Chapter 1: The accountant’s in the organization

Accounting, costing and strategy

Management accounting: measures and reports financial information as well as other types of

information that are intended primarily to assist managers in fulfilling the goals of the

organisation.

Formulating business strategy

Planning and controlling activities

Decision making

Efficient resource usage

Performance improvement and value enhancement

Safeguarding tangible and intangible assets

Corporate governance and internal control

Financial accounting focuses on external reporting that is directed by authoritative guidelines

Organisation are required to follow these guidelines in their financial reports to outside parties.

Cost accounting measures and reports financial and non-financial information related to the

organisation’s acquisition or consumption of resources. It provides information for both

management accounting and financial accounting.

Cost management and accounting systems; Strategic decisions and management accounting

Cost management describes the actions managers undertake in the short-run and long-run

planning and control of costs that increase value for customers and lower the costs of products

and services.

Outperformers in business are those with the strategic and external awareness to evolve and

change when need arises.

Management accounting information is called upon not only to help managers make balanced

decisions in the face of organizational changes and the opportunities their environments offer

but also to monitor and evaluate strategic and operational progress.

Accounting systems and management controls

Major purposes of accounting systems:

Formulating overall strategies and long-range plans

Resource allocation decisions such as product and customer emphasis and pricing.

Cost planning and cost control of operations and activities

Performance measurement and evaluation of people

Meeting external regulatory and legal reporting requirements

Planning: choosing goals, predicting results under various ways of achieving those goals, and

the deciding how to attain the desired goals.

Budget is the quantitative expression of a plan of action and an aid to the coordination and

implementation of the plan.

Control covers both the action that implements the planning decision and deciding on

performance evaluation and the related feedback.

Management by exception is the proactive of concentrating on areas not operating as expected

and placing less attention on areas operating as expected.

Variance refers to the difference between the actual results and the budgeted amounts.

Management control is primarily a human activity that tends to focus on how to help

individuals do their jobs better.

Feedback involves managers examining performance and systematically exploring alternative

ways to improve future performance.

Management accountants can be considered to perform 3 important functions:

Scorekeeping refers to the accumulation of data and the reporting of reliable results to all levels

of management (for example recording of sales, purchases of materials, and payroll payments).

Attention directing attempts to make visible both opportunities and problems on which

managers need to focus.

Problem solving refers to the comparative analysis undertaken to identify the best alternatives

in relation to the organisation’s goals.

Key themes in management decision-making:

Customer focus

Value chain is the sequence of business functions in which utility (usefulness) is added to the

products or services of an organization. The value chain model creates value in the

organization through cost reduction and/or differentiation advantages based on how value

chain processes and activities are carried out. Individual parts of the value chain should work

concurrently. Focus on analysing its value-added chain in order to reduce its costs while

enhancing perceived value by the customer.

Research and development

Design of products, services or processes

Production

Marketing

Distribution

Customer service

Supply chain describes the flow of goods, services and information from cradle to grave

Key success factors directly affect the economic viability of the organization

Cost

Quality

Time

Innovation

Continuous improvement and benchmarking - a never-ending search for higher levels of

performance

Chapter 2: An introduction to cost terms and purposes

Costs in general

Cost is defined as a resource sacrificed or forgone to achieve a specific objective.

Cost object is anything for which a separate measurement of costs is desired (for instance a

product, service, customer, brand category, activity, project, department or programme). This

helps to guide decisions.

Managers assign costs to designated cost objects to help decision-making. A costing system

typically accounts for costs in two basic stages:

1. It accumulates costs by some ‘natural’ classification such as materials, labour, fuel,

advertising or shipping

2. It assigns these costs to cost objects

Cost accumulation is the collection of cost data in some organised way through an accounting

system.

Cost assignment is a general term that encompasses both tracing accumulated costs to a cost

object (direct cost) and allocating accumulated costs to a cost object (indirect costs).

Actual costs are the costs actually incurred (historical costs) as opposed to budgeted or

forecasted costs.

Direct costs and indirect costs

Direct costs of a cost object are costs that are related to the particular cots object and that can

be traced to it in an economically feasible (cost-effective) way.

Indirect costs of a cost object are costs that are related to the particular cost object but cannot

be traced to it in an economically feasible (cost-effective) way. Indirect costs are allocated to

the cots object using a cost allocation method.

The direct/indirect classification depends on the choice of the cost object.

Cost tracing is the assigning of direct costs to the chosen cost object.

Cost allocation is the assigning of indirect costs to the chosen object.

Several factors will affect the classification of cost as direct or indirect:

1. The materiality of the cost in question: The higher the cost in question, the more likely

the economic feasibility of tracing that cost to a particular cost object.

2. Available information-gathering technology

3. Design of operations.

Cost drivers and costs management

The continuous cost reduction efforts frequently identify two key areas:

1. Focusing on value-added activities, that is, those activities that customers perceive as

adding value to the products or services they purchase.

2. Efficiently managing the use of the cost drivers in those value-added activities.

Cost driver (cost generator or cost determinant) is any factor that affects total costs.

Variable costs and fixed costs (cost behaviour pattern)

Variable cost is a cost that changes in total in proportion to changes in the related level of total

activity or volume.

Fixed cost is cost that does not change in total despite changes in the related level of total

activity or volume.

Assumptions of variable and fixed costs:

1. Costs are defines as variable or fixed with respect to a specific cost object.

2. The time span must be specified.

3. Total costs are linear.

4. There is only one cost driver. The other cost drivers are held constant.

5. Variations in the level of the cost driver are within a relevant range.

Relevant range is the range of the cost driver in which a specific relationship between cost and

the level of activity or volume is valid. A fixed cost is fixed only in relation to a given relevant

range (usually wide) of the cost driver and a given time span (usually a particular budget

period).

Total costs and unit costs

Unit cost (average cots) is calculated by dividing some amount of total cost by related number

of units (for example hours worked, packages delivered or cars assembled).

Cost behaviour pattern Total cost Unit cost

When item is a variable cost Total costs change with

changes in level of cost

driver

Unit costs remain the same

with changes in level of cost

driver

When item is a fixed cost Total costs remain the same

with changes in level of cost

driver

Unit costs change with

changes in level of cost

driver

Manufacturing-sector companies

Manufacturing-sector companies provide tangible products that have been converted to a

different form from that of the products purchased from suppliers. At the end of an accounting

period, a manufacturer has stock that can include direct materials, work in progress or finished

goods.

Stock-related costs (inventoriable costs) are those costs associated with the purchase of goods

for resale or costs associated with the acquisition and conversion of materials and all other

manufacturing inputs in to goods for sale. Inventoriable costs become part of cost of goods sold

in the period in which the stock item is sold.

Operating cost are all costs associated with generating revenues, other than cost of goods sold.

Types of stocks:

1. Direct materials stock: Direct materials in stock and awaiting use in the manufacturing

process.

2. Work in progress stock: Goods partially worked on but not yet fully completed.

3. Finished goods stock: goods fully completed but not yet sold.

Absorption costing – method in which all manufacturing costs are inventoriable

Variable costing – only variable manufacturing costs are inventoriable; fixed manufacturing

costs are treated as period costs; they are treated as expenses in the period in which they are

incurred rather than being inventoried

The language of management accounting has specific terms for manufacturing costs:

Direct material costs are the acquisition costs of all materials that eventually become a part of

the cost object and that can be traced to the cost object in an economically feasible way. (for

example inward delivery charges, sales taxes and customs duties).

Direct manufacturing labour costs include the compensation of all manufacturing labour that

is specifically identified with the cost object and that can be traced to the cost object in an

economically feasible way. (For example wages, fringe benefits paid to assembly line workers).

Indirect manufacturing costs (manufacturing overhead costs, factory overhead costs) are all

manufacturing costs considered to be part of the cost object, but that cannot be individually

traced to that cost object in an economically feasible way. (For example: indirect

manufacturing labour, plant rent, plant insurance, property taxes, plant depreciation).

Prime costs are all direct manufacturing costs (direct materials, direct manufacturing labour…)

Conversion costs are all manufacturing costs other than direct materials costs.

Product cost is the sum of the costs assigned to a product for a specific purpose.

Three different purposes:

1. Product pricing and product emphasis: All areas of the value chain taken part in the

product creation should be included.

2. Contracting with government agencies: Government agencies frequently provide

guidelines on the allowable and non-allowable items in a product-cost amount.

3. Financial statements: The focus here is on inventoriable costs.

Classification of costs

1. Business function:

a. Research and development

b. Design of products, services

and processes

c. Production

d. Marketing

e. Distribution

f. Customer service

2. Assignment to a cost object

a. Direct costs

b. Indirect costs

3. Behaviour pattern in relation to

changes in the level of a cost driver

a. Variable costs

b. Fixed costs

4. Aggregate or average

a. Total costs

b. Unit costs

5. Assets or expenses

a. Inventoriable costs

b. Period costs

Direct Materials used

Direct Manufacturing Labour

Indirect Manufacturing Costs

Manufacturing costs incurred

+ Opening WIP

Total Manufacturing costs to account for

+ Closing WIP

Cost of goods manufactured (to IS)

opening finished goods stock

+ cost of goods manufactured

cost of goods available for sale

– closing finished goods stock

Cost of goods sold

Chapter 9: Determining how costs behave

General issues in estimating cost functions

A cost function is a mathematical function describing cost behaviour patterns – how costs

change with changes in the cost driver.

Two assumptions for estimating cost functions:

1. Variations in the total costs of a cost –object are explained by variations in a single cost

driver.

2. Cost behaviour is adequately approximated by a linear cost function of the cost driver

within the relevant range.

Examples of linear cost functions:

Y=a + bX; a is the constant, b is the single slope coefficient.

Alternative 1: Only variable costs exist as a cost driver. Intersection with y-axis is (0/0). The

relevant range is the range of the cost driver where the relationship between total costs and the

driver is valid.

Alternative 2: Only fixed costs exist as a cost driver. The line intersects with the y-axis at the

amount of the fixed cost and is a linear horizontal line (slope is zero) without intersection with

the x-axis.

Alternative 3: Mixed cost or semivariable cost is a cost that has both fixed and variable

elements. This graph intercepts with the y-axis at the constant, and the slope is the variable

cost.

Basic terms

Cost estimation is the attempt to measure past cost relationships between total costs and the

drivers of those costs.

Cost predictions are forecasts about future costs.

The cause-and-effect criterion in choosing cost drivers

The most important issue in estimating a cost function is to determine whether a cause-and-

effect relationship exists between the cost driver and the resulting costs. The relationship might

arise in several ways:

1. It may due to a physical relationship between costs and the cost driver: For instance,

relationship between units of production and materials cost.

2. Cause and effect can arise from a contractual arrangement.

3. Cause and effect can be implicitly established by logic and knowledge of operations.

Be careful however that correlation does not mean that there is a cause-and-effect relationship.

Only a true cause-and-effect relationship establishes an economically plausible relationship

between costs and their cost drivers.

Cost estimation approaches

Four approaches exist to cost estimation. They differ in the costs of conducting the analysis,

the assumptions they make and the evidence they provide about the accuracy of the estimated

cost function. They are not mutually exclusive; they can be used in combination.

The industrial engineering method, or work-measurement method, estimates cost functions by

analysing the relationship between inputs and outputs in physical terms. This method is very

time-consuming, but required sometimes by governments. More frequently, organisations use

it for direct-cost categories.

Conference method estimates cost functions on the basis of analysis and opinions about costs

and their drivers gathered from various departments of an organisation. This method is quick

and credible.

Account analysis method estimates cost functions y classifying cost accounts in the ledger as

variable, fixed or mixed with respect to the identified cost driver. Typically managers use

qualitative rather than quantitative analysis when making these cost-classification decisions.

Quantitative analysis of current or past cost relationships

There are six steps in estimating a cost function on the basis of an analysis of current or past

cost relationships.

1. Choose the dependent variable.

2. Identify the independent variable(s) or cost driver(s).

3. Collect data on the dependent variable and the cost drivers.

4. Plot the data.

5. Estimate the cost function.

6. Evaluate the estimated cost

The high-low method entails using only the highest and lowest observed values of the cost

driver within the relevant range. The line between these two points becomes the estimated cost

function.

Slope coefficient b = (Difference between costs associated with highest and lowest

observations of the cost driver) / (difference between highest and lowest observations of the

cost driver)

Constant a = y – bX, where we use either the highest or the lowest observation of the cost

driver.

The constant, or intercept, term does not serve as an estimate of the fixed costs, because it may

be outside the relevant range.

Sometimes the high-low method is modified so that the two observations chosen are

representative high and a representative low. The reason is that management wants to avoid

having extreme observations affecting the cost function. Even with such a modification this

method ignores information from all but two observations when estimating the cost function.

Regression analysis is a statistical method that measures the average amount of change in the

dependent variable that is associated with a unit change in one or more independent variables.

This method uses all available data.

Simple regression analysis estimates the relationship between the dependent variable and one

independent variable

Multiple regression analysis estimates the relationship between the dependent variable and

multiple independent variables.

Residual term is the difference between actual and predicted cost.

Evaluating and choosing cost drivers

What guidance to the different cost estimation method provide for choosing among cost

drivers? The industrial engineering method relies on analysing physical relationships between

costs and cost drivers. The conference method and the account analysis method use subjective

assessments to choose a cost driver and to estimate the fixed and variable components of the

cost function. The major advantage of quantitative methods is that managers can use these

methods to evaluate different cost drivers.

We consider three of the most important criteria for choosing a cost driver:

1. Economic plausibility.

2. Goodness of fit. Compare the vertical differences between actual and predicted costs;

choose the one with the smaller ones. Coefficient of determination, R2, which measures

the percentage of variation in Y explained by X. Requirement: Economic plausibility.

3. Slope of regression line. Choose the steeper one, since it shows a strong relationship.

Cost drivers and activity-based costing

In activity-based costing systems, discussed in chapter 11, operations manager and cost

analysts identify key activities and the cost drives and costs of each activity at the output unit

level, batch level or product sustaining level. The basic approach to evaluate the cost drivers

stays the same. ABC systems emphasize long-run relationships.

Non-linearity and cost functions

A non-linear cost function is a cost function where, within the relevant range, the graph of total

costs versus the level of a single activity is not a straight line (due to for example economies

of scale, or quantity discounts).

Economies of scale

Quantity discounts

A step cost function is a cost function in which the cost is constant over various ranges of the

cost driver, but the cost increases by discrete amounts (=in steps) as the cost driver moves from

one range to the next. There are step variable-cost functions and step fixed-cost functions. The

main difference between variable and fixed is that the cost in a step fixed-cost function is

constant over large ranges of the cost driver in each relevant range.