CHAPTER

Cost Management Concepts and

Cost Behavior

Central Focus and Learning Objectives

This chapter outlines the fundamentals of cost management concepts, cost
classifications, and cost behavior. After studying this chapter, students
should be able to:
1. Explain why the appropriate derivation of a cost depends on how the
cost will be used
2. State the difference between flexible costs and capacity-related costs
and why the difference is important
3. Use cost behavior information to compute the organizations break
even sales level
4. Show why the concept of opportunity cost is used in short-run
decision-making and how opportunity cost relates to conventional
accounting costs
5. Explain why management accountants have developed the notions of
long-run and short-run costs and how these different costs are used in
decision making
6. Explain the modern approach to cost classifications based on activity
levels
7. Explain the notion of life cycle cost and how that idea is used in new
product and product purchasing decisions

Cost Management Concepts and Cost Behavior 1

Chapter overview This chapter introduces a number of important definitions of the
various types of costs. Traditional concepts of direct and indirect
costs, as well as how support costs arise, are presented. One
important feature is the description of the way that we have thought
about costing terminology.
The chapter illustrates the transition in thinking from the traditional
approach to new concepts of classification such as unit-related,
batch-related, product-sustaining, and facility-sustaining activity
cost drivers.
Relations between costs and activity drivers are expressed in a
series of equations. Material is presented that discusses how
information is collected to estimate activity costs.

Teaching tips As you present this material, it may be useful to mention to

students at several points how cost concepts have changed so
much over the past few years. This is also the time to present
one major development in thinking about costing and, that is, the
classification based on unit-related, batch-related, product-
sustaining, customer-sustaining, and business-sustaining costs.
Emphasize that managers have the latitude to design the cost
accounting system for their organization to meet their needs for
internal decision-making, without being constrained by external
reporting requirements such as those imposed by the FASB.
The rather dramatic decrease in direct labor cost as a percentage
of total product cost in many of todays manufacturing
organizations was a signal that much more attention needed to
be paid to the increasing cost of support activities. Point out to
students that the large increase in this account was an impetus
for management accountants and others to devise much more
accurate systems for tracing support costs to products.
Examples of opportunity costs include whether to rent out
warehouse space or use it for manufacturing a product, investing
in artwork or mutual funds, purchasing a robot or hiring more
employees. It should also be noted that opportunity costs are not
recorded on the books of the organization, as no cash outlays
have occurred.
Emphasize that the number of units produced need not vary
proportionately with the number of batches produced if the
batch size (number of units per batch) differs considerably across
batches.
The complexity of a manufacturing information system increases
substantially when it must keep track of more batches
manufactured, more parts assembled into products, and more
products offered to consumers.
Note that often there is a cost-benefit tradeoff to consider when

Cost Management Concepts and Cost Behavior 2

 deciding whether it is worthwhile to have the greater level of
accuracy by analyzing more activities in greater detail.
One exercise that you might try is to have students list 3 or 4
different types of services. Ask them to discuss what the output
of the service is, whether it can be measured easily, and how they
would know if the service was effective. You could discuss
organizations such as a taxi service (satisfies customer on
dimensions such as relaxation, timeliness and safety of arrival
and courteous treatment by driver) and a homeless shelter
(nutritious meals, and safe and warm place to stay).
Note that the proportion of support costs has grown
substantially also in service organizations, as more services are
being automated instead of being provided by human servers.
For instance, when banks began to install ATMs a few years ago,
the number of tellers needed decreased significantly. Thus,
analysis of support costs has assumed critical importance also
for service organizations in the competitive environment that
they face today.
Ask students to define an accurate product cost. Answers will
vary, and at least some students will probably focus on precision
(how many decimal places, and what the digits in those decimal
places are). I try to get students to think about the economic
value of the resources consumed in the manufacturing process.
Accuracy is thus dependent on our ability to estimate what that
economic value is. Note also that the reported product cost (the
number generated by the accounting system) is a surrogate for
the true cost, which is unobservable due to the complexities
inherent in the manufacturing process.

Recommended 1. An introductory case is Englehardt Art Glass Cases in

cases Management Accounting and Control Systems, 3rd edition, by
Rotch, Allen, and Brownlee (Prentice Hall, 1995).
2. A more advanced case is Bridgeton Industries HBS Case 190-
185 (teaching note 5-191-168), which covers cost concepts and
overhead rates.
3. An excellent case which forces students to think about a variety
of issues associated with starting a small business is Caribbean
Internet Caf, Ivey School of Business case no. 9A98B002
(teaching note is 8A98B02). I have used this case as a semester
project for undergraduate BBA students; it is very effective
when used as the context for the development of a business
plan.
4. Another service industry case is The Admiral Benbow Motel
(Journal of Accounting Case Research, V. 6, No. 1, 2001,
pp. 10 20.) This case provides especially dramatic evidence of
the impact of changes in fixed costs on the profitability and
viability of a business.

Cost Management Concepts and Cost Behavior 3

Chapter outline I.
Learning Objective 1:
Explain why the
appropriate derivation
of a cost depends on
how the cost will be
used.
Learning Objective 2: II.
State the difference
between flexible costs
and capacity-related
costs and why the
difference is
important.
Point out that the key concept for assigning costs to products
is the amount of resources consumed in the products
manufacture. This emphasis on the consumption of resources
in this textbook is different from many traditional
presentations of this material.
A. Direct costs are those that can be traced easily to the
product manufactured or service tendered. These costs are
assigned to products directly based on the measured
quantity of the resources consumed for their manufacture.
Examples are:
1. Direct materials costs the costs of all materials
and parts that can be traced directly to the product.
2. Direct labor costs wages and fringe benefits paid
to workers involved directly in manufacturing a
product.
3. Indirect costs are those that cannot be traced easily to
products or services produced; also referred to as
support costs.
a. Manufacturing support costs are indirect costs
of transforming raw materials into finished
products. Examples include:
(1) Wages and benefits paid to production
supervisors who do not directly produce the
product.
(2) Wages and benefits paid to other support
personnel who are involved with activities such
as scheduling, setting up machinery, moving
materials, cleaning the factory, and inspection.
(3) Costs related to facilities (rent, property
insurance, and depreciation)
(4) Cost of other resources consumed in
production (heat, light & power, small tools,
abrasives and lubricants).
B. Full cost vs. marginal or incremental cost
Flexible and capacity-related costs
A. Flexible resources are resources whose costs are
proportional to the amount of resource used. The costs of
these resources are called flexible costs. Historically, these
costs have been called variable costs.
B. Capacity-related resources are acquired and paid for in
advance of when the work is done. Costs associated with
capacity-related resources are called capacity-related
costs. Historically, these costs have been called fixed costs.
Cost Management Concepts and Cost Behavior 4
Learning Objective 3: III. The break even point is the level of sales at which total
Use cost behavior
information to
compute the
organizations break
even sales level.
revenue equals total costs.
A. Contribution margin = revenue - flexible costs
B. Contribution margin ratio = flexible costs/revenue
C. The break even point in units sold = capacity related
costs/contribution margin per unit
D. The break even point in dollar sales = capacity related
costs/contribution margin ratio

Learning Objective 4: IV. The Impact of Opportunity Costs

Show why the concept
of opportunity cost is
used in short-run
decision-making and
how opportunity cost
relates to conventional
accounting costs.
A. When a decision maker chooses one alternative over
another, an opportunity cost may arise.
B. An opportunity cost is the potential benefit sacrificed
when, in selecting one alternative, another alternative is
given up.

Learning Objective 5: V.
Explain why
management
accountants have
developed the notions
of long-run and short-
run costs and how
these different costs
are used in decision
making.
The short run is the period over which a decision maker
cannot make changes in capacity. The availability of capacity-
related resources (and consequently capacity-related costs) are
fixed in the short run. Costs that vary in the short run vary in
proportion to production. Long-run costs include the costs of
all the resources consumed in design, manufacture, and
distribution of the product.

Learning Objective 6: VI. The activity level hierarchy gives a broader framework for
Explain the modern cost classification than the traditional dichotomy of fixed
approach to cost (capacity-related) and variable (flexible) costs.
classification based on A. Unit related
activity levels.
B. Batch related
C. Product sustaining
D. Customer sustaining
E. Business sustaining

Learning Objective 7: VII. Life cycle costing is a relatively new concept that argues that
Explain the notion of
life cycle cost and
how that idea is used
in new product and
product purchasing
decisions.
organizations should consider a products costs over its entire
lifetime, taking into account operating costs as well as the
initial purchase price in evaluating decisions.
A. There are five distinct phases in a typical products life
cycle.
1. Product development and planning
2. Product introduction
3. Growth
4. Maturity
5. Decline and abandonment
B. The motivation for considering the costs is to identify the

Cost Management Concepts and Cost Behavior 5

magnitude and nature of the costs so that they can be
managed.

Cost Management Concepts and Cost Behavior 6

Chapter quiz

1. Which of the following costs is NOT a manufacturing cost?

a. direct materials
b. overtime premiums
c. rent on a factory building
d. sales force training

2. Which of the following costs are marketing costs?

a. sales commissions
b. assistant controllers salaries
c. advertising expenses
d. plant depreciation

3. All of the following are indirect costs EXCEPT:

a. assembly workers wages.
b. supervisors salaries.
c. marketing managers salaries.
d. accountants salaries.

4. Support costs have increased in todays manufacturing environment because:

a. managers have let them get out of control.
b. there is now a shift toward greater automation.
c. fewer direct materials are being used in production.
d. direct labor costs have increased.

5. Which of the following is a product-sustaining activity cost driver?

a. machine hours
b. property and equipment cost
c. setup hours
d. numbers of engineering change orders

6. Which of the following would be an example of a customer-sustaining activity cost

driver?
a. commissions paid to sales personnel
b. advertising expenses
c. salaries of field representatives stationed at a major customers facility
d. sales clerical salaries

7. What activity measure might be appropriate for the cost of cleaning the rooms in a
hotel?
a. the number of registered guests
b. the number of hours required to clean the rooms
c. the number of personnel required to clean the rooms
d. none of the above

Cost Management Concepts and Cost Behavior 7

8. If setup activity costs are $360,000, number of setups is 1,800, direct labor hours are
60,000, and machine hours are 36,000, then the setup activity cost driver rate is:
a. $200 per setup.
b. $6 per direct labor hour.
c. $10 per machine hour.
d. There is no appropriate cost driver rate.

9. A key difference between service and manufacturing organizations is that:

a. in a service organization, output is more tangible and measurable than in a
manufacturing organization.
b. in a manufacturing organization, output is less tangible and measurable than in a
service organization.
c. in a service organization, output is less tangible and measurable than in a
manufacturing organization.
d. services produced can be inventoried much more easily than manufactured
products can.

10. Which of the following costs is not easily traced to production?

a. direct labor
b. direct material
c. selling expenses
d. indirect manufacturing costs

Cost Management Concepts and Cost Behavior 8

Solutions to chapter quiz

1. d
2. c
3. a
4. b
5. d
6. a
7. a
8. a
9. c
10. d

Cost Management Concepts and Cost Behavior 9