INTRODUCTION TO    MANAGEMENT ACCOUNTING

A. Introduction   
1. Accounting provides essential information and is known as the language of business.
2. Financial accounting focuses on external users and, as such, must comply with GAAP. Finan-
cial accounting information is:
a. typically historical, verifiable, quantifiable, and monetary;
b. usually quite aggregated and related to the organization as a whole; and
c. often a business essential because it is necessary for obtaining loans, preparing tax re-
turns, and understanding how well or how poorly the business is performing.
3. Management accounting focuses on the information needs of an organization's internal man-
agers’ needs that are related to their planning, controlling, and decision-making functions.
a. Some management needs are satisfied by historical, monetary information based on
generally accepted accounting principles.
b. Other needs require forecasted, qualitative, and frequently nonfinancial information
that has been developed and computed for their specific decision purposes.
c. A company's business intelligence (BI) system is a formal process for gathering and
analyzing information and producing intelligence to meet decision making needs.
4. Relationship of Financial and Management Accounting.    Accounting information is supposed
to address three different functions:
a. provide information to external parties (stockholders, creditors, and various regulatory
bodies) for investment and credit decisions;
b. estimate the cost of products produced and services provided by the organization; and
c. provide information useful for making decisions and controlling operations.
1. Cost accounting creates an overlap between financial accounting and managerial accounting.
a. Cost accounting integrates with financial accounting by providing product costing information
for financial statements and with management accounting by providing some of the quantita-
tive, cost-based information managers need to perform their tasks.   
b. The boundaries between financial and managerial accounting are not clearly and definitively
drawn.   
6. Relationship of Management and Cost Accounting
a. The Institute of Management Accountants (IMA) is an organization composed of
individuals interested in the field of management accounting; was previously the Na-
tional Association of Accountants (NAA); coordinates the Certified Management Ac-
countant (CMA) program through its affiliate organization, the Institute of Certified
Management Accountants (ICMA)
b. Management accounting is defined by the IMA as a discipline that includes almost
all manipulations of financial information for use by managers in performing their or-
ganizational functions and in assuring the proper use and handling of an entity's re-
sources. The objectives of management accounting reflect its comprehensive nature..
c. The functions of cost accounting focus primarily on the determination of the cost of
making products or performing services; cost accounting is an integral part of the
broader field of management accounting.
d. Cost accounting is defined as "a technique or method for determining the cost of a
project, process, or thing... This cost is determined by direct measurement, arbitrary
assignment, or systematic and rational allocation."
e. Cost accounting creates an overlap between financial accounting and management ac-
counting.
f. The cost accounting overlap causes the financial and management accounting systems
to be joined together to form a complete informational network.
 g. This discipline integrates with financial accounting by providing product costing in-
formation for financial statements.
h. Cost accounting also integrates with management accounting by providing some of
the quantitative, cost based information managers need to perform their tasks.
7. Management accountants should strive to recognize:
a. what information is needed by managers;
b. why the information is needed; and
c. how to provide the information in the best possible form and in the timeliest manner
to enhance understandability and usefulness in decision making.
8. Managers need information to make decisions about:
a. acquiring and financing production capacity;
b. determining which products to market;
c. pricing jobs, products, or services;
d. determining the best method of delivering finished goods to warehouses;
e. locating the best property for production facilities; and
f. financing the costs of production.
9. Data and information are clearly different.
a. Data are bits of knowledge or facts that have not been summarized and categorized in
a manner useful to a decision maker.
b. Information represents knowledge or facts that have been carefully chosen from a
body of data and arranged in a meaningful way.
10. Management accountants should provide both quantitative and qualitative information to assist
managers in decision making.
a. Quantitative information allows managers to witness the numerical impact of alterna-
tive choices.
b. Qualitative information furnishes facts that help eliminate some of the inherent uncer-
tainty related to such choices.
11. Management accountants play an important role in controlling and performance evaluation.
a. Controlling is the process of exerting managerial influence on operations so that they
conform to previously prepared plans.
b. Controlling involves setting performance standards, measuring performance, periodi-
cally comparing actual performance with standards, and taking corrective action when
operations do not conform with established standards.
c. A performance evaluation is the process of determining the degree of success in ac-
complishing a task; equates to both effectiveness and efficiency. Such evaluations are
conducted to determine if operations are proceeding according to plan or if actual re-
sults differ materially from expected results. Once performance has been measured by
the control process, managers must evaluate the effectiveness and efficiency of that
performance.
d. Effectiveness is a measure of how well an organization's goals and objectives are
achieved; compares actual output results to desired results; determination of the suc-
cessful accomplishment of an objective.
e. Efficiency is a measure of the degree to which tasks were performed to produce the
best yield at the lowest cost from the resources available; the degree to which a satis-
factory relationship occurs when comparing outputs to inputs.
12. Management accountants play an important role in decision               
                                                                        making.
a. Decision making is the process of choosing among the alternative solutions available
to a course of action or a problem situation. A manager’s ability to manage depends on
good decision making.
b. Managers are the information users while accountants are the information providers.
c. The quantity of information? Desired is partially based on the expected consequences
of the decision.
 d. The purpose of management accounting is basically two-fold: First, it must provide
the basis for appropriate cost estimations that are needed for the financial statement
presentations of inventory and cost of goods/services sold. Second, it must provide
adequate, useful information to assist managers in performing the basic functions of
planning, controlling, evaluating performance, and decision making.
13. Management accountants are not required to adhere to GAAP in providing information for
managers' use internally.
14. The Certified Management Accountant (CMA) is a professional designation in the area of
management accounting that recognizes the successful completion of an examination, accept-
able work experience, and continuing education requirements.
B. The Global Environment of Business
1. E-commerce has increased the globalization of business. E-commerce is any business activity
that uses the internet and world-wide web to engage in financial transactions.
2. The transition in the United States from a manufacturing-based to a service-oriented economy
is a significant development.
3. The world has become effectively smaller due to technology development, with    firms and
consumers taking an international, rather than domestic, market view.
a. Globalization of markets involves a changeover in local markets from competition
among national or local suppliers to competition among international suppliers.
b. The global economy represents an economy characterized by the international trade
of goods and services, the international movement of labor, and international flows of
capital and information.
4. Companies are now emphasizing performance from the perception of the consumer rather than
from the perspective of quantity of output or the ability to meet budget figures.
5. Good quality is necessary in both manufacturing and service environments; and if poor quality
occurs, a company should acknowledge and correct its failures.
C. Organizational Strategy
1. Management accountants play an important role in planning.
a. Planning is the process of translating the goals and objectives for an organization and
developing a strategy for achieving them in a systematic manner.
b. The planning functions differ in large and small organizations.
c. Managers depend heavily on management accountants when planning is being con-
ducted. Long-term plans usually address such issues as market share, which is based
on projections of costs, prices, volume, quality, and service. Short-term plans may be
in the form of budgets for such resources as cash, inventory, and personnel.
2. A strategy is a long-term plan that is formulated to fulfill the goals and objectives of the organiza -
tion.
a. Strategy involves all three organizational functions in which accountants interact with
managers:    planning,    controlling, and    decision making.
b. Strategy is the link between the organization's goals and objectives and the activities
actually conducted by the organization; therefore strategies frequently determine the
extent to which an organization is successful in achieving its goals.
c. Each organization has a unique set of opportunities and constraints that play a role in
determining which alternative strategies are feasible and likely to be successful.
D. Influences on Organizational Strategy
1. Organizational structure refers to how authority (and responsibility) for making decisions is distrib-
uted in the organization.
a. Segments need to be organized according to their missions in order to effectively define segments, man-
age resources, and implement strategies.
b. Managers set goals and objectives when planning for the future.
c. Goals are desired abstract achievements.
d. Objectives are desired quantifiable achievements for a period of time. Objectives should logically result
from goals.
2. The most desired types of business intelligence include:
a. competitor activities,
 b. changing market structure,
c. customer/supplier activities,
d. emerging technology initiatives,
e. regulatory climate,
f. political climate, and
g. global economic conditions.
3. Managers must acknowledge and deal with organizational constraints in making strategic deci-
sions for their firms.
a. Level of capital availability is a major constraint faced by all organizations. Manage-
ment must answer the following: two questions before attempting to eliminate a capi-
tal constraint:    can the capital be obtained at a reasonable cost, and would realloca-
tion of current capital be more effective and efficient?
b. The level of a firm’s intellectual capital or the intangible assets of skill, knowledge,
and information that encompasses human capital and structural capital represents an-
other significant constraint on organizational strategy.

c. Technology availability is another meaningful constraint on organizational strategies,

and the acquisition of new technology is one way to create new strategic opportuni-
ties.

4. Management style and organizational culture are two significant and related variables in deter-
mining organizational strategy.

a. Management style can be described as a preference in the manner that management

interacts with other stakeholders in the organization.

b. Organizational culture is the set of basic assumptions about the organization and its
goals and ways of doing business; describe the norms of an organization in both inter-
nal and external, as well as formal and informal, transactions.

c. Management style and organizational culture are heavily influenced by the national
culture of the organization,    the extent of diversity in the work force, and    the experi-
ences and philosophies of the top management team.

5. An environmental constraint is any limitation on strategy options caused by cultural, fiscal,

legal/regulatory, or political situations.

a. The operating environment of an organization does not operate in isolation from the
other factors affecting corporate strategy.

b. Management, through its actions and the organizational culture, influences the organi-
zation and may work to affect the operating environment through numerous activities.

D. Role of Accounting in Organizations

1. Strategy formulation is the foundation level of organizational   
                                                planning.
2. Measurement of profitability is a function of the accounting information system.
3. Organizational management must consider the financial implications of its actions in determin-
ing what strategies to pursue.
4. Operating plans contain the details necessary to implement and maintain an organization's
strategies.
5. Accounting information plays a vital role in linking the objectives of top managers to the in-
centives of segment managers.
a. Accounting information is normally the basis for measuring or evaluating segment
managers in terms of efficiency and effectiveness.
b. The accounting measurements must be tied to the segment's mission for accounting to
provide the correct incentives to a segment manager.
c. Long-term performance measures are more appropriate for build missions, while
shorter-term performance measures are more appropriate for harvest missions.
 d. Responsibility accounting is the use of accounting information to evaluate the per-
formance of segment managers.
e. Opportunity cost is an amount that represents the potential benefit foregone because
one course of action is chosen over another.
f. Companies deciding to implement empowerment concepts characteristically introduce
teams to the organization structure.
6. A company can determine its core competencies only by analyzing its activities and comparing
hem to internal or external benchmark measurements.
7. New strategic initiatives including development of new products and services are possible only
if both monetary and intellectual capital is available for new investment.
a. Corporate managers depend: on public capital markets to acquire the funds necessary
to pursue new investment.
b. Companies are concerned about the cost of capital (COC) they can acquire since capi-
tal is a primary organizational constraint.
c. The expected average annual growth rate is an estimate of the increase expected in
dividends or in market value per share of stock; is a function of a company's predicted
earnings, dividend policy, and market price appreciation per share.
d. Strategic resource management (SRM) involves the organizational planning for de-
ployment of resources to create value for customers and shareholders.
e. SRM is concerned with:    how to deploy resources to support strategies; how re-
sources are used in, or recovered from, change processes;    how customer value and
shareholder value will serve as guides to the effective use of resources; and    how re-
sources are to be deployed and redeployed over time.
f. The focus of SRM is the value chain, the set of processes that convert inputs (hence,
the term conversion activities) into products and services consumed by the firm's
customers.
g. The value chain includes the processes of suppliers as well as internal processes, and
managers are able to relate activities in the firm to value created for customers by fo-
cusing on the value chain.
h. Employees earn compensation and suppliers earn revenues for their contributions to
the value chain.
i. Synergies or economies in operation may be somewhat obvious in the vertical value
chain, but they may be much more difficult to recognize in conglomerates.
j. The build mission is an organizational segment mission that implies a goal of in-
creased market share, even at the expense of short-term earnings and cash flow.
k. The hold mission is an organizational segment mission that is geared to the protection
of the business unit's market and competitive position.
l. The harvest mission is an organizational segment mission that implies a goal of max-
imizing short-term earnings and cash flow, even at the expense of market share.
m. The product life cycle refers to the sequential stages that a product passes through
from the time that the idea is conceived until production of the product is discontin-
ued.
n. Top managers are constantly challenged to identify ways to persuade each segment
manager to operate the segment according to that segment's mission.
o. An organizational structure in which all authority for making decisions is retained by
top management is referred to as centralization.
p. At the other end of the continuum, an organizational structure in which the authority
for making decisions is distributed to many people in the organization including lower
level managers is referred to as decentralization.
q. Empowerment of employees involves giving people the authority and responsibility
to make decisions about their work.
r. The authority structure in the organization is a short-term constraint on organizational
strategy, and the structure can therefore be changed in the long term.
s. Strategy creation is often the responsibility of only top management, but in decentral -
ized organizations, lower level managers are frequently responsible for strategy im-
plementation.
8. The balancing of short-run and long-run demand for resources is one of the most meaningful challenges of
efficiently and effectively managing organizational resources.
9. A rational application of resources must prioritize strategic resource needs and balance short-term and long-
term value considerations.
10. Managers must also take care to structure strategic initiatives such that they allow flexibility in operational
management.
11. A core competency is a higher proficiency relative to competitors in a critical function or activity.
a. Core competencies are the roots of competitiveness and competitive advantage.
b. The core competencies may be industry-specific or firm-specific.
c. Core competencies are apt to be both firm-specific and industry-specific.
12. Management accounting provides information for internal users.
a. Managers are often concerned with individual segments of the business rather than the
organization as a whole, so management accounting information normally addresses
specific concerns rather than the "big picture" of financial accounting.
b. Management accountants are expected to be flexible in providing information that
serves the needs of management and is useful to managers' functions.
c. Cost-benefit analysis is the analytical process of comparing the relative costs and
benefits that result from a specific course of action (such as providing information or
investing in a project). Information should be developed and provided only if the cost
of producing the information is less than the benefit of having it.
13. The objectives and nature of financial and management accounting differ, but all accounting
information tends to rely on the same basic accounting system and set of accounts.

COST TERMINOLOGY    AND COST FLOWS

Terminology

Actual cost system a valuation method that uses actual direct materials, direct labor, and overhead charges in de-
termining the cost of Work in Process Inventory

Allocate cost assignment based on the use of a cost predictor or an arbitrary method
Applied overhead the amount of overhead assigned to Work in Process Inventory as a result of productive activ-
ity; credits for this amount are made to an overhead account
Capacity a measure of production volume or some other activity base

Conversion cost the sum of direct labor and factory overhead costs; the costs incurred in changing raw materials
or purchased parts into salable finished products
Cost a monetary measure of the resources given up to attain some objective such as acquiring a good or service
Cost allocation the assignment of an indirect cost to one or more cost objects using some reasonable basis

Cost driver a factor that has a direct cause-effect relationship to a cost

Cost of goods manufactured (CGM) the total cost of the goods that were completed and transferred to Finished
Goods Inventory during the period
Cost object anything to which costs attach or are related
Cost pool a collection of monetary amounts incurred either for the same purpose or at the same organizational
level
Dependent variable an unknown variable that is to be predicted using one or more independent variables
Direct cost a cost that is distinctly traceable to a particular, specified cost object
Direct labor the cost of the time spent by individuals who work specifically on manufacturing a product or per-
foming a service
Direct material any readily identifiable part of a product
Distribution cost a cost incurred to warehouse, transport, or deliver a product or service
Expected    capacity a short-run concept that represents the anticipated level of capacity to be used by the firm in
the upcoming year
Expired cost an expense or a loss
Fixed cost a cost that remains constant in total within a relevant range of activity
High-low method a technique used to determine the fixed and variable portions of a mixed cost; uses only the
highest and lowest levels of activity and related costs within the relevant range
Historical cost a cost that was incurred in the past, is objective and verifiable, and is usually used in financial ac-
counting
Independent variable a variable that, when changed, will cause consistent, observable changes in another vari-
able; a variable used as the basis of predicting the value of a dependent variable
Indirect cost a cost that cannot be traced explicitly to a particular, specified cost object common cost
Inventoriable cost a cost associated with making or acquiring inventory (see product cost)
Least squares regression analysis a statistical technique that analyzes the association between dependent and
independent variables; determines the line of "best fit" for a set of observations by minimizing the sum of the
squares of the vertical deviations between actual points and the regression line; can be used to determine the
fixed and variable portions of a mixed cost
Manufacturer any company engaged in a high degree of conversion of raw material input into other tangible
output
Mixed cost a cost that has both a variable and a fixed component; changes with changes in activity, but not pro-
portionately
Multiple regression a statistical technique that uses two or more independent variables to predict a dependent
variable
Normal capacity the average activity of the firm over a long period of time such as five to ten years.
Normal cost system a valuation method that uses actual costs of direct materials and direct labor in conjunction
with a predetermined overhead rate or rates in determining the cost of Work in Process Inventory
Outliers abnormal or nonrepresentative observations within a data set that may be inadvertently used in the ap-
plication of the high-low method
Overapplied overhead the amount of overhead that remains at the end of the period when the applied overhead
is greater than the actual overhead
Overhead any factory or production cost that is indirect to manufacturing a product or providing a service; does
not include direct materials or direct labor
Period cost any cost other than one associated with making or acquiring inventory
Practical capacity the activity level that can be achieved during regular working hours.    Practical capacity is
less than theoretical capacity by the amount of ongoing, regular operating interruptions such as holidays, down-
time, and start-up time.
Predetermined overhead rate an estimated, average constant charge per unit of activity used to assign overhead
cost to production or services of the period, and can be calculated by dividing total budgeted annual overhead by
the related measure of volume or activity
Predictor an activity measure that, when changed, is accompanied by consistent, observable changes in a cost
item
Prime cost the total cost of direct materials and direct labor
Product cost a cost associated with making or acquiring inventory (see inventoriable cost) Relevant range the
specified range of activity over which a variable cost remains constant per unit or a fixed cost remains fixed in
total
Regression line any line that goes through the means (or averages) of the set of observations for an independent
variable and its dependent variables; mathematically, there is a line of "best fit" which is the least squares regres-
sion line
Relevant range the range of activity over which fixed costs remain fixed.
Replacement cost an amount that a firm would currently have to pay to replace an asset or to buy one that per-
forms functions similar to an asset currently held
Service company a firm engaged in a high or moderate degree of conversion that uses a significant amount of
labor
Simple regression a statistical technique that uses only one independent variable to predict a dependent variable
Standard error of the estimate (Se) a measure of dispersion that reflects the average difference between actual
observations and expected results provided by a regression line (From Appendix)
Step cost a type of cost that shifts upward or downward when activity changes by a certain interval or "step"
Theoretical capacity the estimated maximum potential activity level for a specified period of time.    This mea-
sure assumes that all factors are operating in a technically and humanly perfect manner and ignores realities such
as machinery breakdowns and holidays.
Underapplied overhead the condition wherein actual overhead is greater than overhead charged to production.
Unexpired cost an asset
Variable cost a cost that varies in total in direct proportion to changes in activity

A. Cost Classifications on the Financial Statements

1. Cost reflects a monetary measure of the resources given up to attain some objective such as ac-
quiring a good or service.

2. Cost classifications are used to define costs in terms of their relationships to the following four
items:

a. time of incurrence,

b. reaction to changes in activity,

c. classification on the financial statements, and

d. impact on decision making.

3. Some costs are associated with the time of incurrence.

 a. A historical cost represents a cost that was incurred in the past, is objective and veri-
fiable, and is usually used in financial accounting.

b. A replacement cost is an amount that a firm would currently have to pay to replace
an asset or to buy one that performs functions similar to an asset currently held.

c. A budgeted cost is a planned future expenditure that might be the same amount as the
replacement cost.

4. Some costs demonstrate reactions to changes in activity within a normal operating or relevant
range of activity.

a. The relevant range is the specified range of activity over which a variable cost re-
mains constant per unit or a fixed cost remains fixed in total.

b. A variable cost is a cost that varies in total in direct proportion to changes in activity.

c. A fixed cost remains constant in total within a relevant range of activity.

d. A mixed cost is a cost that has both a variable and a fixed component; changes with
changes in activity, but not proportionately. A mixed cost is assumed by accountants
to be linear.
e. A step cost is a type of cost that shifts upward or downward when activity changes by
a certain interval or "step." Step variable costs have small steps, while step fixed costs
have large steps.
f. A predictor is an activity measure that, when changed, is accompanied by consistent,
observable changes in a cost item.
g. A cost driver is a factor that has a direct cause-effect relationship to a cost.
5. Some costs are identified as to how they are classified on the financial statements.
a. The balance sheet is a statement of unexpired costs, and an unexpired cost is an asset.
b. The income statement is a statement of revenues and expired costs, and an expired
cost is an expense or a loss.
c. A product cost is a cost that is associated with producing or acquiring inventory, and
is therefore referred to as an inventoriable cost.    Product costs include direct mate-
rial, direct labor, and overhead costs.
d. A direct material is any readily identifiable part of a product.
e. Direct labor refers to the cost of the time spent by individuals who work specifically
on manufacturing a product or performing a service. The wages (or salaries) of these
individuals are considered direct labor cost.
f. Overhead is any factory or production cost that is indirect to manufacturing a product
or providing a service; does not include direct materials or direct labor. Overhead may
be variable or fixed.
g. A period cost is any cost other than one associated with making or acquiring inven-
tory. Period costs are related to other business operations and are more closely associ-
ated with a particular time frame rather than with the production or acquisition of a
product or the performance of a service.
h. A distribution cost is a cost incurred to warehouse, transport, or deliver a product or
service. Even though distribution costs are expensed as incurred (like many other pe-
riod costs), managers cannot lose sight of the fact that these costs relate directly to
products and services.
B. The Conversion Process
1. Different types of firms have low, moderate, or high degrees of conversion.
a. Firms that engage in a low-to-moderate degree of conversion conveniently expense
insignificant labor and overhead costs related to conversion. Such firms usually have
just one inventory account--Merchandise Inventory.
b. High conversion firms reap informational benefits by assigning labor and overhead
costs to the output produced. Such benefits significantly exceed the clerical costs of
assigning these costs. Such manufacturers normally use three inventory accounts--
Raw Materials, Work in Process, and Finished Goods.
c. A manufacturer refers to any company engaged in a high degree of conversion of
raw material input into a tangible output.

d. A service company refers to a firm engaged in a high or moderate degree of conver-

sion that uses a significant amount of labor. The output of a service business may be
either tangible or intangible and usually cannot be inspected prior to its use.
e. Service companies may be profit-making or not-for-profit organizations.
2. Retail companies purchase goods in finished or nearly finished condition that normally need
little or no conversion before being sold to customers, while manufacturers and service compa-
nies engage in activities that involve the physical conversion or transformation of inputs into
finished products or services.
 a. The primary difference between retail companies and manufacturers and service com-
panies is the absence or presence of a production center that involves the conversion
of raw material inputs into final products.
b. Several differences in accounting for production activities exist between manufactur-
ers and service companies. A manufacturer must account for raw materials, work in
process, and finished goods to maintain control over the production process. Most ser-
vice firms need only to keep track of their work in process (incomplete jobs).
C. Stages of Production
1. Production processing or conversion can be perceived as existing in three basic stages of pro-
duction:
a. Work not started (raw materials);
b. Work in process; and
c. Finished work.
2. The total costs incurred in stages one and two are equal to the total production cost of finished
goods in the third stage.
3. The primary accounts involved in the cost accumulation process     
                                            are:
a. Raw Materials Inventory,
b. Work in Process Inventory, and
c. Finished Goods Inventory.
4. Service firms usually do not have the same degree of cost complexity as do manufacturing
firms.
a. Supplies are inventoried in the work not started stage until they are placed into a work
in process stage, where labor and overhead are added to achieve finished results.
b. Service firms usually have a Supplies Inventory account (no Raw Materials Inven-
tory) and a Work in Process account (no Finished Goods Inventory).
5. Firms in merchandising, manufacturing, and service can all use management accounting con-
cepts and techniques, although to varying degrees.
D. Cost Reactions to Changes in Activity
1. Accountants describe a given cost’s behavior pattern according to the way its total cost (rather
than its unit cost) reacts to changes in a related activity measure.
2. A fixed cost remains fixed in total within the relevant range of activity under consideration.
3. A variable cost varies as production changes, but the cost per unit remains the same.
4. A mixed cost has both a variable and a fixed component.
5. Separating Mixed Costs--Mixed costs contain both a variable and a fixed cost element and
are assumed by accountants to be linear rather than curvilinear.
6. The high-low method is a technique used to determine the fixed and variable portions of a
mixed cost; uses only the highest and lowest levels of activity and related costs within the rele-
vant range.
a. The method uses the highest and lowest observed levels of actual activity to determine
the change in costs which reflects the variable cost element b as follows.
(Cost at high activity level) - (cost at low activity level)
b =            __________________________________________
(High activity level) - (low activity level)

Change in total cost

b =            ________________________
Change in activity level
b. The fixed portion of a mixed cost is found by subtracting total variable cost from total
cost.
7. Outliers are abnormal or non representative observations within a data set that may be inad-
vertently used in the application of the high-low method.
E. Components of Product Cost
1. A cost object is anything to which costs attach or are related.
a. A direct cost is a cost that is distinctly traceable to a particular, specified cost object.
b. An indirect cost is a cost that cannot be traced explicitly to a particular, specified cost
object and, therefore, must be allocated to the cost object using one or more predictors
or arbitrarily chosen bases. An indirect cost is a common cost.
c. The term allocate means that a cost assignment is made based on the use of a cost
predictor or an arbitrary method.
2. A direct material is any readily identifiable part of a product.
3. Direct labor refers to the cost of the time spent by individuals who work specifically on manu-
facturing a product or performing a service. The wages (or salaries) of these individuals are
considered direct labor cost.
4. Overhead is any factory or production cost that is indirect to manufacturing a product or pro-
viding a service; does not include direct materials or direct labor. Overhead may be variable or
fixed.
5. Quality cost is an important type of overhead cost.
 a. Prevention cost is a quality control cost that is incurred to improve quality by prevent-
ing defects from occurring.
b. An appraisal cost is a quality control cost that is incurred for monitoring or inspection.
Appraisal costs compensate for mistakes not eliminated through prevention.
c. A failure cost is a quality control cost that is associated with goods or services that
have been found not to conform or perform to the required standards as well as all re-
lated costs (such as that of the complaint department). Such cost may be internal or
external.
6. Prime cost is the total cost of direct materials and direct labor.
7. Conversion cost is the sum of direct labor and factory overhead costs; the costs incurred in
changing raw materials or purchased parts into salable finished products.
F. Accumulation and Allocation of Overhead
1. Cost of Goods Sold cannot be calculated until ending inventories are determined by physical
count in a periodic inventory system.    All product costs flow through Work in Process Inven-
tory to Finished Goods Inventory and, ultimately, to Cost of Goods Sold in a perpetual inven-
tory system.
2. Overhead costs are allocated to cost objects for three reasons.
a. to determine a full cost of the cost object.
b. To motivate the manager in charge of the cost object to manage it efficiently, and
c. To compare alternative courses of action for management planning, controlling, and
decision making.
3. Using Flexible Budgets in Setting Predetermined Overhead
Rates
a. A flexible budget is a series of individual budgets that present costs according to their
behavior at different levels of activity.
b. A flexible budget presents variable and fixed costs at various levels of activity within
a relevant range of activity.
c. Flexible budgets are prepared for both product and period costs.
d. A step fixed cost is a distinct change in a fixed cost due to increased activity.
e. Capacity is a measure of production volume or some other activity base.
f. Expected annual capacity is a short-run concept that represents the anticipated level
of capacity to be used by the firm in the upcoming year.
4. Applying Overhead to Production
a. Applied overhead is the amount of overhead assigned to Work in process Inventory
as a result of productive activity; credits for this amount are made to an overhead ac-
count.
b. The amount of applied overhead is determined by multiplying the predetermined rate
by the actual activity level.
c. The cost accountant can record overhead in the accounting system in separate ac-
counts for actual and applied overhead or in a single overhead account.
d. The general ledger may contain a single overhead account or separate accounts for
variable and fixed overhead.
5. Actual overhead incurred during a period will rarely equal applied overhead; this difference
represents under-applied or over- applied overhead.
a. Under-applied overhead is the amount of overhead that remains at the end of the pe-
riod when the applied overhead is less than the actual overhead.
b. Over-applied overhead is the amount of overhead that remains at the end of the pe-
riod when the applied overhead is greater than the actual overhead.
6. Disposition of under-applied or over-applied overhead is recorded     
                                            annually.
a. The method of disposition of under-applied or over-applied overhead depends upon
the materiality of the amount involved.
b. The amount is closed to Cost of Goods Sold if it is     
                                            immaterial.
c. The amount, if it is material, should be allocated among the accounts containing ap-
plied overhead:    Work in process Inventory,    Finished Goods Inventory, and    Cost
of Goods Sold.
7. There are three causes of under-applied or over-applied overhead:
a. A difference between actual and budgeted variable overhead cost per unit;
b. A difference between actual and budgeted total fixed overhead cost; and
c. A difference between actual activity and the budgeted capacity used to calculate the
fixed overhead application rate--only if the company's actual activity level exactly
equals the expected activity level will the total budgeted amount of fixed overhead be
applied to production.
G. Accumulation of Product Costs—Actual Cost System
1. Product costs can be accumulated using either a perpetual or a periodic inventory system.
H. Cost of Goods Manufactured and Sold
1. A schedule of cost of goods manufactured needs to be prepared as a preliminary step to the de-
termination of cost of goods sold (CGS) for a company using the periodic inventory system.
 Cost of goods manufactured (CGM) is the total cost of the goods that were completed and
transferred to Finished Goods Inventory during the period.
2. Accountants will prepare a formal schedule of cost of goods manufactured and a formal sched-
ule of cost of goods sold for management regardless of the type of inventory valuation method
employed.
I.         Accumulation of Product Costs—Normal Cost System
1. There is little difference between a normal cost system and an actual cost system.    Only the
application of overhead to work-in-process differs between the two methods.
J. Least Squares Regression Analysis is a statistical technique that analyzes the association between depen-
dent and independent variables. It determines the line of "best fit" for a set of observations by minimizing
the sum of the squares of the vertical deviations between actual points and the regression line. It can be used
to determine the fixed and variable portions of a mixed cost.
1. A dependent variable is an unknown variable that is to be predicted using one or more inde-
pendent variables.
2. An independent variable is a variable that, when changed, will cause consistent, observable
changes in another variable; a variable used as the basis of predicting the value of a dependent
variable.
3. Simple regression is a statistical technique that uses only one independent variable to predict a
dependent variable.
4. Multiple regression is a statistical technique that uses two or more independent variables to
predict a dependent variable.
5. A regression line is any line that goes through the means (or averages) of the set of observa-
tions for an independent variable and its dependent variables. Mathematically, there is a line of
"best fit" which is the least squares regression line.

A scatter graph is a graph that plots all known activity observations and the associated costs; used to separate
mixed costs into their variable and fixed components and to examine patterns reflected by the plotted observa-
tions