Cost accounting

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Course Name: Cost Accounting
Student’s Name:
Course Code: ACCT 301
Student’s ID Number:
Semester: Second
CRN:
Academic Year: 1445 H
Instructions – PLEASE READ THEM CAREFULLY
• Students must mention question number clearly in their answer.
• Avoid plagiarism, the work should be in your own words, copying from students or
other resources without proper referencing will result in ZERO marks. No exceptions.
• All answers must be typed using Times New Roman (size 12, double-spaced) font.
No pictures containing text will be accepted and will be considered plagiarism.
Assignment Question(s):
(Marks 15)
Q1. Explain the role of accounting information in strategic management. How does accounting
information assist in the formulation and implementation of organizational strategies? Support
your answer by providing an example of one Saudi Company in this regard.
(2 Marks)
Note: Your answer must include a suitable example showing the role of accounting information in
strategic management of an organization.
(Chapter 1, Week 1)
Answer:
Q2. What do you mean by cost function and for what purpose does it serve for? What are the
various methods used to estimate cost functions? Explain each method with suitable numerical
examples.
Answer:
(3 Marks) (Chapter 2, Week 2)
[Type here]
Q3. “Job costing is a method of cost accounting used by companies to find out the cost of specific
jobs or projects.” Comment on this statement and examine how actual allocation rates and
estimated allocation rates are analyzed by the companies? Support your answer with an example
of one Saudi company that use job costing.
Answer:
(2 Marks) (Chapter 5, week 4 )
Cost Management
Measuring, Monitoring, and Motivating Performance
Chapter 5
Job Costing
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 1
Chapter 5: Job Costing
Learning objectives
•
Q1: How are costs assigned to customized goods and services?
•
Q2: How is overhead allocated to individual jobs?
•
Q3: How does job costing information affect managers’
incentives and decisions?
•
Q4: How are spoilage, rework, and scrap handled in job costing?
•
Q5: What are the quality and behavioral implications of
spoilage?
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 2
Q1: Job Costing versus Process Costing
Job
Costing
• Used when products can be
distinguished from one
another
Process
Costing
• Used when similar products
are mass produced
Hybrid
Costing
• Includes characteristics of
both job and process costing
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 3
Q1: Job Costing versus Process Costing
Job Costing
Process Costing
Discrete
Continuous
Product
Fewer units
Many units
Units
Readily identifiable
Fungible
Job or batch
Processing
department
One
Same as the # of
processing
departments
Operations
Cost object
# of WIP
accounts
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 4
Q1: Assigning Costs to Jobs
Direct
Cost Tracing
Costs
Cost
Cost
Assign-
Object
ment
(Job)
Indirect
Costs
© John Wiley & Sons, 2011
Cost Allocation
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 5
Q1: Job Cost Records
Each job’s costs are maintained on a job cost record.
The job cost records form the subsidiary ledger for
Work in process inventory.
Date Dir. Materials Dir. Labor Overhead
This information comes
from Materials
Requisition Forms
Total
Overhead costs must be
allocated to each job
This information comes
from Labor Time Reports
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 6
Q2: Allocating Overhead Costs to Jobs
•
Direct costs are traced to the individual jobs using
source documents.
•
Overhead costs are indirect and cannot be traced
to individual jobs; they must be allocated.
•
An overhead allocation base must be chosen.
•
The overhead allocation base should be some
measure of activity; it should be a reasonably
good cost driver for overhead costs.
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 7
Q2: Steps in Allocating Overhead
1. Identify the relevant cost object.
2. Identify one or more overhead cost pools and
allocation bases.
3. For each overhead cost pool, calculate an
overhead allocation rate.
4. For each overhead cost pool, allocate costs to the
cost object.
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 8
Q2: Overhead Allocation Rates
•
Companies may use an actual or an estimated
overhead allocation rate.
Actual allocation rate =
•
Actual overhead cost
Actual quantity of the allocation base
The actual allocation rate cannot be
computed until the accounting period is over.
Estimated allocation rate =
•
Estimated overhead cost
Estimated quantity of the allocation base
The estimated allocation rate can be computed at
the beginning of the accounting period (normal
costing).
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 9
Q2: Overhead Allocation Rates
Chausse Manufacturing makes road paving equipment. At the
beginning of the year, overhead costs were estimated to be $450,000.
However, actual overhead was $504,000. Chausse uses direct labor
hours as the cost allocation base. At the beginning of the year, total
direct labor hours were estimated at 10,000 hours, but actual direct
labor hours for the year totaled 12,000 hours. Compute the actual
overhead rate and the estimated overhead rate.
Actual allocation rate =
$504,000
= $42/hr
12,000 hours
Estimated allocation rate =
$450,000
= $45/hr
10,000 hours
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 10
Q2: Actual and Normal Costing
Direct costs
Indirect costs
Actual Costing Normal Costing
Actual costs
Actual costs
Actual rate
Estimated rate
x actual usage x actual usage
of cost
of cost
allocation base allocation base
In normal costing, annual budgeted rates are used
• smoothing effect on numerator
• smoothing effect on denominator
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 11
Q2: Job Costing Example (Service Sector)
Serena-Sturm is an architectural firm with a professional staff of 5 architects
and a support staff of 7. Some projects are done for a fixed fee, while
others are billed for the actual hours spent on the project. You are given the
following information for Serena-Sturm (SS) for 2005. What is the
estimated indirect cost rate if # of projects is used as the cost allocation
base? Is this a good choice for the cost allocation base?
BUDGETED
ACTUAL
Direct Costs:
Professional labor costs
Professional labor hours
Professional labor rate/hour
$400,000
10,000
$40
$420,000
12,000
$35
Indirect Costs:
Designers, drafters
Office costs
Office salaries & wages
Travel & entertainment
Total indirect costs
$360,000
40,000
45,000
5,000
$450,000
$360,000
80,000
56,800
7,200
$504,000
1,000
3,600
1,200
4,000
Other Information:
Number of projects
Number of blueprints prepared
© John Wiley & Sons, 2011
Estimated indirect cost rate =
$450,000/1,000 projects =
$450/project
Terrible choice for a cost
allocation base; ignores
resource consumption of
the projects.
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 12
Q2: Job Costing Example (Service Sector)
SS has a costing system with a single direct cost pool. If SS uses a single
indirect cost pool, determine both the estimated and actual indirect cost
rates using (a) number of professional labor hours and (b) number of
blueprints prepared as cost allocation bases.
BUDGETED
ACTUAL
Direct Costs:
Professional labor costs
Professional labor hours
Professional labor rate/hour
$400,000
10,000
$40
$420,000
12,000
$35
Indirect Costs:
Designers, drafters
Office costs
Office salaries & wages
Travel & entertainment
Total indirect costs
$360,000
40,000
45,000
5,000
$450,000
$360,000
80,000
56,800
7,200
$504,000
Other Information:
Number of projects
Number of blueprints prepared
© John Wiley & Sons, 2011
1,000
3,600
1,200
4,000
Potential Cost
Allocation Base
Actual
Rate
Estimated
Rate
Professional
labor hours
$504,000
12,000 hrs
= $42/hr
$450,000
10,000 hrs
= $45/hr
Number of
blueprints
$504,000
4,000 bpts
= $126/bpt
$450,000
3,600 bpts
= $125/bpt
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 13
Q2: Job Costing Example (Service Sector)
SS was asked to prepare a fixed fee bid for an out-of-town project called
The Culebra Complex. The budgeted professional hours for this project
was 400, and the job is expected to require the preparation of 7 blueprints.
Compute the budgeted project cost using (a) professional labor hours and
(b) number of blue prints prepared as a cost driver for indirect costs.
Potential Cost
Allocation Base
Professional
labor hours
Number of
blueprints
Estimated
Rate
$45/hr
$125/bpt
Costs
Cost Allocation Base
Professional
Number of
labor hours
blueprints
Direct costs
$40/hr x
400 hrs =
$16,000
$40/hr x
400 hrs =
$16,000
Indirect costs
$45/hr x
400 hrs =
$18,000
$125/bpt x
7 bpts =
$875
$34,000
$16,875
Total
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 14
Q2: Why Are Costs so Different?
Why do the different cost allocation bases yield vastly different project costs?
BUDGETED
Direct Costs:
Professional labor costs
Professional labor hours
Professional labor rate/hour
$400,000
10,000
$40
Indirect Costs:
Designers, drafters
Office costs
Office salaries & wages
Travel & entertainment
Total indirect costs
$360,000
40,000
45,000
5,000
$450,000
Other Information:
Number of projects
Number of blueprints prepared
1,000
3,600
Costs
Direct costs
Indirect costs
Total
Cost Allocation Base
Professional
Number of
labor hours
blueprints
$16,000
$16,000
$18,000
$875
$34,000
$16,875
If professional labor hours is a good
measure of activity, then this project is
expected to be 400 hrs/10,000 hrs, or
4% of the year’s activity.
If # of blueprints is a good measure of activity, then this project is
expected to be 7 bpts/3,600 bpts, or less than 0.2% of the year’s activity.
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 15
Q2: Job Costing in Manufacturing
Logo lamps makes desk lamps stamped with the customer’s logo.
Shipping & Receiving
© John Wiley & Sons, 2011
Materials
Storage
Finished Goods
Storage
Sheet Metal
Stamping
Inspection &
Packing
Painting
Area
Assembly
Area
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 16
Q2: Journal Entries in Job Costing
• Flow of costs matches flow of the goods through
the factory
• Source documents used to update accounts for
direct costs
• Normal costing is used, so overhead is charged to
jobs based on estimated overhead rates
• Overhead cost control is a temporary account
used in normal costing
• debit Overhead cost control for actual overhead costs
• credit Overhead cost control when overhead allocated to WIP
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 17
Q2: Flow of Costs in Job Costing
Shipping & Receiving
When raw materials
Finished Goods
Materials
are received, costs
Storage
are debited to raw Storage
materials inventory;
Sheet Metal no distinction between
Inspection &
Stamping
direct and indirect Packing
materials is made at
this stage.
Assembly
Area
Painting
Area
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 18
Q2: Flow of Costs in Job Costing
Shipping & Receiving
Materials
Storage
When raw materials are sent to the
Finished
Goods costs
factory floor, direct
materials
Storage forms) are
(per materials requisition
debited to Work in process inventory.
Sheet Metal
Stamping
Indirect materials Inspection
costs are&debited to
Packing
Overhead cost
control.
Assembly
Area
Painting
Area
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 19
Q2: Flow of Costs in Job Costing
When Shipping
labor costs
are incurred, direct
& Receiving
labor costs (per time records) are
debited to Work in process inventory.
Finished Goods
Materials
Storageto
StorageIndirect labor costs are debited
Overhead cost control.
© John Wiley & Sons, 2011
Sheet Metal
Stamping
Inspection &
Packing
Painting
Area
Assembly
Area
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 20
Q2: Flow of Costs in Job Costing
Shipping & Receiving
When a Materials
job is completed,
Storage
costs are removed from WIP
inventory and transferred to
Sheet
Metal
FG
inventory.
© John Wiley & Sons, 2011
Finished Goods
Storage
Stamping
Inspection &
Packing
Painting
Area
Assembly
Area
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 21
Q2: Flow of Costs in Job Costing
Shipping & Receiving
When a job is shipped to a
Materials
customer, costs
are removed
Storage
from FG inventory and
transferred to CGS;
Sheet Metal
The revenue
Stampingand the
Finished Goods
Storage
Inspection &
Packing
receivable are also recorded.
Assembly
Area
Painting
Area
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 22
Q2: Journal Entries in Job Costing
The materials storeroom receives a shipment of direct and
indirect materials that cost $12,500. Prepare the journal entry.
Raw materials inventory
12,500
Accounts payable
12,500
Materials are sent to the stamping and assembly areas. The
cost of the direct materials is $1,400 and the cost of the
indirect materials is $800. Prepare the journal entry.
Work in process inventory
Overhead cost control
Raw materials inventory
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
1,400
800
2,200
Slide # 23
Q2: Journal Entries in Job Costing
Wages totaling $2,000 are accrued; 75% of these costs are
direct labor and 25% are indirect labor. Prepare the journal
entry.
Work in process inventory
Overhead cost control
1,500
500
Wages Payable
2,000
Overhead costs are allocated to work in process using an
allocation rate of 200% of direct labor costs. Prepare the
journal entry.
Work in process inventory
Overhead cost control
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
3,000
3,000
Slide # 24
Q2: Journal Entries in Job Costing
Job #1208, with a total cost of $2,200 is completed. Prepare
the journal entry.
Finished goods inventory
2,200
Work in process inventory
2,200
Job #1208 is shipped to the customer, who is billed for $4,000.
Prepare the journal entry.
Accounts receivable
Cost of goods sold
Sales
Finished goods inventory
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
4,000
2,200
4,000
2,200
Slide # 25
Q2: Disposition of Misallocated Overhead
• Under normal costing, actual overhead is different
from allocated overhead.
• Misallocated overhead is the difference between
actual and allocated overhead.
• At the end of the year, the Overhead cost control
account is closed out to WIP, FG & CGS.
• Misallocated overhead (if material) is prorated to
the 3 accounts based on a ratio of their account
balances; if immaterial it is closed to CGS.
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 26
Q2: Disposition of Misallocated Overhead
Suppose budgeted overhead was $100,000 fixed overhead plus variable
overhead of $10/DL hour. Expected DL hours were 50,00, so that the
estimated overhead rate was $12/DL hour. Actual DL hours totaled 40,000
for the year and actual overhead was $550,000. At the end of the year,
WIP, FG & CGS had the account balances shown below. Prepare the yearend entry to close the Overhead cost control account.
WIP
FG
CGS
$ 100,000 5%
200,000 10%
1,700,000 85%
$2,000,000
Overhead cost control
$550,000
Work in process inventory
3,000
Finished goods inventory
Cost of goods sold
Overhead cost control
7,000
59,500
70,000
$480,000 ($12/DL hr x 40,000 DL hrs)
$70,000
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 27
Q3: Uses & Limitations of Job Costing Information
• Job cost information is used for
•
•
•
•
Financial statement preparation
Income tax returns
Bidding for jobs
Comparing expected to actual costs (diagnostic control)
• Job cost information may not be useful for nonroutine short term decision making as allocated
fixed costs may not be relevant
• Accountant’s judgment is used to determine:
•
•
•
Direct vs. allocated costs
Type and number of overhead pools
Type of cost driver
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 28
Q4: Job Costing and Spoilage – Terminology
• Spoilage – unacceptable units that are discarded or
sold for disposal costs
– Normal spoilage arises under efficient operating
conditions & is treated as an inventoriable cost
– Abormal spoilage is not part of normal operations & is
treated as a period cost
• Reworked units – unacceptable units that are
reprocessed and sold
• Scrap – left over direct materials that are discarded
or sold for a minimal amount
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 29
Q4: Job Costing and Spoilage
In job costing, spoilage could be normal spoilage that
coincidentally occurred on this job, but was not due to
any demanding aspects of this job
– spoilage costs removed from Work in process inventory
– spoilage costs are debited to Overhead cost control
– in this case a job without spoilage has the same
manufacturing cost per unit as a job where spoilage
occurred
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 30
Q4: Job Costing and Spoilage
In job costing, spoilage could be abnormal spoilage
that coincidentally occurred on this job, but was not
due to any demanding aspects of this job
– spoilage costs removed from Work in process inventory
– spoilage costs are debited to Loss from abnormal
spoilage
– in this case a job without spoilage has the same
manufacturing cost per unit as a job where spoilage
occurred
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 31
Q4: Job Costing and Spoilage
In job costing, spoilage could be spoilage that
occurred on this job due to the job’s demanding
specifications
– spoilage costs are not removed from Work in process
inventory
– in this case a job without spoilage has a lower
manufacturing cost per unit than a job where this type of
spoilage occurred
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 32
Q4: Job Costing and Spoilage Example
On January 1 Leia Corp. budgeted the following factory overhead:
Factory rent
$40,000
Leia expected to use 28,000 DL hours this
Utilities
10,000
year; overhead is allocated to WIP using
Normal spoilage
6,000
DL hours. Job #3 shows total costs of
$56,000
$12,200. An inspection reveals that 20%
of Job #3 must be scrapped and sold for $100. Prepare the journal entry to record
the spoilage and the sale of the scrap if the spoilage is considered normal and is not
due to the demanding specifications of Job #3. If Job #3 was originally a batch of
10,000 units, what is the manufacturing cost per unit for the good units in Job #3?
Overhead cost control
Cash
2,340
100
Work in process inventory
2,440
(20% x $12,200)
Mfg cost/unit = ($12,200 – $2,440)/8,000 good units = $1.22/unit.
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 33
Q4: Job Costing and Spoilage Example
On January 1 Leia Corp. budgeted the following factory overhead:
Factory rent
$40,000
Leia expected to use 28,000 DL hours this
Utilities
10,000
year; overhead is allocated to WIP using
Normal spoilage
6,000
DL hours. Job #3 shows total costs of
$56,000
$12,200. An inspection reveals that 20%
of Job #3 must be scrapped and sold for $100. Prepare the journal entry to record
the spoilage and the sale of the scrap if the spoilage is considered abnormal. If Job
#3 was originally a batch of 10,000 units, what is the manufacturing cost per unit for
the good units in Job #3?
Loss from abnormal spoilage 2,340
Cash
100
Work in process inventory
2,440
(20% x $12,200)
Mfg cost/unit = ($12,200 – $2,440)/8,000 good units = $1.22/unit.
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 34
Q4: Job Costing and Spoilage Example
On January 1 Leia Corp. budgeted the following factory overhead:
Factory rent
$40,000
Leia expected to use 28,000 DL hours this
Utilities
10,000
year; overhead is allocated to WIP using
Normal spoilage
6,000
DL hours. Job #3 shows total costs of
$56,000
$12,200. An inspection reveals that 20%
of Job #3 must be scrapped and sold for $100. Prepare the journal entry to record
the spoilage and the sale of the scrap if the spoilage occurred to the demanding
specifications of Job #3. If Job #3 was originally a batch of 10,000 units, what is the
manufacturing cost per unit for the good units in Job #3?
Cash
100
Work in process inventory
100
Mfg cost/unit = ($12,200 – $100)/8,000 good units = $1.5125/unit.
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 35
Q5: Effect of Spoilage Accounting
on Manager Behavior
• If spoilage costs are ignored, there is no incentive
for managers to control these costs.
• If company has a zero defect policy, all spoilage is
considered abnormal; the loss on the income
statement may force managers to control spoilage.
• If rework costs are not accounted for separately,
managers may rework units that should be
scrapped.
© John Wiley & Sons, 2011
Chapter 5: Job Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 36
Cost Management
Measuring, Monitoring, and Motivating Performance
Chapter 2
The Cost Function
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 1
Chapter 2: The Cost Function
Learning objectives
•
Q1: What are the different ways to describe cost behavior?
•
Q2: What process is used to estimate future costs?
•
Q3: How are engineered estimates, account analysis, and
two-point methods used to estimate cost functions?
•
Q4: How does a scatter plot assist with categorizing a cost?
•
Q5: How is regression analysis used to estimate a cost
function?
•
Q6: How are cost estimates used in decision making?
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 2
Q1: Different Ways to Describe Costs
• Costs can be defined by how they relate to a cost
object, which is defined as any thing or activity for
which we measure costs.
• Costs can also be categorized as to how they are
used in decision making.
• Costs can also be distinguished by the way they
change as activity or volume levels change.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 3
Q1: Assigning Costs to a Cost Object
Cost Assignment
Determining the costs that should attach to a cost object is
called cost assignment.
cost tracing
Direct
Costs
Cost
Object
Indirect
Costs
Direct costs are
easily traced to the
cost object.
Indirect costs are
not easily traced to
the cost object, and
must be allocated.
cost allocation
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 4
Q1: Direct and Indirect Costs
• In manufacturing:
• all materials costs that are easily traced to the product are called
direct material costs
• all labor costs that are easily traced to the product are called direct
labor costs
• all other production costs are called overhead costs
• Whether or not a cost is a direct cost depends upon:
• the definition of the cost object
• the precision of the bookkeeping system that tracks costs
• the technology available to capture cost information
• whether the benefits of tracking the cost as direct exceed the
resources expended to track the cost
• the nature of the operations that produce the product or service
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 5
Q1: Linear Cost Behavior Terminology
• Total fixed costs are costs that do not change (in
total) as activity levels change.
• Total variable costs are costs that increase (in total)
in proportion to the increase in activity levels.
• Total costs equal total fixed costs plus total variable
costs.
• The relevant range is the span of activity levels for
which the cost behavior patterns hold.
• A cost driver is a measure of activity or volume
level; increases in a cost driver cause total costs to
increase.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 6
Q1: Behavior of Total (Linear) Costs
$
Total Costs
If costs are linear, then total costs
graphically look like this.
Cost Driver
$
Total Fixed Costs
Total fixed costs do not change as the cost
driver increases.
Higher total fixed costs are higher above
the x axis.
Cost Driver
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 7
Q1: Behavior of Total (Linear) Costs
$
Total Costs
If costs are linear, then total costs
graphically look like this.
Cost Driver
$
Total Variable Costs
Total variable costs increase as the cost
driver increases.
A steeper slope represents higher variable
costs per unit of the cost driver.
Cost Driver
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 8
Q1: Total Versus Per-unit (Average) Cost Behavior
$
Total Variable Costs
If total variable costs look
like this . . .
slope = $m/unit
Cost Driver
$/unit
Per-Unit Variable Costs
. . . then variable costs per
unit look like this.
m
Cost Driver
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 9
Q1: Total Versus Per-Unit (Average) Cost Behavior
$
Total Fixed Costs
If total fixed costs look
like this . . .
Cost Driver
$/unit
Per-Unit Fixed Costs
. . . then fixed costs per
unit look like this.
Cost Driver
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 10
Q1: Total Versus Per-Unit (Average) Cost Behavior
Lari’s Leather produces customized motorcycle jackets. The leather for
one jacket costs $50, and Lari rents a shop for $450/month. Compute the
total costs per month and the average cost per jacket if she made only
one jacket per month. What if she made 10 jackets per month?
Average variable costs are constant
1 Jacket Total variable costs go up 10 Jackets
Total Average
Costs/ Cost/
Month Jacket
Total Average
Costs/ Cost/
Month Jacket
Leather
$50
$50
Leather
$500
$50
Rent
$450
$450
Rent
$450
$45
Total
$500
$500
Total
$950
$95
Total fixed costs are constant
© John Wiley & Sons, 2011
Average fixed costs go down
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 11
Q1: The Cost Function
When costs are linear, the cost function is:
TC = F + V x Q, where
F = total fixed cost, V = variable cost per unit of the cost
driver, and Q = the quantity of the cost driver.
$
Total Costs
The intercept is the total fixed cost.
The slope is the variable cost per
unit of the cost driver.
slope = $V/unit of cost driver
F
Cost Driver
© John Wiley & Sons, 2011
A cost that includes a fixed cost
element and a variable cost
element is known as a mixed cost.
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 12
Q1: Nonlinear Cost Behavior
Sometimes nonlinear costs exhibit linear cost behavior over a
range of the cost driver. This is the relevant range of activity.
intercept = total fixed costs
Total
Costs
slope = variable cost per
unit of cost driver
Cost Driver
Relevant Range
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 13
Q1: Stepwise Linear Cost Behavior
Some costs are fixed at one level for one range of activity and
fixed at another level for another range of activity. These are
known as stepwise linear costs.
Total Supervisor Salaries Cost in $1000s
Example: A production
supervisor makes
$40,000 per year and
the factory can produce
100,000 units annually
for each 8-hour shift it
operates.
120
80
40
100
200
300
Number of units produced, in 1000s
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 14
Q1: Piecewise Linear Cost Behavior
Some variable costs per unit are constant at one level for one
range of activity and constant at another level for another
range of activity. These are known as piecewise linear costs.
Total Materials Costs
slope=
$9/gallon
slope=
$7.50/gallon
slope=
$8/gallon
1000
© John Wiley & Sons, 2011
Example: A supplier
sells us raw materials
at $9/gallon for the first
1000 gallons, $8/gallon
for the second 1000
gallons, and at
$7.50/gallon for all
gallons purchased over
2000 gallons.
2000
Gallons purchased
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 15
Q1: Cost Terms for Decision Making
• In Chapter 1 we learned the distinction between
relevant and irrelevant cash flows.
• Opportunity costs are the benefits of an alternative
one gives up when that alternative is not chosen.
• Opportunity costs are difficult to measure because they
are associated with something that did not occur.
• Opportunity costs are always relevant in decision
making.
• Sunk costs are costs that were incurred in the past.
• Sunk costs are never relevant for decision making.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 16
Q1: Cost Terms for Decision Making
• Discretionary costs are periodic costs incurred for
activities that management may or may not
determine are worthwhile.
• These costs may be variable or fixed costs.
• Discretionary costs are relevant for decision making
only if they vary across the alternatives under
consideration.
• Marginal cost is the incremental cost of producing
the next unit.
• When costs are linear and the level of activity is within
the relevant range, marginal cost is the same as
variable cost per unit.
• Marginal costs are often relevant in decision making.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 17
Q2: What Process is Used to Estimate
Future Costs?
Past costs are often used to estimate future,
non-discretionary, costs. In these instances,
one must also consider:
• whether the past costs are relevant to the
decision at hand
• whether the future cost behavior is likely to
mimic the past cost behavior
• whether the past fixed and variable cost
estimates are likely to hold in the future
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 18
Q3: Engineered Estimates of Cost Functions
• Use accountants, engineers, employees, and/or
consultants to analyze the resources used in the
activities required to complete a product, service,
or process.
• For example, a company making inflatable rubber
kayaks would estimate some of the following:
• the amount and cost of the rubber required
• the amount and cost of labor required in the cutting department
•
•
•
•
the amount and cost of labor required in the assembly department
overhead costs and the best cost allocation base to use
the selling costs, including commissions and advertising
the distribution costs
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 19
Q3: Account Analysis Method of
Estimating a Cost Function
• Review past costs in the general ledger and past
activity levels to determine each cost’s past
behavior.
• For example, a company producing clay wine
goblets might review its records and find:
• the cost of clay is piecewise linear with respect to the number of
pounds of clay purchased
• skilled production labor is variable with respect to the number of
goblets produced
• unskilled production labor is mixed, and the variable portion varies
with respect to the number of times the kiln is operated
• production supervisors’ salary costs are stepwise linear
• distribution costs are mixed, with the variable portion dependent
upon the number of retailers ordering goblets
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 20
Q3: Example – Account Analysis Method of
Estimating a Cost Function
•The table on the right
contains the
expenditures for Scott
Manufacturing during the
last year.
•100,000 units were
produced and sold
•$500,000 of sales
revenue was recorded
Required:
1. Determine the cost
function using units
produced as the
driver
2. Repeat using sales
dollars as the driver
© John Wiley & Sons, 2011
Expense
Amount
Direct Materials
$500,000
Direct Labor
300,000
Rent
25,000
Insurance
15,000
Commissions
200,000
Property Tax
20,000
Telephone
10,000
Depreciation
85,000
Power & Light
30,000
Admin Salaries
100,000
Total
1,285,000
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Variable
Fixed
Slide # 21
Q3: Example – Account Analysis Method of
Estimating a Cost Function
• Steps in estimating a cost function using account
analysis
– Separate fixed and variable costs
– Total the fixed costs
– Total the variable costs
– Calculate a variable cost per driver
– Write out the cost function
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 22
Q3: Solution – Account Analysis Method of
Estimating a Cost Function
Expense
Amount
Variable
Direct Materials
$500,000
500,000
Direct Labor
300,000
300,000
Rent
25,000
25,000
Insurance
15,000
15,000
Commissions
200,000
Property Tax
20,000
Cost Function on Dollars:
20,000
Telephone
10,000
10,000
TC = FC + VC/Sales $ * Sales $
Depreciation
85,000
TC = $285,000 + ($0.20) * Sales $
85,000
Power & Light
30,000
30,000
Admin Salaries
100,000
100,000
Total
1,285,000
1,000,000 285,000
© John Wiley & Sons, 2011
Fixed
Cost Function on Units:
TC = FC + VC/Unit * Qty
TC = $285,000 + ($10/unit) * Qty
200,000
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 23
Q3: Two-Point Method of
Estimating a Cost Function
• Use the information contained in two past
observations of cost and activity to separate
mixed and variable costs.
• It is much easier and less costly to use than the
account analysis or engineered estimate of cost
methods, but:
• it estimates only mixed cost functions,
• it is not very accurate, and
• it can grossly misrepresent costs if the data points
come from different relevant ranges of activity
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 24
Q3: Example – Two-Point Method of
Estimating a Cost Function
In July the Gibson Co. incurred total overhead costs of $58,000 and
made 6,200 units. In December it produced 3,200 units and total
overhead costs were $40,000. What are the total fixed factory costs per
month and average variable factory costs?
We first need to determine V, using the equation for the slope of a line.
$
rise/run = $58,000 – $40,000
6,200 – 3,200 units
= $18,000/3,000 units
= $6/unit
Then, using TC = F + V x Q, and one
of the data points, determine F.
$58,000
$58,000 = F + $6/unit x 6,200 units
$40,000
$58,000 = F + $37,200
$20,800
$20,800 = F
3,200
© John Wiley & Sons, 2011
6,200
Units
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 25
Q3: High-Low Method of
Estimating a Cost Function
• The high-low method is a two-point method
• the two data points used to estimate costs are
observations with the highest and the lowest
activity levels
• The extreme points for activity levels may not
be representative of costs in the relevant
range
• this method may underestimate total fixed costs
and overestimate variable costs per unit,
• or vice versa.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 26
Q4: How Does a Scatterplot
Assist with Categorizing a Cost?
• A scatterplot shows cost observations plotted
against levels of a possible cost driver.
• A scatterplot can assist in determining:
• which cost driver might be the best for
analyzing total costs, and
• the cost behavior of the cost against the
potential cost driver.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 27
Q4: Which Cost Driver Has the Best
Cause & Effect Relationship with Total Cost?
8 observations of total selling expenses plotted against 3 potential cost drivers
$
$
# units sold
$
# customers
The number of salespersons
appears to be the best cost
driver of the 3.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
# salespersons
Slide # 28
Q4: What is the Underlying Cost Behavior?
$
This cost is probably linear and fixed.
# units sold
$
This cost is
probably linear and
variable.
# units sold
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 29
Q4: What is the Underlying Cost Behavior?
$
This cost is probably linear and mixed.
# units sold
$
This is likely a
stepwise linear
cost.
# units sold
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 30
Q4: What is the Underlying Cost Behavior?
$
This cost may be piecewise linear.
# units sold
$
This cost appears to
have a nonlinear
relationship with units
sold.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
# units sold
Slide # 31
Q5: How is Regression Analysis Used to
Estimate a Mixed Cost Function?
• Regression analysis estimates the parameters for a linear
relationship between a dependent variable and one or more
independent (explanatory) variables.
• When there is only one independent variable, it is called
simple regression.
• When there is more than one independent variable, it is
called multiple regression.
Y=α+βX+
dependent
variable
independent
variable
α and β are the parameters;
© John Wiley & Sons, 2011
is the error term (or residual)
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 32
Q5: How is Regression Analysis Used to
Estimate a Mixed Cost Function?
We can use regression to separate the fixed and
variable components of a mixed cost.
Yi = α + β Xi +
i
the predicted total cost for
Xi and the actual total cost
for observation i
Yi is the
actual total
costs for
data point i
Xi is the actual quantity
of the cost driver for
data point i
the intercept
term is total
fixed costs
© John Wiley & Sons, 2011
i is the difference between
the slope
term is the
variable cost
per unit
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 33
Q5: Regression Output Terminology:
Adjusted R-Square
• Goodness of fit
• How well does the line from the regression output fit the
actual data points?
• The adjusted R-square statistic shows the percentage
of variation in the Y variable that is explained by the
regression equation.
• The next slide has an illustration of how a regression
equation can explain the variation in a Y variable.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 34
Q5: Regression Output Terminology:
Adjusted R-Square
100,000
90,000
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
Values of Y by Observation #
Observation #
0
5
10
15
20
25
30
• We have 29 observations of a Y variable, and the average of the Y variables is
56,700.
• If we plot them in order of the observation number, there is no discernable pattern.
• We have no explanation as to why the observations vary about the average of
56,700.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 35
Q5: Regression Output Terminology:
Adjusted R-Square
If each Y value had an
associated X value, then we
could reorder the Y
observations along the X axis
according to the value of the
associated X.
100,000 Values of Y by X Value
90,000
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
0
1,000
2,000
3,000
Now we can measure how the Y observations vary from the “line of
best fit” instead of from the average of the Y observations. Adjusted RSquare measures the portion of Y’s variation about its mean that is
explained by Y’s relationship to X.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 36
Q5: Regression Output Terminology:
p-value and t-statistic.
• Statistical significance of regression coefficients
• When running a regression we are concerned about
whether the “true” (unknown) coefficients are non-zero.
• Did we get a non-zero intercept (or slope coefficient) in
the regression output only because of the particular
data set we used?
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 37
Q5: Regression Output Terminology:
p-value and t-statistic.
• The t-statistic and the p-value both measure our
confidence that the true coefficient is non-zero.
• In general, if the t-statistic for the intercept (slope) term
> 2, we can be about 95% confident (at least) that the
true intercept (slope) term is not zero.
• The p-value is more precise
• it tells us the probability that the true coefficient
being estimated is zero
• if the p-value is less than 5%, we are more than
95% confident that the true coefficient is non-zero.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 38
Q5: Interpreting Regression Output
Suppose we had 16 observations of total costs and activity levels
(measured in machine hours) for each total cost. If we regressed the total
costs against the machine hours, we would get . . .
Regression Statistics
Multiple R
0.885
R Square
0.783
Adjusted R Square 0.768
Standard Error
135.3
Observations
16
Std
Coefficients Error t Stat P-value
Intercept
2937 64.59 45.47 1.31E-16
Machine Hours 5.215 0.734 7.109 5.26E-06
The coefficients give you the parameters of the estimated cost function.
Predicted total costs = $2,937 + ($5.215/mach hr) x (# of mach hrs)
Total fixed costs are
estimated at $2,937.
© John Wiley & Sons, 2011
Variable costs per machine
hour are estimated at $5.215.
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 39
Q5: Interpreting Regression Output
Regression Statistics
Multiple R
0.885
R Square
0.783
Adjusted R Square 0.768
Standard Error
135.3
Observations
16
Std
Coefficients Error t Stat P-value
Intercept
2937 64.59 45.47 1.31E-16
Machine Hours 5.215 0.734 7.109 5.26E-06
The regression line explains
76.8% of the variation in the total
cost observations.
(5.26E-06 means 5.26 x 10-6,
or 0.00000526)
© John Wiley & Sons, 2011
The high t-statistics . . .
. . . and the low p-values on
both of the regression
parameters tell us that the
intercept and the slope
coefficient are “statistically
significant”.
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 40
Q5: Regression Interpretation Example
Carole’s Coffee asked you to help determine its cost function for its chain
of coffee shops. Carole gave you 16 observations of total monthly costs
and the number of customers served in the month. The data is presented
below, and the a portion of the output from the regression you ran is
presented on the next slide. Help Carole interpret this output.
Costs Customers
$5,100
1,600
$10,800
3,200
$7,300
4,800
$17,050
6,400
$9,900
8,000
$16,800
9,600
$29,400
11,200
$26,900
12,800
$20,000
14,400
$24,700
16,000
$30,800
17,600
$26,300
19,200
$39,600
20,800
$42,000
22,400
$32,000
24,000
$37,500
25,600
© John Wiley & Sons, 2011
$40,000
Carole’s Coffee – Total Monthly Costs
$35,000
$30,000
$25,000
$20,000
$15,000
$10,000
$5,000
Customers Served
$0
0
5,000
10,000
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
15,000
20,000
25,000
Slide # 41
Q5: Regression Interpretation Example
Regression Statistics
Multiple R
0.91
R Square
0.8281
Std
Adjusted R Square 0.8158
Coefficients Error t Stat
P-value
Standard Error
4985.6 Intercept
4634 2614 1.7723 0.0980879
Observations
16 Customers 1.388 0.169 8.2131 1.007E-06
What is Carole’s estimated cost function? In a store that serves 10,000
customers, what would you predict for the store’s total monthly costs?
Predicted total costs = $4,634 + ($1.388/customer) x (# of customers)
Predicted total
costs at 10,000
customers
© John Wiley & Sons, 2011
=
$4,634 + ($1.388/customer) x 10,000 customers
=
$18,514
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 42
Q5: Regression Interpretation Example
Regression Statistics
Multiple R
0.91
R Square
0.8281
Std
Adjusted R Square 0.8158
Coefficients Error t Stat
P-value
Standard Error
4985.6 Intercept
4634 2614 1.7723 0.0980879
Observations
16 Customers 1.388 0.169 8.2131 1.007E-06
What is the explanatory power of this model? Are the coefficients
statistically significant or not? What does this mean about the cost function?
The model
The slope coefficient is
explains 81.58%significantly different from zero.
of the variation This means we can be pretty
in total costs, sure that the true cost function
which is pretty includes nonzero variable costs
good.
per customer.
The intercept is not
significantly different
from zero. There’s a
9.8% probability that
the true fixed costs are
zero*.
*(Some would say the intercept is significant as long as the p-value is less than 10%, rather than 5%.)
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 43
Q6: Considerations When Using
Estimates of Future Costs
• The future is always unknown, so there are
uncertainties when estimating future costs.
• The estimated cost function may have misspecified the cost behavior.
• The cost function may be using an incorrect cost
driver.
• Future cost behavior may not mimic past cost
behavior.
• Future costs may be different from past costs.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 44
Q6: Considerations When Using
Estimates of Future Costs
• The data used to estimate past costs may not be of
high-quality.
• The accounting system may aggregate costs in a
way that mis-specifies cost behavior.
• Information from outside the accounting system
may not be accurate.
• The true cost function may not be in agreement
with the cost function assumptions.
• For example, if variable costs per unit of the cost
driver are not constant over any reasonable
range of activity, the linearity of total cost
assumption is violated.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 45
Appendix 2A: Multiple Regression Example
We have 10 observations of total project cost, the number of
machine hours used by the projects, and the number of
machine set-ups the projects used.
$10,000 Total Costs
$10,000
$8,000
$8,000
$6,000
$6,000
$4,000
$4,000
$2,000
Total Costs
$2,000
Number of Set-ups
$0
Number of Machine Hours
$0
0
© John Wiley & Sons, 2011
2
4
6
0
10 20 30 40 50 60 70 80 90
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 46
Appendix 2A: Multiple Regression Example
Regress total costs on the number of set-ups to get the
following output and estimated cost function:
Regression Statistics
Multiple R
0.788
R Square
0.621
Std
Coefficients Error t Stat P-value
Adjusted R Square 0.574
2925.6 1284 2.278 0.0523
Standard Error
1804 Intercept
Observations
10 # of Set-ups 1225.4 338 3.62 0.0068
Predicted project costs = $2,926 + ($1,225/set-up) x (# set-ups)
The explanatory power is 57.4%. The # of set-ups
is significant, but the intercept is not significant if
we use a 5% limit for the p-value.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 47
Appendix 2A: Multiple Regression Example
Regress total costs on the number of machine hours to get
the following output and estimated cost function:
Regression Statistics
Multiple R
0.814
R Square
0.663
Std
Adjusted R Square 0.621
Coefficients Error t Stat P-value
Standard Error
1701 Intercept
-173.8 1909 -0.09 0.9297
Observations
10 # Mach Hrs 112.65 28.4 3.968 0.0041
Predicted project costs = – $173 + ($113/mach hr) x (# mach hrs)
The explanatory power is 62.1%. The intercept shows up
negative, which is impossible as total fixed costs can not
be negative. However, the p-value on the intercept tells us
that there is a 93% probability that the true intercept is
zero. The # of machine hours is significant.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 48
Appendix 2A: Multiple Regression Example
Regress total costs on the # of set ups and the # of
machine hours to get the following:
Regression Statistics
Multiple R
0.959
Std
Coefficients Error t Stat P-value
R Square
0.919
-1132 1021 -1.11 0.3044
Adjusted R Square 0.896 Intercept
857.4 182.4
4.7 0.0022
Standard Error
891.8 # of Set-ups
Observations
10 # of Mach Hrs 82.31 16.23 5.072 0.0014
Predicted
project = – $1,132 + ($857/set-up) x (# set-ups) + ($82/mach hr) x (# mach hrs)
costs
The explanatory power is now 89.6%. The p-values on both
slope coefficients show that both are significant. Since the
intercept is not significant, project costs can be estimated
based on the project’s usage of set-ups and machine hours.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 49
Appendix 2B: What is a Learning Curve?
A learning curve is
• the rate at which labor hours per unit decrease as the
volume of activity increases
• the relationship between cumulative average hours per
unit and the cumulative number of units produced.
A learning curve can be represented mathematically as:
Y = α Xr, where
Y = cumulative average labor hours,
α = time required for the first unit,
X = cumulative number of units produced,
r = an index for learning = ln(% learning)/ln(2), and
ln is the natural logarithmic function.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 50
Appendix 2B: Learning Curve Example
Deanna’s Designer Desks just designed a new solid wood desk for
executives. The first desk took her workforce 55 labor hours to make, but
she estimates that each desk will require 75% of the time of the prior desk
(i.e. “% learning” = 75%). Compute the cumulative average time to make 7
desks, and draw a learning curve.
First compute r:
r = ln(75%)/ln(2) = -0.2877/0.693 = -0.4152
Then compute the cumulative
average time for 7 desks:
60
x 7(-0.4152) = 25.42 hrs
40
Y = 55
Cumulative Average Hours Per Desk
50
30
In order to draw a learning curve,
you must compute the value of Y for
all X values from 1 to 7. . . .
Hrs
per
Desk
20
10
Cumulative Number of Desks
0
1
© John Wiley & Sons, 2011
2
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
3
4
5
6
7
Slide # 51
Cost Management
Measuring, Monitoring, and Motivating Performance
Chapter 1
The Role of Accounting Information in
Management Decision Making
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 1
Chapter 1: The Role of Accounting Information in
Management Decision Making
Learning objectives
➢Q1 – What is the process of strategic management and
decision making?
➢Q2 – What types of control systems do managers use?
➢Q3 – What is the role of accounting information in strategic
management?
➢Q4 – What information is relevant for decision making?
➢Q5 – How does business risk affect management decision
making?
➢Q6 – How do biases affect management decision making?
➢Q7 – How can managers make higher-quality decisions?
➢Q8 – What is ethical decision making, and why is it
important?
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 2
Q1: Organizational Vision and Core Competencies
• The organizational vision is the core purpose and
ideology of the organization.
• Determining the organizational vision precedes all
other management decision making.
• Management must also isolate the organization’s
core competencies – its strengths relative to
competitors.
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 3
Q1: Organizational Vision and Core Competencies
Organizational
Vision
The organizational vision and the
core competencies are closely
related.
The organization’s strengths
should help shape the vision.
Core
Competencies
The vision should help locate the
organization’s strengths.
If you were starting an accounting practice, what would be your
organizational vision?
What do you think would be your core competencies?
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 4
Q1: Organizational Strategies
Organizational
Vision & Core
Competencies
Organizational strategies are the tactics
that managers use to work toward the
organizational vision while taking
advantage of the core competencies.
These strategies are long-term in nature.
Organizational
Strategies
Examples include organization structure,
financial structure, and long-term
resource allocation strategies.
If you were starting an accounting practice, what would be some of your
organizational strategies?
How do these work toward your organizational vision?
How do they take advantage of your core competencies?
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 5
Q1: Operating Plans
Organizational
Strategies
Operating
Plans
Operating plans are the short-term
implementations of the organizational
strategies.
Operating plans usually include
budgeted goals for revenues and
expenses.
Examples include schedules for
employees and procedures for daily
relationship management decisions
with suppliers.
If you were starting an accounting practice, what would be some of your
operating plans?
How do these relate to your organizational strategies?
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 6
Q1: Actual Operations
Actual operations are the actions
taken and the results achieved.
Operating
Plans
Actual
Operations
The organization’s information
system measures the results of
actual operations.
Examples include number of units
sold, advertising expense, and the
wage expense for the period.
If you had an accounting practice, what would information would you
want to collect about the results of your actual operations?
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 7
Q1: Monitoring and Motivating Performance
Actual
Operations
Organizational
Vision & Core
Competencies
Managers use the results of actual
operations to monitor performance and
ensure that it is in line with the
organizational vision.
Managers may find that the results of
actual operations make them re-think the
organizational vision or their view of the
organization’s core competencies.
If you had an accounting practice, can you think of an example of a
measure of actual operations and how you would use it to motivate
performance?
Can you think of an example of a measure of actual operations that
might make you redefine your organizational vision or your view of your
core competencies?
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 8
Q2: Management Control Systems
• Belief Systems
– Vision, Mission, Core Values Statements
• Boundary Systems
– Code of Conduct, Procedure Manuals, Compliance
Actions
• Diagnostic Control Systems
– Measure, monitor, and motivate employees against
preset goals
• Interactive Control Systems
– Recurring information and reports to evaluate
performance and direct actions
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 9
Q3: Financial, Managerial, and Cost Accounting
Financial accounting
prepares reports most
frequently used by decision
makers external to the
organization.
Managerial accounting
prepares reports most
frequently used by decision
makers internal to the
organization.
Cost accounting includes both financial and nonfinancial
information and is used for both financial and managerial
accounting.
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 10
Q3: Strategic Cost Management
and the Balanced Scorecard
• Strategic cost management is an approach to
reducing costs while strengthening the
organization’s strategic position.
• The balanced scorecard can be used to formalize
strategic cost management efforts by detailing
financial and nonfinancial benchmarks for all
segments of the organization.
• Examples of such benchmarks include:
• Personnel can reduce costs by completing all hiring within 20
days of initial interview.
• Production can reduce costs and improve quality if Engineering
can reduce the number of processes in the production process.
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 11
Q4: What Information is Relevant
for Decision Making?
• Information is relevant if:
• Differs across the alternatives, and
• Is about the future.
• Relevant information can be quantitative or
qualitative
• Information is irrelevant if:
• Does not vary with the option chosen or action taken
Irrelevant information is NOT useful in
decision making!
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 12
Q4: Relevant Cash Flows
• Relevant cash flows are future cash flows that
differ across the alternatives.
• also called incremental cash flows
• also called avoidable cash flows
• Irrelevant cash flows are:
• non-incremental and unavoidable cash flows
• do not vary among alternatives
• Must look at the cash flow relevance to the
decision being made
• Electricity costs are relevant to the decision to open a
business or not
• Electricity costs are not relevant in the decision to
lease or buy a building for your business
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 13
Q4: What Information is Relevant
for Decision Making?
You have a small computer repair company and are deciding whether to
replace your old copy machine or repair it. In the list of information
below, identify which data are relevant to this decision and which are
irrelevant.
• The purchase price of the copy machine was $1200.
• The repair costs are $320.
• The copy machine can make 20 copies per minute.
• If you repair it, the machine will use less toner than it does now.
• You make approximately 1000 copies per month.
• The repair won’t fix the broken stapler.
• The repair carries a one-year warranty.
• The copy machine was a gift from your spouse.
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 14
Q4: Relevance of Income Statement Information
• Income Statements include:
– Period costs
– Product costs (recorded as cost of goods sold)
• Many business decisions require the incremental
cost to produce a unit
• Cost per unit on the income statement includes
both fixed and variable costs
• Including fixed costs does not represent the true
incremental cost of a unit
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 15
Q5: Impact of Business Risk on Decision Making
• Business Risk is the possibility an event will occur
and interfere with the organization’s strategic goals
Economic &
Financial
People,
Legal &
Health
Political and
Social
Reputation
Weather
Criminal and
Terrorist
Informational
&
Operational
Environment
& Man Made
• The existence of business risk can cloud
management’s decision making process
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 16
Q6: Uncertainties, Biases, and Decision Quality
• Uncertainties are issues and information about
which there is doubt.
• Biases are preconceived notions adopted without
careful thought.
• Decision quality refers to the characteristics of a
decision that affect the likelihood of achieving a
positive outcome.
• Both uncertainty and bias reduce decision quality.
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 17
Q6: Uncertainties and Biases in Information
• Uncertainties come from many sources and can be
exogenous or endogenous.
• The future is always uncertain.
• Managers may be uncertain that the right information
was captured in a report.
• Biases can come from many sources.
• The decision maker may be biased towards or against a
particular alternative (predisposition bias)
• The methods used to collect information could have
introduced bias (information bias)
• The decision maker may exercise an error in judgment or
processing information (cognitive bias)
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 18
Q6: Motorola’s Iridium Project
• How did uncertainties and bias effect Motorola’s
decision making process?
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 19
Q6: Uncertainties, Biases, and Decision Quality
Lori loves to sew and has always made her own clothes. People often
tell her that she is the best-dressed person they’ve ever met. She can
design and sew a lovely outfit in under 2 days. She is considering
opening a store that could sell her home-made fashions. Then she could
combine her work with her hobby.
Can you identify some of the uncertainties Lori faces? Can you think of
any way she can reduce some of these uncertainties?
Can you identify any possible personal biases that Lori may have? How
could these affect her decision making process?
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 20
Q7: Characteristics of Higher-Quality Decisions
Higher quality decisions come from a
higher quality decision making process.
Such a process is thorough, unbiased,
focused, strategic, creative, and visionary.
This process requires reports that are
relevant, understandable, and available.
These reports must contain information
that is more certain, complete, relevant,
timely and valuable.
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 21
Q8: Components of Ethical Decision Making
Identify
ethical
problems as
they arise
© John Wiley & Sons, 2011
Consider the
well being of
others and
society
Clarify and
apply ethical
values
Continuously
improve your
personal
ethics
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 22
Q8: The IMA’s Code of Ethics
• The Institute of Management Accountants (IMA)
has a Code of Ethics that states that IMA
members have a responsibility to:
• maintain an appropriate level of professional competence
and perform their professional duties in accordance with
laws, regulations, and standards;
• refrain from disclosing confidential information (unless
legally obligated), or using (or even appearing to use)
confidential information to illegal advantage;
• avoid actual and apparent conflicts of interest; and
• communicate information fairly and objectively, and disclose
all relevant information to decision makers.
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 23
Q8: Ethical Decision Making
Suppose you work for the Lee K. Fawcett Plumbing Company as Mr.
Fawcett’s administrative assistant. Recently Mr. Fawcett asked you to
type some financial statements from his hand-written notes so that he
can take them to the bank as part of a loan application.
This exercise seems odd to you because the company’s CPA recently
delivered the monthly financial statements that she prepares.
While typing the financial statements you notice that the building the
company rents is listed as an asset. Also, you write checks each month
for the monthly payments on two car loans, and these are not listed as
liabilities.
Do you have an ethical dilemma? Discuss your approach to handling
this situation.
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 24
Appendix: Steps for
Better Thinking
Steps for Better
Thinking is a
process to help
address openended questions.
Open-ended
questions have no
single correct
solution; managers
must seek the best
solution.
© John Wiley & Sons, 2011
(c) 2002. Information
C. L. Lynch, in
S. Management
K. Wolcott, andDecision
G. E. Huber,
“Steps for Better Thinking: A
Chapter 1: The RoleSource:
of Accounting
Making
Developmental
Problem-Solving
Process”
(August
5,
2002).
Eldenburg & Wolcott’s Cost Management, 1e
Slide # 25
Appendix: Steps for Better Thinking – Foundation
(Knowing)
• Foundation level skills include a knowledge of the
terminology and basic concepts that are relevant
to the decision at hand.
• An individual with Foundation level skills can:
• perform calculations to arrive at correct answer
• define terms in his/her own words
• describe a concept
• list the elements contained in a concept or
process
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 26
Appendix: Steps for Better Thinking – Identifying
• Step 1 skills include the ability to identify relevant
information and uncertainties.
• An individual with Step 1 skills can:
• create a list of issues related to the decision
• sort information that is relevant
• identify the reasons for the underlying
uncertainties
• perform research to obtain input into the
decision
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 27
Appendix: Steps for Better Thinking – Exploring
• Step 2 skills include the ability to explore
interpretations of the information and connections
between alternative solutions approaches.
• An individual with Step 2 skills can:
• recognize and control for his/her own biases
• articulate assumptions and reasoning
associated with alternative points of view
• organize information in meaningful ways to
encompass problem complexities
• compare and contrast different approaches to
a problem’s solutions
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 28
Appendix: Steps for Better Thinking – Prioritizing
• Step 3 skills include the ability to prioritize
alternatives, come to a decision, and implement
the decision.
• An individual with Step 3 skills can:
• develop guidelines for prioritizing alternatives
• prioritize alternatives after objective analysis
• communicate findings in a manner appropriate
to the audience
• describe how the solution or decision might
change if priorities change
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 29
Appendix: Steps for Better Thinking – Envisioning
• Step 4 skills include the ability to monitor the
decision and innovate new strategies to modify
the decision when circumstances change.
• An individual with Step 4 skills can:
• explain the limitations of the decision made
• establish a plan for monitoring the performance
of the decision
• explain how conditions may change in the
future and how this may change the decision
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 30