The theme of this chapter is "different cost for different purposes". On page 83
ABKY say that cost is like a chameleon. Most of the chapter is related to
defining the terminology related to costs, i.e., the different types of costs that
are associated with different types of decisions. Costs are assigned to cost
objects following generally accepted accounting principles (GAAP) so that
general purpose financial statements can be prepared for external reporting.
Many other types of cost information are developed to support internal
decisions. Illustrations 5 and 6 in the ABKY Chapter 1 summary show that
different audiences need different types of information. In addition to defining
a considerable number of cost types and other terms, the authors discuss why
GAAP uses a functional approach to defining types of cost, the concept of cost-
benefit analysis, how cost structures differ today, the activity cost hierarchy,
and life cycle cost. They also provide an example to illustrate the concept of
2. MANAGEMENT ACCOUNTING TERMINOLOGY
More Specific Definition
Cost or other Term Definition
Cost Sacrifice The price of any resource.
Cost object Any segment or element A product, service, project,
for which cost activity, department,
information is desired. division, etc.
Direct cost Cost used by a single cost A cost that would be
object. eliminated if the cost object
is eliminated. A
supervisor's salary is a
direct cost to the
production department he
or she is in charge of or
Indirect cost Cost that is common or A production supervisor's
shared by more than one salary is an indirect cost to
cost object. the products produced
within his or her
Flexible resource Resources that generate Direct material.
cost in proportion to the
Flexible cost Cost of flexible resources. Direct material costs, i.e.,
Always direct costs. Cost cost of materials or
that vary in proportion to components that go into or
the amount used. become the product.
Capacity related Resources purchased in Resources that generate
resource advance. Committed cost based on the amount
resources. acquired rather than the
amount used. Buildings
Capacity related cost Cost that are based on the Can be direct or indirect,
amount acquired rather but are fixed in the short
than the amount used. run. Depreciation on
buildings and equipment.
Variable cost This term is not defined Direct material.
in Chapter 3, but it is a
cost that changes or varies
with changes in the
activity level. See Chapter
5, p. 182.
Fixed cost A cost that does not Capacity related cost. See
change or vary with page 83. Straight line
changes in the activity depreciation, a supervisor's
level. salary, property taxes.
Matching concept I don't think matching is Accrual accounting where
defined in this chapter, benefits (revenues) are
but it is the idea of matched with the costs
bringing cost and benefits (expenses) associated with
together on the income generating the benefits.
statement in the same
Expired cost A cost associated with an An expense such as cost of
object who's benefits have goods sold.
been obtained or
Unexpired cost An asset. Inventory until sold,
Expense An expired cost. See Cost of goods sold.
Asset An unexpired cost. An Inventory, book value or
object with expected undepreciated cost of
future benefits. buildings and equipment.
Product cost Costs associated with Direct manufacturing costs
producing a product that such as direct materials and
are capitalized in the direct labor, as well as
inventory, i.e., become indirect manufacturing
assets until the products costs usually referred to as
are sold. factory overhead.
Inventory cost Product costs. See above. See cell above.
Manufacturing cost Cost associated with the Includes direct material,
production of products. direct labor (direct
Factory costs. These are manufacturing costs) and
unexpired costs (assets) indirect manufacturing
until the products are costs also referred to as
sold, then are charged off factory overhead and
as expense, i.e., cost of factory burden.
Non-manufacturing cost Cost not associated with Distribution, selling,
the production of marketing, customer
products, but with some service, research and
other function such as development. See page 77.
distribution. Treated as
period costs by GAAP.
Period cost Cost that are expensed in Non-manufacturing costs
the period in which according to GAAP. See
Incremental cost Cost of one more item, Cost of one more passenger
unit or customer. on an airline.
Full cost Direct plus indirect cost. GAAP product costs is
Variable plus a share of considered full costs
the fixed costs. although this is misleading
because it does not include
Historical cost Recorded costs. Any costs that are recorded
Sometimes referred to as such as labor costs,
actual cost, but this is materials costs,
misleading because the depreciation etc. For
cost recorded depends on example, accounting
the accounting alternative alternatives for
chosen. depreciation include
straight line and several
Future cost Estimated costs. Budgeted costs.
Average cost Usually refers to the mean The unit cost of a product
of a category of costs. that flows through a
Implicit cost Unstated and unrecorded Opportunity costs.
Opportunity cost Benefit foregone by not The income or interest on
accepting or pursuing the an alternative investment.
next best alternative. The opportunity cost of
owning anything is what
you could have obtained
with the money.
Short run ABKY define this as the Usually thought of as a
time period where a year in accounting, but this
decision maker cannot is just a ball park number
adjust capacity. See page and depends on the type of
83. resource involved. The
short run for an inter-state
highway, or factory
building is longer than a
year and for a resource like
fork lift trucks, it would be
much shorter than a year.
Long run The opposite of the above See the cell above.
where capacity can be
increased or decreased.
Short run cost ABKY define these as Direct material.
flexible costs. See page
Long run cost These can be flexible or Depreciation on plant and
capacity related according equipment.
Discretionary cost Can be increased or Advertising, employee
decreased at the training, research &
discretion of the decision development, preventive
maker. Not committed. maintenance.
Business level or Capacity related cost. Buildings and equipment.
Activity cost Cost associated with Unit level, batch level,
different types, or levels product level, customer
of activities. level and business level.
See below and exhibit 3-7
on page 93.
Unit level cost Cost of an activity that is Direct material required for
required or performed a unit of product.
each time a unit of
product or service is
produced or provided.
Batch level cost Cost of an activity that is Setting up the production
required or performed line to produce a batch of
each time a batch of product X. Also inspecting
products or services is the batch, moving the batch
Product level cost Cost of an activity that is Product engineering.
required or performed to
support a specific
Customer level cost Cost of an activity that is Sales calls, installation of a
required or performed to product and technical
support a specific support.
Business (or facility) Cost associated with Maintenance,
level cost maintaining the business housekeeping, and
and facilities. administrative functions.
Relevant cost Cost that will be different The cost that will be
when two or more different if a product is
alternatives are involved. dropped. See note below
Also called differential related to the example on
cost. pages 93-96.
Life cycle cost Cost associated with the Cost of product:
various stages of a 1. Development and
product's life cycle. See design.
page 98. 2. Introduction.
5. Post sales service.
6. Product take back.
3. WHY GAAP USES A FUNCTIONAL APPROACH TO COST
This section relates to why costs are separated into manufacturing and non-
manufacturing categories. On page 79 ABKY say the answer to this question is
not clear, but it is probably related to idea that different people are responsible
for different functions. Other explanations are related to the matching concept
(i.e., why manufacturing costs are charged to the inventory and non-
manufacturing costs are charged to expense) and include the following.
1) The benefits associated with many of the non-manufacturing activities are
received in the period in which the activities are performed and the costs are
incurred, e.g., most distribution, selling, and after sale service.
2) The amount and timing of receipt of the benefits from other non-
manufacturing activities are too difficult to estimate, even though future
benefits are expected, e.g., advertising and research and development.
4. COST BENEFIT ANALYSIS
There is a short discussion on pages 79 and 80 related to the cost-benefit
tradeoff for cost information. The idea is to develop the expected value of
different alternatives. Determining the expected value of an alternative is
calculated by multiplying the expected result by an estimate of the probability
of the result. This topic extends well beyond the scope of this textbook, but the
point is that information is not costless. A decision to capture a new type of
information, or develop or improve an information system, always involves
costs. The question is always whether the expected benefits will exceed the
5. COST STRUCTURES TODAY
In the section on pages 88 and 89, the authors discuss why the old cost
allocation systems that allocate indirect cost based on a production volume
related measurement such as direct labor cost now produce inaccurate or
distorted product costs. There are a number of reasons for this but in general,
capacity related costs now represent a much larger proportion of total
manufacturing costs than in the past, and direct labor costs represent a much
smaller proportion. There is also a lot more automation and a lot more product
diversity than in the past. Many indirect costs, or support costs, do not vary in
proportion to production volume. The ABKY example of an electric company
shows that meter reading and billing costs do not vary with the volume of
electricity produced and sold. When these costs are allocated to the various
classes of customers based on the volume of electricity (i.e., the conventional
costing shown in Exhibit 3-6), industrial and commercial customers are
overcharged and apartments and homes are significantly undercharged. The
electric company is actually losing money on Apartment customers as shown in
6. THE ACTIVITY COST HIERARCHY
The cost hierarchy is included in the table above and discussed on pages 90-93
in the text. The implications of separating cost into activity cost pools is
illustrated fairly well in Exhibit 3-7. Cost are separated into different cost
categories based on whether they are related to units, batches, specific products,
specific customers, or facilities. This allows the cost in each category to be
traced to cost objects in different ways, instead of combining all indirect cost
into a single cost pool and treating them as unit level or unit related costs. The
main idea is to avoid the cost distortions mentioned above. This is the activity
based cost approach that is illustrated in Chapter 5.
7. RELEVANT COST EXAMPLE
There is a somewhat involved example on pages 93-96 designed to show that
the cost of acquiring resources is very different from the cost of using
resources. The example involves three products and the decision of whether or
not to drop product 3. The illustration shows that all of the costs, except the
$2,400 cost of plastic, are capacity related costs and will not change if product
3 is dropped. In the short run, the only relevant cost for this decision are those
costs that will be different. ABKY cover relevant costing in more depth in
8. LIFE CYCLE STAGES
Different authors define the stages of the product life cycle in different ways.
ABKY define these stages as: Product development & planning Introduction
Growth Maturity Decline & abandonment.
Some authors indicate that the stages are different depending on the perspective
as indicated in the table below. As ABKY point out on page 98, there are many
types of product related costs and these costs occur unevenly over a product's
life cycle. All costs need to be considered in product related decisions, not just
the current costs of production and distribution. Also, products need to be
evaluated differently at different stages of their life cycle. Mature products
support products in the design and development stages. A company's strategy
changes from growth and market share in the early stages to profits and cash
flow in the later stages of the life cycle. The PLC concept is closely related to
the value chain concept and recognizes that everyone along the value chain is
important including society as a whole. For more specifics on the product life
cycle concept click on the link below the table.
Perspective Product Life Cycle Stages
Marketing or Sales Startup Growth Maturity Decline Abandon
Production Perspective Conception Design Development Production Logis
Customer or Consumption Operations Support Disposal
Project Management is the acquired knowledge and skills applied using a formal set of tools
and techniques to initiate, plan, execute, monitor, control and close projects.
In today's economy, all business lines have incorporated Project Management as an integral
part of their operational practices. Project Management has helped businesses to accompalish
their pre-defined objectives within the defined time limits. Project Management has facilitated
all business sectors to make profitable decisions as well as operationalize strategies to bring
their projects to completion.
Project Management has brought profitability to various Business Lines in numerous ways.
Few of the important ones have been summarized below. Project Management has provided:
A clear project framework for achieving project specific goals and business goals.
An emphasis on phased development i.e. regular and measurable progress.
A systematic approach to resolving high-risk factors associated with an objective.
A focus on team thus inculcating the concept of teamwork and skill specialization –
delegating tasks to team members selected for their skills that correspond to the
requirements of the project, leading to specialized input into the development process.
A built-in mechanism for assessing the feasibility of a proposed project – assessing
requirements and matching available resources to those requirements.
A process for involving all concerned parties into project execution, ensuring that the end
product perfectly matches the requirements and thus avoiding last minute glitches.
A measure for incorporating Quality Assurance within the project life cycle thus
producing Quality Outputs.
The above list is by no means exhaustive, but it gives very accurate picture of what value add
Effective Project Management can do to the business and its projects.
To get a better understanding on what Project Management is, lets us now have a look on the
various Project Management Objectives.
Project Management Objectives
Coordinate the various interrelated processes of the project.
Ensure project includes all the work required, and only the work required, to complete the
Ensure that the project is completed on time and within budget.
Ensure that the project will satisfy the needs for which it was undertaken.
Ensure the most effective use of the people involved with the project.
Promote effective communication between the projects team members and key
Ensure that project risks are identified, analyzed, and responded.
In practice, Project Management follows a Phased Approach for Project Excution and have a
standard defined Project Life Cycle. Teamwork and Quality Assurance are few important
inherent characteristics of successful Project Management.
Cost management is one of the fundamental and yet most challenging tasks for a project
7 Things You Need to Know About Development
Whether you are a project manager planning for a smooth implementation of a plan or a
project sponsor on whose decisions a project depends, you cannot escape from the fact
that project estimation is essential to its success. In the first place, there are three basic
requirements that a project must satisfy: schedule, budget, and quality. The need to work
within these essential project boundaries poses a huge challenge to everyone in the
central management team.
Estimating: Part 3
In this last article of the series, I'll cover a potpourri of other estimating topics including
the key outcome of estimating, converting effort estimates into budgets, dealing with
poorly defined work, and what to do when management thinks it should cost less or take
Estimating: Part 2
This is the second of three articles on estimating. It may seem obvious, but the first
requirement for developing an estimate is to know what you are estimating. For now, let's
assume that you have been asked to estimate how much effort (how much of your time) is
likely to be required to paint your bedroom. Although this is a fairly small activity, it is
still one with a significant amount of uncertainty.
Effort Estimating: A Primer
Estimating is a forbidding topic for some. I've even heard intelligent, experienced project
managers assert that it is "impossible" to estimate the work on their project. I think that
these people just don't understand estimating. I think that these people may be confusing
estimating (making informed assessments of uncertain events) with extra sensory
perception (making exact predictions of uncertain events). Or in some cases, they may be
trying to prepare budgets or prices in the absence of estimates.
5 Ways to Finesse Budget Discussions for New Client
Do you have difficulty engaging in budget discussions for new projects, particularly
during initial client meetings when it can be tempting to make promises that will be
challenging to carry out? If so, you're not alone! This article explores five ways to help
you gracefully avoid backing yourself into a corner.
Make or Break: Why Accurate Cost Estimation Is Key
The accuracy of your cost estimation process can make or break project success. Learn
the strategies that will help you gain control of this key area and ensure future project
profitability! One of the greatest challenges for a project leader is to successfully deliver
on all aspects of a project both according to the client's specifications and within the
3 Main Benefits of Project Baselining
When you have finished planning your project, and you have all the scheduled dates,
hours, and costs (and charges if applicable) agreed, why is it a good idea to store those
values? We explore the reasons.
Project Cost Management
How do we know what a project will cost? We really don't, until the project is complete. I
sound more like a car mechanic than a project manager, but the truth is, and this may
sting just a little, we can't know the final project cost until the project is complete because
we can't accurately predict the future. What we can do is create an estimate.
12 Tips for Accurate Project Estimating
Projects typically involve many dynamic aspects, yet they're often constrained by finite
conditions. These contradictory forces make it very difficult to determine with pinpoint
accuracy the time and effort required. By using a set of proactive estimating techniques to
scope, plan, and constrain your project conditions, you can dramatically improve your
estimating practices, reduce and mitigate risks, and increase your project success rate.
Estimating Project Costs
Estimating is the process of forecasting a future result in terms of cost, based upon
information available at the time. Many techniques, books and software packages exist to
help with estimating project costs. A few basic rules will also help ensure that an accurate
and realistic estimate is produced.
Monte Carlo Simulation in MS Excel
The Monte Carlo method is based on the generation of multiple trials to determine the
expected value of a random variable. There are a number of commercial packages that
run Monte Carlo simulation; however a basic spreadsheet program (such as Microsoft
Excel) can be used to run a simulation.
Forecasting Support Costs
Did you know that maintenance accounts for 50% to 80% of the overall product cost?
Well, it does! And while most project managers are fairly good at sizing new product
features, many are terrible at estimating the effort required to support a product once it
becomes generally available. As a result, maintenance projects are inadequately staffed,
companies can't respond to customer requests in a timely manner, and products never
Cost Benefit Analysis
The cost benefit analysis is based on the comparison of a base case and one or more
alternatives. For each case all the cash flows over a period of time are identified and
organised into a spreadsheet. The bottom line is the net cash flow after tax. This series of
cash flows can be converted to a present value (NPV) by using an appropriate discount