PART 1

Financial Planning,
Performance and
Control
C. Cost Management (25% - Levels A, B, and C)

This section represents 25% of the Part 1 Exam. This section focuses on the process of determining and also
ways of controlling how much it costs to produce a product. This includes several types of cost accumulation
and cost allocation systems as well as sources of operational efficiency and business process performance for
a firm. An important concept in the business process performance portion is the concept of competitive
advantage and how a firm can attain it.

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 STUDY UNIT THREE
COST MANAGEMENT TERMINOLOGY AND CONCEPTS

MANAGEMENT ACCOUNTING, FINANCIAL ACCOUNTING, AND COST ACCOUNTING (different goals)

Management accounting (internal reporting)
 Measures and reports financial and nonfinancial information that helps managers make decisions to
fulfill the goals of an organization.
Financial accounting (external reporting based on generally accepted accounting principles (GAAP).
Cost accounting
 provides information for management accounting and financial accounting.
Cost Management
 describe the approaches and activities of managers in short-run and long-run planning and control
decisions that increase value for customers and lower costs of products and services.
Three features of cost accounting and cost management across a wide range of applications are:
1. Calculating the cost of products, services, and other cost objects (CMA Part 1).
2. Obtaining information for planning and control and performance evaluation (CMA Part 1).
3. Analyzing the relevant information for making decisions (CMA Part 2).

Cost, Cost objects and Cost pools

Cost
Cost a resource sacrificed or forgone to achieve a specific objective. An actual cost is the cost incurred (a
historical cost), as distinguished from a budgeted (or forecasted) cost.
Cost Pool
Often costs are collected into meaningful groups called cost pools.

Cost object (anything for which a measurement of costs is desired)

Examples: A cost object is any
 product,
 service,
 customer,
 activity, or
 organizational unit
to which costs are assigned for some management purpose.
Cost accumulation and Cost assignment
A costing system typically accounts for costs in two basic stages: accumulation followed by assignment.
Cost accumulation is the collection of cost data in some organized way by means of an accounting system.
Beyond accumulating costs, managers assign costs to designated cost objects
Cost assignment is a general term that encompasses both:
1. tracing accumulated costs that have a direct relationship to a cost object and
2. allocating accumulated costs that have an indirect relationship to a cost object.

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 Direct cost and Indirect cost (TRACING COSTS TO COST OBJECTS)
Direct costs of a cost object (EASILY TRACED)
A direct cost can be easily (i.e., conveniently and economically without excessive cost and without significant
effort) traced to a cost pool or object, as the cost directly relates to that item.
Common direct costs include:
1. Direct Raw Materials:
2. Direct Labor

Indirect costs of a cost object (not easily traceable to a cost pool or cost object)
Indirect costs are related to the particular cost object but cannot be traced to a cost object in an economically
feasible (cost-effective) way. Indirect costs are typically incurred to benefit two or more cost pools or objects.
Examples of indirect costs include:
1. Indirect Materials
2. Indirect Labor
3. Other Indirect Costs (Common cost)

"OVERHEAD" ALLOCATION USING ALLOCATION BASES (COST DRIVERS)

Cost allocation is made by using cost drivers (also called allocation bases), management accountants use cost
allocation techniques in cases which direct tracing is not possible, and so cost drivers are used instead.
Cost drivers are: Activities that cause costs to increase as the activity increases
For example, if the cost driver for materials handling cost is the number of parts, the total cost of materials
handling can be assigned to each product on the basis of its total number of parts relative to the total number of
parts in all other products.

Cost allocation is necessary for, among other things,

 product costing (P1 CMA),
 pricing(P2 CMA),,
 investment and disinvestment decisions(P2 CMA),,
 managerial performance measurement(P1 CMA),,
 make-or-buy decisions(P2 CMA),
 determination of profitability(P2 CMA), and
 measuring income and assets for external reporting(P1 CMA).

Cost allocation is less meaningful for internal purposes because responsibility accounting systems
emphasize controllability, a process often ignored in cost allocation.

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Example: Cost Assignment

Cost
Tracing

Cost
Allocation

Reasons for indirect cost allocation to cost objects

 measure income and assets for external reporting purposes.
 justify costs for reimbursement purposes.
 provide information for economic decision making
 To motivate managers and employees

Manufacturing and Nonmanufacturing costs

Manufacturing Costs (Treated as Product Costs)
Most manufacturing companies separate manufacturing costs into three broad categories:
1. Direct Materials costs are the acquisition costs of all materials that eventually become part of the cost object
(work in process and then finished goods) and that can be traced to the cost object in an economically feasible
way.
Examples of direct material costs are the aluminum used to make Pepsi cans and the paper used to print
Sports Illustrated.

2. Direct manufacturing labor costs include the compensation of all manufacturing labor that can be traced to
the cost object (work in process and then finished goods) in an economically feasible way.
Examples include wages and fringe benefits paid to machine operators and assembly-line workers who convert
direct materials purchased to finished goods.
3. Indirect manufacturing costs are all manufacturing costs that are related to the cost object (work in process
and then finished goods) but that cannot be traced to that cost object in an economically feasible way.
Indirect manufacturing costs “Manufacturing overhead” includes items such as
I. indirect materials;
II. indirect labor and
III. other MOH costs.
Common practice (single cost pool)
Usually all indirect costs-for indirect materials, indirect labor, and other indirect items-are commonly combined
into a single cost pool called overhead.

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The previous costs can be combined as follows
1. Prime costs which include (DM & DL) and
2. Conversion cost which include (DL & MOH).

Nonmanufacturing costs (selling, general, and administrative (SG&A) costs) (Treated as

Period Costs)
Nonmanufacturing costs are often divided into two categories:
(1) Selling costs and
(2) General & administrative costs.
Nonmanufacturing costs can be viewed by the value chain costs other than manufacturing:
o Research and development costs
o Design costs
o Marketing costs
o Distribution costs
o Customer service costs
o Administrative costs

Product costs and period costs

Product (inventoriable) costs
For financial accounting purposes, product costs include all costs involved in acquiring or making a product
(only the costs necessary to complete the product), product costs are capitalized as part of finished goods
inventory, then become a component of cost of goods sold.
Product costs for a manufacturing firm include,
1. Direct materials. The materials used to manufacture the product, which become a physical part of it.
2. Direct labor. The labor used to manufacture the product.
3. Factory overhead. The indirect costs for materials, labor, and facilities used to support the
manufacturing process.

Period (expired) costs

Period costs are all the costs that are not product costs. Thus it includes all nonmanufacturing costs in the
income statement such as general, selling, and administrative costs that are necessary for the management of
the company but are not involved directly or indirectly in the manufacturing process (or in the purchase of the
products for resale).For financial accounting purposes, period costs include all the value-chain costs except the
production costs.

Types of inventory in manufacturing firms

Manufacturing firms have three types of inventory:
1. Direct materials inventory. Direct materials in stock and awaiting use in the manufacturing process
(for example, the computer chips and components needed to manufacture cellular phones).
2. Work-in-process (also called work in progress) inventory. Goods partially worked on but not yet fully
completed (for example, cellular phones at various stages of completion in the manufacturing process).
3. Finished-goods inventory. Goods (for example, cellular phones) fully completed but not yet sold.
Exhibit 5-3 contains a summary of the cost terms that we have introduced so far.

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 PASS KEY
Cost accounting systems are designed to meet the goal of measuring cost objects or objectives. The most
frequent objectives include:
• Product Costing (inventory and cost of goods manufactured and sold)
• Efficiency Measurements (comparisons to standards)
• Income Determination (profitability)

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Cost behavior Patterns: Variable costs and fixed costs
A. VARIABLE COST
1. Behavior
A variable cost changes proportionally with the cost driver (e.g., typical cost drivers include sales volume and
production volume).
2. Amount (Constant Per Unit, Total Varies)
Variable cost & activity
A variable cost is a cost that varies, in total, in direct proportion to changes in the level of activity or volume (the
cost driver). The activity can be expressed in many ways, such as units produced, units sold, miles driven, beds
occupied, lines of print, hours worked, and so forth.
Example: A good example of a variable cost is direct materials. The cost of direct materials used during a
period will vary, in total, in direct proportion to the number of units that are produced, another examples direct
labor and part of manufacturing overhead.

Variable cost per unit remains constant in the short run regardless of the level of production. Straight line,
parallel to the horizontal axis.

Variable costs in total, on the other hand, vary directly and proportionally with changes in volume. Straight line,
sloping upward to the right.

B. FIXED COST
1. Behavior
In the short-term and within a relevant range, a fixed cost does not change when the cost driver changes.
A fixed cost is a cost that remains constant, in total, for a given time period despite, regardless of changes in
the level of activity.
2. Amount (Varies per Unit, Total Remains Constant)

PASS KEY
The distinction between variable costs and fixed costs allows managers to determine the effect of a given
percentage change in production output on costs. Be careful! The examiners often attempt to trick candidates
by providing a fixed cost per unit for a given volume of production. As fixed costs are "fixed," the candidate
must convert this format to a dollar amount that will not change as production volume changes within a
relevant range.

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3. Long-Run Characteristics
Given enough time (and a long enough relevant range), any cost can be considered variable.

Total Fixed cost, Straight line,

parallel to the horizontal axis.

Fixed cost per unit, on the other hand, varies indirectly with the activity level, the unit cost decreases as volume
increases.

Relevant range (cost relationships hold constant)

The relevant range is the range for which the assumptions of the cost driver (i.e., linear relationship with the
costs incurred) are valid. Total costs are assumed to be linear when plotted on a graph.

A summary of both variable and fixed cost behavior is presented in Exhibit 3-8.

C. SEMI-VARIABLE COSTS (MIXED COSTS)

Costs frequently contain both fixed and variable components. A cost that includes components which remain
constant over the relevant range and includes components that fluctuate in direct relation to production are
termed semi variable.
Mixed (semivariable) costs combine fixed and variable elements, e.g., rental expense on a car that carries a flat
fee per month plus an additional fee for each mile driven.

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Step Costs a cost is said to be a step cost when it varies with the cost driver but does so in discrete steps
(Exhibit 3-15).step costs is another type of nonlinear-cost function, one that is constant over small ranges of
output but increases by steps (discrete amounts) as levels of activity increase.

Methods of estimating mixed costs

Sometimes the fixed and variable portions of a mixed cost are not set by contract as in the above example and
thus must be estimated. Two methods of estimating mixed costs are in general use:
 The high-low method
 The regression (scattergraph) method

The high-low method

The high-low method is the less accurate but the quicker of the two methods. The difference in cost between
the highest and lowest levels of activity is divided by the difference in the activity level to arrive at the variable
portion of the cost.
EXAMPLE: A company has the following cost data:

The numerator can be derived by subtracting the cost at the lowest level
(July) from the cost at the highest level (May) [$3,400 – $1,900 = $1,500].
The denominator can be derived by subtracting the lowest level of activity
(July) from the highest level (May) [1,600 – 800 = 800].
The variable portion of the cost is therefore $1.875 per machine hour ($1,500 ÷ 800).
The fixed portion can be calculated by inserting the appropriate values for either the high or low month in the
range:

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Fixed portion = Total cost – Variable portion
= $1,900 – ($1.875 × 800 hours)
= $1,900 – $1,500
= $400

The regression (scattergraph) method

The regression (scattergraph) method is considerably more complex and determines the average rate of
variability of a mixed cost rather than the variability between the high and low points in the range.

Total costs and unit costs

In general, focus on total costs, not unit costs. When making total cost estimates think of variable costs as an
amount per unit and fixed costs as a total amount. The unit cost of a cost object should be interpreted
cautiously when it includes a fixed cost component.

Relationships of types of costs

We have introduced two major classifications of costs: direct/indirect and variable/fixed costs may
simultaneously be
 Direct and variable
 Direct and fixed
 Indirect and variable
 Indirect and fixed
Exhibit 3-9 shows examples of costs in each of these four cost classifications for the Ford Windstar.

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Cost of goods sold in merchandising and manufacturing firms

1. Cost of goods sold in merchandising firms.

Cost of goods sold is a straightforward computation for a retailer because merchandising-sector companies
purchase and then sell tangible products without changing their basic form, it have only a single class of
inventory.

2. Cost of goods sold in manufacturing firms.

The calculation is more complex for a manufacturer, because manufacturing-sector companies purchase
materials and components and convert them into finished goods, manufacturers have three distinct classes of
inventory.
Cost of goods sold contains an additional component called cost of goods manufactured, analogous to the
retailer’s purchases account.

A comparison of these computations in full is as follows:

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Cost Classification for decision making
To facilitate management decision making and planning, the management accountant provides relevant, timely,
and accurate information at a reasonable cost. Relevance is the most critical of the decision-making concepts;
timeliness, accuracy, and cost are unimportant if the information is irrelevant.

Relevant Cost
The concept of relevant cost arises when the decision maker must choose between two or more options. To
determine which option is best, the decision maker must determine which option offers the highest benefit,
usually in dollars. Thus, the decision maker needs information on relevant costs.

A relevant cost has two properties: (1) it differs for each decision option and (2) it will be incurred in the future. If
a cost is the same for each option, including it in the decision only wastes time and increases the possibility for
simple errors. Costs that have already been incurred or committed are irrelevant because there is no longer any
discretion about them.

Differential Cost & Incremental cost

A differential cost is a cost that differs for each decision option and is therefore relevant for the decision maker's
choice. In practice, another term are often used interchangeably with differential cost called Incremental cost
and it is the additional cost inherent in a given decision.
EXAMPLE: A company must choose between introducing two new product lines. The incremental choice of the
first option is the initial investment of $1.5 million; the incremental choice of the second option is the initial
investment of $1.8 million. The differential cost of the two choices is $300,000.

Opportunity Cost (Implicit cost)

Opportunity cost is the benefit lost when choosing one option precludes receiving the benefits from an
alternative option.
For example, if a sales manager chooses to forgo an order from a new customer to ensure that a current
customer's order is filled on time, the potential profit from the lost order is the manager's opportunity cost for this
decision.
The opposite of the opportunity cost is the outlay costs (explicit, accounting, or out-of-pocket costs) that require
actual cash disbursements.
Sunk Cost
Sunk costs are costs that have been incurred or committed in the past and are therefore irrelevant because the
decision maker no longer has discretion over them.
For example, if a company purchased a new machine without warranty that failed the next day, the purchase
price is irrelevant for the present decision to replace or to repair the machine.

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Avoidable vs. Committed (establish the current level of operating capacity/ typically fixed costs)
Avoidable costs are those that may be eliminated by not engaging in an activity or by performing it more
efficiently. An example is direct materials cost, which can be saved by ceasing production.
Committed costs
 Committed costs are Costs which are governed mainly by past decisions that established the present
levels of operating and organizational capacity and which only change slowly in response to small
changes in capacity.
 Committed costs are those which are required as a result of past decisions and cannot be altered in the
short run.
 Committed costs arise from holding property, plant, and equipment.
Examples are insurance, real estate taxes, Long-term lease payments, and depreciation. They are by nature
long-term and cannot be reduced by lowering the short-term level of production.

Engineered vs. Discretionary

Engineered costs are those having a direct, observable, quantifiable cause-and effect relationship between the
level of output and the quantity of resources consumed.
Examples are direct materials and direct labor.
Discretionary costs
 are those characterized by an uncertainty in the degree of causation between the level of output and
the quantity of resources consumed.
 They tend to be the subject of a periodic (e.g., annual) outlay decision.
 “Discretionary costs” are costs which: Management decides to incur in the current period to enable the
company to achieve objectives other than the filling of orders placed by customers.
 Costs that arise from periodic budgeting decisions that have no strong input-output relationship are
commonly called Discretionary costs.
Examples are advertising and R&D costs

Other COST CLASSIFICATION

Joint vs. Separable
 Often a manufacturing process involves processing a single input up to the point at which multiple end
products become separately identifiable, called the split-off point.
 Joint costs are those costs incurred before the split-off point, i.e., since they are not traceable to the
end products, they must be allocated.
 Separable costs are those incurred beyond the split-off point, i.e., once separate products become
identifiable.
 By-products are products of relatively small total value that are produced simultaneously from a
common manufacturing process with products of greater value and quantity (joint products).
 An example is petroleum refining. Costs incurred in bringing crude oil to the fractionating process are
joint costs.

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Normal vs. Abnormal Spoilage
 Normal spoilage is the spoilage that occurs under normal operating conditions. It is essentially
uncontrollable in the short run, since normal spoilage is expected under efficient operations, it is treated
as a product cost, that is, it is absorbed into the cost of the good output.
 Abnormal spoilage is spoilage that is not expected to occur under normal, efficient operating conditions.
The cost of abnormal spoilage should be separately identified and reported to management,
 When compared with normal spoilage, abnormal spoilage: Is generally thought to be more controllable
by production management than normal spoilage.

Abnormal spoilage is typically treated as a period cost (a loss account) because of its unusual nature.
Abnormal spoilage should be charged to in the period that detection of the spoilage occurs

Rework, Scrap, and Waste

 Rework consists of end products that do not meet standards of salability but can be brought to salable
condition with additional effort, the decision to rework or discard is based on whether the marginal
revenue to be gained from selling the reworked units exceeds the marginal cost of performing the
rework.
 Scrap consists of raw material left over from the production cycle but still usable for purposes other
than those for which it was originally intended, Scrap may be used for a different production process or
may be sold to outside customers, usually for a nominal amount.
 Waste consists of raw material left over from the production cycle for which there is no further use,
Waste is not salable at any price and must be discarded.
Other Costs
 Carrying costs are the costs of storing or holding inventory. Examples include the cost of capital,
insurance, warehousing, breakage, and obsolescence.
 Transferred-in costs are those incurred in a preceding department and received in a subsequent
department in a multi-departmental production setting.
 Value-adding costs are the costs of activities that cannot be eliminated without reducing the quality,
responsiveness, or quantity of the output required by a customer or the organization.

Capacity levels Denominator-level capacity choices

Capacity levels can be measured in terms of
 what a plant can supply-theoretical capacity or practical capacity.
 demand for the output of a plant-normal capacity utilization or master-budget capacity utilization.
What a plant can supply
Theoretical capacity (ideal goal of capacity usage)
 based on producing at full efficiency all the time.
 does not allow for any plant maintenance, interruptions because of bottle breakage on the filling lines,
or any other factor.
 is unattainable in the real world as it assume continuous operations with no holidays, downtime, etc.

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Practical capacity
 is the level of capacity that reduces theoretical capacity by unavoidable operating interruptions, such as
scheduled maintenance time, shutdowns for holidays, so It allows for unavoidable delays in production
for maintenance, holidays, etc.
 is the maximum level at which output is produced efficiently.
 Is the upper limit of a company’s productive output capacity given its existing resources.
 Use of practical capacity as a denominator value usually results in underapplied overhead because it
always exceeds the actual level of use (U.7)

Capacity levels in terms of demand

In contrast, normal capacity utilization and master budget capacity utilization measure capacity levels in terms
of demand for the output of the plant - the amount of the available capacity that the plant expects to use based
on the demand for its products. In many cases, budgeted demand is well below the production capacity
available.
Normal capacity utilization
 is the long-term average level of capacity utilization that satisfies average customer demand over a
period (say, 2 to 3 years) that includes seasonal, cyclical, and trend factors. Deviations in a given year
will be offset in subsequent years.

Master-budget capacity utilization

 is expected level of capacity utilization for the current budget period, typically one year.

These two capacity utilization levels can differ-for example, when an industry has cyclical periods of high and
low demand or when management believes that the budgeted production for the coming period is not
representative of long-run demand.

Costing Techniques
The rest of the current chapter provide you with a brief explanation with the various topics that will be studied in
more details in the rest of the current part, the major topics are:
1. Inventory Costing: absorption costing (AC) Vs. variable costing (VC), (Ch.5)
2. Cost Accumulation, Cost Measurement and Overhead Assignment in traditional costing system and in
ABC. (Ch.4& 5)
3. Cost Allocation (Ch .5)
a. Allocating joint costs
b. Allocating service department costs
4. Standard Costing, Flexible Budgeting, and Variance Analysis (Ch.7)
5. Target costing :market price of the product is taken as a given.(P2 CMA)

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