Cost terms and concepts

The term cost is used in many different ways in managerial accounting. The reason is that there are many types of costs, and these costs are classified differently according to the immediate need of management.

For example, managers may want cost data to prepare external financial reports, to prepare planning budgets, or to make decisions.

Each different use of cost data demands a different classification and definition of cost.

For example, the preparation of external financial reports requires historical cost data, whereas decision making may require predictions about future costs.

1. Manufacturing and Non-manufacturing costs:

Manufacturing costs are those costs that are directly involved in manufacturing of products and services. Manufacturing cost is divided into three broad categories:

a. Direct materials cost: Materials that become an integral part of the finished product and that can be physically and

conveniently traced to it.b. Direct labour cost:

Labour costs that can be essentially traced to individual units of products.c. Manufacturing overhead cost:

Includes all costs of manufacturing except direct material and direct labour. Examples include items such as indirect material, indirect labour, maintenance and repairs on

production equipment, depreciation, and insurance on manufacturing facilities

Prime Cost = Direct Materials Cost + Direct Labour Cost

Conversion Cost = Direct Labour Cost + Manufacturing Overhead Cost

Non-manufacturing costs are those costs that are not incurred to manufacture a product. Generally non-manufacturing costs are further classified into two categories:

a. Marketing and selling costs Include all costs necessary to secure customer orders and get the finished product into the hands

of the customers. These costs are often called order getting or order filling costs. Examples include advertising costs, shipping costs, sales commission and sales salary.

b. Administrative costs Include all executive, organizational, and clerical costs associated with general management of an

organization rather than with manufacturing, marketing, or selling. Examples include executive compensation, general accounting, secretarial, public relations, and

similar costs involved in the overall, general administration of the organization as a whole.

2. Product and period cost

The matching principle states that costs incurred to generate revenue should be recognized as an expense in the same period that the revenue is recognized. This means that if a cost is incurred to acquire or make something that will eventually be sold, then the cost should be recognized as an expense only when the sale takes place (i.e. when the benefit occurs). Such costs are called product costs.

Product costs include all the costs that are involved in acquiring or making product. In the case of manufactured goods, these costs consist of direct materials, direct labour, and manufacturing overhead. Product costs are initially assigned to an inventory account on the balance sheet. When the goods are sold, the costs are released from inventory as an expense (typically called Cost of Goods Sold) and matched against sales revenue. Since product costs are initially assigned to inventories, they are also known as inventoriable costs.

Period costs are all the costs that are not included in product costs. These costs are expensed on the income statement in the period in which they are incurred. Period costs are not included as part of the cost of either purchased or manufactured goods. Sales commissions and office rent are good examples of period costs. Other examples of period costs are selling and administrative expenses.

Pricing decisions

Cost-plus pricing is a pricing approach that applies a mark-up on cost. Most managers consider product costs to some degree when setting prices. There are several reasons for this.

First, most companies sell a range of goods and services and cost-based pricing formulas provide a quick and straightforward method for setting prices.

Second, a cost-based pricing formula gives managers a good place to start in the process of determining a price.

Third, the cost of a product or service provides a floor and prices should not be set below this level because ultimately a product’s price should cover its costs in the long run.

In cost plus pricing a predetermined mark-up percentage is applied to the cost base to determine a target selling price.

Selling price = Cost + (Mark-up × Cost)

There are a variety of definitions of ‘product cost’.

Absorption costing is a costing method that includes all manufacturing costs - direct materials, direct labour, and both variable and fixed overhead - as part of the cost of a finished unit of product.

Advantages:

Basing a price on the total cost of production and other product-related costs that occurs outside production, plus a reasonable profit margin, seems fair to many customers

Full recovery of all costs of the product Absorption cost information is usually provided by firm’s costing system because it is required for external

financial reporting.

Disadvantages:

Obscures the effects of changes in prices and sales volume on profit because no distinction is made between variable and fixed costs.

Variable costing is a costing method that includes only variable manufacturing costs–direct materials, direct labour, and variable manufacturing overhead–in unit product cost.

Advantages:

Do not obscure the cost behaviour by unitising fixed costs and making them variable. Thus, variable cost information is consistent with cost-volume-profit analysis, which managers can use to assess the profit implications of changes in price and volume.

Variable cost data do not require the allocation of fixed costs to individual product lines (which may not be meaningful).

Variable cost data are useful when managers have to make tactical short term pricing decisions.

Disadvantages:

In the long term, prices must be set to cover all costs and a normal profit margin. The prices set using variable cost pricing formulas may be too low to cover the firm’s fixed costs. Managers must understand the need to set higher mark-ups to cover the firm’s costs.

Target costing is the process of determining the maximum allowable cost for a new product and then developing a prototype that can be profitably made for that maximum target cost figure.

Target Cost = Anticipated selling price – Desired profit

The target costing approach was developed in recognition of two important characteristics of markets and costs.

First, companies have less control over price than they would like to think. The market (i.e., supply and demand) really determines prices and a company that attempts to ignore this does so at its peril. Therefore, the anticipated market price is taken as a given in target costing.

Second, most of the cost of a product is determined in the design stage. Once a product has been designed and has gone into production, not much can be done to significantly reduce its cost. Most of the opportunities to reduce cost come from designing the product so that it is simple to make, uses inexpensive parts, and is robust and reliable. If the company has little control over market price and little control over cost once the product has gone into production, then it follows that the major opportunities for affecting profit come in the design stage where valuable features that customers are willing to pay for can be added and where most of the costs are really determined. So that is where the effort is concentrated--in designing and developing the product.

Value engineering is a systematic evaluation of all aspects of the value-chain business function with the objective of reducing costs. A non-value added cost is a cost that customers do not perceive as adding value, or utility, to a product or service.

The difference between target costing and other approaches to product development is profound. Instead of designing the product and then finding out how much it costs, the target cost is set first and then the product is designed so that the target cost is attained.

Target costing has the following main advantages or benefits:

Proactive approach to cost management. Orients organizations towards customers. Breaks down barriers between departments. Implementation enhances employee awareness and empowerment. Foster partnerships with suppliers. Minimize non value-added activities. Encourages selection of lowest cost value added activities. Reduced time to market.

Target costing approach has the following main disadvantages or limitations:

Effective implementation and use requires the development of detailed cost data. its implementation requires willingness to cooperate Requires many meetings for coordination May reduce the quality of products due to the use of cheap components which may be of inferior quality.

Normal costing

Normal costing is a method of determining product costs used primarily for companies with more than one product. Direct materials and direct labour are added directly to WIP as the costs are incurred. Recall that 'incurred' is a term used in accrual basis accounting and generally refers to the point in which the costs are used. For a manufacturing firm, incurred refers to when these are used in the production process.

As production work occurs, direct costs are added to WIP. Indirect costs are accumulated in a temporary expense account called Manufacturing Overhead Expense. Costs are moved out of manufacturing overhead expense into the WIP based on an estimate of an activity that will occur. Based on a predetermined rate, MOH is applied with a debit to WIP.

Many companies calculate and apply this overhead rate using the budgeted overhead costs and the budgeted quantity of the allocation base. When a company uses budgeted overhead rates in its costing system, but all other information in the costing system is based on actual costs, the company is using what is called a normal costing system.

A distinction is made between actual manufacturing overhead costs and applied manufacturing overhead costs. In a normal costing system, the budgeted overhead rate is multiplied by the actual quantity of the allocation base incurred to get the amount of manufacturing overhead to be applied.

Advantages of Using Budgeted Overhead Rates:

There are three principal reasons for using budgeted overhead rates:

Actual overhead rates are not known in a timely manner. Overhead rates are subject to short-run fluctuations. When actual overhead rates are used, production volume of each product affects the reported costs of all other

products. o This issue arises because the production volume of each product affects the total quantity of the

allocation base in the denominator of the overhead rate, whereas an important component of the numerator—fixed overhead—is invariant to changes in production volume.

o Hence, as production volume of one product decreases below budget, the overhead rate (which is common across all products) increases, and when that overhead rate is applied to other products, those products absorb more overhead (and so have higher reported costs) than was budgeted.

When budgeted overhead rates are used, it is very likely that the amount of overhead applied to production (the debits to work-in-process) will differ from the actual overhead incurred (credits to cash, accounts payable, and various other accounts) during the period. This difference, which will occur whenever the budgeted overhead rate differs from the actual overhead rate, is called misapplied overhead (either over- or under- applied).

Misapplied overheads are closed out at the end of the period either to cost of goods sold or pro-rated based on the ending balances in WIP, finished goods and COGS.

Job costing

Job order costing is a costing system that assigns manufacturing and other product related costs to individual jobs. It is used by firms that produce a wide range of products either individually or on small, distinct batches.

Allocation of overhead cost is accomplished by selecting an allocation base that is common to all of the company's products and services. The most widely used allocation bases are direct labour hours, and direct labour cost, with machine hours and even units of product. The allocation base is used to compute "predetermined overhead rate" in the following formula or equation:

Predetermined Overhead Rate = Estimated total manufacturing overhead cost / Estimated total units in the allocation base

Predetermined overhead rate is based on estimates rather than actual results. This is because the predetermined overhead rate is computed before the period begins and is used to apply overhead cost throughout the period. The process of assigning overhead cost to jobs is called overhead application. The formula for determining the amount of overhead cost to apply to a particular job is:

Overhead applied to a particular job = Predetermined overhead rate × Amount of allocation incurred by the job

Managers cite several reasons for using predetermined overhead rates instead of actual overhead rates:

Managers would like to know the accounting system's valuation of completed jobs before the end of the accounting period.

If actual overhead rates are computed frequently, seasonal factors in overhead costs or in the allocation base can produce fluctuations in the overhead rates.

The use of predetermined overhead rate simplifies the record keeping. To determine the overhead cost to apply to a job, we can simply multiplies the direct labour hours recorded for the job by the predetermined overhead rate.

Uses of Job Cost Information

Assign costs to work in process, finished goods, and cost of goods sold for financial statement and income tax returns

Provide information to help managers: Monitor operating costs Develop job bids Make short-term or long-term decisions

Process costing

Process costing is a method of costing used mainly in manufacturing where units are continuously mass-produced through one or more processes. In process costing, the cost incurred during the process is accumulated and average out over the units of production to determine the unit cost for a specific period.

Important terms to understand:

In a manufacturing process the number of units of output may not necessarily be the same as the number of units of inputs. There may be spoilage.

Normal spoilage: This is the term used to describe normal expected wastage under usual operating conditions. This spoilage is a necessary part of the production, which is unavoidable, and hence treated as part of the cost of the product.

Abnormal spoilage: This is when a loss occurs over and above the normal expected loss. The costs of abnormal spoilage are expensed in the current period.

Work in progress (WIP): This is the term used to describe units that are not yet completed at the end of the period. Opening WIP is the number of incomplete units at the start of a process and closing WIP is the number at the end of the process.

Equivalent units: This refers to a conversion of part completed units into an equivalent number of wholly completed units. Equivalent units need to be established for each type of cost (e.g. direct materials and conversion costs).

When there is beginning or ending WIP, we need to choose between the first-in first-out (FIFO) method and the weighted average (WA) method. The two methods give different valuations for the closing WIP.

The key difference between the FIFO and the WA method lies in their treatment of the beginning WIP inventory.

With no beginning WIP, the difference between the WA and FIFO method disappears.

In the weighted average method, no distinction is made between units of opening inventory and new units introduced to the process during the accounting period.

The formula for analysing the physical flow of units including spoiled units is:

Physical units in the beginning WIP + Physical units started – Physical units completed and transferred out – Physical units spoiled = Physical units in ending WIP

Allocating overhead costs

Management accountants often use cost pools to simplify the allocation of indirect costs. A cost pools is a collection of costs that are to be allocated to cost objects. The general process of allocating costs in a cost pool to cost objects is called cost allocation. To allocate indirect costs to cost objects, cost allocation bases are used. An allocation base should be a cost driver. A cost driver is an activity that causes cost to be incurred. There should be some correlation between the allocation base (cost driver) used and the indirect costs (overhead costs).

When selecting an overhead cost driver, we have to determine:

What is the major factor that causes manufacturing overhead costs to be incurred? To what extent does the overhead cost vary in proportion with the cost driver? How easy is it to measure the cost driver?

Volume-based cost drivers are a measure of the volume of production. These can be in terms of outputs (e.g. units produced) and inputs (e.g. direct labour hours or direct material used).

Non-volume based cost drivers are those drivers that are not directly related to production volume.

Cost drivers measured in dollar amounts are subjected to price fluctuations and tend to be less stable than physical measures.

There are three approaches for the allocation of overhead costs:

1. Plant-wide overhead rates2. Departmental overhead rates3. Activity-based costing

A plant-wide overhead rate is a single overhead rate that is calculated for the entire production plant. All the manufacturing overhead costs are combined into a single cost pool and a single cost driver is used as the allocation base for the entire production plant.

Departmental overhead rates are based on the estimated overhead cost divided by the level or cost driver for each department.

First, all manufacturing overhead costs are distributed to each department which may be a production or a support department. Support department costs are reassigned to the production department. At the end of this, all manufacturing overheads costs will have been assigned to overhead cost pools in the production departments.

After this step, the overhead rate is determined individually by each department using a cost driver of its choice. The overhead costs are applied to the products using overhead rates and actual usage of the cost drivers, both of which are specific to each production department.

Allocation of indirect costs to responsibility centres are done for three main reasons:

To help managers understand the economic effect of their decisions on the organisation. To encourage a particular pattern of resource usage such as allocating interest costs based on usage of scarce

funds to encourage managers to spend more effectively. To support product costing system.

Budgeted, not actual allocation data should be used during indirect cost allocation so as to minimise the possibility that the activities of one department will affect the costs allocated to the other departments. This may cause problems because the costs may be used to evaluate the performance of the department or its managers and managers should not be held accountable for costs which they have no control over. If actual allocation data is used, the efficiencies or inefficiencies of one department may affect another.

Another reason to use budgeted allocation date is to provide better information for managers to plan and control their use of indirect resources. Knowing the budgeted rates in advance allows the manager to plan their activity with greater certainty.

Joint product costing

Joint products are products from the same production process that have relatively substantial sales values.

3 methods to allocate joint costs to joint products:

1. Physical measure method: Use the relative proportions of inputs/outputs to pro-rate the joint costs among the joint products.

2. Sales value at split-off: Use the relative sales values of the joint products at the split-off point to pro-rate the joint costs among the joint products.

3. Net realisable value method: Use the NRV of the joint products to pro-rate joint costs among the joint products. NRV is equals to the difference between the ultimate sales value and the additional processing and selling costs.

By-product costing

By-products are products which total sales values are minor in comparison with the sales values of the joint products.

2 methods to value by-products:

1. Asset recognition approach: Recognised at time of production. All units produced.a. Net realisable value method: As a deduction of manufacturing cost.b. Other income at production point method: As other income at time of production.

2. Revenue approach: Recognised at time of sale. Only those units sold.a. Other income at selling point method: As other income at time of sale.b. Manufacturing cost reduction at selling point method: As a reduction in cost of joint products at time

of sale.

Allocating support department costs

Companies that allocate service department costs do so for one or more of the following reasons:

1. To provide more accurate product cost information. Allocating service department costs to production departments, and then to products, recognizes that these services constitute an input in the production process.

2. To improve decisions about resource utilization. By imposing on division managers the cost of the service department resources that they use, division managers are encouraged to use these resources only to the extent that their benefit exceeds their cost.

3. To ration limited resources. When production departments have some discretion over their utilization of a service department resource, charging production departments for the resource usually results in less demand for it than if the resource were “free” to the production departments.

The motivation for the first reason, to provide more accurate product cost information, can be to improve decision-making within the organization, to improve the quality of external financial reporting, or to comply with contractual agreements in regulatory settings where cost-based pricing is used.

Service department costs can be allocated based on actual rates or budgeted rates. Actual rates ensure that all service department costs are allocated. Budgeted rates provide service department managers incentives to control costs, and also provide user departments more accurate information about service department billing rates for planning purposes. In either case, service department costs should be allocated using an allocation base that reflects a cause-and-effect relationship, whenever possible.

The Direct Method:

The direct method is the most widely-used method. This method allocates each service department’s total costs directly to the production departments, and ignores the fact that service departments may also provide services to other service departments.

Under the direct method, service department to service department services are ignored, and no costs are allocated from one service department to another.

The Step-Down Method:

The step-down method is also called the sequential method. This method allocates the costs of some service departments to other service departments, but once a service department’s costs have been allocated, no subsequent costs are allocated back to it.

The choice of which department to start with is important. The sequence in which the service departments are allocated usually effects the ultimate allocation of costs to the production departments, in that some production departments gain and some lose when the sequence is changed. Hence, production department managers usually have preferences over the sequence.

The most defensible sequence is to start with the service department that provides the highest percentage of its total services to other service departments, or the service department that provides services to the most number of service departments, or the service department with the highest costs, or some similar criterion.

The characteristic feature of the step-down method is that once the costs of a service department have been allocated, no costs are allocated back to that service department. The intermediate allocations from service department to service department improve the accuracy of those final allocations.

The Reciprocal Method:

The reciprocal method is the most accurate of the three methods for allocating service department costs, because it recognizes reciprocal services among service departments. It is also the most complicated method, because it requires solving a set of simultaneous linear equations.

Activity based costing

Activity-based costing (ABC) is a better, more accurate way of allocating overhead.

Recall the steps to product costing:

1. Identify the cost object;2. Identify the direct costs associated with the cost object;3. Identify overhead costs;4. Select the cost allocation base for assigning overhead costs to the cost object;5. Develop the overhead rate per unit for allocating overhead to the cost object.

Activity-based costing refines steps #3 and #4 by dividing large heterogeneous cost pools into multiple smaller, homogeneous cost pools. ABC then attempts to select, as the cost allocation base for each overhead cost pool, a cost driver that best captures the cause and effect relationship between the cost object and the incurrence of overhead costs. Often, the best cost driver is a nonfinancial variable.

ABC focuses on activities. A key assumption in activity-based costing is that overhead costs are caused by a variety of activities, and that different products utilize these activities in a non-homogeneous fashion. Usually, costing the activity is an intermediate step in the allocation of overhead costs to products, in order to obtain more accurate product cost information.

Sometimes, however, the activity itself is the cost object of interest. For example, managers at Levi Strauss & Co. might want to know how much the company spends to acquire denim fabric, as input in a sourcing decision. The “activity” of acquiring fabric incurs costs associated with negotiating prices with suppliers, issuing purchase orders, receiving fabric, inspecting fabric, and processing payments and returns.

In ABC, cost pools are often established for each level in a hierarchy of costs. For manufacturing firms, the following cost hierarchy is commonly identified:

Unit-level costs: For any given product, these costs change in a more-or-less linear fashion with the number of units produced. For example, fabric and thread are unit-level costs for an apparel manufacturer: if the company wants to double production, it will need twice as much fabric and thread.

Batch-level costs: These costs change in a more-or-less linear fashion with the number of batches run. Machine setup costs are often batch-level costs. The time required to prepare a machine to run one batch of product is usually independent of the number of units in the batch: the same time is required to prepare the machine to run a batch of 100 units as a batch of 50 units. Hence, batch-level costs do not necessarily vary in a linear fashion with the number of units produced.

Product-level costs: These costs are usually fixed and direct with respect to a given product. An example is the salary of a product manager with responsibility for only one product. The product manager’s salary is a fixed cost to the company for a wide range of production volume levels. However, if the company drops the product entirely, the product manager is no longer needed.

Facility-level costs: These costs are usually fixed and direct with respect to the facility. An example is property taxes on the facility, or the salaries of front office personnel such as the receptionist and office manager.

One reason why ABC provides more accurate product cost information is that traditional costing systems frequently allocate all overhead, including batch-level, product-level, and facility-level overhead, using an allocation base that is appropriate only for unit-level costs. The better information obtained from explicitly incorporating the cost hierarchy is illustrated in the following example:

When to use ABC?

When overhead costs are a significant portion of total costs and a large part of these overhead costs are not directly related to production volume.

When the company has a diverse product range and individual products’ use of support resources differs from their use of volume-based cost drivers.

Production activity involves diverse batches and product complexity The proportion of product-related costs incurred outside of manufacturing is increasing relative to

manufacturing costs. There are likely to be high costs associated with making inappropriate decisions based on inaccurate product

costs (e.g. in a highly competitive environment where product cost is a key input to business decision)

The cost of designing and implementing ABC is low due to sophisticated IT support.

Activity based costing system has the following main advantages / benefits:

More accurate costing of products/services, customers, Stock Keeping Units, distribution channels. Better understanding overhead. Easier to understand for everyone. Utilizes unit cost rather than just total cost. Integrates well with Six Sigma and other continuous improvement programs. Makes visible waste and non-value added activities. Supports performance management and scorecards Enables costing of processes, supply chains, and value streams Activity Based Costing mirrors way work is done Facilitates benchmarking

Standard costing

A standard, as the term is usually used in management accounting, is a budgeted amount for a single unit of output.

A standard cost is the predetermined cost of manufacturing a single unit or a number of product units during a specific period in the immediate future. It is the planned cost of a product under current and / or anticipated operating conditions. A standard cost for one unit of output is the budgeted production cost for that unit.

A standard costing system initially records the cost of production at standard. Units of inventory flow through the inventory accounts (from work-in-process to finished goods to cost of goods sold) at their per-unit standard cost. When actual costs become known, adjusting entries are made that restate each account balance from standard to actual (or to approximate such a restatement). The components of this adjusting entry provide information about the company’s performance for the period, particularly with regard to production efficiency and cost control.

There is an important connection between flexible budgeting and standard costing. In fact, a standard costing system tracks inventory during the period at the flexible budget amount.

The flexible budget adjusts the static budget for the actual level of output. The flexible budget asks the question: “If I had known at the beginning of the period what my output volume (units produced or units sold) would be, what would my budget have looked like?”

The motivation for the flexible budget is to compare apples to apples. If the factory actually produced 10,000 units, then management should compare actual factory costs for 10,000 units to what the factory should have spent to make 10,000 units.

The flexible budget is the budgeted per-unit cost multiplied by the actual number of units. Hence, a standard costing system answers the question: what would the income statement and balance sheet look like, if costs and per-unit input requirements were exactly as planned, given the actual output achieved (units made and units sold).

It follows that the adjustment made at period-end to restate the inventory accounts for the difference between the standard cost account balance and the actual cost account balance constitutes the difference between the flexible budget amount and actual costs.

For direct costs, such as materials and labour, this adjusting entry represents the sum of the price (or labour wage rate) variance and the efficiency (or quantity) variance.

For overhead costs, this adjusting entry represents misapplied overhead. For variable overhead, misapplied overhead consists of the sum of the spending variance and the efficiency variance. For fixed overhead, misapplied overhead consists of the sum of the spending variance and the volume variance.

There are several reasons for using a standard costing system:

Cost Control: A standard costing system records both budgeted amounts (via debits to work-in-process, finished goods, and cost-of-goods-sold) and actual costs incurred. The difference between these budgeted amounts and actual amounts provides important information about cost control. The advantage of a standard costing system is that the general ledger system itself tracks the information necessary to provide detailed performance reports showing cost variances.

Smooth out short-term fluctuations in direct costs. When actual overhead rates are used, production volume of each product affects the reported costs of all

other products. This reason represents an advantage of standard costing over actual costing, but does not represent an advantage of standard costing over normal costing.

The following table summarizes and compares three commonly-used costing systems. 

Actual Costing System Normal Costing System Standard Costing System

Direct Costs: (Actual prices or rates x actual quantity of inputs per

output) x actual outputs

(Actual prices or rates x actual quantity of inputs per

output) x actual outputs

(Budgeted prices or rates x standard inputs allowed for each

output) x actual outputs

Overhead Costs:

Actual overhead rates x actual quantity of the

allocation base incurred.

Budgeted overhead rates x actual quantity of the

allocation base incurred.

Budgeted overhead rates x (standard inputs allowed for

actual outputs achieved)

 The following points are worth noting:

All three costing systems record the cost of inventory based on actual output units produced. The static budget level of production does not appear anywhere in this table.

Actual costing and normal costing are identical with respect to how direct costs are treated. With respect to overhead costs, actual costing and normal costing use different overhead rates, but both

costing systems multiply the overhead rate by the same amount: the actual quantity of the allocation base incurred.

Normal costing and standard costing use the same overhead rate. Standard costing records the cost of inventory using a flexible budget concept: the inputs “that should have

been used” for the output achieved.

Cost variances

Direct material price variance (or Direct labour rate variance) is the actual inputs used in production (AQ) multiplied by the difference between the budgeted price (SP) and the actual price (AP) paid per unit of input. The price variance is abbreviated PV. Hence:

PV = AQ x (AP – SP)

If the term in parenthesis is positive, the factory paid more per unit of input than budgeted, and the price variance is unfavourable.

If the term in parenthesis is negative, the factory paid less per unit of input than budgeted, and the price variance is favourable.

In either case, the price variance can be interpreted as answering the following question: What was the total impact on the cost of production caused by the fact that the actual price per unit of input differed from the budgeted price.

Direct material quantity variance (or Direct labour efficiency variance) is the budgeted price per unit of input (SP) multiplied by the difference between the quantities of inputs that should have been used for the output units produced (SQ) and the quantity of inputs actually used (AQ). The quantity variance is abbreviated QV. Hence:

QV = SP x (AQ – SQ)

If the term in parenthesis is positive, the factory used more inputs than it should have used for the amount of output units produced, and the quantity variance is unfavourable.

If the term in parenthesis is negative, the factory used fewer inputs than it should have used for the amount of output units produced, and the quantity variance is favourable.

In either case, the quantity variance can be interpreted as answering the following question: What was the total impact on the cost of production caused by the fact that the quantity of inputs used to make each unit of output differed from budget.

Timing of Recognition of the Price Variance:

Some firms recognize the price variance for direct materials when the raw materials are purchased, rather than waiting until the raw materials are put into production. In this case, the AQ in the price variance will generally differ from the AQ in the quantity variance, which is denoted in the following expressions for these variances:

PV = AQ Purchased x (AP – SP)

QV = SP x (AQ Used – SQ)

Where usually, AQ Purchased ¹ AQ Used

Recognizing the price variance when raw materials are purchased provides more timely information to management about the cost of direct materials and the performance of the purchasing department. Hence, this method for calculating the price variance has much to commend it. However, in this situation, the sum of the price variance and quantity variance will not equal the flexible budget variance, except by coincidence or when beginning and ending quantities of raw materials are zero.

Who is Responsible for Direct Material Price Variance?

Generally speaking, the purchase manager has control over the price paid for goods and is therefore responsible for any price variation. Admittedly, the price of direct materials is largely beyond his or her control. Many factors influence the price paid for the goods, including number of units ordered in a lot, how the order is delivered, the quality of materials purchased, quantity discounts, distance of the source from the plant, and so on. These factors are often under the control of the agent. A deviation in any of these factors from what was assumed when the standards were set can result in price variance.

For example purchase of second grade materials rather than top-grade materials may be a reason of favourable price variance, since the lower grade material will generally be less costly but perhaps less suitable for production and can be a reason of unfavourable materials quantity variance.

However, someone other than purchasing manager could be responsible for materials price variance. For example, production is scheduled in such a way that the purchasing manager must request express delivery. In this situation the production manager should be held responsible for the resulting price variance.

Using the price variance to evaluate the performance of purchasing has some limitations. Emphasis on meeting or beating the standard can produce some undesirable outcomes. For example, if the purchasing agent feels pressured to produce favourable variances, he or she may purchase direct materials of a lower quality than desired or acquire too much inventory in order to take advantage of quantity discounts.

Who is Responsible for Material Quantity Variance?

Excessive usage of materials that is usually a reason of unfavourable direct materials quantity variance may be due to inferior quality of materials, untrained workers, poor supervision etc. Minimizing scrap, waste, and rework are all ways in which the manager can ensure that the standard is met.

Generally speaking production managers are held responsible for this variance. However purchasing department may also be held responsible for purchasing materials of inferior quality to economize on prices. Where purchasing department purchases low grade direct materials at low prices to show a favourable materials price variance, the materials quantity variance is usually unfavourable due to inferior quality of direct materials.

As with the price variance, applying the usage variance to evaluate performance can lead to undesirable behaviour. For example, a production manager feeling pressure to produce a favourable variance might allow a defective unit to be transferred to finished goods. While this avoids the problem of wasted direct materials, it may create customer-relations problems once a customer gets stuck with the bad product.

Who is responsible for the labour rate variance?

Since rate variances generally arise as a result of how labour is used, production supervisors bear responsibility for seeing that labour price variances are kept under control.

Rates paid to the workers are usually predictable. Nevertheless, rate variances can arise through the way labour is used. Skill workers with high hourly rates of pay may be given duties that require little skill and call for low hourly rates of pay. This will result in an unfavourable labour rate variance, since the actual hourly rate of pay will exceed the standard rate specified for the particular task. In contrast, a favourable rate variance would result when workers who are paid at a rate lower than specified in the standard are assigned to the task. However, the low pay rate workers may not be as efficient. Finally, overtime work at premium rates can be reason of an unfavourable labour price variance if the overtime premium is charged to the labour account

Production managers may be tempted to engage in dysfunctional behaviour if too much emphasis is placed on the direct labour variances. For example, to avoid losing hours and using additional hours because of possible rework, a production manager could deliberately transfer defective units to finished goods.

Who is Responsible for Labour Efficiency Variance?

The manager in charge of production is generally considered responsible for labour efficiency variance. However, purchase manager could be held responsible if the acquisition of poor materials resulted in excessive labour processing time. Possible causes / reasons of an unfavourable efficiency variance include poorly trained workers, poor quality materials, faulty equipment, and poor supervision. Another important cause / reason of an unfavourable labour efficiency variance may be insufficient demand for company's products.

If customer orders are insufficient to keep the workers busy, the work centre manager has two options, either accept an unfavourable labour efficiency variance or build up inventories. The second option is opposite to the basic principle of just in time (JIT). Inventories with no immediate prospect of sale are a bad idea according to just in time approach. Inventories, particularly work in process inventory leads to high defect rate, obsolete goods, and generally inefficient operations. As a consequence, when the work force is basically fixed in the short term, managers must be cautious about how labour efficiency variances are used. Some managers advocate dispensing with labour efficiency variance entirely in such situations―at least for the purpose of motivating and controlling workers on the shop floor.

Cost Variances for Variable Overhead:

Spending variance = PV = AQ x (AP – SP)

Efficiency variance = EV = SP x (AQ – SQ)

Where AP is the actual overhead rate used to allocate variable overhead, and SP is the budgeted overhead rate.

The “Q’s” refer to the quantity of the allocation base used to allocate variable overhead, so that AQ is the actual quantity of the allocation base used during the period, and SQ is the standard quantity of the allocation base. The standard quantity of the allocation base is the amount of the allocation base that should have been used (i.e., would have been budgeted) for the actual output units produced.

Given the use of the allocation base in these formulas for the cost variances for variable overhead, the meaning of these variances differs fundamentally from the interpretation of the variances for direct materials and direct labour.

A favourable variable overhead spending variance means that the actual variable overhead expenses incurred per unit of the allocation base were less than expected.

A favourable variable overhead efficiency variance does not necessarily mean that a company has incurred less actual overhead. It simply means that there was an improvement in the allocation base that was used to apply overhead

If there is a cause-and-effect relationship between the allocation base and the variable overhead cost category (e.g., if more direct labour hours implies more electricity used), then the negative efficiency variance suggests that more electricity was used than the flexible budget quantity, but the efficiency variance does not measure kilowatts directly.

Cost Variances for Fixed Overhead:

Whereas the cost variances for direct materials, direct labour, and variable overhead all use the same two formulas, the cost variances for fixed overhead are different, and do not use these formulas at all.

Also, whereas cost variances for direct materials, direct labour, and variable overhead can be calculated for individual products in a multi-product factory, cost variances for fixed overhead can only be calculated for the factory or facility as a whole. (More precisely, fixed overhead cost variances can only be calculated for the combined operations to which the resources represented by the fixed costs apply.)

There are two fixed overhead cost variances: the spending variance and the volume variance.

The Fixed Overhead Budget Variance:

The fixed overhead budget variance is the difference between two lump sums:

Actual fixed overhead costs incurred - Budgeted fixed overhead costs

The amount of expense related to Fixed overhead should (as the name implies) be relatively fixed, and so the fixed overhead spending variance should not theoretically vary much from the budget. However, if the manufacturing process reaches a step cost trigger point, where a whole new expense must be incurred, then this can cause a significant unfavourable variance. Also, there may be some seasonality in fixed overhead expenditures, which may cause both favourable and unfavourable variances in individual months of a year, but which cancel each other out over the full year. Other than the two points just noted the level of production should have no impact on this variance.

The fixed overhead budget variance will be unfavourable if the actual overhead costs incurred are greater than the budgeted amount.

Fixed Overhead budget Variance Example:

The production manager of Hodgson Industrial Design estimates that the fixed overhead should be $700,000 during the upcoming year. However, since a production manager left the company and was not replaced for several months, actual expenses were lower than expected, at $672,000. This created the following favourable fixed overhead spending variance:

($672,000 Actual fixed overhead - $700,000 Budgeted fixed overhead) = $(28,000) Fixed overhead spending variance

Fixed overhead is made up of a number of individual items such as salaries, depreciation, taxes, and insurance. Many fixed overhead items—long-run investments, for instance—are not subject to change in the short run; consequently, fixed overhead costs are often beyond the immediate control of management.

Since many fixed overhead costs are affected primarily by long-run decisions, not by changes in production levels, the budget variance is usually small. For example, depreciation, salaries, taxes, and insurance costs are not likely to be much different than planned.

Because fixed overhead is made up of many individual items, a line-by-line comparison of budgeted costs with actual costs provides more information concerning the causes of the spending variance.

The fixed overhead volume variance:

Budgeted fixed overhead (a lump sum) - amount of fixed overhead that would be allocated to production under a standard costing system using a fixed overhead rate.

For example, a company budgets for the allocation of $25,000 of fixed overhead costs to produced goods at the rate of $50 per unit produced, with the expectation that 500 units will be produced. However, the actual number of units produced is 600, so a total of $30,000 of fixed overhead costs are allocated. This creates a fixed overhead volume variance of $5,000.

The fixed overhead costs that are a part of this variance are usually comprised of only those fixed costs incurred in the production process. Examples of fixed overhead costs are:

Factory rent Equipment depreciation Salaries of production supervisors and support staff Insurance on production facilities Utilities

Being fixed within a certain range of activity, fixed overhead costs are relatively easy to predict. Because of the simplicity of prediction, some companies create a fixed overhead allocation rate that they continue to use throughout the year. This allocation rate is the expected monthly amount of fixed overhead costs, divided by the number of units produced (or some similar measure of activity level).

Conversely, if a company is experiencing rapid changes in its production systems, as may be caused by the introduction of automation, cellular manufacturing, just-in-time systems, and so forth, it may need to revise the fixed overhead allocation rate much more frequently, perhaps on a monthly basis.

When the actual amount of the allocation base varies from the amount built into the budgeted allocation rate, it causes a fixed overhead volume variance. Examples of situations in which this variance can arise are:

The allocation base is the number of units produced, and sales are seasonal, resulting in irregular production volumes on a monthly basis. This disparity tends to even out over the course of a full year.

The allocation base is the number of direct labour hours, and the company implements new efficiencies that reduce the actual number of direct labour hours used in production.

The allocation base is the number of machine hours, but the company then outsources some aspects of production, which reduces the number of machine hours used.

When the cumulative amount of the variance becomes too large over time, a business should alter its budgeted allocation rate to bring it more in line with actual volume levels.

Sales variance

Sales Price Variance: The comparison between actual sales value & actual sales at standard values is done by Sales Price variance. The formula is:

Actual Sales – Standard Sales

(Actual price – Standard price)* Actual quantity sold

Sales Volume Variance: The comparison between budgeted sales & actual sales at standard values are done by Sales Volume variance. The formula is:

(Budgeted quantity – Actual quantity) * Budgeted unit contribution margin

Responsibility accounting

Responsibility accounting is a reporting system in which a cost is charged to the lowest level of management that has responsibility for it. The basic idea is that large diversified organizations are difficult, if not impossible to manage as a single segment, thus they must be decentralized or separated into manageable parts.

These parts or segments are referred to as responsibility centres that include:

1. revenue centres,2. cost centres,3. profit centres4. investment centres

This approach allows responsibility to be assigned to the segment managers that have the greatest amount of influence over the key elements to be managed.

These elements include

1. revenue for a revenue centre (a segment that mainly generates revenue with relatively little costs), 2. costs for a cost centre (a segment that generates costs, but no revenue), 3. a measure of profitability for a profit centre (a segment that generates both revenue and costs) and 4. return on investment (ROI) for an investment centre (a segment such as a division of a company where the

manager controls the acquisition and utilization of assets, as well as revenue and costs)

Controllability is an underlying concept of responsibility accounting. Conceptually, a manager should only be held responsible for those aspects of performance that he or she can control.

Responsibility accounting enables accountability for financial results and outcomes to be allocated to individuals throughout the organization. The objective is to measure the result of each responsibility centre. It involves accumulating costs and revenues for each responsibility centre so that deviation from performance target (typically the budget) can be attributed to the individual who is accountable for the responsibility centre.

RESPONSIBILITY CENTRESEVALUATION METHODSRevenue Centre Sale Price Variance

Sale Quantity VarianceSale Mix Variance

Cost Centre Raw Material Variances:Labour Variances

Overhead VariancesProfit Centre Gross Profit

Contribution MarginInvestment Centre ROI

Residual IncomeEconomic Value Added

Goal-congruence is one of the problems that may arise when authority is decentralized and passed on to managers Management will constantly review all operations and activities of individual divisions to insure that none of them is working against the overall objectives of the company.

While evaluating, performance of an individual manager, two factors have to be considered:

Should the manager’s job be separated and a manager is rewarded or penalized only for those activities over which the manager has control (Controllability)

Should the manager’s decision be seen in a wider prospective and final judgment given only after reviewing full impact of such decisions (Goal congruence)

Transfer pricing

A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company.

There are two major reasons to operate a transfer pricing system:

o Appropriate transfer prices help to coordinate the production, sales and pricing decisions of the different divisions. Transfer prices make managers aware of the value that the goods and services have to other segments of the firm.

o The use of transfer prices allows the company to generate separate profit figures for each division and thereby to evaluate the performance of each division separately.

Transfer pricing serves the following purposes.

When product is transferred between profit centres or investment centres within a decentralized firm, transfer prices are necessary to calculate divisional profits, which then affect divisional performance evaluation.

When divisional managers have the authority to decide whether to buy or sell internally or on the external market, the transfer price can determine whether managers’ incentives align with the incentives of the overall company and its owners.

o The objective is to achieve goal congruence, in which divisional managers will want to transfer product when doing so maximizes consolidated corporate profits, and at least one manager will refuse the transfer when transferring product is not the profit-maximizing strategy for the company.

When multinational firms transfer product across international borders, transfer prices are relevant in the calculation of income taxes, and are sometimes relevant in connection with other international trade and regulatory issues.

The goal in setting transfer prices is to establish incentives for autonomous division managers to make decisions that support the overall goal of the organisation.

The transfer price should be chosen so that each division manager when striving to maximise his own division’s profit, make the decision that maximises the company’s profit as well. (Goal congruence)

A general rule that will ensure goal congruence is:

Transfer price = Additional outlay cost per unit incurred by supplying division + opportunity cost per unit to the supplying division

This general rule separates the transfer price into two pieces.

The first piece is just the additional costs incurred to manufacture the product (or provide the service), plus any applicable costs that are directly related to the transaction to transfer goods internally.

The second piece of the transfer price, the opportunity, represents the amount of contribution margin given up to make the sale internally. In other words, if a sale could be made to an outside buyer, the difference between the outside buyer’s price and the additional outlay costs per unit equals the opportunity cost. The opportunity cost of selling internally depends on whether the selling division has excess capacity or not.

There are three general methods for establishing transfer prices.

1. Market-based transfer price: In the presence of competitive and stable external markets for the transferred product, many firms use the external market price as the transfer price.

2. Cost-based transfer price: The transfer price is based on the production cost of the upstream division. A cost-based transfer price requires that the following criteria be specified:

a. Actual cost or budgeted (standard) cost.b. Full cost or variable cost.c. The amount of mark-up, if any, to allow the upstream division to earn a profit on the transferred

product.3. Negotiated transfer price: Senior management does not specify the transfer price. Rather, divisional managers

negotiate a mutually-agreeable price.

Each of these three transfer pricing methods has advantages and disadvantages.

Market Price:

Some form of the competitive marketed price (i.e., the price charged for an item on the open market) is often regarded as the best approach to the transfer pricing problem. Particularly if transfer prices negotiations routinely become bogged down.

The market price approach is designed for situations in which there is an outside market for the transferred product or service; the product or service is sold in its present form to outside customers.

If the selling division has no idle capacity, the market price in the outside market is the perfect choice for the transfer price. The reason for this is that if the selling division can sell a transferred item on the outside market instead, then the real cost of the transfer as for as the company is concerned is the opportunity cost of the lost revenue on the outside sale. Whether the item is transferred internally or sold on the outside market, the production costs are exactly the same. If the market price is used as the transfer price, the selling division manager will not lose anything by making the transfer, and the buying division manager will get the correct signal about how much it really costs the company for the transfer to take place.

Difficulties occur when the selling division has idle capacity.

Cost-based Transfer Prices:

Cost-based transfer prices can also align managerial incentives with corporate goals, if various factors are properly considered, including the outside market opportunities for both divisions, and possible capacity constraints of the upstream division.

First consider the case in which the upstream division sells the intermediate product to external customers as well as to the downstream division.

In this situation, capacity constraints are crucial.

If the upstream division has excess capacity, a cost-based transfer price using the variable cost of production will align incentives, because the upstream division is indifferent about the transfer, and the downstream division will fully incorporate the company’s incremental cost of making the intermediate product in its production and marketing decisions.

o However, senior management might want to allow the upstream division to mark up the transfer price a little above variable cost, to provide that division positive incentives to engage in the transfer.

If the upstream division has a capacity constraint, transfers to the downstream division displace external sales. In this case, in order to align incentives, the opportunity cost of these lost sales must be passed on to the downstream division, which is accomplished by setting the transfer price equal to the upstream division’s external market sales price.

Next consider the case in which there is no external market for the upstream division.

If the upstream division is to be treated as a profit centre, it must be allowed the opportunity to recover its full cost of production plus a reasonable profit.

If the downstream division is charged the full cost of production, incentives are aligned because the downstream division will refuse the transfer under only two circumstances:

o First, if the downstream division can source the intermediate product for a lower cost elsewhere; To the extent the upstream division’s full cost of production reflects its future long-run

average cost the company should consider eliminating the upstream division. o Second, if the downstream division cannot generate a reasonable profit on the sale of the final product

when it pays the upstream division’s full cost of production for the intermediate product. The optimal corporate decision in this case might be to close the upstream division and stop

production and sale of the final product.

However, if either the upstream division or the downstream division manufactures and markets multiple products, the analysis becomes more complex.

Also, if the downstream division can source the intermediate product from an external supplier for a price greater than the upstream division’s full cost, but less than full cost plus a reasonable profit margin for the upstream division, suboptimal decisions could result.

Another problem with cost based price is that they may not provide incentive to control costs. If the actual cost of one division is simply passed on to the next division, then there is little intensive for anyone to work to reduce any costs. This problem can be overcome by using standard cost rather than actual costs or transfer prices.

Negotiated Transfer Prices:

Negotiated transfer pricing has the advantage of emulating a free market in which divisional managers buy and sell from each other in a manner that simulates arm’s-length transactions. However, there is no reason to assume that the outcome of these transfer price negotiations will serve the best interests of the company or shareholders.

The transfer price could depend on which divisional manager is the better poker player, rather than whether the transfer results in profit-maximizing production and sourcing decisions.

Also, if divisional managers fail to reach an agreement on price, even though the transfer is in the best interests of the company, senior management might decide to impose a transfer price. However, senior management’s imposition of a transfer price defeats the motivation for using a negotiated transfer price in the first place.

If the transfer has no effect on fixed costs, then from the selling division's standpoint, the transfer price must cover both the variable costs of producing transferred units and any opportunity costs.

Seller's perspective:

Transfer price > Variable cost + (Total contribution margin of lost sales / Number of units transferred)

The buying division will be interested in the proposal only if its profit increases. In case, a buying division or segment has an outside supplier, the buying division's decision is simple. Buy from the inside supplier if the price is less than the price offered by the outside supplier.

Purchaser's perspective:

Transfer price < Cost of buying from outside suppliers

Dual Transfer Pricing:

Under a dual transfer pricing scheme, the selling price received by the upstream division differs from the purchase price paid by the downstream division. Usually, the motivation for using dual transfer pricing is to allow the selling price to exceed the purchase price, resulting in a corporate-level subsidy that encourages the divisions to participate in the transfer.

In the following example, the Clear Mountain Spring Water Company changes from a negotiated transfer price of $18 per case (see the above example) to a dual transfer price in which the upstream division receives the local market price of $19 per case, and the downstream division pays $17 per case.

Upstream Division:

(1) Intercompany Receivable/Payable $9,500

Revenue from Intercompany Sale $9,500

(2) Cost of Goods Sold – Intercompany Sales $8,000

Finished Goods Inventory $8,000

(To record the transfer of 500 cases of Clear Mountain Spring Water, at $19 per case, to the Florida marketing division, and to remove the 500 cases from finished goods inventory at the production cost of $16 per case.)

Downstream Division:

(1) Finished Goods Inventory $8,500

Intercompany Receivable/Payable $8,500

(To record the receipt of 500 cases of Clear Mountain Spring Water at $17 per case, from the bottling division in Nebraska)

Corporate Headquarters:

(1) Interco. Receivable/Payable – Florida $8,500

Corporate Subsidy for Dual Transfer Price $1,000

Interco. Receivable/Payable – Nebraska $9,500

(To record the transfer of 500 cases of Clear Mountain Spring Water from Nebraska to Florida, at a dual transfer price of $19/$17 per case.)

Corporate Subsidy for Dual Transfer Price is an expense account at the corporate level. This account and the revenue account that records the intercompany sale affect the calculation of divisional profits for internal reporting and performance evaluation, but these accounts—as well as the intercompany receivable/payable accounts—are eliminated upon consolidation for external financial reporting.

To the extent that the Florida Division has ending inventory, the cost of that inventory for external financial reporting will be the company’s cost of production of $16 per case. In other words, the transfer price has no effect on the cost of finished goods inventory.

Divisional Autonomy and Sub-optimization:

How much autonomy should be granted to divisions in setting their own transfer prices and in making decisions concerning whether to sell internally or to sell outside?

Should the divisional heads have complete authority to make these decisions, or should top corporate management step in if it appears that a decision is about to be made that would result in sub-optimization?

Efforts should always be made, of course, to bring disputing managers together, but if a manager flatly refuses to change his or her position in dispute then this decision should be respected even if it results in sub-optimization. This is simply the price that is paid for divisional autonomy.

If top management steps in and forces the decision in difficult situations, then the purposes of decentralization are defeated and the company simply becomes a centralized operation with decentralization of only minor decisions and responsibilities. In short, if a division to be viewed as an autonomous unit with independent profit responsibility, then then it must have control over its own destiny--even to the extent of having the right to make bad decisions.

Divisional autonomy and independent profit responsibility are thought to lead to much greater success and profitability than closely controlled, centrally administrated operations. Part of the price of this success is occasional sub-optimization due to pettiness, bickering, or just plain stubbornness.

Furthermore, one of the major reasons for decentralizing is that top managers cannot know enough about every detail of operation to make every decision themselves. To impose the correct transfer price, top management would have to know details about the outside market, variable costs, and capacity utilization. If top managers have all of this information, it is not clear why they decentralized in first place.

Performance measurement and compensation

Agency Theory is the study of the relationship between a person (the principal) another person (the agent) who they contract to act on their behalf. If this contract is not created in a fashion that aligns the interests of both parties it is likely that the agent will interpret the contract in ways that maximise their own reward, possibly to the detriment of the principal.

The principal, hires an agent (e.g. a sales or finance manager) to perform tasks on his behalf but he cannot ensure that the agent performs them in precisely the way the principal would like. The decisions and the performance of the agent are impossible and or expensive to monitor and the incentives of the agent may differ from those of the principal.

o Risk Appetite: Agents can have different appetites for risk causing an organisation to take too many or few ‘entrepreneurial decisions’ for the owners.

o Goal Conflict: An agent may pursue goals that do not match with the principal’s. For instance if an agent is remunerated on revenue growth they may do so at the expense of profitability and cause an organisation to become bankrupt.

o Adverse Selection: The hiring of an agent that lacks skills or attitudes necessary for the role.o Self-Interest: It is assumed that all humans place their own interests ahead of others to some extent.o Moral Hazard: The agent may deliberately not perform to the level they have been contracted for.o Exploiting Perquisites: Roles have benefits that go with them and senior roles can have access to quite extensive

benefits. A CEO using company money to outfit his house is exploiting his perquisites.o Bounded Rationality: Within the limits of their experience a person is always assumed to act in a rational fashion.o Information Asymmetry: As the agent works directly within the organisation they will have more detailed

information. This asymmetry can be used to slant interpretation of how the organisation is performing or as leverage in negotiations regarding rewards.

o Agent Risk Aversion: An agent is generally aware that taking a risk and failing will be damaging to their on-going employment. This knowledge can cause agents to avoid taking risks out of self-interest even when those risks are in the benefit of the principal.

Incentive compensation refers to tying agent’s compensation to the performance of the agent.

Expectancy theory suggests that doing so should encourage the agent to put in a higher level of effort.o Agent must expect that by increasing effort, performance will improveo Agent must expect that better performance will be rewardedo Compensation must be attractive to the agent

Agent must perceive that effort can influence outcomes. Outcomes must be controllable.

Incentive plans should be designed to reward results or behaviours that are in line with the firm’s objectives and agents’ rewards should be clearly linked to results. There should be goal congruence.

The Incentive Problem

An emphasis on variable compensation, which is linked to performance/results, motivates the effort-averse agent to put in more effort. (Motivational effect)

However, the agent does not have full control over the performance. Therefore, basing the compensation on performance imposes risk on the agents and there is inefficient risk sharing.

The agent will be more risk-averse

Compensating agents with a fixed compensation, which means greater risk sharing, will encourage agents to take more risks.

However, doing so will reduce the motivational effect of the compensation scheme.

Effective compensation has to balance the trade-off between motivating effort and encouraging risk taking.

The incentive problem is a result of imperfect information and can be solved with better information.

Greater precision in measuring the agent’s effort reduces the cost of inefficient risk sharing and increases the motivational effect of incentive compensation.

Relative performance evaluations can help mitigate the incentive problem. Comparing one agent’s performance to the group’s performance should enable the principal to filter out common environmental uncertainties.

Divisional Income:

Divisional income is a measure of divisional performance that is analogous to corporate net income for evaluating overall company performance. The calculation of divisional income must consider transactions that occur between divisions, and between the division and corporate headquarters. One type of intra-company transaction is the transfer of goods between divisions. These transfers represent revenue to the selling division and a cost of inventory to the buying division. Another type of transaction is the receipt of services from corporate headquarters or from other responsibility centres within the company. Examples of such services are human resources, legal, risk management, and computer support. In many companies, these services are “charged out” to the divisions that utilize them.

Because divisional income fails to account for the size of the division, it is ill-suited for comparing performance across divisions of different sizes. Divisional income is most meaningful as a performance measure when compared to the same division in prior periods, or to budgeted income for the division.

Return on investment (ROI) is calculated as: 

Return on Investment = Divisional IncomeDivisional Investment

The same issues arise in determining the numerator in ROI as arise in deriving divisional income. For the denominator, management must decide how to value the capital assets that comprise the division’s investment.

These assets can be valued at

their gross book value (the acquisition cost), their net book value (usually the acquisition cost minus depreciation expense), replacement cost, net realizable value or fair market value

The calculation of the numerator should be consistent with the choice of valuation technique in the denominator. For example, if divisional investment is calculated using gross book value, then divisional income in the numerator should not be reduced by depreciation expense.

One advantage of using gross book value instead of net book value in the ROI calculation is that net book value can discourage divisional managers from replacing old equipment, even if new equipment would be more efficient and would increase the economic profits of the division. This dysfunctional managerial incentive occurs because if the existing equipment is fully depreciated, but is still functional, its replacement can reduce the division’s ROI by lowering the numerator (due to increased depreciation expense) and increasing the denominator (because fully depreciated assets have a net book value of zero).

ROI can be broken down into the following two components: 

ROI = Divisional Income = Divisional Income X Divisional RevenueDivisional Investment Divisional Revenue Divisional Investment

The first term on the right-hand side is called the return on sales (ROS). It is also called the operating profit percentage. This ratio measures the amount of each dollar of revenue that “makes its way” to the bottom line. ROS is often an important measure of the efficiency of the division, and the divisional manager’s ability to contain operating expenses.

The second term on the right-hand side is called the asset turnover ratio or the investment turnover ratio. This ratio measures how effectively management uses the division’s assets to generate revenues.

At the divisional level, ROI controls for the size of the division, and hence, it is well-suited for comparing divisions of different sizes.

On the other hand, ROI can discourage managers from making some investments that shareholders would favour. For example, if a divisional manager is evaluated on ROI, and if the division is currently earning an ROI in excess of the company’s cost of capital, then the manager would prefer to reject an additional investment opportunity that would earn a return above the cost of capital but below the division’s current ROI. The new investment opportunity would lower the division’s ROI, which is not in the manager’s best interests. However, because the investment opportunity provides a return above the cost of capital, shareholders would favour it.

Residual Income:

One way in which financial accounting practice fails to follow corporate finance theory is that the cost of debt is treated as an expense in arriving at net income, but the cost of equity is not. Specifically, interest expense appears as a

deduction to income on the income statement, but dividends are shown on the statement of changes in shareholders’ equity. Hence, net income is affected by the company’s financing strategy as well as by its operating profitability, which can obscure the economic performance of the firm.

A simple solution to this problem is to add back interest expense (net of the tax effect) to net income, to arrive at operating income after taxes. The performance measure called residual income makes this adjustment, and then goes one step further, by deducting a charge for capital based on the organization’s total asset base: 

Residual Income = Operating Income (Investment Base x Required Rate of Return)

The company’s cost of capital is often appropriate for the required rate of return.

Residual income is probably the closest proxy that accounting provides for the concept of economic profits; hence, residual income probably comes close to measuring what shareholders really care about (to the extent that shareholders only care about maximizing wealth).

Residual income can be calculated both at the corporate level and at the divisional level. Many companies that use residual income at the divisional level do so because management believes that residual income aligns incentives of divisional managers with incentives of senior management and shareholders.

Economic Value Added

EVA in its calculation includes a deduction for the cost of capital, and also adjusts accounting income to more accurately reflect the economic effect of transactions and the economic value of assets and liabilities. In general, these adjustments move the income calculation further from the reliability-end of the relevance-versus-reliability continuum, and closer to the relevance-end of that continuum.

EVA = Net Operating Profit After Taxes (NOPAT) - (Capital * Cost of Capital)

Contemporary management accounting practices

The Economic Order Quantity (EOQ) is the number of units that a company should add to inventory with each order to minimize the total costs of inventory—such as holding costs, order costs, and shortage costs. The EOQ is used as part of a continuous review inventory system in which the level of inventory is monitored at all times and a fixed quantity is ordered each time the inventory level reaches a specific reorder point. The EOQ provides a model for calculating the appropriate reorder point and the optimal reorder quantity to ensure the instantaneous replenishment of inventory with no shortages.

The cost of inventory under the EOQ model involves a trade-off between inventory holding costs (the cost of storage, as well as the cost of tying up capital in inventory rather than investing it or using it for other purposes) and order costs (any fees associated with placing orders, such as delivery charges). Ordering a large amount at one time will increase a small business's holding costs, while making more frequent orders of fewer items will reduce holding costs but increase order costs. The EOQ model finds the quantity that minimizes the sum of these costs.

EOQ=√ 2×D×SH

Re-order point = [D / (Working days per year)] * Lead time (in days)

= daily demand * lead time (in days)

D = Annual demand (units)

S = Incremental cost per order ($)

H = Incremental annual carrying cost per unit ($)

Just in time is a ‘pull’ system of production, so actual orders provide a signal for when a product should be manufactured. Demand-pull enables a firm to produce only what is required, in the correct quantity and at the correct time.

This means that stock levels of raw materials, components, work in progress and finished goods can be kept to a minimum. This requires a carefully planned scheduling and flow of resources through the production process. Modern manufacturing firms use sophisticated production scheduling software to plan production for each period of time, which includes ordering the correct stock. Information is exchanged with suppliers and customers through EDI (Electronic Data Interchange) to help ensure that every detail is correct.

Supplies are delivered right to the production line only when they are needed. For example, a car manufacturing plant might receive exactly the right number and type of tyres for one day’s production, and the supplier would be expected to deliver them to the correct loading bay on the production line within a very narrow time slot.

The purpose of JIT production is to avoid the waste associated with overproduction, waiting and excess inventory.

Advantages of JIT

Lower stock holding means a reduction in storage space which saves rent and insurance costs As stock is only obtained when it is needed, less working capital is tied up in stock There is less likelihood of stock perishing, becoming obsolete or out of date Avoids the build-up of unsold finished product that can occur with sudden changes in demand Less time is spent on checking and re-working the product of others as the emphasis is on getting the work

right first time

Disadvantages of JIT

There is little room for mistakes as minimal stock is kept for re-working faulty product Production is very reliant on suppliers and if stock is not delivered on time, the whole production schedule can

be delayed There is no spare finished product available to meet unexpected orders, because all product is made to meet

actual orders – however, JIT is a very responsive method of production

Target Costing (Continued from above)

Target cost is the cost that can be incurred while still earning the desired profit

Selling price – desired profit = target cost

The customer sets the price and profit must be achieved through cost control

Cost control from the beginning

70-90% of costs are committed to at the design stage

Focus on product and process design to engineer out costs from the beginning

Saves costly changes later on

Cost control at all phases of the product life cycle

o Design

o Production

o Delivery/setup

o Customer’s cost of ownership

Emphasizes future sales instead of current cost savings

o Service and repair

o Disposal and recycling

Two stage process

Establish the target cost

o Market research

o Product planning, concept development stages

Achieve the target cost (cost objective)

o Value engineering, continuous improvement

o Design stage

o Continuous improvement in later stages

Must include the features the customer wants while maintaining cost at or below target

Want to meet the customers’ needs, but not exceed themo Eliminating desired features will result in an undesirable producto Adding unwanted features will increase cost

Failing to keep cost at or below target will result in unacceptable profits

Lifecycle costing

As mentioned above, target costing places great emphasis on controlling costs by good product design and production planning but those up-front activities also cause costs. There might be other costs incurred after a product is sold such as warranty costs and plant decommissioning.

When seeking to make a profit on a product it is essential that the total revenue arising from the product exceeds total costs, whether these costs are incurred before, during or after the product is produced.

This is the concept of life cycle costing, and it is important to realise that target costs can be driven down by attacking any of the costs that relate to any part of a product’s life. The cost phases of a product can be identified as:

Phase Examples of types of costDesign Research, development, design and toolingManufacture Material, labour, overheads, machine set up, inventory,

training, production machine maintenance and depreciation

Operation Distribution, advertising and warranty claimsEnd of life Environmental clean-up, disposal and decommissioningThere are four principal lessons to be learned from lifecycle costing:

All costs should be taken into account when working out the cost of a unit and its profitability. Attention to all costs will help to reduce the cost per unit and will help an organisation achieve its target cost. Many costs will be linked. For example, more attention to design can reduce manufacturing and warranty

costs. More attention to training can machine maintenance costs. More attention to waste disposal during manufacturing can reduce end-of life costs.

Costs are committed and incurred at very different times. A committed cost is a cost that will be incurred in the future because of decisions that have already been made. Costs are incurred only when a resource is used.

By the end of the design phase approximately 80% of costs are committed. For example, the design will largely dictate material, labour and machine costs. The company can try to haggle with suppliers over the cost of components but if, for example, the design specifies 10 units of a certain component, negotiating with suppliers is likely to have only a small overall effect on costs. A bigger cost decrease would be obtained if the design had specified only eight units of the component. The design phase locks the company in to most future costs and it this phase which gives the company its greatest opportunities to reduce those costs.

Customer Profitability

While customers are clearly important to profit, some are more profitable than others. Companies that assess the profitability of various customer groups can more accurately target their markets and increase profits. The first step in determining customer profitability is to identify the customer. The second step is to determine which customers add value to the company. The company should work with existing profitable customers and add more of them. Sometimes, the company may need to add an initially unprofitable customer group and increase efficiency to make the group profitable.

To calculate customer profitability, an activity-based model can be used to track revenues and costs to each trading transaction.

Quality Costs

Quality-linked activities are those activities performed because poor quality may or does exist. The costs of performing these activities are referred to as costs of quality. Thus, costs of quality are the costs that exist because poor quality may or does exist.

The definitions of quality-related activities imply four categories of quality costs: (1) prevention costs, (2) appraisal costs, (3) internal failure costs, and (4) external failure costs.

Prevention costs are incurred to prevent poor quality in the products or services being produced. As prevention costs increase, we would expect the costs of failure to decrease. Examples of prevention costs are quality engineering, quality training programs, quality planning, quality reporting, supplier evaluation and selection, quality audits, quality circles, field trials, and design reviews.

Appraisal costs are incurred to determine whether products and services are conforming to their requirements or customer needs. Examples include inspecting and testing materials, packaging inspection, supervising appraisal activities, product acceptance, process acceptance, measurement (inspection and test) equipment, and outside certification. Two of these terms require further explanation. Product acceptance involves sampling from batches of

finished goods to determine whether they meet an acceptable quality level; if so, the goods are accepted. Process acceptance involves sampling goods while in process to see if the process is in control and producing non-defective goods; if not, the process is shut down until corrective action can be taken. The main objective of the appraisal function is to prevent nonconforming goods from being shipped to customers.

Internal failure costs are incurred because products and services do not conform to specifications or customer needs. This non-conformance is detected prior to being shipped or delivered to outside parties. These are the failures detected by appraisal activities. Examples of internal failure costs are scrap, rework, downtime (due to defects), re-inspection, re-testing, and design changes. These costs disappear if no defects exist.

External failure costs are incurred because products and services fail to conform to requirements or satisfy customer needs after being delivered to customers. Of all the costs of quality, this category can be the most devastating. Costs of recalls, for example, can run into the hundreds of millions of dollars. Other examples include lost sales because of poor product performance, returns and allowances because of poor quality, warranties, repair, product liability, customer dissatisfaction, lost market share, and complaint adjustment. External failure costs, like internal failure costs, disappear if no defects exist.

Prevention CostsQuality engineering

Quality training Recruiting

Quality auditsDesign reviewsQuality circles

Marketing researchPrototype inspectionVendor certification

Appraisal (Detection) CostsInspection of materialsPackaging inspectionProduct acceptanceProcess acceptance

Field testingContinuing supplier verification

Internal Failure CostsScrap

ReworkDowntime (defect-related)

Re-inspectionRetesting

Design changesRepairs

External Failure CostsLost sales (performance-related)

Returns/allowancesWarranties

Discounts due to defectsProduct liability

Complaint adjustmentRecallsIll will

Quality costs can also be classified as observable or hidden. Observable quality costs are those that are available from an organization’s accounting records. Hidden quality costs are opportunity costs resulting from poor quality. (Opportunity costs are not usually recognized in accounting records.)

A detailed listing of actual quality costs by category can provide two important insights. First, it reveals the magnitude of the quality costs in each category, allowing managers to assess their financial impact. Second, it shows the distribution of quality costs by category, allowing managers to assess the relative importance of each category.

Understand, however, that reduction in costs should come through improvement of quality. Reduction of quality costs without any effort to improve quality could prove to be a disastrous strategy.

Business sustainability

Non-Economic Goals and Management Accounting:

Regardless of whether one believes that companies should adopt non-economic goals as well as profit maximization as ultimate goals, or whether one believes that the profit motive is sufficient to encourage companies to act in socially and environmentally responsible ways, there is an important role for management accounting.

Specifically, shareholders, potential shareholders, and customers must have access to the information that enables them to make investment and purchase decisions consistent with their values.

Traditional accounting and financial reporting systems were not designed to collect and report information about social and environmental performance, in part because many of these measures are non-monetary, and accounting systems traditionally relied on the monetary-unit as the common denominator in which to measure economic activities and transactions.

Two relatively recent innovations in management accounting and corporate reporting that provide a framework for companies to formally incorporate nonfinancial objectives into management decision-making and corporate reporting are the balanced scorecard and the triple-bottom-line.

The Balanced Scorecard:

The balanced scorecard is a performance measurement tool and a performance management. The balanced scorecard emphasizes traditional financial measures, but also adds nonfinancial measures.

An important motivation for adding these nonfinancial measures is the observation that many financial measures are backward-looking, while many important forward-looking measures of performance are nonfinancial.

The four original components of the balanced scorecard were

1. The learning and growth perspective2. The internal business process perspective3. The customer perspective4. The financial perspective

Sometimes, sustainability is added as an additional perspective. Each of these perspectives has performance measures associated with it, and these performance measures are tailored for the specific circumstances of the company implementing the scorecard. An important advantage of the balanced scorecard is that it explicitly acknowledges the fact that companies have multiple stakeholders: investors, creditors, customers, and employees.

The Triple-Bottom-Line:

The triple-bottom-line is an external reporting tool designed for shareholders and other financial statement users. The triple-bottom-line reports periodic (quarterly or annual) information about the company’s performance along environmental and social dimensions, as well as the usual information about the company’s economic performance. Reporting under the triple-bottom-line is divided into three components:

1. Economic performance reports traditional measures of financial performance, and possibly additional statistics related to economic performance such as product market share or information about new product development.

2. Social performance reports measures of performance related to employee welfare, such as employee injury rates, training programs, and hiring and retention statistics. This category also reports other social performance measures such as charitable contributions, and the company’s activities in shaping local, national and international public policy.

3. Environmental performance reports the impact of the company’s products, services and processes on the environment. This component of the triple-bottom-line might report on the release of pollutants into the air and public waters, the utilization of renewable and non-renewable natural resources, and the company’s stewardship of natural resources on company-owned or company-controlled lands.

There are no “Generally Accepted Accounting Principles” for reporting under the triple-bottom-line. However, the Global Reporting Initiative (GRI), sponsored by the United Nations Environment Program, has emerged as a prominent source of guidance for triple-bottom-line reporting. According to GRI, over 500 organizations worldwide follow its reporting guidelines.

An alternative framework that is widely used for reporting on environmental performance is ISO 14000, established by the Organization de Standards International. This organization is a management practice standard-setting body founded in Amsterdam in 1947. ISO establishes standards for a variety of products and production processes, and compliance with ISO is a contractual requirement by some corporate customers.

Investors and consumers that wish to make investment and purchase decisions based, in part, on companies’ environmental and social performance are hampered by the lack of universal reporting (not all public companies report this information) and by the lack of uniform reporting (among companies that report this information, they do not report the information using the same criteria in the same way).

Another component in the reporting framework that is present for financial data, but generally absent for environmental and social reporting, is third-party attestation. Financial statements are audited by public accountants, and financial statement users can place more reliance on the accuracy of that information because of the independent auditor’s third-party verification role. No such audit requirement exists for information that U.S. companies report voluntarily about environmental and social performance.

Hence, whether one believes that the profit-motive and reputational effects are sufficient to induce companies to engage in responsible environmental and social behaviour, or one believes that companies should include environmental and social goals as ultimate objectives along with traditional economic objectives, it would seem that the following elements are essential—but currently absent—for either mechanism to work effectively: First, the regulatory reporting regime should require that environmental and social performance information be reported to investors and consumers using commonly-accepted criteria. Second, the information should be audited, to enhance the credibility of this information with financial statement users.