7/31/2022

Overview: Decisions and Cost Terminology

Managerial Accounting for Decision Making (MADM)
Session 1

About course requirements

• Cases 15% weight: Baldwin Bicycles due 8 am on August 10 and Buckeye

National Bank due 8 am on August 18
• Midterm exam after Week 2, 40% weight, Final Exam 40% weight
• Class participation (zoom polls): 5% weight
• Main advice: DO NOT fall behind!
• READ text before coming to class
• TRY the practice problems yourself before looking at the provided solutions
• Academic associates and my contact details and office hours provided on LMS

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About me

What is this course about?

financial Accounting- historical and forward-looking.

Users are external. Fin statements are made public.

• A decision support
system
• User perspective
• Forward looking

Management
accounting

Planning Control
(facilitating decisions) (influencing decisions)

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Answers to planning questions like …

• What is my profit, if sales grow by 5%?

• What is the cost to make another batch of my product?
(partly in second half)
• Is the proposed ad budget a viable expenditure?

• How much capacity should I put in?

• Which products to keep and which to drop?
• What if market conditions are bad? Should I close
shop, downsize, or pay for maintaining capacity?
long term decisions

NO
Is accounting procedural? Can you query these
answers from SAP?

• What is my profit if sales grow by 5%?

• Could be different from “what if sales decrease by 5%.” Or from “what if sales increase
by 50%.”
• Could be different in the short term versus the long term
• The accounting information system cannot give pre-programmed answers to all these
questions
• What is the cost to make another batch of my product?
• Depends on what is the causal relation between the number of batches and cost.
Partly programmable through Activity Based Costing (2nd half)
• Is the proposed ad budget a viable expenditure?
• What would be the sales if the ad budget were lower, and what would be the sales if
the ad budget is at the proposed level? Contextual, cannot be programmed
• The relevant cost number depends on the decision in question: “Different costs
for different purposes,” cannot be queried from SAP
• Implies that we need a conceptual understanding rather than an algorithm to
determine costs

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The Microsoft CEO talks about hard-won hard skills in a conversation with dean Sunil Kumar.
October 10, 2015

Answers to control questions like …

2nd half
• Is our plant running efficiently?
• How should we motivate and
compensate employees?
• Are our employees working hard? Are
they working on the right stuff?

• What is the profitability of our

organization?
• How is our strategy execution? Are we
investing for the future adequately?
• What strategic threats do we face?
How should we respond to them?

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Almost 100 years ago, a famous firm was founded by

an accounting professor to implement his ideas about
control

James O. McKinsey

Steps in decision-making

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Steps in decision making

Our focus

1 2 3 4

First Step Second Step Third Step Fourth Step

Specify the Identify Measure benefits Make the
decision options (advantages) and decision,
problem, costs (disadvantages) choosing
including to determine the the option
the decision value (benefits with the
maker’s reaped less costs highest
goals incurred) of each value
option

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Example

• Decision to be made: How to watch a movie, say Radhe.

Goals: reduce cost, enjoy the experience, minimize time and cost of
travel, avoid exposure to Covid
• Identify options: watch in a theatre or on PPV
• Benefits and Costs:
• Theatre – better experience, more expensive, need to spend time and incur cost
on travel, exposure to Covid
• PPV: flip all the above
• Decision: Based on weighing these benefits and costs
• Business problems are slightly more structured than this
• Not everything can be measured in dollars (e.g., customer satisfaction), but value
(=benefit – cost) is not as subjective as in the above example
• Practice problem 1.36 gives you the opportunity to test your
understanding

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Opportunity costs, relevance, and controllability

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Opportunity Cost

• Opportunity Cost (OC) is the value of the next best alternative

foregone
• This amount is the foregone benefit -- what we have given up
• The cost of joining the ISB PGP is not just the fees payable (33 lakhs) but
also foregone salary (say 10 lakhs) = total 43 lakhs. This 10 lakhs is the
opportunity cost of joining ISB relative to continuing to work instead.
• The cost of joining the IIMA PGDM is not just the fees charged (23 lakhs)
but also foregone salary 10 lakhs for Year 1 + (say) 11 lakhs for Year 2 =
total 44 lakhs. The opportunity cost of joining IIMA relative to continuing
to work instead is 10 + 11 = 21 lakhs.
• Opportunity cost is relative to the best among feasible alternatives. You
cannot count a McKinsey partner’s one year salary as the opportunity
cost of joining ISB, unless that is a feasible alternative.
• If you have a choice among two jobs instead of joining ISB, one paying 10 lacs
and the other paying 9 lacs, your opportunity cost is 10 lacs and not 19 lacs—you
can do only one of two jobs, it is not feasible to do both

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• Suppose Indigo’s normal HYD-BOM fare is 5,000. Its flight tomorrow has
one empty seat and someone offers to pay 1,000 for it. What is Indigo’s
opportunity cost of selling a ticket at that price? What is the opportunity
cost of not selling that ticket?

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Relevant costs

• If somebody has a choice of going to ISB and instead goes to IIMA’s

PGDM, their cost is 23 lakhs fees + 28 lakhs in foregone post-ISB-PGP
salary for second year = 51 lakhs total, compared to just fees (33 lakhs)
at ISB
• We have ignored the 10 lakh foregone salary for the first year in this
case but not on the previous slide. Why?
• Foregoing the first year salary is common to the IIMA and ISB alternatives, but
not for the ISB v continue working alternatives
• Relevant Costs are the costs (including opportunity costs) that differ
between the alternatives being considered
• Specific to alternatives under consideration
• Cannot be programmed into SAP

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Tabular comparison
relevant to compare costs that are different. Just considering
Year 1, the cost is
not only the fees
plus also the
foregone salary.
Option 1 Option 2 Option 3 Needs to be
Continue ISB IIMA compared with
working
salary differentials
in Years 2 and
Fees 0 -33 -23 beyond
Salary, Year 1 10 0 0 Foregone salary in
ISB v Option 1 Difference = Year 1 can be ignored.
0 – 10 = -10 Need to consider
Salary, Year 2 11 28 0 salary in Year 2

Children’s school fees -2 -2 -2 Common to all

options, ignore

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• Practice problems
• 1.36 – four-step decision framework
• 1.41, 1.42, 1.57 practice problems about opportunity costs in different
contexts. (1.42 Greyhound is similar to the airline example we discussed)
• Article: “Persuasive power of opportunity cost”

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Role of time in cost analysis

• Time plays two roles in cost analysis

• First, before versus after commitment
• Until you buy a noncancelable airline ticket, it is relevant to the decision of
traveling by air versus rail. After you have bought the ticket, you must ignore it if
something happens to make you re-think your decision (it has now become
common to the alternatives of air v rail).
• These are known as sunk costs. They are irrelevant to further decisions.
• Second, commitment period.
• Cost commitments such as buying a machine are irreversible in the short run.
• But the machine has a finite life. Beyond that, in the long run, the further costs
are not committed and therefore relevant.

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Time and cost analysis, contd

• After commitment is made (e.g., machine is purchased), the costs are

not controllable for the life of that decision
• Before commitment – controllable
• After commitment, in the short run – not controllable
• In the long run – controllable (you can control whether you want to buy a new
machine or not)
• Short or long is relative to decision (not fixed in years/months)—For an
automobile it may be 15 years and for a computer it may be 3
• But short run may influence long run. If you buy a Windows machine you might
get used to it and that might influence your next computer purchase as well,
even though technically speaking you are not committed
• Controllability is always defined in comparison to the status quo,
regardless of whether it is feasible to continue with the status quo (HW
P2.36)
• Before commitment, the status quo is that you have not bought the machine;
after commitment, the status quo is that you own the machine

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Time, cost controllability & relevance

• Control over costs and benefits increases with passage of time

• Commitments and contracts expire

• Ability to change capacity resources varies over time

• Cannot change capacity level in the short-term
• Can change capacity level in long-term
• Opportunity cost computations differ accordingly

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• Relevance and controllability: Practice problems 2.36, 2.37, 2.41, 2.51

• Learnings:
• Relevant costs depend on feasible alternatives including whether status quo is
feasible, but controllable costs depend only on status quo regardless of whether
it is feasible (2.36, 2.51)
• Variability is with respect to a volume measure (2.41)

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Comparison of managerial and financial

accounting

• Managerial accounting is broader

• Actual as well as opportunity costs
• Financial as well as non-financial measures (e.g., companies may choose to
reward managers based on customer satisfaction)
• Not constrained by GAAP
• Decision-making and control issues are not definable in advance, so managerial
accounting cannot be reduced to an algorithm

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Summary

• Managerial accounting is about information (not just financial but non-

financial as well) relevant to decisions and control
• It is not reducible to an algorithm—it is not procedural
• The relevant concepts are opportunity costs (e.g., foregone salary),
relevance (costs, including opportunity costs, that differ between
alternatives)
• Relevant costs are a function of time (after the event, a non-reversible
incurred cost is sunk), and differ between the short term and the long
term. Costs are more controllable in the long term (because status quo
changes).
• Short and long term are defined in terms of the time horizon over which
the relevant cost is either not controllable or controllable

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Cost Terminology and Cost Flows

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Manufacturing costs (same as in financial

accounting, but more detailed)

Manufacturing Direct Material – The wood in a table

Costs: primary materials
associated with directly traceable
the production to the final product
of goods
Direct Labor - Salaries and fringe
labor costs directly benefits paid to line
traceable to the workers
product

Manufacturing Indirect materials and

Overhead - all supplies, Indirect labor,
other production Depreciation on plant
costs including and factory equipment,
Factory utilities.

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• Whether a cost is direct or indirect depends on whether the cost is

traceable to the cost object. Indirect costs are also known as overheads
• Cost incurred in a department (say X-ray dept of a hospital) is traceable to the X-
ray dept cost object, but not traceable to individual patients (cost objects) who
had their X-ray imaging done there. The X-ray machine cost is a direct cost of the
X-ray dept, but an overhead for each X-ray.
• Traceable costs are direct costs. Non-traceable costs are indirect
(overheads)
• Fixed costs are fixed with respect to a unit of volume, and variable costs
vary with volume
• Direct and indirect costs are not the same as variable and fixed costs
• Direct costs such as materials are typically variable, but X-ray machine cost which
is a direct cost of X-ray dept is fixed with respect to number of X-rays
• Indirect costs (of each widget made in a factory) such as depreciation of a
machine, are fixed, but factory maintenance or lubrication supplies are variable

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Non-manufacturing costs

Non-manufacturing Selling costs: costs Advertising, sales

costs: Not associated associated with personnel salaries,
with the production of selling and filling depreciation on
goods. customer orders equipment used by
sales personnel,
shipping costs,
warehouse costs

General and Management’s

administrative salaries, depreciation
costs: costs of the general office
associated with the building or equipment
used by management,
firm’s general supplies used by
management clerical employees.

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Presentation of data – Financial Accounting

Item Amount
Revenue
Cost of goods sold
Gross margin
SG&A costs
Net income

• Groups costs by product and period costs (see next slide)

• Does not care about cost behavior (fixed versus variable)
• Required for reporting data to external parties
• Governed by GAAP / IFRS

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Costs: financial accounting

• Expenses in income statement show up either above or below “the line [for gross
margin]”
• GAAP dictates this grouping
• Product cost: All costs required to make a product ready for sale. Above the line for gross
margin
• Period cost: Everything else. Below the line for gross margin.
• Product costs (the costs of manufacturing resources), which show up as COGS (“cost
of goods sold”) include
• Direct materials and components
• Direct labor
• Manufacturing overhead (capacity costs, indirect labor, indirect materials)
• Period costs (the costs of selling, general, & administration (SG&A) resources)
include
• Selling costs
• Distribution costs
• Administration costs
• The reason to distinguish product versus period costs is that product costs go into
inventory asset and flow into an expense on the income statement only when that
inventory is sold

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When do costs show up in I/S?

• When a cost shows up in the Income Statement (I/S), it is called an

expense
• The routes vary
• Some costs go directly as expenses (e.g., when we spend cash to buy advertising)
• Some costs become assets on B/S and flow to I/S as the underlying asset is used
up (e.g., inventories)
• Some costs become assets on B/S and these costs are depreciated over time. The
depreciation expense shows up in the I/S
• Profit = (revenue – expenses) flows from the income statement to the
equity portion of the balance sheet

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Product and period costs of airline

Salaries of Product or period cost?

Pilots Product cost
Flight attendants Product cost
Employees who develop reservation web site Period cost
Gate agents Product cost
CEO Period cost
Call center employees Period cost

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• Why not distinguished into product costs and period costs?

when the distinction b/w period & product costs matter?

when there are inventories involved. Service companies do not have inventories.

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Breakdown of costs

Direct or Prime
cost, usually
variable

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Another breakdown of costs

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Connecting resources and inventory values

• Cost flow is the generic term used to describe how and when what we
spend on inputs show up in the income statement (i.e., become product
and period costs)
• Note that we are using the terms cost and expense interchangeably
(not quite right but is convenient)

• The actual flowchart depends on the nature of the firm

• Service firms / Merchandising / Manufacturing

• For manufacturing, inventory accounts play a crucial role in determining

gross margins

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Flow of product costs: overview

As we work on units, we
attach costs to units

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Practice problems

• 3.31: Product and period costs

• After watching Async Lecture, 13.33, 3.39, 3.47, 3.61: Stock and flow
equation, computing COGS, preparing income stmt
• 3.57 requires allocation of overheads to 3 products, which we are going
to see next

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Introduction to cost allocation

Purpose: illustrate the mechanics of the allocation process and the tradeoff involved in it, using a
simple example

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Meaning of allocation

• Many costs are joint, i.e., common to multiple cost objects

• Cost object is any object whose cost is being determined. E.g.,
• different products such as cars, trucks, and buses of Tata Motors; the common
factory and common machines are joint costs
• different departments such as Oncology and Cardiology of Apollo Hospitals;
hospital-wide common services such as facilities maintenance, patient
administration and billing, are joint costs
• Inventory and goods sold are different cost objects; manufacturing overheads
are joint costs
• The method of applying joint costs to individual cost objects is called
“allocation”

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Housing society details

• Assume the society has 2 Apt 1 Apt 2 total

types of Apts which are the
cost objects. Details are as #apts 20 10 30
shown to the right sft per apt 1,000 1,500
Total area 20,000 15,000 35,000

• Society incurs common costs Costs Rs/month

as shown. Building repairs 25,000
Water charges 10,000
Common facilities 50,000
Swimming pool 20,000
Total 1,05,000

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Nature of the costs

• Some like water charges are traceable to the units in principle, but
others cannot be traced. They are truly common costs – which we call
overheads
• Other than water, they do not vary with occupancy in the units

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Why allocate these costs to individual apartment

units?

• To recover costs (there are other possible reasons which we will see
later)
• If we must allocate, then the question is how?
• Possible ways to allocate
• Equally to each unit – each occupant has an equal right to use the common
facilities, and there is no necessary relation between apt size and the number of
occupants
• By apartment size (sft) – larger apts need more maintenance
• Based on actual usage--in principle water usage can be traced although it is
impractical to do so

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Cost allocation by different bases

Apt 1 Apt 2 total

#apts 20 10 30

sft per apt 1,000 1,500

Total area 20,000 15,000 35,000

Total Cost 105,000

Allocation based on equal

amount per apt 3,500 3,500 =105,000/30

Allocation based on sft 3,000 4,500

=105,000 x 1000 =105,000 x 1500
35,000 35,000

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A pictorial view
Swimming Resources or
Repairs Water Facilities
pool cost items

Total common
Single cost pool
costs 105,000

Units or sft are the

alternative allocation
bases
Small apt Large apt Cost objects

• This is a one-stage system

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Can I refine more? Add pools

Cost item amt allocation basis

Building repairs/repair fund 25,000 per sft
Water charges 10,000 per sft
35,000 Pool 1 Total
Common facilities 50,000 per unit
Swimming pool maintenance 20,000 per unit
70,000 Pool 2 Total
1,05,000 Grand Total

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per sft
Pool 1 Total cost 35,000 (cost/35,000) 1 Allocation
rates
Pool 2 Total cost 70,000 per apt (cost/30) 2,333

Apt 1 allocation (=1000sft*1per sft + 2,333 per apt) 3,333

Apt 2 allocation (=1500 sft*1 per sft + 2333) 3,833

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Pictorial view

Swimming Resources or
Repairs Water Facilities pool cost items

STAGE
1
Cost Cost
Pool 1 Pool 2

Based Equal amt

on sft per unit STAGE
2 Cost objects
Small apt Large apt

• This is a two-stage system

• If the top-level cost items are departments, then the dept cost could go into
multiple pools (e.g., repairs and facilities cost might be included within a single
maintenance dept)

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The tradeoff

• More cost pools can increase accuracy

• But causes more complication – costs have to be correctly classified,
whereas if there is a single allocation base then it does not matter
whether the cost of the water used for the swimming pool is classified
as water charges or swimming pool costs
• In this case the allocation bases are structurally fixed. If they were based
on activity (e.g., if you wanted to allocate swimming pool costs based on
how many times each person used it) then one would have to track the
activity level
• The tradeoff is between accuracy and complexity

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Incentives

• Should swimming pool costs be allocated according to use?

• If you do so, the cost will be quite high and people might choose to go to other
places such as public swimming pools. It will cause a death spiral (when some
people leave, the costs allocated over a fewer number of users will increase,
inducing a few others to leave …)
• Does the same logic apply to the clubhouse?
• If you do not charge for use, then people will have incentives to overuse, so it is
better to impose some fee (usually not the fully allocated cost)
• In addition to cost recovery, there is another reason to allocate costs,
which is to give users the right incentives
• Incentives work only if the allocation basis (use of swimming pool or
clubhouse) is controllable by users

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How does this apply to business organizations?

• Like in this example, businesses also allocate costs to recover full cost by
pricing products appropriately
• The same considerations apply –
• there is no one “correct basis” to allocate costs that are truly common
• In some cases there is a correct basis, but applying it would require tracking that
may not be feasible (like water charges in our example)
• There is a tradeoff between accuracy and complexity
• Businesses also use allocations to encourage and discourage certain activities
(like not charging for swimming pool use, and charging for clubhouse, in our
example)
• Like in the hsg society, allocation decisions can involve political compromise
• In addition, businesses allocate costs to value inventory

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Next session

• Here we saw the concepts of opportunity costs, relevance, and

controllability; and introduced the idea of cost allocations
• Async lecture 1 goes into details of cost flows in manufacturing and
service organizations
• Next time we will put these concepts together to understand how to
estimate costs in the context of short-term volume decisions: cost-
volume-profit (CVP) analysis
• Skim the Phelps Industries case uploaded to LMS (under Session 2). We
will use it in each of the next three sessions.
• CVP analysis leads us to the concept of break-even analysis and risk

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