Managerial Accounting: Cost Behaviors, Systems and Analysis

Table of Contents

Managerial accounting information facilitates and aligns decisions made by managers and employees inside the organization, and it helps the organization achieve its goals and objectives. Managerial accounting is defined as “The process of obtaining, creating, and analyzing relevant information to help achieve organization goals.”

Managerial vs Financial

Financial accounting

1. Very useful to users who are outside of the organization: investors (ownership), creditors (debt relationship), tax authorities, regulatory agencies, suppliers, customers, or even competitors.
2. General, aggregated financial information.
3. Perspective of reporting of the past, historical transactions.
4. Guided by principles, standards, and rules (Generally Accepted Accounting Principles)

Managerial accounting

1. Focuses on those users inside the organizations: managers and employees who are making decisions, that help the organization try to achieve its goals.
2. Detailed, specialized information for a specific decision, setting, etc.
3. Being designed for the future decisions.
4. No rules. It is case specific, and the result of best practices.

Managerial accounting has two main purposes:

facilitate decisions
- create, organize, and share the right information to allow for the best decision.
guide and influence decisions
- help align managers’ and employees’ decisions with what is for the firm.

Any firm that is engaged in decision making benefits from managerial accounting. Any information (regardless of its form) that is helping to guide or facilitate the decisions made by managers and employees is under the umbrella of managerial accounting information.

Cost Behavior

We’ll use the term cost in reference to the notion of a usage of resources. Resources being something you own or have the right to use, but once you use them, you no longer have that right or that ownership. The cost object is anything we wanna know the cost of, for instance, a service, a product, a department inside the firm, a business unit, a division, or even a particular employee.

There are multiple ways in which we can organize cost information:

By relation to the cost object
- direct costs: materials, labor, …
- indirect costs: overhead, necessary but difficult or infeasible to trace to the cost object.
In according to how costs behave
- how costs are associated with some activity of interest
- predict how costs will behave in the future

Cost behavior is important, take an instance from producing a product, it helps determine:

product profitability (i.e. choose among potential products to produce)
whether to change product price
add or drop a product line
whether to outsource

The basic idea here is to partition our cost into two types: fixed and variable. It allows us to predict how costs will behave, and make better decisions.

Total cost = Fixed costs + Variable costs

Costing Systems

Under a financial perspective, product costing is done according to Generally Accepted Accounting Principles (GAAP), which are the rules, regulations, and other forms of guidance that instruct accountants how to prepare and share information related to product costs. The distinction in financial accounting of the most importance is inventoriable product costs versus period costs (selling + admin costs).

Product costs	They are included as inventory on the balance sheet because they have created value that the firm expects some economic benefit in future. Product costs can be further distinguished in a managerial perspective: 1) direct product costs 2) indirect product costs
Period costs	They are expenses. They don’t show up in inventory but are booked on the income statement in the period in which they are incurred.

Also note the distinction between costs and expenses.

Costs	The general usage of resources.
Expenses	More specifically refers to costs that are reflected on the income statement in the period in which they are incurred.

Flow of Costs Through the Financial Statements

The distinction between inventory and expenses as reported on the income statement influence the decisions that are made by managers and employees.

From	*balance sheet*
Inventory (Asset)	1. Raw resources: direct materials, direct labor, manufacturing overhead… 2. Work-in-process inventory Costs accumulated either: a) by individual job (Job costing systems) or b) by production department (Process costing systems) 3. Finished-goods inventory (The value of those costs are accounted for on the *balance sheet* as an asset)
To	*income statement*
Expenses	4. Cost of goods sold (Once sold, the costs that have been accounted for thus far become expenses on the *income statement*)

One way in which we can think about costing systems is by distinguishing them according to cost object type. Many types of costing systems are usually broken down into two types:

Job costing systems: cost object is a unit or multiple units of a distinct product or service. Usually these are created in low volume. (E.g. law firms, consulting firms, plane, yacht, etc)
Process costing systems: cost object is masses of identical or similar units of product or service. (E.g. computer manufacturing, food products, mail, express delivery, etc)

Often firms have a continuum between these two. The products and services that they create are a hybrid of both multiple units as well as customized units.

Overhead

One important thing about overhead is the nature of its timing throughout the year, there is the beginning of the period and the end of the period. At the beginning of the period, we have an estimate, or a budgeted amount of overhead that we think we will spend. And it isn’t until the end of the year that we actually know how much we actually spent.

Also, the spending of overhead throughout the year is not as smooth as it is for other types of costs. The problem is, is that we’re making decisions along the way – throughout the year, managers are trying to understand the cost of the service that they’re providing, so that they can price these services appropriately.

Not knowing what the actual costs were until the end of the period, incorporating this information into that pricing decision can be difficult. So what we need is an estimate. This allows us to inform what the costs of our services that we’re providing during the year are, so that we can make appropriate pricing and other decisions based on this information.

Predetermined overhead rate = Budgeted overhead (in $) / Total volume of drivers (in n)

A driver (or a cost driver) is the measure of an activity that we think corresponds to the spending of overhead. We’re using this rate to ultimately allocate overhead to the cost objects of interest.

Now, there are 2 steps in applying overhead:

Calculate this predetermined overhead rate. For example $1,500,000 / 30,000 (labor hours) = $50 per hour.
Apply the overhead. Suppose a consulting engagement used 350 labor hours, then $50 per hour * 350 hours = $17,500, which is the amount of overhead that gets applied to this particular engagement. This number, in conjunction with the amount spent on direct labor for the engagement, would provide a nice estimated cost incurred for this consulting engagement.

However, estimates from the beginning of the year likely do not match actual overhead at the end of the year. Thus, an adjustment is usually made to reflect this difference in the costing system. Large discrepancies can oftentimes throw managers off.

Absorption Accounting and Fixed Costs

For financial reporting purpose, how to account for costs using absorption accounting? In a manufacturing setting, recall the nature of the income statement from a financial perspective:

Revenue
 - Direct material (variable)
 - Direct labor (variable)
 - Overhead (variable & fixed)
 = Gross margin
 - Other expenses (variable & fixed)
 = Profit

Take an example, suppose following information from a manufacturer is available:

Selling price (per unit)	$21,000
Variable costs (per unit)
Materials	$5,000
Labor	$3,000
Selling	$2,000
Fixed costs (total)
Manufacturing	$1,500,000
Selling	$450,000

We also know some things about the coming months:

	Month 1	Month 2
Beginning inventory	0	100
Production	400	350
Sales	300	400
Ending inventory	100	50

The income statement of Month 1 is calculated as below:

Revenue = 21,000 * 300 = 6,300,000
Variable manufacturing costs = (5,000 + 3,000) * 400 = 3,200,000
Variable manufacturing costs reported
- on Income Statement: 8,000 * 300 = 2,400,000 (as costs of goods sold)
- on Balance Sheet: 8,000 * 100 = 800,000 (as inventory)
Fixed manufacturing costs per unit: 1,500,000 / 400 = 3,750
Fixed manufacturing costs reported
- on Income Statement: 3,750 * 300 = 1,125,000 (as costs of goods sold)
- on Balance Sheet: 3,750 * 100 = 375,000 (as inventory)
Variable selling and admin: 2,000 * 300 = 600,000
Fixed selling and admin: 450,000

Putting all together, the Income statement of Month 1 is:

Income statement of scenario 1

Revenue 6,300,000
 - COGS(var) 3,200,000
 - COGS(fix) 1,125,000
 = Gross margin 2,775,000
 - Selling(var) 600,000
 - Selling(fix) 450,000
 = Operating income 1,725,000

Now suppose, instead of 400 units in the original scenario, but 800 units were actually manufactured, and other information are all the same.

Revenue = 21,000 * 300 = 6,300,000
Variable manufacturing costs = (5,000 + 3,000) * 800 = 6,400,000
Variable manufacturing costs reported
- on Income Statement: 8,000 * 300 = 2,400,000 (as costs of goods sold)
- on Balance Sheet: 8,000 * 500 = 4,000,000 (as inventory)
Fixed manufacturing costs per unit: 1,500,000 / 800 = 1,875
Fixed manufacturing costs reported
- on Income Statement: 1,875 * 300 = 562,500 (as costs of goods sold)
- on Balance Sheet: 1,875 * 500 = 937,500 (as inventory)
Variable selling and admin: 2,000 * 300 = 600,000
Fixed selling and admin: 450,000

By doubling production, we’re spreading the same pool of fixed manufacturing cost over a much larger volume (800 units), which makes each unit look much cheaper than it did compared to the first version (400 units).

Income statement of scenario 2

Revenue 6,300,000
 - COGS(var) 2,400,000
 - COGS(fix) 562,500
 = Gross margin 3,337,500
 - Selling(var) 600,000
 - Selling(fix) 450,000
 = Operating income 2,287,500

Now compare the two scenarios. Because we’ve taken the same pool of fixed cost, and spread them over a larger volume, more costs end up in the inventory amount and off of the income statement. Therefore, cost of goods sold looks less than it did under the original scenario, which then pushes up Gross Margin relative to that original scenario. And ultimately, Operating Income is much higher as well. All because we produced more units, not necessarily because we sold more units.

Assume unit manager’s evaluation and compensation is determined by Operating Income, eventually this might lead to problems. What is the root cause of this problem?

Accounting for fixed cost is quite complicated.
Absorption costing, which is required for financial accounting purposes, treats fixed costs as product costs.

The production volume might influence what the cost of each product looks like, so financial accounting information may not be the best for internal decision-making. Well for internal purposes, firms can account for cost however they like. They don’t have to use absorption accounting. They can design whatever system that best suits the decision or the setting that they’re in.

Activity-Based Costing

Activity-based costing is the general approach is that it’s a costing method focuses on 2 key aspects, intended to increase the accuracy of cost information.

Activities that use resources (which is measured by drivers)
The causal relationship among activities, resources and cost objects.

We treat overhead quite differently in activity-based costing systems relative to more traditional simplified costing systems and that buys us a lot more information.

In a traditional system, direct material and direct labor are feasible in terms of measurement. It’s pretty easy to understand what materials and labor belong with what product that we produce. Overhead, on the other hand, is a big bucket or conglomerate of other types of costs. In a traditional system, it might simplify things by splitting them up into 1 or 2 cost pools, and then we allocate costs from those pools to the cost objects of interest.

Overhead costs ⟹ Cost pool x ⟹ Cost object

In an activity-based costing system, however, we treat overhead quite differently. In the process of creating value, resources are assigned to different activities that the firm engages in. We tend to group different activities into activities groups, which helps simplify a complex system. Finally, costs in each activity pool get assigned to different cost objects, so that we understand the cost of those objects so we can make decisions.

Resources ⟹ Activity n ⟹ Activity group x ⟹ Driver ⟹ Cost object

Design and Implementation

The steps to design and implement an activity-based costing system is not linear. It is very iterative.

Design phase
- Step1, Identify and estimate resources
- Step2, Identify activities than consume resources
- Step3, Group activities into pools
  - Informed by two attributes
    1. Activity type,
    2. Measure / driver type
- Step4, Identify and compute appropriate driver
Implementation phase
- Step5, Assign costs to cost objects according to associated activities and drivers

With respect to the type of activity (or type of cost), it’s useful to think about costs and activities in the form of a hierarchy.

Unit level	activities / costs correspond to production volume
Batch level	activities / costs correspond to batches of production (regardless of production volume)
Product level	activities / costs correspond to product lines
Facility / organization	catch-all category

Drivers are the connector between the activity pool and the cost object itself. They are the measure of activity that allows for the assignment of costs to the cost objects from each pool. Examples are the number of units, batches, inspections or orders. Whatever activity is inside that activity pool, we choose a measure of that activity to serve as the driver.

An Example

Step1: Managers of a healthy drink firm has estimated the following resources:

Support staff wages	30,000
Benefit and insurance	12,000
Information systems	8,000
Equipment	7,000
Maintenance	3,000
Utilities	4,000
Total	64,000

Step2: The activities are identified as following:

Processing production orders
Scheduling production runs
Prepping line for new flavor
Purchasing
Preparing and releasing materials
Ensuring quality
Management and record-keeping
etc…

Step3: Management has decided to group activities according to activity / cost types:

Run machines (unit level)
Process production runs (batch level)
Setup equipment (batch level)
Manage products (product level)

We take our resources and ultimately allocate those resources to the different pools:

	Total	Process product run	Setup equip	Mgmt products	Run machines
Wages	$30000	40% 12000	40% 12000	20% 6000
Benefits	$12000	40% 4800	40% 4800	20% 2400
Info systems	$8000	30% 2400		70% 5600
Equipment	$7000				100% 7000
Maintenance	$3000	50% 1500			50% 1500
Utilities	$4000	10% 400	10% 400	10% 400	70% 2800
Total	$64000	21100	17200	14400	11300

Step4, Compute drivers that allow us to allocate the costs from the activity pools to the cost objects, once managers have identified the activity pools and the drivers, they can calculate a rate for each pool. This rate is used to allocate costs to cost objects.

Predetermined overhead rate
= Activity pool amount (in $) / Total volume of drivers (in n)

	Process product run	Setup equip	Mgmt products	Run machines
Amount	$21100	17200	14400	11300
Driver volume	105 (runs)	688 (hours)	4 (prod lines)	9000 (hours)
Rate	$200.95 / run	25 / hour	3600 / line	1.26 / hour

Step5. Assign costs. Next they could multiply the calculated rate by the resources used by (or estimated for) each cost object, and sum these amounts to calculate the total cost.

The in depth information, the detail underlying in activity-based costing system provides us with a more accurate view of the firm, the cost that it incurs, and the profitability of each product.

When overhead is a substantial portion of cost structure, the information accuracy that’s brought to the table by activity based costing systems really harnesses benefits of that information. More accurate information, better decisions.

Cost-Volume-Profit Analysis

We can think of Cost-Volume-Profit-Analysis as an analytic tool that’s useful for asking “what-if” type questions. We can ask these questions to try to hedge risk or leverage opportunities that we might have in the future. Basically, CVP analysis uses the relationships among fundamental components of the basic accounting equation, that’s used to calculate income.

Instead of the financial perspective (see above), we can look at the income statement from a more managerial or decision-oriented perspective:

Revenue
 - Direct material (variable)
 - Direct labor (variable)
 - Overhead (variable)
 - Other expenses (variable)
 = Contribution margin
 - All fixed expenses (fixed)
 = Profit

The financial perspective and managerial perspective are quite different, not in their starting and end points, but the organization of the information in between.

In financial, we think about cost of goods sold and operating and other expenses.
In managerial, we organize the information according to cost behavior.

The fundamental equation is below.

Operating profit = Revenues 
 - Total variable costs
 - Total fixed costs

A very basic question is “How many units do we have to sell for the firm to break even?” Do some math, we have:

Units
= Total fixed costs / (Selling price per unit - Variable costs per unit)
= Total fixed costs / Contribution margin per unit

Assumptions

Now often times a firm will ask more questions than just where we break even, but this is a great starting point, especially for firms as they enter into a new market. However, bear in mind that there are critical assumptions to the validity of the CVP analysis, and violations of these assumptions means that our outputs come into question:

Costs can be categorized as fixed or variable, or if they’re mixed in some way, can be broken down appropriately. If there’s any uncertainty about which costs are which, that might throw a wrench into our analysis.
Everything is linear.
The number of units being applied to sale price and the the number of units being applied to variable costs are the same. We produce what we sell, and we sell what we produce, there’s no major change in inventory.
The efficiency and the productivity of the production process remains constant.
When we have multiple products, the relative proportion of sales of our products (the sales mix) remains constant over the relevant range that we’re focused on.

When desired profit (Net income before tax) is considered, the equation should be like this, since the “desired profit” is similar to fixed costs, in that it is an amount the organization is wishing to “cover.”

Units
= (Total fixed costs + Net income before tax) / Contribution margin per unit

Income tax also should be considered as expense. Since Net income before tax is a function of both variable costs and fixed cost, so is the Income tax. So Income tax is one of those costs that violates the assumption that we can parse our costs between categories of variable or fixed. So the answer here is to avoid the use of income taxes in our analysis. Try and back out the effect of those in order to avoid the violation of this assumption.

Net income
= Net income before tax - Income tax
= Net income before tax - Income tax rate * Net income before tax
⟹
Net income before tax = Net income / (1 - Income tax rate)

This allows us to plug in what we know about net income, or the desired net income, the tax rate, and back into the desired net income before taxes. As you can see, these calculations can become quite complex, and the same backing out that we’ve just done with income taxes can be done with any cost that it’s difficult to parse between fixed or variable components. This allows us to keep in check with our assumptions and therefore rely on the output of our analysis.

Weighted Average Contribution Margin

it’s often the situation that firms will use the same product line in the same factory to produce each of the products. In this case, all products share a total fixed cost for that factory or that capacity. A different piece of information, sales mix, can help us adopt a different methodology in this multi-product scenario.

Weighted average contribution margin
= Σ_i (Weight of product i * Contribution margin of product i)

Weighted average contribution margin relies on the production and sales mix to create or compute a composite contribution margin number, and what that allows is a single break-even calculation in multi-product scenarios, without worrying about the allocation of fixed costs between products. We can use this number than to calculate the break-even point for the firm as a whole.

Composite units
= Total fixed costs / Weighted average contribution margin

And it’s important to identify what units are, generically we refer to them as composite units. We can further break composite units down into the relative proportions / weights of each product.

Units
= Composite units * Weight of a product in sales mix

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