Accounting System - a formal mechanism for gathering, organizing, and

communicating information about an organization's activities. A good

accounting system helps an organization achieve its goals and objectives by
helping to answer three types of questions.

1. Scorecard Questions (Am I doing well or poorly?) -

Accumulation and classification of data,
2. Attention-Directing Questions (Which problems should I
look into?) - focuses on operating problems and
opportunities, and
1. Problem-Solving Questions (Of the several ways of doing the
job, which one is best?) - quantifies the likely results of
possible courses of action for long-range planning.
B. Influences on Accounting Systems
Foreign Corrupt Practices Act

Management Audit
Sarbanes-Oxley Act

I. Cost-Benefit and Behavioral Considerations

Cost-Benefit Balance - weighing estimated costs against probable

benefits. This is the primary consideration in choosing among accounting
systems and methods. The value of a system must be seen as exceeding its
cost.

Behavioral Implications - the accounting system's effects on the behavior

(decisions) of managers. A system that managers believe in and trust will
be used more in making decisions than one they distrust.

Performance Reports - provide feedback by comparing results with plans and by

highlighting Variances

Management by Exception - concentrating on areas that need attention and ignoring

areas that appear to be running smoothly.

Product Life Cycle - the various stages through which a product passes, from
conception and development through introduction into the market through maturation
and, finally, withdrawal from the market.

The Value Chain - set of business functions that add value to the products or services
of an organization. These functions, not of equal importance, include Research and
Development, Design of products or services, Production, Marketing, Distribution,
and Customer Service.

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Accounting's Position in the Organization

A. Line and Staff Authority

Line Authority - authority extended downward over subordinates. Staff
Authority - authority to advise but not command.
A. Controller and Treasurer Functions {L. O. 5}
Controllers are responsible for planning for control, reporting and
interpreting, evaluating and consulting, tax administration, government reporting,
protection of assets, and economic appraisal.

Adaptation to Change
As decisions change, demands for information change. Accountants must
adapt their systems to the changes in management practices and technology.

Ethical Conduct for Professional Accountants

A. Standards of ethical conduct

Standards of ethical conduct have been adopted by professional accounting

organizations because of the reliance by so many parties on the product of
accountants

B. Ethical dilemmas

Competing obligations to shareholders, customers, suppliers, fellow

managers, society, and self and family create ethical dilemmas for management
accountants.

Cost Drivers - Output measures of resources and activities

Organizations can have many cost drivers. In this chapter, volume-based cost
drivers are used in order to examine cost behavior. for examples of costs
and potential cost drivers for value-chain functions.
Comparing Variable and Fixed Costs {L. O. 2}
Variable and fixed costs refer to how cost behaves with respect to changes
in a particular cost driver.

Variable Cost - a cost that changes in direct proportion to changes in the cost
driver (i.e., costs per unit do not change, total costs do change). graph of variable
cost behavior within a relevant range.

Fixed Cost - a cost that is not immediately affected by changes in the cost driver
(i.e., costs per unit do change; total costs do not change within the relevant range).
Fixed Costs and Time Period - All costs become variable as the time period is
expanded.

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C. Relevant Range

Relevant Range - the limits (i.e., time period and/or activity) of cost-driver
activity within which a specific relationship between costs and the cost driver is
valid.

II. Cost-Volume-Profit Analysis {L. O. 3}

Cost-Volume-Profit (CVP) Analysis - the study of the effects of output
volume on revenue (sales), expenses (costs), and net income (net profit).
The major simplifying assumption is to classify costs as either variable or
fixed with respect to the volume of output activity. A CVP scenario
follows.

A. Break-Even Point: Contribution-Margin and Equation Methods

Break-Even Point (BEP) - the level of sales at which revenues

equals expenses and net income is zero. One direct use of the BEP
is to assess possible risk. By comparing planned sales with the
BEP, managers can determine a Margin of Safety - how far sales
can fall below the planned level before losses occur.

Margin of Safety = planned unit sales - break-even unit

sales
1. Contribution-Margin Method. Contribution Margin (CM) Per Unit -
the sales price per unit minus the variable expenses per unit.
The BEP is reached when total contribution margin equals
total fixed costs. Dividing total fixed costs by the CM per
unit gives the BEP in number of units.

CM Percentage or Ratio - the portion of every sales dollar

that contributes to covering fixed costs and, hopefully,
provides for profit (divide total contribution margin by total
sales). Dividing total fixed costs by the CM percentage
(total contribution margin / total sales) yields the sales
dollars needed to break even. The use of the CM percentage
is necessary when a firm produces more than one product.

2. Equation Method. The basic income statement equation used for CVP
analysis is:

sales - variable expenses - fixed expenses = net income

This can be decomposed to:

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 unit sales price x number of units
- unit variable cost x number of units
- fixed expenses
net income

At the BEP, net income is zero. Let N = the number of units

to be sold to break even, put in values for the unit sales
price, unit variable cost and fixed expenses, and solve for N.

To compute the sales dollars needed to break even using the

equation technique, the variable expenses must be expressed
as a proportion of sales, which is called the Variable-Cost
Ratio or Percentage. Then, letting S = the sales dollars to
break even, solve for S in the equation:

S - (variable-cost ratio x S) - fixed expenses = 0

Alternatively, if you have previously solved for the number

of units required to break even, you can multiply that result
by the unit-selling price to give the sales dollars needed to
break even.

3. Relationship Between the Two Techniques. Both approaches result in

the following short-cut formulas:

Break-even (units) = (fixed expenses)/(CM per unit)

Break-even (dollars) = (fixed expenses)/(CM ratio)

The assumptions used in constructing the typical break-even graph include the
following:

1. Expenses may be classified into variable and fixed

categories.

2. The behavior of revenues and expenses is accurately

portrayed and is linear over the relevant range.

3. Efficiency and productivity will be unchanged.

4. Sales Mix (i.e., the relative proportions or combinations of

quantities of products that constitute total sales) is constant.
[See APPENDIX 2A for more on sales mixes.]

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5. The difference in inventory level at the beginning and end of a period is
insignificant.

B. Changes in Fixed Expenses

Increases (decreases) in fixed expenses increase (decrease) the

BEP.

C. Changes in Unit Contribution Margin.

Increases (decreases) in the CM per unit decrease (increase) the

BEP.
D. Target Net Profit and an Incremental Approach. {L. O. 5}
CVP analysis can be used to determine the target sales, in units and
dollars, needed to earn a target profit. Using either the contribution
margin or equation techniques results in the following shortcut
equations.

Target sales volume in units = fixed expenses + target net income

CM per unit

Target sales volume in dollars = fixed expenses + target net income

CM ratio

III. Additional Uses of Cost-Volume Analysis

A. Best Cost Structure

When the CM percentage of sales is low, great increases in volume are necessary
before significant improvements in net profits are possible. As
sales exceed the BEP, a high CM percentage increases profits faster
than a low CM percentage.

B. Operating Leverage

Operating Leverage - the firm’s ratio of fixed and variable costs. In

highly leveraged firms (i.e., those with high fixed costs and low variable costs)
small changes in sales volume will result in large changes in net income. Less
leveraged firms show smaller changes in net income with changes in sales
volume.

C. Margin of Safety

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 The margin of safety show how far sales can fall below the
planned level of sales before losses occur. It compares the level of
planned sales with the break-even point:

Margin of Safety = Planned Unit Sales – Break-even Unit Sales

A small margin of safety may indicate a more risky situation

D. Contribution Margin and Gross Margin {L. O. 6}

Gross Margin (or Gross Profit) - the excess of sales over the Cost of
Goods Sold
Contribution Margin is the excess of sales over all variable expenses.

IV. Appendix 2A: Sales-Mix Analysis {L. O. 7}

Sales Mix - the relative proportions or combinations of quantities of
products that comprise total sales. If the proportions of the mix change, the CVP
relationships may also change.
Evaluations can be made using the contribution margin statement, however, the
equation approach is easier in most cases.

Revenue – Variable Costs – Fixed Costs = Profit

(Sp * Sv) – (Vc * Sv) – Fc =P

Sp = Sales price
Sv = Sales Volume
Vc = Variable cost of sales
Fc = Fixed costs
P = Profit

Consolidated:

[(Sp – Vc) * Sv] - Fc = P

C. Step- and Mixed-Cost Behavior Patters {L. O.

1}
4. Step costs - change abruptly at intervals of activity because the resources
and their costs come in indivisible chunks. A large step (e.g., the cost of leasing

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oil and gas drilling equipment) is a step-fixed cost. A small step (e.g., the wage
cost of cashiers in a supermarket) is a step-variable cost

5. Mixed costs - contain elements of both fixed and variable cost behavior.
The fixed portion is determined by the planned range of activity level, while the
variable cost element varies proportionately with activity within the relevant
range

V. Management Influence on Cost Behavior {L. O. 2}

A. Product and Service Decisions and the Value Chain -
product mix, design, performance, quality, features,
distribution, and so on influence costs (i.e., the value
chain).

B. Capacity Decisions. Strategic decisions about the scale and

scope of an organization's activities result in fixed
levels of capacity costs. Capacity Costs are the
fixed costs of being able to achieve a desired level of
production or service. Companies, like Ford, must
be careful in controlling the level of capacity costs
when they have long-term variation in demand.

C. Committed Fixed Costs - usually arise from the possession

of facilities, equipment, and a basic organization.
These are large, indivisible chunks of cost that the
organization is obligated to incur or usually would
not consider avoiding (e.g., mortgage or lease
payments, interest payments on long-term debt,
property taxes, insurance, and salaries of key
personnel).

D. Discretionary Fixed Costs - no obvious relationship to

levels of output activity but are determined as part of
the periodic planning process. Management decides
that certain levels of these costs should be incurred to
meet the organization's goals (e.g., advertising and
promotion costs, public relations, research and
development costs, charitable donations, employee
training programs, and purchased management
consulting services). Discretionary fixed costs can
be easily altered but become fixed until the next
planning period.

E. Technology Decisions (e.g., labor-intensive versus

robotic manufacturing or traditional banking services

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 versus automated tellers) position a company to meet
current goals and to respond to changes in the
environment and impact the costs of products and
services.

F. Cost-Control Incentives - created by management

in order to have employees control costs. Managers
use their knowledge of cost behavior to set
expectations, and employees may receive
compensation or other rewards that are tied to
meeting these expectations while maintaining quality
and service.

VI. Cost Functions {L. O. 3}

Cost Measurement (or measuring cost behavior) - the first step in
estimating or predicting costs as a function of appropriate cost drivers.
The second step is to use these cost measures to estimate future costs at
expected levels of the cost-driver activity. Measuring costs without
obvious links to cost drivers presents some difficulty. Assumed
relationships between costs and cost drivers are often used.

A. Form of Cost Functions. Cost Function - Algebraic equations

that describe the relationship between a cost and its cost driver(s).
A typical cost function equation is:

Y = F + VX where: Y = Total cost

F = Fixed cost
V = Variable cost
X = Cost-driver activit
B. Developing Cost Functions

Two principles should be applied to obtain accurate and useful cost

functions: plausibility (i.e., believable) and reliability (conformity
between a cost function’s estimate of costs at actual levels of
activity and actually observed costs).

C. Choice of Cost Drivers: Activity Analysis {L. O. 4}

Activity Analysis - identifies appropriate cost drivers and their
effects on the costs of making a product or providing a service.

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 The final product or service may have a number of cost drivers
because a number of separate activities may be involved.

Cost Prediction - applies cost measures to expected future activity

levels to forecast future costs. Activity analysis is especially
important for measuring and predicting costs for which cost drivers
are not obvious.

Methods of Measuring Cost Functions {L. O. 5}

D. Engineering Analysis - measures cost behavior according to what costs
should be, not by what costs have been. It entails a systematic
review of materials, supplies, labor, support services, and facilities
needed for products and services.
E. Account Analysis - selects a volume-related cost driver and classifies each
account from the accounting records as a variable or fixed cost.
High-Low, Visual Fit, and Least-Squares Methods

These methods rely on the use of past cost data to predict costs. These
methods may not be particularly useful in predicting costs for changing
organizations. If these methods are used, the cost analyst must be careful that the
historical data that is from a past environment is not obsolete.

1. High-Low Method - makes use of the costs and activity levels for the
high and low activity levels in a set of data (unless one of these levels is
viewed as an outlier).
2. Visual-Fit Method - more reliable than the high-low method because all
the available data are used. In the visual fit method, the cost analyst
visually fits a straight line through a plot of all of the available data. The
line is extended back until it intersects the vertical axis of the graph.

3. Least-Squares Regression Method - uses statistics to fit a cost function

to all the data. Using one cost driver requires simple regression, while
using more than one cost driver requires the use of multiple regression.
Regression analysis usually measures cost behavior more reliably than
other cost measurement methods.

TEACHING TIP: Detail Regression Assumptions -

1. Linearity within the relevant range
2. Constant variance of residuals
3. Independence of residuals
4. Normality of residuals

VII. Cost Management Systems {L. O. 1}

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 A collection of tools and techniques that identifies how management's
decisions affect costs.

The primary purposes are

1) aggregate measures of inventory value and cost of goods manufactured for
external reporting to investors, creditors, and other external stakeholders;
2) Cost information for strategic management decisions, and
3) Cost information for operational control.

The cost accounting system typically involves two processes:

(1) Cost Accumulation - collecting costs by some "natural" classification such as
materials or labor, and
(2) Cost Allocation/Assignment - tracing and reassigning costs to one or more
cost objectives.
II. Cost Terms Used for Strategic Decision Making and
Operational Control Purposes

F. Cost Objectives {L. O. 2}

Cost - a sacrifice or giving up of resources for a particular purpose.
Cost Objective (or Cost Object) - something which managers want the cost of
(e.g., a product, a department, a sales region, a program, or
something else for which decisions are made).
Direct Costs - identified specifically and exclusively with a given cost objective
in an economically feasible way.
Indirect Costs - not identified specifically and exclusively with a given cost
objective in an economically feasible way.
Unallocated Costs are too difficult to establish a cause-and-effect relationship

III. Cost Terms Used for External Reporting Purposes

A. Categories of Manufacturing Costs

Direct-Materials Costs - the acquisition costs of all materials that are physically
identified as a part of the manufactured goods and that may be
traced to the manufactured goods in an economically feasible way.

Direct-Labor Costs - the wages of all labor that can be traced specifically and
exclusively to the manufactured goods in an economically feasible
way.

Indirect Manufacturing Costs (Factory Burden or Manufacturing

Overhead) - include all costs other than direct material or direct
labor that are associated with the manufacturing process (e.g.,

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 power, supplies, indirect labor, supervisory salaries, property
taxes, rent, insurance, and depreciation).

B. Product Costs and Period Costs

Product Costs - costs (e.g., direct materials, direct labor, and

factory overhead) initially identified with goods produced or
purchased for resale (i.e., inventory) and become expenses (i.e.,
cost of goods sold) only when the inventory is sold.

Period Costs - costs (e.g., selling and general administration

expenses) that are deducted as expenses during the current period
without going through the inventory stage.
C. Balance Sheet Presentation of Costs

Direct-Materials Inventory - materials on hand and awaiting use in the

production process.

Work-In-Process Inventory - goods undergoing the production process

but not yet fully completed. Costs include appropriate amounts of
the three major manufacturing costs (i.e., direct material, direct
labor, and factory overhead).

Finished-Goods Inventory - goods fully completed but not yet sold.

IV. Traditional and Activity-Based Cost Accounting Systems

In the past, almost all companies used traditional costing systems - those that do
not accumulate or report costs of activities or processes

Activity-Based Accounting (ABA) or Activity-Based Costing (ABC) systems

first accumulate overhead costs for each of the activities of an
organization, and then assign the costs of activities to the products,
services, or other cost objects that caused that activity.

Cost Drivers are identified for each activity to establish a cause-effect

relationship between an activity and a cost object. Traditional
systems often use only one cost driver and do not attempt to
identify, accumulate, or report costs by activities performed.

There are many variations in the design of ABC systems. In a two-

stage ABC system (see EXHIBIT 4-6), there are two stages of
allocation to get from the original resource cost to the final product
or service cost. The first stage allocates costs to activity-cost pools.

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 A cost pool is a group of individual costs that is allocated to cost
objectives using a single cost driver. The second stage is allocating
activity costs to the products or services. The first-stage cost
drivers are usually percentages.

V. Activity-Based Management: A Cost Management System

Tool

Activity-based management (ABM) is using the output of an activity-based cost

accounting system to aid strategic decision making and to improve operational
control of an organization.

One of the most useful applications of ABM is distinguishing between

value-added cost (the necessary cost of an activity that a company cannot
eliminate without affecting a product’s value to the customer), and
nonvalue-added cost (unnecessary costs that a company tries to minimize
and eliminate without affecting a product’s value to the customer).
Examples of non-value-added costs are handling and storing inventories,
and changing the setup of production-line operations to produce a different
model of the product.

A. Benefits of Activity-Based Costing and Activity-Based

Management

Many organizations in the manufacturing industry and service

sector are adopting ABC systems because:

1. Fierce competitive pressure has resulted in shrinking profit

margins. Companies often do not have confidence in the
accuracy of the margins for individual products or services.
2. Greater diversity in the types of products and services, as
well as customer classes, results in greater business
operating complexity. The consumption of a company’s
shared resources also varies substantially across products
and customers.
3. New production techniques have increased the proportion of
indirect costs.
4. The rapid pace of technological change has shortened
product life cycles. Companies do not have time to make
price or cost adjustments once they discover costing errors.
5. The costs associated with bad decisions that result from
inaccurate cost determinations are substantial (e.g., lost bids
and hidden losses from undercosted products).

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 6. Computer technology has reduced the costs of developing
and operating ABC systems.
A. Design of an Activity-Based Cost Accounting System {L. O.
6}
1. Determine project scope, cost objectives, key activities,
resources, and related cost drivers (i.e., key components).
2. Develop a process-based map representing the flow of
activities, resources, and their interrelationships
3. Collect relevant data concerning costs and the
physical flow of cost-driver units among
resources and activities (see EXHIBIT 4-11).
4. Calculate/interpret the new activity-based information (see
EXHIBIT 4-12).

VII. APPENDIX: Multistage ABC (MSABC) Systems

Some organizations prefer to design a multistage ABC (MSABC) with

more than two stages of allocations and resource cost drivers other than
percentages. The added complexity yields more accurate costs and a
deeper understanding of operations. This leads to better ideas for process
improvement, with more satisfied customers and a competitive edge.

Three key attributes distinguish MSABC systems from two-stage ABC

systems:

1. There are more than two stages of allocation.

2. Cost behavior of resources is considered.
3. There is greater use of operational information, such as cost drivers
and consumption rates.

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