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Understand what a master budget is and explain its benefits
Describe the advantages of budgets
Prepare the operating budget and its supporting schedules
Use computer-based financial planning models in sensitivity analysis
Explain kaizen budgeting and how it is used for cost management
Prepare an activity-based budget
Describe responsibility centers and responsibility accounting
Explain how controllability relates to responsibility accounting

Chapter 6 describes a major feature of management planning and control systems, budgets. The
importance of satisfying customers and succeeding in the marketplace compels the use of a common
accounting tool for planning and controlling, budgeting. As noted in the chapter, Few businesses plan to
fail, but many of those that flop, failed to plan. The chapter describes how budgeting is used in
implementing plans developed through strategic planning, assisting managers in their planning function.
Chapter 7 will describe how budgets aid managers in their control function. The wise and skillful
administration of the budget is what gives budgets value because budgets, in themselves, are neither good
nor bad.
The report models used in budgeting are familiar, as they are the basic financial statements. The
statements are approached from a different perspective, as typically projected sales are the starting point
for preparing a budget. In costing systems studied in the previous two chapters, sales are the result of
operations rather than the beginning consideration. Preparation of an operating budget is illustrated. Cash
budgeting, a part of financial budgeting, is illustrated in the appendix to the chapter.
The theme of continuous improvement is featured through a description of kaizen budgeting. For
organizations that use activity-based costing and activity-based management, activity-based budgeting
works back through the activity-based costing system using the s ame defined activities and relationships.
Responsibility accounting is introduced as a means of coordinating the efforts of all employees in an
organization to attain the goals described in the master budget. The notion of controllability is addressed.

The chapter closes with a crucial aspect of budgeting the human factor. The importance of the role of
people in the budgeting process is acknowledged throughout the chapter.

Budgeting common accounting tool companies use for planning and controlling to satisfy
customers and succeed in the marketplace
Budgets and the budgeting cycle
Budgetsassisting managers in their planning function
Quantitative expression of a proposed plan of action by management for a specified period
An aid to coordinating what needs to be done to implement that plan
Budgeting cycle: guide to well-managed organizations {thought process/decision making}
Planning the performance of company as a whole as well as subunits: management at all levels
agree on what is expected
Providing a frame of reference, a set of specific expectations for use in comparing actual results
Investigating variations from plans: makes possible corrective action after investigation
Planning again in light of feedback and changing conditions
Terms used
Learning Objective 1:
Understand what a master budget is and explain its benefits
Master budget
Summarizes financial projections of all of companys budgets and plans
Expresses managements operating and financing plans with formalized outline of financial
objectives and how to attain
iii. Provides a tool that is neither good nor bad, but valuable when administered skillfully

Pro forma statements: term used for budgeted financial statements

Do multiple choice 1 and 2.

Assign Problem 6-31.

Learning Objective 2:
Describe the advantages of budgets
Advantages and benefits of budgeting: big part of most management control systems
(Prepared when expected benefits exceed expected costs)

Compels strategic planning and implementation of plans

Considers strategy questions integral to companys strategic analysis
Effects both long-run and short-run planning
Provides feedback that can signal revisions to plan and possibly strategies
Provides framework for judging performance
Can overcome limitation of using past results that incorporate miscues and substandard
Can overcome limitation of using past performance when future conditions may be expected to
differ from the past
Motivates managers and employees
Individuals likely to work more intensely to avoid failure than to achieve success

A little anxiety improves performance

Promotes coordination and communication among subunits within the company

Need to think of relationships among individual operations, departments, company as a whole, and across

companies during budgeting process as well as production process for satisfying customers

Need to have goals understood and accepted by all employees

Administration of budgets [Surveys of Company Practice]

Benefits of budgeting comes when management at all levels of company understand and
support the budget and all aspects of management control system
Top management support critical for obtaining active line-management participation
Attainment of budget should not be an end in itself
Time coverage of budgets
Purpose of budget should guide time period chosen
Ongoing coverage through use of rolling budget
Do multiple choice 3.

Assign Exercise 6-16.

The master budget

Financial budget: includes capital expenditures, cash, balance sheet, and cash flows
Learning Objective 3:
Prepare the operating budget and its supporting schedules

Steps in developing an operating budget: budgeted income statement and its supporting budget
schedules [Exhibit 6-2]
Step 1: Prepare the revenues budget: usual starting point in budgeting
Step 2: Prepare the production budget (in units)
Step 3: Prepare the direct materials usage and purchases budgets
Step 4: Prepare the direct manufacturing labor budget
Step 5: Prepare the manufacturing overhead budget
Step 6: Prepare the ending inventories budget
Step 7: Prepare the cost of goods sold budget
Step 8: Prepare the nonmanufacturing costs budget
Step 9: Prepare the budgeted income statement [Exhibit 6-3] [Concepts in Action]
Do multiple choice 4 and 5.

Assign Exercises 6-17 through 6-19 and Problems 6-30 and 6-34.

Learning Objective 4:
Use computer-based financial planning models in sensitivity analysis
Computer-based financial planning models assist in sensitivity analysis
Do multiple choice 6.

Assign Problem 6-29.

Variations [Exhibit 6-4]

Learning Objective 5:
Explain kaizen budgeting and how it is used for cost management
Kaizen budgeting: based on idea it is possible to continuously reduce costs over time
Do multiple choice 7.

Assign Exercise 6-25 (a continuation of 6-24and of 5-24).

Learning Objective 6:
Prepare an activity-based budget
Activity-based budgeting: focuses on budgeted costs of activities needed to produce and sell
products and servicesemphasizes future costs and future use of activity areas
Do multiple choice 8.

Assign Exercise 6-24 (see 5-24).

Learning Objective 7:
Describe responsibility centers and responsibility accounting
Responsibility accounting: system that measures the plans and actions of each responsibility center
Structure of organization shapes efforts of coordinationassigning responsibility to managers
who are accountable for actions in planning and controlling human and physical resources
Organization structure: an arrangement of lines of responsibility within the organization

Responsibility center: part , segment, or subunit of an organization whose manager is accountable for
a specified set of activities
Cost center manager accountable for costs only
Revenue center manager accountable for revenues only
Profit center manager accountable for revenues and costs

Investment center manager accountable for investments, revenues, and costs

Responsibility accounting: system that measures plans by budgets and actions by actual results of
each responsibility center
Feedback, use of variancesearly warning, performance evaluation, and evaluating strategy
Do multiple choice 9.

Assign Exercises 6-25 and 6-26 and Problem 6-29.

Learning Objective 8:
Explain how controllability relates to responsibility accounting
Controllability: degree of influence that a specific manager has over costs, revenues, and related items
for which responsible
Difficult to pinpoint
Few costs clearly under influence of one manager
b. Long enough time span, all costs come under somebody s control
Emphasis on information and behavior
Responsibility focuses on whom to ask to obtain information, not on whom to blame
Performance reports may include uncontrollable items because could change behavior in
directions top management desire
Do multiple choice 10.

Assign Problem 6-32.

Human aspects of budgetinghuman factors are a crucial part of budgeting

Cash budgeting [appendix]
Do multiple choice 11 and 12. Assign Exercise 6-27 and Problem 6-35.



2.a 3.b 4.d 5.c 6.b 7.c 8.a 9.d 10.b 11.c 12.b

Budgeting is the common accounting tool companies use for planning and controlling. Budgets
provide a measure of planned financial results.
focus managers energies on exploiting opportunities.
help managers anticipate potential problems.
enable managers to control through a set of specific activities with defined corrective actions.
[AICPA Adapted] Dewitt Co. budgeted its activity for October 2002 from the following information:

Sales are budgeted at $750,000. All sales are credit sales and a provision for doubtful accounts is made
monthly at the rate of 2% of sales.
Merchandise inventory was $120,000 at September 30, 2002, and an increase of $10,000 is
planned for the month.
All merchandise is marked up to sell at invoice cost plus 50%.
Estimated cash disbursements for selling and administrative expenses for the month are
Depreciation for the month is projected at $25,000.
Dewitt is projecting operating income for October 2002 in the amount of
a. $105,000.

b. $119,000.

c. $129,000.

d. $230,000.

Which of the following is not a major benefit of budgets?

compels planning
eliminates innovation

c. provides performance criteria

d. promotes coordination and communication

The following data apply to questions 4 and 5.

Hester Company budgets on an annual basis for its fiscal year. The following beginning and
ending inventory levels (in units) are planned for the fiscal year of July 1, 2001, through June 30, 2002.
July 1, 2001
June 30, 2002
Raw material
Work in process
Finished goods
1 Three (3) units of raw material are needed to produce each unit of finished product.
[CMA Adapted] If Hester Company plans to sell 500,000 units during the 2001-2002 fiscal year,
the number of units it would have to manufacture during the year would be
a. 505,000 units.

b. 500,000 units.

c. 480,000 units.

d. 475,000 units.

5. [CMA Adapted] If 450,000 finished units were to be manufactured during the 2001-2002 fiscal year
by Hester Company, the units of raw material needed to be purchased would be
a. 1,350,000 units.

b. 1,360,000 units.

c. 1,320,000 units.

d. 1,330,000 units.

Which of the following does not pertain to financial planning models in software form?

Reduces computational burden and time required to prepare budgets

Eliminates need to update budgets as uncertainty resolved
Assists managers with sensitivity analysis
Performs calculations that are mathematical representations of relationships in master budget
The major cost management concept used in kaizen budgeting is that of
eliminating inventories of every type but materials.
refinements in the indirect-cost categories for costing systems.
continuous improvement.
sensitivity analysis using computer-based financial planning models.
Activity-based budgeting for a setup activity would require budgeting costs
separately for the setup activity.
for the department in which the setup activity would occur.

on a per unit basis for the number of units involved in the setup.
separately for variable and fixed categories for the setup activity.
Which of the following statements does not describe responsibility accounting?
It measures the plans and actions of each responsibility center.
It budgets to emphasize that for which each responsibility center is accountable.
It calculates variances between budgeted and actual for each responsibility center.
It identifies managers at fault for operating problems by reports for each responsibility center.
The important question to ask in explaining how controllability relates to responsibility
accounting is:
Whom to blame?
Whom to

c. Whom to hold responsible?

d. Who has control?

The following data apply to questions 11 and 12 [Appendix]:

Information pertaining to Brenton Corporation's sales revenue is presented in the following table:

Cash sales
Credit sales
Total sales







Management estimates that 5% of credit sales are not collectible. Of the credit sales that are collectible,
60% are collected in the month of sale and the remainder in the month following the sale. Cost of
purchases of inventory each month are 70% of the next month's projected total sales. All purchases of
inventory are on account; 25% are paid in the month of purchase, and the remainder is paid in the month
following the purchase.

[CMA Adapted] Brenton's budgeted total cash receipts in April are

a. $448,000.


b. $437,000.

c. $431,600.

d. $328,000.

[CMA Adapted] Brenton's budgeted total cash payments in March for inventory purchases are
a. $385,000.

b. $358,750.

c. $306,250.

d. $ 280,000.

Understand what a master budget is and explain its benefits

Describe the evolution of a management control system, including how budgets became
a major feature of that system. In a small, new organization, personal observation is usually the
dominant means of control. A manager sees, touches, and hears the relationship between inputs and
outputs; he or she oversees the work and actions of various personnel.
Over time, managers add historical records to their personal observations. Historical records allow
managers to compare current performance with past performance. How well were customer needs
satisfied in the current year compared with last year? Analyses of past performance can help improve
future performance. Managers must deal with a series of periods, not just one at a time.

As the organization matures, budgeting becomes an important step in the growth and improvement of the
accounting system. A manager would find it helpful to compare actual performance in the current year
with the plans prepared for the current year. Budgeting systems help promote this future perspective.
Describe the advantages of budgets

If budgeting is filling in the financial statements with what-if numbers, why is

budgeting considered such a major task and so important to an organization? The
mechanics of preparing a budget may seem simplistic. What lies behind the numbers is of consequence.
A budget is similar to a blueprint. Before the process of drawing out the blueprints for a building or piece
of equipment, many factors have to be considered. Of particular importance for a company are the
objectives and the strategy to accomplish those. If the objectives are clear and the strategy determined,
people must make it happen over a period of time in a variety of environments. And even the nicest of
blueprints must give way to events and unforeseen circumstances. Blueprints, as initially developed, do
not often become floor plans. For who would not want to take advantage of having better materials used
or a slightly different design if the opportunity arose. An ancient proverb expresses some of the problem
in developing a budget, Many a slip twixt cup and lip. It is not possible to plan for everything, and yet
the process of budgeting requires thinking about most things and incorporating all possibilities to the
extent they are cost/beneficial.
Computers have decreased the importance of technical number-crunching skills, allowing the focus to
shift to strategy and the human aspects of budgeting.
Prepare the operating budget and its supporting schedules

Why is budgeting described as an accounting tool? Accounting is the language of business. A

language has conventions and structure that enable communication to take place. Budgets are a proposed
plan of action by management for a future time period for the business or organization as a whole. To
communicate ideas and criteria throughout the organization, language is necessary. Accounting provides
that communication toollanguage. The advantages that budgets provide are those typical of a language.
The advantage of putting ideas into concrete plans, of expressing expectations into performance criteria,
and of making aspirations into common goals and objectives.
Accounting provides key information to managers for the purpose of making decisions.
Information is provided by means of language. Accounting is the language of business, using
both financial and nonfinancial terms.
Use computer-based financial planning models in sensitivity analysis

Sensitivity analysis was discussed in earlier chapters. How are these references
related? Sensitivity analysis was discussed in Chapter 3 for cost-volume-profit analysis. The technique
of examining how a result will change if the original predicted data are not achieved or if underlying
assumptions change is pervasive in costing systems. Except for actual costing systems, estimates or
assumptions are an integral aspect of the system.
Chapter 6 uses financial accounting statements, including the absorption costing income statement, as the
basis of developing the operating and production budgets rather than the variable costing approach to the
income statement. As part of sensitivity analysis one could examine the what-if of using different
methods to report information. For example, in problem 6-30 in the text Thingone and Thingtwo are
products produced in greater quantity than expected sales. An income statement prepared using
absorption costing will differ from one prepared using variable costing. Would a manager make a
different decision if using one type rather than the other? Which is right? Sensitivity analysis can include
being sensitive to the methods used as well as predicted data and model assumptions.

Explain kaizen budgeting and its importance for cost management

Everyone should use kaizen budgeting because the objective of continuous improvement is
important to every organization. Why isnt kaizen budgeting considered the basic approach to
preparing a budget? Budgets, by their very nature of compelling planning, require thinking toward

improvement. Kaizen is a specific budgetary approach that explicitly incorporates continuous

improvement. Because of its explicit nature, to be used appropriately and properly, kaizen budgeting
would have to be learned. The cost-benefit guideline recognizes that learning is a cost. Not all
organizations would benefit more than the cost of learning the specific method of kaizen and applying
that particular type of budgeting.
As with activity-based costing or other approaches that would change the way in which a company
accounted for its operations, an organization would need to consider costs compared to benefits before
attempting implementation. If a companys strategy and overall objectives would be better served by the
use of a particular approach, typically the benefits would outweigh the costs over a period of time. The
strategy is primary; the specific accounting approaches to helping managers administer and coordinate
activities must reflect that strategy.
Prepare an activity-based budget

Arent activity-based costing and activity-based management enough without adding

activity-based budgeting too? Refer to Learning Objective 1 for description of the evolution of a
management control system. The text notes in the section on activity-based budgeting that the domain of
activity-based costing is the reporting and analysis of past and current costs. A natural extension is to use
an activity-based approach in the budgeting of future costs within an activity-based costing system. This
is an example of a management control system evolving.
Describe responsibility centers and responsibility accounting

How does the saying, The whole is more than the sum of its parts, apply to
responsibility accounting? Requiring budgets and reports from individual units within the
larger organization provides information useful for the whole. In preparing budgets, each unit
must consider its role in the larger organization and work toward coordinating efforts for
achieving company goals as well as individual goals. With the requirement of reporting activities
by individual unit, individual feedback can be linked with other units for comparison and
evaluation. Careful and wise selection of individual units can result in more effort toward
achieving the organizations goals, better information for making decisions, and more useful
performance reports. With each individual unit working to achieve its own objectives and those
of the overall organization, more can be accomplished. Energy to the organization is lost if one
group is working in a way that is counterproductive to the whole. Responsible accounting or
reporting can contribute to identifying such behavior.
Explain how controllability relates to responsibility accounting

How can it possibly be advantageous to an organization to hold a person

responsible for things beyond her/his control? The idea of holding a person responsible
for costs or revenues for which s/he has little or no control can be used to promote certain types
of behavior, for eliciting information, and to broaden perspective. The concept of what is
controllable changes with time and circumstance. To hold no one controllable is probably to
have no control. To overemphasize controllability could lead to undesirable behavior that would
not promote the interests of the company as a whole.

Worksheet for Computing Units

Production & Direct Materials Purchases
(With no change in Work-in-Process Inventory amount from beginning to ending)

Finished Goods Inventory: units

Direct Materials Inventory: units



+ Production ____________


+ Purchase


DM units

for sale

to FG units

for use


Goods sold


FG units to
DM units
Units used




Distinguish a static budget from a flexible budget
Develop a flexible budget and compute flexible-budget variances and sales-volume variances
Explain why standard costs are often used in variance analysis
Compute price variances and efficiency variances for direct-cost categories
Explain why purchasing performance measures should focus on more factors than just price variances
Integrate continuous improvement into variance analysis
Perform variance analysis in activity-based costing systems
Describe benchmarking and how it can be used in cost management

Chapter 7 illustrates specific tools used by accountants for providing managers information for improved
decision making. The tool developed from the assumptions and use of cost behavior in relation to volume
found in cost-volume-profit analysis is that of the flexible budget. Having the ability to compare what
actually happened with what should have happened furnishes the accountant with another helpful tool,
variance analysis. As illustrated in the chapter, the calculation of a variance is the process of closely
examining the details of the static budget, that one point ideal or bulls eye, with the point of actual
impact (dart thrown at the bulls eye) by use of multiple flexible budgets acting as concentric rings
emanating from the ideal. By increasing the level of detail, more opportunity exists for comparison and
more levels of variance calculation.
In the previous chapter, the emphasis was on the planning aspect of budgeting. This chapter incorporates
the control aspect of the study of budgeting. Control, as defined in Chapter 1, comprises (a) taking
actions that implement the planning decisions, and (b) deciding how to evaluate performance and what
feedback to provide that will help future decision making. Thus the action taken with actual results are
compared to planned or budgeted amounts for control purposes. Of special interest is the use of flexible
budgets and variance analysis in performance measurement and evaluation as an aspect of control.
Caution is always necessary when evaluating the performance of individuals. In keeping with the key
management accounting guideline of behavior consideration, the authors highlight that the important task
is to understand why variances arise and to use that knowledge to promote learning and continuous


Budgetsaiding managers in their control functions [Chapter 6 Budgetsassisting managers in their

planning function]
Variances: differences between amount based on actual result and amount supposed to be according to
budget amount
Management by exception: practice of concentrating on areas not operating as expected and
giving less attention to areas operating as expected
Performance evaluation use

Strategy changes possible

Learning Objective 1:
Distinguish a static budget from a flexible budget
Static budgets and flexible budgets
Static budget: budget for a single planned output level at the start of the budget period
Flexible budget: adjusted (flexed) to recognize actual output level of budget period and help managers
gain more insight into causes of variances than available from static budgets
Static budget variances: difference between actual result and corresponding amount in static budget
[Exhibits 7-1and 7-4]
Various levels of detail reported [Levels 0 3 in this chapter with 0 as least detail]
Level 0 Static-budget variance: static budget to actual resultsoperating income only
Level 1 Static-budget variance: static budget to actual results by line items
Variance designations in reference to operating income
Favorable variance: effect of increasing operating income relative to budgeted amount
Unfavorable variance: effect of decreasing operating income relative to budgeted amount
Do multiple choice 1.

Assign Exercise 7-16.

Learning Objective 2:
Develop a flexible budget and compute flexible-budget variances and sales-volume variances
Steps in developing a flexible budget
Assumption: all costs either variable with respect to output unit produced or fixed
Three-step procedure [Exhibit 7-2]
Identify the actual quantity of output

Calculate the flexible budget for revenues based on budgeted selling price and actual quantity of output
Calculate the flexible budget for costs based on budgeted variable costs per output unit, actual quantity of
output, and the budgeted fixed costs
Level 2Variances [Exhibit 7-4]
Difference due to inaccurate forecasting of output units sold
Sales-volume variance: difference caused solely by difference in volume sold and volume expected to be
sold in static budgethence the name
Variance calculated because budget developed based on volume soldflexible budget
Response to variance influenced by presumed cause of variance

Difference due to companys performance

Flexible-budget variance: difference between actual results and flexible-budget amounts

Selling-price variance: solely pertains to revenues (selling priceactual to budgeted)
Variance analysis: provides suggestions for further investigation not evidence of good or bad performance
Do multiple choice 2 and 3.

Assign Exercises 7-17, 7-23, and 7-24.

Level 3Variances for direct cost inputs

Sources of information for budgeted input prices and quantities
Actual input data from past periods
Data from other companies that have similar processes
Learning Objective 3:
Explain why standard costs are often used in variance analysis
Standards developed by company [Surveys of Company Practice]
Standard: carefully predetermined price, cost, or quantity based on efficient operations and usually
expressed on a per unit basis
Standard input: carefully predetermined quantity of inputs required for one unit of output
Standard price: carefully determined price expected to pay for a unit of input
Standard cost: carefully predetermined cost of a unit of output
Standard can be used to obtain budgeted amounts but budget is broader term

Standards can be set as attainable through efficient operations or as ideal or theoretical

Do multiple choice 4.

[See next section for assignment using standards.]

Learning Objective 4:
Compute price variances and efficiency variances for direct-cost categories
TEACHING TIP: See note at end of this Outline section before Chapter Quiz Solutions.

Price variance [Exhibits 7-3 and 7-4]

Difference between the actual price and the budgeted price multiplied by actual quantity of input
Also known as input-price variance or rate variance
Response to variance influenced by presumed cause of variance [Concepts in Action]
Efficiency variance [Exhibits 7-3 and 7-4]
Difference between actual quantity of input used and budgeted quantity of input that should have been
used to produce the actual output, multiplied by the budgeted price
Also known as usage variance
Response to variance influenced by presumed cause of variance [Concepts in Action]
Impact of inventories on calculation of variances
Variance analysis concepts apply whether quantities are purchased and used within the same period or
quantities purchased differ from those used within the same period
Computation and interpretation of variances may differ if quantities purchased differ from quantities used
within the same time period [Exhibit 7-6]
Do multiple choice 5 and 6.

Assign Exercises 7-19 and 7-20 and Problems 7-36, 7-37, 7-39, 7-40.

Learning Objective 5:
Explain why purchasing performance measures should focus on more factors than just price variances
Managerial uses of variances
Performance measurement using variances
Two attributes of performance commonly measured
Effectiveness: the degree to which a predetermined objective or target is met
Efficiency: the relative amount of inputs used to achieve a given level of output
Caution: Understand the cause(s) of a variance before using it as a performance measure
Focus should be on reducing the total costs of the company as a whole

Excessive emphasis on a single performance measure may conflict with achievement of overall company
Multiple causes of variances and organizational learning
Always consider possible interdependencies among variances; do not interpret them in isolation of each
Use broad perspective of actions taken in the supply chain of organizations (supply chain: flow of goods,
services, and information from purchase of materials to delivery of products to consumers regardless of
whether those activities occur in same organizations or other organizations)
Focus on understanding why variances arise and how to use that understanding to learn and improve
performance most important task in variance analysis
Delicately balance two uses of variances: performance evaluation and organization learning
Use cost-benefit test to decide when and which variances should be investigated
Realize that the standard is a range of possible acceptable outcomes
Do multiple choice 7.

Assign Problem 7-34 .

Learning Objective 6:
Integrate continuous improvement into variance analysis
Continuous improvement
Use of continuous improvement budgeted cost : cost that is progressively reduced over succeeding time
Use of varied rates for products that have just started to those in production for several years
Financial and nonfinancial performance measures
Standard costing
Journal entries for use with standard costs
Unfavorable cost variances always debits (reduce operating income) and favorable cost variances always
credits (increase operating income)
Simplified product costing as actual costs do not have to be tracked
Variances isolated at earliest possible time
Variances written off or dealt with as described in Chapter 4
Standard costing and information technology: facilitates usage

Wide applicability of standard costing systems with other systems by use for control of costs

Do multiple choice 8.

Assign Exercises 7-27, 7-28, 7-29, 7-30, and 7-31.

Learning Objective 7:
Perform variance analysis in activity-based costing
Flexible budgeting and activity-based costing
Focus on individual activities as the fundamental cost objects
Classification of costs into cost hierarchy
Output-unit level costs: direct costs of materials and manufacturing labor
Batch-level costs: illustrated with material-handling costs
Step 1: Using the budgeted batch size, calculate the number of batches in which the actual output units
should have been produced
Step 2: Using the budgeted material-handling labor-hours per batch, calculate the number of materialhandling labor-hours that should have been used
Step 3: Using the budgeted cost per material-handling labor-hour, calculate the flexible-budget amount
for material-handling labor-hours
Examine price and efficiency components of flexible-budget variance
Product-sustaining costs: focus flexible-budget on costs at that level
Facility-sustaining costs: focus flexible-budget on costs at that level
Do multiple choice 9.

Assign Problems 7-41 and 7-42.

Learning Objective 8:
Describe benchmarking and how it can be used in cost management
Benchmarking and variance analysis [Exhibit 7-5]
Benchmarking: continuous process of comparing the level of performance in producing products and
services and doing activities against the best levels of performance
Problem of ensuring comparability between organization and chosen benchmark
Problems of ensuring benchmark numbers are comparable


Problems of nonfinancial comparisons and need to consider differences

Value of management accountants in providing insight into why costs or revenues differ across companies
or plants as opposed to simply reporting magnitude of such differences
Do multiple choice 10.

Assign Exercises 7-25 and 7-26.

TEACHING TIP: The columnar approach to variance analysis seems easier for most students to
understand because it is so easy to see or visualize. As one works from actual results to planned
amounts based on actual level of output, one works with one change at a time. The item that changes
from one column to the next is the name of the variance in most cases. For example, using Level 3
variances of price and efficiency, the columns are headed

Price variance

SIQ (allowed for actual output) x BP

Efficiency variance

If the price varies from AP (actual price) to BP (budgeted price that may be the standard price if
budgeting was done using standard prices), then the input quantity must stay the same, AIQ. The same
holds true for the change of input quantity in which the price must stay the same (BP).
Students will often be confused by the two actual quantities of which one is an input actual quantity of
direct materials purchased/used or direct manufacturing labor hours. The other actual quantity is an
output quantity used for the allowed quantity of input. The difference in an item of direct material and an
item of finished goods the start and end of the conversion process. Flexible budgets can be developed
after the fact and therefore use actual output quantity as a basis. Sometimes it is helpful to incorporate
the journal entries (illustrated in the chapter) with the variance analysis. The amounts for the journal
entries can be noted as AIQ x BP for purchases of direct materials, debited to Direct Materials Inventory
with a corresponding credit to Accounts Payable of AIQ x AP.
Also note the purchase-price variance for direct materials used in the Self-Study Problem for the chapter.
The middle column if simply labeled Actual Input x Budgeted Price because actual input can be either
actual input quantity purchased or actual input quantity used (Exhibit 7-6).




3.a 4.b 5.c

6.d 7.a 8.c

9.a 10.d

[CMA Adapted] Flexible budgets

accommodate changes in the inflation rate.
accommodate changes in activity levels.
are used to evaluate capacity utilization.
are static budgets that have been revised for changes in prices.
[CMA Adapted} The following information is available for the Gabriel Products Company for the month
of July:
Static Budget
Sales revenue
Variable manufacturing costs
Fixed manufacturing costs
Variable marketing and administrative expense
Fixed marketing and administrative expense



The total sales-volume variance for the month of July would be

a. $2,550 unfavorable.

b. $1,350 unfavorable.

c. $700 favorable.

d. $100 favorable.

[CMA Adapted] Bartholomew Corporations master budget calls for the production of 6,000 units of
product monthly. The master budget includes indirect labor of $396,000 annually; Bartholomew
considers indirect labor to be a variable cost. During the month of September, 5,600 units of product
were produced, and indirect labor costs of $30,970 were incurred. A performance report utilizing flexible
budgeting would report a flexible budget variance for indirect labor of
a. $170 unfavorable. b. $170 favorable.

c. $2,030 unfavorable.

d. $2,030 favorable.

Which of the following is not an advantage for using standard costs for variance analysis?
Standards simplify product costing.
Standards are developed using past costs and are available at a relatively low cost.
Standards are usually expressed on a per unit basis.
Standards can take into account expected changes planned to occur in the budgeted period.
Information on Pruitt Companys direct-material costs for the month of July 2003 was as follows:
Actual quantity purchased
30,000 units
Actual unit purchase price
Materials purchase-price variance
unfavorable (based on purchases)
Standard quantity allowed for actual production
24,000 units
Actual quantity used
22,000 units
[CPA Adapted] For July 2003 there was a favorable direct-materials efficiency variance of
a. $7,950.
b. $5,5 00.
c. $5,400.
d. $5,600.
Information for Garner Companys direct-labor costs for the month of September 2003 is as follows:
Actual direct-labor hours
Standard direct-labor hours
Total direct-labor payroll
Direct-labor efficiency variancefavorable

34,500 hours
35,000 hours
$ 3,200

[CPA Adapted] What is Garners direct-labor price (or rate) variance?

a. $21,000 favorable b. $21,000 unfavorable c. $17,250 unfavorable d. $20,700 unfavorable
Performance evaluation using variance analysis should guard against
emphasis on a single performance measure.
emphasis on total company objectives.
basing effect of a managers action on total costs of the company as a whole.
highlighting individual aspects of performance.
Which of the following statements does not describe continuous improvement?
Continuous improvement can be readily incorporated into budgets.
A product may have higher budgeted improvement rates during initial production than the budgeted
improvement rates for products that have been manufactured for longer periods.
A company using continuous improvement is signaling that it is in trouble because of its costs.

Variances and flexible budgets can be used to measure performance such as continuous improvement.
The basic principles and concepts of variance analysis can be applied to activity-based costing
by application as to the levels of cost hierarchy.
through careful classification of costs as direct and indirect as applied to the product or job.
with use of standard costing systems only.
only through those activities related to individual units of product or service.
Benchmarking is
relatively easy to do with the amount of available financial information about companies.
best done with the best in their field regardless of type of company.
simply reporting the magnitude of differences in costs or revenues across companies.
making comparisons to direct attention to why differences in costs exist across companies.

Distinguish a static budget from a flexible budget

How is the preparation of a flexible budget like a parent or coach instructing a child?
Flexible budgets are usually prepared after the fact or when the actual results are known. In this way,
the preparation of a flexible budget is based upon the oughts and shoulds of how something could
have happened. Many times one instructs another person by comparing what did happen with what could
have happened by using the phrase You ought to have . . . or You should have . . . done such-andsuch.
The static budget is the plan that is used to develop a flexible budget so the actual results are
appropriately compared to a budget based upon the same level of performance. When a student or child
has done something (actual behavior), then the coach or parent can specifically instruct for the situation in
point (desired behavior).
Develop a flexible budget and compute flexible-budget variances and sales-volume variances

What is the flex in a flexible budget? The budgeted selling price and budgeted variable costs that
stay the same per unit (within the relevant range) are used to configure the flexible budget. The fixed
costs stay the same in total in each flexible budget as they are in the static budget (relevant range). The
assumptions and concepts of cost-volume-profit analysis are used in the developing of budgets at any
given level of output or saleswithin the relevant range. The use of the cost behavior based upon
variable and fixed in relation to volume has enabled accountants to provide managers with useful
information for controlling as well as planning.
Explain why standard costs are often used in variance analysis

The text notes that standards are developed using engineering studies . . .
based on work performed by a skilled operator using equipment operating in an
efficient manner. What is some of the history of these engineering studies? With
the greater use of machines for manufacturing in the late 1800s, some industrialists searched for the best
way to do a job. Much of the work was repetitive and could be learned by most people. The idea of
using a best way to do most jobs became the basis of standards in manufacturing. Frederick W. Taylor
was perhaps the most well-known of the promoters of scientific management during the last of the
nineteenth century and into the twentieth century.

A humorous account of a couple known as efficiency experts, Frank and Lillian Gilbreth, industrial
engineers who performed time-and-motion studies for large corporations, is in the book, Cheaper by the
Dozen, written by two of their twelve children. Stories of how their father used his ideas of the most
efficient method of accomplishing a task are quite entertaining as well as providing insight into the times
when companies were looking to science, specifically engineering, to lead the way in production
Compute price variances and efficiency variances for direct cost-categories

Why use the actual input quantity for calculating the price variance? Some could argue that
the use of the actual input quantity rather than the quantity allowed for actual output for calculating the
price variance does include an element of efficiency as well as price difference. The following graph may
be used to explain a combined price-efficiency variance. The following standards exist: $5.00 per pound
of material and 40,000 pounds allowed for actual output produced. The actual amounts were $5.40 per
pound paid and 50,000 pounds of material used [The calculation of the purchase-price variance for
materials eliminates this combined variance for materials. A purchase-price variance, of course, cannot be
calculated for direct manufacturing labor because the purchase and use of labor cannot be separated.]
Total price variance: $16,000 + $4,000 = $20,000 U
Pure price variance
($0.40 x 40,000 = $16,000 U)
Combined price-efficiency variance
($0.40 x 10,000 = $4,000 U)


Efficiency variance
(10,000 x $5 = $50,000 U)

40,000 50,000
Quantity in pounds
Explain why purchasing performance measures should focus on more factors than just price variances

Explain the benefit of using the value-chain concept when using variance analysis as a
basis for performance evaluations. Production is an integral part of a larger operation as
characterized by the value-chain concept. The understanding that the whole of the company is greater
than the sum of its parts is necessary for realizing that any decision made about one aspect of the
companys operations will impact another aspect of the company. The explanation is given in the text to
support the idea that sometimes increasing costs in one aspect of operations will reduce overall costs in
the other parts of the company. The opposite can also be truereducing costs in one area can increase
costs in several other areas. To achieve the overall best for the company, these interactions must be
considered. Top management must take the lead in emphasizing achievement of total organizational
objectives rather than a piecemeal approach.

Integrate continuous improvement into variance analysis

What other variances can be used (other than those described in the text) in the quest
for continuous improvement? Variances can be calculated for any aspect of a job or task in which
some preplanning or forward thinking has been done. Variances can be financial or nonfinancial.
Variances measure a difference. As an organization seeks continuous improvement, they may wish to
examine ways to develop more comparisons by subjecting activities to predetermined levels of
achievement. Areas for further investigation, and therefore improvement, could be in orders shipped by
comparing jobs produced and shipped to jobs produced and not shipped. An interesting article about the
use of standard costs is Redesigning Cost Systems: Is Standard Costing Obsolete? by Carole B.
Cheatham and Leo R. Cheatham, Accounting Horizons, (December 1996) pp. 23-31.
Perform variance analysis in activity-based costing systems

Using the three steps illustrated for developing a flexible budget for batch-level costs,
describe developing a flexible budget for either product-sustaining costs or facilitysustaining costs. Some possible candidates of each type are given in Chapter 5 in the
Plastim example. For product-sustaining costs in the Plastim example, design costs are noted. The
desi gn costs are dependent upon the time spent by designers on designing and modifying the product,
mold, and process. Aspects of the design and modification process are noted as a measure of the number
of parts in the mold multiplied by the square feet area over which the molten plastic must flow. Using
predetermined number of parts and/or square feet compared to actual results would be a basis for
calculation of a variance. Price and quantity are two common elements in most measures.
Describe benchmarking and how it can be used in cost management

What is the origin of the term benchmark? The term bench mark is used in the work of
surveying. A mark with known precision as to elevation, latitude, and longitude is made by a surveyor on
a permanent landmark to serve as a reference point in making maps or determining other altitudes in the
surrounding area.

Excel spreadsheet for variance analysis-insert here


Anderson, Industrial Benchmarking for Competitive Advantage, Human Systems Management (1999)
p.287 [10p].
Cheatham, C. and Cheatham, L., Redesigning Cost Systems: Is Standard Costing Obsolete? Accounting
Horizons (December 1996) p.23 [7p].
Dervitsiotis, K., Benchmarking and Business Paradigm Shifts, Total Quality Management (July 2000)
p.S641 [6p].
Johnson, D. and Sopariwala, P., Standard Costing Is Alive and Well at Parker Brass, Management
Accounting Quarterly (Winter 2000) p.12 [9p].
Lapide, L., New Developments in Business Forecasting, Journal of Business Forecasting Methods and
Systems (Summer 2001) p.13 [3p].
Palmer, R. & Green, L., ITT Automotive North America: A Case Study Requiring Use of Benchmarking,
Activity/Process Analysis, Issues in Accounting Education (August 1999) p.465 [32p].
Sen, P., Another Look at Cost Variance Investigation, Issues in Accounting Education (February 1998)
p.127 [8p].
Stammerjohn, W., Better Information through the Marriage of ABC and Traditional Standard Costing
Techniques, Management Accounting Quarterly (Fall 2001) p.15 [7p].
Wing, K., Using Enhanced Cost Models in Variance Analysis for Better Control and Decision Making,
Management Accounting Quarterly (Winter 2000) p.27 [9p].
Yarrow, D., Mitchell, E. & Robson, A., The Hidden Factory: The Naked Truth about Excellence in the
Real World, Total Quality Management (July 2000) p.S439 [9p].



Explain the two assumptions frequently used in cost-behavior estimation
Describe linear cost functions and three common ways in which they behave
Understand various approaches to cost estimation
Outline six steps in estimating a cost function on the basis of past cost relationships
Describe three criteria used to evaluate and choose cost drivers
Explain and give examples of nonlinear cost functions
Distinguish the cumulative average-time learning model from the incremental unit-time learning
Be aware of data problems encountered in estimating cost functions

Chapter 10 provides additional tools to those introduced in Chapter 3 for using cost-volume-profit
analysis so important to planning and control decisions made by managers. CVP analysis uses costs
categorized by behavior, variable or fixed, in relation to a cost driver. Recognizing that some costs
display behavior that does not fit either category, the concepts and tools presented here enable one to sort
a mixed or semivariable cost into component parts of variable and fixed. The process of identifying and
measuring costs as variable or fixed based on past relationships is called cost estimation. Cost estimation
is useful for cost prediction in the decision-making process.
Basic assumptions for cost estimation are carefully described. Approaches to the process of identifying
and measuring costs using a cost function are explained. The analytical basis of the process of cost
estimation is illustrated in step form. Criteria for evaluation of the relationship between a cost and a level
of activity, the cost driver, as developed from the cost estimation process are presented. One of the more
troublesome aspects of cost estimation, data problems, is described with specific illustrations. Some
possible steps to overcome these problems are included.
The appendix to the chapter contains a detailed explanation of one of the approaches to estimating a cost
function, regression analysis. A simpler quantitative approach, high-low method, is illustrated within the
main body of the chapter.
Themes carried through the text are integral to the chapter material: accounting systems that provide
useful information to managers for improved decision making, cost/benefit analysis, behavioral and
technological considerations, and different costs for different purposes.

General issues in estimating cost functions
Learning Objective 1:
Explain the two assumptions frequently used in cost-behavior estimation
Basic assumptions
Changes in total costs can be explained by changes in the level of a single activity
Learning Objective 2:
Describe linear cost functions and three common ways in which they behave
Cost behavior can adequately be approximated by a linear function of the activity level within
the relevant range
Cost function: mathematical expression of how a cost changes with changes in the level of an activity
relating to that cost
b. Linear cost function: y = a + bXthe graph of total cost versus the level of a single activity related
to that cost is a straight line within the relevant range (y is the total cost or intercept)
Examples of alternative cost functions [Exhibit 10-1]
Variable cost: y = bX when b is variable cost per unit (slope coefficient) and X is number of units
(independent variable)
Fixed cost: y = a when a is the amount of fixed cost in total (constant)
Mixed or semivariable cost: y = a + bX
Do multiple choice 1.

Assign Exercises 10-18 and 10-19.

Criteria for classifying a cost into its variable and fixed components
Choice of cost object: cost item may be variable with respect to one cost object but fixed with respect
to another cost object
Time horizon: more costs are variable with longer time span
Relevant range: costs may behave nonlinearly outside relevant range [Exhibit 10-2]
Cause-and-effect criterion in choosing cost drivers [Surveys of Company Practice]
Cost estimation: attempt to measure a past relationship based on data from past costs and the related
level of an activity
Cause-and-effect relationship important for cost prediction and cost management
Physical relationship between the level of activity and the costs

Contractual arrangement
Implication of logic and knowledge of operations
Cautionhigh correlation exists in cause-and-effect relationship but high correlation does not mean a
cause-and-effect relationship exists between two variables
Learning Objective 3:
Understand various approaches to cost estimation
Cost estimation approaches that may be used in combination
Industrial engineering method or work-measurement method
Analyzes the relationship between inputs and outputs in physical terms
Inputs and outputs may be difficult to specify, may be time-consuming and very costly
Conference method
Analyzes using opinions about costs and their drivers from groups within the company
Pooling of expert knowledge gives credibility but dependent upon care and skill of people
providing input
Account analysis method
Analyzes using qualitative rather than quantitative approach to classify cost accounts in the ledger as
variable, fixed, or mixed with respect to the identified level of activity
Thorough knowledge of operations necessary; more credible if supplemented by conference
Quantitative analysis methods [Exhibit 10-3]
Analyzes using formal mathematical methods to fit cost functions to past data observations
Systematic model approach
Do multiple choice 2.

Assign Exercises 10-20 and 10-21.

Learning Objective 4:
Outline six steps in estimating a cost function on the basis of past cost relationships
Steps in estimating a cost function using quantitative analysis
Choose the dependent variable depends upon the purpose for estimating a cost function
Identify the independent variable or cost driver: measurable with economically plausible relationship
with the dependent variable

Collect data on the dependent variable and the cost driver

Plot the data [Exhibit 10-4]
Estimate the cost function [Exhibits 10-5 and 10-6]
High-low method: simplest method that defines lines connecting two points
Do multiple choice 3.

Assign Exercises 10-16, 17, 22, and 23 and Problem 10-29.

b. Regression analysis method: statistical method that uses all available data
Do multiple choice 4 and 5.

Assign Exercises 10-24 and 10-25 and Problem 10-30.

Learning Objective 5:
Describe three criteria used to evaluate and choose cost drivers
Evaluate cost driver of the estimated cost function [Exhibits 10-7 and 10-8]
Economic plausibility
Goodness of fit
Significance of independent variable: steep slope, stronger relationship; flat slope, weak relationship
Cost drivers and activity-based costing [Concepts in Action]
Great number and variety of cost drivers and cost pools
Careful attention to cost hierarchy for each cost pool
Cost drivers evaluated using criteria described above
Do multiple choice 6.

Assign Exercise 10-26, Problems 10-31 and10-32.

Other issues in determining how costs behave

Learning Objective 6:
Explain and give examples of nonlinear cost functions
Nonlinearity and cost functions
Economies of scale (quantity discounts) [Exhibit 10-9]
Step cost function: cost increases by discrete amounts as level of activity changes
Learning Objective 7:
Distinguish the cumulative average-time learning model from the incremental unit-time learning model

Learning curves; experience curves

Cumulative average-time learning model [Exhibits 10-10 and 10-11]
Incremental unit-time learning model [Exhibits 10-12, 10-13, and 10-14]
Do multiple choice 7, 8, and 9.

Assign Exercises 10-27 and 10-28, Problems 10-33 and 10-34.

Data collection and adjustment issues

Ideal database
Numerous reliably measured observations of the cost driver (independent variable) and the
costs (dependent variable)
b. Many values spanning a wide range for the cost driver
Learning Objective 8:
Be aware of data problems encountered in estimating cost functions
Frequently encountered problems and steps to overcome them
Differing time periods used for measuring dependent variable and cost driver use accrual
accounting to measure consumption for better matching
Misrepresenting fixed costs as unit costs rather than total costs distinguish carefully between
cost behaviors
Missing data design data collection reports that regularly and routinely obtain the required
data; immediately follow up whenever missing data
Extreme values of observations adjust or eliminate unusual observations before estimating a
cost relationship
Lack of homogeneous relationship between cost items in pool and cost driver (estimate separately
for each activity)
Unstable relationship over time pool data to form a single cost relationship
Effects of inflation remove purely inflationary price effects from data
Do multiple choice 10.
Appendix: Regression analysis



2.c 3.d 4.b 5.d 6.c

7.c 8.a 9.b 10.a

A mixed cost function has a constant component of $20,000. If the total cost is $60,000 and the
independent variable has the value 200, what is the value of the slope coefficient?
a. $200

b. $400

c. $600

d. $40,000

[CMA Adapted] Of the following methods, the one that would not be appropriate for analyzing how
a specific cost behaves is
the scattergraph method.
the industrial engineering approach.
linear programming.
statistical regression analysis.
When the high-low method is used to estimate a cost function, the variable cost per unit is found
performing regression analysis on the associated cost and cost driver database.
subtracting the fixed cost per unit from the total cost per unit based on either the highest or
lowest observation of the cost driver.
dividing the difference between the highest and lowest observations of the cost driver by the
difference between costs associated with the highest and lowest observations of the cost driver.
dividing the difference between costs associated with the highest and lowest observations of the
cost driver by the difference between the highest and lowest observations of the cost driver.
The following data apply to questions 4 and 5.
Tory Company derived the following cost relationship from a regression analysis of its monthly
manufacturing overhead cost.
y = $80,000 + $12X

where: y = monthly manufacturing overhead cost

X = machine-hours

The standard error of estimate of the regression is $6,000.

The standard time required to manufacture one six-unit case of Torys single product is four machinehours. Tory applies manufacturing overhead to production on the basis of machine-hours, and its normal
annual production is 50,000 cases.
[CMA Adapted] Torys estimated variable manufacturing overhead cost for a month in which
scheduled production is 10,000 cases would be
a. $80,000.

b. $480,000.

c. $160,000.

d. $320,000.

[CMA Adapted] Torys predetermined fixed manufacturing overhead rate would be

a. $4.80/MH.

b. $4.00/MH.

c. $3.20/MH.

d. $1.60/MH.

Three criteria to use in identifying cost drivers from the potentially large set of independent
variables that can be included in a regression model are

goodness of fit, size of the intercept term, and specification analysis.

independence between independent variables, economic plausibility, and specification analysis.
economic plausibility, goodness of fit, and significance of independent variable.
spurious correlation, expense of gathering data, and multicollinearity.
Companies that take advantage of quantity discounts in purchasing their materials have
decreasing cost functions.
linear cost functions.
nonlinear cost functions.
stationary cost functions.
The following data apply to questions 8 and 9.
Stone Isle Manufacturing recently completed and sold an order of 50 units having the following costs:
Direct materials
Direct labor (1,000 hours @ $8.50)
Variable overhead (1,000 hours @ $4.00)
Fixed overhead

$ 1,500

Allocated on the basis of direct labor-hours.

Allocated at the rate of 10% of variable cost.
The company has now been requested to prepare a bid for 150 units of the same product.
[CMA Adapted] If an 80 % learning curve is applicable, Stone Isles total cost on this order would be
estimated at
a. $26,400.

b. $31,790.

c. $37,950.

d. $38,500.

[CMA Adapted] If Stone Isle had experienced a 70 % learning curve, the bid for the 150 units would
show a 30 % reduction in the total direct labor-hours required with no learning curve.
include 6.40 direct labor-hours per unit at $8.50 per hour.
include 1,404 total direct labor-hours at $8.50 per hour.
be 10 % lower than the total bid at an 80 % learning curve.
Which of the following is not a common problems encountered in collecting data for cost estimation?
Lack of observing extreme values
Missing data
Changes in technology
Distortions resulting from inflation

Explain the two assumptions frequently used in cost-behavior estimation

Cost-behavior estimation occurs through the use of mathematical models. What

purpose(s) do models serve? Mathematical models serve three purposes:

1 generalize a relationship
2 enable prediction based upon a relationship
3 derive values within a relationship
The cost-behavior estimation models describe how costs y change with changes in the level of an activity
X. The mathematical statement y = a + bX is a general description of the costs. This statement can be
used to predict costs based upon the level of activity. A manager (through the work of the cost accountant)
can evaluate a situation at a given level of activity by comparing actual costs to derived costs from use of
the model or statement.
Describe linear cost functions and three common ways in which they behave

How many different ways can a line be drawn within a two dimensional space (up/down
and side-to-side)? The line could be drawn top to bottom or vice versa, side-to-side, or diagonally. The
diagonal line represents a proportion of the x-axis to the y-axis, a variable cost. A line side-to-side represents a
constant cost (y value) across a changing volume of activity (x values), a fixed cost. The vertical, top-to-bottom line
is not representative of a cost function as the cost will not vary at one level of activity unless another variable is
involved and that would negate the two-dimensional aspect. The diagonal could rise to the right or fall to the right.

A diagonal line that falls to the right would be represented by the cost function y = a bX. From a longrun viewpoint, a negative slope is not economically plausible. An example of a negative relationship in
the short run is that of maintenance costs and the activity level of miles driven. Decreases in maintenance
costs could be associated with increases in miles driven because
maintenance could be deferred from periods of high demand to periods of low demand,
some seasons require high maintenance due to adverse weather conditions, or
low times of miles driven arise from vehicles being taken out of operation for maintenance.

Over time an obvious relationship exists of higher mileage, higher maintenance. Anyone familiar with
operations would recognize the proper relationship and adjust the time frame for data accordingly.
Maintenance costs would tend to lag behind miles driven as the cost driver.

Understand various approaches to cost estimation

When asked what the most important thing science students needed to learn to be good
scientists, a college biology professor involved with the teaching of science in high
schools across the nation replied, They need to learn to observe. Why is observation
an important aspect of cost estimation? To observe is to notice patterns or relationships. The
methods used in cost estimation result in the development of a relationship between a cost and a level of
activity. All of the methods require someone with knowledge of the activities associated with the work
that incurs the cost be involved at some point in the process of identifying that connection between the
cost incurred and the specific activity.
Outline six steps in estimating a cost function on the basis of past cost relationships

What might cause a cost function that was carefully developed using a combination of
acceptable approaches and the six steps not work? One of the purposes of a cost function, a
mathematical model, is that of prediction. Cost estimation is obviously prediction. The approaches
identified as well as the six steps use historical data to develop the cost function. If the processes or
operations underlying the historical relationship were to change, a cost function developed using past data

would no longer be useful for predicting. Historical information must be used with other information to
be most effective.
Describe three criteria to evaluate and choose cost drivers

A company invests considerable time and money to develop sophisticated cost

functions that rate high on all evaluative criteria. In the course of using the cost
functions, a manager notes that, in several instances, the actual costs were different
than the predicted costs resulting in lower profits during one quarter of the year. The
question of the value of the cost function is asked. Give some suggestions on how to
answer the manager. Exercise 10-23 in the text illustrates a situation in which a cost function is used
to reject a job. At some point, actual costs were known and the job would have been profitable to accept.
The opposite situation could occur. A job could be accepted with the actual costs greater than anticipated,
resulting in a loss. Models, regardless of the level of sophistication, are used to make predictions not to be
relied upon for actual data, which can only be known after the fact.
Models are generalizations that do not capture every variable.
Models need to be updated to adequately reflect that which they model.
Models make fewer errors when used than would be made if they were not used. (If this is not the case,
the model needs to be redone so that it does work to provide information resulting in improved decision

The appendix to Chapter 3 highlights the role of events and outcomes as part of dealing with uncertainty.
Explain and give examples of nonlinear cost functions

What is the easiest way to check for linearity or nonlinearity with one independent
variable and dependent variable? A scatter diagram is an easy and effective method of
checking for the shape of a relationship. Plotting observed data is an essential step for
developing cost functions. A picture is worth a thousand words.
Distinguish the cumulative average-time learning model from incremental unit-time learning

The two learning curve models, cumulative average-time and incremental unit-time, are
so similar, why choose one rather than the other? Though the models are similar, they generate
different numbers or information for a manager s use. The one that more accurately approximates the
relationship between costs and labor activity is the better model to choose. Technological and
mathematical advances have enabled the development of more sophisticated models that can be readily
used by many companies. A company should, therefore, take advantage of the best models available.

Be aware of data problems encountered in estimating cost functions

With so much data to analyze and use, is precision ever important in data collection? As
emphasized throughout the chapter the decision maker needs to have an understanding of the costs with
which he or she works. Some costs need to be exact or precise while other costs can be within a range
and still be useful. Consider the concept of a foot in measurement: if one orders a foot-long hot dog
the hot dog will probably be about 11 long but acceptable. If the halfback on a football team runs a few
feet before being tackled on fourth down, the chain may need to be brought out onto the field to measure

the fractions of an inch before a ruling on the down. Ones hunger may accept something less than 12 to
suffice for a foot-long hot dog, but the referee cannot accept less than an exact measurement for the
down if close.

(Illustration of the high-low method used for cost estimation)
Tina Moretti, the president of Shuz, Inc., enlisted the assistance of the vice presidents in charge of sales
and of production. Together they constructed two budgetsone optimistic, one pessimistic. These are
shown in columns (1) and (2) below. The actual results are shown in column (3). The companys cost
accountant was perplexed as to how to present an analysis. Consequently, he produced variances of
actual results against both the optimistic projection and the pessimistic projection, columns (4) and (5),

Units sold
$ 650,000
Direct materials
Direct labor
Indirect labor

$ 200,000


$ 75,000


$ 140,000

$ (60,000)

$ 65,000


Moretti is baffled by the analysis. She has asked you for a more understandable performance report. In
the columns below, in clear and orderly fashion, prepare a new report. Explain your work to the
president. Show supporting computations as needed.
Units sold


Sales or
Cost Function

y = $10X



Direct materials
Direct labor
Indirect labor

$ 140,000

y = $1X
y = $2X
y = $6,000 + $0.50X

$ 135,000

$ 5,000U


The problem can be used with Learning Objective 2: Describing linear cost functions and three common ways in
which they behave. The three behaviors are used variable, fixed, and mixed or semivariable. One can usually spot
the three fixed cost behaviors by looking at the amounts budgeted under each of the two budgets, optimistic and
pessimistic. Looking at units sold and dollar amounts in the budgets fairly quickly distinguish two of the three
pure variable costs. The other four line items must be divided into variable and fixed components by use of the
high-low method of deriving a cost function.
Units sold
Direct materials
Direct labor
Indirect labor
Direct materials:

$ 140,000
$ 803,900

Sales or
Cost Function

y = $10X
y = $1X
y = $2X
y = $6,000 + $0.50X
y = $20,000
y = $8,000 + $0.10X
y = $0.80X
y = $50,000
y = $3,000 + $0.02X
y = $80,000
y = $10,000 + $0.05X

$200,000 = a + b200,000 units

$ 75,000 = a + b 75,000 units
$125,000 =
b125,000 units
$1 =

$ 135,000
$ 780,450


$200,000 = a + $1200,000 units

-0- = a
y = $1X

$ 5,000U

$160,000 = a + b200,000 units

$ 60,000 = a + b 75,000 units
$100,000 =
b125,000 units
$0.80 =
$160,000 = a + $0.80200,000
-0- = a
y = $0.80X

Direct labor:

$250,000 = b125,000 units

$2 = b
-0- = a
y = $2X



= -0= b
= a
= $50,000

Indirect labor:

$106,000 = a + b200,000
$ 43,500 = a + b 75,000
$ 62,500 =
$0.50 = b
$106,000 = a + $100,000
$6,000 = a
= $6,000 + $0.50X



= a + b200,000
= a + b 75,000
= b
= a + $4,000
y = $3,000 + $0.02X


= $20,000

$28,000 = a + b200,000
$15,500 = a + b 75,000
$12,500 =
$0.10 = b
$28,000 = a + $20,000
$8,000 = a
= $8,000 + $0.10X



y = $80,000
$ 6,250

= a + b200,000
= a + b 75,000
= b
= a + $10,000
= $10,000 + $0.05X

The Cooper Corporation has received a contract to supply 240 units of new telecommunication
equipment. The direct materials costs are $60,000 per unit. The average direct manufacturing labor costs
for each unit (in the first lot of 30 units) was estimated to be $40,000. Direct manufacturing labor on a
per lot basis is subject to a 90% cumulative average-time-learning model. (A 90% learning curve implies
q = 0.1520.) Variable manufacturing overhead was estimated to be 60% of direct manufacturing labor
cost. Coopers price includes a markup of 25% on total variable manufacturing costs.

Determine the Cooper Corporations cumulative average unit cost of manufacturing labor for
producing the 240 units.
Assume that the Cooper Corporation is asked to produce additional telecommunication equipment
beyond the 240 units currently under contract. Cooper anticipates that the expected average cost incurred

to produce the last 120 units is the expected manufacturing cost per unit for each additional unit after 240
units. Calculate Coopers average unit cost of manufacturing labor for units beyond the original 240


(Illustration of cumulative average-time learning model with concept of leveling)
[CMA, adapted--from 9th edition of text]
The learning curve is on a per lot basis. The manufacturing labor cost per unit in the f irst lot is $40,000.

Cumulative Average Direct
Number of
Manufacturing Labor Cost
Number of Lots
Per Unit in Each Lot
(30 units per lot)


36,000 (40,000 x .9)
32,400 (36,000 x .9)
29,160 (32,400 x .9)

The average cost per unit for 240 units in 8 lots = $40,000 x 8


Total Cost
(3) = (1) x (2)
= $29,160.

The average cost per unit for the last round of learning when going from 4 lots to 8 lots (120
units to 240 units) is the change in cumulative total costs divided by 120 units (240 units for 8
lots 120 units for 4 lots):
This is Coopers expected average cost per unit for each additional unit beyond the first 240 units.
The learning curve is a leveling type of model. At some point, though the rate of change continues, the
absolute amount of change between lot sizes becomes ever increasingly smaller. An organization could
factor in a leveling off point such as Cooper Corporation did in this example. This concept does not
negate continuous improvement, however.


Bailey, C., Forgetting and the Learning Curve: A Laboratory Study, Management Science (March
1989) p.340 [13p].
, Learning-Curve Estimation of Production Costs and Labor Hours Using A Free Excel AddIn, Management Accounting Quarterly (Summer 2000) p.25 [7p].
Bailey, C. and McIntyre, E., Some Evidence on the Nature of Relearning Curves, The Accounting
Review (April 1992) p.368 [11p].
Chen, J., Manes, R. and Richardson, A., Learning Curves and Appropriate Regression Methodologies,
Issues in Accounting Education (Fall 1991) p.284 [16p].
Gilllespie, J., An Application of Learning Curves to Standard Costing, Management Accounting
(September 1981) p.63 [3p].
McKenzie, P., An Alternative Learning Curve Formula, Issues in Accounting Education (Fall 1987)
p.383 [5p].
Nurnberg, H., The Ambiguous High-Low Method, Issues in Accounting Education (Spring 1986) p.143
Pattison, D. and Teplitz, C., Are Learning Curves Still Relevant? Management Accounting (February
1989) p.37 [4p].



Use the five-step decision process to make decisions
Differentiate relevant from irrelevant costs and revenues in decision situation
Distinguish between quantitative and qualitative factors in decisions
Beware of two potential problems in relevant-cost analysis
Explain the opportunity-cost concept and why it is used in decision making
Know how to choose which products to produce when there are capacity constraints
Discuss what managers must consider when adding or discontinuing customers and segments
Explain why the book value of equipment is irrelevant in equipment-replacement decisions
Explain how conflicts can arise between the decision model used by a manager and the performance
evaluation model used to evaluate the manager

Chapter 11 is about the decision-making process. Accountants are an integral part of this process,
providing information to decision makers. A five-step approach to making decisions, beginning with the
point in the process in which the accountants typically become involved, is described in the chapter.
An extremely useful concept is presented. The information needed for the decision process must be
relevant to the decision. Relevant is defined as revenues and costs that occur in the future and differ
among the alternative courses of action available to the decision maker. This definition is illustrated
through various situations. In this chapter the information needed for decisions of one-time-only special
orders, make-or-buy, drop-or-add, and keep-or-replace are explained. Several of the chapters that follow
will introduce other types of decisions that use the concept of relevant revenues and costs.
A major theme of the text is that information generated by the accounting system is used for the benefit of
managers in making decisions. The roles performed by accountants are implicit in the illustrations of
relevant information gathered for decisionsproblem solving, scorekeeping, and attention directing. A
review of those roles from Chapter 1 could be used to highlight their importance in the decision process.
The last step of the decision process is evaluating performance. The last section of the chapter deals with
conflicts between the decision model used by a manager and the performance model then used to evaluate
that manager. This is an important discussion.
Linear programming as a tool in the decision process is described in the appendix.

Information and the decision process
Define the decision under consideration
TEACHING TIP: A clear understanding of the purpose of the decision is helpful in working through the
steps in the decision process. By carefully and quite specifically defining the decision to be made, the
determination of relevant costs and relevant revenues for each alternative is usually easier. Continued
emphasis on the definition of relevant cannot be overdone.
Learning Objective 1:
Use the five-step decision process to make decisions
Employ five-step decision-making process [Exhibit 11-1]
Obtain information
Historical costs
Other information
Make predictions
Choose an alternativemust have at least two
Implement decision
Evaluate performance to provide feedback
Use feedback [Refer to Chapter 1]
Affect future decisions
Affect prediction method
Affect implementation of the decision
Do multiple choice 1.

Assign Exercise 11-16.

The meaning of relevance [Exhibit 11-2]

Learning Objective 2:
Differentiate relevant from irrelevant costs and revenues in decision situations
Definition of relevant costs and revenues
Occur in the future

Past costs may be useful basis for making informed predictions of expected future costs/revenues

Unavoidable past costs that cannot be changed are sunk costs

Differ among alternative courses of action (What difference does it make?)

Same conclusion if use only that which differs and if use all data

Pertinent data used saves time and maintains focus

Do multiple choice 2.

Assign Exercise 11-18.

Outcomes of alternatives [Exhibit 11-3]

Learning Objective 3:
Distinguish between quantitative and qualitative factors in decisions
Quantitative factors: outcomes measured in numerical terns
Qualitative factors: outcomes that cannot be measured in numerical terms
Illustrations of relevance
Choosing output levelsexample of one-time-only special order [Exhibits 11-4 and 11-5]
Understand conditions of decision (obtain information)
Decision to accept or reject one-time-only special order
Idle capacity available
No long-run implications of accepting the order
Identify relevant revenues and costs
Income statement formatmaximize income
Full costs identified by amount and type
Do multiple choice 3.

Assign Exercises 11-19.

Learning Objective 4:
Beware of two potential problems in relevant-cost analysis
Beware of two potential problems in relevant-cost analysis
Avoid incorrect general assumptions such as all variable costs are relevant and all fixed costs are
Avoid losing sight of grand totals and focusing instead on unit costs

Unit costs mislead when irrelevant costs are included

Unit costs mislead when same unit costs are used at different output levels

Require each item to be expressed as total future revenue or cost

Insourcing-versus-outsourcingexample of make-versus-buy decisions

Understand conditions of decision (obtain information)
Idle capacity available
Qualitative factors
If outsourcing, what use made of idled facility (new choice)
Identify relevant revenues and costs
Minimize costs
Know full costs by amount and type
Incremental costs: additional total costs incurred for an activity
Differential cost: difference in cost between two alternatives
Use strategic and qualitative factors in choosing among alternatives [Exhibit 11-6]
In-house to maintain control over design, quality, reliability, delivery schedules
Outsource to be smaller and leaner organization, focusing on areas of core competencies
Use long-run contracts to minimize risks of dependence on suppliers
Build partnership with suppliers
Allow suppliers to gain expertise and grow [VW Concepts in Action]
Choose best use of available facilities [Exhibit 11-7]
Continue to make productdo not outsource
Buy product choice of use for idled facilities and of schedule for purchasing product
Do multiple choice 4.

Assign Exercise 11-20 and Problem 11-35.

Learning Objective 5:
Explain the opportunity-cost concept and why it is used in decision making
Consider opportunity cost: contribution to income that is forgone by not using a limited resource in its
next-best alternative use

Include opportunity cost because it represents best alternative way organization may have used its
resources had it not made the decision it did [AA Concepts in Action]
Do multiple choice 5 and 6.

Assign Exercise 11-21 and Problems 11-30 and 11-31.

Product-mix decisions under capacity constraints

Learning Objective 6:
Know how to choose which products to produce when there are capacity constraints
Understand conditions of decision (obtain information)
Level of capacity is a constraintonly be expanded in the long run
Demand is a constraint
Other constraints: availability of direct materials, components, skilled labor, financial factors, display
space, etc.
Identify relevant revenues and costs
Maximize operating income
Analyze individual product contribution margin
Focus on maximizing total contribution margin by choosing products with highest contribution margin
per unit of the constraining factor
Do multiple choice 7.

Assign Exercises 11-22 and 11-23, Problems 11-29 and 11-32.

Add or discontinue a product lineexample of customer profitability

Understand conditions of decision (obtain information)
Customer (product line) as cost object
Activities associated with servicing customer (activity-based costing approach)
Identify relevant revenues and costs [Exhibit 11-8]
Maximize profit
Know full costs of activities and types of costs (hierarchy)
Learning Objective 7:
Discuss what managers must consider when adding or discontinuing customers and segments
Ignore allocated overhead costs
Focus on how total costs differ among alternatives [Exhibit 11-9 and 11-10]

Choose among alternatives

Reduce companys costs of supporting the customer
Charge higher prices to customer
Discontinue the customer as an account
Work with customer to reduce costs of supplying product
Consider strategic factors and long-run relationship
Do multiple choice 8.

Assign Exercises 11-24, 25, and 26, Problems 11-33 and 11-34.

Keep or replace decisionsexample of equipment

Learning Objective 8:
Explain why the book value of equipment is irrelevant in equipment-replacement decisions
Understand conditions of decision
If keep, company has equipment because of past decision (past cost)
Past costs, particularly book value of existing equipment, is irrelevant
Identify relevant revenues and costs [Exhibit 11-11]
Minimize costs (maximize income if revenues are relevant)
Future revenues and costs are relevant [Exhibit 11-12]
Cash operating cost relevant
Disposal price of old machine relevant
Cost of new machine relevant
Do multiple choice 9.

Assign Exercises 11-27 and 11-28.

Learning Objective 9:
Explain how conflicts can arise between the decision model used by a manager and the performance
evaluation model used to evaluate the manager
Decisions and performance evaluation
Manager will favor decision alternative that looks best for performance whether decision is best for
Time frame for decision is longer than time frame for performance evaluation

Accounting systems rarely track each decision separately so impacts of many different decisions are
combined in a single performance report
Managers may hesitate because of how a decision would look to supervisors if supervisors have no
knowledge of alternative choices
Do multiple choice 10.

Assign Problems 11-37 and 11-38.

Appendix: Linear programming [Exhibit 11-13]

Steps in solving a linear programming problem
Determine the objective function: goal to be maximized (income) or minimized (costs)
Specify the constraints: mathematical inequality or equality that must be satisfied by the variables in a
mathematical model
Compute the optimal solution
Trial-and-error approach
Graphic approach
Sensitivity analysis
Do multiple choice 11 through 16.


2.b 3.a 4.d 5.b 6.a 7.c 8.d 9.c 10.b

11.b 12.a 13.d 14.b 15.c 16.d

Which of the following should not be considered for every option in the decision process?
Relevant revenues
Relevant costs

c. Historical costs
d. Opportunity costs

What is always the question to ask to determine if revenues or costs are relevant?
What is the time frame for achieving results?
What difference will an action make?

c. Who will be responsible?

d. How much will it cost?

[CPA Adapted] Mikaelabelle Products sells product A at a selling price of $40 per unit. Mikaelabelles
cost per unit based on the full capacity of 500,000 units is as follows:
Direct materials
Direct labor
Indirect manufacturing (60% of which is fixed)

$ 6


A one-time-only special order offering to buy 50,000 units was received from an overseas distributor.
The only other costs that would be incurred on this order would be $4 per unit for shipping. Mikaelabelle
has sufficient existing capacity to manufacture the additional units. In negotiating a price for the special
order, Mikaelabelle should consider that the minimum selling price per unit should be
a. $17.

b. $19.

c. $21.

d. $23.

The following data apply to questions 4 and 5.

Troy Instruments uses ten units of Part Number S1798 each month in the production of scientific
equipment. The unit cost to manufacturing one unit of S1798 is presented below.
Direct materials
Materials handling (10% of direct materials cost)
Direct manufacturing labor
Indirect manufacturing (200% of direct labor)
Total manufacturing cost

$ 4,000

Materials handling represents the direct variable costs of the Receiving Department that are applied to
direct materials and purchased components on the basis of their cost. This is a separate charge in addition
to indirect manufacturing cost. Troys annual indirect manufacturing cost budget is one-fourth variable
and three-fourths fixed. Duncan Supply, one of Troys reliable vendors, has offered to supply Part
Number S1798 at a unit price of $17,000.
[CMA Adapted] If Troy purchases the S1798 units from Duncan, the capacity Troy used to manufacture
these parts would be idle. Should Troy decide to purchase the parts from Duncan, the unit cost of S1798
a. decrease by $3,700. b. decrease by $5,600. c. increase by $3,600.

d. increase by $5,300.

[CMA Adapted] Assume that Troy Instruments does not wish to commit to a rental agreement to rent all
idle capacity but could use idle capacity to manufacture another product that would contribute $60,000
per month. If Troy elects to manufacture S1798 in order to maintain quality control, Troys opportunity
cost is
a. $(53,000).
b. $7,000.
c. $(24,000).
d. $36,000.
Which of the following is not a correct use of the term opportunity cost?
Opportunity costs are considered period costs rather than inventoriable costs for accounting purposes.
Opportunity costs must be considered by managers when making decisions
Opportunity cost plus the incremental future revenues and costs equal the relevant revenues and costs of
any alternative when capacity is constrained.
The opportunity cost of holding inventory is the income forgone by tying up money in inventory and not
investing it elsewhere.
Nicholas, Inc., has provided the following unit data for review:
Simple Product
Selling price
Variable cost

Advanced Product

Pounds of scarce raw material per unit



Which product, Simple or Advanced, is most profitable for Nicholas, Inc., to manufacture?

a. Both in ratio of 3 : 5

b. Both in ratio of 5 : 8

c. Simple

d. Advanced

RCG Services is investigating its profitability relationship with each of its customers. What is the key
question RCG should ask in deciding to keep or to drop a particular customer?
Will the customer meet a specific designated gross margin percentage?
Will the customer be willing to pay a higher price to insure RCGs profitability?
Will enough customers be found to replace any customers dropped for lack of profitability?
Will expected total corporate office costs decrease if decision is to drop the customer?
[CPA Adapted] At December 31, 2001, Brown Co. had a machine with an original cost of $90,000,
accumulated depreciation of $75,000, and an estimated salvage value of zero. On December 31, 2001,
Brown was considering the purchase of a new machine having a five-year life, costing $150,000, and
having an estimated salvage value of $30,000 at the end of five years. In its decision concerning the
possible purchase of the machine, how much should Brown consider as sunk cost at December 31, 2001?
a. $150,000

b. $120,000

c. $90,000

d. $15,000

Which of the following is not a reason for the performance evaluation model to differ from the decision
The use of different time frames: one being an annual basis, the other a period of several years.
The accounting systems enable each decision to be tracked separately.
The accrual accounting method incorporates irrelevant costs.
Top management is rarely aware of particular desirable alternatives that were not chosen by subordinate

Questions 11-16 demonstrate the use of linear programming (appendix to Chapter 11)
Belmont Company manufactures and sells two products, shirts and gloves, in its two-department plant.
Belmont employs linear programming to determine its optimum product mix. Economic data pertaining to the two
products are presented below.
Selling price per unit
Cost data per unit
Variable manufacturing cost
Variable marketing cost
Fixed manufacturing cost
Fixed marketing cost

Shirt [S]
Gloves [G]
Monthly capacity


Direct Labor Data

10 minutes
15 minutes
6 minutes
30 minutes
960 hours
1,920 hours

[CMA Adapted] The algebraic formulation of Belmont's objective function is

MAX TCM = 10S + 16G.


MAX TCM = 12S + 24G.

MAX TCM = 14S + 28G.
MAX TCM = 7S + 15G.

[CMA Adapted] The algebraic formulation of Belmont's monthly direct labor constraints is

(1/6)S + (1/10)G 960; (1/4)S + (1/2)G 1,920.

(1/6)S + (1/4)S + (1/10)G + (1/2)G 2,880.
10S + 6G 960; 15S + 30G 1,920.
10S + 15S + 6G + 30G 2,880.

[WOS] The solution where S = 0 and G = 3,000 would

be the optimal solution.

be an infeasible solution.
be a corner point.
be a feasible solution.

[WOS] A feasible solution for Belmont Company is where [to the nearest whole dollar]
a. G = 0; S = 7,680.


b. G = 0; S = 5,760.

c. G = 9,600; S = 0.

d. G = 3,840; S = 5,760.

[WOS] At the optimal mix, Belmont will

have a contribution margin of $69,120.

produce 5,760 shirts.
produce 3,840 gloves.
have no excess direct labor capacity.
[WOS] If the selling price of gloves is $34 rather than the predicted $40, what will be the cost to Belmont
of this prediction error?
Zero, since gloves are not produced under either cost

c. $8,238
d. $14,802

Use the five-step decision process to make decisions

How does a five-step decision process differ from the decision process illustrated for planning and
control in an earlier chapter? Do different kinds of decisions require the use of different models? The
basic model for decision making is quite similar to a thinking model because decision making is
thinking. The two processes mentioned are not different in approach but in how they are described. Each
thinking or decision model require the similar steps of
defining or clarifying the problem to be solved or the situation about which a decision is to be made or an
objective to be achieved
gathering relevant information about the problem, situation, or objective
choosing from among at least two different solutions, alternatives, or approaches
implementing the solution, alternative, or approach chosen
evaluating the results of the action taken
using feedback to improve next decision

Each decision does not require a formal process. The steps are not rules or a checklist but are
descriptive of how people process situations.
[Refer to Writing/Discussion Exercises Chapter 1, Learning Objective 3 and Chapter 9, Learning
Objective 7]
Differentiate relevant from irrelevant costs and revenues in decision situations

In the study of financial accounting, a primary characteristic of accounting information is

relevance. How does that fit with the concept of relevance in cost accounting? The In the
Statements of Accounting Concepts issued by the Financial Accounting Standards Board, the two
primary characteristics of accounting information are relevance and reliability. These
characteristics support the overall characteristic of decision usefulness. Accounting information,
whether developed for cost accounting or financial accounting, derives its value from improving
decisions. Each of the two primary qualities, relevance and reliability, have significance in any
type of accounting. As studied in financial accounting (FASB Statements of Accounting
Concepts), relevance has three aspects: timeliness, feedback value, and predictive value. These
same aspects are incorporated in the definition of relevant in the text future costs or revenues
that make a difference among the alternatives.

Distinguish between quantitative and qualitative factors in decisions

Why should the accountants have to concern themselves with qualitative factors? Numbers are
neutral. Numbers are neutral but they are also symbols. Symbols represent an idea, a thought, a concept,
or some thing. Qualitative factors are the more basic factors because numbers typically represent some
quality. Ways are found to value or assign numbers to those things that were considered quality factors,
such as product quality that is now studied in cost accounting as costs of quality with numbers
representing aspects of product quality.
Is a basketball player worth $2,000,000 when a day-care worker is paid $22,000 per year? The
numbers are neutral but speak boldly to qualitative issues. The imperative for accountants is that
they understand what is behind the numbers so they know what numbers to gather and report.
Understanding the qualitative issues in any decisions will make a difference in the numbers
gathered and reported. The difference should not be due to bias but due to purpose.
Beware of two potential problems in relevant-cost analysis

Can costs be stereotyped? If one deals with costs such that generalizations are always used in place of
careful consideration of an individual situation, then the problem of stereotyping can occur. To think that
all fixed costs are irrelevant would be a kind of cost stereotyping. To use a unit cost across several levels

of activity without considering the relevant range might result in a generalization that could be harmful if
used in making a decision.
Explain the opportunity-cost concept and why it is used in decision making

Are opportunity costs like grass that is always greener on the other side of the fence?
Opportunity costs are those costs that might have been. Because they do not happen, one cannot
know opportunity costs with any certainty. The exercise of considering what might be if . . .
can be useful to a company. Having to consider other alternatives clarifies the action to be taken
to choose this is also to reject that. The use of scarce resources or limited resources should
always be seen in the light of alternatives. Obviously one cannot make a decision if only one
action is availablewith one action possible, there is dictate, not decision. To have to think
about other possibilities and realize opportunities as alternatives could expand the options. The
opportunities are not always better, but it is better to consider them before the decision is made.
Know how to choose which products to produce when there are capacity constraints

How is the concept of constraining factors or resources related to the concept of the accounting system
reflecting the underlying operations of a company? Constraining resources are a short-run concept, but
accounting works for providing information for both the short run and the long range. If the accounting
systems accurately reflect the operations of a company, the accountant can notice trends and direct
attention to them. For example, in the case of limited machine-hours, the accountant can report
contribution margin per machine-hour. If skilled labor is in short supply, the accounting reports can
highlight costs in terms of how they support the workers in accomplishing their tasks. The accounting
system can be designed to insure that the company gets the most out of the things that do the most for it.

Discuss what managers must consider when adding or discontinuing customers and segments

In dropping or adding customers or segments, should the way in which costs are assigned to
the cost objects be considered? Assigning costs to the cost object includes both cost tracing and
cost allocation. For decisions of adding or dropping customers or segments, one needs to be
careful of those costs that have been allocated. Allocated costs should be looked at as a total for
all of the cost objects to which they relate. If one cost object is dropped, does the total cost
decrease? If another cost object is added, does the total cost increase? Total cost to be allocated
is more important than how it is allocated in making these decisions. Traced costs can be readily
noted as to their disposal or addition.
Explain why the book value of equipment is irrelevant in equipment-replacement decisions

Explain the statement All future costs are not relevant but all relevant costs are future costs.
Book value that would be written off in the future is not a relevant cost. Book value represents a
cost that has already happened and any decision made afterwards could not change the decision
that caused the equipment to be purchased initially (except in science fiction stories).

Costs that do not affect the decision, though they are costs yet to be, are not relevant. A relevant
cost must be one that makes a difference among the alternatives.
If nothing can be done to prevent the cost from occurring, that cost is not a matter of choice
decisions are making choices and a future cost that cannot be prevented from occurring is not
relevant (must make a difference).
One must have a choice as to whether to incur the cost or not to incur the cost for the cost to be
relevant to a decision or choice. A cost that has already been incurred is no longer in the category
of to be or not to be.
Explain how conflicts can arise between the decision model used by a manager and the performance
evaluation model used to evaluate the manager

Why can the conflict between the decision model used by a manager and the performance
model used to evaluate the manager be compared to a chemical change?
As stated in the text, the practical difficulty is that accounting systems rarely track each decision
separately. Individual managers are making many decisions at any given time. Hopefully the
results of the decisions weave together in such a way that the company operates like a well oiled
machine. One particular manager might look good because his/her decisions occurred in
combination with decisions of another manager and that combination worked just right at that
given moment in that given place. Both managers benefit and are so evaluated. Can a
performance model be developed that would consider the wide possibilities that could result from
the various combinations of decisions and events? Cost-benefit approach would have to be used.
A chemical change results from a combination of individual factors creating a different product.
With enough experimentation, feedback, and knowledge, one can predict the product that will
result from the combinations of different factors. A performance evaluation model could be
developed in a similar fashion.

Brimson, J., Technology, Sunk Costs, and the Make-or-Buy Decision, Journal of Cost Management
(Fall 1987) p.52 [4p].
Christensen, L. and Sharp, D., How ABC Can Add Value to Decision Making, Management Accounting
(May, 1993) p.38 [5p].
Einhorn and Hogarth, Going Forward in Reverse, Harvard Business Review (January-February 1987)
p.66 [5p].
Harrison, P. and Shanteau, J., Do Sunk Cost Effects Generalize to Cost Accounting Students? Advances
in Management Accounting (1993) p.171 [16p].
Rudd, M. and Deutz, J., Moving Your Company Online, Management Accounting (February 1999) p.28
Yankelovich, D., How Public Opinion Really Works, Fortune (October 5, 1992) p.102 [7p].



Discuss the three major influences on prices
Distinguish between short-run and long-run pricing decisions
Price products using the target-costing approach
Apply the concepts of cost incurrence and locked-in costs
Price products using the cost-plus approach
Use life-cycle budgeting and costing when making pricing decisions
Describe two pricing practices in which noncost factors are important when setting price
Explain the effects of antitrust laws on pricing

Chapter 12 demonstrates the broader sphere of influence for cost accounting. Pricing decisions are
influenced primarily by costs, customers, and competitors, which are the specific market factors of
demand and supply. This chapter does not present another costing system for determining product cost
for use in pricing but utilizes necessary concepts of cost-behavior, cost drivers, and relevance to manage
those costs.
Concepts presented are those of relevant costs in relation to a time horizon (short run or long run),
strategy of product positioning (market-based pricing or cost-based pricing), value engineering
(relationship of product design and timing of cost incurrence), the life-cycle of a product (cradle-tograve), and legal considerations in pricing decisions.
Target pricing and target costing are an example of market-based pricing. Implementation of target prices
and target costs is illustrated through a four-step process. Target costs are costs that the company aims to
achieve. Costs are managed to reduce the cost of products and processes. Value engineering is used to
reduce the nonvalue-added activities/costs and achieve greater efficiency in value-added activities. This
type of cost management, lower costs, efficiency improvements, elimination of nonvalue-added activities,
is used to develop cost leadership, a type of strategy used by some companies (described in Chapter 13).
Cost-plus pricing, also known as cost-based approach to pricing, is described as a starting point for
pricing decisions. Though cost is a key factor in pricing a product or service, other factors must be
considered. Some noncost factors are considered for their impact on pricing decisions.
An example of life-cycle pricing and costing is used to highlight the importance of full costs for pricing.

Pricing decisions in general
Management decisions about what to charge for products and services to achieve profitability
Evaluate demand at different prices
Manage costs across the value chain and over the products life cycle
Consider type of market and degree of competition
Learning Objective 1:
Discuss the three major influences on prices
Major influences on demand and supply
Customers (demand)
Competition (demand and supply)
Costs (supply)
Do multiple choice 1.

Assignments after L. O. 2.

Learning Objective 2:
Distinguish between short-run and long-run pricing decisions
Time horizon of pricing decisionsdictates which costs are relevant, how costs are managed, and the
profit that needs to be earned
Short-run pricing decisions
Time horizon of less than one year
More opportunisticprices decreased when demand weak and increased when strong
Types include adjusting product mix and output volume in a competitive market
Long-run pricing decisions
Time horizon of one year or longer
Price of products in major market with some leeway in setting price
More costs relevant because can alter in long run
Earn reasonable rate of return on investment through setting profit margins
Do multiple choice 2.

Assignments after L.O. 2.

Pricing decisions relative to time horizon

Short run illustrationspecial order [Exhibit 12-1]
Costs: necessary information
Existing fixed manufacturing overhead costs irrelevant because no change
All direct and indirect variable manufacturing costs related to special order relevant
All material procurement and process-changeover costs related to special order relevant
All nonmanufacturing costs unaffected by accepting special order irrelevant
Note that unit costs can mislead
Data on capacity conditionsidle or need to reduce product to regular customers
Minimum price identified
Price must cover incremental costs
Price may also need to cover revenues lost on existing sales if price lowered
Price may be set at what market will bear if strong customer demand and limited capacity
Long-run time horizon
Basic conceptsstrategic decisions
Buyers typically prefer stable (and predictable) prices over a long time horizon
Company must know and manage costs, over the long run, of supplying product to customers
Calculation of product costs
Full costs of producing and selling product used to set price in long run using any costing system, such as
activity-based costing [Exhibits 12-2 and 12-3]
Market-based approach
Asks: Given what our customers want and how our competition will react to what we do, what price
should we charge?

Starting point for product differentiation industries: look at customers and competitors first, then at cost
must accept prices set by market
Cost-based approach
Asks: Given what it costs us to make this product, what price should we charge that will recoup our costs
and achieve a required return on investment?
Starting point for product differentiation industries: look at costs first, then consider customers and
Market forces of demand and supply always important
Do multiple choice 3.

Assign Exercises 12-16, 17, 18, and Problems 12-27, 28, 29, 30, 31.

Target costing for target pricinga long-run approach to pricing

Learning Objective 3:
Price products using the target-costing approach
Target pricinga market-based approach
Definition of target price: estimated price for product or service that potential customers will pay
Understanding what customers value
Understanding how competitors will price competing products
Analysis of competitors
What to know: technologies, products, costs, and financial conditions
How to know: customers, suppliers, competitors employees, and reverse engineering
Target cost
Based on target price and is target price minus target operating income per unit
Estimated long-run cost per unit of a product or service that enables the company to achieve target
operating income per unit when selling at target price
Includes all future costs, both variable and fixed
Is a target: something to aim for (lower existing full cost per unit of product)

Implementing target pricing and target costing

Step 1: Develop a product that satisfies needs of potential customers

Step 2: Choose a target price

Step 3: Derive a target cost per unit by subtracting target operating income per unit from the target
Step 4: Perform value engineering to achieve target cost
Value engineering: systematic evaluation of all aspects of the value-chain business functions, with
objective of reducing costs while satisfying customer needs
Value engineering can result in improvements in product design, changes in materials specifications, or
modifications in process methods
Value engineering
Distinguishing between value-added and nonvalue-added activities and costs
Value-added costs
Definition: A cost that, if eliminated, would reduce the actual or perceived value or usefulness customers
obtain from using the product or service
Examples: Costs of specific product features and attributes desired by customers such as special designs
on notebooks and stationery [others mentioned in text]
Nonvalue-added costs
Definition: A cost that, if eliminated, would not reduce actual or perceived value or usefulness customers
obtain from using the product or service
Examples: Costs of expediting, rework, and repair
Challenge is to make cost improvements necessary through value-engineering methods to achieve the
target cost
Do multiple choice 4.

Assign Exercises 12-19 and 12-20.

Learning Objective 4:
Apply the concepts of cost incurrence and locked-in costs
Distinguishing between costs incurred and costs locked in [Refer to Exhibit 12-4]
Cost incurrence
Describes when a resource is consumed (or benefit forgone) to meet a specific objective
Emphasized in costing systems
Locked-in or designed-in costs [Exhibits 12-5 and 12-6]
Definition: Costs that have not yet been incurred but, based on decisions that have already been made,
will be incurred in the future

Difficult to alter or reduce if occur early in process, at design stage

Cost reduction achievable through operating efficiency and productivity up to time costs incurred if cost
not locked in early
Cost accountant needs solid understanding of technical and business aspects of entire value chain for
knowledgeable interaction with others in organization
Strategic implications
Combine with kaizen or continuous improvement methods aimed at improving productivity and
eliminating waste, with value engineering and better designs
Focus on the customer
Pay attention to schedules
Build a culture of teamwork and cooperation across business functions
Do multiple choice 5.

Assign Exercise 12-22 and Problem 12-32.

Learning Objective 5:
Price products using the cost-plus approach
Cost-plus pricing approach: adding a markup component to a cost base
1. Cost-plus target rate of return on investment
First calculate target rate of return on investment
Define investment specifically from one of many possibilities
Divide target annual operating income from organization by investment to obtain target rate of return or
use required target rate of return on investment to obtain target annual operating income
Secondly, express target operating income per unit as a percentage of full product cost to determine markup
Size of the plus determined by the market
Alternative cost-plus methods [Exhibit 12-7 and Surveys of Company Practice]
Use of different reliable cost bases (variable manufacturing cost, variable product cost, manufacturing cost, full cost
of product as examples)
Choice of markup percentage (to recover costs and earn a required rate on investment)
Cost bases that include fewer costs have higher markup percentages to compensate for costs excluded

from the base

Nature of competition in the marketplace (lower markups in competitive markets)

Advantages to use of full cost of product for pricing decisionsfull recovery of all costs of product, price

stability, and simplicity

Cost-plus pricing and target pricing
Cost-plus pricing determines prospective prices that balance costs, markup, and customer reaction

Target pricing determines product characteristics and target price on basis of customer preferences and
expected competitor responses
Cost-plus pricing usually used by providers of unique products and services
Do multiple choice 6 and 7.

Assign Exercises 12-23 and 12-24.

Learning Objective 6:
Use life-cycle budgeting and costing when making pricing decisions
Life-cycle product budgeting and costingconsidering how to cost and price product over multiyear
product life cycle
Product life cycle: spans the time from R&D on a product to when customer servicing and support no

longer offered for that product

Life-cycle budgeting: estimates of revenues and costs attributable to each product over life cycle

Life-cycle costing: tracks and accumulates individual value-chain costs attributable to each product

Life-cycle budgeting and pricing decisions

Nonproduction costs are significant and identifying by product is essential for target pricing, target
costing, value engineering, and cost management
High percentage of total life-cycle costs are incurred before any production begins and any revenues are
received requires accurate revenue and cost predictions in deciding whether to commence costly R&D
and design activities
Cause-and-effect relationships between business functions highlighted throughout products life cycle
before costs locked in
Uses of life-cycle budgeting and costing
Multiyear time horizon for products with long life cycles with large portion of total life-cycle
costs locked in at design stage

Management of environmental costs

Customer life-cycle costs: total costs incurred by customer to acquire and use a product or
service until replaced

Considerations other than cost in pricing

Do multiple choice 8.

Assign Exercise 12-25 and Problem 12-34.

Learning Objective 7:
Describe two pricing practices in which noncost factors are important when setting prices
Noncost factors
Price discrimination
Practice of charging different customers different price for the same product
Market force of demandprice inelasticity concept: insensitivity of demand to price changes
Peak-load pricing
Practice of charging a higher price for the same product or service when demand approaches physical
capacity limits to produce that product or service
Market force of demand with capacity constraints (supply issue)
Same product sold in different countries
Costs of delivery
Differences in purchasing power of consumers
Government restrictions
Do multiple choice 9.

Assign Exercise 12-26 and Problems 12-35 and 12-36.

Learning Objective 8:
Explain the effects of antitrust laws on pricing
Legal considerations
Key features of price discrimination laws
Apply to manufacturers, not service providers
Price discrimination permissible if differences in prices justified by differences in costs
Price discrimination illegal only if intent is to destroy competition
U. S. antitrust laws
Sherman Act
Clayton Act

Federal Trade Commission Act

Robinson-Patman Act
Laws against the intent of lessening or preventing competition for customers
Predatory pricing: deliberately pricing below cost in effort to drive out competitors and restrict supply,
and then raising prices rather than enlarging demand
Predator company charges a price below an appropriate measure of its costs, and
Predator company has a reasonable prospect of recovering in the future, through larger market share or higher
prices, the money it lost by pricing below cost
Non-U. S. company sells product in United States at price below market value in the country where produced,
materially injuring or threatening to materially injure industry in the United States
Antidumping duty imposed under U. S. tariff laws
Collusive pricing [Concepts in Action]
Companies within an industry conspire in their pricing and production decisions to achieve a price above the
competitive price
Violates antitrust laws of U. S. because it restrains trade
Accounting system used in checking for conformance to antitrust laws
Data collected in manner that permits relatively easy compilation of variable costs
Detailed records kept of variable costs for all value-chain business functions with review of all proposed prices

below variable costs in advance, with presumption of claims about predatory intent occurring
Do multiple choice 10.

Assign Problem 12-37.


2.d 3.c 4.c 5.b 6.a 7. d 8.b 9.d 10.c

Major influences of competitors, costs, and customers on pricing decisions are factors of
supply and demand.
activity-based costing and activity-based management.
key management themes that are important to managers attaining success in their planning and contr ol decisions.

the value-chain concept.

Short-run pricing decisions include
pricing a main product in a major market.
considering all costs in the value-chain of business functions.
adjusting product mix and volume in a competitive market while maintaining a stable price if demand fluctuates

from strong to weak.

pricing for a special order with no long-term implications.
[CPA Adapted] Pritchard Company manufactures a product that has a variable cost of $30 per unit. Fixed costs
total $1,500,000, allocated on the basis of the number of units produced. Selling price is computed by

adding a 20% markup to full cost. How much should the selling price be per unit for 300,000 units?
a. $49

b. $43.75

c. $42

d. $35

The first step in implementing target pricing and target costing is

choosing a target price.
determining a target cost.
developing a product that satisfies needs of potential customers.
performing value engineering.
The best opportunity for cost reduction is
during the manufacturing phase of the value chain.
during the product/process design phase of the value chain.
during the marketing phase of the value chain.
during the distribution phase of the value chain.

The following data apply to questions 6 and 7.

Each month, Haddon Company has $275,000 total manufacturing costs (20% fixed) and
$125,000 distribution and marketing costs (36% fixed). Haddons monthly sales are $500,000.
The markup percentage on full cost to arrive at the target (existing) selling price is

a. 25%.

b. 75%.

c. 80%.

d. 20%.

The markup percentage on variable costs to arrive at the existing (target) selling price is

a. 20%.

b. 40%.

c. 80%.

d. 66 %.

The price of movie tickets for opening day and the few days following compared to the price six months later is an

example of
price gouging.
peak-load pricing.
demand elasticity.
The World Trade Organization (WTO) is an international institution created with the goal of
levying punitive damages (as much as triple) for proven instances of dumping.
requiring a finding of material injury to an industry before any dumping tariffs can be levied.

putting companies from the more developed countries at a competitive disadvantage to encourage lesser developed
promoting and regulating trade practices among countries by lowering import duties and tariffs.
Which of these do antitrust laws on pricing not cover?
collusive pricing
peak-load pricing
predatory pricing

Discuss the three major influences on prices

Using the basic economic concepts of supply and demand, explain why customers, competitors,
and costs are considered major influences on pricing decisions.
The text addresses each of these in the section, Major Influences on Pricing Decisions in terms
of demand and supply. The basic connections are that costs affect supply, customers affect
demand, and competitors affect both demand and supply. An expanded discussion of alternate or
substitutable products could be added regarding supply. Students may have the opportunity to
make connections between the concepts studied in economics and the application of those
concepts through accounting.
Distinguish between short-run and long-run pricing decisions

How does the saying, A lifetime is but the repetition of one day, describe the relationship
between the short run and the long run?
The authors of the text use the phrase one-time-only special order when referring to the shortrun opportunity of selling goods through a special arrangement. A manager could label any
number of these opportunities as special and find the special opportunities become more and
more frequent, even to the point of being the main portion of the business. Pricing for the short
run is usually different than pricing for the long run. The pricing of special orders would not
necessarily cover long-run costs, and the business could become dependent upon such special
orders and would eventually suffer loss. Economists picture the long-run cost curve as a series
of short-run cost curves that intersect one after the other. A one-time-only special order should be
just that one time only.
Price products using the target-costing approach

Why is the development of a product that satisfies needs of potential customers given as the
first step in implementing target pricing and target costing?
A discussion of products that have not sold, at any price, would fit in at this point. Marketing
bloopers, such as the Edsel by Ford Motor Company, could be used as illustration. Almost any
product has had its detractors. Some people were quite skeptical that television would ever be
marketable. Facsimile machines were used in the first half of the twentieth century but were not
popular or highly marketable until the later half of that century. In many instances, the company
that introduces a new product does not succeed with the product, but those companies that follow
with similar products are highly successful. The personal computer and cell phone industries
have given illustration of these phenomena.

Apply the concepts of cost incurrence and locked-in costs

How does an understanding of cost incurrence and locked-in costs help a manager prevent
unintended consequences from occurring in the value chain of business functions? If a
manager cuts time and cost in the development and design stages of a product, the consequence
might well be additional costs in the manufacturing process (scrap and rework costs) and in the
warranty phase (greater costs to satisfy customer). The perceived good of reducing costs might
result in the development of a bad situation an unintended consequence.
Students could be asked, Can warranty costs that result from producing a faulty product be
easily reduced after (or even during) production? What kind of decisions might have been made
in the planning stages of the product that could cause a company to manufacture a faulty
Price products using the cost-plus approach

Does a company that uses a market-based approach to pricing need to be more concerned with
continuous improvement than a company using a cost-based approach?
In the discussions of fixed and variable costs, one notes that over a long enough time period all
costs are variable. Given time, all things change. A company must incorporate the possibility of
change in planning and control decisions. The concept of continuous improvement is relevant to
all products or services. In the marketplace, costs change, competitors change, and customers
change. No one company or product should be lax about making improvements. As noted in the
text, the market ultimately determines the markup component for cost-plus pricing.
Use life-cycle budgeting and costing when making pricing decisions

How does life-cycle product budgeting and costing illustrate the concept of different costs for
different purposes? Life-cycle product costing is done using a different time frame than the
usual reporting done on a calendar basis. Life-cycle product reporting spans costs over several
years. The life-cycle budget must reflect this same time frame for comparison to be effective.
The costs are different in that they are spread over a longer time than the usual annual report time
frame, may be greater in amount in the nonproduction phase, and may be locked in at the research
and design stages.
In the margin notes of the text, a method is presented for implementing life-cycle costing: coding
revenues and expenses through the journal entries by product as well as by function.
Describe two pricing practices in which noncost factors are important when setting prices

Why study pricing practices in which cost is not a factor in a cost accounting course?
Cost accounting provides managers with various types of information, not just that which pertains
to costs. Cost accountants gather and use information on capacity for allocating fixed costs.
Capacity information is critical for peak-load pricing and in similar special situations. For
example, ground transportation was in high demand after 9-11-01 when the airlines were
grounded for several days following the World Trade Center tragedy. Car rental companies
experienced extraordinary demand for their product. Supply (capacity) was limited and prices
could have reflected the huge gap between supply and demand. Some companies did charge
premium prices for their product/service. To meet their demand for travel, some people were
actually buying cars for short-term rental to be able to move from one part of the country to
another (increasing the capacity in a rather expensive way). Enterprise Rent-A-Car, for example,

did follow their usual guidelines of pricing during that period of time at their airport locations (no
discounts granted but prices not raised above regular quoted prices). At their nonairport locations
that do not engage in one-way rentals (thus increasing capacity in another manner), exception was
made to not only allow such rentals but also to not add the typical drop charge for returning the
car to its previous locationa cost to the company. Cost to the company was not a factor in their
In a similar manner, information about revenues and their sources would be gathered in the accounting
system and would be useful for price discrimination among different market segments. One of the
purposes of accounting is to provide a communication channel for the organization.
Explain the effects of antitrust laws on pricing

What is one of the best ways to insure that a company complies with the antitrust laws on
pricing? The authors of the text note at the end of Chapter 23 the importance of tone at the top
in promoting ethical behavior within the organization. Top management must make clear the type
of behavior that is acceptable and expected through all layers and in all parts of the organization.

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