Advanced Cost Accounting

and
Management Control
System
by
Mekonnen Mengistie
(PhD Candidate)
COURSE CONTENTS
Chapter 1: Cost Concepts, Cost Behavior And Cost
Estimation
 Introduction-cost concept
 Cost behavior pattern
 Estimating cost behaviors

Chapter 2: Multiple Product CVP Analysis

 CVP analysis over view
 Multiple product CVP analysis without constraints
 Multiple product CVP analysis with constraints
 CVP analysis under uncertainty
 Chapter 3: Activity Based
Costing/ABC/ System
Traditional cost allocation Vs ABC
costing system
Activity based costing illustration

Chapter 4: cost analysis and pricing

decision
Profitmaximization pricing models
Target ROI pricing and asset valuation
Cost based pricing
Strategic pricing for new products
Chapter 5: Responsibility Centers And
Performance Management
 Profit centers and transfer pricing
Profitas performance measures
Transfer pricing
 Investment centers
Relating profits to assets employed
ROI and residual income
Economic value added (EVA)
 ASSESSMENT
The learning process will be assessed using:

 Test (20%)
 Individual 20%
 Group 20%
 Final Exam 40%

12/06/2021 5
 Chapter One

Cost concepts, Cost

Classification and Estimation

By Mekonnen Mengistie
 Chapter one
Basic Cost Management Concepts
 Introduction
Resources are needed to manufacture products.
Resources need to be properly managed to enhance
profitability of the products or services considered.
How much of the resources consumed for each product
need to be known.
That is we need to know:
 What are the type of resources needed for the product
 For what purpose resources are used
 What is the condition of their traceability
 Cost Concepts
 Definition of Cost; it could be defined as a
measure of the supply or use of a scarce resource
to achieve a specific objective.

 Cost: is a resource sacrificed or forgone to

achieve a specific objective. A cost is usually
measured as the monetary amount that must be
paid to acquire goods and services.
 Continued,

A Cost object: is anything for which a separate

measurement of costs is desired.

Cost pool: A cost pool is a grouping of individual

cost items possessing identical nature. Cost pools
can range from broad, such as all costs within a
manufacturing plant, to narrow, such as the costs of
operating machine.
 Cost Concepts
Cost accumulation: is the collection of costs in some organized
way by means of an accounting system, i.e., by some natural or self
descriptive classification.
Eg. material cost, labor cost, fuel, Advertisement cost etc.

Cost assignment: is a general term that includes:

a. Tracing accumulated costs: For direct costs
b. Allocating accumulated costs: For indirect costs

Cost driver is a variable, such as an activity level or volume, the

change of which causally affect costs over a given time span. That is,
there is a specific cause-and-effect relationship between change in
level of activity or volume and change in level of cost.
Classification of costs:

 Different cost classifications are used to develop

cost information for a given purpose.
 Managers use this information to support product
and service decisions, enables cost control, provide
historical data for cost management.
 Thus, different classification of costs provide
different information that helps for decision
making.
Cont’d
 Cost classification is the process of grouping costs
according to their common characteristics.
 There are various criteria on the basis of which
costs can be classified.
 The classification can be:
1. Based on physical characteristics
a. materials
b. labor
c. overheads(expenses)
 Continued,
2. By function/operation/purposes:
 Production(manufacturing); direct materials, direct labor and

manufacturing overhead), and

 Non manufacturing costs( selling, distribution, administration, R&D)

3. Based on their traceability to a particular cost object:

Direct: costs that have a relationship with the cost object and can
be traced to that cost object in an economically feasible (cost
effective) way.
Indirect: costs that have a relationship with the cost object but
cannot be traced to that cost object in an economically feasible
way.
Continued,
4. Based on their behavior pattern  :
 Fixed (are total costs that remain constant regardless

of the level of activity up to a certain relevant range

but unit costs vary according to the level of activity.),

 Variable (are total costs that changes in direct

proportion to changes in the level of activity but unit
costs remain constant).
 Continued,
5. By control ability:
 Controllable (Avoidable): costs that can be influenced by management
action..Relevant Cost
 Uncontrollable(Unavoidable): cost beyond the control of
management.

6. By normality:
Normal: costs incurred in the normal course of activity for producing
normal level of out put under normal circumstances.
Abnormal: costs incurred on account of abnormal conditions or
abnormal activity.
Continued,

7. Based on timing they are charged against revenue

 Product costs : (Inventoriable cost) are costs that are necessary
and integral part of producing (acquiring) the finished product.
They are considered as an asset/inventory when they are incurred.
Under the matching principle, these costs do not become expenses
until the finished goods inventory is sold.
Example: Cost of direct material
 Period Costs: are costs of income statement other than cost of
goods sold. They are treated as expense of the period in which
they are incurred because they are expected to benefit revenue in
the current period.
Example: Advertising costs
 Relevant Vs Irrelevant Cost

Relevant costs are those future costs that will be

changed by a decision.

Irrelevant costs are those that will not be affected

by the decision.
 Sunk Costs Vs Opportunity Cost
Sunk Costs: These costs are the cost of resources
already acquired where the total will be unaffected
by the choice between various alternatives. They are
costs that have been created by a decision made in
the past and that cannot be changed by any decision
that will be made in the future.
Opportunity Cost: An opportunity cost is a cost
that measures the opportunity that is lost or
sacrificed when the choice of one course of action
requires that an alternative course of action is given
up.
Incremental costs Vs Marginal cost

Incremental costs, which are also called

differential costs, are the difference between the
costs of each alternative action that is being
considered.
Additional total cost incurred for an activity

Marginal cost represents the additional cost of

one extra unit of output
 Cost according to elements of cost

Direct material
Direct labor
Direct expenses
Overheads
Cost According to function- Manufacturing Vs. Non-
manufacturing costs

Manufacturing Costs
 Manufacturing costs involves the cost of raw

material, labour and use of equipment to finished

goods
 Composed up of the following elements.

 Direct material
 Direct labour
 Overheads
Elements of Manufacturing Cost

 Materials
 Labour

 Overheads- indirect material labors and

factory expenses
Non manufacturing Cost
 Cost other than manufacturing cost that are
incurred for sale
 Non-manufacturing costs are:
 Selling expenses /marketing expenses
 Promotion, or Advertisement costs,
 Administrative costs
Cost according to behavior
 Variable cost
 Mixed cost
 Fixed cost
Variable costs
 Variable costs are based on activity.
 The variable costs should be zero at zero activity.
 They change directly with changes in activity level in a
responsibility center.
 If output is doubled, variable expenses is to be doubled,
 if output increases by 15% the variable expenses also increase
by 15%,
 if output is zero, the variable cost also zero.
Variable costs are usually characterized by:

 Unit cost remains constant.

 Total costs that increase as activity
increases.
 Total costs that decrease as activity
decreases.
 Total costs changes proportionality with
changes in output.
 Variable cost

cost

Variable
cost
Variable cost per unit

0 Units of products
Fixed Cost
 Fixed cost is also called period cost or capacity
cost.
 It does not change in short term period or within a
relevant range.
 They accrue primarily with the passage time.
 Fixed costs are caused by holding of assets and
other factors of production in a state of readiness to
produce.
 Characteristics of fixed cost

 Unit cost increase as activities/outputs decrease.

 Costs that remain constant even activities are
decreased or decreased
 Cost per unit that increases as activity decreases
and vice versa
 Total costs that remain constant.
Fixed cost curve

cost

Fixed cost

0 Units of products
Committed fixed cost

 Committed cost arises from the ownership, facilities

or possession of assets.
 Committed cost can not be changed by a simple
decision.
 Major decisions to change.
For example: property tax, Loan installments
depreciation, insurance etc.
Discretionary fixed Cost
 Arises from management decision
 Controllable costs

 Can be easily changed by decisions

 Examples:

Advertisement,
Training costs
marketing expenses,
promotional expenses etc.
Step fixed costs
Remains constant over fixed range of activities but jumps to
different amount for the activities levels outside the range
Semi–Variable Expenses/ Mixed costs

 Semi–variable expenses also changes with changes

in output or activity but not in proportion to
changes in activity or output
 Semi variable expenses have some of the
characteristics of both fixed and variable costs.
 Semi variable expenses are caused by combined
effect of passage of time, activity or output and
management discretion decisions.
Cost Estimation
 A cost estimate is the approximation of the cost of a
program, project, or operation.
 The cost estimate is the product of the cost estimating
process.
 The cost estimate has a single total value and may have
identifiable component values.
 A problem with a cost overrun can be avoided with a
credible, reliable, and accurate cost estimate.
 An estimator is the professional who prepares cost
estimates.
 Methods Used to Estimate
Cost Behavior

Charlene, owner of Charlene’s Computer Care

(3C), wants to estimate the cost of a
new computer repair center.

3 Methods:

1. Engineering estimates
2. Account analysis
3. Statistical methods
Engineering Estimates
Estimate costs using engineering estimates.

Cost estimates are based on measuring and

then pricing the work involved in a task.

Identify the activities involved:

– Labor
– Rent
– Insurance

Estimate the time and cost for each activity.

Account Analysis
Estimate costs using account analysis.

Review each account comprising the total

cost being analyzed.

Identify each cost as either fixed or variable.

Fixed Variable
Account Analysis
3C Cost estimation using account analysis
Costs for 360 repair-hours
Variable Fixed
Account Total cost cost

Office rent $ 3,375 $1,375 $2,000

Utilities 310 100 210
Administration 3,386 186 3,200
Supplies 2,276 2,176 100
Training 666 316 350
Other 613 257 356
Total $10,626 $4,410 $6,216
Per repair hour $12.25
 Account Analysis
3C Cost estimation using account analysis
Fixed costs + (Variable cost/unit × No. of units) = Total cost

Cost at 360 repair-hours:

$6,216 + ($12.25 × 360) = $10,626

Cost at 480 repair-hours:

$6,216 + ($12.25 × 480) = $12,096
Statistical Cost Estimation
Estimate costs using statistical analysis.

Analyze costs within a relevant range, which is

the limits within which a cost estimate may be valid.

Relevant range for a projection is usually between

the upper and lower limits (bounds) of past activity
levels for which data is available.
Overhead Cost Estimation
for 3C
Overhead Repair-
Month costs hours
1 $ 9,891 248
2 $ 9,244 248
3 $13,200 480
4 $10,555 284 These data will be used
5 $ 9,054 200 to estimate costs using
6 $10,662 380 a statistical analysis.
7 $12,883 568
8 $10,345 344
9 $11,217 448
10 $13,269 544
11 $10,830 340
12 $12,607 412
13 $10,871 384
14 $12,816 404
15 $ 8,464 212
Scattergraph

Does it look like a relationship exists

between repair-hours and overhead costs?
Scattergraph

We use “eyeball judgment” to determine the intercept and slope of

the line.
Hi-Low Cost Estimation

This is a method to estimate cost based on two cost

observations, the highest and lowest activity level.

Overhead Repair-
Month costs hours
High $12,883 568

Low $ 9,054 200

Change $ 3,829 368

Hi-Low Cost Estimation
Variable cost per unit (V) =
(Cost at highest activity level – Cost at lowest activity level)
(Highest activity level – Lowest activity level)

Fixed cost (F) =

Total cost at
– (Variable cost × Highest activity level)
highest activity

or
Total cost at
– (Variable cost × Lowest activity level)
lowest activity
 Hi-Low Cost Estimation

Variable cost ($12,883 – $9,054) $3,829 $10.40

= = =
per RH (V) 568 RH – 200 RH 368 RH per RH

Fixed costs (F) = ($12,883 – ($10.40 × 568 RH) = $6,976

or
Fixed costs (F) = ($9,054 – ($10.40 × 200 RH) = $6,974

Rounding
difference
Hi-Low Cost Estimation

TC = F + VX

TC = $6,976 + ($10.40 × 480) = $11,968

Regression Analysis

Regression is a statistical procedure to

determine the relation between variables.

It helps managers determine how well the

estimated regression equation describes
the relations between costs and activities.
Regression Analysis

Hi-low method:
Uses two data points

Regression:
Uses all of the data points
Needs computer application to estimate costs
Regression Analysis

The Regression Equation:

Y = a + bX

Y = Intercept + (Slope × X)

For 3C:
OH = Fixed costs + (V × Repair-hours)
Interpreting Regression
Interpret the results of regression output.

Independent variable:
– The X term, or predictor
– The activity that predicts (causes)
the change in costs
Activities:
– Repair-hours

Dependent variable:
– The Y term
– The dependent variable
– The cost to be estimated

Costs:
– Overhead costs
Linear Regression -example.
 Consider the following cost data in the past 12 years,
and Compute
1. Unit Variable Cost
2. Fixed Cost
3.Estimate total cost subsequent five years
using Linear Regression .

Year
(T) 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Cost
(Y) 2,109 2,530 2,287 3,194 3,785 3,372 3,698 3,908 3,725 4,129 4,532 4,487
Linear Regression -example.
Y= a + bx
Where
 Y is Toal cost
 a is the intercept(FC)
 b is slope (UVC)
x is independent variable (Quantity,time)
 Linear regression example
…
 
 Steps
1. Find summation of “T” starting from T zero…….Time
2. Find average “T”
3. Find summation of “Y”…………Cost
4. Find average “Y”
5. Find summation of TY…Product of time & Revenue
6. Find summation of T square
7. Find average T square
8. Compute b……Slope (V.C/U)
9. Compute a…. Intercept ( FC)
10. Forcast cost for year “X” using the formula

Y= a + bx
 Time series analysis
Quantity
(T) 0 1 2 3 4 5 6 7 8 9 10 11

Cost(Y) 2,1092,5302,287 3,194 3,785 3,3723,698 3,908 3,725 4,129 4,532 4,487
-
TY 2,530 4,574 9,582 15,140 16,86022,188 27,356 29,800 37,16145,32049,357

T2 0 1 4 9 16 25 36 49 64 81 100 121
Time series model, Linear regression
…
 
Time series analysis
b = (259,868- (12 x5.5x 3,479.70))
506- (12 x 30.25)
259,868-229,660.2
143
30207.8
143
b = 211.26 UVC
a= 3479.70 – 211.26(5.5)
a = 2,317.90 FC
 Forecast for 5 years

Yr. 13= 2,317.90+ 211.26 X 12= 4853.

Yr. 14= 2,317.90+ 211.26 X 13= 5064
Yr. 15= 2,317.90+ 211.26 X 14= 5276
Yr. 16= 2,317.90+ 211.26 X 15= 5487

Yr. 17= 2,317.90+ 211.26 X 16= 5698

 Cost Flow in a Manufacturing
Firm
Work-in-Process Inventory Finished Goods Inventory
Direct material cost Product cost transferred
Direct labor cost
Manufacturing overhead when product is finished

Cost of Goods Sold Income Summary

Expense closed into

Income Summary at end

of accounting period
End of chapter one