Chapter 2 Reading

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Chapter Introduction The study of cost accounting and cost management requires an understanding of fundamental cost concepts, terms, and the associated information systems that produce them We need a basic framework to help us make sense of the variety of topics that appear in the field of cost accounting and cost management A systems perspective provides a useful framework for achieving this objective But what is an information system? Are there different systems for different purposes? Similarly, what is meant by cost? Are there different costs for different purposes? This chapter addresses these basic questions and provides the necessary foundation for the study of the rest of the text In providing this foundation, we make no attempt to be exhaustive in our coverage of different systems and costs Other system and cost concepts will be discussed in later chapters However, a thorough understanding of the concepts presented in this chapter is essential for success with later chapters –  ◊  □  ○ - 2-1 A Systems Framework A system is a set of interrelated parts that performs one or more processes to accomplish specific objectives Consider a home theater system This system has a number of interrelated parts such as the speakers, the receiver, the amplifier, the television, and the DVD player The most obvious process (or series of actions designed to accomplish an objective) is the playing of a movie; another is the delivery of surround sound throughout the room The primary objective of the system is to provide a theater-quality experience while watching a movie Notice that each part of the system is critical for achievement of the overall objective For example, if the speakers were missing, the amplifier and receiver would not be able to provide theater-quality sound even if the other parts were present and functional  ◊  □  ○ - A system works by using processes to transform inputs into outputs that satisfy the system’s objectives Consider the movie-playing process This process requires inputs such as a movie (typically on Blu-ray or DVD), a Blu-ray or DVD player, a television set, and electricity The inputs are transformed into the replay of the movie, an output of this process The output of the process, delivery of surround sound, is obviously critical to achieving the overall objective of the system The encoded sound on the DVD, the amplifier, and the speakers become inputs to the delivery process This process transforms the inputs so that tracks of sound are delivered to each of the speakers throughout the room In this way, the theater experience is reproduced at –  ◊  □  ○ - Chapter 2: Basic Cost Management Concepts Saturday, November 4, 2023 9:44 PM Week 1 Page 1

In this way, the theater experience is reproduced at home (minus, of course, the people on cell phones or the sticky floors that are all too often part of the theater experience) The operational model for the home theater experience is shown in Exhibit 2.1  – Exhibit 2.1 Operational Model of the Home Theater System ○ - 2-1a Accounting Information Systems An information system is designed to provide information to people in the company who might need it For example, the human resource (HR) information system and materials requirements planning (MRP) system are both information systems The HR system tracks people as they are hired. It includes data on date of hire, entry- level title and salary/wages, and any information needed for determining employee benefits  The MRP is a computerized system that keeps track of the purchase and use of raw materials used in manufacturing  These systems may also have subsystems For example, a subsystem of the HR system is the payroll system This is a transaction processing system The payroll system uses information from the HR database along with information on taxes and benefits needed to pay the employees and to remit appropriate amounts to various governmental agencies, in order to process periodic payroll transactions ◊  □  ○ - An accounting information system is one that consists of interrelated manual and computer parts and uses processes such as collecting, classifying, summarizing, analyzing, and managing data to provide information to users - Week 1 Page 2

provide information to users Like any system, an accounting information system has objectives, interrelated parts, processes, and outputs The overall objective of an accounting information system is to provide information to users The interrelated parts include database(s) and database management programs The databases are simply collections of data or information, usually in digital form The database management system is needed to control, maintain, and use a given database For accounting purposes, databases are formed to keep track of orders, sales, and other transactions  ◊  The database management system allows the company to handle billing, accounts receivable and cash receipts, inventory, general ledger, and cost accounting Each of these interrelated parts is itself a system and is therefore referred to as a subsystem of the accounting information system Processes of the database management system may include collecting, classifying, summarizing, and managing data Some processes may also be formal decision models— models that use inputs and provide recommended decisions as the information output The outputs are data and reports that provide needed information for users.  –  ◊  □  ○ Two key features of the accounting information system distinguish it from other information systems First, an accounting information system’s inputs are usually economic events ○ Second, the operational model of an accounting information system is critically involved with the user of information, since the output of the information system influences users and may serve as the basis for action This is particularly true for tactical and strategic decisions but less true for day-to-day decisions  In other cases, the output may serve to confirm that the actions taken had the intended effects Another possible output is feedback, which becomes an input for subsequent operational system performance The operational model for an accounting information system is illustrated in Exhibit 2.2 Examples of the inputs, processes, and outputs are provided in the exhibit (The list is not intended to be exhaustive.) Notice that personal communication is an information output Often, users may not wish to wait for formal reports and can obtain needed information on a timelier basis by communicating directly with accountants  –  ◊  □  ○ - Exhibit 2.2 Operational Model of an Accounting Information System - Week 1 Page 3

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○ The accounting information system can be divided into two major subsystems: (1) the financial accounting information system and (2) the cost management information system While we emphasize the second, it should be noted that the two systems need not be independent Ideally, the two systems should be integrated and have linked databases Output of each of the two systems can be used as input for the other system. □  ○ - Financial Accounting Information System The financial accounting information system is primarily concerned with producing outputs for external users It uses well-specified economic events (e.g., payment of wages, purchases of materials) as inputs, and its processes follow certain rules and conventions For financial accounting, the nature of the inputs and the rules and conventions governing processes are defined by the Securities and Exchange Commission (SEC), the Financial Accounting Standards Board (FASB), and potentially the International Accounting Standards Board (IASB) Among its outputs are financial statements such as the balance sheet, income statement, and statement of cash flows for external users (investors, creditors, government agencies, and other outside users) Financial accounting information is used for investment decisions, stewardship evaluation, activity monitoring, and regulatory measures ◊  □  ○ - The Cost Management Information System The cost management information system is primarily concerned with producing outputs for internal users using inputs and processes needed to satisfy management objectives The cost management information system is not bound by externally imposed criteria that define inputs and processes Instead, the criteria that govern the inputs and processes are set by people in the company The cost management information system provides information for three broad objectives: Costing services, products, and other objects of interest to management 1. Planning and control 2. Decision making 3.  □  ○ How much does a product or service cost? That depends on the reason why management wants to know the cost For example, product costs calculated in accordance with GAAP (Generally Accepted Accounting Principles) are needed to value inventories for the balance sheet and to calculate the cost of goods sold expense on the income statement These product costs include the cost of materials, labor, and overhead  □  In other cases, managers may want to know all costs that are associated with a service for purposes of tactical and strategic profitability analysis For example, a bank might want to know the costs and revenues associated with providing small business loans □  ○ - Week 1 Page 4

providing small business loans Then additional cost information may be needed concerning service provision, the cost of funds, collection costs, and so on  Cost information is also needed for planning and control. It should help managers decide what should be done, why it should be done, how it should be done, and how well it is being done For example, pharmaceutical companies may want to consider life cycle costing of individual drugs or drug families The expected revenues and costs may cover the entire life of the new product Thus, projected costs of research, development, testing, production, marketing, distribution, and servicing would be essential information These costs form the basis of the value chain  ◊  □  ○ The value chain is the set of activities required to design, develop, produce, market, deliver, and provide post-sales service for the products and services sold to customers Exhibit 2.3 illustrates the business processes of the value chain Emphasizing customer value forces managers to determine which activities in the value chain are important to customers The cost management information system should track information about the wide variety of activities that span the value chain Consider, for example, the delivery segment Timely delivery of a product or service is part of the total product and, thus, is of value to the customer Customer value can be increased by increasing the speed of delivery and response Federal Express exploited this part of the value chain and successfully developed a service that was not being offered by the U.S. Postal Service Today, many customers believe that delivery delayed is delivery denied This indicates that a good cost management information system ought to develop and measure indicators of customer satisfaction    –  ◊  □  ○ Exhibit 2.3 The Value Chain - Week 1 Page 5

○ Companies have internal customers as well For example, the procurement process acquires and delivers parts and materials to producing departments Providing high-quality parts on a timely basis to managers of producing departments is just as vital for procurement as it is for the company as a whole to provide high- quality goods to external customers The emphasis on managing the internal value chain and servicing internal customers has revealed the importance of a cross-functional perspective □  ○ - Finally, cost information is important for many managerial decisions For example, a manager may need to decide whether to continue making a component in- house or to buy it from an external supplier In this case, the manager would need to know the cost of materials, labor, and other productive resources associated with the manufacture of the component and which of these costs would disappear if the product were no longer produced Also needed is information about the cost of purchasing the component, including any increase in cost for internal activities such as receiving and storing goods □  ○ - 2-1b Relationship to Other Operational Systems and Functions The cost information produced by the cost management information system benefits the whole organization and should have an organization-wide perspective Managers in many different areas of a business require cost information For example, an engineering manager must make strategic decisions concerning product design Later costs of production, marketing, and servicing can vary widely, depending on the design An engineer at Hewlett-Packard once told us that 70 percent of eventual product costs are “locked in” during the design process  □  To provide accurate cost information for the different design options, the cost management system must not only interact with the design and development system but also with the production, marketing, and customer service systems Cost information for tactical decision making is also important For example, a sales manager needs reliable and accurate cost information when faced with a decision concerning an order that may be  □  ○ - Week 1 Page 6

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information when faced with a decision concerning an order that may be sold for less than the normal selling price Such a sale may only be feasible if the production system has idle capacity. In this case, a sound decision requires interaction among the cost management system, the marketing and distribution system, and the production system ◊ These two examples illustrate that the cost management system should have an organization-wide perspective and that it must be properly integrated with the nonfinancial functions and systems within an organization In the past, little effort was made to integrate the cost management system with other operational systems The current competitive environment, however, dictates that companies pay much greater attention to cost management in all functional areas  □  An integrated cost management system receives information from and provides information to all operational systems To the extent possible, the cost management system should be integrated with the organization’s operational systems Integration reduces redundant storage and use of data, improves the timeliness of information, and increases the efficiency of producing reliable and accurate information One way of accomplishing this is to implement an enterprise resource planning (ERP) system ERP systems are integrative, cross-functional systems that coordinate information to facilitate timely and accurate reporting and decision making Ideally, in an ERP system, data must be input only once; then it is available to people across the company for whatever purpose it may serve. In this way, information collected for one need may be used for others as well For example, a sales order entered into an ERP system is used by marketing to update customer records, by production to schedule the manufacture of the goods ordered, and by accounting to record the sale –  ◊  □  ○ - 2-1c Different Systems for Different Purposes The financial accounting and cost management systems show us that different systems exist to satisfy different purposes As indicated, these two systems are subsystems of the accounting information system The cost management information system also has two major subsystems: the cost accounting information system and the operational control information system The objectives of these two subsystems correspond to the first and second objectives mentioned earlier for the cost management information system (the costing, and planning and control objectives) The output of these two cost systems satisfies the third objective (the decision-making objective)  □  ○ - The cost accounting information system is a cost management subsystem designed to assign costs to individual products and services and other objects of interest to managers For external financial reporting, the cost accounting system must assign costs to products in order to value inventories and determine cost of sales Furthermore, these assignments must conform to the rules and conventions set by the SEC, the FASB, and (potentially) the IASB These rules and conventions do not require that all costs assigned to individual products be causally related to the demands of individual products Thus, using financial accounting principles to define product costs may □  ○ - Week 1 Page 7

Thus, using financial accounting principles to define product costs may lead to under- and overstatements of individual product costs For reporting inventory values and cost of sales, this may not matter Inventory values and cost of sales are reported in the aggregate, and the under- and overstatements may wash out to the extent that the values reported on the financial statements are reasonably accurate  ◊  At the individual product level, however, distorted product costs can cause managers to make poor decisions For example, a manager might erroneously deemphasize and overprice a product that is, in reality, highly profitable at a lower price ○ For decision making, accurate product costs are needed If possible, the cost accounting system should produce product costs that simultaneously are accurate and satisfy financial reporting conventions  If not, then the cost system must produce two sets of product costs: one that satisfies financial reporting criteria and one that satisfies management decision-making needs  ○ - The operational control information system is a cost management subsystem designed to provide accurate and timely feedback concerning the performance of managers and others relative to their planning and control of activities It helps to ensure that the day-to-day activities support the long-range strategic objectives of the organization Operational control is concerned with determining what activities should be performed and assessing how well they are performed It identifies opportunities for improvement A good operational control information system provides information that helps managers engage in a program of continuous improvement of all aspects of their businesses  □  ○ - While product cost information is important to this process, it is not sufficient The information needed for planning and control is broader and encompasses the entire value chain For example, every profit-making manufacturing and service organization exists to serve customers  Thus, one objective of an operational control system is to improve the value received by customers Products and services should be produced that fit specific customer needs (Observe how this affects the design and development system in the value chain.) Quality, affordable prices, and low post-purchase costs for operating and maintaining the product are also important to customers ◊  □  ○ - A second, related objective is to improve profits by providing this value Well- designed, quality, affordable products can be offered only if they also provide an acceptable return to company owners Cost information concerning quality, different product designs, and post-purchase customer needs is vital for managerial planning and control  ○ - Exhibit 2.4 illustrates the various subsystems of the accounting information system that we have been discussing - Exhibit 2.4 Subsystems of the Accounting Information System - Week 1 Page 8

○ 2-2 The Growing Importance of Data Analytics within Cost Management Organizations operate in an increasingly complex and interconnected global business environment As a result, organizational decisions impact investors and other key stakeholders, such as employees, customers, suppliers, regulators, and community residents, in increasingly broad and deep ways The rapid expansion in the amount of data available to organizations and their stakeholders presents an important opportunity increasingly used by organizations to better understand and manage their impacts within this business environment For example, accounting experts estimate that the size of the digital universe, including the amounts of traditional business data and rapidly growing machine- generated data, grows exponentially by doubling every two years Not surprisingly, organizations increasingly expect accountants to be able to collect, transform, and incorporate such data—also known as big data —into various cost management analyses to improve organizational decisions Data analytics represents the process through which an organization utilizes various amounts and types of data to help connect strategy and other key goals to improved decision making throughout the organization Developing accounting expertise with data analytics requires a concerted effort and wide-ranging practice Therefore, each chapter in this book emphasizes, where appropriate, the role played by data analytics in various cost management analyses –  ◊  □  ○ - 2-2a A Framework for Understanding the Role of Data Analytics in Cost Management Exhibit 2.5 presents an overview of the broad role that data analytics plays within various cost management analyses Traditionally, data analytics in cost management has been defined rather narrowly by focusing primarily on the use of analytical methods within various scenario models, such as relatively simple high-low analyses or more complex regression analyses Such analytical methods remain important However, accountants must define data analytics much more broadly in order to be able to provide value-adding insights to business decision makers □  ○ - Exhibit 2.5 The Role of Data Analytics in Cost Management Step Core Issue Question Answered Cost Management Application Example 1 What What am I measuring? The cost of innovating Apple’s product and - Week 1 Page 9

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1 What What am I measuring? The cost of innovating Apple’s product and service offerings, including the cost objects (e.g., research and development) involved with such innovation efforts. 2 Why Why am I measuring it? Apple’s strategy requires that it strives for continuous and industry-leading innovation. 3 How How am I measuring it? Consider the cost drivers (e.g., activities required by cutting-edge scientists and new product engineers; laboratory and testing facilities) for Apple’s continuous innovation cost objects. 4 Where Where can I find the data needed to conduct my desired statistical analysis? Apple can collect and analyze in-house data regarding the existence and performance of its new product features as compared to external data regarding competitors’ product offerings. 5 Which Which analytical method should be employed in my analysis? Time-series multiple regression analyses of Apple’s core innovation activity drivers help management better understand the relationship between various research and development costs and innovation outcomes. 6 When When is my analysis complete and ready to be used in decision making? Apple’s newest innovation involves a first- mover product launch, and thus, the cost analysis concludes sooner because the profit margin is wider for mature products that face more competition. 7 Who Who in the business needs to understand my analysis, and how should I communicate its results? An innovation cost analysis helps sales personnel better understand which new product features are more or less costly and relies on less sophisticated statistical and accounting terminology as compared to an analysis intended for product engineers. Therefore, before crunching numbers using analytical methods, accountants should begin their data analytic journey by clearly understanding what they are trying to measure, as well as why it should be measured For example, an item should be measured when doing so is expected to provide important decision insights, such as assessing the success or failure of the company’s strategy On the contrary, an item should not be measured simply because the underlying data are available or because other companies measure it Such unnecessary efforts often waste resources and divert attention away from potentially more valuable uses of limited data analytic resources □  ○ Finally, understanding the why of data analytics also provides useful insights into how accurate the measure must be, given the decision it ultimately intends to inform For example, the framework likely would be employed more intensely to a decision involving the discontinuation of an entire product line rather than to the discontinuation of only a product feature  ○ - The next two steps go hand in hand and concern how to measure an item and where to find the data for such measurements One important consideration involves whether the measurement should be quantitative or qualitative in nature Quantitative measurement implies the use of data expressed using numerical quantities, such as a count of the number of new model jet skis sold or a ratio of its full cost to sales  ○ - Week 1 Page 10

full cost to sales Also, data used in quantitative measurement usually are structured in nature and arise from formal sources, such as information systems □ Qualitative measurement implies the use of data expressed in categories, such as customer reviews of new model jet skis Data used in qualitative measurement usually are unstructured in nature and arise from less formal sources, including various internal business documents, texts, customer loyalty programs, or focus group transcripts The challenge of how to measure is particularly strong when the item has never before been measured For example, mystery or secret shopper programs were first created to help accountants assess difficult-to-measure business environments, such as customer experiences at newly redesigned Mobil gas station pumps or different Victoria’s Secret store layouts ◊  □  The how and where steps often present accountants with the greatest challenge across the entire data analytic framework For example, appropriate data must be identified (e.g., knowing which data are necessary to the measurement of interest), obtained (e.g., either internally from existing legacy and new information systems or externally through licensed access to an industry database), and transformed into a usable format (e.g., combining data from multiple sources, converting data into a single usable format, and cleansing data to improve its accuracy) These efforts—sometimes referred to as “extract, transform, and load”—are important as some experts estimate the cost of using bad data (i.e., incomplete, poorly defined, or inaccurate) to be as high as 15 to 25 percent of a company’s revenue While these steps can be outsourced to third parties, accountants must be sure to understand them sufficiently so that the resulting data are used appropriately throughout the data analytic framework Interestingly, creativity becomes particularly valuable in these steps because accountants often do not have access to the data they most prefer and, instead, must find a way to utilize the data to which they do have access in a manner that ultimately provides the needed decision insights  □  ○ - Deciding which analytical method to employ in the analysis represents the next step. An analytical method (e.g., a quantitative or qualitative model) includes any method that converts raw data into useful information with decision insights Examples of analytical methods in cost management include models for costing, linear programming, net present value, activity-based costing, and cost-volume-profit scenarios The choice of analytical method should depend on other aspects of the framework, such as the strategic or operational importance of the decision it will inform, as well as the complexity of the particular business scenario being assessed For example, a single food truck likely would require only a simple method (e.g., high-low method) for understanding its cost drivers and constructing the associated cost functions, whereas a large restaurant chain likely would benefit from a more complex method (e.g., multiple regression) given its greater product- and service-line diversity with respect to resource consumption Additionally, sentiment analysis might use qualitative data from social media sites to interpret and classify customer reactions to the company’s product or service performance or employee perception of the company’s work culture  □  ○ - Another challenging aspect within data analytics involves deciding when the analysis is complete For example, few cost management analyses contain a set of clearly enumerated steps for their performance, obvious starting and ending points, or check figures for confirming the ○ - Week 1 Page 11

their performance, obvious starting and ending points, or check figures for confirming the final result In other words, many cost management tasks involve data analyses where it is not clear “what to do first,” “when it is finished,” or “whether the answer is correct" Instead, many cost management analyses that involve data analytic measures require the use of considerable judgment to determine when the analysis has reached the point at which its results will sufficiently improve the decision for which it was conducted □  The final step in the framework focuses on who within the business will be using the results of cost management analysis As such, this step revolves around the need for clear and concise communication to the eventual decision maker Oftentimes this step involves data visualization tools, such as Tableau or Microsoft Power BI Depending on the cost management task for which data analytics was employed, the end user could vary widely from a fellow accountant to an executive with no accounting experience and very little familiarity with the steps by which the results were created Therefore, the perspective of the end user should be considered, and care should be taken to use communication tools (e.g., visual charts versus numeric tables versus qualitative descriptions) and approaches (e.g., face- to-face versus email versus virtual conference) that most effectively and efficiently lead to user understanding Decision makers who do not understand analyses frequently disregard them as ineffective or incorrect Therefore, accountants must be sure that the results of their analyses are clearly understood so that they inform decision making as intended  ◊  □  ○ - 2-2b Data Analytic Types and Cost Management Analyses As discussed in the previous section, accountants increasingly are expected to be familiar with each step within the framework of Exhibit 2.5, that is, “The Role of Data Analytics in Management Accounting” However, many accountants are unlikely to be experts within each step For instance, Step 5 (Which Analytical Method Should Be Employed in My Analysis?) represents one example where accountants are likely to seek assistance and expertise from subject matter experts, including statisticians, business analysts, and computer scientists, inside and outside of their organization to help run and interpret analytical methods Therefore, Exhibit 2.6 presents a deeper dive into Steps 1, 2, and 3 and Step 5 of Exhibit 2.5 Specifically, Exhibit 2.6 illustrates that the business question to be answered should drive the specific data analytic tool type to employ in conducting the relevant cost management analysis  □  ○ - Exhibit 2.6 Matching Data Analytic Types to Cost Management Analyses Data Analytic Type Question Answered Cost Management Analysis Example Descriptive What is happening? A profit and loss analysis assesses historic trends in the company’s profitability. Diagnostic Why is it happening? What-if (i.e., sensitivity), root cause, and activity driver analyses decipher the significant drivers that cause changes in key revenues and costs. Predictive What is likely Forecasting and budgeting analyses predict customer demand - Week 1 Page 12

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Predictive What is likely to happen? Forecasting and budgeting analyses predict customer demand patterns to help the company more effectively synchronize its service provision and product manufacturing capabilities. Prescriptiv e What do I need to do? Strategic cost management analysis identifies specific process reengineering actions to reduce the cost of service provision and product manufacturing activities. 2-3 Cost Assignment: Direct Tracing, Driver Tracing, and Allocation To study cost accounting and operational control systems, we need to understand the meaning of cost and to become familiar with the cost terminology associated with the two systems We must also understand the process used to assign costs Cost assignment is one of the key processes of the cost accounting system Improving the cost assignment process has been one of the major developments in the cost management field in the past 30 or so years First, let’s define cost  □  ○ - Cost is the cash or cash equivalent value sacrificed for goods and services that are expected to bring a current or future benefit to the organization We say cash equivalent because noncash assets can be exchanged for the desired goods or services For example, it may be possible to trade equipment for materials used in production  ○ - Costs are incurred to produce future benefits In a profit-making firm, future benefits usually mean revenues As costs are used up in the production of revenues, they are said to expire Expired costs are called expenses In each period, expenses are deducted from revenues on the income statement to determine the period’s profit A loss is a cost that expires without producing any revenue benefit For example, the cost of uninsured inventory destroyed by a flood would be classified as a loss on the income statement  ◊  □  ○ - Many costs do not expire in a given period These unexpired costs are classified as assets and appear on the balance sheet Computers and factory buildings are examples of assets lasting more than one period Note that the main difference between a cost being classified as an expense or as an asset is timing This distinction is important and will be referred to in the development of other cost concepts later in the text  □  ○ - 2-3a Cost Objects Cost accounting information systems are structured to measure and assign costs to cost objects. Cost objects can be anything for which costs are measured and assigned; they may include products, customers, departments, projects, activities, and so on For example, if we want to determine what it costs to produce a bicycle, then the cost object is the bicycle  If we want to determine the cost of operating a maintenance department within a factory, then the cost object is the maintenance department  If we want to determine the cost of developing a new toy, then the cost object is the new toy development project  Activities are a special kind of cost object An activity is a basic unit of work performed within an organization An activity can also be defined as an aggregation of actions within an organization useful to managers for purposes of planning, controlling, and decision making In recent years, activities have emerged as important cost objects ◊  □ Activities play a prominent role in assigning costs to other cost objects and are essential elements of an activity-based cost accounting system □  ○ - Week 1 Page 13

essential elements of an activity-based cost accounting system Examples of activities include setting up equipment for production, moving materials and goods, purchasing parts, billing customers, paying bills, maintaining equipment, expediting orders, designing products, and inspecting products □ Notice that an activity is described by an action verb (e.g., paying or designing) and an object that receives the action (e.g., bills or products) □ 2-3b Accuracy of Cost Assignments Assigning costs accurately to cost objects is crucial Accuracy is not evaluated based on knowledge of some underlying “true” cost Rather, it is a relative concept and has to do with the reasonableness and logic of the cost assignment methods that are being used The objective is to measure and assign as accurately as possible the cost of the resources used by a cost object Some cost assignment methods are clearly more accurate than others For example, suppose you want to determine the cost of lunch for Elaine Day, a student who frequents Hideaway, an off-campus pizza parlor One cost assignment approach is to count the number of customers at the Hideaway between 12:00 P.M. and 1:00 P.M. and then divide that into the total sales receipts earned by Hideaway during this period Suppose that this comes to $6.25 per lunchtime customer Based on this approach we would conclude that Elaine spends $6.25 per day for lunch  –  Another approach is to go with Elaine and observe how much she spends Suppose that she has a chef’s salad and a medium drink each day, costing $4.50 –  It is easy to see which cost assignment is more accurate The $6.25 cost assignment is distorted by the consumption patterns of other customers (cost objects) As it turns out, most lunchtime clients order the luncheon special for $5.95 (a mini-pizza, small salad, and medium drink)  –  ◊  □  ○ - Distorted cost assignments can produce poor decisions For example, if a plant manager is trying to decide whether to continue producing power internally or to buy it from a local utility company, then an accurate assessment of how much it is costing to produce the power internally is fundamental to the analysis If the cost of internal power production is overstated, the manager might decide to shut down the internal power department in favor of buying power from an outside company, whereas a more accurate cost assignment might suggest the opposite It is easy to see that poor cost assignments can prove to be costly □  ○ - Traceability Understanding the relationship of costs to cost objects can increase the accuracy of cost assignments Costs are directly or indirectly associated with cost objects Indirect costs are costs that cannot be traced easily and accurately to a cost object □ Direct costs are those costs that can be traced easily and accurately to a cost object For costs to be traced easily means that the costs can be assigned in an economically feasible way  □  ○ - Week 1 Page 14

economically feasible way For costs to be traced accurately means that the costs are assigned using a causal relationship  Thus, traceability is the ability to assign a cost directly to a cost object in an economically feasible way by means of a causal relationship The more costs that can be traced to the object, the greater the accuracy of the cost assignments  ○ One additional point needs to be emphasized Cost management systems typically deal with many cost objects Thus, it is possible for a particular cost item to be classified as both a direct cost and an indirect cost It all depends on which cost object is the point of reference For example, if the plant is the cost object, then the cost of heating and cooling the plant is a direct cost; however, if the cost objects are products produced in the plant, then this utility cost is an indirect cost ◊  □  ○ Methods of Tracing Traceability means that costs can be assigned easily and accurately, using a causal relationship Tracing costs to cost objects can occur in one of two ways: (1) direct tracing and (2) driver tracing Direct tracing is the process of identifying and assigning costs to a cost object that are specifically or physically associated with the cost object Direct tracing is most often accomplished by physical observation For example, assume that the power department is the cost object The salary of the power department’s supervisor and the fuel used to produce power are examples of costs that can be specifically identified (by physical observation) with the cost object (the power department)  ◊ As a second example, consider a pair of blue jeans The materials (denim, zipper, buttons, and thread) and labor (to cut the denim according to the pattern and sew the pieces together) are physically observable; therefore, the costs of materials and labor can be directly charged to a pair of jeans  ◊ Ideally, all costs should be charged to cost objects using direct tracing ◊  □  ○ Unfortunately, it is often impossible to physically observe the exact amount of resources being used by a cost object The next best approach is to use cause-and-effect reasoning to identify factors— called drivers —that can be observed and which measure a cost object’s resource consumption Drivers are factors that cause changes in resource usage, activity usage, costs, and revenues Driver tracing is the use of drivers to assign costs to cost objects Although less precise than direct tracing, driver tracing can be accurate if the cause-and-effect relationship is sound Consider the cost of electricity for the jeans manufacturing plant The factory manager might want to know how much electricity is used to run the sewing machines Physically observing how much electricity is used would require a meter to measure the power consumption of the sewing machines, which may not be practical  –  ◊  □  ○ - Week 1 Page 15

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not be practical Thus, a driver such as “machine hours” could be used to assign the cost of electricity If the electrical cost per machine hour is $0.10 and the sewing machines use 200,000 machine hours in a year, then $20,000 of the electricity cost ($0.10 × 200,000) would be assigned to the sewing activity   Assigning Indirect Costs Indirect costs cannot be traced to cost objects Either there is no causal relationship between the cost and the cost object, or tracing is not economically feasible  ○ Assignment of indirect costs to cost objects is called allocation Since no causal relationship exists, allocating indirect costs is based on convenience or some assumed linkage For example, consider the cost of heating and lighting a plant that manufactures five products Suppose that this utility cost is to be assigned to the five products Clearly, it is difficult to see any causal relationship A convenient way to allocate this cost is simply to assign it in proportion to the direct labor hours used by each product  ◊  □  Arbitrarily allocating indirect costs to cost objects reduces the overall accuracy of the cost assignments Accordingly, the best costing policy may be that of assigning only traceable direct costs to cost objects However, it must be admitted that allocations of indirect costs may serve other purposes besides accuracy For example, allocating indirect costs to products may be required for external reporting Nonetheless, most managerial uses of cost assignments are better served by accuracy At the very least, direct and indirect cost assignments should be reported separately –  ◊  □  ○ - Cost Assignment Summarized There are three methods of assigning costs to cost objects: direct tracing, driver tracing, and allocation Of the three methods, direct tracing is the most precise since it relies on physically observable causal relationships  Driver tracing relies on causal factors called drivers to assign costs to cost objects The precision of driver tracing depends on the strength of the causal relationship described by the driver Identifying drivers and assessing the quality of the causal relationship are more costly than either direct tracing or allocation  □  Allocation, while the simplest and least expensive method, is the least accurate cost assignment method; its use should be avoided where possible In many cases, the benefits of increased accuracy by driver tracing outweigh its additional measurement cost This cost-benefit issue is discussed more fully later in the chapter The process really entails choosing among competing cost management systems ◊  □  ○ - 2-4 Product and Service Costs One of the most important cost objects is the output of organizations - Week 1 Page 16

One of the most important cost objects is the output of organizations The two types of output are tangible products and services Tangible products are goods produced by converting raw materials into finished products through the use of labor and capital inputs such as plant, land, and machinery Televisions, hamburgers, automobiles, computers, clothes, and furniture are examples of tangible products □  Services are tasks or activities performed for a customer or an activity performed by a customer using an organization’s products or facilities Services are also produced using materials, labor, and capital inputs □ Insurance coverage, medical care, dental care, funeral care, and accounting are examples of service activities performed for customers □ Car rental, video rental, and skiing are examples of services where the customer uses an organization’s products or facilities □  ○ - Services differ from tangible products on three important dimensions: intangibility, perishability, and inseparability Intangibility means that buyers of services cannot see, feel, hear, or taste a service before it is bought Thus, services are intangible products  ○ Perishability means that services cannot be stored (there are a few unusual cases where tangible goods cannot be stored) ○ Finally, inseparability means that producers of services and buyers of services must usually be in direct contact for an exchange to take place In effect, services are often inseparable from their producers For example, an eye examination requires both the patient and the optometrist to be present □ However, producers of tangible products need not have direct contact with the buyers of their goods Buyers of automobiles, for instance, never need to have contact with the engineers and assembly line workers who produce automobiles  □  ○ - Organizations that produce tangible products are called manufacturing organizations Those that produce intangible products are called service organizations Managers of organizations that produce goods or services need to know how much individual products cost for a number of reasons, including profitability analysis and strategic decisions concerning product design, pricing, and product mix  ○ - Service companies also relate cost to profit - Given the importance of cost to both manufacturing and service firms, when we discuss product costs, we are referring to both intangible and tangible products - 2-4a Different Costs for Different Purposes A fundamental cost management principle is “different costs for different purposes" Product cost definitions can differ according to the objective being served Exhibit 2.7 illustrates this principle by displaying the costs that should be considered for several important yet different decisions that involve particular managerial objectives Exhibit 2.7 also provides numerous examples of costs across the value chain (The value chain was introduced in Chapter 1 and also is discussed in detail in Chapter 11.) For example, in making decisions regarding external financial reporting (i.e., which must adhere to FASB rules and conventions), such as inventory and cost of goods sold, manufacturing organizations should consider only product costs (i.e., the production costs as shown in green) However, in making pricing decisions, all traceable costs  ◊  □  ○ - Week 1 Page 17

However, in making pricing decisions, all traceable costs across the entire value chain should be considered (i.e., from research and design costs shown in purple through customer service costs shown in orange) as companies need to generate enough sales revenues to exceed their full costs if they are to make a positive net income Furthermore, in special-order tactical decisions that do not require the company to incur any additional research and design or development costs (shown in yellow), only costs to manufacture, ship (e.g., marketing and distribution costs as shown in blue), and service the special-order product should be considered when deciding whether to accept or reject the order Decisions involving other managerial objectives, some of which are displayed in Exhibit 2.7, use other product cost definitions For example, often costs incurred prior to production are referred to as upstream costs, while costs incurred after production are referred to as downstream costs   –  Exhibit 2.7 Understanding Different Cost Definitions Exhibit 2.7 also pertains to merchandising and service organizations For merchandising organizations, such as American Eagle, product cost consists solely of the cost to purchase inventory and prepare it for sale □ For service organizations, such as Berkshire Hathaway, Inc., there is no product cost because they do not manufacture physical products but instead provide services However, just as for manufacturing organizations, merchandising and service organizations consider costs up and down the value chain, as appropriate, to understand the particular costs associated with the decision under consideration  □  ○ - 2-4b Product Costs and External Financial Reporting An important objective of a cost management system is the calculation of product costs for external financial reporting Externally imposed conventions require costs to be classified in terms of the special purposes, or functions, they serve ○ - Week 1 Page 18

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purposes, or functions, they serve Costs are subdivided into two major functional categories: production and nonproduction  Production (or product) costs are those costs associated with manufacturing goods or providing services  Nonproduction costs are those costs associated with the functions of selling and administration  For tangible goods, production and nonproduction costs are often referred to as manufacturing costs and nonmanufacturing costs, respectively Production costs can be further classified as direct materials, direct labor, and overhead Only these three cost elements can be assigned to products for external financial reporting  □  Direct Materials Direct materials are those materials traceable to the good or service being produced The cost of these materials can be directly charged to products because physical observation can be used to measure the quantity used by each product Materials that become part of a tangible product or those materials that are used in providing a service are usually classified as direct materials For example, steel in an automobile, wood in furniture, alcohol in cologne, denim in jeans, braces for correcting teeth, surgical gauze and anesthesia for an operation, ribbon in a corsage, and soft drinks on an airline are all direct materials  □  ○ - Direct Labor Direct labor is labor that is traceable to the goods or services being produced As with direct materials, physical observation is used to measure the quantity of labor used to produce a product or service Employees who convert raw materials into a product or who provide a service to customers are classified as direct labor Workers on an assembly line at Dell, a chef in a restaurant, a surgical nurse for an open-heart operation, and a pilot for Southwest Airlines are examples of direct labor  □  ○ - Overhead All production costs other than direct materials and direct labor are lumped into one category called overhead In a manufacturing firm, overhead is also known as factory burden or manufacturing overhead The overhead cost category contains a wide variety of items Many inputs other than direct labor and direct materials are needed to produce products Examples include depreciation on buildings and equipment, maintenance, supplies, supervision, materials handling, power, property taxes, landscaping of factory grounds, and plant security Supplies are generally those materials necessary for production that do not become part of the finished product or are not used in providing a service Dishwasher detergent in a fast-food restaurant and oil for production equipment are examples of supplies –  ◊  □  ○ Direct materials that form an insignificant part of the final product are usually lumped into the overhead category called indirect materials This treatment is justified on the basis of cost and convenience The cost of the tracing is greater than the benefit of increased accuracy The glue used in making furniture or toys is an example  □  ○ - Week 1 Page 19

The cost of overtime for direct labor is usually assigned to overhead as well The rationale is that typically no particular production run caused the overtime Accordingly, overtime cost is common to all production runs and is therefore an indirect manufacturing cost Note that only the overtime cost itself is treated this way If workers are paid $16 per hour regular rate and a premium of $8 per overtime hour, then only the $8 overtime premium is assigned to overhead The $16 regular rate is still regarded as a direct labor cost In certain cases, however, overtime is associated with a particular production run, such as a special order taken when production is at 100 percent capacity In these special cases, it is appropriate to treat overtime premiums as a direct labor cost  –  ◊  □  ○ Prime and Conversion Costs The manufacturing and nonmanufacturing classifications give rise to some related cost concepts The functional distinction between manufacturing and nonmanufacturing costs is the basis for the concepts of noninventoriable costs and inventoriable costs—at least for purposes of external reporting Combinations of different production costs also produce the concepts of prime costs and conversion costs □  ○ Prime cost is the sum of direct materials cost and direct labor cost ○ Conversion cost is the sum of direct labor cost and overhead cost For a manufacturing firm, conversion cost can be interpreted as the cost of converting raw materials into a final product  ○ - Nonproduction Costs Nonproduction costs are divided into two categories: marketing (selling) costs and administrative costs Marketing and administrative costs are not inventoried and are called period costs Period costs are expensed in the period in which they are incurred Thus, period costs are not inventoried and are not assigned to products Period costs appear on the income statement—not the balance sheet In a manufacturing organization, the level of these costs can be significant (often greater than 25 percent of sales revenue), and controlling them may bring greater cost savings than the same control exercised in the area of production costs  ◊  □  ○ - For service organizations, the relative importance of selling and administrative costs depends on the nature of the service being produced Physicians and dentists, for example, generally do very little marketing and thus have very low selling costs ○ An airline, on the other hand, may incur substantial marketing costs ○ - Those costs necessary to market and distribute a product or service are marketing (selling) costs They are often referred to as order-getting and order-filling costs Examples of marketing costs include the following: salaries and commissions of sales personnel, advertising, warehousing, shipping, and customer service The first two items are examples of order-getting costs; the last three are order- filling costs □  ○ - All costs that cannot be reasonably assigned to either marketing or production are administrative costs - Week 1 Page 20

costs Administration is responsible for ensuring that the various activities of the organization are properly integrated in accordance with the overall mission of the firm The president of the firm, for example, is concerned with the efficiency of both marketing and production as they carry out their respective roles Proper integration of these two functions is essential for maximizing the overall profits of a firm Examples of administrative costs are top-executive salaries, legal fees, printing and distributing the annual report, and general accounting Research and development also is part of administrative costs and is expensed in the period incurred Exhibit 2.7 provides numerous cost examples within each value chain component  ◊  □  ○ 2-5 External Financial Statements The functional classification is the cost classification required for external reporting In preparing an income statement, production and nonproduction costs are separated The reason for the separation is that production costs are product costs—costs that are inventoried until the units are sold—and the nonproduction costs of marketing and administration are viewed as period costs Thus, production costs attached to the units sold are recognized as an expense (cost of goods sold) on the income statement Production costs attached to units that are not sold are reported as inventory on the balance sheet Marketing and administrative expenses are viewed as costs of the period and must be deducted each and every period as expenses on the income statement Nonproduction costs never appear on the balance sheet  ◊  □  ○ - 2-5a Income Statement: Manufacturing Firm The income statement prepared for external parties follows the standard format taught in an introductory financial accounting course This income statement is frequently referred to as absorption-costing income or full-costing income because all manufacturing costs (direct materials, direct labor, and overhead) are fully assigned to the product ○ - Under the absorption-costing approach, expenses are separated according to function and then deducted from revenues to arrive at operating income The two major functional categories of expense are cost of goods sold and operating expenses These categories correspond to a firm’s manufacturing and nonmanufacturing (marketing and administrative) expenses  Cost of goods sold is the cost of direct materials, direct labor, and overhead attached to the units sold To compute the cost of goods sold, it is first necessary to determine the cost of goods manufactured □  ○ - Cost of Goods Manufactured The cost of goods manufactured represents the total manufacturing cost of goods completed during the current period The only costs assigned to goods completed are the manufacturing costs of direct materials, direct labor, and overhead The details of this cost assignment are given in a supporting schedule, called the statement of cost of goods manufactured □  ○ Work in process consists of all partially completed units found in production at a given point in time ○ - Week 1 Page 21

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in time Beginning work in process consists of the partially completed units on hand at the beginning of a period  Ending work in process consists of the incomplete units on hand at the period’s end  In the statement of cost of goods manufactured, the cost of these partially completed units is reported as the cost of beginning work in process and the cost of ending work in process  The cost of beginning work in process represents the manufacturing costs carried over from the prior period; the cost of ending work in process represents the manufacturing costs that will be carried over to the next period  In both cases, additional manufacturing costs must be incurred to complete the units in work in process  Cost of Goods Sold Once the cost of goods manufactured statement is prepared, the cost of goods sold can be computed The cost of goods sold is the manufacturing cost of the units that were sold during the period It is important to remember that the cost of goods sold may or may not equal the cost of goods manufactured In addition, we must remember that the cost of goods sold is an expense, and it belongs on the income statement  □  ○ - Often, the income statement includes a column showing each line item as a percent of sales Clearly, sales is 100 percent of sales Management can review these percentages and compare them with past history of the firm and with industry averages to see whether expenses are in line with expectations If the industry generally spends 15 percent of sales on selling expense, then a company that spends significantly more or less than that amount may want to carefully consider whether its marketing strategy is appropriate □  ○ - 2-5b Income Statement: Service Organization The income statement for a service organization looks very similar to the one shown in Example 2.4 for a manufacturing organization The cost of goods sold does, however, differ in some key ways For one thing, the service firm has no finished goods inventories since services cannot be stored, although it is possible to have work in process for services For example, an architect may have drawings in process and an orthodontist may have numerous patients in various stages of processing for braces □ Additionally, some service firms add order fulfillment costs to the cost of goods sold □  ○ - 2-6 Traditional and Activity-Based Cost Management Systems Cost management systems can be broadly classified as traditional or activity-based While both of these systems are found in practice, the traditional cost management systems are more widely used than the activity-based systems As the need for highly accurate cost information increases, however, savvy cost accountants have learned to apply activity-based costing concepts to the determination of costs for management decision making This is particularly true in organizations faced with increased product diversity, more product complexity, shorter product life cycles, increased quality requirements, and intense competitive pressures These organizations often adopt a just-in-time manufacturing approach and implement advanced manufacturing technology (discussed in detail in Chapter 11)  □  ○ - Week 1 Page 22

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in Chapter 11) For firms operating in this advanced manufacturing environment, the traditional cost management system may not work well More relevant and timely cost information is needed for these organizations to build a sustainable long-term competitive advantage Organizations must improve the value received by their customers while increasing their own profits at the same time Better assessment of cost behavior, increased accuracy in product costing, and an attempt to achieve continuous cost improvement are all critical for the advanced manufacturing environment  –  ◊ 2-6a Traditional Cost Management Systems: A Brief Overview Cost management systems are made up of two subsystems: the cost accounting system and the operational control system It is logical and convenient to discuss each subsystem separately Of course, what is true for a subsystem is true for the overall cost management system  ○ - Traditional Cost Accounting A traditional cost accounting system assumes that all costs can be classified as fixed or variable with respect to changes in the units or volume of product produced Thus, units of product or other drivers highly correlated with units produced, such as direct labor hours and machine hours, are the only drivers assumed to be of importance These unit- or volume-based drivers are used to assign production costs to products A cost accounting system that uses only unit-based activity drivers to assign costs to cost objects is called a traditional cost system Since unit-based activity drivers usually are not the only drivers that explain causal relationships, much of the product cost assignment activity must be classified as allocation (recall that allocation is cost assignment based on assumed linkages or convenience) Therefore, traditional cost accounting systems tend to be allocation intensive.  ◊  □  ○ The product costing objective of a traditional cost accounting system is typically satisfied by assigning production costs to inventories and cost of goods sold for purposes of financial reporting More comprehensive product cost definitions, such as the value-chain and operating cost definitions illustrated in Exhibit 2.7, are not available for management use Traditional cost accounting systems, however, often furnish useful variants of the product cost definitions For example, prime costs and variable manufacturing costs per unit may be reported  □  ○ - Traditional Cost Control A traditional operation control system assigns costs to organizational units and then holds the organizational unit manager responsible for controlling the assigned costs Performance is measured by comparing actual outcomes with standard or budgeted outcomes The emphasis is on financial measures of performance; nonfinancial measures may be ignored □  ○ - Week 1 Page 23

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may be ignored Managers are rewarded based on their ability to control costs This approach traces costs to individuals who are responsible for the incurrence of costs The reward system is used to motivate these individuals to manage costs The approach assumes that maximizing the performance of the overall organization is achieved by maximizing the performance of individual organizational subunits (referred to as responsibility centers ) –  ◊  2-6b Activity-Based Cost Management Systems: A Brief Overview Activity-based cost management systems have evolved in response to significant changes in the competitive business environment faced by both service and manufacturing firms The overall objective of an activity-based cost management system is to manage activities to reduce costs and improve customer value A well-designed activity-based cost management system helps managers achieve operational and strategic objectives Operational activity-based management relates to efficiency or “doing things right” Thus, activity-based costing information is used to improve efficiency and lower cost while maintaining or improving customer value Strategic activity-based management relates to effectiveness or “doing the right things” Thus, activity-based costing information helps managers choose which services or products to produce and which activities would be most appropriate to produce them Generally, more managerial objectives can be met with an activity-based system than with a traditional system –  ◊  □  ○ - Activity-Based Cost Accounting An activity-based cost accounting system emphasizes tracing over allocation The role of driver tracing is significantly expanded by identifying drivers unrelated to the volume of product produced (called non-unit-based activity drivers ) The use of both unit- and non-unit-based activity drivers increases the accuracy of cost assignments and the overall quality and relevance of cost information A cost accounting system that uses both unit- and non-unit-based activity drivers to assign activity costs to cost objects is called an activity-based cost (ABC) system For example, consider the activity called “moving materials” (moving raw materials and partially finished goods from one point to another within a factory) The number of moves required for a product may be a much better measure of the product’s demand for the materials handling activity than the number of units produced In fact, the number of units produced may have little to do with measuring products’ demands for materials handling (A batch of 10 units of one product could require as much materials handling activity as a batch of 100 units of another product.) Thus, an activity-based cost accounting system tends to be tracing intensive   –  ◊  □  ○ - Week 1 Page 24

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system tends to be tracing intensive Product costing in an activity-based system tends to be flexible The activity-based cost management system is capable of producing cost information for a variety of managerial objectives, including the financial reporting objective More comprehensive product costing definitions are emphasized for better planning, control, and decision making Therefore, the maxim of “different costs for different purposes” takes on real meaning  □  ○ Activity-Based Cost Control The activity-based operational control subsystem also differs significantly from that of a traditional system The emphasis of the traditional cost management accounting system is on managing costs However, the management of activities—not costs—is the key to successful control in the advanced manufacturing environment, and activity-based management is at the heart of a contemporary operational control system Activity-based management (ABM) focuses on the management of activities with the objective of improving the value received by the customer and the profit received by the company in providing this value It includes driver analysis, activity analysis, and performance evaluation and draws on ABC as a major source of information In Exhibit 2.8, the vertical dimension, or cost view , traces the cost of resources to activities and then to the cost objects The cost view serves as an important input to the control dimension, which is called the process view The process view identifies factors that cause an activity’s cost (explains why costs are incurred), assesses what work is done (identifies activities), and evaluates the work performed and the results achieved (how well the activity is performed) Thus, an activity-based control system requires detailed information on activities   –  ◊  □  ○ - Exhibit 2.8 Activity-Based Management Model - Week 1 Page 25

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○ This new approach focuses on accountability for activities rather than costs to maximize systemwide, rather than individual, performance Activities cut across functional and departmental lines, are systemwide in focus, and require a global approach to control Essentially, this form of control admits that maximizing the efficiency of individual subunits does not necessarily lead to maximum efficiency for the system as a whole Another significant difference exists; in the ABM operational control information system, both financial and nonfinancial measures of performance are important Exhibit 2.9 compares the characteristics of the traditional and activity- based cost management systems  □  ○ - Exhibit 2.9 Comparison of Traditional and Activity-Based Cost Management Systems Traditional Activity-Based Unit-based drivers Unit- and non-unit-based drivers Allocation intensive Tracing intensive Narrow and rigid product costing Broad, flexible product costing Focus on managing costs Focus on managing activities Sparse activity information Detailed activity information Maximization of individual unit performance Systemwide performance maximization Uses financial measures of performance Uses both financial and nonfinancial measures of performance - 2-6c Choice of a Cost Management System An activity-based cost management system offers significant benefits, including greater product costing accuracy, improved decision making, enhanced strategic planning, and an increased ability to manage activities These benefits, however, are expensive - Week 1 Page 26

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These benefits, however, are expensive An activity-based cost management system is more complex and requires considerably more measurement activity—and measurement can be costly As Kaplan and Anderson point out, “ABC systems (are) expensive to build, complex to sustain, and difficult to modify” □  ○ In deciding whether to implement an activity-based cost management system, a manager must assess the trade-off between the cost of measurement and the cost of errors Measurement costs are the costs associated with the measurements required by the cost management system ○ Error costs are the costs associated with making poor decisions based on bad cost information ○ Optimally, a cost management system would minimize the sum of measurement and error costs Note, however, that the two costs conflict More complex cost management systems produce lower error costs but have higher measurement costs (Consider, for example, the number of activities that must be identified and analyzed, along with the number of drivers that must be used to assign costs to products.) The tradeoff between error and measurement costs is illustrated in Exhibit 2.10 The message is clear  ◊  □  ○ - Exhibit 2.10 Trade-Off between Measurement and Error Costs ○ - New approaches to activity-based costing are being developed For example, time-driven activity-based costing streamlines the cost drivers and focuses on the time it takes to perform an activity Alternatively, for some organizations, the optimal cost system may not be an ABM system Depending on the trade-offs, the optimal cost management system may very □  ○ - Week 1 Page 27

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Depending on the trade-offs, the optimal cost management system may very well be a simpler, traditional system This could explain, in part, why most firms still maintain this type of system  □ Recent changes in the manufacturing environment may increase the attractiveness of more accurate, yet complex, cost management systems New information technology decreases measurement costs; computerized production planning systems and more powerful, less expensive computers make it easier to collect data and perform calculations As measurement costs decrease, the measurement cost curve shown in Exhibit 2.10 shifts downward and to the right, causing the total cost curve to shift to the right The optimal cost management system is now one that allows more accuracy □  ○ - As the cost of measurement has decreased, the cost of errors has increased Basically, errors consist of over- or under-costing products If competition heats up for an overcosted product, the firm may drop what appears to be an unprofitable product under a traditional system If the nature of the competition changes, error costs can increase as well □  ○ - For example, if single-product-focused competitors emerge, then their pricing and marketing strategies will be based on more accurate cost information (since all costs are known to belong to the single product) Because of better cost information, the more focused firms may gain market share at the expense of multiple-product producers (whose cost systems may be allocating rather than tracing costs to individual products) Other factors such as deregulation and just-in-time manufacturing (which leads to a more focused production environment) can also increase the cost of errors As the cost of errors increases, the error cost curve in Exhibit 2.10 shifts upward and to the right, causing the total cost curve to shift to the right, making a more accurate cost system the better choice □  ○ - Another cost, which is increasing for some firms, is the cost of unethical conduct - Exhibit 2.11 Shifting Measurement and Error Costs - Week 1 Page 28

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○ 2-7a Summary of Learning Objectives LO1 Describe a cost management information system, its objectives, and its major subsystems, and indicate how it relates to other operating and information systems Cost management system, a subsystem of the accounting information system, designed to satisfy costing, controlling, and decision-making objectives ○ Two major subsystems: cost accounting system and the operational control system ○ - LO2 Define data analytics, and describe its role in cost management Data analytics represents the process through which an organization utilizes various amounts and types of data to help connect strategy and other key goals to improved decision making ○ Effectively utilizing data analytics requires accountants to answer seven important questions—What, Why, How, Where, Which, When, and Who—in order to improve cost management decisions ○ - LO3 Explain the cost assignment process Objective of the cost accounting system is assigning costs to cost objects ○ Three methods of cost assignment: Direct tracing—physical observation, most accurate  Driver tracing—more expensive, more accurate than allocation  Allocation—least accurate, easiest to apply  ○ - LO4 Define tangible and intangible products, and explain why there are different product cost definitions Products are tangible ○ Services are: Intangible  Perishable (cannot be inventoried)  Inseparable (buyer and provider interact)  ○ Product cost definitions: - Week 1 Page 29

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Product cost definitions: Value chain includes research and development, production, marketing, and customer service Used for pricing decisions, product mix decisions, strategic profitability analysis □  Operating product costs include production, marketing, and customer service Used for strategic design decisions, tactical profitability analysis □  Traditional product costs include only production (direct materials, direct labor, overhead) and are used for external financial reporting  ○ LO5 Prepare income statements for manufacturing and service organizations Income statements rely on: Cost of goods manufactured or services provided  Cost of goods sold or services sold (typically the same as services provided)  ○ Gross margin is the difference between sales revenue and the cost of goods (or services) sold ○ Operating income is the difference between gross margin and selling (or marketing) and administrative expense ○ - LO6 Explain the differences between traditional and contemporary cost management systems Traditional systems characterized by: Use of unit-based drivers  Allocation  Narrow and rigid product costing  Focus on managing costs  Maximization of individual unit performance  Use of financial measures of performance  ○ Activity-based systems characterized by: Use of unit- and non-unit-based drivers  Tracing  Broad, flexible product costing  Focus on managing activities  Systemwide performance maximization  Use of both financial and nonfinancial measures of performance  ○ - Week 1 Page 30

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Chapter 2 Reading

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