CHAPTER

Cost Management Concepts and Cost Behavior

Central Focus and Learning Objectives This chapter outlines the fundamentals of cost management concepts, cost classifications, and cost behavior. After studying this chapter, students should be able to:
1. Explain why the appropriate derivation of a cost depends on how the

cost will be used

2. State the difference between flexible costs and capacity-related costs

and why the difference is important

3. Use cost behavior information to compute the organizations break

even sales level

4. Show why the concept of opportunity cost is used in short-run

decision-making and how opportunity cost relates to conventional accounting costs

5. Explain why management accountants have developed the notions of

long-run and short-run costs and how these different costs are used in decision making
6. Explain the modern approach to cost classifications based on activity

levels
7. Explain the notion of life cycle cost and how that idea is used in new

product and product purchasing decisions

Cost Management Concepts and Cost Behavior 1

Chapter overview

This chapter introduces a number of important definitions of the various types of costs. Traditional concepts of direct and indirect costs, as well as how support costs arise, are presented. One important feature is the description of the way that we have thought about costing terminology. The chapter illustrates the transition in thinking from the traditional approach to new concepts of classification such as unit-related, batch-related, product-sustaining, and facility-sustaining activity cost drivers. Relations between costs and activity drivers are expressed in a series of equations. Material is presented that discusses how information is collected to estimate activity costs.

Teaching tips

0. As you present this material, it may be useful to mention to students at several points how cost concepts have changed so much over the past few years. This is also the time to present one major development in thinking about costing and, that is, the classification based on unit-related, batchrelated, productsustaining, customersustaining, and businesssustaining costs. 1. Emphasize that managers have the latitude to design the cost accounting system for their organization to meet their needs for internal decision-making, without being constrained by external reporting requirements such as those imposed by the FASB. 2. The rather dramatic decrease in direct labor cost as a percentage of total product cost in many of todays manufacturing organizations was a signal
Cost Management Concepts and Cost Behavior 2

that much more attention needed to be paid to the increasing cost of support activities. Point out to students that the large increase in this account was an impetus for management accountants and others to devise much more accurate systems for tracing support costs to products. 3. Examples of opportunity costs include whether to rent out warehouse space or use it for manufacturing a product, investing in artwork or mutual funds, purchasing a robot or hiring more employees. It should also be noted that opportunity costs are not recorded on the books of the organization, as no cash outlays have occurred. 4. Emphasize that the number of units produced need not vary proportionately with the number of batches produced if the batch size (number of units per batch) differs considerably across batches. 5. The complexity of a manufacturing information system increases substantially when it must keep track of more batches manufactured, more parts assembled into products, and more products offered to consumers. 6. Note that often there is a cost-benefit tradeoff to
Cost Management Concepts and Cost Behavior 3

consider when deciding whether it is worthwhile to have the greater level of accuracy by analyzing more activities in greater detail. 7. One exercise that you might try is to have students list 3 or 4 different types of services. Ask them to discuss what the output of the service is, whether it can be measured easily, and how they would know if the service was effective. You could discuss organizations such as a taxi service (satisfies customer on dimensions such as relaxation, timeliness and safety of arrival and courteous treatment by driver) and a homeless shelter (nutritious meals, and safe and warm place to stay). 8. Note that the proportion of support costs has grown substantially also in service organizations, as more services are being automated instead of being provided by human servers. For instance, when banks began to install ATMs a few years ago, the number of tellers needed decreased significantly. Thus, analysis of support costs has assumed critical importance also for service organizations in the competitive environment that they face today.

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9. Ask students to define an accurate product cost. Answers will vary, and at least some students will probably focus on precision (how many decimal places, and what the digits in those decimal places are). I try to get students to think about the economic value of the resources consumed in the manufacturing process. Accuracy is thus dependent on our ability to estimate what that economic value is. Note also that the reported product cost (the number generated by the accounting system) is a surrogate for the true cost, which is unobservable due to the complexities inherent in the manufacturing process.
Recommended cases

An introductory case is Englehardt Art Glass Cases in Management Accounting and Control Systems, 3rd edition, by Rotch, Allen, and Brownlee (Prentice Hall, 1995). 2. A more advanced case is Bridgeton Industries HBS Case 190-185 (teaching note 5-191-168), which covers cost concepts and overhead rates. 3. An excellent case which forces students to think about a variety of issues associated with starting a small business is Caribbean Internet Caf, Ivey School of Business case no. 9A98B002 (teaching note is 8A98B02). I have used this case as a semester project for undergraduate BBA students; it is very effective when used as the context for the development of a business plan. 4. Another service industry case is The Admiral Benbow Motel (Journal of Accounting Case Research, V. 6, No. 1, 2001, pp. 10 20.) This case provides especially dramatic evidence of the impact of changes in fixed costs on the profitability and viability of a business.
1.

Chapter outline

I.

Point out that the key concept for assigning costs to products
Cost Management Concepts and Cost Behavior 5

Learning Objective 1: Explain why the appropriate derivation of a cost depends on how the cost will be used.

is the amount of resources consumed in the products manufacture. This emphasis on the consumption of resources in this textbook is different from many traditional presentations of this material. A. Direct costs are those that can be traced easily to the product manufactured or service tendered. These costs are assigned to products directly based on the measured quantity of the resources consumed for their manufacture. Examples are: 1. Direct materials costs the costs of all materials and parts that can be traced directly to the product. 2. Direct labor costs wages and fringe benefits paid to workers involved directly in manufacturing a product. 3. Indirect costs are those that cannot be traced easily to products or services produced; also referred to as support costs. a. Manufacturing support costs are indirect costs of transforming raw materials into finished products. Examples include: (1) Wages and benefits paid to production supervisors who do not directly produce the product. (2) Wages and benefits paid to other support personnel who are involved with activities such as scheduling, setting up machinery, moving materials, cleaning the factory, and inspection. (3) Costs related to facilities (rent, property insurance, and depreciation) (4) Cost of other resources consumed in production (heat, light & power, small tools, abrasives and lubricants). B. Full cost vs. marginal or incremental cost II. Flexible and capacity-related costs A. Flexible resources are resources whose costs are proportional to the amount of resource used. The costs of these resources are called flexible costs. Historically, these costs have been called variable costs. B. Capacity-related resources are acquired and paid for in advance of when the work is done. Costs associated with capacity-related resources are called capacity-related costs. Historically, these costs have been called fixed costs. III. The break even point is the level of sales at which total revenue equals total costs. A. Contribution margin = revenue - flexible costs B. Contribution margin ratio = flexible costs/revenue
Cost Management Concepts and Cost Behavior 6

Learning Objective 2: State the difference between flexible costs and capacity-related costs and why the difference is important.

Learning Objective 3: Use cost behavior information to compute the

organizations break even sales level.

C. The break even point in units sold = capacity related costs/contribution margin per unit D. The break even point in dollar sales = capacity related costs/contribution margin ratio

Learning Objective 4: IV. The Impact of Opportunity Costs Show why the concept A. When a decision maker chooses one alternative over of opportunity cost is another, an opportunity cost may arise. used in short-run B. An opportunity cost is the potential benefit sacrificed decision-making and when, in selecting one alternative, another alternative is how opportunity cost given up. relates to conventional accounting costs. Learning Objective 5: Explain why management accountants have developed the notions of long-run and shortrun costs and how these different costs are used in decision making.

V. The short run is the period over which a decision maker cannot make changes in capacity. The availability of capacityrelated resources (and consequently capacity-related costs) are fixed in the short run. Costs that vary in the short run vary in proportion to production. Long-run costs include the costs of all the resources consumed in design, manufacture, and distribution of the product.

Learning Objective 6: VI. The activity level hierarchy gives a broader framework for Explain the modern cost classification than the traditional dichotomy of fixed approach to cost (capacity-related) and variable (flexible) costs. classification based on A. Unit related activity levels.

B. C. D. E.

Batch related Product sustaining Customer sustaining Business sustaining

Learning Objective 7: Explain the notion of life cycle cost and how that idea is used in new product and product purchasing decisions.

VII. Life cycle costing is a relatively new concept that argues that organizations should consider a products costs over its entire lifetime, taking into account operating costs as well as the initial purchase price in evaluating decisions. A. There are five distinct phases in a typical products life cycle. 1. Product development and planning 2. Product introduction 3. Growth 4. Maturity 5. Decline and abandonment B. The motivation for considering the costs is to identify the magnitude and nature of the costs so that they can be managed.

Cost Management Concepts and Cost Behavior 7

Chapter quiz
1.

Which of the following costs is NOT a manufacturing cost? a. direct materials b. overtime premiums c. rent on a factory building d. sales force training Which of the following costs are marketing costs? a. sales commissions b. assistant controllers salaries c. advertising expenses d. plant depreciation All of the following are indirect costs EXCEPT: a. assembly workers wages. b. supervisors salaries. c. marketing managers salaries. d. accountants salaries. Support costs have increased in todays manufacturing environment because: a. managers have let them get out of control. b. there is now a shift toward greater automation. c. fewer direct materials are being used in production. d. direct labor costs have increased. Which of the following is a product-sustaining activity cost driver? a. machine hours b. property and equipment cost c. setup hours d. numbers of engineering change orders Which of the following would be an example of a customer-sustaining activity cost driver? a. commissions paid to sales personnel b. advertising expenses c. salaries of field representatives stationed at a major customers facility d. sales clerical salaries What activity measure might be appropriate for the cost of cleaning the rooms in a hotel? a. the number of registered guests b. the number of hours required to clean the rooms c. the number of personnel required to clean the rooms d. none of the above

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3.

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6.

7.

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8.

If setup activity costs are $360,000, number of setups is 1,800, direct labor hours are 60,000, and machine hours are 36,000, then the setup activity cost driver rate is: a. $200 per setup. b. $6 per direct labor hour. c. $10 per machine hour. d. There is no appropriate cost driver rate. A key difference between service and manufacturing organizations is that: a. in a service organization, output is more tangible and measurable than in a manufacturing organization. b. in a manufacturing organization, output is less tangible and measurable than in a service organization. c. in a service organization, output is less tangible and measurable than in a manufacturing organization. d. services produced can be inventoried much more easily than manufactured products can. Which of the following costs is not easily traced to production? a. direct labor b. direct material c. selling expenses d. indirect manufacturing costs

9.

10.

Cost Management Concepts and Cost Behavior 9

Solutions to chapter quiz

1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

d c a b d a a a c d

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