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2. COST BASICS AND MANAGEMENT

ACCOUNTING RESEARCH
MANAGEMENT ACCOUNTING INFORMATION

COMPONENTS OF MANAGEMENT ACCOUNTING SYSTEMS

Management accounting systems are tailored to an organization’s needs but they often include the following:

1. Costing system: estimates the cost of goods and services, as well as the cost of organizational units
such as departments
2. Budgeting system: used to prepare a detailed plan, summarising the financial consequences of an
organization’s operating activities for a specific future time period
3. Performance Measurement system: measures performance by comparing actual results with some
target
4. Cost management system: focuses on improving cost effectiveness through understanding and
managing real causes of costs

TRADITIONAL VERSUS MODERN APPROACHES TO MANAGEMENT ACCOUNTING

Traditional
Costing Systems  Focus on the costs of
departments and products
 Assume production volume
(VBC) is the only factor that
can cause costs to vary
Budgeting  Built around departments
Systems
Performance  Monitor financial
Measurement performance
Systems  Control what’s going on
inside the organization
Cost  No separate system
Management  Costs mainly controlled
Systems through financial
performance measurement
Modern
 Focus on the costs of activities, products,
customers and suppliers (ABC)
 Recognize that a range of factors can cause costs
to vary
 Built around departments and activities
 Monitor performance across a range of critical
success factors*, such as quality, delivery and
sustainability, not just financial performance
 Also look at what’s happening outside the
organization, for example at customers,
competitors and broader stakeholders
 Support the management of both customer value
and shareholder wealth
 Pro-active approaches to managing resources and
reducing costs, rather than just controlling them
 Analyses real causes of costs and eliminate
wasteful activities

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*Critical Success Factors: factors that derive from competitive strategy, and are critical to the survival of the
business

2.1 COST AND COST CLASSIFICATIONS

INTRODUCTION TO COSTING

Costs: are resources given up to achieve a particular objective

WHY STUDY COST?

Value Creation:

- Customer Value:
o Do product costs accurately reflect value created for our customers?
o Will customers be willing to pay for our products?
- Shareholder value:
o Do resources consumed generate returns to shareholder  shareholder value

We need to consider:

- What drives cost?

- How does cost behave?
- How do we predict cost movement?
- How do we manage cost?

COST CLASSIFICATION

- Different costs and classifications are used for different purposes

- Need to understand how managers intend to use the information
- The same cost can be classified in a number of ways depending on the intended use of the cost
information

We can classify costs by:

1. Behaviour patterns
2. Traceability
3. Function
4. Controllability
5. Value chain
6. Product Costs and Timing
7. Activity hierarchy (Discussed in 2.3: Cost Behaviour)

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Basis of Classification Cost Classification Used To

 Plan (budget) costs
Behaviour  Variable  Control costs
 Fixed  Make decisions
 Estimate the cost of goods and services
Traceability  Direct  Estimate the cost of organizational units,
 Indirect such as departments or activities
 Estimate the cost of products
Function  Manufacturing  Estimate the cost of goods sold for the
- Direct Material income statement, and inventory for the
- Direct Labour balance sheet
- Manufacturing
Overhead
 Non-Manufacturing
 Measures managers’ performance
Controllability  Controllable  Control costs
 Uncontrollable
 Analyse cost structures and identify
Value Chain  Upstream strategies
- R&D  Measure performance
- Design  Control/manage costs
- Supply
 Manufacturing/Production
 Downstream
- Marketing
- Distribution
- Customer Service
 Prepare income statement and balance
Product Costs and  Product sheet
Timing  Period
- Administrative
- Selling
 Assigning costs to cost objects
Activity Hierarchy  Unit level  Planning and controlling costs
 Batch level
 Product level
 Facility level

1. BEHAVIOUR PATTERNS

Behaviour Patterns refers to the movement of costs as the level of activity/cost driver changes.

Level of activity: the level of work performed in the organization

Cost driver: a factor or activity that causes a cost to be incurred

The costs can be classified as:

- Variable Cost: a cost that changes, in total, in direct proportion to a change in the level of activity
- Fixed Cost: a cost that remains unchanged in total despite changes in the level of activity

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2. TRACEABIITY

Traceability refers to whether the cost can be traced back to a cost object which is simply an item for which
management wants a separate measure of cost

The costs can be classified as:

- Direct costs: a cost that can be identified with, or traced to, a cost object in an economic manner
- Indirect costs: a cost that cannot be identified with, or traced to, a cost object in an economic manner

3. FUNCTION

The costs can be classified as

- Manufacturing Costs: the cost of direct material, direct labour and manufacturing overheads
1. Direct Material: the cost of materials consumed in the manufacturing process to produce a
product, physically incorporated in the product and able to be traced to the product in an
economic manner
2. Direct Labour: the cost of salary, wages and labour on-costs for personnel who work directly on
the manufactured product
3. Manufacturing Overhead (aka indirect manufacturing costs/ factory burden costs): all
manufacturing costs other than direct material and direct labour costs
- Non-Manufacturing Costs: all costs incurred outside of manufacturing – that is, the cost of upstream
and downstream activities

Other classifications:

- Prime costs: the costs of direct material and direct labour incurred to produce a product
- Conversion costs: the cost of direct labour and manufacturing overhead incurred to convert raw
material to a finished product

4. CONTROLLABILITY

Costs can be classified in reference to controllability in order to improve performance evaluations and
accountability as managers should only be held responsible for costs they can control or significantly
influence.

The costs can be classified as:

- Controllable costs: a cost that a specific manager can control or significantly influence
- Uncontrollable costs: a cost that a manager cannot control or significantly influence

5. VALUE CHAIN

The Value Chain is a set of linked processes or activities that begins with acquiring resources and ends with
providing (and supporting) products that customers value. The framework can be used to analyse cost
structures and strategies as well as to measure performance

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The costs can be classified as:

- Upstream Costs
o Research and Development (R&D) Costs: all the costs incurred in the development of new
products and processes
o Design Costs: all the costs associated with the design of the product and of the processes that
will produce the new product
o Supplier Costs: the costs of sourcing and managing incoming parts, assemblies and supplies
- Manufacturing/production Costs: the costs
incurred during the production process
- Downstream Costs
o Marketing Costs: the overall costs of
selling goods and services
o Distribution Costs: the costs of
storing, handling and shipping finished
products
o Customer Service Costs: the costs
incurred in servicing customers,
including after-sales support and
warranty claims

6. PRODUCT COSTS AND TIMING

Costs can be classified as:

- Product cost: is a cost assigned to goods that were either manufactured or purchased for resale and is
the amount quoted as inventory and expensed as Cost of Goods Sold Expense.
o Also known as inventoriable costs or inventoried costs since a product cost can be stored as
the cost of inventory until the goods are sold
- Period cost: costs that are expensed in the accounting period in which they are incurred
o Selling expenses: the costs of selling and distributing the firm’s goods or services
o Administrative expenses: the costs of running a business as a whole, including the costs of
senior management and administrative support departments

2.2 CASH FLOWS IN A MANUFACTURING BUSINESS

There are four steps in the flow of costs in manufacturing

1. Raw material inventory an account that records the costs of the major materials that will be used in
production
2. Work in progress an account that records the cost of manufactured products that are only partially
completed at balance date. Also includes direct labour and manufacturing overhead.
3. Finished goods inventory an account that records the cost of manufactured goods that are complete
and ready for sale
4. Cost of Goods Sold: an expense during the period when the sale is made

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2.3 COST DRIVERS

Cost driver: any activity or factor that causes costs to be incurred

SIMPLE VIEW: VOLUME-BASED COST DRIVERS

- Underlying assumption is that production volume causes costs

- Volume-Based Cost Drivers: are cost drivers that assumes that costs are driven, or caused, by the
volume of production and include:
o Units produced,
o Direct labour hours,
o Direct labour cost, and
o Machine hours worked

REALISTIC VIEW: NON-VOLUME BASED COST DRIVERS

- Not all costs vary in proportion to, or are fixed to production volume
- Non-Volume-Based Cost Driver: a cost driver not directly related to production volume such as:
o Number of deliveries made
o Amount of electricity/power used
o Etc.

A MODERN VIEW: COST DRIVERS CATEGORIZED IN AN ACTIVITY HIERARCHY

Costs are assigned to activities that describe the work done in the business
Costs and Cost Drivers can be classified into a hierarchy of four distinct levels:

1. Unit level costs: costs of activities that are performed for each unit produced
2. Batch level costs: cost of activities performed for a group of produced units
3. Product level costs: cost of activities performed for specific products or product families
4. Facility level costs: costs of activities incurred to support the business as a whole

Note: Activity Hierarchy can only be used for costing activities

SELECTING THE BEST COST DRIVER

- Cause and effect relationship:

o The cost driver must cause the cost
o MV fuel cost: #products produced vs #km travelled

- Correlation between cost and cost driver:

o The higher the correlation, the ore accurate will be the description and understanding of cost
behaviour

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o MV fuel costs: # km travelled vs # delivery weight

- Inputs vs Outputs
o Either one can be used
o e.g. Fuel Costs: number of deliveries (output) or litres of fuel (input)

- Timeframes for analysis

o Short term vs Long term
o Longer time frame: more costs become variable

- Costs and benefits of each driver must be assessed

o MV fuel cost: #km travelled vs #litres of fuel
o Amount of Detail: accuracy of cost behaviour analysis can be improved by disaggregating the
total costs into smaller cost categories
 Each cost categories can have different cost drivers
 The number of cost categories increases the accuracy of resulting information
 Increased number of cost categories and cost drivers also increases the cost of gathering
and analysing information
 Must consider the cost and benefit of this accuracy

2.4 COST BEHAVIOUR PATTERNS

Costs Behaviour: relationship between a cost and the level of activity or cost driver

Purpose:

- Cost estimation: the process of determining the cost behaviour of a particular cost item
- Cost prediction: using knowledge of cost behaviour to forecast of a cost at a particular level of activity
- Cost management: understanding “true” causes of costs

Understanding of cost behaviour patterns can be extended by examining:

1. Variable costs
2. Fixed costs
3. Step-fixed costs
4. Semi-variable costs
5. Curvilinear costs

These costs will be examined using cost Functions which are equations that are used to describe cost
behaviours

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1. VARIABLE COSTS

Variable Cost: a cost that changes, in total, in direct proportion to a change in the level of activity

The variable cost per unit cost driver is also the slope of the cost line. We can express all linear cost functions
in the form:

Y = Total Cost
a = Fixed Cost Component (vertical intercept)
Y = a + bX
b = Variable Cost per unit of activity (slope)
X = level of activity (cost driver)

2. FIXED COSTS

Fixed Costs: are costs that remains unchanged in total, despite changes in the level of activity

It is important to distinguish fixed cost from variable costs as changes in levels of activity will affect the total
variable cost but not the total fixed costs

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3. STEP-FIXED COSTS

Step-Fixed Costs: a cost that remains fixed over a wide range of activity levels, but jumps to a different
amount for levels outside that range

4. SEMI-VARIABLE COSTS

Semi-variable (or mixed) Costs: a cost that consists of both fixed and variable components

5. CURVILINEAR COSTS

Curvilinear Costs: a cost that exhibits a cost behaviour that can be described by a curved line

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COST BEHAVIOUR AND THE RELEVANT RANGE

Relevant Range: the range of activity over which a particular cost behaviour is assumed valid

- When analysing cost behaviour it is important that the relevant range is identified
- Outside of the relevant range, the cost behaviour pattern may not hold
- We should be careful in assuming that fixed and variable costs will always exhibit consistent cost
behaviours especially when there are dramatic changes in the levels of the business

ENGINEERED, COMMITTED AND DISCRETIONARY COSTS

It is often useful to distinguish between engineered, committed and discretionary costs

- Engineered Cost: a cost that bears a defined physical relationship to the level of output
o Direct materials
- Committed Cost: a cost resulting from an organisation’s basic structure and facilities, which is very
difficult to change in the short term
o Council rates
o Depreciation on building and equipment
o Cost of renting building or equipment
o Salaries of management
- Discretionary Cost: a cost resulting from a management decision to spend a particular amount of
money for some purpose and where the decision can be changed easily
o Research and development
o Advertisement and promotion
o Management development programs
o Contributions to charitable organizations

SHIFTING COST STRUCTURES IN MODERN BUSINESS ENVIRONMENT

- Traditionally volume based costing

- As organizations become more automated, they rely more on equipment and less on direct labour
- Equipment costs such as depreciation, maintenance and insurance do not vary with production
- Labour force is now regarded as indirect labour as they do not directly contribute to products
- Important IT infrastructure are now regarded as one off fixed costs
- As a result, modern companies adopt activity based costing

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2.5 COST ESTIMATION

Before estimating costs, we must understand the two underlying assumptions of cost estimation:

1. Cost behaviour depends on one activity or a few independent variables (However, in reality, costs are
actually affected by a host of factors including weather, employee od, quality of raw materials etc.)
2. Cost behaviours are modelled as straight lines within the relevant range

Approaches to Cost Estimation:

1. Managerial Judgement
2. Engineering Method
3. Quantitative analysis
a. Scatter diagrams
b. High-Low method
c. Regression analysis

1. MANAGERIAL JUDGEMENT

Managerial Judgement: where managers estimate, costs using their experience rather than any formal
analysis

- Costs are classified using the account classification method

- Account classification method (account analysis): the process in which managers use their
judgement to classify costs as fixed, variable or semi variable costs.
- Once costs are classified, the accountant can estimate future costs by examining past costs and
identifying any other factors that may affect costs in the future
- Reliability of cost estimates depends on the ability of the manager

2. ENGINEERING METHOD

Engineering Method: the study of the processes that result in the incurrence of a cost

Engineering studies: are studies that identify the relationships that should exist between inputs and outputs
Time and Motion Studies (aka task analysis or work measurement): observations of the steps required and
time taken by employees to perform particular activities, in order to estimate a cost function

- Often used to set standard costs for direct material and direct labour, particularly for new products
- Useful when not reliable past data exists
- Considered expensive and time-consuming

Accuracy concern: there are doubts that employees will ‘act naturally’ when they know they are being
observed  often employees may purposely slow operations or use generous amount of material during the
task analysis to ‘lower the standard’ of work

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3. QUANTITATIVE ANALYSIS

Quantitative Analysis: formal analysis of past data to identify the relationship between cost and activities

SCATTER DIAGRAMS

Advantages:

- Visual assessment
- Highlight outliers

Disadvantages

- Judgement in selecting
“best” line
- Only 1 cost driver

HIGH-LOW METHOD

- Purpose: develop cost function to estimate costs

- Method: observations with the highest & lowest levels of activity are used to calculate the cost
function:

Steps:

1. Identify highest and lowest activity level

2. Calculate variable cost per activity
3. Calculate fixed cost – using either highest or lowest activity level
4. Develop cost function

EXAMPLE –
HIGH-LOW METHOD

Hobart Bus Tours Incurred the

following bus maintenance costs over
the first half of the year

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Advantages: Disadvantages:

- More easy computation - Accuracy?

- Little data required - Considers only 2 data points
- Cost function affected by outliers
- Relevant range
- Multiple cost drivers?

REGRESSION ANALYSIS

Regression Analysis: a statistical technique used to estimate the relationship between a dependent
variable (cost) and independent variables (cost driver)

Estimate the (cost) line of best fit:

- Utilises all data points

- Make deviations between cost line & data points as small as possible

Simple regression
Estimate relationship between dependent variable (Y) and one independent variable (X)

Multiple regression Y = a + bX
2 or more independent variables

Where: Y = total cost

X = quantity of activity cost driver
Y = a + b1X1 + b2X2
a = fixed cost component (intercept)
b = variable cost per unit of cost driver

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Steps:

1. Identify cost object and its cost

2. Identify cost driver and its level
3. Collect data
4. Estimate cost function using
regression analysis
5. Evaluate

Regression Evaluation

1. Economic Plausibility (non-

statistical):
- Does it make economic
2. Goodness of fit
- Purpose: determine how well Y
(cost object) is predicted by the all
X (cost drivers(s))
- Evaluate: adjusted R2 indicates % change in Y that is explained by change in all cost drivers
3. F-Statistic
- Purpose: determine the probability that the relationship between the cost and all the cost drivers has
occurred by chance.
- Evaluate p-value: benchmark for significance; probability <5%
4. T-Statistic
- Purpose: determine the probability that the relationship between each cost driver and the cost has
occurred by chance
- Evaluate p-value: benchmark for significance; probability <5%

PRACTICAL ISSUES IN COST ESTIMATION

Why do some managers prefer to use judgement instead of quantitative analyses?

- Lack of knowledge
- Data Related Problems:
o Time required to collect or collate data is too costly
o Problems with data collection:
 Missing data: misplaces source documents or failure to record transactions accurately
 Outliers: extreme observations of cost/activity relationships which represent highly
unusual circumstances
 Mismatched time periods: monthly costs may be matched with daily costs (solution would
be to aggregate costs to a monthly totals)
 Trade-offs in choosing the time period:
a) Increasing observation increases accuracy of cost function
b) By increasing observations further into the past, we take on less relevant/outdated
information

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 Allocated fixed costs: fixed cost are sometimes allocated on a per unit basis and appear as
variable costs  need to distinguish between fixed and variable costs
 Inflation: during periods of high inflation, historical data may not reflect future cost
behaviour
 Future events etc.
- A low priority is given to high accuracy
o Subjective cost estimates may be good enough
 Use of this information?

INTRODUCTION TO MANAGEMENT ACCOUNTING RESEARCH

MANAGEMENT ACCOUNTING RESEARCH

Accounting research:

- Looks at how accounting affects the world and how the world affects accounting
- Creation of accounting knowledge

MA research

- MA information (e.g. budgets, performance measures, product costs etc.) and MA practices (e.g.
budgeting, measuring performance etc.)
- Issues regarding budgeting, compensation, decision making withn an enterprise, incentives and the
allocation of resources within an enterprise

RESEARCH METHODS

Empirical: research is verifiable based on observation or experimentation

- Experimental: manipulates independent variables and observes (measures) their effects on

dependent variables. Analysis and conclusions based on data gathered by administering treatments
to subjects
- Case study: empirical inquiry that investigates accounting phenomenon in its real-ife context. Analysis
and conclusions based on data gathered from interview and observations
- Survey: examines relationships between independent and dependent variables holds for a specific
population. Analysis and conclusions based on data gathered from sent questionnaires
- Archival: analyse data collected from repositories of third parties

Non-Empirical: research does have data

- Analytical modelling: analysis and conclusions derived from modelling theory, usually via
mathematical terms

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