business law books notes chap 5

Becker – 2008 Edition Chapter 5 of 26

Chapter 5 – Planning, Budgeting, and Cost Management

Cost Measurement and Cost Measurement Concepts

Cost Measurement Concepts:• Cost of goods manufactured and budgeting cost vs. actual cost.• Managerial accounting and internal reporting• Future orientation: usefulness and future orientation • Most accounting reports are for externals (creditors, etc)• Managerial accounting reports are for internal users

Cost drivers:• Cost drivers change total costs• Direct causal relationship between change in cost driver and total costs• May be based on volume, activity, or other operational characteristic• Types of cost driver: executional (short-term) and structural (long-term)

o Executional: manage short-term costso Structure: decisions having long-term effects on cost

• Type of operational cost driver: volume-based and activity-basedo Volume-based: aggregate volume of output. Associated with traditional cost accounting

systemso Activity-based: activity that adds value to output. Associated with contemporary cost

accounting systems• Cost drivers as overhead (OH) allocation bases:

o OH costs are indirect and must be applied on some basis.o OH must be added to direct material (DM) and direct labor (DL) to arrive at COGMo Allocation basis -7 cost drivers.

• Traditional industries use direct labor hours as allocation base for overhead• Cost driver = direct labor hours

o Activity centers -7 production departments (advertising, inspection, packaging).• Are activity bases closely correlated with incurrence of manufacturing OH• Contemporary industries accumulate OH with manufacturing and add value to

its products• Cost drivers = machine hours

Cost objects: resources or activities that serve as the basis for management decisions• i.e. products, product lines, departments, geographic territories• product costing + cost control measurement = maximize effectiveness of management

accounting systems• Valuation = cost of goods manufactured• Cost control = cost comparison to standards and budgets


Common Flow of Costs Identified by Cost Objects

Prime Costs = DM/DL Conversion Costs = DL/OH

Direct Materials Direct Labor Factory Overhead

Work in Process

Finished Goods

Cost of Goods Sold

Product costs = not expensed until the product is sold (manufacturing costs)• They sit on the balance sheet as an asset before being sold• Costs attach to the units of output• Consist of DM, DL, and mfg OH applied

Period costs = non-mfg costs• Expensed in the period incurred and are NOT inventorial• Expenses include selling and administrative expenses, interest expense• Consist of selling the product and administering and managing the operations of the firm

Manufacturing costs = treated as product costs• Sit as inventory until sold• Consist of direct and indirect costs

Non-manufacturing costs = treated as period costs• Expensed in the period incurred• i.e. selling, general, administrative expenses

***Cost accounting systems are designed to meet the goal of measuring cost objects or objectives. The most frequent objectives include:

• product costing (inventory and COGM and sold)• efficiency measurements (comparisons to standards)• income determination (profitability)

Tracing Costs to Cost Objects (Product)

Direct costs -7 Easily traced to cost pool or object• direct raw materials -7 used in production or purchased (incl. Freight-in net of any discounts)• direct labor -7 directly related to product or performance of a service plus reasonable

amount of expected “down time” for labor


Indirect costs -7 in the “factory” – mfg. OH• NOT easily traceable to cost pool or cost object• Indirect materials -7 not used specifically or could not be easily traced to the completed product• Indirect labor -7 supports the manufacturing process but not directly on specific job

Other indirect costs -7 in the “factory” (not materials, not labor) = i.e. depreciation of the

factory

***Prime Cost = Direct Labor + Direct Material***Conversion Cost = Direct Labor + Manufacturing Overhead

Indirect costs are allocated to benefit cost pools or cost objects using cost drivers that are considered to have a strong relationship to the incurrence of these costs.

• Allocation basis = cost drivers that are used to allocate indirect costs• Accounting = all indirect costs = OH.

Cost Behavior (Fixed vs. Variable)• DM and DL are variable costs

o As volume 1', Total variable costs (DM & DL) 1'• Indirect costs, incl. mfg., are fixed and variable costs

o Fixed costs (rent, insurance) are not related to volumeo Variable costs (indirect labor, indirect material, utilities) dependent on volume

• Total costs = FC + VC

Variable Costs:• Behavior: Changes proportionally with the cost driver• Amount: Constant per unit, Total varies

o An item costs $25. If produce 10, total cost = $250. If produce 100, total cost = $2500• Long-run characteristics: short-run and long-run impacts of VC are same

Fixed Costs:• Behavior: In short-term, fixed cost does not change when the cost driver changes• Amount: Varies per unit, total remains constant

o Rent is $1000. If produce 10 items, unit cost = $100. If produce 100, unit cost = $10.• Long-run characteristics: given enough time, any cost can be considered variable

Semi-variable Costs:• Contain fixed and variable components• SEE EXAMPLES ON PAGE B5-9

Relevant Range:• Range which the assumptions of cost driver are valid• If cost driver activity is no longer in relevant range, the VC and FC assumptions cannot allocate

costs to cost objects


Cost behavior -7 Summary review page B5-11

Keep costs under control!

Standard Costs:• Based on attainable (realistic) performance• Standard cost per unit -7 Lower the better• Efficiency (cost) and effectiveness (productivity) -7 Higher the output (volume) the

better Standard Costing Systems:• Used for all manufacturing costs (raw materials, DL, mfg OH)• Direct costs

o Standard price x Standard quantity = Standard direct costs• Indirect OH costs

o Standard (predetermined) application rate x Standard quantity = Standard indirect costs• Purpose of standard costing systems

o Cost controlo Data for performance evaluations (variance analysis)o Ability to learn from standards and improve various processes

Joint Product Costing and By-Product Costing (Common Cost Allocation)• Allocating the cost of a single process (joint costs) among several final products (or by-products)

if two or more final products are produced from the same raw material or input• Common (or joint) costs relate to more than one product and cannot be separately identified.• Common costs must be allocated in some manner to the benefiting cost object

Joint products: “Main” products. 2 or more products that are from a common input

By-products: Minor products of relatively small value that incidentally result from the main product

Split-off point: point in production where the joint products can be recognized as individual products

Joint product cost: costs incurred in producing products up to the split-off point . Generally, allocate to main product only, not by-product.

Separable costs: costs incurred on a product after the split-off point

Joint products:∇ Method #1: Allocation by Unit Volume Relationships -7 Example page B5-14∇ Method #2: Relative Net Realizable Values at Split-off Point -7 Example page B5-15

o Net realizable values = sales value – cost of completion and disposalo Assuming the sales price quotations are available at split-off point

∇ Method #3: Sales values not available at split-off -7 Example page B5-16o Work backwardso Identifiable costs incurred after the split-off point must be subtracted from the final

selling price to arrive at the net realizable value at split-off

Formula for materials used:Beginning materials+ Net purchases Available for use- Ending Inventory Materials Used

Cost of goods manufactured:Work in process inventory, beginning

$40,000Add:Direct material used$30,000Direct labor$50,000Manufacturing OH$40,000Total manufacturing costs incurred$120,000 Total manufacturing costs available$160,000Less: Work-in-process inventory, ending$10,000Costs of goods manufactured$150,000


By-products:• Very low sales value• Cannot even cover their share of common costs (otherwise they would be joint products)• Revenue accounting can take one of two forms:

o Applied to main product:• Proceed from sales of by-products are a reduction to common costs for joint

product costing• Revenue earned goes to joint costs incurred either at time of production or sale

o Miscellaneous income

Decisions regarding which method to use (by-product or joint) is based on the demand.

Accumulating and Assigning Costs

Cost object -7 custom order = job costingCost object -7 mass-produced (i.e. steel) = process costingActivity based costing may be used to assign costs, regardless of the cost accumulation system used

• Operations costing = uses components of both job order costing and process costing• Back-flush costing = accounts for certain costs at the end of the process in circumstances where

there is little need for in-process inventory valuation• Life cycle costing = monitor costs throughout the product’s life cycle and expand on the

traditional costing systems that focus only on the manufacturing phase of a product’s life

Costs of goods manufactured:• DM, DL, mfg OH• Manufacturing costs in a period increase or decrease by the net change in WIP inventory

o Beginning WIP – Ending WIP = costs of goods manufactured

Retailers add “Purchases”, not COGM. COGS

Finished goods inventory, beginning $20,000 Add: COGM$150,000COG available for sale$170,000 Less: Finished goods inventory, ending ($50,000) COGS$120,000


Cost of goods sold: for a manufacturer, it is similar to retailer, but COGM is used instead of purchases

JOB-COSTING

Job order costing (cost accumulation system):• Method of product costing that identifies the job as the cost objective• Used when there are few units produced and when each unit is unique or easily identifiable• Cost allocated to specific job as it moves through the manufacturing process -7

“sequential” Job cost records:• Maintained for products, services, or batch of products• Serve as primary records used to accumulate all costs for the job• Also known as job-cost sheets or job orders• Include data from:

o Materials requisitions: docs that show materials requested for use on the jobo Labor time tickets (time cards): docs that show the labor hours and labor rate for the

time applied to the jobo Overview of job order costing: require a limited number of W-I-P accounts. (a new job

cost account will be added every time there is a new job)

RM + DL + OH -7 WIP -7 FG -7 (when sold) COGS is

expensed INVENTORY (Balance Sheet)

MUST SEE CHART ON PAGE B5-19

***Application of OH is accomplished in two ways:• Step #1: Calculate OH Rate = Budgeted OH Costs / Estimated Cost Driver• Step #2: Apply OH = Actual Cost Driver x Overhead Rate (from step #1)

Labor Hours Machine Hours Labor

Based on actual production


PROCESS COSTING Process Costing (Cost Accumulation System): Method of product costing that averages costs and applies them to a large number of homogeneous items .

***Computation of how each segment of the process should compute COG transferred out and the COG remaining in WIP (inventory) is the central product costing issue in process cost environments. Five steps are normally followed to resolve this issue:

1. Summarize the flow of physical unites (beginning with the Production Report)2. Calculate “equivalent unit” output3. Accumulate the total costs to be accounted for (Production Report)4. Calculate the unit costs based on total costs and equivalent units5. Apply the average costs to the units completed and the units remaining in ending WIP inventory

Production Report -7 Keep track of physical flow of units and costs• incl. beginning inventory, # of units started, # of units completed, # of units remaining in

inventory• Unit (quantity) Accounting: # of units accounted equal the # of units charged to department• Cost accounting: amount of costs accounted for must also equal the amount of costs charged to

the department

***Accounting for the physical flow of units is an important first step in process costing. The pure physical flow of units will be different than the equivalent units of production.

I n ven tory: Raw M a terials

B Beginning inventory of raw materials A Add: Purchases of raw materials

Raw materials available for use S Subtract: Raw materials used E Ending Inventory of raw materials

I n ven tory: Wo rk-I n - P rocess

B Beginning inventory of WIPA Add: Raw materials used + DL +OH used

WIP inventory available to be finishedS Subtract: Inventory transferred to finished goods E Ending inventory of WIP

I n ven tory: Fin ished Go ods

B Beginning inventory of finished goods A Add: Inventory transferred from WIP

Finished goods inventory available for sale S Subtract: COGS E Ending inventory of finished goods

Equivalent unit:• An equivalent unit of DM, DL, or conversion costs (DL+OH) = to the amount of DM, DL,

or conversion costs necessary to complete one unit of production• Any material added at the very end of a process will not be in WIP inventory at month end

Calculations of average unit costs:• Averaging of costs from prior month’s WIP: costs from previous month’s WIP inventory are

different from costs of current month. Costs must be averaged.• Cost averaging computations depend upon FIFO and/or weighted (or moving) average cost flow

assumptions.Normal Spoilage (or shrinkage) -7 Inventory cost

• Lost or spoiled units reduce the denominator and raise the cost per unit• Occurs under regular operating conditions and is included in the standard cost of manufactured

product• Is capitalized as part of inventory cost.


o If accounted for separately, are allocated to good units produced Abnormal spoilage -7 Period expense

• Per unit cost is based on actual units. Equivalent units of production include spoiled units• Expensed separately on the income statement as a period cost• Is charged against income of the period as a separate components of COGS

Specific Cost Flow Assumptions:• Calculation with FIFO:

o Ending inventory is priced at cost of mfg during the period, assuming that beginning inventory was completed during the period

o Equivalent units are composed of three separate elements: completion of units on hand at the beginning of the period, units started and completed, and units partially complete at the end of the period

o Cost components: current costs incurred during the period are allocated to the equivalent units produced during the period

• Calculation using weighted-averageo Averages the cost of production during the period with the costs in the beginning WIP

inventoryo Equivalent unit components: output divisor. Units completed during the month

+ equivalent units of work done on the WIP at the end of the periodo Total costs include the costs of beginning inventory and current costs are allocated to

equivalent units

FIFO method:Equivalent units of production:

• FIFO consists of 3 elements• FIFO represents only costs incurred in the current period

Beginning WIP x % to be completed XXX Units completed – Beginning WIP + XXX End in g W IP x % comp let ed + XXX Equivalent units XXX

Cost per equivalent unit:FIFO = Current costs ONLY

Equivalent units

Weighted-average method:Equivalent units of production:

• Weighted-average consists of only 2 elements• Weighted-average consists current period and prior period units

Units completed XXXEnd in g W IP x % comp let ed + XXX Equivalent units XXX


Cost per equivalent unit:Weighted-average = Beginning cost + Current cost

Equivalent units

SEE EXAMPLE PAGE B5-24 & B5-25

Record-keeping for process-costing is less costly than job-order costing system since individual units produced are not identified.

• Increased accounts: Focuses on processes and typically requires more WIP accounts than job order costing

• Record sequence: follow sequential pattern of production process

ACTIVITY-BASED COSTING (ABC)

Activity-based costing = cost-assigning system

Traditional cost systems assign overhead as a single cost pool with a single plant-wide overhead application rate using a single allocation base. These rates are volume-based and use an application basis (i.e. DL hours or machine hours).

ABC = uses multiple OH rates• Assigns indirect costs to products (cost objects) is based on the product’s demand for resource-

consuming activities (costs assigned based on consumption of resources).

Activity = work performed inside a firm. Identified for ABC Resource = element that is used to perform an activity Cost drivers =

• “multiple”• Denominator• Causes cost to be incurred.• Closely correlated with the incurrence of mfg OH costs• Has ability to change the total cost

Resource cost driver = amount of resources usedActivity cost driver = amount of activity that a cost object will use. Used to assign costs to cost objects Activity centers =

• “multiple”• OH incurred in that department• Operation necessary to produce a product

Cost pool = group of costs

Characteristics of ABC:• More focused and detailed approach• Focuses on multiple causes and effects and then assigns cost to them.• “build-up”• Job order system or process cost system• Used for manufacturing or service business• Long-term view point


• Production costs = variable• Cost driver is a non-financial variable• Used for internal purposes, not external

ABC = transaction-based costing -7 cost driver is # of transactions in an activity

Focuses on cost/benefit of activities:• Value-added activities• Value chain (value-added activities): add value to the product. Support activities directly support

value-added activitieso i.e. direct costs, mfg costs

• Non-value added activities: do not increase product valueo Eliminate costs – warehousing, overproduction, insurance

Effects of activity based costing:• High OH to products that have high demands on expensive resources• Removes cost distortion

EXAMPLE PAGE B5-29 AND B5-30

Factors Affecting Production Costs

Types of costs:• Explicit Costs: out-of-pocket expenses (wages, materials, and utilities)• Implicit Costs: opportunity costs by owners (entrepreneurship, equity, capital)• Opportunity costs: value of the next best alternative foregone

Analysis of costs:• Accounting costs: explicit costs of operating a business. Do not consider opportunity costs.• Economic costs: sum of both accounting (explicit) and opportunity (implicit) costs. (rent, wages)

Production costs in the short run and long run:• Short-run: period of time in which some of the inputs used for production are fixed• Period of time in which all of the inputs used for production are variable

Accounting profits = Total revenue - total accounting costsEconomic profits = Total revenue - total economic costs (implicit and explicit)*Accounting profits are higher because economic profits reduce revenue by explicit and implicit costs.

Economies of Scale:• Produce more = lower fixed cost per unit = increase in profit per unit• Economies of scale will eventually be lost, and diseconomies of scale will result• Factors:

o Opportunity for specializationo Utilization of advanced technologyo Ability to use by-productso Volume purchases and discounts


o Proportionately lower costs of purchasing and installing larger pieces of equipmento Lower capital costs per unit -7 spreading FC over more units

Diseconomies of Scale:• Large firms become inefficient and are not cost effective• Increase in average operational costs because of problems in managing large-scale enterprise• Factors:

o Bottlenecks and costs of transporting materialso Difficulty of supervising and managing a large bureaucracy

Sunk Costs:• Costs that have been incurred and are unavoidable.• Will not vary with the course of action taken• NOT relevant in decision-making

Opportunity Costs:• Potential benefit lost by selecting a particular course of action• Relevant• Do not represent actual cash outlays• Not recorded in the accounting records, but must be considered in every decision (economics)

Time Value of Money:• Cash flow over a # of years represents consideration of opportunity costs• Cash flows devoted to a particular project are expected to yield amounts that equal or exceed

the returns associated with alternative investments

Financial Models Used for Operating Decisions

Cost-Volume-Profit (CVP) Analysis for Decision Making: Breakeven Analysis• Revenues and costs in an economic model that allows managers to anticipate profits at

different levels of sales and production volume• All costs can be separated into either VC or FC, depending on their behavior• Volume is the only relevant factor affecting cost• TC = FC + VC(volume)

Contribution Approach (Direct Costing): NON-GAAP• Approach to income statement uses FC• Extremely useful for internal decision making• The contribution of each transaction to covering FC and in computing breakeven in revenue $$

RevenueLess: Variable Costs � DM + DL + Var. OH + Var. Selling, General & Admin. Contribution MarginLess: Fixed Costs � Fixed OH + Fixed Selling, General & Admin. Net Income

• Variable costs include DL, DM, var. Mfg OH, shipping and packaging, and var. selling & admin.

Steps to compute differences between contribution and absorption method:Compute fixed cost per unit (fixed manufacturing OH/units produced)Compute the change in income (change in inventory units x fixed cost per unit)Determine the impact of the change in income:

No change in inventory:Absorption Net Income = Variable Net IncomeIncrease in inventory:Absorption Net Income > Variable Income (Less fixed OH expensed under absorption)Decrease in inventory:Absorption Net Income < Variable Net Income (More fixed OH expensed under absorption)


• Fixed costs include fixed OH, fixed selling, and most general and administrative expenses• Allows to be calculated either as a total or per unit• Unit contribution margin = unit sales price – unit variable cost• Contribution margin ratio = contribution margin expressed as a % of revenue

Contribution margin ratio = contribution margin / revenue

Absorption Approach: GAAP• Does not segregate FC and FC• Equation:

RevenueLess: COGS � DM + DL + Var. OH + Fixed OH Gross MarginLess: Operating Expenses � Fixed & Var. Selling, General, & Admin Net Income

• Approach to income statement is required by GAAP for external reporting

Comparison of Costs Included in Product Cost

Absorption Costing 1. Direct materials2. Direct labor3. Manufacturing OH, both variable and

fixed

Variable (Direct) Costing 1. Direct materials2. Direct labor3. Variable mfg overhead ONLY

All fixed manufacturing costs are treated as period costs

The difference between contribution and absorption approaches is the treatment of fixed factory OH. Selling, general, and administrative expenses are period costs under both methods.

Fixed Factory OH:• Contribution approach: Period Cost -7 NOT GAAP -7 Expense immediately• Absorption approach: Product Cost -7 GAAP -7 Expense when

sold Selling, General, & Administrative:• Are period costs used in the determination of net income under both methods


Breakeven Computation

Breakeven for units:Breakeven points in units = Total fixed costs / Contribution margin per unit

Contribution margin per unit:Unit price x Breakeven point in units = Breakeven point in dollars

Contribution margin ratio:Total fixed costs / Contribution margin ratio = Breakeven point in dollars

Required sales volume for target profit:

Sales = Variable Costs + (Fixed Costs 9 Net Income Before Taxes)

Sales = Fixed Cost + Profit Contribution Margin Ratio (or per unit)

Calculate target profit before tax:Target profit before tax = Target profit after tax + Tax

Target profit before tax = Target profit after tax / (1 – tax rate)

Calculate the breakeven point in sales:Sales = Variable costs + Fixed costs + Target profit before taxes

A company’s profit after breakeven = units sold after breakeven x the CM per unit

Margin of safety in dollars = Total sales in dollars – Breakeven sales in dollars

Margin of safety in percentage = Margin of safety in dollars Total sales

SEE EXAMPLE ON PAGE B5-43...Step 1: TC = FC + VC per unit (units produced)Step 2: FC = y intercept = $150,000 – not dependent on volumeStep 3: VC per unit – slope = ∇

DV = 280,000 – 150,000 = $50

∇IV 2600 - 0Step 4: TC = 150,000 + 50 (2,600) = 280,000

Target Costing = technique to establish the product cost allowed to ensure both profitability per unit and total sales volume

• Requires the selling price of the product to determine the production costs to be allowed• Competition sets prices, any change in price could easily cause a customer defection• Cost control, ongoing profitability


Target Cost = Market price – Required profit• May have to compromise on quality (by reducing costs) = loss of sales due to the poor quality• Increase downstream cost (differentiate their products, create brand loyalty, competitive

advantage)• Advanced cost management techniques -7 to attain a higher productivity level• Redesign product to reduce costs throughout the life cycle of a product (The Kaizen Method)

Economic Value Added (EVA) • Similar to residual income method (computes required rate of return based on hurdle rate)• Measures the excess of income after taxes earned by an investment over the return rate

defined by the company’s cost of capital

Step 1: Calculate the required amount of return and income after taxes

Investment 1,000,000x Cost of Capital x 12% Required Return 120,000

Step 2: Compare income to the required return

Income after taxes 150,000- Required return 120,000

Economic Value Added 30,000

• Positive EVA: performance is meeting standards• Negative EVA: performance is not meeting standards• Refined using any number of investment or income adjustments to produce more accurate

analysis of economic profit• Organization will capitalize research and development costs as part of its asset base• Balance sheet accounts are re-valued to represent current cost• Adjustments to the balance sheet impact the income statement (Deferred taxes are ignored)

Forecasting and Projection Techniques

Budget Policies: technique for developing forecasts and budgets.∇ Involves a budget committee, which includes members of senior management∇ Resolve dispute and make final decisions for major budget changes∇ Management give guidelines based on strategic goals and long-term plan. Include:

o Evaluation of current conditions: consideration of the changes to the environment sincethe adoption of the strategic plan, organizational goals for the coming period & operating results year-to-date

o Management instructions: setting the tone for the budget, corporate policies

Standards and benchmarking -7 manufacturing, service

Standards set below expectations to motivate productivity and efficiency -7 revised at least once a year


Ideal standards -7 perfect efficiency and effectiveness. Not historical, but future. Unrealistic because no provision for normal spoilage or down time.o Advantage: emphasis on continuous quality improvement (CQI) to meet idealo Disadvantage: de-motivation b/c unrealistic standards

Currently attainable standards -7 used with flexible budgets. Costs that result from work performed by employees with appropriate training and experience but without extraordinary effort. Provision for normal spoilage and down time.o Advantage: reasonable standardso Disadvantage: use of judgment and potential manipulation

Authoritative standards -7 set by managemento Advantage: implemented quickly and will include all costs o Disadvantage: workers might not accept

Participative standards -7 by managers and individuals held accountableo Advantage: works will accepto Disadvantage: slower to implement

Benchmark -7 best practices of different firms to establish standardso Purpose: promotes achievement of competitive advantage

Data-driven Techniques for Forecasting and Projection

Sensitivity analysis: experimenting with different parameters (i.e. size of FC, size of VC per unit, volume) and assumptions regarding a model and cataloguing the range of results to view the possible consequences of a decision

Forecasting analysis: risk analysis. Extension of sensitivity analysis:o Predicting future values of depending variables (total cost) using information from previous time

periods (FC, VC per unit, volume)

Regression analysis: predict total costs.o Studying the relationship between two or more variables.o Predict the dependent variable (y) given independent variable (x)o Simple regression = one independent variable (volume) o Multiple regression = two or more independent variables o One type of goal: predict total costs based on outputo y = A + Bx

DV TC-

VCTotal +Cost FC

Quantity IV

o y = dependent variableo x = independent variable (regressor)o A = y-intercept for regression lineo B = slope of regression line

→ Variable cost per unit• ∇ DV = cost• ∇IV = volume


The coefficient of correlation (r):- Measures the strength of the linear relationship between independent (volume) and dependent

(total cost) variables- Range of r is from -1.0 to +1.0:

o -1.0 = perfect inverse relationshipo 0 = no relationshipo +1.0 = perfect direct relationship

The coefficient of determination (R):- Proportion of the total variation in the dependent variable (total cost) explained by the

independent variable (volume)- Range from 0 to +1.0- The higher the R2, the greater is the proportion of the total variation in y that is explained by the

variation in x. The higher the R2, the better fit of the regression line

***How much of the ∇TC (DV) is explained by ∇output (IV)?***When selection cost drivers, choose the one with the highest r/R2

Learning curve: method of logically projecting costs when learning is a variable, often for repetitive tasks

Learning rate: percentage expression of the decrease in avg time (or total time) as production doubles

High-low method: used to estimate the fixed and variable portions of cost, usually production costs- Enables preparation of flexible/performance budget by identifying total fixed costs and variable

costs per unit- Can estimate total costs at any volume

Flexible budget formula:- Series of budgets for a range of activity level

o Total Cost = Fixed Cost + (Variable cost per unit x Number of units)• (y-intercept) + slope: ∇ DV = cost x IV

∇IV = volumeo Really helpful example on page B5-54

Planning/Budgeting Overview and Planning/Budgeting Techniques

Tactical planning -7 short-term up to 18 months

Single use plans: Tactical plans are also called single use plans because they are developed to apply to specific circumstances during a specific timeframe

Annual budget: type of single-use tactical plan. Place responsibility for achievement of strategic goals in the hands of managers promotes routine accomplishment of strategy as part of the manager’s job function


Master budget (annual budget): short-term operating performance goals for up to one year’s time- Includes operating budget and financial budget for a single level of sales volume- Comprehensive and coordinated budget guidance for an organization consistent with

overall strategic objectives- Control objective -7 criteria for performance- known as static budgets, annual business plans, profit planning, targeting budgets- useful specifically in manufacturing industry because of coordination of financial and

operating budgets- Limitations:

o Master budget confined to one year at a single level of activity .o Budget may differ from actual results, even though the relationship between

expenses and revenues is consistent -7 NOT flexibleo Product: Pro forma financial statements -7 Don`t provide management

information useful for decision making- Driven by sales budget

o Unit sales drive unit productiono Sales volume drives support cost

- Operating budget include:o Sales budgetso Production budgets (begins with sales budget)o Selling and administrative budgets Support Casto Personnel budgets

- Financial budgets: detail sources and uses of funds to be used in operationso Pro forma financial statementso Cash budgets

- Annual plan overview: for relationships between annual plan components, SEE PAGE B5-57


Flexible budgeting:- Used with most budgets & in most industries- Focus on substantive variances from standards rather than simple changes in volume or activity- Adjustable economic models designed to predict outcomes and accommodate changes in actual

activity- Consider revenue per unit, variable costs per unit, and fixed costs over the relevant range where

the relationship between revenues and variable costs will remain unchanged and fixed costs will remain stable

- Flexible budgets derive the expenses and revenues allowed from the output achieved for comparison to actual activity and performance evaluation

- Limitation: dependent on accurate identification of fixed and variable costs and determination of the relevant range

- Uses standard cost

Standard cost -7 flexible budget.Zero-budget starts with zero, and all cost is justified.Static budget is opposite of flexible budget, and is used only for one specific volume. Strategic budget is long-term and does not use standard cost.


Budget Variance Analysis

Variance analysis: comparison of actual results to the annual business plan = 1st and basic level of control and evaluation of operations (performance).

Standard cost system: realistic budgeted cost for use in planning and decision-making.

Variance from standard could have been prevented -7 controllable variance -7 VC (i.e. DM,

DL)- If not preventive -7 uncontrollable -7 FC

Variances calculated for the following elements:- DM- DL- VOH (variable mfg overhead)- FOH (fixed mfg overhead)

Direct Materials and direct labor variance -7 two variances are typically calculated:1. Price or rate variance2. Quantity or efficiency variance

o DM price variance = Actual quantity purchased * (Actual price - Standard price)o DM quantity variance = Standard price * (Actual quantity used - Standard quantity allowed)o DL rate variance = Actual hours works * (Actual rate - Standard rate)o DL efficiency variance = Standard rate * (Actual hours worked - Standard hours allowed)o Standard quantity allowed (SQA) = actual output * standard allowed outputo Tabular method: B5-63 variance chart

To calculate the difference in variance analysis -7 Remember S-A-D: Standard – Actual = Difference

S Standard- A - Actual

D Difference

Four main types of variances for RM and DL (not OH):P Price variance (DM)U Usage (quantity) variance (DM)R Rate variance (DL)E Efficiency variance (DL)

Memorizing the variance formula, apply “DADS” twice!!

P Price variance (DM) DA Difference x ActualU Usage (quantity) variance (DM) DS Difference x StandardR Rate variance (DL) DA Difference x ActualE Efficiency variance (DL) DS Difference x Standard

Becker – 2008 Chapter of

Example page B5-66

Manufacturing Overhead Varianceo Net overhead variance (one-way variance): (debit) under vs. (credit) over appliedo Two-way variance consisting of:

o Budget (controllable) variance -7 variable OHo Volume (uncontrollable) variance -7 fixed OH

o Three-way variance consisting of:o Spending variance -7 the less we spend on OH, the bettero Efficiency variance -7 the less hours worked, the bettero Volume (uncontrollable) variance -7 the more units produced, the better

o Production volume variance:

OH variances = applied OH – budgeted OH based on standard hours

Applied OH = (Std VOH rate x Std DLH allowed) + (Std FOH rate x actual production)

Budgeted OH on std hours = (Std VOH rate x Std DLH allowed) + (Std FOH rate x standard production)

o MUST PRACTICE example page B5-69 (listen to the lecture item 13 of 20)

Target Market Analysis - Essential to development of consistent strategy for the success of a company

Selling price x Volume = Sales(high price, low volume OR low price, high volume) (ex. Hyundai vs. Mercedes)

- Sales volume variance: flexible budget variance that distils volume activity from other sales performance components

Sales volume variance = (Actual sold units – Budgeted sales units) x Std contribution margin per unit

- Sales mix variance: impact of company’s departure from planned mix products in budget

Sales mix variance = (actual product sales mix ratio - budgeted product sales mix ratio) * actual sold units * budgeted contribution margin per unit of that product

- Sales quantity variance: difference of actual sold units and budgeted, incl. market size and share of target market


Sales quantity variance = (actual units sold - budgeted unit sales) * budgeted sales mix ratio * budgeted contribution margin per unit

- Market size variance: the effect the size of the entire market for the product has on the contribution margin for the firm

Market size variance = (actual market size in units - expected market size in units) * budgeted market share * budgeted contribution margin per unit weighted avg

- Market share variance: effect of firm`s market share on the firm`s contribution margin

Market share variance (actual market share - budgeted market share) * actual industry units * budgeted contribution margin per unit weighted avg

- Selling price variance: aggregate impact of selling price different from budgeto Lower price -7 cost leadership strategyo Higher price -7 product differentiation strategy

Selling price variance = (actual SP per unit - budgeted selling price per unit) * actual units sold

Organizational Performance Measures

Responsibility accounting: dependent on proper delegation & authority

Responsibility segments -7 strategic business units (SBUs).- Classified around four financial measures (performance objectives) managers are responsible for- SBUs effective in organizing performance requirements and financial responsibility

1. Cost SBU -7 managers responsible for controlling costs (materials, labor, OH) – has least responsibility

2. Revenue SBU -7 managers responsible for generating revenues (# units sold x SP per unit) – has more responsibility than cost SBU

3. Profit SBU -7 managers responsible for producing target profit (revenue and costs) – More responsibility than Cost and Revenue SBUs

4. Investment SBU -7 managers responsible for return on the assets invested (highest level: board of directors) – line an independent business – has the most responsibility

Financial scorecards: feedback function links planning, control, and performance evaluations and is integral to evaluating and reporting performance

1. Accurate and timely2. Understandable3. Specific accountability (each SBU is subdivided into additional categories)

a. Product lines


b. Geographic lines-c. Customer

Allocation of common costs: managers have control over variable costs and over controllable fixed costs (i.e. insurance). Common costs are NOT controllable (i.e. rent on factory, long term lease)

Contribution margin: Controllable -7 the excess of revenues over FC.

Controllable margin: Refinement of contribution margin reporting and represents the difference between contribution margin and controllable fixed costs

- Controllable fixed costs = costs that managers can impact in less than one year (i.e. advertising)

Non-financial scorecards:1. Qualitative: measurements that may be difficult or imprecise and are not numerical.

a. Employee morale, customer satisfaction2. Quantitative: numerical measurements, but not in dollars

a. Reduction in travel time, distance displayed in hours or miles

Balanced scorecard: gathers information on multiple dimensions of an organization’s performance defined by critical success factors necessary to accomplish firm strategy.- Critical success factors are:

o F – Financial -7 Profito I – Internal business processes -7 Efficient productiono C – Customer satisfaction -7 Market shareo A – Advancement of innovation and human resource development (learning & growth)

-7 employee moral, retaining key employees- No one dimension of operations will accomplish an organization’s business objectives

Benchmarking Techniques and Best Practices

Benchmark: identifies standards defining success factors, used for comparison to actual performance (or gaps in performance), and implementation of improvements to meet or exceed the benchmark.

External benchmarks: Productivity Measures

- Measure efficiency- Compare actual performance to similar organizations

Objective:1. Determine whether more inputs have been used than necessary to obtain the actual output.2. Determine whether the best mix of inputs has been used.


Two types of productivity ratios:

1. Total productivity ratios (TPR): value of all output relative to the value of all input

Quantity of output produced / Cost of inputs

2. Partial productivity ratios (PPRs): value of all outputs as compared to the value of major categories of input

Quantity of output produced / Quantity of the single input used

Internal benchmarks: Techniques to find and analyze problems

- Monitoring and investigative techniques

Control Charts: “Determine zero defects”- Graphically display the impact of measuring goalpost conformance- Show if there is a trend toward improved quality conformance or deteriorating quality

conformance- “Statistical control”: where n one of the actual measures fall outside of boundaries

Pareto Diagrams: frequency diagram- histogram of quality control issues displayed in order of most to least frequent with a line graph

that displays the cumulative occurrence of the problems- managers use this to determine the quality control issues that are most frequent and demand

the greatest attention- 6 types.- Type 1, 2, and 3 are 75% of all defects.

Cause and effect fishbone diagram:- Analyze the source/location of problems- Managers analyze the problems that contribute to the occurrence of defects- Trace defects back to source- Diagram on PAGE B5-80- Elements of manufacturing process include:

o Machinery o Method o Materialso Manpower

Continuous Improvement (Kaizen) - Continuous improvement efforts that improve the efficiency and effectiveness of organizations

through greater operational control- Manufacturing stage (where it is ensured that resource uses stay within target costs)


Process improvements / Activity-based Management (ABM) - ABC and ABM are highly compatible with process improvements and total quality management

(TQM)- Availability of cost data by activity make the identification of costs of quality and value-added

activities more obvious- Process management has many of the attributes of ABC, TQM, and value chain analysis

Quality control principles Goalpost conformance:

- Compliance within an acceptable range- Zero-defects conformance because management has the full expectation that production will

conform to the range of quality standards with no exception- Goalpost is not absolute conformance

o Absolute conformance = higher quality products

Quality control principles: Costs of Quality

1. Conformance costs: conformance with quality standards -7 prevention and appraisal costsa. Prevention costs: incurred to prevent the production of defective units

i. Employee trainingii. Inspection expenses

iii. Preventive maintenanceiv. Redesign of productv. Redesign of processes

vi. Search for higher quality suppliersb. Appraisal costs: incurred to discover and remove defective parts

i. Statistical quality checksii. Testing

iii. Inspectioniv. Maintenance of the laboratory

2. Non-conformance costs: Cost of “failure”a. Internal failure: costs to cure a defect discovered before the product is sent to customer

i. Rework costsii. Scrap

iii. Tooling changesiv. Costs to disposev. Cost of the lost unit

vi. Downtimeb. External failure: costs to cure a defect discovered after the product is sent to customer

i. Warranty costsii. Cost of returning the good

iii. Liability claimsiv. Lost customersv. Re-engineering an external failure

3. Quality reporting: financial impact of quality in four categories


a. Inverse relationship between conforming and non-conforming costs

A – Appraisal – costs to identify defective products – conformingP – Prevention – costs to prevent the production of defective products - conforming I – Internal failure – cost of defective parts or lost production time – non-conforming E – External failure – cost of returns and lost customer loyalty – non-conforming

Total Quality Management (TQM):- Commitment to customer-focused performance – quality and continuous improvement- Seven factors:

o Customer focus:• External customers• Internal customers (each link in value chain)

o Continuous improvemento Workforce involvement: Quality circleso Top management support: delegation and empowermento Objective measures o Timely recognition o Ongoing training

Regression analysis :- Statistical model that can estimate the dependent cost variable based on changes in the

independent variable- Independent variable is assumed (not estimated) in regression analysis and is based on activity,

not costs- separate costs into fixed and variable components- Estimates the dependent cost variable- No probabilities are used!!- The coefficient of determination is a statistical measure used to evaluate the results of

regression analysis

Trend analysis : project costs (expenses) out into the future.

Monte Carlo simulation : generate individual values for a random variable.

Dynamic programming : make a series of interrelated decisions.

Learning curve analysis : determine increases in efficiency or production as experience is gained.

Expected value analysis : long-term average of repeated trials and is found by multiplying the probability of each outcome by its payoff and then summing the results

Continuous probability simulation : procedure that studies a problem by creating a model of the process and then, through trial and error solutions, attempts to improve the problem solution

business law books notes chap 5

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