THE GRADUATE SCHOOL OF HEALTH SCIENCE, MANAGEMENT AND PEDAGOGY

Southwestern University
Villa Aznar, Urgello St., Cebu City, 6000 Philippines

Managerial Accounting

Submitted by: J Walter T. Palacio

Submitted to: Rolito Canene

Midterm & Final Requirements

Part I. Fundamentals of Managerial Accounting and Cost

Accumulation System

We all know that basic accounting procedures involves three

main financial statements the balance sheet, income statement,
and cash flow statement. These statements are prepared for and
provided to users external to the organization such as
shareholders, bankers, and government. Accounting focused on the
external user is known as financial accounting. The term
“accounting” covers many different types of accounting on the
basis of the group or groups served. Accounting information
typically provided to users internal to the organization is
another type which is known as managerial accounting. Managerial
accounting serves the needs of users within the organization,
such as managers. In order to achieve organizational objectives,
the management team is responsible for planning, directing,
motivating, and controlling the activities of the business.
Managerial accounting will show how accounting information can
and should be used by management to carry out its mandate on a
more efficient and effective basis. In many organizations, most
of the accounting is performed to generate the financial
statements required by external users. As an entity develops and
grows, managers need information to help them manage the
organization. Sometimes, this information can be obtained from
the financial accounting system. In some organizations, whole new
systems are designed to meet the needs of the managers.

Managerial accounting is defined as the process of

identifying, measuring, analyzing, interpreting, and
communicating financial information to the manager/s for the
pursuit of an organization’s goals. Managerial accounting
information includes the following:
• Information on the costs of an organization’s product and
service.
• Budgets.
• Performance reports.
• Other information which assist managers in their planning
and control activities.
Organizations, large or small have managers and that person is
responsible for making plans, resources, directing personnel, and
controlling operations. Basically, managers carry out three
major activities namely planning, directing and motivating,
controlling, and improving.

Cost is part in managerial accounting. Having a clear

perspective about it would help give a person better
understanding about the subject. A cost may be defined as the
sacrifice made, usually measured by the resources given up, to
achieve a particular purpose. Step in studying managerial
accounting is to gain an understanding of the various types of
costs incurred by organizations and how those costs are actively
managed.

Cost accumulation system or management in general is the

organized collection of cost data via a set of procedures or
systems. Cost classification is the grouping of all manufacturing
costs into various categories in order to meet the needs of
management.

A figure indicating the total cost of production provides

little useful information about a company’s operations, since the
volume of production (and therefore cost) varies from period to
period. Thus, some common denominator, such as unit costs, must
be available in order to compare various volumes and costs. Unit
cost figures can be readily computed by dividing the total cost
of goods manufactured by the number of units produced. Unit costs
are stated in the same terms of measurement used for units of
output, such as cost per ton, per gallon, per foot, per assembly,
and so on. This is where cost management implies. Cost
management is defined as "the establishment of programs that
regularly analyze purchase requirements and suppliers to
identify lowest total cost and maximize total value to the
company. The development of a savings forecast by commodity is
necessary to define budget parameters for building cost-of-goods
structures." When we say strategic cost management it is about
scrutinizing every process within your organization, knocking
down departmental barriers, understanding your suppliers'
business, and helping improve their processes".

An expense is defined as the cost incurred when an asset is

used up or sold for the purpose of generating revenue. The terms
product cost and period cost are used to describe the timing with
which various expenses are recognized, an important issue in both
managerial and financial accounting.

A product cost is a cost assigned to goods that were either

purchased or manufactured for resale. The product cost is used to
value the inventory of manufactured goods or merchandise until
the goods are sold. All costs that are not product costs are
called period costs and are recognized as expenses during the
time period as incurred.

All costs that are not product costs are called period costs
and are recognized as expenses during the time period as
incurred.

Mass customization has been defined as the ability to design

and manufacture customized products at mass production efficiency
and speed. Customization and mass customization are often
justified because different customers can give different values
to the same product.

Manufacturing is the use of machines, tools and labor

to produce goods for use or sale. The term may refer to a range
of human activity, from handicraft to high tech, but is most
commonly applied to industrial production, in which raw materials
are transformed into finished goods on a large scale. Such
finished goods may be used for manufacturing other, more complex
products, such as aircraft, household appliances or automobiles,
or sold to wholesalers, who in turn sell them to retailers, who
then sell them to end users – the "consumers". In manufacturing,
raw material is transformed with the help of labor and machinery.

Manufacturing entails costs. Manufacturing cost is the

cumulative total of resources that are directly used in the
process of making various goods and products. In some formulas,
the cost of manufacturing includes the expenses associated with
the purchase of raw materials. At other times, the cost for raw
materials is excluded. In general, factors such as labor,
equipment operation, and the general overhead for maintaining the
production facility are common components that are included in
determining the overall manufacturing costs.

Since the goal of most production companies is to earn a

profit by selling goods manufactured and sold by the company,
paying close attention to the overall manufacturing
cost/manufacturing cost flow (direct materials, direct labor, and
manufacturing overhead) is extremely important. By monitoring the
various elements that make up the cost for manufacturing, it is
possible to ensure that available resources are being used to
best advantage, and thus earning the highest amount of return on
each unit that is sold at the current price.

Multi-product firms have to account for costs that can be

tied to a product, direct costs. They also have to account for
indirect costs not directly measurable (e.g., electricity). A
'cost object' can be a product, service, process or any items
which management requires cost information. The way that costs
are assigned depends on their nature. A direct cost is easily
traceable with a high degree of accuracy and indirect, or
overhead, cost cannot be easily identifiable with a particular
object.

Product costs are costs allocated to a product; this is not

just physical products. All other costs are period costs. Such
costs are expenses to the income statement in the period they are
incurred. Product costs are recognized as an expense in the
income statement only when the product is sold. Prior to sale the
cost of products is shown as an asset (work in progress or
finished good) due to the accrual principle.

Following are the three broad elements of cost:

1. Material

The substance from which a product is made is known as

material. It may be in a raw or a manufactured state. It can be
direct as well as indirect.

a. Direct Material

The material which becomes an integral part of a

finished product and which can be conveniently assigned to
specific physical unit is termed as direct material. Following
are some of the examples of direct material:

o All material or components specifically purchased,

produced or requisitioned from stores
o Primary packing material (e.g., carton, wrapping,
cardboard, boxes etc.)
o Purchased or partly produced components

Direct material is also described as process

material, prime cost material, production material, stores
material, constructional material etc.

b. Indirect Material
 The material which is used for purposes ancillary to
the business and which cannot be conveniently assigned to
specific physical units is termed as indirect material.
Consumable stores, oil and waste, printing and stationery
material etc. are some of the examples of indirect material.

Indirect material may be used in the factory, office

or the selling and distribution divisions.

2. Labor

For conversion of materials into finished goods, human

effort is needed and such human effort is called labor. Labor can
be direct as well as indirect.

a. Direct Labor

The labor which actively and directly takes part in

the production of a particular commodity is called direct labor.
Direct labor costs are, therefore, specifically and conveniently
traceable to specific products.

Direct labor can also be described as process labor,

productive labor, operating labor, etc.

b. Indirect Labor

The labor employed for the purpose of carrying out

tasks incidental to goods produced or services provided, is
indirect labor. Such labor does not alter the construction,
composition or condition of the product. It cannot be practically
traced to specific units of output. Wages of storekeepers,
foremen, timekeepers, directors’ fees, salaries of salesmen etc,
are examples of indirect labor costs.

Indirect labor may relate to the factory, the office

or the selling and distribution divisions.

3. Expenses

Expenses may be direct or indirect.

a. Direct Expenses

These are the expenses that can be directly,

conveniently and wholly allocated to specific cost centers or
cost units. Examples of such expenses are as follows:

 Hire of some special machinery required for a particular

contract
 Cost of defective work incurred in connection with a
particular job or contract etc.

Direct expenses are sometimes also described as

chargeable expenses.

b. Indirect Expenses

These are the expenses that cannot be directly,

conveniently and wholly allocated to cost centers or cost units.
Examples of such expenses are rent, lighting, insurance charges
etc.

4. Overhead

The term overhead includes indirect material, indirect

labor and indirect expenses. Thus, all indirect costs are
overheads.

A manufacturing organization can broadly be divided into

the following three divisions:

 Factory or works, where production is done

 Office and administration, where routine as well as policy
matters are decided
 Selling and distribution, where products are sold and
finally dispatched to customers

Overheads may be incurred in a factory or office or selling

and distribution divisions. Thus, overheads may be of three
types:

a. Factory Overheads

They include the following things:

 Indirect material used in a factory such as lubricants, oil,

consumable stores etc.
 Indirect labor such as gatekeeper, timekeeper, works
manager’s salary etc.
 Indirect expenses such as factory rent, factory insurance,
factory lighting etc.
 b. Office and Administration Overheads

They include the following things:

 Indirect materials used in an office such as printing and

stationery material, brooms and dusters etc.
 Indirect labor such as salaries payable to office manager,
office accountant, clerks, etc.
 Indirect expenses such as rent, insurance, lighting of the
office.

c. Selling and Distribution Overheads

They include the following things:

 Indirect materials used such as packing
material, printing and stationery material etc.
 Indirect labor such as salaries of salesmen and
sales manager etc.
 Indirect expenses such as rent, insurance,
advertising expenses etc.

The stages in the allocation of overheads to products are as

follows;

1) Identify overhead costs collected from production and

service cost centers and apportion as appropriate and
possible.
2) Once identified allocate to production departments.
3) Allocate overheads to a single product by dividing the
number of products into the total overhead. The resulting
sum can then be applied as cost to the product.

Total Overheads of a Production Costs Centre ($s)/Level of

Activity (units)

Predetermined overhead absorption rates are estimates of

future expenditures. Estimates are used because some overhead
costs are not known for some time until after they have incurred
(e.g., electricity). Normal costing is where the cost object is
determined using the actual costs for the direct the direct costs
and a predetermined rate for the allocation of indirect costs.

Functional-based cost accounting classifies all costs as

either fixed or variable in relation to changes in the volume of
units produced.
 Activity-based costing tries to capture changes in
technology by apportioning overheads to product costs taking into
account activity and transactions that drive the cost. An
activity cost pool is where the costs of an activity under the
ABC system are accumulated. Drives are factors that cause changes
in the use of resources. The focus in ABC is managing activities
instead of costs.

Absorption costing is where the cost of inventories is

determined in order to include an appropriate share of variable
and fixed costs. Fixed costs are allocated on the basis of normal
operating capacity. In variable costing, only the production
costs are used.

Using absorption costing, production overhead costs are

included as a product cost whereas in variable costing they are
treated as a period cost. This leads to different values of
inventory and therefore different net profit figures.

The difference in profits derived from the application of

the two methods can be reconciled by the following:

Fixed Overhead Absorption Rate x Movement of Inventories in a

period = Difference in Profits

Part II. Cost Management Systems, Activity-Based Costing, and

Activity-Based Management

Activity-based cost management is an accounting method used

by companies which allocates overhead costs for each activity
based on the specific circumstances of each activity. This is in
contrast to the common method of allocating costs based solely on
the hours spent manufacturing a product or catering to a specific
customer. The main advantage of activity-based cost management is
that it provides a truer representation of the worth of each
specific activity conducted by a business, thus reducing wasteful
overhead costs. It can be a difficult process to implement, but,
used effectively, can save a company a significant amount of
money.

As a business grows, the costs of maintaining and operating

that business usually grow in kind. When these costs grow,
companies must have accounting practices in place to allocate the
necessary funds for each specific business activity. These
activities can include either the manufacturing of a specific
product or the cultivation of a specific client. By using
activity-based cost management, a company can separate these
activities according to the actual costs incurred and their
importance in the company's operations.

For example, imagine a company that has to account for the

manufacturing of two specific products. Product A is produced at
low cost but at a high volume, meaning that a lot of hours are
spent on it. On the other hand, Product B is only rarely
produced, but it requires a great deal of technical expertise and
it costs the company a significant amount to produce a single
unit. A traditional accounting approach might allocate more
overhead to Product A based on the amount produced and the time
spent. Activity-based cost management would account for the fact
that Product B requires a much-more cost-intensive approach and
would allocate costs for it accordingly.

In the same manner, a company that serves clients in some

manner can also allocate costs accordingly based on activity-
based cost management. Imagine a law firm dealing with many
clients that pay less in retainer fees but require more man hours
of labor than a few high-paying clients that only call on the
firm in rare occasions. An activity-based approach would see the
worth of the higher-paying clients, since the man hours spent
serving them might not represent the costs associated with that
time.

Some companies shy away from activity-based cost management

because it can be a much more intricate process that simply
divvying up overhead based on the hours spent on an activity.
Several well-known international companies have benefitted from
this approach though, saving on overhead costs in the process.
Software programs devoted to activity-based allocation of costs
can make implementation the technique a bit easier.

Activity-Based Costing Sample Data:

Mode l Board Mode ll Board Mode lll Board

Production: Units 10,000 20,000 4,000
Runs 1 run of 10,000 4 runs of 5,000 each 10 runs of 400 each
Direct Material:
(raw boards and components) 50.00 90.00 20.00
Direct Labor:
(not including setup time) 3 hrs/board 4 hrs/board 2 hrs/board
Setup time 10 hrs/run 10 hrs/run 10 hrs/run
Machine time 1 hr/board 1.25 hrs/board 2 hrs/board

“Direct labor and setup labor costs is 20.00 per hour, including fringe benefits”.
Product Cost,TVBPCS Mode l Board Mode ll Board Mode lll Board
Direct Marerial
(raw boards , component) 50.00 90.00 20.00
Direct Labor
(not including setup time) 60.00(3hrat20) 80.00(4hrat20) 40.00(2hrat20)
Manufacturing overhead 99.00(3hrat33) 132.00(4hrat33) 66.00(2hrat33)
Total 209.00 302.00 126
Calculation of predetermine overhead rate:
Budget manufacturing overhead 3,894,000
Direct labor, budgeted hours:
Made 1 10,000 units x 3 hours 30,000
Mode ll 20,000 units x 4 hours 80,000
Mode lll 4,000 units x 2 hours 8,000
Total direct labor hours 118,000 hrs

Activity-Based Cost Identification of Activity Cost Pools:

Overhead Costs
Total budgeted cost – 3,894,000

Activity Cost Pools

Unit Level Batch Level Product Sustaining Facility Level
-Machinery -Setup -Engineering -Facility
1,212,600 3,000 700,000 507,400
Receiving/Inspection-200,000
Material handling-600,000
Quality Assurance-421,000
Packaging/shipping-250,000

Activity-Based Costing: Machinery Cost Pool

Stage 1 Various overhead costs Maintenance Lubrication

related to machinery Depreciation Electricity
Computer Calibration

Activity cost pool Machinery cost pool

Total budgeted cost – 1,212,600

Stage 2
Calculation of pool rate Total budgeted mc = 1,212,600
Total budgeted hours 43,000
 = 28.20/machine hr

Cost Assignment: Mode 1 Mode 2 Mode 3

Pool rate/machine hr 28.20/m hr 28.20/ m hr 28.2/ m hr
X machine hr/unit x 1 hr/unit x 1.25 hr/unit x 2 hr/unit

28.20 per unit 35.25 per unit 56.40 per unit

Activity-Based Costing: Setup Cost Pool

Stage 1
Calculation of Total budget setup cost
Setup cost -(10hr/setup)(20/hr)(15 production runs)

Activity Cost Pool Setup cost pool

Total budgeted cost – 3,000

Stage 2
Calculation of pool rate Total budget setup cost 3,000
Total planned production run 15 runs 200/run

Cost assignment Mode1 Mode 2 Mode 3

Pool rate per setup 200/run 200/run 200/run
Unit per prodction run 10,000 unit/run 5,000unit/run 400unit/run
= .02 per run =.04 per run = .50 per run

Activity-based costing: Engineering cost pool

Stage 1
Various overhead costs Engineers’ salary Engineering software
Related to engineering Engineering supplies Depreciation on
Engineering equipment.

Activity Cost Engineering cost pool

pool Total budgeted cost = 700,000.

Stage 2
Allocation to product lines Total budgeted
Based on production of engineering cost = 700,000
Engineering transaction
25% of 45% of 30% of
transactions transactions transactions

Cost assignment: Mode 1 Mode 2 Mode 3

Cost allocated to each 25%x700,000 45%x700,000 30%x700,000
Product line/number 10,000 unit 20,000units 4,000 units
Of units of each product = 17.5 per unit = 15.75 per units =52.5 per unit

Activity-Based Costing: Facility Cost Pool

Stage 1
Various overhead costs
Related to facilities Plant depreciation Property taxes
and general operation Plant management Insurance
Plant maintenance Security

Activity Cost Facility cost pool

pool Total budgeted cost = 507,400

Stage 2
Calculation of Total budgeted facilities cost 507,400
pool rate Total budgeted direct labor hrs 118,000
= 4.30/direct-labor hr

Cost assignment: Mode 1 Mode 2 Mode 3

Pool rate/direct-labor 4.30/direct-labor hr 4.30/direct-labor hr 4.30/direct-labor hr
Hr x Direct-labor hrs x 3 hr per unit x 4 hr per unit 2 hr per unit
Per unit 12.9 per unit 17.2 per unit 8.60 per unit

Part III. Planning and Control

As business environments have become increasingly dynamic

and competitive, it has become increasingly important for
managers to develop coherent, internally and logically consistent
business strategies and to have tools and models which provide
useful information to support strategic decision-making, planning
and control. In response to these needs, there have been many
important developments, in both management accounting research
and practice that focus on the use of accounting data and related
information regarding strategy and operations for these purposes.
Some of the most important developments in strategic planning and
control have been: (a) the balanced scorecard, a comprehensive
set of performance measures designed to assist managers in
implementing competitive strategies and monitoring performance
with respect to them (see Kaplan and Norton 2000), (b) strategic
variance/profitability analysis, systems which decompose measures
of budgeted versus actual net income into variances which
managers can relate logically to a firm's or strategic business
unit's (SBU's) mission and business strategy and therefore use to
analyze performance from a strategic
perspective (Shank and Govindarajan 1993; Simons 2000), (c)
profit-linked performance measurement systems, models which
decompose measures of changes in profitability over time into
measures of changes in constructs such as productivity and price
recovery, which can be logically linked to a firm's/SBU's mission
and business strategy and analyzed from those perspectives
(American Productivity Center (APC; now the American Productivity
and Quality Center) 1981; Banker, Chang and Majumdar 1993;
Banker, Datar and Kaplan 1989; Banker and Johnston 1989), and (d)
levers of control, a comprehensive framework for organizing and
employing management control systems to promote strategic
objectives.

THE DESIGN OF STRATEGIC COST MANAGEMENT AND CONTROL SYSTEMS

If management accounting information systems are to be

useful for strategic purposes, that is, to help managers increase
the likelihood that they can achieve their strategic goals and
objectives, their designs and use must follow from firms'
missions and competitive strategies. In Porter's framework,
strategy should follow from an analysis of the determinants of
the nature and intensity of competition: the firm's/SBU's
bargaining over its consumers and suppliers, threats from new
entrants and substitute products (barriers to entry and exit),
and the intensity of rivalry in product markets. To generate a
sustainable competitive advantage, a strategy must: (a) establish
a unique market position based on low cost leadership, product
differentiation, or a workable combination of the two, with an
appropriate scope of markets (broad or focused/niche); (b) be
differentiated from competitors' strategies, through unique
product variety, ability to satisfy customer needs, and/or access
to particular customer segments; and (iii) employ chains of
complementary, value-adding activities which are difficult for
competitors to replicate. The chosen strategy, in turn: (1)
determines the SBU's critical success factors, such as delivering
superior product and service quality and achieving high price
recovery for SBUs pursuing differentiation strategies, or
achieving economies of scale, improving productivity and
delivering threshold product and service quality at low prices
for SBUs pursuing low cost leadership strategies, and (2) informs
choices regarding the design of products and configuration of
operations which drive costs and revenues. For a set of
performance measures to exhibit content validity in a strategic
context, then, it must measure constructs related to the mission
and strategic framework, the selected strategies, the
firm's/SBUs' critical success factors, and operating choice
variables.

In addition, the constructs, and their measures, must be

causally linked. Performance measurement systems should
explicitly incorporate models of profit-generating processes, so,
when managers take actions the models suggest will improve
performance along one or more dimensions, the intended
improvements are likely to materialize. Thus, the models should
incorporate relationships over time as well as contemporaneous
relationships and linkages capturing cause-and-effect
relationships between constructs and measures of performance
throughout the firm (horizontally and vertically; aggregated to
disaggregated; across the entire value chain). Finally, the
measures should also have 'good' theoretical and empirical
measurement properties (see, for example, Johnston and Banker
2000a,b).

STRATEGIC VARIANCE ANALYSIS

Shank and Govindarajan (1993) decompose profit variances

into mutually exclusive, collectively exhaustive sets of
variances which capture the separate impacts of key underlying
causal factors, for example, deviations between actual and
budgeted sales volumes and mixes, market sizes and shares,
manufacturing costs, contribution margins, and discretionary
costs. Conceptualizing mission in terms of profitability and a
build, hold or harvest perspective and strategy in terms of low
cost leadership or product differentiation, Shank and
Govindarajan show that, by analyzing the variances with explicit
reference to a firm's/SBU's mission and business strategy, they
can determine the extent to which deviations between actual and
budgeted performance are or are not consistent with the mission
and strategy and identify specific dimensions of performance
which need improvement. Analyzing the variances without reference
to mission and strategy can be uninformative or misleading.
Simons (2000) decomposes profit variances into effectiveness
variances (market size, market share, selling prices, and product
volume and mix variances) and efficiency variances (materials and
labor price and efficiency, discretionary and committed cost
spending variances, and/or activity-based cost variances).
Simons points out that effectiveness variances are of particular
importance to business units pursuing differentiation strategies
and efficiency variances to units pursuing low cost, high volume
strategies.

PROFIT-LINKED PERFORMANCE MEASUREMENT SYSTEMS

Profit-linked models decompose measures of return-on-

investment and net income into measures of productivity, price
recovery, capacity utilization, and other managerially relevant
dimensions of performance. Practitioners led the development
efforts, with models which decompose measures of profitability
into measures of productivity and price recovery (APC 1981;
Miller 1984, 1987). Academics have contributed by refining and
extending the models from the perspectives of management
accounting, business strategy and the economic theory of
production, showing how the models can be used to analyze cross-
sectional differences and time-series changes in performance in
the context of changing competitive environments and strategies,
and examining the measures' mathematical, economic and empirical
properties (see, for example: Banker, Chang and Majumdar 1993,
1996; Banker, Datar and Kaplan 1989; Banker and Johnston 1989;
Grifell-Tatjé and Lovell 1999; Johnston and Banker 2000a,b).

COST ESTIMATION
Cost estimation is the determination of cost behavior in a
way of analyzing historical data concerning costs and activity
levels.

Diagram:
Cost estimation Cost behavior Cost prediction

The process of The relationship Using knowledge

determining between cost and of cost behavior to
cost behavior. activity. Forecast the level
of Cost at a
particular
Often focuses on level of activity.
historical data. Focus is on the
future.

Cost Behavior Patterns is also called cost functions.

 Variable Costs – change in total in direct proportion to a

change in activity level. As the activity level changes,
total variable cost increase in direct proportion to the
change in activity level but the variable cost per unit
remains constant.
  Step-Variable Costs – a nearly variable cost that increase
in small step instead of continuously and usually include
inputs that are purchased and used in relatively small
increment.

 Fixed Costs – remain unchanged in total as the activity

level varies. As the activity level increases, total fixed
cost does not change but unit fixed cost declines.

 Step-Fixed Costs – some cost remain fixed over a wide range

of activity but jump to a different amount for the activity
levels outside that range.

 Semi-variable Cost – a mixed cost that has both a fixed and

a variable component.

 Engineered Cost – bears a definitive physical relationship

to the activity measure.

 Committed Cost – result from an organization’s ownership or

use of facilities and its basic organization structure.

 Discretionary Cost – arises as a result of a management

decision to spend a particular amount of money for some
purpose.

Using Cost Behavior Patterns to Predict Costs:

A sales forecast is made for each month during the budget year.
Cost Item Cost Prediction
(15,000 dozen of items per month)
Direct material 12,500
Direct labor 10,000
Overhead: Facilities Costs 30,000
Indirect labor 15,000
Delivery trucks 6,000
Utilities 2,500

SHIFTING COST STRUCTURE IN THE CONTEMPORARY MANUFACTURING

ENVIRONMENT
Fixed costs are becoming more prevalent in many industries
due to two factors such as: Automation is replacing labor to an
increasing extent and labor unions have been increasingly
successful in negotiating agreements that result in a relatively
stable workforce. This makes management less flexible in
adjusting a firm’s workforce to the desired level of production.

Advanced manufacturing environment is emerging and costs

were largely variable have become fixed, most becoming committed
fixed costs.

COST BEHAVIOR IN THE INDUSTRIES:

In manufacturing firms, production quantity, direct
labor hours and machine hours are common cost drivers. Direct
material and direct labor costs are usually considered variable
costs. Other variable costs include some manufacturing over head
cost such as indirect material and indirect labor. Fixed
manufacturing costs are generally the cost of creating production
capacity.
In merchandising firms, the activity base is sales
revenue. The cost of merchandise sold is a variable cost. Most
labor costs are fixed or step-fixed costs.
Cost behavior in one industry is not necessarily
transferable to another industry.

COST ESTIMATION
- is the process of determining how a particular cost
behaves.

Cost Estimation Methods

 Account-Classification Method of cost is also called account
analysis – involves a careful examination of the
organization’ ledger accounts.

 Visual-Fit Method - The cost is semi-variable or analyst has

no clear idea about the behavior of a cost item, it is
helpful to use this method to plot recent observations of
the cost at various activity levels. Historical data for the
company’s utility cost is the basis to help visualize the
relationship between cost and level of activity to be
presented in scatter diagram.

Sample diagram:

Company’s utility costs: (per dozen)

Month Utility cost/month Items sold/month
January 5,100 75,000
February 5,300 78,000
March 5,650 80,000
April 6,300 92,000
May 6,400 98,000
June 6,700 108,000
July 7,035 118,000
August 7,000 112,000
September 6,200 95,000
October 6,100 90,000
November 5,600 85,000
December 5,900 90,000

HIGH – LOW METHOD

Semi-variable cost approximation is computed using exactly
two data points. Its activity levels are chosen from the
available data set. The associated cost levels are used to
compute the variable and fixed cost components as follows:

Difference between the costs corresponding

Variable cost of items = to the highest and lowest activity levels
(by dozen) Difference between the highest
and lowest activity levels
= 7,035 – 5,100 = 1,935
118,000 – 75,000 = 43,000
= .045 per dozen

ENGINEERING METHOD OF COST ESTIMATION

-A completely different method of cost estimation is to
study the process that results in cost incurrence and called as
engineering method of cost estimation. In a manufacturing firm,
a detailed study is made of the production technology, materials,
and labor used in the manufacturing process rather than asking
what the cost of material was last period. The engineering
approach is to ask how much material should be needed and how
much it should cost.

COST-VOLUME-PROFIT ANALYSIS
Examines the behavior of total revenues, total costs, and
operating income as changes occur in the output level, selling
price, variable costs or fixed costs.
Assumptions of CVP Analysis:
 revenues change in relation to production and sales
 costs can be divided in variable and fixed categories
 revenues and costs behave in a linear fashion
  costs and prices are known
 if more than one product exists, the sales mix is constant
 we can ignore the time value of money

CONTRIBUTION MARGIN
Contribution margin is equal to the difference between total
revenue and total variable costs.

Contribution margin per unit

Selling price - Variable cost per unit

Contribution margin percentage

Contribution margin per unit / selling price per unit

Total for
Per Unit 2 units %

Revenue $200 $400 100%

Variable costs 120 240 60%
Contribution margin $80 $160 40%

CONTRIBUTION MARGIN INCOME STATEMENT

Income statement that groups line items by cost behavior to
highlight the contribution margin.

Packages Sold
0 1 2 25 40
Revenue $0 $200 $400 $5,000 $8,000
Variable costs 0 120 240 3,000 4,800
Contribution margin 0 80 160 2,000 3,200
Fixed costs 2,000 2,000 2,000 2,000 2,000
Operating income $(2,000) $(1,920) $(1,840) $0 $1,200

BREAK-EVEN POINT
 Quantity of output where total revenues equal total costs.
 Point where operating income equals zero.

Breakeven point in units Breakeven point in dollars

=Fixed costs / Contribution margin per unit =Fixed costs / contribution margin %
=$2,000 / $80 =$2,000 / 40%
= 25 units = $5,000

COST-VOLUME-PROFIT GRAPH
 Total costs
line
TARGET OPERATING INCOME
For most firms in the private sector, the main objective is not to breakeven

Convert after-tax desired net income to its before-tax equivalent operating income

Target operating income:

=Target net income / (1 - tax rate)

Target Unit Sales:

= (Fixed costs + Target operating income)
/ Contribution margin per unit

Target Dollar Sales:

= (Fixed costs + Target operating income)
/ Contribution margin %

SENSITIVITY ANALYSIS
 sensitivity analysis is a “what-if” technique that examines
how a result will change if the original predicted data are
not achieved or if an underlying assumption changes
 What will happen to operating income if volume declines by
5%?
 What will happen to operating income if variable costs
increase by 10% per unit?
 sensitivity analysis broadens management’s perspectives
about possible outcomes

CVP helps managers assess the risks and potential benefits

of adopting alternative cost structures.

Example: Alternative rental arrangements

Option 1
$2,000 Fixed Fee
$ Rev
Cost

Units
 Option 1
$2,000 Fixed Fee
$ Rev
Cost

Units
Breakeven = 25 units
REVENUE MIX
Revenue mix (or sales mix) is the relative combination of
quantities of products or services that make up total revenue.

Ex:

Sales mix of Do-All : Superword = 2 : 1

Breakeven point in units

= 30 units 20 units of Do-All
10 units of Superword

MULTIPLE COST DRIVERS

In many cases there may be multiple cost drivers.

Do-All Software Example

Variable costs: $40 per software package sold

$15 per invoice issued
Operating income
= Revenue – ($40 x packages sold) – ($15 x invoices issued) – Fixed costs
In cases where there are multiple cost drivers there are multiple Superword
breakeven points.

Contribution Margin Format

CONTRIBUTION MARGIN & GROSS MARGIN
Revenues $200
Variable costs:Sector
Merchandising
Cost of goods sold $120
Other variable 43 163 Gross Margin Format
Contribution margin 37 Revenues
Fixed costs: $200
Cost of goods sold 5 Cost of goods sold (120+5) 125
Other fixed 19 24 Gross margin 75
Operating income $13 Operating costs (43+19) 62
Manufacturing Sector

Contribution Margin Format

Revenues $1,000 Gross Margin Format

Variable costs:
Manufacturing $250 Revenues $1,000
Non-manufacturing 270 520 Cost of goods sold (250+160) 410
Contribution margin 480 Gross margin 590
Fixed costs: Non-manufacturing (270+138) 408
Manufacturing 160 Operating income $182
Non-manufacturing 138 298
Operating income $182

DECISION MODELS AND UNCERTAINTY

 Managers make predictions and decisions in a world of

uncertainty.
 Estimate events that are likely to occur and assign
probabilities to each outcome.
 Probability distribution describes the likelihood of each
mutually exclusive and collectively exhaustive set of events
(must add to 1.00).
 Expected value is a weighted average of the outcomes with
the probability of each outcome serving as the weight.
Uncertainty Example

Proposal A: Spy Novel

Expected value
= (0.1x$300,000) + (.02x$350,000) + (.04x$400,000) + (0.2x$450,000) + (0.1x$500,000)
= $400,000

RESPONSIBILITY ACCOUNTING

Responsibility accounting is an underlying concept of

accounting performance measurement systems. The basic idea is
that large diversified organizations are difficult, if not
impossible to manage as a single segment, thus they must be
decentralized or separated into manageable parts. These parts or
segments are referred to as responsibility centers that include:
1) revenue centers, 2) cost centers, 3) profit centers and 4)
investment centers. This approach allows responsibility to be
assigned to the segment managers that have the greatest amount of
influence over the key elements to be managed. These elements
include revenue for a revenue center (a segment that mainly
generates revenue with relatively little costs), costs for a cost
center (a segment that generates costs, but no revenue), a
measure of profitability for a profit center (a segment that
generates both revenue and costs) and return on investment (ROI)
for an investment center (a segment such as a division of a
company where the manager controls the acquisition and
utilization of assets, as well as revenue and costs).

Controllability Concept

An underlying concept of responsibility accounting is

referred to as controllability. Conceptually, a manager should
only be held responsible for those aspects of performance that he
or she can control. In my view, this concept is rarely, if ever,
applied successfully in practice because of the system variation
present in all systems. Attempts to apply the controllability
concept produce responsibility reports where each layer of
management is held responsible for all subordinate management
layers as illustrated below.
Advantages and Disadvantages

Responsibility accounting has been an accepted part of

traditional accounting control systems for many years because it
provides an organization with a number of advantages. Perhaps the
most compelling argument for the responsibility accounting
approach is that it provides a way to manage an organization that
would otherwise be unmanageable. In addition, assigning
responsibility to lower level managers allows higher level
managers to pursue other activities such as long term planning
and policy making. It also provides a way to motivate lower level
managers and workers. Managers and workers in an individualistic
system tend to be motivated by measurements that emphasize their
individual performances. However, this emphasis on the
performance of individuals and individual segments creates what
some critics refer to as the "stovepipe organization." Others
have used the term "functional silos" to describe the same idea.
Consider 9-6 Exhibit below. Information flows vertically, rather
than horizontally. Individuals in the various segments and
functional areas are separated and tend to ignore the
interdependencies within the organization. Segment managers and
individual workers within segments tend to compete to optimize
their own performance measurements rather than working together
to optimize the performance of the system.
Summary and Controversial Question

An implicit assumption of responsibility accounting is that

separating a company into responsibility centers that are
controlled in a top down manner is the way to optimize the
system. However, this separation inevitably fails to consider
many of the interdependencies within the organization. Ignoring
the interdependencies prevents teamwork and creates the need for
buffers such as additional inventory, workers, managers and
capacity. Of course, a system that prevents teamwork and creates
excess is inconsistent with the lean enterprise concepts of just-
in-time and the theory of constraints. For this reason, critics
of traditional accounting control systems advocate managing the
system as a whole to eliminate the need for buffers and excess.
They also argue that companies need to develop process oriented
learning support systems, not financial results, fear oriented
control systems. The information system needs to reveal the
company's problems and constraints in a timely manner and at a
disaggregated level so that empowered users can identify how to
correct problems, remove constraints and improve the process.
According to these critics, accounting control information does
not qualify in any of these categories because it is not timely,
disaggregated, or user friendly.

This harsh criticism of accounting control information leads us

to a very important controversial question. Can a company
successfully implement just-in-time and other continuous
improvement concepts while retaining a traditional responsibility
accounting control system? Although the jury is still out on this
question, a number of field research studies indicate that
accounting based controls are playing a decreasing role in
companies that adopt the lean enterprise concepts. In a recent
study involving nine companies, each company answered this
controversial question in a different way by using a different
mix of process oriented versus results oriented learning and
control information. Since each company is different, a
generalized answer to this question for all firms in all
situations cannot be provided.

Part IV. Using Accounting Information in Decision Making

The Managerial Accountant’s Role in Decision Making

Managerial Accountant

Designs and implements Cross-functional management

accounting information teams who make production,
system marketing and finance decisions

Make substantive economic

decisions affecting operations

Steps in the Decision-Making Process

1. Clarify the decision problem
- The decision to be made is clear.
“Accept or Reject is the decision problem”
2. Specify the criterion
- Once a decision problem has been clarified, the
manager should specify the criterion upon which a decision will
be made. ”Determining the objective of the decision”
3. Identify the alternatives
- A decision involves selecting between two or more
alternatives. “Determining the possible alternatives is a
critical step in the decision process”

IDENTIFYING RELEVANT COSTS AND BENEFITS:

 Sunk Costs are costs that have already been incurred. They
do not affect any future cost and cannot be changed by any
current or future action. Sunk costs are irrelevant to decisions.

Example:
Book Value of Equipment that has a three year old used
to transport product from production area to storage room. The
book value of the equipment defined as the asset’s acquisition
cost less the accumulated depreciation to date.

Acquisition cost of older equipment-----100,000.00

Less: Accumulated depreciation----------75,000.00
Book value------------------------------25,000.00
==========
A decision to take since old equipment has one year useful life
with excessive additional variable cost. The decision is about
the replacement of the old equipment. It could be sold to 20% of
its useful life and annual cost- 80,000.

The new kind of equipment is much cheaper than the old and
cost less to operate. However, the new equipment would be
operable for only one year before it would need to be replaced.
The pertinent data of new equipment are:

Acquisition cost-----------------15,000.00
Useful life---------------------- 1 year
Salvage value after one year----- 0
Annual depreciation--------------15,000.00
Annual operating costs-----------45,000.00

Equipment Replacement Decision: Worldwide Airways

Cost of Two Alternatives

(a) (b) (c)
Do not replace Replace Differential
(Sunk Cost) old equipment old equip. cost
Depreciation (old) 25,000
Write-off book value 25,000 0
(Relevant Data)
Proceed from disposal 0 (5000) 5000
Depreciation (cost) new 0 15,000 (15,000)
Operating costs 80,000 45,000 35,000

Total 105,000 80,000 25,000

======= ====== ========

Obsolete Inventory Decision: Worldwide Airways

Cost of Two Alternatives

(a) (b) (c)
Modify and Dispose of Differential
(Sunk Cost) use parts Parts cost
Asset value written off 20,000 20,000 0
(Relevant Data)
Proceed from disposal 0 (17,000) 17,000
Cost of modify parts 12,000 0 12,000
Cost to buy new parts 0 26,000 (26,000)
Total 32,000 29,000 3,000
======= ======= =======

Analysis of Special Decisions:

a. Accept or Reject a Special Offer

b. Outsource a Product or Service
c. Add or Drop a Service, Product, or Department
d. Joint Products: Sell or Process Further

Manager in all organizations periodically face major

decisions that involve cash flows over several years. Decisions
involving the acquisition of machinery, vehicles, buildings, or
land are examples of such decisions. Other examples include
decisions involving significant changes in a production process
or adding a major new line of products or service to the
organization’s activities.

Capital-budgeting decision is a decisions involving

cash inflows and outflows beyond the current year.
Type:
1. Acceptance-or-Rejection Decisions: managers must
decide whether they should undertake a particular
capital investment project. In such a decision,
the required funds are available or readily
obtainable and management must decide whether the
project is worthwhile.
2. Capital-Rationing Decision: managers must decide
 which of several worthwhile projects makes the
best use of limited investment funds.

Aspect of Capital Expenditure Decision:

 Discounted-Cash-Flow Analysis
a method of evaluating an investment by estimating
future cash flows and taking into consideration the
time value of money, also called capitalization of
income.

Steps in constituting net-present-value analysis:

1. Prepare a table showing the cash flows during each year

of the proposed investment.
2. Compute the present value of each cash flow, using a
discount rate that reflects the cost of acquiring
investment capital.
3. Compute the net present value, which is the sum of the
present values of the cash flows.
4. If the net present value is equal to or greater than
zero, accept the investment proposal.

ANALYTICAL TECHNIQUE:

Discounted-Cash-Flow Analysis
The managerial accountant or controller of Mountain
view Hotel routinely advises the mayor and city council on major
capital-investment decisions. Currently under consideration in
the purchase of a new street cleaner, the controller has
estimated that the city’s old street-cleaning machine would last
another five years. A new street cleaner, which also would last
for five years, can be purchased for $50,470. It would cost the
city $14,000 less each year to operate the new equipment than it
costs to operate the old machine. The expected cost savings with
the new machine are due to lower expected maintenance costs.
Thus, the sew street cleaner will cost $50,470 and save $70,000
over its five-year life. ($70,000= 5 X $14,000 savings per year).
Since the $70,000 in cost savings exceeds the $50,470 acquisition
cost, one might be tempted to conclude that the new machine
should be purchased. However, this analysis is flawed, since it
does not account for the time value of money. The $50,470
acquisition cost will occur now, but the cost savings are spread
over a five years period. It is a mistake to add cash flows
occurring at different points in time.

Method:
 Net-Present-Value Method
Mountainview City Government
Step 1 Time 0 Time 1 Time 2 Time 3 Time 4 Time 5
Acquisition cost $(50,470)
Annual cost saving $14 k $14 K $ 14 k $ 14 k $ 14 k
Step 2 Present value of annuity=$14,000 (3.791)
Annuity discount factor for r=.10 n=5
Present value $(50,470) $53,074
Step 3 Net present value $2,604
Step 4 Accept proposal, since net present value is positive

INTERNAL-RATE-OF-RETURN METHOD
- It is an alternative discounted-cash-flow method for
analyzing investment proposals.
Internal rate of return or Time-adjusted rate of return
of an asset is the true economic return earned by the asset over
its life. An asset’s internal rate of return is the discount rate
that would be required in a net-present-value analysis in order
for the asset’s net present value to be exactly zero.
The higher the discount rate used in a net-present-
value analysis, the lower the present value of all future cash
flows will be.

Finding the internal rate of return for the investment

proposal:
- It could be a trial and error presenting with a
different discount rates until to yields a zero net-present-
value.

where r=IRR (Internal Rate of Return)

IRR of an annuity:

where:

Q (n,r) is the discount factor

Io is the initial outlay
C is the uniform annual receipt (C1 = C2 =....= Cn).

Example 1:

What is the IRR of an equal annual income of $20 per annum which
accrues for 7 years and costs $120?
 = 6

From the tables = 4%

Economic rationale for IRR:

If IRR exceeds cost of capital, project is worthwhile, i.e. it is

profitable to undertake.

Example 2:
r
N=5 10% 12% 14%
3.791 3.605 3.433

10% : ( 3.791 ) ($14,000 ) - $ 50,470 = $2,604 Yields a positive NPV

12% : ( 3.605 ) ($14,000 ) - $ 50,470 = $ 0 Yields a zero NPV
14% : ( 3.433 ) ($14,000 ) - $50,470 = $(2,408) Yields a negative NPV

Cash-Inflows in 5 years time

Time 0 1 2 3 4 5
cash flow $(50,470) $14,000 $14,000 $14,000 $14,000 $14,000

Initial cash outflow

(acquisition cost) Equal cash inflow
( Operating CostSaving)

A cash flows exhibit a very special pattern, the rate of

return is determined in two steps:

1. Divide the initial cash outflow by the equivalent

annual cash inflows.

$50,470 / 14,000= 3.605 equal to Annuity discount factor

2. Refer to the above table.

Recovery of Investment
- Provide benefits in the future such as expected
future operating-cost saving.

- Expected future benefits must be sufficient for the

purchaser to recover the investment and earn a return on the
investment equal to or greater than the cost of acquiring
capital.

Mountainview City Gorvernment

 Purchase of Street Cleaner
(r=.12 n=5)
1 2 3 4 5
1.) unrecovered investment
at beginning of year ----------------------- 50,470 42,526 33,629 23,664 12,504

2.) Cost saving during year------------------------- 14,000 14,000 14,000 14,000 14,000

3.) Return on unrecovered 6,056 5,103 4,035 2,840 1,500

investment 12% x amount in row 1

4.) Recovery of investment 7,944 8,897 9,965 11,160 12,500

during year raw 2 amount minus row 3 amount

5.) Unrecovered investment at 42,526 33,629 23,664 12,504 4*

end of year raw 1 amount minus row 4 amount

*There is an unrecovered investment of $4 because of accumulated

rounding errors in the table. If it had carried out each number
to cents, the table would have finished up with an unrecovered
investment of zero.

Comparing the NPV and IRR

Net-Present-Value:
1. Compute the investment proposal’s net present value
using the organization’s hurdle rate as the
discount rate.
2. Accept the investment proposal if its net present
value is equal to or greater than zero, otherwise
reject it.

Internal-Rate of Return:
1. Compute the investment proposal’s internal rate of
return which is the discount rate that yields a zero
net present value for the project.
2. Accept the investment proposal it its internal rate of
return is equal to or greater than the organization’s
hurdle rate, otherwise reject it.

PROFIT MAXIMIZATION
In economics, profit maximization is the process by which a
firm determines the price and output level that returns the
greatest profit. There are several approaches to this problem.
The total revenue -- total cost method relies on the fact that
profit equals revenue minus cost, and the marginal revenue --
marginal cost method is based on the fact that total profit in a
perfect market reaches its maximum point where marginal revenue
equals marginal cost.

Basic Definitions

Any costs incurred by a firm may be classed into two groups:

fixed cost and variable cost. Fixed costs are incurred by the
business at any level of output, including none. These may
include equipment maintenance, rent, wages, and general upkeep.
Variable costs change with the level of output, increasing as
more product is generated. Materials consumed during production
often have the largest impact on this category. Fixed cost and
variable cost, combined, equal total cost.

Revenue is the total amount of money that flows into the

firm. This can be from any source, including product sales,
government subsidies, venture capital and personal funds.

Average cost and revenue are defined as the total cost or

revenue divided by the amount of units output. For instance, if a
firm produced 400 units at a cost of 20000 USD, the average cost
would be 50 USD.

Marginal cost and revenue, depending on whether the calculus

approach is taken or not, are defined as either the change in
cost or revenue as each additional unit is produced, or the
derivative of cost or revenue with respect to quantity output.
For instance, taking the first definition, if it costs a firm 400
USD to produce 5 units and 480 USD to produce 6, the marginal
cost of the sixth unit is approximately 80 dollars, although this
is more accurately stated as the marginal cost of the 5.5th unit
due to linear interpolation. Calculus is capable of providing
more accurate answers if regression equations can be provided.

Total Cost-Total Revenue Method

To obtain the profit maximizing output quantity, we start by

recognizing that profit is equal to total revenue minus total
cost. Given a table of costs and revenues at each quantity, we
can either compute equations or plot the data directly on a
graph. Finding the profit-maximizing output is as simple as
finding the output at which profit reaches its maximum. That is
represented by output Q in the diagram.
 There are two graphical
ways of determining that Q is
optimal. Firstly, we see that
the profit curve is at its
maximum at this point (A).
Secondly, we see that at the
point (B) that the tangent on
the total cost curve (TC) is
parallel to the total revenue
curve (TR), the surplus of
revenue net of costs (B,C) is
the greatest. Because total
revenue minus total costs is
equal to profit, the line
segment C,B is equal in length
to the line segment A,Q.

Computing the price at which to sell the product requires

knowledge of the firm's demand curve. The price at which quantity
demanded equals profit-maximizing output is the optimum price to
sell the product.

Marginal Cost-Marginal Revenue Method

If total revenue and total cost figures are difficult to procure,
this method may also be used. For each unit sold, marginal profit
equals marginal revenue minus marginal cost. Then, if marginal
revenue is greater than marginal cost, marginal profit is
positive, and if marginal revenue is less than marginal cost,
marginal profit is negative. When marginal revenue equals
marginal cost, marginal profit is zero. Since total profit
increases when marginal
profit is positive and total
profit decreases when
marginal profit is negative,
it must reach a maximum
where marginal profit is
zero - or where marginal
cost equals marginal
revenue. This
intersection of marginal
revenue (MR) with marginal
costs (MC) is shown in the
next diagram as point A.
If the industry is
competitive (as is assumed
in the diagram), the firm
faces a demand curve (D) that is identical to its Marginal
revenue curve (MR), and this is a horizontal line at a price
determined by industry supply and demand. Average total costs are
reprsented by curve ATC. Total economic profits are represented
by area P,A,B,C. The optimum quantity (Q) is the same as the
optimum quantity (Q) in the first diagram.

Profit Maximization - The Marginal Approach

If the firm is operating in a non-competitive market, minor

changes would have to be made to the diagrams.

Modes of Operation

It is assumed that all firms are following rational

decision-making, and will produce at the profit-maximizing
output. Given this assumption, there are four categories in which
a firm's profit may be considered.

A firm is said to be making an economic profit when its

average total cost is greater than the price of the product at
the profit-maximizing output. The economic profit is equal to the
quantity output multiplied by the difference between the average
total cost and the price.

A firm is said to be making a normal profit when its

economic profit equals zero. This occurs where average total cost
equals price at the profit-maximizing output.

If the price is between average total cost and average

variable cost at the profit-maximizing output, then the firm is
said to be in a loss-minimizing condition. The firm should still
continue to produce, however, since its loss would be larger if
it was to stop producing. By continuing production, the firm can
offset at least its fixed cost and part of its variable cost, but
by stopping completely they would lose equivalent to their fixed
cost.

If the price is below average variable cost at the profit-

maximizing output, the firm is said to be in shutdown. Losses are
minimized by not producing at all, since any production would not
generate returns significant enough to offset any fixed cost and
part of the variable cost. By not producing, the firm loses only
its fixed cost.