BASTRCSX - Module 2 - Lecture - CT - Cost Terms, Concepts, and Classifications New

Strategic Cost Management Module 2
1 Strategic Cost Management-AJA

Cost
Classifications
& Behavior
BASTRCSX Module 2
3 Learning Outcomes:
At the end of the session, the learners will be able to:

1. Identify and give examples of each of the three basic manufacturing cost categories.
2. Identify and differentiate variable costs from fixed costs.
3. Identify and differentiate direct costs from indirect costs.
4. Define and give examples of cost classifications used in making decisions: differential
costs, opportunity costs, and sunk costs.
5. Properly account for labor costs associated with idle time, overtime, and fringe benefits.
6. Identify the four types of quality costs and explain how they interact.
7. Prepare and interpret a quality cost report.
8. Define learning curve and discuss its impact on cost behavior
9. Prepare an income statement using the contribution format.
Strategic Cost Management-AJA

Identify and give examples
of each of the three basic
manufacturing cost
categories.
Learning Outcome 1

General Cost
Classification

6 Manufacturing Costs
Direct Direct Manufacturing

Materials Labor Overhead
The Product

7 Direct Materials
Raw materials that become an

integral part of the product and that
can be conveniently traced directly
to it.
Example: A radio installed in an automobile

8 Examples of direct materials
– the aircraft engines on a Boeing 777,

– the Intel processing chip in a personal computer
– the blank video cassette in a pre-recorded video,
– a radio in an automobile.
– the seats that Airbus purchases from subcontractors to
install in its commercial aircraft
– tiny electric motor that Panasonic uses in its DVD players

9 Direct Labor
Those labor costs that can be easily
traced to individual units of product.
Example: Wages paid to automobile assembly workers

10 Examples of direct labor
– Assembly-line workers at Toyota,

– Carpenters at the home builder Kaufman and Broad,
– Electricians who install equipment on aircraft at Bombardier
Learjet

11 Manufacturing Overhead
Manufacturing costs that cannot be traced
directly to specific units produced.
Examples: Indirect materials and indirect labor
Materials used to support Wages paid to employees

the production process. who are not directly
involved in production
Examples: lubricants and work.
cleaning supplies used in the Examples: maintenance
automobile assembly plant. workers, janitors and
security guards.
12 Examples of indirect materials
– Solder used to make electrical connections in a Sony TV

– Glue used to assemble an Ethan Allen chair

13 Examples of indirect labor
– Labor costs of janitors, supervisors, materials handlers, and

night security guards

14 Examples of other manufacturing
overhead
– Maintenance and repairs on production equipment;
– heat and light,
– property taxes,
– Depreciation of factory machine & equipment,
– insurance on manufacturing facilities.

15 Nonmanufacturing/Period Costs
Selling Administrative
Costs Costs
Costs necessary to All executive,

secure the order and organizational, and
deliver the product. clerical costs.

16 Examples of selling costs
– advertising,
– shipping/freight-out,
– sales travel,
– sales commissions,
– sales salaries, and
– costs of finished goods warehouses.

17 Examples of administrative costs
– executive compensation,
– general accounting,
– secretarial,
– public relations, and
– similar costs involved in the overall, general administration
of the organization as a whole

Product Costs vs Period
Costs

19 Product Costs Versus Period Costs
Product costs include Period costs include all

direct materials, selling costs and
direct labor, and administrative costs.
manufacturing
overhead.
Inventory Cost of Good Sold Expense
Sale
Balance Income Income

Sheet Statement Statement
20 Classifications of Costs
Manufacturing costs are often
classified as follows:
Direct Direct Manufacturing
Material Labor Overhead
Prime Conversion
Cost Cost

21 Quick Check ✓
Which of the following costs would be considered
a period rather than a product cost in a
manufacturing company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.

22 Quick Check ✓
Which of the following costs would be considered
a period rather than a product cost in a
manufacturing company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.

Identify and differentiate
variable costs from fixed costs.
Learning Outcome 2

Cost Classifications for
Predicting Cost Behavior

Cost Classifications for Predicting
25
Cost Behavior
How a cost will react
to changes in the
level of activity within
the relevant range.
– Total variable costs
change when activity
changes.
– Total fixed costs remain
unchanged when
activity changes.

26 Variable Cost
Your total texting bill is based on how

many texts you send.
Total Texting Bill
Number of Texts Sent

27 Variable Cost Per Unit
The cost per text sent is constant at

5 cents per text.
Cost Per Text Sent

Number of Texts Sent
28 Illustration
– A good example of a variable cost is direct materials. The cost of

direct materials used during a period will vary, in total, in direct
proportion to the number of units that are produced.
– To illustrate this idea, consider the Saturn Division of GM . Each
auto requires one battery.
– As the output of autos increases and decreases, the number of
batteries used will increase and decrease proportionately. If auto
production goes up 10%, then the number of batteries used will
also go up 10%.
29

Examples of Variable Costs
30
1. Merchandising companies – cost of goods sold.
2. Manufacturing companies – direct materials,
direct labor, and variable overhead.
3. Merchandising and manufacturing companies –
commissions, shipping costs, and clerical costs
such as invoicing.
4. Service companies – supplies, travel, and
clerical.

31 Fixed Cost
Your monthly contract fee for your cell phone is fixed for the
number of monthly minutes in your contract. The monthly
contract fee does not change based on the number of calls
Monthly Cell Phone
you make.
Contract Fee
Number of Minutes Used

Within
Strategic Monthly Plan
Cost Management-AJA
32 Fixed Cost Per Unit
Within the monthly contract allotment, the average fixed cost

per cell phone call made decreases as more calls are made.
Monthly Cell Phone

Contract Fee
Number of Minutes Used
Strategic Cost Management-AJA Within Monthly Plan
33 Example of fixed costs
– Straight-line depreciation,
– insurance,
– property taxes,
– rent,
– supervisory salaries,
– administrative salaries, and
– advertising.

34 Types of Fixed Costs
Committed Discretionary
Long-term, cannot be May be altered in the
significantly reduced in short-term by current
the short term. managerial decisions
Examples Examples
Depreciation on Buildings Advertising and
and Equipment and Real Research and
Estate Taxes Development
35
Fixed Costs and the Relevant Range
Rent Cost in Thousands 90
The relevant range
Relevant of activity for a fixed
of Dollars
60 cost is the range of

Range activity over which
the graph of the
cost is flat.
30
0
0 1,000 2,000 3,000
Rented Area (Square Feet)
36
For example, assume office space is available at

a rental rate of $30,000 per year in increments of
1,000 square feet.
Fixed costs would increase

in a step fashion at a rate of
$30,000 for each additional
1,000 square feet.

37
Step-variable costs
can be adjusted more
How does this quickly as conditions
step-function change and . . .
pattern differ from a The width of the activity
step-variable cost? steps is much wider for
the fixed cost.
38 Illustration
– Suppose the Mayo Clinic rents a machine for $8,000 per month
that tests blood samples for the presence of leukemia cells. The
$8,000 monthly rental cost will be incurred regardless of the
number of tests that may be performed during the month.
– Very few costs are completely fixed. Most will change if activity
changes enough.

39 Illustration
– For example, suppose that the capacity of the leukemia diagnostic machine at the
Mayo Clinic is 2,000 tests per month. If the clinic wishes to perform more than
2,000 tests in a month, it would be necessary to rent an additional machine, which
would cause a jump in the fixed costs. When we say a cost is fixed, we mean it is
fixed within some relevant range.
– The relevant range is the range of activity within which the assumptions about
variable and fixed costs are valid. For example, the assumption that the rent For
diagnostic machines is $8,000 per month is valid within the relevant range of 0 to
2,000 tests per month.

40 Illustration

41 Cost Classifications for Predicting Cost
Behavior
Behavior of Cost (within the relevant range)

Cost In Total Per Unit
Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Average fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.

Quick
42
Check ✓
Which of the following statements about cost
behavior are true?
a. Fixed costs per unit vary with the level of activity.
b. Variable costs per unit are constant within the relevant
range.
c. Total fixed costs are constant within the relevant range.
d. Total variable costs are constant within the relevant
range.

Quick Check ✓
43
Which of the following statements about
cost behavior are true?
a. Fixed costs per unit vary with the level of
activity.
b. Variable costs per unit are constant within the
relevant range.
c. Total fixed costs are constant within the
relevant range.
d. Total variable costs are constant within the
relevant range.
44 Quick Check ✓
Which of the following costs would be
variable with respect to the number of
cones sold at a Baskins & Robbins shop?
(There may be more than one correct
answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
45 Quick Check ✓
Which of the following costs would be
variable with respect to the number of
cones sold at a Baskins & Robbins shop?
(There may be more than one correct
answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
Behavior
❖Mixed – has both a variable and fixed component.
On a per unit basis, it does not fluctuate in direct
proportion to changes in activity, nor does it remain
constant with changes in activity. (e.g. electric bill -
$5,000/month plus $0.018 per kwh)
– Electric bill (Y) = 5,000 + 0.018/kwh
– Cost equation = Y = a + bx
Mixed Costs (also called semivariable
47
costs)
A mixed cost contains both variable and fixed
elements. Consider the example of utility cost.
Y
Total Utility Cost
Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge
48 Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX
Where: Y = The total mixed cost.

a = The total fixed cost (the
Y vertical intercept of the line).
b = The variable cost per unit of
Total Utility Cost
activity (the slope of the line).

X = The level of activity.
Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge
Behavior
❖ Step – shifts upward or downward when activity changes by
a certain interval or “step”. Step variable costs have small
steps; Step fixed costs have large steps.
Step Variable Costs Step Fixed Costs
per gallon gallons
No. of supervisor No. of workers Supervisor salaries
$0.002 Up to 1,000
1 supervisor 10 workers $5,000/supervisor
$0.003 1,001 –
2,000 2 supervisors 15 workers $10,000
$0.005 2,001 –
3 supervisors 22 workers $15,000
3,000

50
Step-Variable Costs
A step-variable cost is a resource that is obtainable only
in large chunks (such as maintenance workers) and
whose costs change only in response to fairly wide
changes in activity.
Cost
Volume
51 Step-Variable Costs
Small changes in the level of production are not
likely to have any effect on the number of
maintenance workers employed.
Cost
Volume
52
Step-Variable Costs
Only fairly wide changes

in the activity level will
cause a change in the
number of maintenance
Cost
workers employed.
Volume
The Linearity Assumption and the
53 Relevant Range
Economist’s A straight line
closely
Curvilinear Cost approximates a
Function curvilinear
variable cost
line within the
Relevant
relevant range.
Total Cost
Range
Accountant’s Straight-Line
Approximation (constant
unit variable cost)
Activity
54 Activity measures
– Common activity measures include production

volume, service and sales volumes, hours of
machine time used, pounds of material moved, and
the number of purchase orders processed.

55 Determining Cost Behavior
– Cost Predictor – Cost Driver

– Activity measure that, when – Activity or cost predictor
changed, is accompanied by that has a direct cause-
consistent, observable effect relationship on cost
changes in a cost item
– Predicts but may not cause – Directly causes the cost to

the cost to change change (e.g. production
volume has direct effect on
the total cost of raw
materials used)

The
56 Activity Base (also called a cost driver)
Units Machine
produced hours
A measure of what
causes the
incurrence of a
variable cost
Miles Labor
driven hours
57 Cost Reaction to Changes in Activity
– Variable cost – Fixed Cost

$ $
Total Total
# of Units # of Units
Unit $ Unit $
Within the
relevant range
58 Cost Reaction to Changes in Activity
– Step Cost (fixed) – Mixed Cost
variable
$ $
fixed
Within the
relevant range
59
Quick Check
– Identification of variable, fixed, and mixed costs. Place a check mark in the
appropriate column to indicate whether the following costs are variable, fixed, or
mixed.
Item Variable Fixed Semivariable
1. Small tools
2. Patent amortization
3. Health and accident insurance
4. Heat, light, and power
5. Straight line depreciation
6. Maintenance of buildings and
grounds
7. Royalties
8. Materials handling
9. Property and liability insurance
10. Maintenance of factory equipment
Identify and differentiate direct
costs from indirect costs.
Learning Outcome 3

Assigning Costs to Cost
Objects

Assigning Costs to Cost Objects
62
Direct costs Indirect costs
– Costs that can be – Costs that cannot
easily and be easily and
conveniently traced conveniently traced
to a unit of product to a unit of product
or other cost or other cost
object.(significant object.
in amount) (insignificant in
– Examples: direct amount)
material and direct – Example:
labor manufacturing
overhead
McGraw-Hill/Irwin
63 Example of direct cost
– If Reebok is assigning costs to its various regional

and national sales offices, then the salary of the
sales manager in its Tokyo office would be a direct
cost of that office.

64 Example of indirect cost
– A Campbell Soup factory may produce dozens of

varieties of canned soups. The factory manager’s salary
would be an indirect cost of a particular variety such as
chicken noodle soup.
– The reason is that the factory manager’s salary is
incurred as a consequence of running the entire
factory—it is not incurred to produce any one soup
variety

65
Quick Check
– indicate whether the cost is direct or indirect with respect to the cost object listed
next to it.
Cost Description Cost Object Type

1. Wages of carpenters on a home building site
A particular home
2. Cost of wiring used in making a personal computer
A particular personal computer
3. Manager’s salary at a hotel run by a chain of hotels
A particular hotel guest
4. Manager’s salary at a hotel run by a chain of hotels
The particular hotel
5. Cost of aluminum mast installed in a yacht at a
yacht manufacturer A particular yacht
6. Monthly lease cost of X-ray equipment at a hospital
The Radiology (X-Ray) Department
7. Cost of screws used to secure wood trim in a yacht
at a yacht manufacturer A particular yacht
8. Cost of electronic navigation system installed in a
yacht at a yacht manufacturer A particular yacht
9. Cost of a replacement battery installed in a car at
the auto repair shop of an automobile dealer
The auto repair shop
10. Cost of a measles vaccine administered at an
outpatient clinic at a hospital A particular patient
Define and give examples of cost
classifications used in making
decisions: differential costs,
opportunity costs, and sunk costs.
Learning Outcome 4

Decision Making

68 Cost Classifications for Decision
Making
– Every decision involves a
choice between at least two
alternatives.
– Only those costs and benefits

that differ between
alternatives are relevant in a
decision. All other costs and
benefits can and should be
ignored.
69 Differential cost and revenue
– A difference in costs between any two alternatives is known as a differential cost.

– A difference in revenues between any two alternatives is known as differential
revenue.
– A differential cost is also known as an incremental cost , although technically an
incremental cost should refer only to an increase in cost from one alternative to
another; decreases in cost should be referred to as decremental costs.
– Differential cost is a broader term, encompassing both cost increases (incremental
costs) and cost decreases (decremental costs) between alternatives.

70 Differential Cost and Revenue
Costs and revenues that differ among alternatives.

Example: You have a job paying $1,500 per month in
your hometown. You have a job offer in a neighboring
city that pays $2,000 per month. The commuting cost
to the city is $300 per month.
Differential revenue is: Differential cost is:

$2,000 – $1,500 = $500 $300
Neighboring city - Hometown Difference
Income 2,000 1,500 500
Cost -300 -0 (300)
Net income 1,700 1,500 200
71 Differential Cost and Revenue
Assume that Nature Way Cosmetics, Inc. is thinking about changing the network of
neighborhood sales representatives. Present costs and revenues are compared to
projected costs and revenues in the following table:
Retailer Sales Differential Costs
Distribution Representatives and Revenues
(present) (proposed)
Revenues $700,000 $800,000 $100,000
Cost of Goods Sold 350,000 400,000 50,000
Advertising 80,000 45,000 (35,000)

Commissions 0 40,000 40,000
Warehouse depreciation 50,000 80,000 30,000
Other expenses 60,000 60,000 0
Total expenses 540,000 625,000 85,000
Net Operating income $160,000
Strategic Cost Management-AJA $175,000 $15,000
72 Opportunity Cost
The potential benefit that is given up when one alternative is selected

over another.
Example:
If you were not attending college, you
could be earning $15,000 per year.
Your opportunity cost of attending

college for one year is $15,000.

73 Opportunity Cost examples
– Suppose that Neiman Marcus is considering

investing a large sum of money in land that may be a
site for a future store. Rather than invest the funds in
land, the company could invest the funds in high-
grade securities.
– The opportunity cost of buying the land is the
investment income that could have been realized by
purchasing the securities instead
74 Opportunity Cost examples
– Steve is employed by a company that pays him a

salary of $38,000 per year. He is thinking about
leaving the company and returning to school.
– Because returning to school would require that he
give up his $38,000 salary, the forgone salary
would be an opportunity cost of seeking further
education.
75 Sunk Costs
Sunk costs have already been incurred and cannot be changed

now or in the future. These costs should be ignored when
making decisions.
Example: You bought an automobile that cost $10,000 two years

ago. The $10,000 cost is sunk because whether you drive it or park
it, you cannot change the $10,000 cost.

76 Sunk cost example
– Assume that a company paid $50,000 several years ago for a special-
purpose machine. The machine was used to make a product that is
now obsolete and is no longer being sold.
– Even though in hindsight purchasing the machine may have been
unwise, the $50,000 cost has already been incurred and cannot be
undone. And it would be folly to continue making the obsolete
product in a misguided attempt to “recover” the original cost of the
machine. In short, the $50,000 originally paid for the machine is a
sunk cost that should be ignored in current decisions.
77 Quick Check ✓
Suppose you are trying to decide whether to
drive or take the train to Portland to attend a
concert. You have ample cash to do either,
but you don’t want to waste money
needlessly. Is the cost of the train ticket
relevant in this decision? In other words,
should the cost of the train ticket affect the
decision of whether you drive or take the
train to Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not
relevant.
78 Quick Check ✓
Suppose you are trying to decide whether to
drive or take the train to Portland to attend a
concert. You have ample cash to do either,
but you don’t want to waste money
needlessly. Is the cost of the train ticket
relevant in this decision? In other words,
should the cost of the train ticket affect the
decision of whether you drive or take the
train to Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not
relevant.
79 Quick Check ✓
Suppose you are trying to decide whether
to drive or take the train to Portland to
attend a concert. You have ample cash to
do either, but you don’t want to waste
money needlessly. Is the annual cost of
licensing your car relevant in this
decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.
80 Quick Check ✓
Suppose you are trying to decide whether
to drive or take the train to Portland to
attend a concert. You have ample cash to
do either, but you don’t want to waste
money needlessly. Is the annual cost of
licensing your car relevant in this
decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.
81 Quick Check ✓
Suppose that your car could be sold now
for $5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.

82 Quick Check ✓
Suppose that your car could be sold now
for $5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.

Properly account for labor costs
associated with idle time, overtime,
and fringe benefits.
Learning Outcome 5

84 Idle Time
Machine Material
Breakdowns Shortages
Power
Failures
The labor costs incurred

during idle time are ordinarily
treated as manufacturing
overhead.
85 Idle Time: Illustrative Example
– Assume that a press operator earns $12 per hour. If

the press operator is paid for a normal 40 hour
workweek but is idle for 3 hours during a given work
week due to breakdowns, labor cost would be
allocated as follows:

86 Overtime
The overtime premiums for all factory
workers are usually considered to be part
of manufacturing overhead.

87 Overtime: Illustrative Example
– Assume that two batches of goods, order A and order B, each take three hours to
complete. The production run on order A is scheduled early in the day, but the
production run on order B is scheduled late in the afternoon. By the time the run
on order B is completed, two hours of overtime have been logged.
– The necessity to work overtime was a result of the fact that total production
exceeded the regular time available. Order B was no more responsible for the
overtime than was order A.
– Therefore, managers feel that all production should share in the premium charge
that resulted. This is considered a more equitable way of handling overtime
premium because it doesn’t penalize one run simply because it happens to occur
late in the day.
88 Overtime: Illustrative Example
– Assume that a press operator in a plant earns $12 per

hour. She is paid time and a half for overtime (time in
excess of 40 hours a week). During a given week, she
works 45 hours and has no idle time. Her labor cost for
the week would be allocated as follows:

89 Labor Fringe Benefits
Fringe benefits include employer paid costs
for insurance programs, retirement plans,
supplemental unemployment programs,
Social Security, Medicare, workers’
compensation, and unemployment taxes.
Some companies Other companies treat

include all of these fringe benefit
costs in expenses of direct
manufacturing laborers as additional
overhead. direct labor costs.
Identify the four types of quality
costs and explain how they interact.
Learning Outcome 6

91 Quality of Conformance
When the overwhelming majority of products

produced conform to design specifications
and are free from defects.

92 Quality Costs
Quality cost refers to all of the cost
that are incurred to prevent defects or
that result from defects in products.
1st Group: are incurred in 2nd Group: are incurred

an effort to keep defective because defects are
products from falling into produced despite efforts to
the hands of customers. prevent them.
Prevention Appraisal Internal External

costs costs failure costs failure costs
93 Prevention and Appraisal Costs
Support activities
Prevention whose purpose is to
Costs reduce the number of
Most defects
effective
way to
manage
quality costs
Incurred to identify
defective products
Appraisal Costs before the products are
shipped to customers

Internal and External Failure Costs
94
Incurred as a result of
Internal Failure
identifying defects
Costs before they are shipped
Incurred as a result of
External Failure defective products
Costs being delivered to
customers

95 Examples of Quality Costs
Appraisal Costs
Prevention Costs
• Testing and inspecting
• Quality training
incoming materials
• Quality circles
• Final product testing
• Statistical process
• Depreciation of testing
control activities
equipment
External Failure Costs

Internal Failure Costs
• Cost of field servicing and
• Scrap
handling complaints
• Spoilage
• Warranty repairs
• Rework
• Lost sales

96

97 Notes about Quality Costs:
First, quality costs don’t relate to just manufacturing;

rather, they relate to all the activities in a company from
initial research and development through customer service.
Second, the number of costs associated with quality

is very large; total quality costs can be quite high
unless management gives this area special attention.
Finally, the costs in

the four groupings
are quite different.

98 Distribution of Quality Costs

99
Quick Check ✓
Classify each cost if it is preventive, appraisal, internal failure or external failure cost
p a Quality engineering $68,000
p b Quality circles $35,000
a c Supervision of testing and inspection activities $72,000
i d Net cost of scrap $76,000
a e Test and inspection of in-process goods $6,000
e f Liability arising from defective products $3,000
i g Warranty repairs and replacements $56,000

h Debugging software errors $68,000
I Rework labor and overhead $19,000
Prepare and interpret a quality cost
report.
Learning Outcome 7

Quality Cost Report
For Years 1 and 2
Year 2 Year 1
Amount Percent* Amount Percent*
101 Prevention costs:
Systems development $ 400,000 0.80% $ 270,000 0.54%
Quality training 210,000 0.42% 130,000 0.26%
Supervision of prevention activities 70,000 0.14% 40,000 0.08%
Quality improvement 320,000 0.64% 210,000 0.42%
Total prevention cost 1,000,000 2.00% 650,000 1.30%
Quality cost Appraisal costs:

Inspection 600,000 1.20% 560,000 1.12%
reports provide Reliability testing 580,000 1.16% 420,000 0.84%
Supervision of testing and inspection 120,000 0.24% 80,000 0.16%
an estimate of Depreciation of test equipment 200,000 0.40% 140,000 0.28%
Total appraisal cost 1,500,000 3.00% 1,200,000 2.40%
the financial
consequences Internal failure costs:
Net cost of scrap 900,000 1.80% 750,000 1.50%
of the Rework labor and overhead
Downtime due to defects in quality
1,430,000
170,000
2.86%
0.34%
810,000
100,000
1.62%
0.20%
company’s Disposal of defective products
Total internal failure cost
500,000
3,000,000
1.00%
6.00%
340,000
2,000,000
0.68%
4.00%
current defect
External failure costs:
rate. Warranty repairs 400,000 0.80% 900,000 1.80%
Warranty replacements 870,000 1.74% 2,300,000 4.60%
Allowances 130,000 0.26% 630,000 1.26%
Cost of field servicing 600,000 1.20% 1,320,000 2.64%
Total external failure cost 2,000,000 4.00% 5,150,000 10.30%
Total quality cost $ 7,500,000 15.00% $ 9,000,000 18.00%
* As a percentage of total sales. In each year sales totaled $50,000,000.
Quality Cost Reports in Graphic Form
102
$10 20
9 18
Quality Cost as a Percentage of Sales

8 16
Quality Cost (in millions)

Quality
7 14
External External reports External External
6 Failure Failure 12 Failure Failure
can also
5 10
be
4 Internal 8 Internal
Failure prepared Failure
3 Internal 6 Internal
Failure in Failure
2 4
Appraisal graphic Appraisal
Appraisal
Appraisal 2
1
form. Prevention Prevention
Prevention Prevention 0
0
1 2 1 2
Year Year
103 Uses of Quality Cost Information
Help managers see the
financial significance of
defects.
Help managers identify

the relative importance
of the quality problems.
Help managers see
whether their quality
costs are poorly
distributed.
Limitations of Quality Cost Information
104
Simply measuring and
reporting quality cost
problems does not solve
quality problems.
Results usually lag

behind quality
improvement programs.
The most important

quality cost, lost sales, is
often omitted from
quality cost reports.
Define learning curve and discuss
its impact on cost behavior
Learning Outcome 8

106 Nonlinear Cost Behavior
– Learning curve: Shows how labor hours per

unit decrease as units produced increases
– Experience curve: Relates cost to increased
efficiency, such that the more often a task is
performed, the lower the cost of doing it

107 Learning curve models
Cumulative Incremental
average-time unit-time
learning curve learning curve
model model

108 Cumulative average-time learning
curve model
States that the cumulative average time per unit
decreases by a constant percentage, or learning
rate, each time the cumulative quantity of units
produced doubles
– Learning rate: Gives the percentage of time needed to
make the next unit, based on the time it took to make
the previous unit
– Expressed as a percent between 50% and <100%
1st unit = 1hour=60mins 1st unit = 1hour=60mins
Learning rate = 80% Learning rate = 100%
2 units, Cum. ave. time per unit = 2 units, Cum. ave. time per unit =
60mins*0.8 = 48mins 60mins*1 = 60mins/unit
curve model
– Mathematically, two methods are used to calculate the estimated
total time required for all units produced and the estimated average
time required per unit for all units produced using the cumulative
average model:
– 1) Calculate the estimated total time required for all units produced,
then use the estimated total time to calculate the estimated cumulative
average time per unit;
– 2) Calculate the estimated cumulative average time per unit, and then
use the estimated average time per unit to calculate the estimated total time
required for all units produced.

curve model
– Method 1: Calculate the estimated total time required for production, then use the estimated total
time to calculate the estimated cumulative average time per unit:
𝑬𝒔𝒕. 𝒕𝒐𝒕𝒂𝒍 𝒕𝒊𝒎𝒆 𝒓𝒆𝒒𝒖𝒊𝒓𝒆𝒅 𝒇𝒐𝒓 𝒂𝒍𝒍 𝒖𝒏𝒊𝒕𝒔 𝒑𝒓𝒐𝒅𝒖𝒄𝒆𝒅
= 𝑻𝒊𝒎𝒆 𝒓𝒆𝒒𝒖𝒊𝒓𝒆𝒅 𝒇𝒐𝒓 𝒕𝒉𝒆 𝒇𝒊𝒓𝒔𝒕 𝒖𝒏𝒊𝒕 × (𝟐 × 𝑳𝑪)𝒏
– Where:
– LC = Learning curve percentage (in decimal format)
– N -= number of doublings of units produced to date
𝑬𝒔𝒕. 𝒄𝒖𝒎𝒖𝒍𝒂𝒕𝒊𝒗𝒆 𝒂𝒗𝒆𝒓𝒂𝒈𝒆 𝒕𝒊𝒎𝒆 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕 𝒓𝒆𝒒𝒖𝒊𝒓𝒆𝒅 𝒇𝒐𝒓 𝒂𝒍𝒍 𝒖𝒏𝒊𝒕𝒔 𝒑𝒓𝒐𝒅𝒖𝒄𝒆𝒅
𝑬𝒔𝒕. 𝒕𝒐𝒕𝒂𝒍 𝒕𝒊𝒎𝒆 𝒓𝒆𝒒𝒖𝒊𝒓𝒆𝒅 𝒇𝒐𝒓 𝒂𝒍𝒍 𝒖𝒏𝒕𝒊𝒔 𝒑𝒓𝒐𝒅𝒖𝒄𝒆𝒅
=
𝑻𝒐𝒕𝒂𝒍 𝒏𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒖𝒏𝒊𝒕𝒔 𝒑𝒓𝒐𝒅𝒖𝒄𝒆𝒅

111 Illustration
A plant that manufactures cars is subject to an 80% learning curve.
Ten hours are required to produce the first car.
According to the cumulative average-time learning model, the estimated total time required to manufacture the
first 2 cars will be 80% of the total time it would have taken to produce 2 cars if no learning had taken place.
The first doubling (to produce 2 units):
– [Note: Any number raised by the exponent 1 is the number itself.]
– 1) Estimated total time required for units 1 and 2 = ?
– 2) Estimated cumulative average time per unit for units 1 and 2 = ?
The second doubling (to produce 4 units):
– 1) Estimated total time required for units 1 through 4 = ?
– 2) Estimated cumulative average time per unit for units 1 through 4 = ?
The third doubling (to produce 8 units):
– 1) Estimated total time required for units 1 through 8 = ?
– 2) Estimated cumulative average time per unit for units 1 through 8 = ?

curve model
– Method 2: Calculate the estimated cumulative average time per unit for all units
produced, then use the estimated cumulative average time per unit to calculate
the estimated total time required for all units produced:
𝑬𝒔𝒕. 𝒄𝒖𝒎𝒖𝒍𝒂𝒕𝒊𝒗𝒆 𝒂𝒗𝒆𝒓𝒂𝒈𝒆 𝒕𝒊𝒎𝒆 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕 𝒇𝒐𝒓 𝒂𝒍𝒍 𝒖𝒏𝒊𝒕𝒔 𝒑𝒓𝒐𝒅𝒖𝒄𝒆𝒅
= 𝑻𝒊𝒎𝒆 𝒓𝒆𝒒𝒖𝒊𝒓𝒆𝒅 𝒇𝒐𝒓 𝒕𝒉𝒆 𝒇𝒊𝒓𝒔𝒕 𝒖𝒏𝒊𝒕 × 𝑳𝑪𝒏
– Where:
– N = Number of doublings of all units produced
𝑬𝒔𝒕. 𝒕𝒐𝒕𝒂𝒍 𝒕𝒊𝒎𝒆 𝒓𝒆𝒒𝒖𝒊𝒓𝒆𝒅 𝒇𝒐𝒓 𝒂𝒍𝒍 𝒖𝒏𝒊𝒕𝒔 𝒑𝒓𝒐𝒅𝒖𝒄𝒆𝒅

= 𝑬𝒔𝒕. 𝒄𝒖𝒎𝒖𝒍𝒂𝒕𝒊𝒗𝒆 𝒂𝒗𝒆. 𝒕𝒊𝒎𝒆 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕 𝒇𝒐𝒓 𝒂𝒍𝒍 𝒖𝒏𝒊𝒔 𝒑𝒓𝒐𝒅𝒖𝒄𝒆𝒅
× 𝑻𝒐𝒕𝒂𝒍 𝒏𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒖𝒏𝒊𝒕𝒔 𝒑𝒓𝒐𝒅𝒖𝒄𝒆𝒅
113 Illustration
According to the cumulative average-time learning model, the estimated total time required to manufacture the
first 2 cars will be 80% of the total time it would have taken to produce 2 cars if no learning had taken place.
The first doubling:
[Note: Any number raised by the exponent 1 is the number itself.]
– 1) Estimated cumulative average time per unit for units 1 and 2 =
– 2) Estimated total time required for units 1 and 2 = 8 × 2 =
The second doubling:
– 1) Estimated cumulative average time per unit for units 1 through 4 =
– 2) Estimated total time required for units 1 through 4 =
The third doubling:
– 1) Estimated cumulative average time per unit for units 1 through 8 =
– 2) Estimated total time required for units 1 through 8 =

Time Required for a Specific Block of Units Using
114
the Cumulative Average Time-Learning Model

According to the cumulative average-time learning model, the estimated total time
required to manufacture the first 2 cars will be 80% of the total time it would
have taken to produce 2 cars if no learning had taken place.
– To find the estimated total time required to produce only units 5, 6, 7, and 8 in the
previous examples, subtract the estimated total time required for units 1 through 4 from
the estimated total time required for units 1 through 8, as follows:
𝐸𝑠𝑡. 𝑡𝑜𝑡𝑎𝑙 𝑡𝑖𝑚𝑒 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑓𝑜𝑟 𝑢𝑛𝑖𝑡𝑠 5 𝑡𝑜 8 = 40.96 − 25.6 = 15.36

Time Required for a Specific Block of Units Using
115
the Cumulative Average Time-Learning Model

According to the cumulative average-time learning model, the estimated total time
required to manufacture the first 2 cars will be 80% of the total time it would
have taken to produce 2 cars if no learning had taken place.
– To find the estimated total time required for units 3 and 4 only in the examples above,
subtract the estimated total time required for units 1 and 2 from the estimated total time
required for units 1 through 4, as follows:
𝐸𝑠𝑡. 𝑡𝑜𝑡𝑎𝑙 𝑡𝑖𝑚𝑒 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑓𝑜𝑟 𝑢𝑛𝑖𝑡𝑠 3 𝑎𝑛𝑑 4 = 25.6 − 16 = 9.6

curve model
𝑌 = 𝑝𝑋 𝑞
– Where:
– Y = Cumulative average time per unit
– X = Cumulative number of units produced
– p = Time in labor hours required to produce the first unit
– q = rate of learning
ln(𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑙𝑒𝑎𝑟𝑛𝑖𝑛𝑔) To calculate the number

– Therefore: 𝑞= of hours required for
ln 2 units that are not
doubles of first.
ln(0.80)
𝑞= = −0.3219 𝑟𝑜𝑢𝑛𝑑𝑒𝑑
ln 2
curve model
ln(0.80)
𝑌 = 𝑝𝑋 𝑞 ln 2
– So, when X = 3, p = 100 hrs/unit and q = - 0.3219,
Y = 100 x 3-0.3219 = 70.12 labor hours/unit
Total hrs = Y * X = 70.12hrs/unit * 3 = 210.36 hrs

curve model
ln(0.80)
𝑌 = 𝑝𝑋 𝑞 ln 2
– So, when X = 5, p = 100 hrs/unit and q = - 0.3219,
Y = (100) x (5^-0.3219) = 59.56373 hrs/unit
Total cum. hrs = Y * X = 59.56373 x 5 = 297.82 hrs

Spreadsheet for Cumulative Average-Time
119 Learning Model 𝑌 = 𝑝𝑋 𝑞
Cumulative Cumulative ave. time
no. of units per unit (Y) Cumulative total Value of q or
(X) time (Y * X) Time for last unit =In(0.8)/In(2) ln(𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑙𝑒𝑎𝑟𝑛𝑖𝑛𝑔)
1 p = 1,000.00 1,000.00 1,000.00 -0.32193 𝑞=
ln 2
2 1,000* 0.8 = 800.00 2*800 = 1,600.00 1,600-1,000= 600.00 -0.321928095
3 (1,000)*(3-0.32193) = 702.10 3*702.104=2,106.31 2,106.31-1,600 = 506.31 -0.321928095
2560-
4 800 * 0.8 = 640.00 2,560 2,106.31=453.69 -0.321928095
5 1,000*(5-0.32193)=595.64 2,978.19 418.19 -0.321928095
6 561.69 3,370.10 391.91 -0.321928095
7 534.49 3,741.43 371.33 -0.321928095
8 640 * 0.8 = 512.00 4,096 354.57 -0.321928095
9 492.95 4,436.55 340.55 -0.321928095
10 476.51 4,765.10 328.55 -0.321928095
11 462.11 5,083.22 318.12 -0.321928095
12 449.35 5,392.16 308.93 -0.321928095
13 437.92 5,692.90 300.75 -0.321928095
14 427.59 5,986.28 293.38 -0.321928095
15 418.20 6,272.99 286.71 -0.321928095
16 512 * 0.80 = 409.60 6,553.60 280.61 -0.321928095
Spreadsheet for Cumulative Average-
120 Time Learning Model 𝑌 = 𝑝𝑋 𝑞
Cumulative Cumulative ave. time Value of q or

Cumulative total time Time for last unit
no. of units per unit (Y) =In(0.8)/In(2) ln(𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑙𝑒𝑎𝑟𝑛𝑖𝑛𝑔)
𝑞=
1 p = 1,000 1,000 1,000 -0.321928095 ln 2
2 P = 0.8*1,000 = 800 800*2= 1,600 1600-1000=600 -0.321928095

Prev. units produced = 4 units = x 506.3111083
3 (1,000)*(3-0.3219)=702.10 702.10*3=2,106.31 -0.321928095
Total
4 time Y=(1,000)*(5^-
required
800*0.8=640 = 2,560 hrs
640*4=2,560 453.6888917 -0.321928095
Learning
5 rate = 80%;
0.319)=595.63 5*595.63=2,978.19 418.1867181 -0.321928095
6 561.6829622 3370.097773 391.9110553 -0.321928095
Time
7 required to produce
534.4895247 an additional
3741.426673 3 units?
371.3288993 -0.321928095
8 640*0.8=512 512*8=4,096 354.5733274 -0.321928095
9 492.9496095 4436.546485 340.5464851 -0.321928095
10 476.5098749 4765.098749 328.5522638 -0.321928095
11 462.1111387 5083.222526 318.1237766 -0.321928095
12 449.3463698 5392.156437 308.9339118 -0.321928095
13 437.9155217 5692.901782 300.7453442 -0.321928095
14 427.5916197 5986.282676 293.3808946 -0.321928095
15 418.1991845 6272.987767 286.7050908 -0.321928095
16 409.6 6553.6 280.612233 -0.321928095
Spreadsheet for Cumulative Average-
121 Time
Prev. unitsLearning
produced = 4 unitsModel
=x
Total time required = 2,560 hrs
𝑌 = 𝑝𝑋 𝑞
Cumulative Cumulative ave. time Value of q or

no. of units
Learning rate = 80%;
per unit (Y)
Cumulative total time Time for last unit
=In(0.8)/In(2) ln(𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑙𝑒𝑎𝑟𝑛𝑖𝑛𝑔)
Time required to produce an additional 3 units? 𝑞=
1 p = 1,000 1,000 1,000 -0.321928095 ln 2
Total cum. units = 4 + 3 = 7
2 P = 0.8*1,000 = 800 800*2= 1,600 1600-1000=600 -0.321928095
3
Y = Cumulative
(1,000)*(3-0.3219)=702.10
ave. time per unit
702.10*3=2,106.31
= ? = Total Cum. Time/x-0.321928095
506.3111083
P = ? = time to make the 1st unit = Y/Xq
4 Eq. 1: Y(4)=p*4
800*0.8=640 -0.3219 640*4=2,560 453.6888917 -0.321928095
Eq.2:Y=(1,000)*(5^-
Total Cum. time(4) = Y * x = 2,560 = Y*4 = 2,560/4
5 0.319)=595.63 5*595.63=2,978.19 418.1867181 -0.321928095
Y= 640
6 561.6829622 3370.097773 391.9110553 -0.321928095
7
640= p*(4 -0.3219)
534.4895247 3741.426673 371.3288993 -0.321928095
8 640=p*(0.64);
640*0.8=512 p = 640/0.64 512*8=4,096 354.5733274 -0.321928095
9 P=1,000492.9496095 4436.546485 340.5464851 -0.321928095
10 476.5098749 4765.098749 328.5522638 -0.321928095
11 Y(7) =1,000*(7 -0.3219)
462.1111387 5083.222526 318.1237766 -0.321928095
12 Y= 534.49 = cum. ave. time
449.3463698 per unit for 7 units
5392.156437 308.9339118 -0.321928095
13 437.9155217
Cum. Total 5692.901782
time(7) = 534.49 * 7=3,741.43 300.7453442 -0.321928095
14 427.5916197
Addt’l time 5986.282676
for the 3 units= 3,741.43 - 2,560 293.3808946 -0.321928095
15 418.1991845 6272.987767 286.7050908 -0.321928095
=1,181.43
16 409.6 6553.6 280.612233 -0.321928095
122 Graph of Cumulative Total Hours Required and
the Cumulative Average time per unit
Graph of Cumulative Total Hours and Cumulative
Average time per unit
7000
6000
5000
TOTAL HOURS
4000
3000
2000
1000
0
0 2 4 6 8 10 12 14 16 18
NO. OF UNITS
Cumulative ave. time per unit (Y) Cumulative total time

123 Incremental unit-time learning curve
model
– Decreases by a constant percentage each time the cumulative
quantity of units produced doubles.
– The same general assumptions for the learning curve hold; however,
the learning rate is assumed to apply to the last unit produced, not
to cumulative average of all units to date
Cumulative average time learning model
Learning rate = 80% Cum. ave. time (2) per unit = 80 hours/unit =100 hrs *
Time required for the 1st unit = 100 hours 0.8
Cumulative ave. time per unit if the no. of Total cumulative time = 80*2 = 160
units is 2?
Incremental unit time learning model
1st unit = 100 hours, 2nd unit = 80 hours
Strategic Cost Management-AJA Total cumulative time = 100+80 =180
124 Incremental Unit-time learning curve
model
– The formula for calculating the estimated time required to produce the last unit of each
production doubling under the incremental unit-time learning model is:
𝑬𝒔𝒕. 𝒄𝒖𝒎𝒖𝒍𝒂𝒕𝒊𝒗𝒆 𝒂𝒗𝒆𝒓𝒂𝒈𝒆 𝒕𝒊𝒎𝒆 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕 𝒕𝒐 𝒑𝒓𝒐𝒅𝒖𝒄𝒆 𝒕𝒉𝒆 𝒍𝒂𝒔𝒕 𝒖𝒏𝒊𝒕
= 𝑻𝒊𝒎𝒆 𝒓𝒆𝒒𝒖𝒊𝒓𝒆𝒅 𝒇𝒐𝒓 𝒕𝒉𝒆 𝒇𝒊𝒓𝒔𝒕 𝒖𝒏𝒊𝒕 × 𝑳𝑪𝒏
– Where:
– N = Number of doublings of all units produced

125 Illustration
– If the incremental unit-time learning model is used, the estimated time required to manufacture the
second car will be 80% of 10 hours, or 8 hours. Thus, the estimated total time required to produce
two cars is 10 hours + 8 hours, or 18 hours. The estimated average time per unit produced will be
18 ÷ 2, or 9 hours.
– However, the last unit produced in the first doubling (the second unit) is the only instance where the
estimated average time per unit produced can be determined under the incremental model without a
financial calculator. Above the level of 2 units (the first doubling), the estimated total time to
produce all the units cannot be calculated.
The first doubling:
– Estimated time required to produce unit 2 (only unit 2) =
The second doubling:
The third doubling:
Prepare an income statement using
the contribution format.
Learning Outcome 9

127 The Contribution Format
Let’s put our
knowledge of cost
behavior to work
by preparing a
contribution
format income
statement.

Total Unit
Sales Revenue $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Net operating income $ 10,000
The contribution margin format emphasizes cost

behavior. Contribution margin covers fixed costs
and provides for income.
129 Uses of the Contribution Format
The contribution income statement format is used
as an internal planning and decision-making tool.
We will use this approach for:
1.Cost-volume-profit analysis.
2.Budgeting.
3.Segmented reporting of profit data.
4.Special decisions such as pricing and make-or-
buy analysis.

Used primarily for Used primarily by

external reporting. management.
131 References:
– Garrison, R. H., Noreen, E. W. & Brewer, P. C., 13th

edition (2010). Managerial Accounting, McGraw-
Hill/Irwin
– Kinney & Raiborn, 8th edition (2011). Cost
Accounting: Foundations and Evolutions, Cengage
Learning
– Stevenson, W. J., 8th edition (2005). Operations
Management, McGraw-Hill/Irwin

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Strategic Cost Management Module 2

1 Strategic Cost Management-AJA

At the end of the session, the learners will be able to:

Strategic Cost Management-AJA

4 Strategic Cost Management-AJA

5 Strategic Cost Management-AJA

Direct Direct Manufacturing

Strategic Cost Management-AJA

Raw materials that become an

Example: A radio installed in an automobile

– the aircraft engines on a Boeing 777,

Strategic Cost Management-AJA

Example: Wages paid to automobile assembly workers

Strategic Cost Management-AJA

– Assembly-line workers at Toyota,

Strategic Cost Management-AJA

Examples: Indirect materials and indirect labor

Materials used to support Wages paid to employees

– Solder used to make electrical connections in a Sony TV

Strategic Cost Management-AJA

– Labor costs of janitors, supervisors, materials handlers, and

Strategic Cost Management-AJA

Strategic Cost Management-AJA

Costs necessary to All executive,

Strategic Cost Management-AJA

Strategic Cost Management-AJA

Strategic Cost Management-AJA

18 Strategic Cost Management-AJA

Product costs include Period costs include all

Balance Income Income

Strategic Cost Management-AJA

Strategic Cost Management-AJA

Strategic Cost Management-AJA

23 Strategic Cost Management-AJA

24 Strategic Cost Management-AJA

Strategic Cost Management-AJA

Your total texting bill is based on how

Number of Texts Sent

The cost per text sent is constant at

Cost Per Text Sent

– A good example of a variable cost is direct materials. The cost of

Strategic Cost Management-AJA

Strategic Cost Management-AJA

Number of Minutes Used

Within the monthly contract allotment, the average fixed cost

Monthly Cell Phone

Strategic Cost Management-AJA

60 cost is the range of

For example, assume office space is available at

Fixed costs would increase

Strategic Cost Management-AJA

Strategic Cost Management-AJA

Strategic Cost Management-AJA

Strategic Cost Management-AJA

Behavior of Cost (within the relevant range)

Strategic Cost Management-AJA

Strategic Cost Management-AJA

Where: Y = The total mixed cost.

activity (the slope of the line).

Strategic Cost Management-AJA

Only fairly wide changes

– Common activity measures include production

Strategic Cost Management-AJA