CHAP 1 AN INTRODUCTION TO COST TERMS AND PURPOSES

1. Cost and cost terminology

Actual cost: cost incurred

Budgeted cost: predicted or forecasted cost

Cost object: anything for which a measurement of costs is desired

2. Direct cost and Indirect cost

The direct cost of a cost object can be traced in an economically feasible way

The indirect cost of a cost object can not be traced

Cost allocation: the assignment of indirect costs to a particular object

Cost assignment: encompasses tracing direct costs to a cost object and Cost allocation

Direct costs of cost objects are easier to measure

Indirect costs are harder to measure
Managers basically want to assign costs accurately to cost objects since this affects decisions
Depending on cost objects, a specific cost may be either direct or indirect cost
3. Variable costs and Fixed costs

A variable cost changes in proportion to a level of volume

(most direct costs are variable cost)

A fixed cost remains unchanged regardless of the level of volume

(the higher the units the lower the fixed cost per unit)

Unlike variable cost, fixed cost cannot be easily changed in the short-run. However, in the long-run it
can be changed to match with the resources needed
(firing workers or switch them to another department)

Labor cost can be classified as fixed cost to enhance employees dedication and loyalty but can also
be variable cost if workers are paid on a piece-unit basis.

Mixed or Semivariable cost

A cost driver is a variable that affects costs over a given time span

Relevant range

4. Total costs and Unit costs: focus on total costs instead of unit costs
5. Types of sectors

Manufacturing: purchase materials and components and then convert them into various finished
goods

Merchandising: sell tangible products without changing their basic forms (retailers)

Service: provide services or intangible products

-----------------------------------Summary Pg. 76
Exercises: 2-17/ 27/ 39

CHAP 2 COST VOLUME PROFIT (CVP) ANALYSIS

1. Basic formula

Operating income

Contribution margin = total revenues total variable costs

Contribution margin per unit

= contribution margin fixed cost

= contribution margin / number of units sold

= contribution margin percentage x revenues

Contribution margin percentage

= contribution margin per unit / selling price per unit

2. Cost-Volume graph (pg. 91)

3. BEP

Break-even point = Q = FC / Contribution margin per unit

Quantity required = Q = (TOI + FC) / Contribution margin per unit

=

{ TNI ( 1tax rate ) } + FC

Contribution margin perunit

Break-even revenue = FC / Contribution margin percentage

4. Other formula

Margin of safety (in dollar)

= Budgeted revenues breakeven revenues

Margin of safety (in units)

= Budgeted sales breakeven sales

Margin of safety percentage = margin of safety / budgeted revenues

5. Operating leverage
Degree of operating leverage = contribution margin / operating income
= (R VC) / operating income
= (FC + OI) / OI
= FC / OI + 1
If Degree of OL = 2.67 => FC / OI = 1.67, which means $1 of operating income requires $1.67 investment
in fixed cost. Therefore, the lower the degree of OL the better because investing in fixed cost is dangerous;
we are all trying to reduce fixed cost.
-----------------------------------Summary Pg. 106
Exercises: 3- 19/ 23/ 28/ 40

CHAP 3 JOB COSTING

1. Terms

Cost pool: a grouping of individual indirect cost items

Cost-allocation base: a systematic way to link an indirect cost or group of indiect costs (cost pool)
to a cost object

Job-costing: the cost object is a unit or multiple units of a distinct product or service called a job.
Job-costing systems accumulate costs seperately for each product or service.

Process-costing: the cost object is masses of identical or similar units of a product or service. This
per-unit cost is the average unit cost that applies to each of the identical or similar units produced in
that period.

Eg: ABC Corp. uses job-costing to calculate the total cost to manufacture each of the 3 distinct types of
products- Corn Flakes, Crispix and Froot Loops. But use process costing to calculate the per-unit cost of
producing each identical box of Corn Flakes.

The 5-step decision-making process: Identify Obtain info Make predictions Make decision
Implement & Learn

2. Actual costing VS Normal costing

General approach to job costing:

1. Identify cost object

2. Identify the direct costs: DM & DML
3. Select the cost-allocation bases
4. Identify cost pool
5. Compute the rate per unit: <4/3>
6. Compute the indirect cost allocated to the job
7. Compute the total cost <6 + 2>

Actual costing
Direct costs

Indirect costs

Pros and Cons

Normal costing

Actual direct cost rate X

Actual direct cost rate X

Actual quantities of direct-cost input

Actual quantities of direct-cost input

Actual indirect cost rate X

Budgeted indirect cost rate X

Actual quantities of cost-allo bases

Actual quantities of cost-allo bases

Able to report a job cost as soon as the Have to wait until the end of the year to
job is completed, assuming that both the compute the job cost.
DM and DML costs are also known at
the time of use.

3. Accounting adjustment

Underallocated indirect costs occur when the allocated amount of indirect costs in an accounting
period is less than the actual amount. And vice versa for overallocated indirect costs.

Manufacturing overhead control: the record of actual costs

Manufacturing overhead allocated: the record of budgeted cost based on the basis of the budgeted
rate multiplied by actual quantities of cost driver

A. Adjusted Allocation-rate approach

Restate and recompute using actual statistics.

Although this is a strenuous work, the widespread adoption of computerized accounting systems has
greatly reduced the cost and workload.

This approach yields the benefits of both the timeliness and convinience of normal costing during the
year and the allocation of actual manufacturing overhead costs at year-end.

B. Proration approach (pg. 144 + 158 2 kinds of proration)

More complex compared with the write-off to COGS approach

Appropriate to use when the amount of under- or overallocated is material (significant). In so doing,
this method will bring about more detail and even more accurate statistics

C. Write-off to cost of goods sold approach (pg. 145)

This is the simplest approach among the three

Appropriate to use when the amount of under- or overallocated is immaterial (small).

Many companies normally make use of the combination of the two approaches B&C to yield the
most benefits and accuracy.

Job costing in a service firm?

Very similar to job costing at a manufacturing company

The main difference is that the company is allocating indirect period costs (marketing and customer
service costs) to each client, rather than to manufacturing costs

Since there is no inventory, no journal entries are needed

-----------------------------------Summary Pg. 149

Exercises: 4- 18/ 19/ 34/ 36

CHAP 4: ACTIVITY-BASED COSTING AND AB-MANAGEMENT

1. Simple costing

Broad averaging can lead to undercosting or over costing of products or services. Product
undercosting occurs when a product consumes a high level of resources but is reported to have a low
cost per unit.

Product-cost cross-subsidization means that if a company undercosts one of its products, then it will
overcost at least one of its other products.

2. Refined costing system

A refined costing system reduces the use of broad averages and provides better measurement of the
costs of indirect resources.

Demands for using a refined costing system: 1. Increase in prodcuct diversity

2. Increase in competition
3. Increase in indirect cost

3. Activity-based costing systems

Cost hierarchies:
Output unit-level: costs of activities performed on each individual unit of a product or service
Batch-level: costs of activities related to a group of units of products or services rather than to
each individual unit of product or service
Product-sustaining: costs of activities undertaken to support individual products or services
regardless of the number of units or batches in which the units are produced. Such kinds of cost
are Product Research and Development costs, Marketing costs.
Facility-sustaining: costs of activities that cannot be traced to individual products or services but
that support the organization as a whole. For instance, Administration costs.

ABC system provides more accurate information to make better decisions. But this benefit must be
weighed against the measurement and implementation costs of an ABC system.

4. The use of ABC systems

Pricing and product-mix decisions

Cost reduction and process improvement decisions (idle capacity)

Design decisions

Planning and managing activities (compare and adjust at the end of the year; eliminate non-added
value activities)

5. Activity-based costing system VS Department costing system

Department costing system uses only one cost pool and an appropriate allocation base

Department costing system yields the same information as ABC and should be used only if: (1) a
single activity accounts for a sizeable proportion of the departments costs; (2) significant costs are
incurred on different activities within a department but each activity has the same cost driver and
hence the same cost-allocation base.

6. ABC in Service and Merchandising companies

ABC has many applications in service and merchadising companies. These companies have used
ABC system to identify profitable product mixes, improve efficiency and satisfy customers.

ABC systems should be used for strategic decisions by managers rather than for inventory
evaluation. Therefore, its suitable for service companies which dont have inventory as well.

Services companies find great value from ABC because a vast majority of their cost structure
comprises indirect costs. This kind of system will provide greater insight than the traditional system.

-----------------------------------Summary Pg. 189

Exercises: 5-27/ 31/ 32/ 33/ 37

CHAP 5 COST ALLOCATION: JOINT PRODUCTS AND BYPRODUCTS

1. Basic terms

Joint costs: costs of a production process that yields multiple products simultaneously

Splitoff point: the juncture in a joint production process when two or more products become
seperately indentifiable

Seperable costs: any costs incurred beyond the splitoff point that are assignable to each of the
specific products identified at the splitoff point

Product: describes any output that has a positive total sales value

Main product: a product with high total sales value compared with other products

Joint products: two or more products with high total sales value compared with the rest

Byproducts: products with low total sales value

Distinction among main product, joint products, byproducts are not so definite
The classification can be changed over time
2. Approaches to allocating joint costs

Using market-based data: 1. Sales value at splitoff

2. Net realizable value (NRV)
3. Constant gross-margin percentage NRV

Using physical measures: this is the simplest method yet least accurate. For this method to be
effective, all products must have the same unit measurement and be of the same value which are
unlikely to happen in reality. Besides, byproducts must be excluded from computation because their
low sale revenues will distort the results.

COMPARISONS:

Sales value at splitoff should be used since it provides accurate results costs are allocated in
proportion to sales value of total production. Besides, this method does not require much information
on the processing steps after splitoff; therefore, its pretty simple to conduct. However, were selling
prices for all products at the splitoff point not available, we could not use this approach.

If we cannot use sales value at splitoff method, NRV and constant gross-margin percentage NRV will
be picked as substitutes. Among the two methods left, NRV is more complex yet provides a better
measure of benefits received compared with the constant gross-margin percentage NRV or physical
measure method. Nevertheless, if the profit brought about from the further-processing decision is
large enough, it will distort the results because NRV at splitoff point comprises this amount of profit
(beside the joint cost and profit at stage 1; and we know that the joint cost allocation shall have
nothing to do with profits occurred at the latter stage).

As mentioned above, if the profit at stage 2 is considerable, we should use constant gross-margin
percentage NRV method. However, this approach is not without its problems. This method applies
the assumption that all products have the same ratio of costs (or profit) to sales value. Such a
situation is very uncommon in the real world context.

3. Sell-or-process-further decisions

If (Incremental revenues incremental processing cost) is positive, we should further process the
product.

In making such decision, joint cost is irrelevant because this cost is the same regardless of the sell-orprocess-further decision. Its already occurred; we cannot change this amount whatsoever.

4. Accounting for Byproducts (pg. 611)

COMPARISON between Production method & Sales method. (pg. 612-613)

-----------------------------------Summary Pg. 616

Exercises: 16-16/ 17/ 21/ 23/ 25/ 26/ 30/ 32

CHAP 6: DECISION MAKING AND RELEVANT INFORMATION

1. One-time-only special orders

Absorption-costing basis: both variable and fixed manufacturing costs are included in inventoriable
costs and cost of goods sold (full cost)

We should consider only relevant costs in this case (such as variable cost). All irrelevant costs such
as fixed cost are unchangeable in the short run so we do not count them in costing the order.

Pay attention to total revenues and total costs rather than unit revenue or unit cost to avoid misled
information. For example, the fixed cost is $135,000 whether the company produces 30,000 or
35,000 units. By mentioning a fixed cost of $4.5 per unit would lead to an assumption that the fixed
cost in producing 35,000 units is larger than one in producing 30,000 units.

2. Insourcing VS Outsourcing (Make VS Buy Decision)

Outsourcing: purchasing goods and services from outside vendors

Insourcing: producing the same goods or providing the same services within the organization

Outsourcing is not without risks. A company outsourcing turns out to be dependent on its supplier
and may face lots of uncertainties. To solve the problem, normally a company will enter into longrun contract with its supplier. Intelligent managers build close partnerships or alliances with a few
key suppliers.

Offshoring: outsourcing services to lower-cost countries

Total-alternatives approach VS Opportunity-cost approach (pg. 423): using the former approach
when more than 2 alternatives are being consider simultaneously.

3. Product-mix decisions

Make decisions regarding which products to sell and in what quantities in order to maximize
operating income, given constraints suh as capacity and demand.

Normally, we only produce the minimum required amount of unprofitable products. The rest of the
capacity should be used to produce one with highest contribution margin per unit.

4. Adding or dropping a customer/ department

Information

A customer

A department

Rent

Irrelevant

Relevant

General administration

Irrelevant

Relevant

Corporate-office costs

Irrelevant

Irrelevant

Depreciation

Depreciation cost is irrelevant in deciding whether to drop or a

customer or a department because it is a sunk cost (past cost). But the
cost of purchasing new equipment (when adding a customer or a
department) that will then be written off as depreciation in the future is
relevant.

5. Replacement decisions

Book value: original cost minus accumulated depreciation. Book value is irrelevant in decision
making.

For example, go to pg. 432

Normally, when deciding to keep or replace, managers will focus on their benefits first. For instance,
replacing can be better for the company (from the view of the whole process) but not for the
managers at some point in the future; therefore, they tend to keep instead of replacing (pg. 433). We
call this the problem of inconsistency telling managers to take a multiple-year view in their
decision making but then to judge their performance only on the basis of the current years operating
income.
BEFORE MAKING ANY DECISIONS, CONSIDERING BOTH
THE QUANTITATIVE AND QUALITATIVE FACTORS.

-----------------------------------Summary Pg. 435

Exercises: 11-19/ 21/ 25/ 28/ 31/ 33/ 36/ 39

CHAP 7: MASTER BUDGET AND VARIANCES

1. Basic terms
Strategic plan: expressed through long-run budgets
Operating plan: expressed through short-run budgets
Operating decision: deal with how to best use the limited resources of the organization
Financing decision: deal with how to obtain the funds to acquire those resources
Advantages of budgets:
1. Coordination and communication
2. Framework for judging performance and facilitating learning
3. Motivation
Budgets is not without its problems such as time-consuming and costly.
Budgets should not be implemented rigidly. The usual period for budget is one year yet many firms use
rolling budget (continuous budget).
Sensitivity analysis: a series of what-if questions

CHAP 8: PRICING DECISIONS AND COST MANAGEMENT

1. Major influences on pricing decisions

Customers: affect demand

Competitors

Costs: affect supply

Inelastic demand curve

Elastic demand curve

The curve is steep, which means a large

increase in price just slightly reduce the
demand for the product.

The curve is much flatter, which means a

large increase in price will dramatically
reduce the demand for the product.

In other words, there are not many substitutes

for the product in the market. The power lies
in the hand of the product manufacturer.

We say, the demand for the product is

insensitive to price.

In other words, if the price increases,

customers will switch toward available
substitute products in the market. The
customers hold power in this context.

The demand for the product is sensitive to

price.

2. Short-run pricing

Set price a bit lower than markets bid but still be able to make profit.

Fixed cost remains unchanged in the short-run.

To decide whether to accept a special order or not, we just need to see if the price is larger than the
variable cost. In this case, we accept the order (if we have idle capacity).

3. Long-run pricing

Market-based: if operating in a competitive market

Cost-based: if operating in a less competitive market

Market-based approach

Cost-based approach

The price is determined by the market. We have to

Price = full cost + markup
take the following steps:
The markup rate is based on:
Analyze customers and competitor Set target
Rate of return on investment
price Minus target operating income Come up
with target cost Compare with full cost Do
Alternative cost bases
cost analysis/ Value engineering.

These two approaches are different only at the beginning of the process.

In the end, price based on cost-based approach will be driven by the market forces.

In the final step, we have to reduce cost

incurred by identifying value-added and
nonvalue-added cost. We have to eliminate as
many nonvalue-added cost as possible.
Other terms include: peak-load pricing/
time-and-material method/ grey area/
locked-in cost/ cost incurrence (pg. 464 for
graph)

4. Other considerations

Antitrust laws

Price discrimination: is allowed as long as not hinder competition.

Predatory pricing: reduce price temporarily to kick other competitors out of business.

Dumping: set price lower than the whole market.

Collusive pricing: collude with suppliers to adjust price.

-----------------------------------Summary Pg. 477

Exercises: 12-36