same organization
The product or service transferred between subunits of an organization is called an intermediate product
Criteria evaluating transfer prices
 Transfer prices should promote goal congruence

 They should induce managers to exert a high level of effort. Subunits selling a product or service
should be motivated to hold down their costs; subunits buying the product or service should be
motivated to acquire and use inputs efficiently
 The transfer price should help top management evaluate the performance of individual subunits
 If top management favors a high degree of decentralization, transfer prices should preserve a
high degree of subunit autonomy in decision making
Calculating transfer prices
 Market based transfer prices

 Cost based transfer prices
 Hybrid transfer prices (both cost and market into account)
Example page 804-805
Market based transfer prices
 The market for the intermediate product is perfectly competitive

 Interdependencies of subunits are minimal
 There are no additional costs or benefits to the company as a whole from buying or selling in the
external market instead of transacting internally
Perfectly competitive market = when there is homogeneous product with buying prices equal to selling
prices and no individual buyers or sellers can affect those prices by their own actions
Distress prices = if the drop in prices is expected to be temporary
If markets are not perfectly competitive selling prices affect the quantity of products sold

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Cost based transfer prices
Cost based transfer prices are helpful when market prices are unavailable or too costly to obtain.
Hybrid transfer prices
Three different ways in which firms attempt to determine the specific transfer price  minimum (to cover
costs) maximum (to be lower than external)
1) Prorating the difference between maximum and minimum transfer prices  example page 810
2) Negotiated pricing
3) Dual pricing  using two separate transfer-pricing methods to price each transfer from one
subunit to another
Full cost based transfer is generally most used  than market based transfer price and negotiated
transfer price
Minimum transfer price:
 Minimum transfer price = incremental cost per unit incurred up to the point of transfer +
opportunity cost per unit to the selling subunit
Financial accounting systems record incremental cost but do not record opportunity cost
A perfectly competitive market for the intermediate product exists, and the selling division has no
unused capacity
 Minimum transfer price per barrel = incremental cost per barrel + opportunity cost per barrel
An intermediate market exists that is not perfectly competitive, and the selling division has
unused capacity
 Minimum transfer price per barrel = incremental cost per barrel
No market exist for the intermediate product
 Minimum transfer price per barrel = incremental cost per barrel
Chapter 23 Performance Measurement, Compensation and Multinational

Considerations
Accounting based performance measures steps
1) Choose performance measures that align with top management’s financial goals
2) Choose the details of each performance measure in step 1
3) Choose a target level of performance and feedback mechanism for each performance measure in
step 1
Behavioral criteria: promoting goal congruence, motivating management effort, evaluating subunit
performance and preserving subunit autonomy
The main weakness of comparing operating incomes alone is that differences in the size of investment
are ignored
Investment = the resources or assets used to generate income
 Return on investment (ROI) = income / investment

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It blends all the ingredients of profitability (revenues, costs and investment) into a single percentage 
ROI also called accounting rate of return or accrual accounting rate of return
 ROI DuPont = (income / revenues) x (revenues/investment)
 Residual income (RI) = income – (required rate of return x investment)
Required rate of return is stated in the question
Whenever a new project has a return higher than the required rate of return but below the ROI the
division manager is tempted to reject it even though it is a project the shareholders would like to pursue
Economic value added (EVA) = specific type of RI calculation
 Economic value added (EVA) = after tax operating income – (weighted average cost of capital x
(total assets – current liabilities))
 After tax cost of debt financing = 0.10 x (1-tax rate) (7%)
Tax rate is given in the question
 WACC = (7% x market value of debt) x (14% x market value of equity) / market value of debt +
market value of equity
 7% and 14% are example figures
 Total assets – current liabilities = long term assets + current assets – current liabilities = long term
assets + working capital
 Working capital = current assets – current liabilities
 Hotel operating income x (1- tax rate) = hotel operating income x (1-0.30) = hotel operating
income x 0.70
 Return on sales (ROS) = operating income / revenues (sales)
High ROI  the assets are being used efficiently
High ROS  indicates that the company has the lowest cost structure per dollar of revenues (measures
how effectively costs are managed)
ROI, RI or EVA measures are more appropriate than ROS because they consider both income and
investment
Time horizon of the performance measures = important element in designing accounting based
performance measures  preferable long time horizons
 Total assets available = all assets

 Total assets employed = all assets – the sum of idle assets and assets purchased for future
expansion
 Total assets employed minus current liabilities = total assets employed, excluding assets
financed by short term creditors
 Stockholder’s equity = calculated by assigning liabilities among subunits and deducting these
amounts from the total assets of each subunit
Current cost = the cost of purchasing an asset today identical to the one currently held, or the cost of
purchasing an asset that provides services like the one currently held if an identical asset cannot be
purchased  example page 839

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Historical costs or current costs?  Gross book value (original cost) or net book value (original cost
minus accumulated depreciation? Used for depreciable assets
Timing of feedback depends largely on
1) How critical the information is for the success of the organization

2) The specific level of management receiving the feedback
3) The sophistication of the organization’s information technology
Basic principles for evaluating the performance of an individual subunit manger
Need to consider tradeoff between creating incentives and imposing risk
Moral hazard = when an employee prefers to exert less effort (or to report distorted information)
compared with the effort (or accurate information) desired by the owner, because the employee’s effort
(or validity of the reported information) cannot be accurately monitored or enforced
Flat salary  will not motivate the manager to work harder or to undertake extra physical and mental
effort beyond what is necessary to retain his job or to uphold his own personal values
Bonuses with extra compensation will be on average higher than flat salary for the company
How large the incentive component of a manager’s compensation be relative to the salary should be 
need to understand how much the performance measure is affected by actions the manager takes to
further the owner’s objectives  sensitive performance measures (non-financial measures)
Evaluating performance in all four perspectives of the balanced scorecard promotes both short and long
run actions
Relative performance evaluation  filters out the effect of the common uncontrollable factors
There are two issues when evaluating performance at the individual activity level:
1) Designing performance measures for activities that require multiple tasks

2) Designing performance measures for activities done in teams
Diagnostic control systems = measures help diagnose whether a company is performing to expectations
(financial and non-financial measures)
To prevent unethical and outright fraudulent behavior, companies need to balance the push for
performance resulting from diagnostic control systems; boundary systems, belief systems and interactive
control systems
Boundary systems = describe standards of behavior and codes of conduct expected of all employees,
especially actions that are off limits.
Belief systems = articulate the mission, purpose and core values of a company  they describe the
accepted norms and patterns of behavior expected of all managers and other employees with respect to
one another, shareholders, customers and communities (intrinsic motivation)
Interactive control systems = are formal information systems that managers use to focus the company’s
attention and learning on key strategic issues

Cost Accounting

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lOMoARcPSD|1277595

Chapter 1 The Manager and Management Accounting

The key questions

Value chain analysis

In addition administrative function  includes functions such as accounting, human resource

CRM = customer relationship management

 Cost and efficiency

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The five step decision making process

Chapter 2 An Introduction to Cost Terms and Purpose

Actual cost = cost incurred

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Factors affecting direct/indirect cost classifications

Available information-gathering technology = improvements in information-gathering technology make it

Service sector companies = provide services (intangible products) (law firms)

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Operating income = total revenues – cost of goods sold – operating costs

Prim costs = all direct manufacturing costs

Prime costs = direct material costs + direct manufacturing labor costs

Conversion costs = direct manufacturing labor costs + manufacturing overhead costs

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Chapter 3 Cost-Volume-profit Analysis

 Contribution margin = total revenues – total variable costs

Three ways expressing CVP relationships

1) The equation method

Contribution margin method

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 Breakeven number of units = fixed costs / contribution margin per unit

 Margin of safety = budgeted (or actual) revenues – breakeven revenues

 Degree of operating leverage = contribution margin / operating income

 Gross margin = revenues – cost of goods sold

Clear examples in chapter 3 about the formulas

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Chapter 4 Job costing

Cost pool = a grouping of individual indirect cost items

7 Steps to assign costs to an individual job – normal costing

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1) Calculate proportion for each account of the total amount

Page 142 clear example

Service sector – Normal costing

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Chapter 5 Activity Based Costing and Activity Based Management

Broad averaging can lead to undercosting or overcosting of products or services

1) Design products and processes

Simple costing system using a single indirect cost pool

1) Identify the products that are the chosen cost objects

Profit margin = operating income / revenues

Reasons for refining a costing system

 Increase products diversity

Guidelines for refining a costing system

1) Direct cost tracing

Activity = an event, task or unit of work with a specified purpose.

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ABC systems use a cost hierarchy with four levels

1) Identify the products that are the chosen cost objects

 ABC systems trace more costs as direct costs

Considerations to implement ABC systems

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ABC systems  costly and need to be updated regularly

Chapter 10 Determining how costs behave

Two assumptions when estimate cost function

Example linear cost functions

Nonlinear = the plot of the relationship on a graph is not a straight line

Cause and effect relationships