Introduction to Strategic Cost Management

and Management Accounting

Cost Concepts and Behavior

ACCO 20113 Strategic Cost Management

James Robert D. Aguila, CPA, CMA
Session 2
 House Rules

• Inform me if I am speaking too fast or unclear.

• Take an active part in class discussions by
asking questions.
• Professional demeanor is expected from
everyone.
• Avoid using mobile phones/gadgets during class
hours. Mobile phones/gadgets must be switched
off or turned to silent mode.
 Strategic Cost Management

• Application of cost management techniques

which aims to reduce costs while strengthening
the strategic position of a business

• Use of cost data to develop and identify superior

strategies that will produce a sustainable
competitive advantage
 Strategic Cost Management
Strategic Positioning: The Key to Creating and Sustaining a Competitive Advantage

COMPETITIVE ADVANTAGE

Creating
better
customer
value

Lower cost
Strategic Cost Management
General Strategies

Cost Differentiation Focus

leadership
Strategic Cost Management
General Strategies

Provide the same or better

value to customers at lower
cost than offered by
competitors

Cost Economies
minimization of scale

COST LEADERSHIP
 Strategic Cost Management
General Strategies

Provide something to
customers that is not
provided by competitors

Value-adding
Brand loyalty
services

Functional,
aesthetic or
stylistic value

DIFFERENTIATION
Strategic Cost Management
General Strategies

Selecting or emphasizing a
market or customer segment
in which to compete

Differentiation
Cost focus
focus

FOCUS
Strategic Cost Management
How to Institutionalize?

Develop systems that would streamline the transactions

between corporate support departments and the operating
units

Establish transfer pricing systems to coordinate the buyer-

supplier interactions between decentralized organizational
operating units

Utilize “pseudo-profit centers” to create profit maximizing

behavior in what were “formerly” cost centers
 Management Accounting

• Management Accounting focuses on the

information needs of an organization’s internal
managers that are related to their planning,
controlling, and decision-making functions. It is
the process of identifying, measuring,
accumulating, analyzing, preparing, interpreting,
and communicating information that helps
managers fulfill organizational objectives.
Objectives of Management Accounting

• Provide managers with

information for decision
making and planning
• Assist managers in directing
and controlling operations
• Motivate managers toward
achieving organization’s
goals
• Measuring performance of
managers and sub-units
within the organization
 Comparison of Financial and Exh.
1-2

Managerial Accounting

Users
FINANCIAL ACCOUNTING MANAGERIAL ACCOUNTING

Primarily external Internal (managers who

(suppliers, creditors, plan and control the
customers, employees, activities of an
regulatory agencies, organization)
investors, general
public)
 Comparison of Financial and Exh.
1-2

Managerial Accounting

Time focus
FINANCIAL ACCOUNTING MANAGERIAL ACCOUNTING

Historical perspective Future emphasis

 Comparison of Financial and Exh.
1-2

Managerial Accounting

Verifiability vs. relevance

FINANCIAL ACCOUNTING MANAGERIAL ACCOUNTING

Emphasis on verifiability Emphasis for relevance

in planning and control
 Comparison of Financial and Exh.
1-2

Managerial Accounting

Precision vs. timeliness

FINANCIAL ACCOUNTING MANAGERIAL ACCOUNTING

Emphasis on precision Emphasis on timeliness

 Comparison of Financial and Exh.
1-2

Managerial Accounting

Subject matter
FINANCIAL ACCOUNTING MANAGERIAL ACCOUNTING

Aggregated financial Compartmentalized /

information segmented financial
information
 Comparison of Financial and Exh.
1-2

Managerial Accounting

Accounting Framework
FINANCIAL ACCOUNTING MANAGERIAL ACCOUNTING

Must adhere to the Need not to follow

requirements of GAAP or prescribed
generally accepted format
accounting principles
(e.g., IFRS, PFRS, US
GAAP)
 Comparison of Financial and Exh.
1-2

Managerial Accounting

Reporting Requirements
FINANCIAL ACCOUNTING MANAGERIAL ACCOUNTING

Mandatory – should be Not mandatory – reports

on a periodic basis, are prepared as the
usually quarterly and/or need arises
annually
 Comparison of Financial and Exh.
1-2

Managerial Accounting
Financial Accounting Managerial Accounting
1. Users External persons who Managers who plan for
make financial decisions and control an organization

2. Time focus Historical perspective Future emphasis

3. Verifiability Emphasis on Emphasis on relevance
versus relevance verifiability for planning and control
4. Precision versus Emphasis on Emphasis on
timeliness precision timeliness

5. Subject Primary focus is on Focuses on segments

the whole organization of an organization

6. GAAP Must follow GAAP Need not follow GAAP

and prescribed formats or any prescribed format
7. Requirement Mandatory for Not
external reports Mandatory
 Work of Management

Planning
Directing and
Motivating

Controlling
 Exh.
1-1
Planning and Control Cycle

Formulating long-
Begin
and short-term plans
(Planning)

Comparing actual
Implementing
to planned Decision plans (Directing
performance Making and Motivating)
(Controlling)

Measuring
performance
(Controlling)
 Planning

Identify
alternatives.

Select alternative that does

the best job of furthering
organization’s objectives.

Develop budgets to guide

progress toward the
selected alternative.
 Directing and Motivating

Directing and motivating involves managing day-

to-day activities to keep the organization
running smoothly.
w Employee work assignments.
w Routine problem solving.
w Conflict resolution.
w Effective communications.
 Controlling

The control function ensures

that plans are being followed.

Feedback in the form of performance reports

that compare actual results with the budget
are an essential part of the control function.
 Organizational Structure

Decentralization is the delegation of decision-

making authority throughout an organization.

Corporate Organization Chart

Board of Directors

President

Purchasing Personnel Vice President Chief Financial

Operations Officer

Treasurer Controller
 Line and Staff Relationships

Line positions are directly Staff positions support

related to achievement of and assist line positions.
the basic objectives of an w Example: Cost
organization. accountants in the
w Example: Production manufacturing plant.
supervisors in a
manufacturing plant.
 The Chief Financial Officer (CFO)

A member of the top management team

responsible for:
w Providing timely and relevant data to support
planning and control activities.
w Preparing financial statements for external users.
 Finance Organization

VP
Finance/CFO

Treasurer Controller

Financial Tax
Credit and Fund Inventory Cost
accounting accounting
Collections management management accounting
and reporting and reporting
Treasury vs. Controllership Functions

TREASURY CONTROLLERSHIP

• Obtain financing • Design of accounting

• Credit and collection systems and
• Investment risk accounting policies
management • Budgeting
• Financial reporting
and variance
analysis
• Internal controls
Treasury vs. Controllership Functions

TREASURY CONTROLLERSHIP

• Obtain financing • Design of accounting

• Credit and collection systems and
• Investment risk accounting policies
- RECORDKEEPING
- STAFF FUNCTION
management
- CUSTODIANSHIP • Budgeting
- LINE FUNCTION
• Financial reporting
and variance
analysis
• Internal controls
Cost Concepts and Behavior
 Classifications of Costs

Manufacturing costs are often

classified as follows:

Direct Direct Manufacturing

Material Labor Overhead

Prime Conversion
Cost Cost
 Manufacturing Cost Flows

Balance Sheet Income

Costs Inventories Statement
Expenses
Material Purchases Raw Materials

Direct Labor Work in

Process
Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold

Selling and Period Costs Selling and

Administrative Administrative
 Summary of the Types of Cost
Classifications

• Financial reporting – PRODUCT VS. PERIOD

• Assigning costs to cost objects – DIRECT VS.
INDIRECT
• Decision making – RELEVANT VS. SUNK
• Predicting cost behavior – FIXED VS.
VARIABLE
 Non-manufacturing Costs

Marketing or Administrative
Selling Cost Cost

Costs necessary to get All executive,

the order and deliver organizational, and
the product. clerical costs.
Product Costs Versus Period Costs

Product costs include Period costs include all

direct materials, direct marketing or selling
labor, and manufacturing costs and
overhead.
administrative costs.

Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
 Assigning Costs to Cost Objects

Direct costs Indirect costs

• Costs that can be • Costs that cannot be easily
easily and conveniently and conveniently traced to
traced to a unit of product a unit of product or other
or other cost object. cost object.
• Examples: direct material • Example: manufacturing
and direct labor overhead
 Cost Classifications for Decision
Making

• Every decision involves a choice between at

least two alternatives.

• Only those costs and benefits that differ

between alternatives are relevant in a decision.
All other costs and benefits can and should be
ignored.
 Differential Costs and Revenues

Costs and revenues that differ among

alternatives.

Example: You have a job paying $1,500 per month in

your hometown. You have a job offer in a neighboring
city that pays $2,000 per month. The commuting cost
to the city is $300 per month.

Differential revenue is:

$2,000 – $1,500 = $500

Differential cost is:

$300
 Opportunity Costs

The potential benefit that is given

up when one alternative is
selected over another.

Example: If you were

not attending college,
you could be earning
$15,000 per year.
Your opportunity cost
of attending college for
one year is $15,000.
 Sunk Costs

Sunk costs have already been incurred and cannot be

changed now or in the future. They should be
ignored when making decisions.

Example: You bought an automobile that cost

$10,000 two years ago. The $10,000 cost is sunk
because whether you drive it, park it, trade it, or sell
it, you cannot change the $10,000 cost.
 The Activity Base

Units Machine
produced hours

A measure of what
causes the
incurrence of a
variable cost

Miles Labor
driven hours
Cost Classifications for Predicting Cost
Behavior

How a cost will react to

changes in the level of
activity within the
relevant range.
w Total variable costs
change when activity
changes.
w Total fixed costs remain
unchanged when activity
changes.
 Total Variable Cost

Your total long distance telephone bill is based

on how many minutes you talk.
Total Long Distance
Telephone Bill

Minutes Talked
 Variable Cost Per Unit

The cost per long distance minute talked is

constant. For example, 10 cents per minute.

Telephone Charge
Per Minute
Minutes Talked
 Total Fixed Cost

Your monthly basic telephone bill probably

does not change when you make more local
calls.
Monthly Basic
Telephone Bill

Number of Local Calls

 Fixed Cost Per Unit

The average fixed cost per local call decreases

as more local calls are made.

Monthly Basic Telephone

Bill per Local Call Number of Local Calls
Cost Classifications for Predicting Cost
Behavior

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Average fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.
 True Variable Cost Example

A variable cost is a cost whose total dollar amount

varies in direct proportion to changes in the activity
level. Your total long distance telephone bill is
based on how many minutes you talk.
Total Long Distance
Telephone Bill

Minutes Talked
 Types of Cost Behavior Patterns

Recall the summary of our cost behavior

discussion from an earlier chapter.
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.
 Variable Cost Per Unit Example

A variable cost remains constant if expressed on

a per unit basis. The cost per minute talked is
constant. For example, 10 cents per minute.

Telephone Charge
Per Minute
Minutes Talked
 Extent of Variable Costs

The proportion of variable costs differs across

organizations. For example . . .
A public utility with
large investments in A manufacturing company
equipment will tend will often have many
to have fewer variable costs.
variable costs.

A merchandising company
A service company
usually will have a high
will normally have a high
proportion of variable costs
proportion of variable costs.
like cost of sales.
 Examples of Variable Costs

1. Merchandising companies – cost of goods sold.

2. Manufacturing companies – direct materials,
direct labor, and variable overhead.
3. Merchandising and manufacturing companies –
commissions, shipping costs, and clerical costs
such as invoicing.
4. Service companies – supplies, travel, and
clerical.
 True Variable Cost

Direct materials is a true or proportionately variable

cost because the amount used during a period will
vary in direct proportion to the level of production
activity.
Cost

Volume
 Step-Variable Costs

A resource that is obtainable only in large chunks (such

as maintenance workers) and whose costs increase or
decrease only in response to fairly wide changes in
activity is known as a step-variable cost.
Cost

Volume
 Step-Variable Costs

Small changes in the level of production are

not likely to have any effect on the number of
maintenance workers employed.
Cost

Volume
 Step-Variable Costs

Only fairly wide changes in the activity level will

cause a change in the number of maintenance
workers employed
Cost

Volume
The Linearity Assumption and the Relevant Range

Economist’s A straight line

closely
Curvilinear Cost approximates a
Function curvilinear
variable cost
Relevant line within the
Total Cost

relevant range.
Range
Accountant’s Straight-Line
Approximation (constant
unit variable cost)

Activity
 Types of Cost Behavior Patterns

Let’s look at fixed cost behavior on the next

screens.
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.
 Total Fixed Cost Example

A fixed cost is a cost whose total dollar amount remains

constant as the activity level changes. Your monthly
basic telephone bill is probably fixed and does not
change when you make more local calls.
Monthly Basic
Telephone Bill

Number of Local Calls

 Types of Cost Behavior Patterns

Recall the summary of our cost behavior

discussion from an earlier chapter.
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.
 Fixed Cost Per Unit Example

Average fixed costs per unit decrease as the activity

level increases. The fixed cost per local call
decreases as more local calls are made.

Monthly Basic Telephone

Bill per Local Call

Number of Local Calls

 Types of Fixed Costs

Committed Discretionary
Long-term, cannot be May be altered in the
significantly reduced short-term by current
in the short term. managerial decisions

Examples Examples
Depreciation on Advertising and
Equipment and Research and
Real Estate Taxes Development
 The Trend Toward Fixed Costs

The trend in many industries is toward

greater fixed costs relative to variable costs.
As machines take over Knowledge workers
many mundane tasks tend to be salaried,
previously performed highly-trained and
by humans, difficult to replace. The
“knowledge workers” cost to compensate
are demanded for these valued employees
their minds rather is relatively fixed
than their muscles rather than variable.
Is Labor a Variable or a Fixed Cost?

The behavior of wage and salary costs can

differ across countries, depending on labor
regulations, labor contracts, and custom.

In France, Germany, China, and Japan management has

little flexibility in adjusting the size of the labor force.
Labor costs are more fixed in nature.

In the United States and the United Kingdom management

has greater latitude. Labor costs are more variable in nature.
 Fixed Costs and Relevant Range

90
Thousands of Dollars

Total cost doesn’t

Rent Cost in

Relevant change for a wide

60 range of activity, and
Range
then jumps to a new
higher cost for the
30 next higher range of
activity.
0
0 1,000 2,000 3,000
Rented Area (Square Feet)
Fixed Costs and Relevant Range

The relevant range of activity for a fixed cost

is the range of activity over which the graph
of the cost is flat.
Example: Office space is
available at a rental rate of
$30,000 per year in
increments of 1,000 square
feet. As the business grows
more space is rented,
increasing the total cost.
Fixed Costs and Relevant Range

Step-variable costs
can be adjusted
How does this more quickly and . . .
type of fixed cost The width of the
differ from a step- activity steps is
much wider for the
variable cost? fixed cost.
 Mixed Costs

A mixed cost has both fixed and variable

components. Consider the example of utility cost.

Y
Total Utility Cost

Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge
 Mixed Costs

The total mixed cost line can be expressed

as an equation: Y = a + bX

Where: Y = the total mixed cost

a = the total fixed cost (the
Y vertical intercept of the line)
b = the variable cost per unit of
Total Utility Cost

activity (the slope of the line)

X = the level of activity

Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge
 Mixed Costs Example

If your fixed monthly utility charge is $40, your

variable cost is $0.03 per kilowatt hour, and your
monthly activity level is 2,000 kilowatt hours,
what is the amount of your utility bill?

Y = a + bX
Y = $40 + ($0.03 × 2,000)
Y = $100
 Analysis of Mixed Costs

Account Analysis and the Engineering Approach

Each account is classified as either

variable or fixed based on the analyst’s
knowledge of how the account behaves.

Cost estimates are based on an

evaluation of production methods, and
material, labor and overhead
requirements.
 The Scattergraph Method

Plot the data points on a graph

(total cost vs. activity).
Y
20
Maintenance Cost
1,000’s of Dollars

* * * ** *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s
 The Scattergraph Method

Draw a line through the data points with about an

equal numbers of points above and below the line.
Y
20
Maintenance Cost
1,000’s of Dollars

* * * ** *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s
 The Scattergraph Method

Use one data point to estimate the total level of activity

and the total cost.
Y Total maintenance cost = $11,000
20
Maintenance Cost
1,000’s of Dollars

* * * ** *
**
10 * *
Intercept = Fixed cost: $10,000

0 X
0 1 2 3 4
Patient-days in 1,000’s
Patient days = 800
 The Scattergraph Method

Make a quick estimate of variable cost per unit and

determine the cost equation.

Total maintenance at 800 patients $ 11,000

Less: Fixed cost 10,000
Estimated total variable cost for 800 patients $ 1,000

$1,000
Variable cost per unit = = $1.25/patient-day
800

Y = $10,000 + $1.25X

Total maintenance cost Number of patient days

 The High-Low Method

Assume the following hours of maintenance work and

the total maintenance costs for six months.
The High-Low Method

The variable cost

per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.

$2,400
= $8.00/hour
300
 The High-Low Method

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($8/hour × 800 hours)
Total Fixed Cost = $9,800 – $6,400
Total Fixed Cost = $3,400
 The High-Low Method

The Cost Equation for Maintenance

Y = $3,400 + $8.00X
Least-Squares Regression Method

A method used to analyze mixed costs if a

scattergraph plot reveals an approximately linear
relationship between the X and Y variables.

This method uses all of the

data points to estimate
the fixed and variable
cost components of a
mixed cost.
The goal of this method is
to fit a straight line to the
data that minimizes the
sum of the squared errors.
Least-Squares Regression Method

• Software can be used to fit

a regression line through
the data points.
• The cost analysis objective
is the same: Y = a + bX

Least-squares regression also provides a statistic,

called the R2, that is a measure of the goodness
of fit of the regression line to the data points.
Least-Squares Regression Method

R2 is the percentage of the variation in total cost

explained by the activity.
Y
20
* ** *
Total Cost

* * **
10 * *2
R varies from 0% to 100%, and
the higher the percentage the better.
0 X
0 1 2 3 4
Activity
Comparing Results From the Three Methods

The three methods just discussed provide

slightly different estimates of the fixed and
variable cost components of the mixed cost.
This is to be expected because each method
uses differing amounts of the data points to
provide estimates.
Least-squares regression provides the most
accurate estimate because it uses all the data
points.
Questions?