1. Review

2. Agenda Review Cost management systems Product and service costing
Management control systems
Budgeting
Variances
Performance measurement
Transfer pricing

3. Cost Management Systems
Costs are caused by
Resources
These Resources are used by
Products
These Products
Generate Revenue
Mapping Resource Costs to Products
A challenge
Requires deep understanding of the organization

4. Cost Management Systems
Direct Costs:
Resources dedicated to a particular product
Direct materials
Direct labor
Overhead:
Resources shared by multiple products
Allocation of these resources to products is imprecise

5. Cost Diagrams Direct Material Direct Labor Overhead Directly traced
Based on
Direct labor $
Fuel Tanks
Mufflers
Manifolds

6. Overhead Allocation: Mechanics
Shared Resource Level
Collect the shared or overhead resources into various cost pools
Figure out the allocation base (or the activity level)
Common allocation bases include direct labor cost, direct labor hours, and machine hours
Overhead or Burden rate = Overhead Cost ÷ Allocation Base
Product Level
Allocated Indirect Cost:
Compute the product’s use of shared resources and charge it accordingly
Total Product Cost = Direct Cost + Allocated Indirect Cost

7. Overhead Mechanics: Two-Stage System
Multiple overhead cost centers
Overhead costs vary with different factors
Different allocation bases can be used for each center
Product Level
Allocate overhead costs to each product based on how much of each overhead cost pool the product uses

8. Diagram: Two-Stage System
(Cost Pools)
Overhead
1st Stage
Directly traced
(Cost Centers)
Administrative
Test Room
Machine
hours
2nd Stage
DL $
(Cost Objects)
Components

9. Overhead Mechanics: Activity-Based Costing
Resource Level Costing
Shared Resource hierarchy
Volume (unit)
Batch (run)
Product
Facility
Cost “centers” are activities
Shared resources exist to conduct these activities
Product Level Costing
Products that “cause” more work get more cost

10. Costing Mechanics at the Boundaries
Cost objects might be customers or suppliers
Customers cause costs by ordering behavior
Suppliers cause costs by delivery failures
Aggregation of costs is different, but the process of developing costs is the same
Shared resource level
Identify the activities
Cost the activities
Product Level
Determine how much resources a customer (supplier) uses

11. Costing Systems: Organizational Issues
From a Mechanics Perspective
More accuracy is better
The only costs are implementation costs
From an Organizational Perspective
Is the organization ready to work with a complex cost system?
Will employees worry about transitioning to a new cost system that changes their profit numbers?
Will the new system display volatility in the cost numbers?
Your judgment and leadership skills are key to managing the transition

12. Budgeting Mechanics Run the Business Process in Reverse
Forecast Sales  Production Volume  Input Purchases
The value of Budgeting to an organization
Exchange and consolidate information from employees about the future
The dual use of Budgeting in an organization
Making Investment Plans
Setting Performance Targets

13. Organizational Issues in Budgeting
Who should make the forecast?
The manager with the knowledge
Will the manager make the correct forecast?
Depends on how the manager is compensated
Organizational costs of improper forecasts
Wasted investment dollars
Managerial judgment and leadership are key budgeting skills

14. Variances Difference between actual and budgeted profits
Decomposed into Revenue and Cost Variances
Further Decomposition of Cost Variances
Volume variances
Price (rate) variance
Efficiency (use) variance
All decompositions have the same unit of measurement ($)
Different variances can therefore be compared

15. Variance Mechanics Actual Costs Flex Budget Master Budget
Flexible Budget: Budget at expected unit costs but actual volume
Price and
Efficiency
Variances
Volume
Variance

16. Organizational Issues in Variance Analysis
The Value of Variance Analysis to an organization
Provide important information about business future
Dual Use of Variances
Refocus Investment Plans
Reevaluate Employee Performance
Variances are highly political
Require much management judgment and skill to manage
Can quickly lead to dysfunction if not properly managed

17. Balanced Scorecards Multiple measure systems Four perspectives
Financial, Customer, Internal, Learning or innovation
Strategy map links perspectives through the business model
Value of Balanced Scorecard
Provide information on business to management
Dual Use of Balanced Scorecards
Tool to guide and help managerial decision-making
Tool to compensate managers

18. Financial Performance Measures
Return on investment (ROI)
ROI = Income ÷ Assets
Residual Income
Income – (Cost of capital x Assets)
Economic value added (EVA)
Adjusted Income – (Cost of capital x Adjusted Assets)
Income and assets modified to “correct” accounting distortions from economic values
Examples include R&D and advertising

19. Organizational Uses of ROI, RI, EVA
Each measure has its strengths and weakness
ROI is easily compared (ratio):
But subject to the ROI dilution problem
RI and EVA do not suffer the ROI dilution problem
But can differ across divisions simply due to accounting rules
Capitalization vs. expensing of various items
These measures’ use
Cannot be formulaic
Top management must understand the division’s situation
Requires managerial judgment and leadership

20. Transfer Pricing Rationale
Basic issue
Divisions are interconnected
Change the reported profit number of the divisions to reflect this interconnection
The “price” at which to transfer products or services from one profit center to another

21. Transfer Pricing Mechanics
Optimal transfer price formula use the “Price = Incremental Cost” formula:
If Price is available use it as the transfer price
Else use Incremental Cost of producing one extra unit
Difficult if producing extra units require investments in “chunky” capacity
Two-step transfer pricing
Charge a lump sum every period
Charge incremental cost

22. Organizational Issues in Transfer Pricing
Value of transfer prices to an organization
Provide important information on divisional profitability
Dual use of a transfer pricing system in an organization
Refocus investment plans
Evaluate divisional manager performance
Optimal formulas exist
But must be applied with organizational judgment in mind
Can we change TP often when outside market is highly volatile?
Rules on splitting the pie can affect the size of the pie

23. Takeaway Understand the production process behind the final product
In particular, understand the nature of the shared resources
These resources generate cost; the product generates sales
In particular, understand the divisional managers
Their responsibilities
Their motivation and compensation
Internal accounting systems will be a crucial source of information
Most of you will use internal accounting systems heavily in MAP and in the early stages of your career as a junior manager