© Pearson Education Limited 2008 MANAGEMENT ACCOUNTING Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse.

© Pearson Education Limited 2008

MANAGEMENT ACCOUNTINGMANAGEMENT ACCOUNTING

Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. MorseCheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse

2-2

© Pearson Education Limited 2008Management Accounting McWatters, Zimmerman, Morse

Measuring and analyzingMeasuring and analyzingactivity costs activity costs

(Planning)(Planning)

Chapter 2

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ObjectivesObjectives

• Use differential costs and benefits to assist in cost-benefit analysis

• Identify and measure opportunity costs for making planning decisions

• Ignore sunk costs for making planning decisions

• Use cost-benefit analysis to make information choices

• Determine how activity costs vary with the rate of output

• Calculate marginal and average costs

• Approximate activity costs using variable and fixed costs

• Use account classification, the high-low and regression methods to estimate variable and fixed costs

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Making Planning DecisionsMaking Planning Decisions

Planning DecisionsPlanning Decisions

What customers should the organization target

and satisfy?

What customers should the organization target

and satisfy?

What products or services should the

organization provide?

What products or services should the

organization provide?

How should the organization

finance its operations?

How should the organization

finance its operations?

What method should be used to price products or

services?

What method should be used to price products or

services?

What activities should be used to

provide the products or

services?

What activities should be used to

provide the products or

services?

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Using Cost/Benefit AnalysisUsing Cost/Benefit Analysis

Benefits and CostsBenefits and Costs

Benefits are aspects of a

decision that help the organization

Benefits are aspects of a

decision that help the organization

Costs are the using of resources

to achieve a benefit

Costs are the using of resources

to achieve a benefit

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Using Cost/Benefit AnalysisUsing Cost/Benefit Analysis

Cost Benefit Analysis is the process of analyzing alternative decisions to determine which decision

has the greatest benefit relative to its cost

Cost Benefit Analysis is the process of analyzing alternative decisions to determine which decision

has the greatest benefit relative to its cost

A method of avoiding measurement is to compare only those costs and benefits that differ among the alternative decisions by considering

differential costs and benefits

A method of avoiding measurement is to compare only those costs and benefits that differ among the alternative decisions by considering

differential costs and benefits

Benefits and costs are not always easily identified and measured

Benefits and costs are not always easily identified and measured

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Using Cost/Benefit Analysis Using Cost/Benefit Analysis Numerical ExampleNumerical Example

Buying a new piece of equipmentBuying a new piece of equipment

Differential CostsDifferential Costs

The new equipment means work is done faster thus there could be a saving in salary

The new equipment means work is done faster thus there could be a saving in salary

Differential BenefitsDifferential Benefits

Even with differential costs and benefits not all costs and benefits can be easily identified and measured

Even with differential costs and benefits not all costs and benefits can be easily identified and measured

Costs that don’t change are irrelevant to the decisionCosts that don’t change are irrelevant to the decision

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Using Cost/Benefit AnalysisUsing Cost/Benefit Analysis Numerical ExampleNumerical Example

Kemp Sports must consider whether to rent only mechanical or manual stringing machines.

A mechanical stringer costs £100 per hour, strings 60 racquets per hour and requires 1 operator. A manual machine costs £10 per hour, strings 10

racquets per hour and requires one operator. Electricity costs £8 per hour and labour £9 per hour. To meet customer demand the company must string

120 racquets per hour (2 mechanical or 12 manual machines)

Kemp Sports must consider whether to rent only mechanical or manual stringing machines.

A mechanical stringer costs £100 per hour, strings 60 racquets per hour and requires 1 operator. A manual machine costs £10 per hour, strings 10

racquets per hour and requires one operator. Electricity costs £8 per hour and labour £9 per hour. To meet customer demand the company must string

120 racquets per hour (2 mechanical or 12 manual machines)

The rest of Kemp Sports is not affected by the choice of stringing machine and revenues will be the same

The rest of Kemp Sports is not affected by the choice of stringing machine and revenues will be the same

The decision hinges on the differential costs of the two types of machine

The decision hinges on the differential costs of the two types of machine

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General Rule: Choose the alternatives where differential benefits exceed differential costs

General Rule: Choose the alternatives where differential benefits exceed differential costs

Type of cost Manual Method Mechanical Method Difference

Rent 12 x £10 = £120 2 x £100 = £200 -£80

Labour 12 x £9 = £108 2 x £9 = £18 +£90

Electricity 2 x £8 = £16 -£16

Totals £228 £234 -£6

The manual method results in lower costs and is the preferred choice

The manual method results in lower costs and is the preferred choice

This decision overlooks the possible qualitative costs and benefits such as the effect on quality and employee morale

This decision overlooks the possible qualitative costs and benefits such as the effect on quality and employee morale

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Problems in Identifying and Problems in Identifying and Measuring BenefitsMeasuring Benefits


What is the monetary benefit of a happy customer?

What is the monetary benefit of a happy customer?

What is the benefit of civic involvement?

What is the benefit of civic involvement?

What is the dollar benefit of an improved working environment?

What is the dollar benefit of an improved working environment?

How do I measure the benefit of

employee training?

How do I measure the benefit of

employee training?

How do I measure the benefit of improved

quality?

How do I measure the benefit of improved

quality?

These decisions have

monetary consequences in later years

These decisions have

monetary consequences in later years

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Problems in Identifying and Problems in Identifying and Measuring CostsMeasuring Costs


What is the cost of a dissatisfied customer? What is the cost of a

dissatisfied customer?

How do I measure the cost of setting my

price too high?

How do I measure the cost of setting my

price too high?

How do I measure the cost of poor quality?

How do I measure the cost of poor quality?

What is the cost of postponing this year’s

training program?

What is the cost of postponing this year’s

training program?What is the cost of using current

facilities?

What is the cost of using current

facilities?

What is the cost of requiring employees to work overtime?

What is the cost of requiring employees to work overtime?

What is the cost of using raw materials in

inventory?

What is the cost of using raw materials in

inventory?

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Opportunity CostsOpportunity Costs

For Example: The opportunity cost of accepting a job is forgoing the opportunity to do something else with our time

If our best alternative to working is playing golf the opportunity cost of working is the forgone opportunity of

playing golf

If the opportunity to play golf has a value greater than the benefits of working we will choose to play golf

For Example: The opportunity cost of accepting a job is forgoing the opportunity to do something else with our time

If our best alternative to working is playing golf the opportunity cost of working is the forgone opportunity of

playing golf

If the opportunity to play golf has a value greater than the benefits of working we will choose to play golf

The size of a foregone opportunity of using a resource is the Opportunity Cost

The size of a foregone opportunity of using a resource is the Opportunity Cost

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Opportunity CostsOpportunity Costs

The opportunity cost is the monetary amount

associated with the next

best use of the resource




The size of a foregone

opportunity of using a resource

The size of a foregone

opportunity of using a resource

Should be measured

in monetary

terms

Should be measured

in monetary

terms

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Measuring Opportunity CostsMeasuring Opportunity Costs







then the sales price

of the resource is

the opportunity

cost

then the sales price

of the resource is

the opportunity

cost

If the next best

opportunity is to sell the resource

If the next best

opportunity is to sell the resource

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then the cost of the

replacement resource is

the opportunity

cost

then the cost of the

replacement resource is

the opportunity

cost

If the next best

opportunity is to use the

resource and then replace it with a new

resource

If the next best

opportunity is to use the

resource and then replace it with a new

resource

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Measuring Opportunity CostsMeasuring Opportunity CostsNumerical ExampleNumerical Example

• Doris Wheaton has 10 bags of cement in her garage• The bags cost £4 per bag• Cement is now £5 per bag• A neighbour will buy the cement for £3 per bag• Doris is considering using the cement to make a patio

• Doris Wheaton has 10 bags of cement in her garage• The bags cost £4 per bag• Cement is now £5 per bag• A neighbour will buy the cement for £3 per bag• Doris is considering using the cement to make a patio

If Doris has no other use for the cement her opportunity cost is the sales price she turned down (£30)

If Doris has no other use for the cement her opportunity cost is the sales price she turned down (£30)

If Doris needs the cement to repair her front steps but uses the cement for the patio the opportunity cost is £50 (the cost of

replacing the cement)

If Doris needs the cement to repair her front steps but uses the cement for the patio the opportunity cost is £50 (the cost of

replacing the cement)

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then the lost value of the

other project is the

opportunity cost

then the lost value of the

other project is the

opportunity cost








If the next best

opportunity is another

project, and replacement

is not possible

If the next best

opportunity is another

project, and replacement

is not possible

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Measuring Opportunity CostsMeasuring Opportunity CostsNumerical ExampleNumerical Example

• An importer rents a building for storage. Presently the importer uses half of the building space

• The rental cost is £1,000 per month• She could sub-let the remaining space for £300 per

month• She is considering a new line of products to import

that would take up the remaining space

• An importer rents a building for storage. Presently the importer uses half of the building space

• The rental cost is £1,000 per month• She could sub-let the remaining space for £300 per

month• She is considering a new line of products to import

that would take up the remaining space

The opportunity cost of choosing to use the remaining space is the foregone opportunity to sub-let the remaining space (£300

per month)

The opportunity cost of choosing to use the remaining space is the foregone opportunity to sub-let the remaining space (£300

per month)

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For Example: Paul Wong is assembling his new home theatre system. He has spend 5 hours thus far and estimates he will

complete the assembly in 2 more hours. Joan informs him he is doing it the hard way and describes a simpler approach

which will take one hour to undo his work and re-assemble the system completely

For Example: Paul Wong is assembling his new home theatre system. He has spend 5 hours thus far and estimates he will

complete the assembly in 2 more hours. Joan informs him he is doing it the hard way and describes a simpler approach

which will take one hour to undo his work and re-assemble the system completely

Sunk CostsSunk CostsNumerical ExampleNumerical Example

Costs that have already been incurred and cannot be changed no matter what action is

taken in the future are called Sunk Costs

Costs that have already been incurred and cannot be changed no matter what action is

taken in the future are called Sunk Costs

The five hours work that he has performed is sunk, and therefore irrelevant

The five hours work that he has performed is sunk, and therefore irrelevant

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Historical CostsHistorical Costs

• Financial reporting to outside investors is based on historical costs

• Historical costs are generally more useful than opportunity costs for control decisions because they:– reveal past actions of managers– are easily verifiable– are less subject to managerial discretion

• When the environment does not change very much from the time of acquisition historical may be used to approximate opportunity costs when making planning decisions

• Managers need to determine when to use historical costs and when to expend effort to determine opportunity costs

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Cost/Benefit Analysis can be used to decide whether to gather additional information


CostsCosts

Cost of acquiring

information

Cost of acquiring

information

Cost of communicating

information

Cost of communicating

information

Cost of analyzing

information

Cost of analyzing

information

Benefit and Cost of InformationBenefit and Cost of Information

Cost of modifying

information

Cost of modifying

information

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BenefitsBenefits

Better DecisionsBetter

DecisionsNew

InformationNew

Information

Benefit and Cost of InformationBenefit and Cost of Information

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• Costs of initiating activities– Cost is high due to start-up costs

• Costs of activities at normal rates– Cost for additional units includes the cost of

additional labour and materials

• Costs of activities when exceeding capacity– Cost increases because of machine failure,

overtime pay, and the cost of additional space

Activity Costs and the Rate of Activity Costs and the Rate of OutputOutput

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Graphical Analysis of Activity Costs Graphical Analysis of Activity Costs and the Rate of Outputand the Rate of Output

Output

Total

(£)

The total activity costs rise sharply at low rates of output

because of start-up costs

A non-linear cost curve

A non-linear cost curve

AB

Total cost

C

Activity costs increase moderately when normal

operating rates are achieved

Output rates near capacity, total costs rise sharply because of

congestion and other capacity related costs

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Marginal costs are highest at very low output rates and at output rates near capacity

Marginal costs are highest at very low output rates and at output rates near capacity

Marginal Costs are the costs to produce one more additional unit of output

Marginal Costs are the costs to produce one more additional unit of output

The slope of the Total Cost Curve at any given level of production is the marginal cost for one

more unit

The slope of the Total Cost Curve at any given level of production is the marginal cost for one

more unit

Marginal CostsMarginal Costs

Output

Total

(£)

Total cost

High marginal costs

A

C

High marginal costsB

Lowest marginal costs

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Average CostsAverage Costs

Average Cost is very high at low levels of output

Average Cost is very high at low levels of output

Average Cost is calculated by dividing the total cost by the total units producedAverage Cost is calculated by dividing

the total cost by the total units produced

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Marginal and Average CostsMarginal and Average CostsNumerical ExampleNumerical Example

Beechcraft Aircraft refinishing specializes in the refurbishment of aircraft. The following are the total

costs of painting aircraft in one month:

Beechcraft Aircraft refinishing specializes in the refurbishment of aircraft. The following are the total

costs of painting aircraft in one month:Number of Units Total Cost (£) Marginal Cost(£) Average Cost (£)

10 100,000 100,000 100,000

20 150,000 50,000 75,000

30 190,000 40,000 63,333

40 220,000 30,000 55,000

50 250,000 30,000 50,000

60 280,000 30,000 46,667

70 320,000 40,000 45,714

80 370,000 50,000 46,250

90 470,000 100,000 52,222

10 600,000 130,00 60,000

The company currently paint 80 aircraft per month. They are asked to paint 10 additional aircraft for £90,000

The company currently paint 80 aircraft per month. They are asked to paint 10 additional aircraft for £90,000

The company should not accept the offer because the marginal cost of painting 10 additional aircraft is £100,00 (the average cost

of £52,222 should not be used)

The company should not accept the offer because the marginal cost of painting 10 additional aircraft is £100,00 (the average cost

of £52,222 should not be used)

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• Activity costs are not always easy to estimate thus managers often use approximations

• One approximation is to use the market value of resources for the opportunity cost

• Total activity costs can be approximated using fixed and variable costs

Approximations of Activity CostsApproximations of Activity Costs

Fixed Costs

Cost of using facilities, Purchasing machines, Hiring and training

employees, using other resources that do not change with the rate of output

Fixed Costs

Cost of using facilities, Purchasing machines, Hiring and training

employees, using other resources that do not change with the rate of output

Variable Costs

Cost of using additional labour, materials and other resources to

increase the output of the activity

Variable Costs

Cost of using additional labour, materials and other resources to

increase the output of the activity

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Fixed and Variable Cost ApproximationFixed and Variable Cost Approximation

The straight line is an approximation of the

graph on slide 24

The straight line is an approximation of the

graph on slide 24

Output

Costs

The approximation assumes that there is a

cost of setting up called a fixed cost

The approximation assumes that there is a

cost of setting up called a fixed cost

FixedCost

The linear representation assumes that the variable

cost of each additional unit is constant over all

rates of output

The linear representation assumes that the variable

cost of each additional unit is constant over all

rates of output

Variable Cost

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Relevant RangeRelevant RangeThe straight line most closely approximates

the activity costs in the range of normal

operations

The straight line most closely approximates

the activity costs in the range of normal

operations

TotalCost

TotalCost

Output

Costs

Relevant Range

This range is called the relevant range

This range is called the relevant range

In the relevant range the variable costs can

be used to estimate the cost of additional units

of output

In the relevant range the variable costs can

be used to estimate the cost of additional units

of output

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The total costs in terms of variable and fixed costs can be described by the following equation

The total costs in terms of variable and fixed costs can be described by the following equation

Fixed and Variable CostsFixed and Variable Costs

Total activity costs = Fixed costs + Variable costs

or

Total activity costs = Fixed costs + Variable costs

or

Total activity costs = Fixed costs + Variable cost per x Number of

unit of output units of output

Total activity costs = Fixed costs + Variable cost per x Number of

unit of output units of output( )

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Jackson company makes computers. One activity is to test the computer before it leaves the plant.

Fixed costs (test equipment, space and plant use and training) are £100,000. The variable costs of labour and electricity to conduct the test are £10 per unit

Jackson company makes computers. One activity is to test the computer before it leaves the plant.

Fixed costs (test equipment, space and plant use and training) are £100,000. The variable costs of labour and electricity to conduct the test are £10 per unit

Total costs for testing 5,000 computers per year is:£100,000 + (£10/test x 5,000 tests) = £150,000




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• Estimating activity costs through fixed and variable costs is often difficult and prone to error

• Other methods of estimating variable and fixed costs are:– Account classification – Using the high-low method to fit historic cost

data– Regression analysis

Estimation of Activity Costs through Estimation of Activity Costs through Variable and Fixed Costs Variable and Fixed Costs

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MANAGEMENT ACCOUNTING MANAGEMENT ACCOUNTING

Measuring and analyzing Measuring and analyzingactivity costs activity costs

(Planning)(Planning)End of Chapter 2

© Pearson Education Limited 2008 MANAGEMENT ACCOUNTING Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse.

Documents

costs benefits

organization costs

fixed costs

measured costs

electricity costs

sunk costs

lower costs

manual machine costs