2. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 1 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 1 Introduction to Management Accounting

3. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 2 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 2 Chapter 3 Introduction to Management Accounting Measurement of Cost Behavior

4. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 3 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 3 Linear-cost Behavior Costs are assumed to be fixed or variable within the relevant range of activity

5. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 4 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 4 Step Cost Behavior Patterns Step costs change abruptly at intervals of activity because the resources and their costs come in indivisible chunks. Learning Objective 1

6. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 5 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 5 Step Cost Behavior Patterns

7. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 6 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 6 Mixed-Cost Behavior Patterns Mixed costs contain elements of both fixed- and variable-cost behavior. The fixed-cost element is unchanged over a range of cost-driver activity. The variable-cost element varies proportionately with cost-driver activity.

8. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 7 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 7 Mixed-Cost Behavior Patterns Parkview Medical Center Predicted costs = fixed + variable costs (patient-days) Predicted costs = $10,000 + $5(4,000) Predicted costs = $30,000

9. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 8 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 8 Distribution channels Choice of process and product design Quality levels Product features Learning Objective 2 Management’s Influence on Cost Behavior

10. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 9 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 9 Capacity Decisions They are the fixed costs of being able to achieve a desired level of production or to provide a desired level of service while maintaining product or service attributes.

11. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 10 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 10 Committed Fixed Costs Salaries of key personnel Committed fixed costs arise from the possession of facilities, equipment, and a basic organization. Lease payments Property taxes

12. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 11 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 11 Discretionary Fixed Costs Discretionary fixed costs are costs fixed at certain levels only because management decided that these levels of cost should be incurred to meet the organization’s goals. These discretionary fixed costs have no obvious relationship to levels of output activity but are determined as part of the periodic planning process. Each planning period, management will determine how much to spend on discretionary items. These costs then become fixed until the next planning period.

13. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 12 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 12 Examples of Discretionary Fixed Costs Advertising and promotion Research and development Managementsalaries Employee training

14. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 13 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 13 Technology Decisions Choice of technology (e-commerce versus in-store or mail-order sales) positions the organization to meet its current goals and to respond to changes in the environment.

15. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 14 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 14 Cost-Control Incentives Managers use their knowledge of cost behavior to set cost expectations. Employees may Receive rewards that are tied to meeting these expectations.

16. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 15 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 15 Cost Functions Planning and controlling the activities of an organization require accurate and useful estimates of future fixed and variable costs. Learning Objective 3

17. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 16 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 16 Cost Functions Understanding relationships between costs and their cost drivers allows managers to... Make better operating, marketing, And production decisions Plan and evaluate actions Determine appropriate costs for short-run and long-run decisions.

18. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 17 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 17 Cost Functions The first step in estimating or predicting costs is measuring cost behavior as a function of appropriate cost drivers. The second step is to use these cost measures to estimate future costs at expected levels of cost-driver activity.

19. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 18 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 18 Cost Function Equation Let: Y = Total cost F = Fixed cost V = Variable cost per unit X = Cost-driver activity in number of units Mixed-cost function: Y = F + VX Y = $10,000 + $5.00X The mixed-cost function is called a linear-cost function.

20. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 19 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 19 Developing Cost Functions A cost function’s estimates of costs at actual levels of activity must reliably conform with actually observed costs. The cost function must be believable.

21. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 20 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 20 Choice of Cost Drivers: Activity Analysis Choosing a cost function starts with choosing cost drivers. Managers use activity analysis to identify appropriate cost drivers. Activity analysis directs management accountants to the appropriate cost drivers for each cost. Learning Objective 4

22. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 21 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 21 Choice of Cost Drivers: Activity Analysis Northwestern Computers makes two products: Mozart-Plus and Powerdrive In the past, most of the support costs were twice as much as labor costs. Northwest has upgraded the production function, which has increased support costs and reduced labor cost.

23. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 22 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 22 Choice of Cost Drivers: Activity Analysis Using the old cost driver, labor cost, the prediction of support costs would be: Mozart-Plus Powerdrive Mozart-Plus Powerdrive Labor cost$ 8.50 $130.00 Support cost: 2 × Direct labor cost$17.00 $260.00

24. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 23 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 23 Choice of Cost Drivers: Activity Analysis Using the more appropriate cost driver, the number of components added to products, the predicted support costs are: Mozart-Plus Powerdrive Mozart-Plus Powerdrive Support cost at $20/component $20 × 5 components $100.00 $20 × 5 components $100.00 $20 × 9 components $180.00 $20 × 9 components $180.00 Difference in predicted support cost$ 83.00$ 80.00 support cost$ 83.00$ 80.00 higher lower higher lower

25. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 24 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 24 Methods of Measuring Cost Functions  1. Engineering analysis  2. Account analysis  3. High-low analysis  4. Visual-fit analysis  5. Least-squares regression analysis Learning Objective 5

26. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 25 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 25 Engineering Analysis Engineering analysis measures cost behavior according to what costs should be, not by what costs have been. Engineering analysis entails a systematic review of materials, supplies, labor, support services, and facilities needed for products and services.

27. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 26 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 26 Account Analysis The simplest method of account analysis selects a plausible cost driver and classifies each account as a variable or fixed cost. Supervisor’s salary and benefits $ 3,800$3,800 Hourly workers’ wages and benefits 14,674$14,674 Equipment depreciation and rentals 5,873 5,873 Equipment repairs 5,604 5,604 Cleaning supplies 7,472 7,472 Total maintenance costs$37,423$9,673$27,750 Monthly cost Amount Fixed Variable Parkview Medical Center

28. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 27 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 27 Account Analysis Example Fixed cost per month = $9,673 Variable cost per patient-day = $27,750 ÷ 3,700 = $7.50 per patient-day 3,700 patient-days Y = $9,673 + ($7.50 × patient-days)

29. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 28 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 28 High-Low Method Focus on the highest- and lowest-activity points. Plot historical data points on a graph. High month: April Maintenance cost: $47,000 Number of patient-days: 4,900 Low month: September Maintenance cost: $17,000 Number of patient-days: 1,200

30. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 29 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 29 High-Low Method Example The point at which the line intersects the Y axis is the intercept, F, or estimate of Fixed Costs, and the slope of the line measures the variable cost.

31. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 30 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 30 High-Low Method Example Variable costs = Change in costs change in activity change in activity V = ($47,000 – $17,000) ÷ (4,900 – 1,200) = $30,000 ÷ 3,700 = $8.1081 What is the variable cost (V)? Using algebra to solve for variable and fixed costs.

32. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 31 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 31 High-Low Method Example F = Total mixed cost – total variable cost At X (high) F = $47,000 - ($8.1081× 4,900 patient days) = $47,000 – $39,730 = $7,270 a month At X (low) F = $17,000 = ($8.1081× 1,200 patient days) = $17,000 – $9,730 = $7,270 a month Cost function measured by high-low method: Y = $7,270 per month + ($8.1081 × patient-days) What is the fixed cost (F)?

33. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 32 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 32 Visual-Fit Method In the visual-fit method, the cost analyst visually fits a straight line through a plot of all of the available data, not just between the high point and the low point, making it more reliable than the high-low method.

34. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 33 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 33 Least-Squares Regression Method Regression analysis measures a cost function more objectively by using statistics to fit a cost function to all the data. Regression analysis measures cost behavior more reliably than other cost measurement methods.

35. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 34 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 34 Coefficient of Determination One measure of reliability, or goodness of fit, is the coefficient of determination, R² (or R-squared). The coefficient of determination measures how much of the fluctuation of a cost is explained by changes in the cost driver.

36. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 35 ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 3 - 35 End of Chapter 3 The End