Description
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Assignment Question(s): (Marks 15)
Q1. Explain the role of accounting information in strategic management. How does accounting information assist in the formulation and implementation of organizational strategies? Support your answer by providing an example of one Saudi Company in this regard. (2 Marks)
Note: Your answer must include a suitable example showing the role of accounting information in strategic management of an organization. (Chapter 1, Week 1)
Answer:
Q2. What do you mean by cost function and for what purpose does it serve for? What are the various methods used to estimate cost functions? Explain each method with suitable numerical examples. (3 Marks) (Chapter 2, Week 2)
Answer:
Q3. TTL Corporation is in the manufacturer of several plastic products. TTL sells its one of the plastic product for SAR 500. The variable costs per unit are SAR 200, and the total fixed costs are SAR 510,000. Based on cost-volume profit analysis, calculate: (4 Marks)
a)Contribution margin per unit and contribution margin ratio.
b)Break-even point in units and sales SAR.
c)Pretax profit if the company sells 2,200 units.
d)Profit/loss if the company sells 1,500 units.
e)Units needed to reach target pretax profit of SAR 180,000.
f)Sales SAR needed to reach the target pretax profit of SAR 180,000. (Chapter 3, Week 3)
Answer:
Q4. “Job costing is a method of cost accounting used by companies to find out the cost of specific jobs or projects.” Comment on this statement and examine how actual allocation rates and estimated allocation rates are analyzed by the companies? Support your answer with an example of one Saudi company that use job costing. (2 Marks) (Chapter 5, week 4 )
Answer:
Q5. A company uses a process costing system for its sole processing department. There were 4,000 units in beginning WIP inventory for June and 36,000 units were started in June. The beginning WIP units were 60% complete and the 3,250 units in ending WIP were 40% complete. All materials are added at the start of processing. (4 Marks) (Chapter 6 Part 1, Week 5)
Required:
a) Compute the no. of units started & completed.
b) Compute the EUP for DM and CC using FIFO and WA methods.
Answer:
Unformatted Attachment Preview
Cost Management
Measuring, Monitoring, and Motivating Performance
Chapter 1
The Role of Accounting Information in
Management Decision Making
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 1
Chapter 1: The Role of Accounting Information in
Management Decision Making
Learning objectives
Q1 – What is the process of strategic management and
decision making?
Q2 – What types of control systems do managers use?
Q3 – What is the role of accounting information in strategic
management?
Q4 – What information is relevant for decision making?
Q5 – How does business risk affect management decision
making?
Q6 – How do biases affect management decision making?
Q7 – How can managers make higher-quality decisions?
Q8 – What is ethical decision making, and why is it
important?
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 2
Q1: Organizational Vision and Core Competencies
• The organizational vision is the core purpose and
ideology of the organization.
• Determining the organizational vision precedes all
other management decision making.
• Management must also isolate the organization’s
core competencies – its strengths relative to
competitors.
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 3
Q1: Organizational Vision and Core Competencies
Organizational
Vision
The organizational vision and the
core competencies are closely
related.
The organization’s strengths
should help shape the vision.
Core
Competencies
The vision should help locate the
organization’s strengths.
If you were starting an accounting practice, what would be your
organizational vision?
What do you think would be your core competencies?
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 4
Q1: Organizational Strategies
Organizational
Vision & Core
Competencies
Organizational strategies are the tactics
that managers use to work toward the
organizational vision while taking
advantage of the core competencies.
These strategies are long-term in nature.
Organizational
Strategies
Examples include organization structure,
financial structure, and long-term
resource allocation strategies.
If you were starting an accounting practice, what would be some of your
organizational strategies?
How do these work toward your organizational vision?
How do they take advantage of your core competencies?
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 5
Q1: Operating Plans
Organizational
Strategies
Operating
Plans
Operating plans are the short-term
implementations of the organizational
strategies.
Operating plans usually include
budgeted goals for revenues and
expenses.
Examples include schedules for
employees and procedures for daily
relationship management decisions
with suppliers.
If you were starting an accounting practice, what would be some of your
operating plans?
How do these relate to your organizational strategies?
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 6
Q1: Actual Operations
Actual operations are the actions
taken and the results achieved.
Operating
Plans
Actual
Operations
The organization’s information
system measures the results of
actual operations.
Examples include number of units
sold, advertising expense, and the
wage expense for the period.
If you had an accounting practice, what would information would you
want to collect about the results of your actual operations?
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 7
Q1: Monitoring and Motivating Performance
Actual
Operations
Organizational
Vision & Core
Competencies
Managers use the results of actual
operations to monitor performance and
ensure that it is in line with the
organizational vision.
Managers may find that the results of
actual operations make them re-think the
organizational vision or their view of the
organization’s core competencies.
If you had an accounting practice, can you think of an example of a
measure of actual operations and how you would use it to motivate
performance?
Can you think of an example of a measure of actual operations that
might make you redefine your organizational vision or your view of your
core competencies?
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 8
Q2: Management Control Systems
• Belief Systems
– Vision, Mission, Core Values Statements
• Boundary Systems
– Code of Conduct, Procedure Manuals, Compliance
Actions
• Diagnostic Control Systems
– Measure, monitor, and motivate employees against
preset goals
• Interactive Control Systems
– Recurring information and reports to evaluate
performance and direct actions
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 9
Q3: Financial, Managerial, and Cost Accounting
Financial accounting
prepares reports most
frequently used by decision
makers external to the
organization.
Managerial accounting
prepares reports most
frequently used by decision
makers internal to the
organization.
Cost accounting includes both financial and nonfinancial
information and is used for both financial and managerial
accounting.
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 10
Q3: Strategic Cost Management
and the Balanced Scorecard
• Strategic cost management is an approach to
reducing costs while strengthening the
organization’s strategic position.
• The balanced scorecard can be used to formalize
strategic cost management efforts by detailing
financial and nonfinancial benchmarks for all
segments of the organization.
• Examples of such benchmarks include:
• Personnel can reduce costs by completing all hiring within 20
days of initial interview.
• Production can reduce costs and improve quality if Engineering
can reduce the number of processes in the production process.
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 11
Q4: What Information is Relevant
for Decision Making?
• Information is relevant if:
• Differs across the alternatives, and
• Is about the future.
• Relevant information can be quantitative or
qualitative
• Information is irrelevant if:
• Does not vary with the option chosen or action taken
Irrelevant information is NOT useful in
decision making!
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 12
Q4: Relevant Cash Flows
• Relevant cash flows are future cash flows that
differ across the alternatives.
• also called incremental cash flows
• also called avoidable cash flows
• Irrelevant cash flows are:
• non-incremental and unavoidable cash flows
• do not vary among alternatives
• Must look at the cash flow relevance to the
decision being made
• Electricity costs are relevant to the decision to open a
business or not
• Electricity costs are not relevant in the decision to
lease or buy a building for your business
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 13
Q4: What Information is Relevant
for Decision Making?
You have a small computer repair company and are deciding whether to
replace your old copy machine or repair it. In the list of information
below, identify which data are relevant to this decision and which are
irrelevant.
• The purchase price of the copy machine was $1200.
• The repair costs are $320.
• The copy machine can make 20 copies per minute.
• If you repair it, the machine will use less toner than it does now.
• You make approximately 1000 copies per month.
• The repair won’t fix the broken stapler.
• The repair carries a one-year warranty.
• The copy machine was a gift from your spouse.
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 14
Q4: Relevance of Income Statement Information
• Income Statements include:
– Period costs
– Product costs (recorded as cost of goods sold)
• Many business decisions require the incremental
cost to produce a unit
• Cost per unit on the income statement includes
both fixed and variable costs
• Including fixed costs does not represent the true
incremental cost of a unit
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 15
Q5: Impact of Business Risk on Decision Making
• Business Risk is the possibility an event will occur
and interfere with the organization’s strategic goals
Economic &
Financial
People,
Legal &
Health
Political and
Social
Reputation
Weather
Criminal and
Terrorist
Informational
&
Operational
Environment
& Man Made
• The existence of business risk can cloud
management’s decision making process
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 16
Q6: Uncertainties, Biases, and Decision Quality
• Uncertainties are issues and information about
which there is doubt.
• Biases are preconceived notions adopted without
careful thought.
• Decision quality refers to the characteristics of a
decision that affect the likelihood of achieving a
positive outcome.
• Both uncertainty and bias reduce decision quality.
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 17
Q6: Uncertainties and Biases in Information
• Uncertainties come from many sources and can be
exogenous or endogenous.
• The future is always uncertain.
• Managers may be uncertain that the right information
was captured in a report.
• Biases can come from many sources.
• The decision maker may be biased towards or against a
particular alternative (predisposition bias)
• The methods used to collect information could have
introduced bias (information bias)
• The decision maker may exercise an error in judgment or
processing information (cognitive bias)
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 18
Q6: Motorola’s Iridium Project
• How did uncertainties and bias effect Motorola’s
decision making process?
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 19
Q6: Uncertainties, Biases, and Decision Quality
Lori loves to sew and has always made her own clothes. People often
tell her that she is the best-dressed person they’ve ever met. She can
design and sew a lovely outfit in under 2 days. She is considering
opening a store that could sell her home-made fashions. Then she could
combine her work with her hobby.
Can you identify some of the uncertainties Lori faces? Can you think of
any way she can reduce some of these uncertainties?
Can you identify any possible personal biases that Lori may have? How
could these affect her decision making process?
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 20
Q7: Characteristics of Higher-Quality Decisions
Higher quality decisions come from a
higher quality decision making process.
Such a process is thorough, unbiased,
focused, strategic, creative, and visionary.
This process requires reports that are
relevant, understandable, and available.
These reports must contain information
that is more certain, complete, relevant,
timely and valuable.
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 21
Q8: Components of Ethical Decision Making
Identify
ethical
problems as
they arise
© John Wiley & Sons, 2011
Consider the
well being of
others and
society
Clarify and
apply ethical
values
Continuously
improve your
personal
ethics
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 22
Q8: The IMA’s Code of Ethics
• The Institute of Management Accountants (IMA)
has a Code of Ethics that states that IMA
members have a responsibility to:
• maintain an appropriate level of professional competence
and perform their professional duties in accordance with
laws, regulations, and standards;
• refrain from disclosing confidential information (unless
legally obligated), or using (or even appearing to use)
confidential information to illegal advantage;
• avoid actual and apparent conflicts of interest; and
• communicate information fairly and objectively, and disclose
all relevant information to decision makers.
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 23
Q8: Ethical Decision Making
Suppose you work for the Lee K. Fawcett Plumbing Company as Mr.
Fawcett’s administrative assistant. Recently Mr. Fawcett asked you to
type some financial statements from his hand-written notes so that he
can take them to the bank as part of a loan application.
This exercise seems odd to you because the company’s CPA recently
delivered the monthly financial statements that she prepares.
While typing the financial statements you notice that the building the
company rents is listed as an asset. Also, you write checks each month
for the monthly payments on two car loans, and these are not listed as
liabilities.
Do you have an ethical dilemma? Discuss your approach to handling
this situation.
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 24
Appendix: Steps for
Better Thinking
Steps for Better
Thinking is a
process to help
address openended questions.
Open-ended
questions have no
single correct
solution; managers
must seek the best
solution.
© John Wiley & Sons, 2011
(c) 2002.Information
C. L. Lynch, in
S. Management
K. Wolcott, andDecision
G. E. Huber,
“Steps for Better Thinking: A
Chapter 1: The RoleSource:
of Accounting
Making
Developmental
Problem-Solving
Process” (August
5, 2002).
Eldenburg
& Wolcott’s
Cost Management,
1e
Slide # 25
Appendix: Steps for Better Thinking – Foundation
(Knowing)
• Foundation level skills include a knowledge of the
terminology and basic concepts that are relevant
to the decision at hand.
• An individual with Foundation level skills can:
• perform calculations to arrive at correct answer
• define terms in his/her own words
• describe a concept
• list the elements contained in a concept or
process
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 26
Appendix: Steps for Better Thinking – Identifying
• Step 1 skills include the ability to identify relevant
information and uncertainties.
• An individual with Step 1 skills can:
• create a list of issues related to the decision
• sort information that is relevant
• identify the reasons for the underlying
uncertainties
• perform research to obtain input into the
decision
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 27
Appendix: Steps for Better Thinking – Exploring
• Step 2 skills include the ability to explore
interpretations of the information and connections
between alternative solutions approaches.
• An individual with Step 2 skills can:
• recognize and control for his/her own biases
• articulate assumptions and reasoning
associated with alternative points of view
• organize information in meaningful ways to
encompass problem complexities
• compare and contrast different approaches to
a problem’s solutions
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 28
Appendix: Steps for Better Thinking – Prioritizing
• Step 3 skills include the ability to prioritize
alternatives, come to a decision, and implement
the decision.
• An individual with Step 3 skills can:
• develop guidelines for prioritizing alternatives
• prioritize alternatives after objective analysis
• communicate findings in a manner appropriate
to the audience
• describe how the solution or decision might
change if priorities change
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 29
Appendix: Steps for Better Thinking – Envisioning
• Step 4 skills include the ability to monitor the
decision and innovate new strategies to modify
the decision when circumstances change.
• An individual with Step 4 skills can:
• explain the limitations of the decision made
• establish a plan for monitoring the performance
of the decision
• explain how conditions may change in the
future and how this may change the decision
© John Wiley & Sons, 2011
Chapter 1: The Role of Accounting Information in Management Decision Making
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 30
Cost Management
Measuring, Monitoring, and Motivating Performance
Chapter 2
The Cost Function
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 1
Chapter 2: The Cost Function
Learning objectives
•
Q1: What are the different ways to describe cost behavior?
•
Q2: What process is used to estimate future costs?
•
Q3: How are engineered estimates, account analysis, and
two-point methods used to estimate cost functions?
•
Q4: How does a scatter plot assist with categorizing a cost?
•
Q5: How is regression analysis used to estimate a cost
function?
•
Q6: How are cost estimates used in decision making?
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 2
Q1: Different Ways to Describe Costs
• Costs can be defined by how they relate to a cost
object, which is defined as any thing or activity for
which we measure costs.
• Costs can also be categorized as to how they are
used in decision making.
• Costs can also be distinguished by the way they
change as activity or volume levels change.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 3
Q1: Assigning Costs to a Cost Object
Cost Assignment
Determining the costs that should attach to a cost object is
called cost assignment.
cost tracing
Direct
Costs
Cost
Object
Indirect
Costs
Direct costs are
easily traced to the
cost object.
Indirect costs are
not easily traced to
the cost object, and
must be allocated.
cost allocation
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 4
Q1: Direct and Indirect Costs
• In manufacturing:
• all materials costs that are easily traced to the product are called
direct material costs
• all labor costs that are easily traced to the product are called direct
labor costs
• all other production costs are called overhead costs
• Whether or not a cost is a direct cost depends upon:
• the definition of the cost object
• the precision of the bookkeeping system that tracks costs
• the technology available to capture cost information
• whether the benefits of tracking the cost as direct exceed the
resources expended to track the cost
• the nature of the operations that produce the product or service
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 5
Q1: Linear Cost Behavior Terminology
• Total fixed costs are costs that do not change (in
total) as activity levels change.
• Total variable costs are costs that increase (in total)
in proportion to the increase in activity levels.
• Total costs equal total fixed costs plus total variable
costs.
• The relevant range is the span of activity levels for
which the cost behavior patterns hold.
• A cost driver is a measure of activity or volume
level; increases in a cost driver cause total costs to
increase.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 6
Q1: Behavior of Total (Linear) Costs
$
Total Costs
If costs are linear, then total costs
graphically look like this.
Cost Driver
$
Total Fixed Costs
Total fixed costs do not change as the cost
driver increases.
Higher total fixed costs are higher above
the x axis.
Cost Driver
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 7
Q1: Behavior of Total (Linear) Costs
$
Total Costs
If costs are linear, then total costs
graphically look like this.
Cost Driver
$
Total Variable Costs
Total variable costs increase as the cost
driver increases.
A steeper slope represents higher variable
costs per unit of the cost driver.
Cost Driver
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 8
Q1: Total Versus Per-unit (Average) Cost Behavior
$
Total Variable Costs
If total variable costs look
like this . . .
slope = $m/unit
Cost Driver
$/unit
Per-Unit Variable Costs
. . . then variable costs per
unit look like this.
m
Cost Driver
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 9
Q1: Total Versus Per-Unit (Average) Cost Behavior
$
Total Fixed Costs
If total fixed costs look
like this . . .
Cost Driver
$/unit
Per-Unit Fixed Costs
. . . then fixed costs per
unit look like this.
Cost Driver
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 10
Q1: Total Versus Per-Unit (Average) Cost Behavior
Lari’s Leather produces customized motorcycle jackets. The leather for
one jacket costs $50, and Lari rents a shop for $450/month. Compute the
total costs per month and the average cost per jacket if she made only
one jacket per month. What if she made 10 jackets per month?
Average variable costs are constant
1 Jacket Total variable costs go up 10 Jackets
Total Average
Costs/ Cost/
Month Jacket
Total Average
Costs/ Cost/
Month Jacket
Leather
$50
$50
Leather
$500
$50
Rent
$450
$450
Rent
$450
$45
Total
$500
$500
Total
$950
$95
Total fixed costs are constant
© John Wiley & Sons, 2011
Average fixed costs go down
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 11
Q1: The Cost Function
When costs are linear, the cost function is:
TC = F + V x Q, where
F = total fixed cost, V = variable cost per unit of the cost
driver, and Q = the quantity of the cost driver.
$
Total Costs
The intercept is the total fixed cost.
The slope is the variable cost per
unit of the cost driver.
slope = $V/unit of cost driver
F
Cost Driver
© John Wiley & Sons, 2011
A cost that includes a fixed cost
element and a variable cost
element is known as a mixed cost.
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 12
Q1: Nonlinear Cost Behavior
Sometimes nonlinear costs exhibit linear cost behavior over a
range of the cost driver. This is the relevant range of activity.
intercept = total fixed costs
Total
Costs
slope = variable cost per
unit of cost driver
Cost Driver
Relevant Range
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 13
Q1: Stepwise Linear Cost Behavior
Some costs are fixed at one level for one range of activity and
fixed at another level for another range of activity. These are
known as stepwise linear costs.
Total Supervisor Salaries Cost in $1000s
Example: A production
supervisor makes
$40,000 per year and
the factory can produce
100,000 units annually
for each 8-hour shift it
operates.
120
80
40
100
200
300
Number of units produced, in 1000s
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 14
Q1: Piecewise Linear Cost Behavior
Some variable costs per unit are constant at one level for one
range of activity and constant at another level for another
range of activity. These are known as piecewise linear costs.
Total Materials Costs
slope=
$9/gallon
slope=
$7.50/gallon
slope=
$8/gallon
1000
© John Wiley & Sons, 2011
Example: A supplier
sells us raw materials
at $9/gallon for the first
1000 gallons, $8/gallon
for the second 1000
gallons, and at
$7.50/gallon for all
gallons purchased over
2000 gallons.
2000
Gallons purchased
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 15
Q1: Cost Terms for Decision Making
• In Chapter 1 we learned the distinction between
relevant and irrelevant cash flows.
• Opportunity costs are the benefits of an alternative
one gives up when that alternative is not chosen.
• Opportunity costs are difficult to measure because they
are associated with something that did not occur.
• Opportunity costs are always relevant in decision
making.
• Sunk costs are costs that were incurred in the past.
• Sunk costs are never relevant for decision making.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 16
Q1: Cost Terms for Decision Making
• Discretionary costs are periodic costs incurred for
activities that management may or may not
determine are worthwhile.
• These costs may be variable or fixed costs.
• Discretionary costs are relevant for decision making
only if they vary across the alternatives under
consideration.
• Marginal cost is the incremental cost of producing
the next unit.
• When costs are linear and the level of activity is within
the relevant range, marginal cost is the same as
variable cost per unit.
• Marginal costs are often relevant in decision making.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 17
Q2: What Process is Used to Estimate
Future Costs?
Past costs are often used to estimate future,
non-discretionary, costs. In these instances,
one must also consider:
• whether the past costs are relevant to the
decision at hand
• whether the future cost behavior is likely to
mimic the past cost behavior
• whether the past fixed and variable cost
estimates are likely to hold in the future
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 18
Q3: Engineered Estimates of Cost Functions
• Use accountants, engineers, employees, and/or
consultants to analyze the resources used in the
activities required to complete a product, service,
or process.
• For example, a company making inflatable rubber
kayaks would estimate some of the following:
• the amount and cost of the rubber required
• the amount and cost of labor required in the cutting department
•
•
•
•
the amount and cost of labor required in the assembly department
overhead costs and the best cost allocation base to use
the selling costs, including commissions and advertising
the distribution costs
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 19
Q3: Account Analysis Method of
Estimating a Cost Function
• Review past costs in the general ledger and past
activity levels to determine each cost’s past
behavior.
• For example, a company producing clay wine
goblets might review its records and find:
• the cost of clay is piecewise linear with respect to the number of
pounds of clay purchased
• skilled production labor is variable with respect to the number of
goblets produced
• unskilled production labor is mixed, and the variable portion varies
with respect to the number of times the kiln is operated
• production supervisors’ salary costs are stepwise linear
• distribution costs are mixed, with the variable portion dependent
upon the number of retailers ordering goblets
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 20
Q3: Example – Account Analysis Method of
Estimating a Cost Function
•The table on the right
contains the
expenditures for Scott
Manufacturing during the
last year.
•100,000 units were
produced and sold
•$500,000 of sales
revenue was recorded
Required:
1. Determine the cost
function using units
produced as the
driver
2. Repeat using sales
dollars as the driver
© John Wiley & Sons, 2011
Expense
Amount
Direct Materials
$500,000
Direct Labor
300,000
Rent
25,000
Insurance
15,000
Commissions
200,000
Property Tax
20,000
Telephone
10,000
Depreciation
85,000
Power & Light
30,000
Admin Salaries
100,000
Total
1,285,000
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Variable
Fixed
Slide # 21
Q3: Example – Account Analysis Method of
Estimating a Cost Function
• Steps in estimating a cost function using account
analysis
– Separate fixed and variable costs
– Total the fixed costs
– Total the variable costs
– Calculate a variable cost per driver
– Write out the cost function
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 22
Q3: Solution – Account Analysis Method of
Estimating a Cost Function
Expense
Amount
Variable
Direct Materials
$500,000
500,000
Direct Labor
300,000
300,000
Rent
25,000
25,000
Insurance
15,000
15,000
Commissions
200,000
Property Tax
20,000
Cost Function on Dollars:
20,000
Telephone
10,000
10,000
TC = FC + VC/Sales $ * Sales $
Depreciation
85,000
TC = $285,000 + ($0.20) * Sales $
85,000
Power & Light
30,000
30,000
Admin Salaries
100,000
100,000
Total
1,285,000
1,000,000 285,000
© John Wiley & Sons, 2011
Fixed
Cost Function on Units:
TC = FC + VC/Unit * Qty
TC = $285,000 + ($10/unit) * Qty
200,000
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 23
Q3: Two-Point Method of
Estimating a Cost Function
• Use the information contained in two past
observations of cost and activity to separate
mixed and variable costs.
• It is much easier and less costly to use than the
account analysis or engineered estimate of cost
methods, but:
• it estimates only mixed cost functions,
• it is not very accurate, and
• it can grossly misrepresent costs if the data points
come from different relevant ranges of activity
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 24
Q3: Example – Two-Point Method of
Estimating a Cost Function
In July the Gibson Co. incurred total overhead costs of $58,000 and
made 6,200 units. In December it produced 3,200 units and total
overhead costs were $40,000. What are the total fixed factory costs per
month and average variable factory costs?
We first need to determine V, using the equation for the slope of a line.
$
rise/run = $58,000 – $40,000
6,200 – 3,200 units
= $18,000/3,000 units
= $6/unit
Then, using TC = F + V x Q, and one
of the data points, determine F.
$58,000
$58,000 = F + $6/unit x 6,200 units
$40,000
$58,000 = F + $37,200
$20,800
$20,800 = F
3,200
© John Wiley & Sons, 2011
6,200
Units
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 25
Q3: High-Low Method of
Estimating a Cost Function
• The high-low method is a two-point method
• the two data points used to estimate costs are
observations with the highest and the lowest
activity levels
• The extreme points for activity levels may not
be representative of costs in the relevant
range
• this method may underestimate total fixed costs
and overestimate variable costs per unit,
• or vice versa.
© John Wiley & Sons, 2011
Chapter 2: The Cost Function
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 26
Q4: How Does a Scatterplot
Assist with Categorizing a Cost?
• A scatterplot shows cost observations plotted
against levels of a possible cost driver.
• A scatterplot can assist in determining:
• which cost driver might be the best for
analyzing total costs, and
• the cost behavior of the cost against the
potential cost driver.
© John Wiley & Sons,
