LESSON 1: INTRODUCTION TO ACCOUNTING—A STRATEGIC CONTEXT

DECISION PROCESS FOR MANAGERS

1. Identify problem: describe the situation, focus on key problem to be solved

2. Perform quantitative & qualitative analysis: analyse the data related to the problem
3. Identify alternative solutions: determine or create feasible action alternatives
4. Evaluate alternative solutions: consider likely consequences of action alternatives
5. Make recommendations: choose the best alternative
6. Implement recommendations: implement the chosen alternative

CHARACTERISTICS OF SERVICE ORGANISATIONS

 Labour intensive; often, highest proportionate expenses = salaries & wages

 Outputs & inputs can’t be stored; service must be consumed when it is provided; no inventory of intangibles
 Inconsistency in service provisioning; output varies from individual to individual

NOT-FOR-PROFIT ORGANISATIONS

 E.g. clinics, hospitals, schools, health maintenance, nursing & retirement homes
 Traditionally  few pressures w/management control b/c acceptable to expend resources to maintain human life;
also, human service areas = difficulty measuring outputs
 Now  sever resource limitations

PERFORMANCE IN HEALTH CARE ORGANISATIONS

 Key variable = critical factor believed to be a direct cause of the achievement or non-achievement of organisational
goals & objectives; can be external or internal
o Traditionally  services delivered; now  where services will have greatest impact
 Output = health care service delivered to patient; outcome = resulting health status of patient

CHAPTER 1: THE STRATEGIC CONTEXT

MANAGEMENT ACCOUNTING DEFINED

 Management accounting = gathering & application of information used to plan, make decisions, evaluate
performance, & control an organisation
o Gathers information from other units
o Provides information to other units
 Financial accounting = generation of accounting information for external reporting

Financial Management
Primary users External Internal
Primary organisational focus Whole (aggregation) Parts (segmentation)
Information characteristics * Historical, accurate * Forecasted, timely & reasonable
* Quantitative * Quantitative or qualitative
* Monetary * Monetary or non-monetary
Overriding criteria * GAAP * Situational relevance
* Consistency * Benefits > costs
* Verifiability & objectivity * Flexibility
Recordkeeping Formal Formal & informal
 Cost accounting = tools & methods applied to determine the cost of making products or performing services

MANAGEMENT ACCOUNTING: A COMPONENT OF MANAGEMENT CONTROL

  Control = exertion of managerial influence on operations so that they will conform to plans
o Needed b/c (1) employees may not understand expectations due to lack of ability, training, or information;
(2) employees may lack goal congruence w/organisation
o Examples: financial accounting, management information systems, employee & manager evaluation
systems, organisational culture (set of basic assumptions about organisation, its goals, & its business
practices; describes organisation’s norms in internal & external, formal & informal transactions)
 Management accounting = organisational control
o Specify appropriate activities
o Specify appropriate results
o Recruit & develop appropriate personnel

MANAGEMENT ACCOUNTING: IMPLEMENTING STRATEGY

 Strategy = long-term dynamic plan that fulfils organisational goals & objectives through satisfaction of customer
needs & wants within the company’s acknowledged operating markets
 Mission statements = first stage of strategy formulation; should
o Clearly state what organisation wants to accomplish
o Express how that organisation meets its targeted customers’ needs
 “Strategy is the art of creating value. It provides the intellectual frameworks, conceptual models, and governing
ideas that allow an organisation’s managers to identify opportunities for bringing value to customers and for
delivering value at a profit. In this respect, strategy is the way a company defines its business and links together
with the only two resources that really matter in today’s economy: knowledge and relationships or an
organisation’s competencies and its customers.”
 Business model = description of a business’s distinguishing operations or mechanisms, functions, and revenues &
expenses
o Matches strategy w/internal skills & external environment opportunities
o Unit strategies should flow from overall strategy to ensure effective & efficient resource allocations are
made, overriding corporate culture is developed, & organisational direction is enhanced
 Management accounting helps managers design, implement, & evaluate organisation’s strategy by providing
information about expectations of what a strategy will accomplish & cost, & strategy’s actual past performance
 Organisational structure = the way in which authority & responsibility for making decisions is distributed in an
organisation
o Designed to implement organisation’s strategy
o Organisation = people, resources, & commitments, acquired & arranged to achieve results specified by the
strategy via goals & objectives
o Goals = desired results or conditions that are expressed in qualitative terms; often formulated for
stakeholders (shareholders, customers, employees, suppliers)
o Objectives = quantitatively expressed results that can be achieved during a pre-established period or by a
specified date; should logically measure progress in achieving goals
o Authority = the right (usually by virtue of position or rank) to use resources to accomplish a task or achieve
an objective; can be delegated or assigned to others
o Responsibility = obligation to accomplish task/achieve objective; can’t be delegated to others
 Line positions = directly related to the achievement of organisation’s basic strategies; e.g. production, sales,
professors
 Staff positions = indirectly associated w/achievement of organisation’s basic strategies; provide support or
assistance to line & other staff positions; e.g. management accountant
 Centralisation = organisational structure in which top management makes most decisions & control s most activities
of organisational units from central headquarters; difficulty diversifying operations b/c top management may lack
necessary industry-specific knowledge
 Decentralisation = downward delegation by top management of authority & decision making to the individuals who
are closest to internal processes & customers; to be successful, must have employee empowerment (practices
designed to give workers training, authority, & responsibility they need to manage their own jobs & make decisions
about their work); uses responsibility accounting
  Core competency = any critical function or activity in which one organisation has a higher proficiency than its
competitors; roots of competitiveness & competitive advantage
o E.g. technological innovation, engineering, product development, after-sale service
 Differentiation strategy = organisation distinguishes its products or services from those of competitors by adding
enough value (incl. quality & features) that customers are willing to pay a higher price; can be based on product,
delivery system, marketing approach, etc.
 Cost leadership strategy = organisation becomes the low-cost producer/provider &  able to charge low prices
that emphasise cost efficiencies
 Environmental constraint = any limitation on strategy caused by external cultural, fiscal (e.g. taxation), legal,
regulatory, or political situations or by competitive market structures; tends to have long run rather than short run
effects
 Management accounting  information for formulating, implementing, & evaluating strategies
o Formulating: information on prospective customers (e.g. numbers, locations, spending patterns,
profitability)  basis for forecasts & plans
 Management accounting  financial & non-financial/operational data for designing, implementing, & assessing
strategies

CONTRIBUTION OF MANAGEMENT ACCOUNTING TO THE VALUE CREATION CHAIN

 Strategic management involves organisational planning for deployment of resources (e.g. fixed assets, employees,
working capital) to create value for customers & shareholders; cannot be measured by financial accounting
(monetary)
o How to deploy resources to support strategies
o How resources are used in, or recovered from, change processes
o How customer value & shareholder value will serve as guides to the effective use of resources
o How resources are to be deployed & re-deployed over time
 Value creation chain (VCC) = set of processes & activities that convert inputs into products & services that add
value to the organisation’s customers; foundation of strategic management of resources
o Includes suppliers, internal processes, & customers
o Can be used by managers to determine which activities create customer value as reflected in
product/service prices &  revenues earned
 Successful organisations must cooperate w/everyone in the value creation chain b/c today’s competition = b/w
value chains, not businesses
 VCC: sourcing  enhancing  aggregating  disseminating  interacting
o Sourcing: obtaining raw or crudely produced materials in order to add value later
o Enhancing: making basic products from raw materials
o Aggregating: putting together various enhanced products to produce a complex product
o Disseminating: distributing products/services to customers; incl. wholesale & retail
o Interacting: conducted by consumer; activities undertaken by customer in obtaining good/service being
produced by value creation chain; e.g. drive to store to buy milk
 Organisations require management accounting information to manage activities; e.g. customer information =
necessary to determine which products/services are desired & how many units of each should be produced, to
project demand levels for existing & future products/services
 Vertical integration = extent to which VCC resides within a single firm (high VI = low number of links to other firms;
low VI = high dependence on suppliers, etc.)
 Strategic alliance = agreement involving 2+ firms w/complementary core competencies to contribute jointly to VCC

RECENT DEVELOPMENTS AND THEIR IMPACT ON MANAGEMENT ACCOUNTING

 Information technology
o Helped automate accounting systems: manual  enterprise resource planning (ERP): fully integrated, full-
service suite of software w/common database that can be used to plan & control resources across an entire
organisation
o Shift to manage at activity level rather than at financial transactions level (possible via ERP)
  Crisis of confidence
o Ethical standards = norms that represent beliefs about moral & immoral behaviours; norms for individuals
conduct in making decisions & engaging in business transactions

LESSON 2: COST BEHAVIOUR AND ANALYSIS—INTRODUCTION

KEY TERMS

 Cost accumulation: process of collecting costs using some natural classification, e.g. materials or labour
 Cost allocation: tracking & allocating indirect costs to one or more objectives
 Cost assignment: tracking & assigning direct costs to one or move objectives
 Overhead costs: any costs, other than direct materials & labour, that are associated w/primary product of an
organisation; e.g. in health care, overhead costs = facilities management, accounting, HR

BASIC COST CONCEPTS

 Cost drivers = activities that affect costs

 Variable cost = cost that ∆ in direct proportion to ∆ in the cost driver
 Fixed cost = fixed in relation to a given period of time & range of activity (relevant range)
o Relevant range = limit of cost-driver activity within which a specific relationship b/w costs & cost driver is
valid

COST-VOLUME-PROFIT RELATIONSHIPS

1. Equation method
a. Profits = revenues per unit x units – (variable costs per unit x units + fixed costs)
2. Graphical method
3. Contribution margin method
a. Units = (fixed costs + desired profit) ÷ contribution margin per unit
i. Contribution margin = revenues – variable costs

COST-VOLUME-REVENUE ANALYSIS (appropriate term for breakeven analysis in not-for-profit organisations)

 Fixed revenues = revenues that, in total, will remain at a constant level in the short run (funding period) regardless
of variations in the level of activity
 Variable revenues = revenues that vary in direct proportion to activity levels (e.g. clinical fees)
 Fixed revenue – fixed costs = (variable revenue/unit – variable costs/unit) x service volume
o If fixed revenues exceed fixed costs  net fixed surplus
o If fixed revenues are less than fixed costs  net fixed deficit
o Contribution margin per unit = variable revenue per unit – variable cost per unit
 Net fixed surplus or deficit = contribution margin per unit x service volume

USING ACTIVITY ANALYSIS TO EXAMINE COST BEHAVIOUR

 Activity analysis = important for measuring & predicting costs where cost drivers ≠ obvious
 Previously hidden activities, e.g. supervision & administration, can influence cost behaviour

MANAGEMENT’S INFLUENCE ON COST BEHAVIOUR

 Product or service decisions (e.g. product mix, design, quality, marketing, etc.)
 Capacity decisions
o Capacity costs: fixed costs related to achieving a desired level of production or service; in economic
downturn, fixed capacity costs can’t be recovered
o Committed fixed costs: costs of facilities, equipment, & basic organisation costs which company is obligated
to incur; e.g. lease payments, mortgage payments, insurance costs, property taxes, salaries
 o Discretionary fixed costs: incurred to achieve organisational goals; no relationship to output levels, but
determined via periodic budget planning; e.g. R&D, advertising, employee training
 Technology decisions (e.g. machine vs. labour-intensive manufacturing)
 Cost control incentives (e.g. cost expectations for employees & providing rewards if expectations are met)

CHAPTER 2: COST TERMINOLOGY AND COST FLOWS

COMPONENTS OF PRODUCT COST

 Cost: a monetary measure of the resource given up to acquire a good or service

 Cost object: anything to which costs attach or are related; can be product or service, department, division, territory,
etc.; as cost object ∆, so do direct & indirect cost allocations
 Direct cost: a cost that is clearly, conveniently, & economically traceable to a particular cost object
 Indirect cost: a cost that can’t be clearly traced to a particular cost object; aka common cost; must be allocated
(assign indirect or overhead costs based on the use of a cost driver, a predictor, or an arbitrary method)
 Period cost: a cost that is incurred during an accounting period to support the activities of the company (incurred in
non-production area); cost of resources consumed during the period; related to business functions like selling,
administration, etc.
 Product cost: a cost associated w/making or acquiring/producing inventory or providing a service; either direct or
indirect to particular cost object; aka inventoriable costs; incl. costs of direct material, direct labour, manufacturing
overhead (set of indirect costs)
 Direct material: a readily identifiable, physical part of a product that is clearly, conveniently, & economically
traceable to that product; may be purchased raw materials or manufactured components (should theoretically
include all materials used in product)
o When costs = too expensive to allocate to each product (e.g. salt for sauce)  indirect
o When costs = too expensive to allocate to each service provided (e.g. pencils for ad campaign designs) 
indirect  these costs ≠ significant
 Direct labour: time spent by individuals who work specifically on manufacturing a product or performing a service,
& whose efforts = conveniently & economically traceable to that product/service; direct labour time; directly adds
value to final product/service; consists of wages/salaries, often: basic compensation, production efficiency bonuses,
employer’s share of employment taxes (when costs = stable, should incl. employer-paid insurance costs, holiday &
vacation pay, pension, retirement benefits)
o Sometimes, some costs get allocated to indirect labour costs, b/c (1) inefficient to trace labour costs (e.g.
fringe benefits in volatile low-pay industry  difficult to predict, not useful), (2) erroneous information (e.g.
overtime pay/shift premiums = overhead costs)
o However, substance > form  e.g. service scheduled during non-work hours (overtime)  direct labour
cost allocated to specific service revenues/expenses (not result of scheduling)
 Overhead: expenses of a business such as rent, insurance, utilities consumed in production of product or in
supplying of service; considered indirect; majority of companies’ expenses (direct labour costs )
o Any indirect manufacturing or production cost; excl. direct materials & labour costs
o Even manufacturing industry  2/3 of costs = overhead
 Total product cost: direct materials + direct labour + overhead; inventoriable until products sold/written off
 Production processing/conversion (also primary accounts; common database for accounting systems)
o Work not started
 Cost incurred reflects prices paid for raw materials & supplies
o Work in process (raw materials + supplies + direct labour + manufacturing overhead)
 Costs related to conversion = accumulated & accrued; incl. wages, overhead
o Finished work (product ready for sale; incl. all production costs)
 Service organisations: work not started = cost of necessary supplies (inventoried until needed)
 Prime cost: total cost of direct materials & direct labour (most convincingly associated w/ & most traceable to a
specific product)
 Conversion cost: sum of direct labour & manufacturing overhead that is directly or indirectly necessary for
transforming direct (raw) materials & purchased parts into saleable finished product
 o NB: direct labour included in both,  prime cost + conversion cost ≠ total product cost

COST BEHAVIOUR

 Cost behaviour: manner in which a cost responds to a ∆ in a related level of activity; two types: variable & fixed
o Relevant range: specified range of activity over which a variable cost remains constant per unit & a fixed
cost remains fixed in total; generally = operating cycle or one year
 Cost driver: factor (activity/occurrence) that has a direct cause–effect relationship to a cost; e.g. production volume
 direct effect on total cost of raw materials used; usually not obvious (costs = affected by multiple factors)  e.g.
quality assurance costs affected by volume of production + quality of materials used + skill level of workers + level of
automation
 Predictor: activity measure that is accompanied by a consistent, observable ∆ in a cost item; does not necessarily
cause ∆ in related item (reflects possible relationship or random related occurrence)
 Variable cost: cost that varies in total in direct proportion to ∆ in activity
 Fixed cost: cost that remains constant in total within a specified range of activity
o Incl. depreciation, property taxes, insurance

Total cost Unit cost

Variable cost Varies in direct proportion to ∆ in activity Is constant throughout the relevant range
Remains constant throughout the relevant Varies inversely with ∆ in activity throughout the
Fixed cost
range relevant range

 Lean production = emphasis on waste elimination, high inventory turnover, & low inventory levels
 Companies often switch variable & fixed costs (e.g. automation, outsourcing, wage structure, depreciation methods
such as units-of-production v. straight-line, rent v. property taxes
 Mixed cost: cost that has both variable & fixed components; doesn’t fluctuate in direct proportion or remain
constant w/∆ in activity; e.g. electricity (flat charge + per-usage charge)
 Step cost: variable or fixed cost that shifts upward or downward when activity ∆ by a certain interval or step (e.g.
volume discounts)  must be divided by fixed & variable components over predicted range/usage (approximate
reality & allows stability)
 Straight-line cost formula: y = a + bx, where y = total cost, a = fixed portion, b = variable portion, x = activity
base/cost driver to which y is being related

Methods for separating mixed costs into variable & fixed elements

 High-low method: cost estimation technique for separating mixed costs that uses actual observations of a total cost
at the highest & lowest levels of activity & calculates ∆ in both activity & cost; levels chosen must be within relevant
activity range (activities influence costs, not vice versa)
o Outlier: non-representative point that falls outside of relevant range of activity, or that is a distortion of
normal costs within relevant range; should be disregarded under high-low method
o Independent variable: variable that, when ∆, will cause consistent, observable ∆ in another variable;
variable used as the basis of predicting the value of dependent variable
o Dependent variable: unknown variable that is to be predicted by use of one or more independent variables
o Total mixed cost or  w/∆ in activities; ∆ in cost = ∆ in activity x unit variable cost
o  b = difference b/w costs at highest & lowest activity levels ÷ difference b/w highest & lowest activity
levels, i.e. ∆ in total cost ÷ ∆ in activity level
 Represents unit variable cost per measure of activity
 Scatter graph method: graphic representation of relationship b/w variables within a population achieved by plotting
each magnitude or item against coordinates provided
o Cost v. activity
o (1) Plot points on diagram—data should cover range of volume wide enough to incl. both lowest & highest
volumes likely to happen in near future, usually monthly, (2) draw straight line through points to represent
a trend—separates fixed & variable costs
  Regression analysis: statistical procedure used to determine & measure a predictive relationship b/w one
dependent variable & 1+ other variables
o Better estimate of cost formula than high-low method; uses all data points
 All are estimation techniques only; appropriateness of cost formula depends on validity of activity measure chosen
(activity base selected should be related to incurrence of overhead cost, should reflect significant correlation—
statistical measure of strength of relationship b/w two variables); beware significant ∆ in industry (historical data
≠ reliable)

DEVELOPING AND USING PREDETERMINED OVERHEAD RATES

Variable overhead rate (VOH): ∆ proportionately in total w/some measure of volume or activity

 Predetermined overhead rate: budgeted constant charge per unit of activity used to assign overhead costs to
production or services; should be computed for each VOH pool  relevant range is chosen, total cost for each pool
÷ level of activity on which estimate was based  = per unit cost of activity
o Since VOH = constant per unit at all activity levels within relevant range, activity level chosen for estimating
total variable cost ≠ important
o Activity measure selected should logically relate measure & overhead cost incurrence
o Predetermined VOH rate = estimated VOH cost ÷ estimated output
o Always calculated in advance of year of application
 Homogeneity (uniform common attribute common to all costs in a given cost pool) underlies all cost allocation, e.g.
direct labour hours, direct labour dollars, machine hours, production orders, production-related physical measures
(e.g. kg, L)
 Typical cost system: overhead = assigned to Work in Process inventory using predetermined rate x actual quantity
of activity base
 Recording overhead: (a) separate accounts for actual & applied, (b) general ledger
 Recording manufacturing overhead: (a) single overhead account, (b) separate accounts for variable & fixed
components ( must separate mixed costs)

Fixed overhead rate (FOH): portion of total overhead that remains constant in total w/∆ in activity within relevant range

 For product costing: all fixed manufacturing overhead costs must be estimated & assigned to appropriate cost pools
to calculate numerator of predetermined fixed manufacturing overhead rate
o Since fixed overhead = constant in total, it varies inversely on per-unit basis w/∆ in activity   specific
activity level must be chosen for denominator
o Level of activity selected = firm’s expected activity
 Expected annual capacity: short-run concept representing anticipated level of activity for upcoming
year
 Capacity: measure of production volume or of some other cost driver related to plant
production capability during a period
 If actual results = close to expected results ($ & volume)  measure of capacity should
result in product costs that most closely reflect actual costs
o Predetermined FOH rate = estimated total fixed costs ÷ estimated output
 May choose activity level other than expected annual capacity, e.g. ideal/theoretical capacity, practical capacity, &
normal capacity
o Theoretical capacity: estimated absolute maximum potential production activity that could occur in
production facility during specific time frame w/perfect operation cycle
o Practical capacity: activity level that could be achieved during normal working hours during unused capacity
& ongoing, regular operating interruptions, e.g. holidays, downtime, start-up time, etc.; takes into account
unused resources
o Normal capacity: firm’s long run average activity (5-10 years) which gives effect to historical & estimated
future production levels & to cyclical and seasonal fluctuations
OVERHEAD APPLICATION

 Applied overhead: amount of overhead assigned to Work in Process inventory as a result of occurrence of the
activity that was used to develop the application rate; result of multiplying the quantity of actual activity by
predetermined rate
o DR Work in Process inventory
 CR Variable manufacturing overhead (variable cost per unit x output)
 CR Fixed manufacturing overhead (fixed cost per time unit x time)
 Under-applied overhead: actual overhead – applied overhead incurred for the period; ending balance = debit
 Over-applied overhead: applied overhead – actual overhead incurred for the period; ending balance = credit
 Manufacturing overhead accounts used for recording actual & applied overhead amounts = temporary, balances
must be closed at year-end
 Typical costing system: actual overhead costs = debited to variable & fixed overhead general ledger accounts,
credited to various sources of overhead costs; applied overhead costs = debited to Work in Process inventory via
predetermined rates & actual levels of activity, credited to variable & fixed overhead general ledger accounts
o Applied overhead = added to actual direct materials & direct labour costs when calculating cost of goods
manufactured
o End-of-period balance in each overhead general ledger account = under-applied (debit) or over-applied
(credit) overhead
 Closing immaterial amounts of over-applied variable overhead
o DR Variable manufacturing overhead
 CR Cost of goods sold
 If under-/over-applied overhead = significant, allocate among accounts containing applied overhead (i.e. Work in
Process, Finished Goods, Cost of Goods Sold/Services Rendered)

COMBINED OVERHEAD RATES

 Combined overhead rates = used b/c (1) clerical ease, (2) clerical cost savings, (3) absence of formal requirements to
separate overhead costs by cost behaviour
o Only one type of activity can be selected for the cost pool (rather than variable & fixed)
 Overhead application rate can be related to particular cost pool (e.g. machine-related overhead) or to overhead
costs in general
 Blurs cause–effect relationships  inability to reduce costs, improve productivity, discover causes of under-/over-
applied overhead  hinders ability to plan operations, control costs, make decisions

ACCUMULATION OF PRODUCT COSTS – Journal entries (p. 67), T-accounts (p. 68)

 Product costs = accumulated for inventory purposes & expensed to Cost of Goods Sold (flow via Work in Process,
Finished Goods, & ultimately Cost of Goods Sold)
 Perpetual inventory control system = continuously provides current inventory & cost of goods sold information for
financial statement preparation & inventory planning, cost control, decision-making

COST OF GOODS MANUFACTURED AND SOLD

 Cost of goods sold (CGS) = beginning merchandise inventory + purchases – ending merchandise inventory; too
simplistic
 Cost of goods manufactured (CGM): total manufacturing costs attached to units produced during an accounting
period
 Cost of goods manufactured statement: total cost of goods that were completed & transferred to Finished Goods
inventory during the period; internal statement only
o Preliminary step to present CGS
o Doesn’t include cost of work still in process at end of period
o Allows to see relationship b/w various production costs & know results of cost flows via inventory accounts
 Cost of goods sold: cost of products/services sold during the period
 o To calculate: CGM + beginning balance of Finished Goods (= cost of goods available for sale) – ending
balance of Finished Goods

LEAST-SQUARES REGRESSION ANALYSIS (Appendix 2A)

 Least-squares regression analysis: statistical technique for mathematically determining the cost line of a mixed cost
that best fits the data set by considering all representative data points; allows the user to investigate the
relationship b/w dependent & independent variables
 Simple regression analysis: regression analysis using only one independent variable to predict the dependent
variable
 Multiple regression analysis: regression analysis using 2+ independent variables
 Regression line: line that represents the cost formula for a set of cost observations fit to those observations in a
mathematically determined manner

CHAPTER 3: COST–VOLUME–PROFIT ANALYSIS

THE BREAKEVEN POINT – Short-term only

 Breakeven point (BEP): level of activity, in units or dollars, at which total revenue = total costs
 Basic assumptions about cost behaviour for BEP calculation
o Relevant range: company operates within relevant range of activity
o Revenue: revenue per unit remains constant
o Variable costs: on per-unit basis, assumed to be constant (production = direct materials, direct labour, &
variable overhead; selling = commission, shipping; administrative, etc.)
o Fixed costs: remain constant within relevant range (manufacturing overhead, fixed selling & administrative,
etc.)
o Mixed costs: must be separated into variable & fixed elements (via any method, e.g. high-low, regression,
etc.)
 Contribution margin (CM): selling price per unit – all variable production, selling, & administrative costs per unit,
i.e. CM = R – VC; CM per unit = constant, total CM = fluctuates
 Breakeven point formula: R(X) – VC(X) – FC = PBT
  X = FC ÷ (R – VC),  X = FC ÷ CM
 Contribution margin ratio (CM%): contribution margin divided by revenue; indicates what proportion of selling
price remains after variable costs have been covered
 CM% = (R – VC) ÷ R,  X($) = FC ÷ CM%
 Variable cost ratio (VC%): 100% – CM%; represents variable cost proportion of each revenue dollar

USING COST–VOLUME–PROFIT ANALYSIS

 Cost–volume–profit analysis (CVP analysis): process of examining relationships among revenues, costs, & profits
for a relevant range of activity & for a particular time period

Fixed amount of profit before tax

 Set PBT desired

 X = (FC + PBT) ÷ CM or R(X) = (FC + PBT) ÷ CM%

Fixed amount of profit after tax

 PBT x TR = tax expense

 PAT = PBT – (PBT)(TR) = PBT(1 – TR)
 PBT = PAT ÷ (1 – TR)
 X = (FC + PBT) ÷ CM or R(X) = (FC + PBT) ÷ CM%
Variable amount of profit before tax (specified variable amount of sales)

 R(X) – VC(X) – FC = PuBT(X), where PuBT = profit per unit before income tax
 X = FC ÷ (CM - PuBT)

Variable amount of profit after tax

 PuBT(X) x TR = tax expense

 PuBT(X) = PuAT(X) ÷ (1 – TR)
 X = FC ÷ (CM - PuBT)

THE INCOME STATEMENT APPROACH

 Income statement approach to CVP analysis  allows preparation of pro forma statements
 Since formula & income statement approaches = based on the same relationships, each should be able to prove the
other
 See p. 123 for proof of computations via income statement approach to CVP

INCREMENTAL ANALYSIS FOR SHORT-RUN CHANGES

 BEP  if FC , VC , selling price per unit , or CM% 

 CM% (unit)  if VC  and/or selling price 
 Incremental analysis: technique used in decision analysis that compares alternatives by focusing on differences in
their projected revenues & costs
o In CVP analysis = based on ∆ occurring in revenues, costs, and/or volume
 Breakeven graph: graphical depiction of relationships b/w revenues, VC, FC, & profts/losses
o X-axis: volume, y-axis: dollars; compare total revenue line & total VC line  CM area
o CM = created by excess of revenues over VC; if VC > revenues, no quantity of volume  profit
o Total CM = total FC + profit or – loss
o Before profit can be generated, CM must > FC
 Profit–volume (PV) graph: graphical presentation of profit or loss associated w/each level of sales
o X-axis: sales units, y-axis: profit/loss in dollars; profit line at y = 0  BEP; profit line at x = 0  FC

COST–VOLUME–PROFT ANALYSIS IN A MULTIPRODUCT ENVIRONMENT

 Must use weighted-average CM% (due to assumption of constant sales mix)

o Pre-product sum of sales mix % (relative to sales dollars) x CM ratio
 Companies can also bundle products to increase sales (e.g. value meals)

UNDERLYING ASSUMPTIONS OF COST–VOLUME–PROFT ANALYSIS

 All VC & revenue behaviour patterns = constant per unit & linear within relevant range
 Total CM (i.e. total revenue – total VC) = linear within relevant range & proportionately w/output
 Total FC = constant amount within relevant range
 Mixed costs can be accurately separated into fixed & variable elements (estimates can be developed via high-low,
regression, etc. analyses)
 Sales & production = equal,  no material fluctuation in inventory levels (needed b/c of allocation of FC to
inventory at potentially different rates each year)
 No capacity additions during period under consideration (FC/VC can’t ∆)
 In multiproduct firm, sales mix = remain constant
 No inflation, or inflation affects all cost factors equally; or if factors ≠ affected equally, appropriate effects
incorporated into CVP figures
 Labour productivity, production technology, & market conditions will not ∆ (if any occurred, costs would ∆
correspondingly, possible that selling prices would ∆  invalidate first three assumptions)
MARGIN OF SAFETY AND OPERATING LEVERAGE

 Margin of safety: excess of estimated (budgeted) or actual sales of a company over its breakeven point; can be
calculated in units or dollars, or as a percentage
o In units: estimated (actual) units – breakeven units
o In dollars: estimated (actual) sales dollars – breakeven sales dollars
o As percentage: margin of safety in units or dollars ÷ estimated (actual) sales in units or dollars
 Operating leverage: factor that reflects the relationship of a company’s variable & fixed costs; measures ∆ in profits
expected to result from a specified percentage ∆ in sales
  VC &  FC (e.g. labour-intensive organisations)   operating leverage &  BEP
  VC &  FC (e.g. capital-intensive organisations)   operating leverage &  BEP
o  operating leverage   CM%; i.e. each unit sold after BEP (i.e. after  FC covered) =  profits
 Degree of operating leverage (DOL): measure of how a percentage ∆ in sales will affect profits; calculated at a
specified sales level as contribution margin divided by income before tax
o DOL = CM ÷ PBT; assumes that FC do not  when sales 
 DOL  as company moves further away from BEP
  margin of safety   DOL; at BEP, DOL = ∞ (any  from 0  ∞ ∆%)

ABSORPTION AND VARIABLE COSTING (Appendix 3A)

 Absorption costing: most common approach to product costing; cost accumulation method that treats costs of all
manufacturing components (direct materials & labour, variable & fixed overhead) as inventoriable or product costs;
aka full costing; approved by CICA (re: matching)
o Product costs  work in process  finished goods  cost of goods sold
o Period costs  selling/administrative/other expenses
o Income statement: revenue – cost of goods sold (= gross margin) – other expenses = PBT
o Functional classification: grouping of costs incurred for the same basic purpose
 Variable costing: cost accumulation method that includes only variable production costs (direct materials & labour,
variable manufacturing overhead) as product or inventoriable costs & treats fixed manufacturing overhead as a
period cost; aka direct costing
o Product contribution margin (PCM): revenue – variable cost of goods sold
o Total contribution margin (TCM): revenue – all variable costs regardless of area of incurrence (production
or non-production)
 Also, TCM = PCM – non-production costs
o Income statement: revenue – variable cost of goods sold (= PCM) – variable non-manufacturing expenses,
e.g. selling/administrative/other (= TCM) – total fixed expenses, e.g.
manufacturing/selling/administrative/other = PBT
 Cost behaviour (relative to ∆ in activity) can’t be observed from absorption costing income statement
  although mandated by regulation, absorption costing shouldn’t be used internally
 Differences b/w absorption & variable costing methods
o Absorption costing  FOH = product cost; variable costing  FOH = period cost
o Absorption costing  classifies expenses by function; variable costing  classifies expenses by behaviour,
then by function if necessary
 Similarities b/w absorption & variable costing methods
o Same basic cost information
o Same treatment of direct materials & labour, VOH (always product costs)
ABSORPTION COSTING VARIABLE COSTING
Composition of product cost
Manufacturing FOH = attached, in separate amounts, to Manufacturing FOH = period cost (expense) when incurred;
units produced; if firm sells all inventory produced in period not attached in separate amounts to units produced; each
+ on hand at beginning of period  previously incurred period, all manufacturing FOH incurred  income
manufacturing FOH  income statement as part of COGS. statement as expense, but not via COGS
Structure of the chart of accounts
Costs = classified according to functional categories, e.g. Costs = classified according to cost behaviour & functional
production, selling, administrative. categories (manufacturing/non-m); mixed costs = separated
Process of accumulating costs
All manufacturing costs = product costs; all non- Classified & accumulated by cost behaviour; manufacturing
manufacturing costs = period costs VC = product costs; manufacturing/non-m FC = period costs
Format of the income statement
Costs  income statement by functional categories  GM Costs  income statement by cost behaviour  CM
highlighted; doesn’t incl. cost behaviour; non-m period highlighted; FC = deducted from CM  income before
costs = deducted from GM  income before taxes taxes; costs may be further categorised by functions
o Selling & administrative expenses = period costs
o No differences b/w accounts other than Work in Process, Finished Goods, & expense accounts
LESSON 3: COST MANAGEMENT SYSTEMS – INTRODUCTION

CONTROLLING COSTS OR COST DRIVERS

 Cost of setups  controlled via (1) volume-related, mass-production solution of having a limited number of
production runs of many items so that only a few production setups are needed (long production runs avoid costly
changeovers), or (2) lower setup costs, e.g. just-in-time (JIT) or total quality management (TQM)  simplifying &
redesigning machinery,  production runs can be shorter, easier to produce to demand

ABC PROVIDES MORE ACCURATE COSTING

 Activity-based costing (ABC): two-step allocation system that (1) accumulates costs that have the same cost driver
into cost pools, (2) uses an activity driver to assign costs to products & services
 Tries to treat overhead costs as variable costs   proportion of overhead costs allocated w/ABC,  accuracy (rest
must be allocated via traditional methods)
 Eliminates product cross-subsidies; inaccurate product costing  inaccurate product pricing
 Traces non-manufacturing costs, e.g. marketing, customer service, engineering, & administrative, to products &
services using additional cost pools & activity measures (advantageous b/c some products & services may use more
than others  better product pricing, planning, design, & distribution)

COST SYSTEM PHILOSOPHY

 Organisation’s decision to adopt ABC  changes emphasis of cost accumulation from cost objects (e.g.
departments) to activities
 Combined w/broader objective to reduce/eliminate non-value-added costs & improve product & process quality 
ABC helps  profitability, efficiency, & effectiveness
o Called cost management system
o Activity-based management: activity analysis + activity-based costing

HOW ENTERPRISE RESOURCE PLANNING BENEFITS ABC

 Challenge in implementing ABC = finding right activity cost driver to use in attributing cost of activity to products or
other cost objects
o Usually number of sales orders, material moves, engineering change notice per type, etc.
 Enterprise resource planning (ERP) systems   availability & reliability of ABC information
o Use relational database to integrate financial accounting, managerial accounting, cost accounting,
production planning, materials management, sales & distribution, human resource management, quality
management, & customer service
o Permits different functional areas to share information w/o re-entering/duplicating data in various
databases in organisation
o Provides reliable activity cost driver information by integrating production planning, materials
management, & cost and management accounting (ABC = used to  accuracy of product-cost information &
to develop activity-based budgets)
 o Before ABC, materials handing/other management costs  allocated to products based on % of direct
material costs associated w/each product (based on relationship b/w budgeted materials management
costs & expected total cost of direct materials)

CHAPTER 4: COSTING SYSTEMS

JOB ORDER COSTING SYSTEM

 Product costing: (1) cost identification, (2) cost management, (3) product cost assignment
 Job order costing system: product costing method used by entities that produce limited quantities of custom-made
goods or services that conform to specifications designated by the purchaser
o Costs = accumulated individually by job (single unit or group of like units identifiable as being produced to
distinct customer specifications)
 Costs of different jobs = maintained in separate subsidiary ledger accounts & not added together
 Typical job order inventory account: actual direct materials & labour, combined w/predetermined overhead rates x
actual cost driver (e.g. direct labour hours, cost/quantity of materials used, materials requisitions units, etc.) 
normal costing method (used b/c actuals = easy to identify)
 Overhead costs = allocated to production

JOB ORDER COSTING: DETAILS AND DOCUMENTS

 Basic stages of production (re: production life cycle)

o (1) Agreed-upon but not yet started, (2) Jobs in process, (3) Completed jobs
 Materials requisition form: source document that indicates the types & quantities of materials to be placed into
production or used in performing a service; causes materials & their costs to be released from the raw materials
warehouse & sent to Work in Process inventory
o DR Work in Process inventory (direct materials)
o DR Manufacturing overhead (indirect materials)
 CR Raw material inventory
 Job order cost sheet: source document that provides virtually all financial information about a particular job; the
set of all job order cost sheets composes Work in Process inventory subsidiary ledger
o Top portion of job order cost sheet: job number, description of task, customer identification, various
scheduling information, delivery instructions, contract price
o Rest of form: actual costs for materials & labour, applied overhead costs; sometimes estimates
 Employee time sheet (time ticket): source document that indicates, for each employee, what jobs were worked on
during the day & for what amounts of time
o DR Work in Process inventory (direct labour)
o DR Manufacturing overhead (indirect labour)
 CR Wages payable
 Cost-plus job: a job being billed at cost plus specified profit margin
 Actual overhead incurred during production = incl. in overhead control account
o If actual overhead = applied to jobs, cost accountant = wait until end of period & divide actual overhead
incurred by some related measure of activity or cost driver
o Actual overhead would be applied to jobs by multiplying actual overhead rate by actual measure of activity
associated w/each job
o Overhead applied at earliest of: (a) completion of job, or (b) end of period
 DR Work in Process inventory
 CR Manufacturing overhead
 Completion of production
o DR Finished Goods inventory
 CR Work in Process inventory
o DR Cost of goods sold
 Finished Goods inventory
INTRODUCTION TO PROCESS COSTING

 Process costing: method of accumulating & assigning costs to units of production in companies that make large
quantities of homogeneous products, i.e. mass-producing
o If products ≠ homogeneous  joint processing costs: allocation of process costs to 2+ products
 Calculating product unit cost in process costing system: weighted average & FIFO
o Major difference: treatment of beginning Work in Process inventory
 Process costing system: product costing system used by companies that produce large amounts of homogeneous
products through a continuous production flow
o Costs = accumulated by cost component in each production department (similar to job order)
 Differences between job order & process costing
o Job order costing: accumulated departmental costs  assigned to specific jobs; process costing:
accumulated departmental costs  assigned to all units that flowed through department during the period
 Valuation method (actual, normal, standard)  affects costs to be incl. in inventory
o Quantity of production for which costs are being accumulated at any one time (specific v. mass-produced)
o Cost object to which costs are assigned (specific v. batch)
 Similar to job order costing, direct material & labour components of product cost = determined via same methods
o Process costing: costs assigned at end of period from departments to units produced; overhead must be
allocated to units
 Process costing  assigns costs to both fully & partially completed units by converting partially completed units
(Work in Process inventory) to equivalent whole units/units of production
 Equivalent units of production (EUP): approximation of number of whole units of output that could have been
produced during a period from actual effort expended during that period
o Actual units being produced x % of completion at end of period
o Use of EUP recognises that: (1) units in beginning Work in Process inventory will be completed during
current period, (2) partially completed units in ending Work in Process were started in current period but
will not be completed until next period

INTRODUCTION TO WEIGHTED AVERAGE AND FIFO PROCESS COSTING

 Weighted average method: method of process costing that computes average cost per equivalent unit of
production; combines beginning inventory units w/current production & beginning inventory costs w/current costs
to compute the average
 FIFO method: method of process costing that computes average cost per equivalent unit of production using only
current production & current cost information; units & costs in beginning inventory = accounted for separately

EUP calculation & cost assignment Formula Comments

1. Calculate physical units to account for BWIP + started in current period Determine units that are in process
Identify groups of units to be costed
2. Calculate physical units accounted for Completed & transferred out + EWIP
(beginning & ending WIP, completed)
Verify that (2) = (1)
Identify related effort incurred for
3. Determine EUP Weighted average or FIFO
each unit group by cost component
4. Determine total cost to account for BWIP cost + current costs Determine costs already incurred
Calculate EUP cost to be assigned per
5. Calculate cost per EUP Weighted average or FIFO
cost component
Calculate total cost to be assigned to
Transferred out (FG or next
6. Assign costs to inventories each group of units worked on during
department) & EWIP
period
Verify that total costs transferred out
+ costs in ending inventory = (4)

 Weighted average method = focuses on units completed in current period & units that remain in EWIP
 o Units started & completed (S&C): total units completed during period – BWIP; or, units started – EWIP
 Cost per EUP = (BWIP + current period cost) ÷ total weighted average EUP
 Cost of production report: document used in process costing system; details all manufacturing quantities & costs,
shows computation of cost per EUP, & indicates cost assignment to goods produced during period
 FIFO (3): only work performed on BWIP during current period = part of EUP, i.e. BWIP x (1 - % work done prior)
 FIFO (5): cost per EUP = current period cost ÷ FIFO EUP (3)

 Spoilage (spoiled unit, defective unit): unit of product w/imperfections that can’t be economically corrected
 Normal spoilage: units lost due to nature of manufacturing process; unavoidable; product cost
 Abnormal spoilage: units lost in production due to events not inherent in manufacturing process; period costs
 Continuous loss: reductions that occur uniformly during processing
 Method of neglect: method of treating spoiled units in schedule calculating equivalent units
CHAPTER 6: ACTIVITY–BASED MANAGEMENT AND COSTING

THE ABC SYSTEM (NB: German cost accounting similarities, p. 370)

 Activity–based costing (ABC): accounting information system that identifies various activities performed in an
organisation & collects costs on the basis of underlying nature & extent of those activities
 3 strategies objectives: (1) report accurate costs that can be used to identify source of firm profits; (2) identify cost
of activities  identify more efficient ways to perform them or produce their outputs; (3) identify future need for
resources  acquire them more efficiently
 Model the way resources = consumed, not acquired

DEVELOPING PRODUCT/SERVICE COST INFORMATION

 Product/service costs = developed to (1) have information for financial & regulatory reporting, (2) help
management make product pricing & produce line expansion/contraction decisions, (3) allow management to
monitor & control operations
 If best estimate results when largest numbers of costs = traced directly, then best estimate will also be obtained
when fewest costs = assigned arbitrarily
o Overhead can’t be directly traced,  must be attached via valid cost predictor (driver) or arbitrarily

ACTIVITY ANALYSIS

 Activity–based management (ABM): discipline that focuses on how activities performed during
production/performance process can improve value received by customer & profit achieved by providing value
o Process & activity analysis, cost driver analysis, activity–based costing, strategic planning, integration w/cost
management system, continuous improvement, operational control, performance evaluation, business
process engineering
 Activity: repetitive action, movement, or work sequence, performed to fulfil a business function
 Process map: flowchart or diagram that indicates every step in making a product or providing a service
 Value chart: visual representation of the value-added and non-value-added activities & the time spent in all of
these activities from beginning to end of the process
 Value-added activity (VA): activity that  worth of product/service to customer, for which customer = willing to pay
o E.g. packaging, compounding
 Value-added processing time: time it takes to perform all necessary manufacturing functions for a customer
 Value-added service time: time it takes to perform all necessary service functions for a customer
 Non-value-added activity (NVA): activity that  time spent on product/service but doesn’t  its value/worth
o E.g. materials receiving, quality control, storage, machine setup, shipping between facilities
o Transfer time: time it takes to move products/components from one place to another; move time
o Idle time: storage time & time spent waiting at production operations for processing
o Inspection time: time taken to perform quality control
o Can be attributed to systemic, physical, & human factors
  Business value-added activity (BVA): activity that is necessary for operation of business but for which customer ≠
willing to pay, e.g. auditing costs
 Cycle time: time from when customer places order to time when product/service = delivered, OR, via full life-cycle
approach: time from conceptualisation of product/service to time product/service = delivered to market/consumer
o Cycle time = value-added processing time + total non-value-added time
o Retail: time from when item = ordered to time when item = sold to customer
o Service: time from when service order = placed to time when service = completed
 Manufacturing cycle efficiency (MCE): value-added processing time ÷ total cycle time; shows production efficiency
 Activity improvement measures: change flows & processes, schedule, train, simplify, combine fragmented activities,
automate, standardise, eliminate duplication, eliminate cause of rework
  cost drivers analysed   accuracy  may costs;  costs v. benefits must be considered (cost–benefit analysis)
 ABC  ability to more directly observe where, how, & why costs = incurred, by focusing on actual activities directly
associated w/providing product

ACTIVITY–BASED COSTING

 Underlying elements of ABC: (1) gathering costs into related cost pools, (2) recognising that various activity & cost
levels exist, (3) using multiple cost drivers to assign costs to products & services
 Overhead = accumulated into one or two cost pools (total overhead, or variable & fixed overhead)
 Levels of cost incurrence

CLASSIFICATION LEVEL DEFINITION TYPE OF COSTS NECESSITY OF COST

Cost created by production
* Direct material
or acquisition of a single unit Once for each unit
Unit-level cost * Direct labour
of production or delivery of a produced
* Some machine costs, if traceable
single unit of service
* Purchase orders
Cost created by group of * Setup
Once for each batch
Batch-level cost similar things made, handled, * Inspection
produced
or processed at a single time * Movement
* Scrap, if related to batch
* Engineering change orders
Cost created by need to
Product- or process- * Equipment maintenance Supports a product
implement or support
level cost * Product development type or a process
specific product
* Scrap, if related to product design
Cost incurred to support
* Building depreciation Supports overall
Organisational- or ongoing operations, which in
* Plant or division manager’s salary production or service
facility-level cost turn provide available
* Organisational advertising process
facilities

 Batch-, product-/process-, & organisational-/facility-level costs = traditionally regarded as fixed; however, can be
seen as long-term variable
 Long-term variable cost: cost that has traditionally been viewed as fixed but that will actually react to some
significant change in activity; aka step fixed cost
 Activity centre: segment of production or service process for which management wants a separate report of costs
of activities performed; consider geographical proximity of equipment, defined centres of managerial responsibility,
magnitude of product costs, need to maintain manageable number of activity centres
o Past: overhead accumulated using vertical or functional approach; e.g. departmental cost separation
o Now: since production & service activities = horizontal, should be gathered in pools reflecting same cost
drivers
 Activity cost centre: measure of demands placed on activities &  resources consumed by products & services;
often indicates activity’s output
 Determining product profitability & company profits:
 o Total product revenue = product unit selling price x product unit volume
o Total product cost = total product cost per unit x product unit volume
o Net product margin = total product revenue – total product cost
o Total margins provided by products = net product margin ± all other net product margins
o Company profit or loss = total margins provided by products – organisational-/facility-level costs (i.e.
corporate/divisional administration, facility depreciation)
 Activity drivers

ACTIVITY CENTRE ACTIVITY COST DRIVERS

Accounting Reports requested; dollars expended
Personnel Job change actions; hiring actions; training hours; counselling hours
Data processing Reports requested; transactions processed; programming hours; program change requests
Hours spend in each shop; job specification changes requested; product change notices
Production engineering
processed
Quality control Hours spent in each shop; defects discovered; samples analysed
Plant services Preventative maintenance cycles; hours spent in each shop; repair maintenance actions
Dollar value of requisitions; numbers of transactions processed; number of personnel in
Material services
direct support
Utilities Direct usage (metered to shop); space occupied
Fixed per-job charge; setups made; direct labour; machine hours; number of moves;
Production shops
material applied

 ABC requires investigation of each department to determine (a) how much time personnel actually spend on each
product, (b) what factor drives costs in that department
 ABC v. traditional costing: ABC = forward-looking,  yields better information for setting appropriate prices &
determining cost & profit impact of different product mixes; traditional costing = company may inappropriately
assume that a particular product is contributing more profit that it actually is (e.g. due to inaccurate breakdown of
associated costs, esp. overhead)
 Assume: 10% cost difference b/w ABC & traditional costing  trigger to switch to ABC; not less b/c even ABC incl.
arbitrary allocation of overhead costs,  at overhead costs of 15%+ of total cost = ABC more accurate, at <15% 
perform cost–benefit analysis first (depends on complexity of product lines & operations, size of firm, & expected
time to implement ABC)

DETERMINING WHETHER ABC IS APPROPRIATE

 Primary assumptions of ABC

o Costs in each cost pool = driven by homogeneous activities
o Costs in each cost pool = strictly proportional to activity

If true, then ABC = advantageous under following conditions

 There is significant product/service variety or complexity

o Product variety: number of different types of products produced
o Service variety: number of different types of services provided
o Mass customisation: relatively low-cost mass production of products to unique specifications of individual
customers; requires use of flexible manufacturing systems
o Product complexity: number of components in a product or number of processes or operations through
which a product flows
 Pareto analysis  20% of components = used in 80% of products; 20:80 rule
 Are remaining components used in key products?
o Could equal quality be achieved by using more common parts?
 Could products be sold at premium to cover costs of low-volume parts?
  Are non-standard parts used in products purchased by important customers who are willing
to pay a premium price for products?
o May be worth it, but would customers be equally satisfied if more common parts
were used & product price were reduced?
 Parts complexity is only acceptable when customer finds it value-added
o Simultaneous (concurrent) engineering: integrated approach in which all primary functions & personnel
contributing to product’s origination & production = involved continuously from beginning of project
 Multifunctional teams = used to design product by considering customer expectations, vendor
capabilities, parts commonality, & production process compatibility
 Design-for-manufacturability approach
o Business process re-engineering: process innovation & redesign aimed at finding & implementing radical
changes in how things are made or how tasks are performed to achieve substantial cost, service, or time
reductions
 Needed b/c even when simultaneous engineering is used in process development, processes may
develop complexity over time
 Appropriate for 70% of firms; alternative = new product design (expensive, may not be necessary)
 There is a lack of commonality in creation & use of overhead
o E.g. some products require substantially more advertising, use higher cost distribution channels, necessitate
use of high-technology machinery; when output volumes differ among products & services  additional
overhead costs  unfair overhead distribution among products & services
 There are problems w/current cost allocations
o Many companies  automated production processes   labour costs,  overhead costs
o Traditional cost allocation = assigns product costs (i.e. direct materials & labour, manufacturing overhead)
to products & expense majority of period costs when incurred; ABC  some period costs can be associated
w/products & should be allocated appropriately
 There has been significant change in environment in which organisation operates
o  competition may occur b/c
 Other companies recognised profit potential of a particular product/service
 Product/service became cost-feasible to make or perform
 Industry became deregulated
o Changes in management strategy, e.g. eliminating NVA activities  ABC helps identify them

 Compared to process costing information, job-order cost system better reflects product cost differences involving
material & labour b/c it recognises that two different products may have different costs; however, it also assumes
that overhead costs = related to amount of direct labour incurred
 Process & job-order costing = systems for allocating costs; ABC = option for allocating overhead, & alternative to
traditional method of allocating w/volume drivers, e.g. labour, machine hours;  ABC works in conjunction
w/process & job-order costing, not as an alternative

OPERATIONAL AND STRATEGIC PLANNING AND CONTROL USING ABC

 Traditional accounting systems concentrate on controlling cost incurrence, while ABC focuses on controlling cause
of cost incurrence  more effective cost reductions
 Reasons why ABC implementation may fail
o Software was not IT integrated
o ABC & ABM applications ≠ integrated into organisation measurement & management systems; as ABC was
deployed as retrospective modelling analysis, managers were not required to use it for planning purposes
o Applications are poorly implemented; no standards for development & deployment of ABC

CRITICISMS OF AND CONCLUSIONS ABOUT ABC

 Individual barriers to ABC adoption: (1) fear of unknown or shift in status quo, (2) possible loss of status, (3) need to
learn new skills
 Organisational barriers: territorial, hierarchical, corporate-culture issues
 Environmental barriers: unions, regulatory agencies, other stakeholders
 ABC doesn’t conform with GAAP (p. 380)
o Traditionally designated period costs (e.g. R&D, service department costs)  allocated to products via ABC
o Traditionally designated product costs (e.g. building depreciation)  not allocated to products via ABC
 ABC does not promote total quality management & continuous improvement (p. 380)
o But, ABC helps to identify & monitor significant technology costs; trace many technology costs directly to
products; promote achievement or market share via use of target costing; identify cost drivers that create
or influence cost; identify activities that don’t contribute to perceived customer value, understand impact
of new technologies on all elements of performance; translate company goals into activity goals; analyse
performance of activities across business functions; analyse performance problems; promote standards of
excellence
 W/ERP systems, ABC = fully integrated w/all other subsystems, e.g. process costing, financial statements, fixed
assets
o Fixed asset costs or depreciation costs  automatically recorded in cost pools & then these costs =
allocated to activities & then to products & services; those allocated costs = transferred to inventory and/or
cost of goods sold, & to the financial statements, which can be produced upon demand