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Sacrificed resource to achieve a specific objective.
cost that has occurred
a predicted cost
anything of interest for which a cost is desired.
Collection of cost data in an organized manner
- general term that includes gathering accumulated costs to a cost object.
- This includes:
- 1. Tracing accumulated costs w/ a direct relationship to the cost object and,
- 2. Allocating accumulated costs w/ an indirect relationship to a cost object.
Direct vs. Indirect
- Direct: can be conveniently and economically traced to a cost object
- Indirect: cannot be conveniently or economically traced to a cost object. These are allocated to a cost object in a rational and systematic manner.
Direct vs. Indirect Costs examples
- Direct costs: Parts, assembly line wages
- Indirect costs: Electricity, rent, property taxes
Cost Behavior: Variable vs. Fixed Costs
Variable Costs: Changes in total in proportion to changes in the related lvl of activity or volume.
Fixed Costs: Remain unchanged in total regardless of changes in the related lvl of activity or volume.
Costs are fixed or variable only w/ respect to a specific activity or a given time period.
Cost Behavior: Variable vs. Fixed based on volume changes
- Variable: constant on a per-unit basis.
- Fixed: change inversely w/ level of production. As more units are produced, the same fixed cost is spread over more and more units.
variable that causally affect costs over a given time.
band of normal activity level in which there is a specific relationship between level of activity and a given cost.
All costs of a product that are considered as assets in the balance sheet when they are incurred and that become COGS only when the product is sold.
- All direct manufacturing Costs
- ie. Prime Cost = Direct Materials + Direct manufacturing labor
all manufacturing costs other than direct material costs
Conversion Costs = Direct manufacturing labor + manufacturing overhead
What is a cost Object?
- Anything for which a separate measurement of a cost is neeeded.
- Example: a product, service, project, customer, activity, department, ect.
Define cost object and give three examples
- Cost Object: Anything for which a separate measurement of costs is desired.
- Examples: product, service, project, customer, brand category, activity, and a department.
Define direct costs and indirect costs
Direct Costs: related to the particular cost object and can be traced to that cost object in an economically feasible (cost effective) way.
Indirect Costs: Are related to the particular costs object but can't be traced to that cost object in a cost effective way.
Why do managers consider direct costs to be more accurate than indirect costs?
Managers believe that direct costs that are traced to a particular cost object are more accurately assigned to that cost object than are indirect allocated costs.
When costs are allocated managers are less certain whether the cost allocation base accurately measures the resources demanded by a cost object.
Managers prefer to use more accurate costs in their decisions.
Name three factors that will affect the classification of a cost as direct or indirect.
- 1. The materiality of the cost in question.
- 2. Available information-gathering technology.
- 3. Design of operations.
Define variable costs and fixed costs - Give an example of each.
Variable Costs: Changes in total in proportion to changes in the related lvl of total activity or volume. Example- sales commission as a % of each sale.
Fixed Cost: Remained unchanged in a total for a given time period, dispite wide changes in the related lvl of total activity of volume. Example: Annual Lease Cost.
What is a cost driver - Give one example
- Cost driver is a variable. Such as the level of activity or volume, that causally affects total costs over a given time span. A change in the cost driver results in a change in the level of total costs.
- Example: Number of vehicles assembled is a driver of the costs of steering wheels on a motor-vehicle assembly line.
What is the relevant Range? What role does it play in explaining how costs behave?
The band of normal activity level or volume in which there is a specific relationship between the lvl of activity or volume and the cost in question.
Costs are described as variable or fixed w/ respect to a particular relevant range.
Explain why units costs must often be interpreted w/ caution.
Unit cost is computed by dividing some amount of total costs by the related number of units. In many cases, the total costs will included a fix cost that will not change despite changes in the number of units.
It is erroneous in those cases to multiply the unit cost by activity/volume change to predict changes in the total costs at different activity or volume levels.
Describe how manufacturing, merchandising, and service-sector companies differ from eachother.
Manufacturing-Sector: purchase materials and convert them into various finished goods.
Merchandising Sector: purchase and then sell tangible products without changing their basic form, for example retailing or distribution.
Service-sector companies provide services or intangible products to their customers, for example, legal advice or audits.
What are three different types of inventory that manufacturing companies hold?
- 1. Direct materials inventory. Direct materials in stock and awaiting use in the manufacturing process.
- 2. Work-in-process inventory. Goods partially worked on but not yet completed. Also called work in progress.
- 3. Finished goods inventory. Goods completed but not yet sold.
Distinguish between inventoriable costs and period costs.
Inventoriable costs are all costs of a product that are considered as assets in the balance sheet when they are incurred and that become cost of goods sold when the product is sold. These costs are included in work-in-process and finished goods inventory (they are “inventoried”) to accumulate the costs of creating these assets.
Period costs are all costs in the income statement other than cost of goods sold. These costs are treated as expenses of the accounting period in which they are incurred because they are expected not to benefit future periods (because there is not sufficient evidence to conclude that such benefit exists). Expensing these costs immediately best matches expenses to revenues.
Direct material Costs vs. direct manufacturing-labor costs vs. Manufacturing over-head costs
Direct material costs are the acquisition costs of all materials that eventually become part of the cost object (work in process and then finished goods), and can be traced to the cost object in an economically feasible way.
Direct manufacturing labor costs include the compensation of all manufacturing labor that can be traced to the cost object (work in process and then finished goods) in an economically feasible way.
Manufacturing overhead costs are all manufacturing costs that are related to the cost object (work in process and then finished goods), but cannot be traced to that cost object in an economically feasible way.
Prime Costs vs. Conversion costs
Prime costs are all direct manufacturing costs (direct material and direct manufacturing labor).
Conversion costs are all manufacturing costs other than direct material costs.
Describe the overtime-premium and idle-time categories of indirect labor.
Overtime premium is the wage rate paid to workers (for both direct labor and indirect labor) in excess of their straight-time wage rates.
Idle time is a subclassification of indirect labor that represents wages paid for unproductive time caused by lack of orders, machine breakdowns, material shortages, poor scheduling, and the like.
Define product costs, and three different purposes for computing product costs.
- A product cost is the sum of the costs assigned to a product for a specific purpose. Purposes for computing a product cost include
- • pricing and product mix decisions,
- • contracting with government agencies, and
- • preparing financial statements for external reporting under generally accepted accounting principles
What are three common features of cost accounting and cost management?
- Three common features of cost accounting and cost management are:
- • calculating the costs of products, services, and other cost objects
- • obtaining information for planning and control and performance evaluation
- • analyzing the relevant information for making decisions
describes the effects that fixed costs have on changes in operating income as changes occur in units sold and CM.
Operating Lev = CM/OI
How can CVP analysis assist managers?
Helps understanding the behavior of a product's or service's total costs, total revenues, and operating income as changes occur in the output level, selling price, variable costs, or fixed costs.
Define CVP analysis
Cost-volume-profit (CVP) analysis examines the behavior of total revenues, total costs, and operating income as changes occur in the units sold, selling price, variable cost per unit, or fixed costs of a product.
The assumptions underlying the CVP analysis outlined in Chapter 3 are:
1. Changes in the level of revenues and costs arise only because of changes in the number of product (or service) units sold.
2. Total costs can be separated into a fixed component that does not vary with the units sold and a variable component that changes with respect to the units sold.
3. When represented graphically, the behaviors of total revenues and total costs are linear (represented as a straight line) in relation to units sold within a relevant range and time period.
4. The selling price, variable cost per unit, and fixed costs are known and constant.
Distinguish between operating income and net income.
Operating income is total revenues from operations for the accounting period minus cost of goods sold and operating costs (excluding income taxes)
Net income is operating income plus nonoperating revenues (such as interest revenue) minus nonoperating costs (such as interest cost) minus income taxes
Define CM, CM per unit, & CM %
Contribution margin is the difference between total revenues and total variable costs.
Contribution margin per unit is the difference between selling price and variable cost per unit.
Contribution-margin percentage is the contribution margin per unit divided by selling price.
Describe three methods that can be used to express CVP Relationships
equation method, the contribution margin method, and the graph method. The first two methods are most useful for analyzing operating income at a few specific levels of sales. The graph method is useful for visualizing the effect of sales on operating income over a wide range of quantities sold
Why is it more accurate to describe the subject matter of this chapter as CVP analysis rather than as breakeven analysis?
Breakeven analysis denotes the study of the breakeven point, which is often only an incidental part of the relationship between cost, volume, and profit. Cost-volume-profit relationship is a more comprehensive term than breakeven analysis.
"CVP analysis is both simple and simplistic. If you want realistic analysis to underpin your decisions, look beyond CVP analysis." - Do you agree? Explain
CVP certainly is simple, with its assumption of output as the only revenue and cost driver, and linear revenue and cost relationships. Whether these assumptions make it simplistic depends on the decision context. In some cases, these assumptions may be sufficiently accurate for CVP to provide useful insights. The examples in Chapter 3 (the software package context in the text and the travel agency example in the Problem for Self-Study) illustrate how CVP can provide such insights. In more complex cases, the basic ideas of simple CVP analysis can be expanded
How does an increase in the income tax rate affect the breakeven point?
An increase in the income tax rate does not affect the breakeven point. Operating income at the breakeven point is zero, and no income taxes are paid at this point.
Describe sensitivity analysis. How has the advent of the electronic spreadsheet affected the use of sensitivity analysis?
Sensitivity analysis is a “what-if” technique that managers use to examine how an outcome will change if the original predicted data are not achieved or if an underlying assumption changes. The advent of the electronic spreadsheet has greatly increased the ability to explore the effect of alternative assumptions at minimal cost. CVP is one of the most widely used software applications in the management accounting area.
Give an example of how a manager can decrease variable costs while increasing fixed costs.
- Examples include:
- Manufacturing––substituting a robotic machine for hourly wage workers.
- Marketing––changing a sales force compensation plan from a percent of sales dollars to a fixed salary.
- Customer service––hiring a subcontractor to do customer repair visits on an annual retainer basis rather than a per-visit basis.
Give an example of how manager can increase variable costs while decreasing fixed costs.
- Examples include:
- Manufacturing––subcontracting a component to a supplier on a per-unit basis to avoid purchasing a machine with a high fixed depreciation cost.
- Marketing––changing a sales compensation plan from a fixed salary to percent of sales dollars basis.
- Customer service––hiring a subcontractor to do customer service on a per-visit basis rather than an annual retainer basis.
What is operating Leverage? How is this helpful to managers?
Operating leverage describes the effects that fixed costs have on changes in operating income as changes occur in units sold, and hence, in contribution margin.
Knowing the degree of operating leverage at a given level of sales helps managers calculate the effect of fluctuations in sales on operating incomes.
"There is no such thing as a fixed cost. All costs can be 'unfixed' given sufficient time." - Do you agree? What is the implication of your answer for CVP analysis?
CVP analysis is always conducted for a specified time horizon. One extreme is a very short-time horizon. For example, some vacation cruises offer deep price discounts for people who offer to take any cruise on a day’s notice. One day prior to a cruise, most costs are fixed. The other extreme is several years. Here, a much higher percentage of total costs typically is variable.
CVP itself is not made any less relevant when the time horizon lengthens. What happens is that many items classified as fixed in the short run may become variable costs with a longer time horizon.
How can a company w/ multiple products compute its breakeven point?
A company with multiple products can compute a breakeven point by assuming there is a constant sales mix of products at different levels of total revenue.
"In CVP analysis, gross margin is a less-useful concept than contribution margin." Do you agree? Explain.
Yes, gross margin calculations emphasize the distinction between manufacturing and nonmanufacturing costs (gross margins are calculated after subtracting variable and fixed manufacturing costs). Contribution margin calculations emphasize the distinction between fixed and variable costs. Hence, contribution margin is a more useful concept than gross margin in CVP analysis
What two assumptions are frequently made when estimating a cost function?
1. Variations in the level of a single activity (the cost driver) explain the variations in the related total costs.
2. Cost behavior is approximated by a linear cost function within the relevant range. A linear cost function is a cost function where, within the relevant range, the graph of total costs versus the level of a single activity forms a straight line.
Describe three alternative linear cost functions.
- 1. Variable cost function––a cost function in which total costs change in proportion to the changes in the level of activity in the relevant range.
- 2. Fixed cost function––a cost function in which total costs do not change with changes in the level of activity in the relevant range.
- 3. Mixed cost function––a cost function that has both variable and fixed elements. Total costs change but not in proportion to the changes in the level of activity in the relevant range.
What is the difference between a linear and nonlinear cost function? Give an example of each type.
A linear cost function is a cost function where, within the relevant range, the graph of total costs versus the level of a single activity related to that cost is a straight line. An example of a linear cost function is a cost function for use of a videoconferencing line where the terms are a fixed charge of $10,000 per year plus a $2 per minute charge for line use.
A nonlinear cost function is a cost function where, within the relevant range, the graph of total costs versus the level of a single activity related to that cost is not a straight line. Examples include economies of scale in advertising where an agency can double the number of advertisements for less than twice the costs, step-cost functions, and learning-curve-based costs.
"High correlation between two variables means that one is the cause and the other is the effect." - Do you agree? Explain.
No. High correlation merely indicates that the two variables move together in the data examined. It is essential also to consider economic plausibility before making inferences about cause and effect. Without any economic plausibility for a relationship, it is less likely that a high level of correlation observed in one set of data will be similarly found in other sets of data.
Name four approaches to estimating a cost function.
- 1. Industrial engineering method.
- 2. Conference method.
- 3. Account analysis method.
- 4. Quantitative analysis of current or past cost relationships.
Describe the conference method for estimating a cost function. What are two advantages of this method?
The conference method estimates cost functions on the basis of analysis and opinions about costs and their drivers gathered from various departments of a company (purchasing, process engineering, manufacturing, employee relations, etc.). Advantages of the conference method include
- 1. The speed with which cost estimates can be developed.
- 2. The pooling of knowledge from experts across functional areas.
- 3. The improved credibility of the cost function to all personnel.
Describe the account analysis method for estimating a cost function.
The account analysis method estimates cost functions by classifying cost accounts in the subsidiary ledger as variable, fixed, or mixed with respect to the identified level of activity. Typically, managers use qualitative, rather than quantitative, analysis when making these cost-classification decisions.
List the six steps in estimating a cost function on the basis of an analysis of a past cost relationship. Which step is typically the most difficult for the cost analyst?
- 1. Choose the dependent variable (the variable to be predicted, which is some type of cost).
- 2. Identify the independent variable or cost driver.
- 3. Collect data on the dependent variable and the cost driver.
- 4. Plot the data.
- 5. Estimate the cost function.
- 6. Evaluate the cost driver of the estimated cost function.
**Step 3 typically is the most difficult for a cost analyst.
When using the high-low method, should you base the high and low observations on the dependent variable or the cost driver?
Causality in a cost function runs from the cost driver to the dependent variable. Thus, choosing the highest observation and the lowest observation of the cost driver is appropriate in the high-low method
Describe three criteria for evaluating cost functions and choosing cost drivers.
- 1. Economic plausibility.
- 2. Goodness of fit.
- 3. Slope of the regression line.
Define learning curve. Outline two models that can be used when incorporating learning into the estimation of cost functions.
A learning curve is a function that measures how labor-hours per unit decline as units of production increase because workers are learning and becoming better at their jobs.
- Two models used to capture different forms of learning are
- 1. Cumulative average-time learning model. The cumulative average time per unit declines by a constant percentage each time the cumulative quantity of units produced doubles.
- 2. Incremental unit-time learning model. The incremental time needed to produce the last unit declines by a constant percentage each time the cumulative quantity of units produced doubles.
Discuss four frequently encountered problems when collecting cost data on variables included in a cost function.
- Frequently encountered problems when collecting cost data on variables included in a cost function are
- 1. The time period used to measure the dependent variable is not properly matched with the time period used to measure the cost driver(s).
- 2. Fixed costs are allocated as if they are variable.
- 3. Data are either not available for all observations or are not uniformly reliable.
- 4. Extreme values of observations occur.
- 5. A homogeneous relationship between the individual cost items in the dependent variable cost pool and the cost driver(s) does not exist.
- 6. The relationship between the cost and the cost driver is not stationary.
- 7. Inflation has occurred in a dependent variable, a cost driver, or both
What are the four key assumptions examined in specification analysis in the case of simple regression?
- 1. Linearity of relationship between the dependent variable and the independent variable within the relevant range.
- 2. Constant variance of residuals for all values of the independent variable.
- 3. Independence of residuals.
- 4. Normal distribution of residuals
"All the independent variables in a cost function estimated w/ regression analysis are cost drivers." - Do you agree? Explain.
No. A cost driver is any factor whose change causes a change in the total cost of a related cost object. A cause-and-effect relationship underlies selection of a cost driver. Some users of regression analysis include numerous independent variables in a regression model in an attempt to maximize goodness of fit, irrespective of the economic plausibility of the independent variables included. Some of the independent variables included may not be cost drivers.
"Multicollinearity exists when the dependent variable and the independent variable are highly correlated." Do you agree? Explain.
No. Multicollinearity exists when two or more independent variables are highly correlated with each other.
Outline the five-step sequence in a decision process.
- 1. Identify the problem and uncertainties
- 2. Obtain information
- 3. Make predictions about the future
- 4. Make decisions by choosing among alternatives
- 5. Implement the decision, evaluate performance, and learn
Define relevant costs. Why are historical costs irrelevant?
- Relevant costs are expected future costs that differ among the alternative courses of action being considered.
- Historical costs are irrelevant because they are past costs and, therefore, cannot differ among alternative future courses of action
"All future costs are relevant." - Do you agree? Explain.
No. Relevant costs are defined as those expected future costs that differ among alternative courses of action being considered. Thus, future costs that do not differ among the alternatives are irrelevant to deciding which alternative to choose
Distinguish between quantitative and qualitative factors in decision making.
Quantitative factors are outcomes that are measured in numerical terms. Some quantitative factors are financial––that is, they can be easily expressed in monetary terms. Direct materials is an example of a quantitative financial factor. Other quantitative nonfinancial factors, such as on-time flight arrivals, cannot be easily expressed in monetary terms.
Qualitative factors are outcomes that are difficult to measure accurately in numerical terms. An example is employee morale.
Describe two potential problems that should be avoided in relevant-cost analysis.
- Two potential problems that should be avoided in relevant cost analysis are
- (i) Do not assume all variable costs are relevant and all fixed costs are irrelevant.
- (ii) Do not use unit-cost data directly. It can mislead decision makers because
- a. it may include irrelevant costs, and
- b. comparisons of unit costs computed at different output levels lead to erroneous conclusions
"Variable costs are always relevant, and fixed costs are always irrelevant." Do you agree? Explain.
No. Some variable costs may not differ among the alternatives under consideration and, hence, will be irrelevant. Some fixed costs may differ among the alternatives and, hence, will be relevant.
"A component part should be purchased whenever the purchase price is less than its total manufacturing cost per unit." Do you agree? Explain
No. Some of the total manufacturing cost per unit of a product may be fixed, and, hence, will not differ between the make and buy alternatives. These fixed costs are irrelevant to the make-or-buy decision. The key comparison is between purchase costs and the costs that will be saved if the company purchases the component parts from outside plus the additional benefits of using the resources freed up in the next best alternative use (opportunity cost). Furthermore, managers should consider nonfinancial factors such as quality and timely delivery when making outsourcing decisions.
Define opportunity cost.
Opportunity cost is the contribution to income that is forgone (rejected) by not using a limited resource in its next-best alternative use.
"Managers should always buy inventory in quantities that result in the lowest purchase cost per unit." - Do you agree? Why?
No. When deciding on the quantity of inventory to buy, managers must consider both the purchase cost per unit and the opportunity cost of funds invested in the inventory. For example, the purchase cost per unit may be low when the quantity of inventory purchased is large, but the benefit of the lower cost may be more than offset by the high opportunity cost of the funds invested in acquiring and holding inventory.
"Management should always maximize sales of the product w/ the highest CM per unit." Do you agree? Why?
No. Managers should aim to get the highest contribution margin per unit of the constraining (that is, scarce, limiting, or critical) factor. The constraining factor is what restricts or limits the production or sale of a given product (for example, availability of machine-hours)
"A branch office or business segment that shows negative operating income should be shut down." Do you agree? Explain.
No. For example, if the revenues that will be lost exceed the costs that will be saved, the branch or business segment should not be shut down. Shutting down will only increase the loss. Allocated costs and fixed costs that will not be saved are irrelevant to the shut-down decision.
"Cost written off as depreciation on equipment already purchased is always irrelevant." Do you agree? Explain.
Cost written off as depreciation is irrelevant when it pertains to a past cost such as equipment already purchased. But the purchase cost of new equipment to be acquired in the future that will then be written off as depreciation is often relevant.
"Managers will always choose the alternative that maximizes operating income or minimizes costs in the decision model." Do you agree? Explain.
No. Managers often favor the alternative that makes their performance look best so they focus on the measures used in the performance-evaluation model. If the performance-evaluation model does not emphasize maximizing operating income or minimizing costs, managers will most likely not choose the alternative that maximizes operating income or minimizes costs.
Describe the three steps in solving a linear programming problem.
- (i) Determine the objective function.
- (ii) Specify the constraints.
- (iii) Compute the optimal solution
How might the optimal solution of a linear programming problem be determined?
- The text outlines two methods of determining the optimal solution to an LP problem:
- (i) Trial-and-error approach
- (ii) Graphic approach
Most LP applications in practice use standard software packages that rely on the simplex method to compute the optimal solution.