lOMoARcPSD|14840171
Management accounting
Lecture 1: Introduction to key concepts and cost terminology
Strategy
• Determines the purpose and long-term direction of the company
• Firms arrive (by choice or market forces) at one of two competitive strategies
o Product diffrentiation – firm offers a superior/unique product or service relative to the product or
services of its competitors
> brand loyalty and willingness to pay high prices
o Cost leadership – firm outperforms competitors in producing products or services at the lowest
costs. Focus on productivity and efficiency improvements, elimination of waste and tight cost
control
> lower selling prices
Strategy without measurement is meaningless: need to look at the results
> Management Accounting provides metrics and tools to assess those results
Introduction
1. Cost allocation -> direct versus indirect costs
2. Cost behavior -> fixed versus variable costs
3. Cost relevance -> relevant versus irrelevant costs
4. Cost recording -> product versus period costs
Cost Allocation: direct versus indirect
Cost objects are things we want to know the cost of
Direct costs can be easily traced to cost objects
Overhead costs (indirect costs) can’t be traced
-> must be allocated to cost objects using a cost
driver (allocation base)
Cost driver is a factor that causes a change in cost
(e.g., production volume)
, lOMoARcPSD|14840171
Direct and indirect costs
• Costs may be direct for some cost objects but
indirect for other cost objects:
o Car versus production plant
-> Cost for salary of a manager overseeing the
production plant is indirect for individual car
but direct for production plant
Cost behavior: fixed versus variable
• Variable costs do change in proportion with volume of a cost driver, such as production or
sales quantity
- Material costs such as tires and engines are variable costs for cars, wages
• Fixed costs do not change in proportion with volume of a cost driver, at least not within the
relevant range
- E.g., insurance of taxes for production plant -> independent of whether 1 or 1000 cars
are produced and sold
Piecewise Linear Variable Costs
In most situations, variable costs do not follow a straight line:
-> When people get used to the production process, they become more efficient until they meet some kind of
stable level at a certain point
, lOMoARcPSD|14840171
• Total cost (x) = fixed cost + variable cost
• Average cost / cost per unit = total cost at x divided by x [=TC(x)/x]
• Marginal cost (x) = the increase in costs from producing an additional unit of output at point x
Assumptions
• Variations in the cost driver explain variations in total costs
• Cost behavior is approximated by a linear cost function within the relevant range
Cost functions – depict how costs change with changes in cost driver
Fixed costs over the long-term
Are fixed costs always fixed?
, lOMoARcPSD|14840171
• Relevant range – range in which the relationship between the activity/volume level and the
respective cost is constant
• When business activity declines, firms divest to eliminate excess capacity
• When business activity increases, firms invest to increase capacity
• Over the long-term fixed costs behave like step functions
Cost relevance: relevant versus irrelevant
Relevant costs and revenues are those that:
• Differ between alternative courses of action and
• Affect future cashf 氀 ows
Irrelevant costs are already incurred costs and thus “sunk”
Cost recording: product versus period
• Product costs – include only the costs necessary to
complete the product at the manufacturing step in the
value chain (manufacturing) or to purchase and
transport the product to the location of sale
(merchandising)
-> only the production process
• Period costs (non-product costs) – include all other costs
incurred by the firm in managing or selling the product
(costs outside the manufacturing step of the value
chain)
-> facilitate sale or support business activities
-> office support salaries, advertising expense,
office expense, salary of accountant etc.
The f 氀 ow of product and period costs
Example of bicycle company
Management accounting
Lecture 1: Introduction to key concepts and cost terminology
Strategy
• Determines the purpose and long-term direction of the company
• Firms arrive (by choice or market forces) at one of two competitive strategies
o Product diffrentiation – firm offers a superior/unique product or service relative to the product or
services of its competitors
> brand loyalty and willingness to pay high prices
o Cost leadership – firm outperforms competitors in producing products or services at the lowest
costs. Focus on productivity and efficiency improvements, elimination of waste and tight cost
control
> lower selling prices
Strategy without measurement is meaningless: need to look at the results
> Management Accounting provides metrics and tools to assess those results
Introduction
1. Cost allocation -> direct versus indirect costs
2. Cost behavior -> fixed versus variable costs
3. Cost relevance -> relevant versus irrelevant costs
4. Cost recording -> product versus period costs
Cost Allocation: direct versus indirect
Cost objects are things we want to know the cost of
Direct costs can be easily traced to cost objects
Overhead costs (indirect costs) can’t be traced
-> must be allocated to cost objects using a cost
driver (allocation base)
Cost driver is a factor that causes a change in cost
(e.g., production volume)
, lOMoARcPSD|14840171
Direct and indirect costs
• Costs may be direct for some cost objects but
indirect for other cost objects:
o Car versus production plant
-> Cost for salary of a manager overseeing the
production plant is indirect for individual car
but direct for production plant
Cost behavior: fixed versus variable
• Variable costs do change in proportion with volume of a cost driver, such as production or
sales quantity
- Material costs such as tires and engines are variable costs for cars, wages
• Fixed costs do not change in proportion with volume of a cost driver, at least not within the
relevant range
- E.g., insurance of taxes for production plant -> independent of whether 1 or 1000 cars
are produced and sold
Piecewise Linear Variable Costs
In most situations, variable costs do not follow a straight line:
-> When people get used to the production process, they become more efficient until they meet some kind of
stable level at a certain point
, lOMoARcPSD|14840171
• Total cost (x) = fixed cost + variable cost
• Average cost / cost per unit = total cost at x divided by x [=TC(x)/x]
• Marginal cost (x) = the increase in costs from producing an additional unit of output at point x
Assumptions
• Variations in the cost driver explain variations in total costs
• Cost behavior is approximated by a linear cost function within the relevant range
Cost functions – depict how costs change with changes in cost driver
Fixed costs over the long-term
Are fixed costs always fixed?
, lOMoARcPSD|14840171
• Relevant range – range in which the relationship between the activity/volume level and the
respective cost is constant
• When business activity declines, firms divest to eliminate excess capacity
• When business activity increases, firms invest to increase capacity
• Over the long-term fixed costs behave like step functions
Cost relevance: relevant versus irrelevant
Relevant costs and revenues are those that:
• Differ between alternative courses of action and
• Affect future cashf 氀 ows
Irrelevant costs are already incurred costs and thus “sunk”
Cost recording: product versus period
• Product costs – include only the costs necessary to
complete the product at the manufacturing step in the
value chain (manufacturing) or to purchase and
transport the product to the location of sale
(merchandising)
-> only the production process
• Period costs (non-product costs) – include all other costs
incurred by the firm in managing or selling the product
(costs outside the manufacturing step of the value
chain)
-> facilitate sale or support business activities
-> office support salaries, advertising expense,
office expense, salary of accountant etc.
The f 氀 ow of product and period costs
Example of bicycle company
