MODULE 1

Understanding Management Information

This module covers the following learning

objectives:

1. Appreciate the importance of financial and

non-financial information for planning,
control and decision-making purposes.
2. Recognize the variety of cost units, cost
centers and profit centers.
3 Differentiate between direct and indirect
costs; fixed and variable costs; period and
product costs; controllable and
uncontrollable costs; avoidable and
unavoidable costs; etc.
4. Identify cost classification for decision-
making and planning.
5. Appreciate cost behavior patterns including
linear, curvy-linear and step functions.
6. Appreciate the importance of unit costs for
both financial and management decision
making.
2 Understanding Management Information Module 1

1.0 COST ACCOUNTING IN MANAGEMENT INFORMATION

ENVIRONMENT
1.1 The business of accounting is information. The business of cost and
management accounting is to provide information for management. And the
business of cost accounting is to provide accurate and timely information about
the cost incurred in producing goods and services.
1.2 Information is a processed data useful in making decisions. Data should be
captured, processed and reported as information to be useful in making
decisions.
1.3 Just like any resource in an organization, data should be managed. Data
management depends on the vision, mission, strategy and structure of an
enterprise. Strategy defines the unique model applied by an enterprise to beat
competition, optimize stakeholders' value, and survive in the business place.
1.4 Structure follows strategy. Structure is the internal and controlled environment by
which the enterprise desires to carry on its strategy. It defines the manner on
how resources are allocated, on how people are grouped, and on how
performances are evaluated. It shows the segments of an organization for
people membership (or grouping), motivation, monitoring, and movements.
Organizational structures vary from an enterprise to another due to the effects of
external and internal business factors. External business factors include the
potential level of buyers in the market, government regulations and laws, sources
of supply, changes in technology, competition, and important social
demographics. Internal business factors include the enterprise vision, mission,
objectives, level of management skills and preparation, process efficiency and
productivity, and organizational culture.
1.5 In each organizational segment, a manager is held in-charge. He is given the
appropriate amount and value of authority to lead his men, produce results, and
be evaluated in the process. It is in this act of performing his duty that a
manager needs information. In simplistic terms, managers may be classified as
those belonging in the top management, middle management, and supervisory
management. Top management needs information for its strategic decisions.
Middle management needs information in planning and controlling tactical
decisions. Operational (i.e., supervisory) management needs information to
execute strategic and tactical policies, monitor performance, and keep on tab
with the daily operational results. Information requirements depend on the
manager needing the information.

2.0 OBJECTIVES OF MANAGEMENT ACCOUNTING INFORMATION

2.1 Cost and management accounting supplies the information needs of
management. This information should be more detailed, forward-looking, and
presented and analyzed differently to suit the unique informational needs of

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Module 1 Understanding Management Information 3

management. To meet these requirements, management accounting information

should have the following purposes:

2.1.1 Profit measurement

Business performance should be measured. In the short-run, business
performance is normally expressed in terms of profitability.

2.1.2 Guide for planning

Managers plan to ensure that organizational resources and systems fit
with what is needed in the future to deliver profitability and sustained
growth.

2.1.3 Standards for controlling

Actions are to be made in accordance with the plan. Errors should be
prevented from the very start. Deviations or planning gap that are
encountered while things are put into action should be immediately
remedied or corrected to execute plans as intended.

2.1.4 Basis for decision making

The primary tool of management in getting its job done is decision
making. A decision that is based on inadequate information may lead to
inferior or even damaging results. A rational decision based on quality
information would mostly likely lead to increased shareholders' value.

3.0 ATTRIBUTES AND PRINCIPLES OF COST AND MANAGEMENT

ACCOUNTING INFORMATION
3.1 With its indispensable usefulness in the process of arriving at a rational business
decision, relevant management accounting information should have the following
attributes:

3.1.1 Completeness
A manager should be informed of all the available information on hand to
avoid unnecessary errors which may lead to increase in costs or
damaged reputation. A collection manager may have erroneously sent a
strongly worded demand letter to a customer without being informed of
the existence of a special credit term agreement with such customer.

3.1.2 Accuracy
Information should be accurate enough for its purpose and there is no
need to go into unnecessary detail for pointless accuracy.

Clerks need to account for the balances up to the last centavo. Middle
managers may round their information to the nearest thousand and still

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4 Understanding Management Information Module 1

treat the information as equally useful. Senior mangers may want figures
reported to them rounded to the nearest hundredths, thousandths, or
even in millions.

3.1.3 Clarity
Lack of clarity, or "noise" in information system theory, is a cause of
miscommunication or breakdown in communication. The choice of the
right channel of communication, of presentation medium would be of
utmost importance in the information business.

3.1.4 Confidence
Users should have confidence on the information provided to them. One
ingredient of developing confidence on the information is the existence of
an error-free information processing systems involving past events.
Strategic information, such as long-term forecasts, involves a lot of
uncertainty as to timing and amount because of the time span involved.
Confidence on strategic forecasts may increase by clearly stating the
underlying assumptions used in arriving at the forecasts.

3.1.5 Communication
Sending right information to the wrong person may make the information
useless, even how potent and powerful such information if correctly sent
to the right person.

Managers should be given the right information at the right time to act
precisely for better and expected results.

3.1.6 Volume
Precise and concise information do not only lessen the cost of absorbing
the right message of the information but could also immediately direct
users to the occurrence of exceptional cases where actions are needed
right away.

3.1.7 Timing
The frequency of giving information depends on the need of the manager
using it. Information that arrives after the decision is already made may
find no usefulness but only to the limits of comparative analysis and long-
term control. Information that is prepared too frequently may be too
expensive to outweigh its benefits.

3.1.8 Channel of communication

Written communication is not always the best channel of sending
information. It may be effectively channeled through email, telephone
conversations, work-of-mouth, face-to-face talk, formal talk, or informal
talk.

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Module 1 Understanding Management Information 5

3.9.2 Written communication could be done through inter-office memorandum,

publication in an in-house journal, professional and other magazines,
local or national newspapers, or other posting centers.

3.1.9 Cost
The information should be cost effective, where the benefits derived from
that information exceeds the costs used in getting and processing it.

3.2 Other attributes of cost and management accounting information

Other attributes of a good management accounting information are as

follows:

• It may be quantitative or qualitative

The focus of business is still the maximization of shareholders' value.
This could easily assessed by reporting financial information as an easy
and understandable way of communicating with the shareholders and
other stakeholders in business. Although monetary information has been
regarded as the lingua franca in business, more managers are now
asking the non-monetary details of information affecting those presented
in the financial reports. In wages, for example, they are now looking for
the number of labor hours used in relation to the wages paid. In
materials, managers would now like to know the number of kilograms or
units used in materials.

They are interested in productivity ratios, efficiency cycles, number of

repeat orders, frequency of customer returns, and, even non-quantitative
effects of business decisions such as those relating to environmental
issues and displacement of communities.

• It should be free from bias

Bias may be manifested in different forms and stages. A report may
indicate that the profit margin of a division is 12% in 2008 without
showing or mentioning that the same division reported a profit margin of
120% last year. Comparative and relative data should be reported to
maintain the integrity of the information. In other cases, the
independence of the data heightens its neutrality and objectivity and
therefore should be maintained to avoid bias.

• It is generally forward looking

Management accounting information should have predictive value. It
must be forward looking to relate with the decisions to be made.
Managers cannot change the past anymore, and so they do not decide
for the past but rather to get involved in the future.

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• It should have the inherent attributes of an accounting process.

Management accounting information should be useful for recordkeeping,
attention directing and problem solving.

4.0 MANAGEMENT ACCOUNTING INFORMATION WITHIN THE

MANAGEMENT ACCOUNTING SYSTEM
4.1 In recent years the systems that comprise the field of business information have
been strategically coordinated and linked. The popularity of the cost accounting
information systems powered by the amazing advances in technology has made
information processing more precise and timely. The traditional accounting
information systems have been absorbed and made one of the components of
the management information system due to a greater managerial craving for
information. Despite the redefinition of information systems, the central
importance of financial data in the planning exercise is indelible. This makes
management accounting information still an important input in managing the
affairs of an enterprise.

4.2 The stability of the demand for useful financial information would make the
business of management accounting relevant in the intermediate years.
However, the continuing massive developments in information technology would
incessantly bring great impacts on the meaning and delivery of management
accounting services. Some of these are already worth mentioning and are
discussed below.

4.3 Open and closed systems

4.3.1 A system connects things up to do something. Management accounting

is a subsystem of a bigger enterprise system, which is also a subsystem
of a much bigger social system. The enterprise could either choose to
isolate itself from the influences of its external relations (eg, closed
system) or be an active factor on the ongoing changes in a bigger
environment (eg, open system).

4.3.2 Management accounting is a system in an enterprise. An enterprise is a

member of a social organization. As such, it deals with external parties
like suppliers, customers, government regulators, investors, analysts,
and internal parties like employees and associations. It receives input
from various sources and gives output as well.

4.3.3 The dynamism of the social world cannot be overemphasized. The

enterprise cannot escape the influences of the social environment.

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Module 1 Understanding Management Information 7

Inversely, it may also opt to influence its environment to impress its

values and processes, and stay relevant.

4.4 Contingent factors

4.4.1 A contingent factor is one whose existence or application may not
happen depending on the existence of another event. Such event may
relate to business environment, technology, or organizational structure.

4.4.2 The dynamism of the business environment creates the factors of

contingency in managing business organizations. If the business
operates in a highly competitive market where there is a high degree of
uncertainty and intense price competition, it has to control costs very
closely. If the strategy is on product differentiation, it has to emphasize
its information systems on quality processes. If the business strategy is
to introduce new products continuously, it has to meet the sophistication
of a credible forecasting capability.

4.4.3 Technology is an independent factor affecting the business place. The

application of advanced manufacturing technology, for example, has
redefined the accounting processes and the quality of its information.

4.4.4 Organizational structure defines the manner in which the strategy of the
business is executed. It determines the grouping of people who are
tasked to accomplish an assigned organizational job in an enterprise.
Essentially, the organizational design and the distribution of people in an
organization are social activities. It creates the environment of the
different relationships that can exist between the various parts of the
organization and the people within them. As the structure changes, the
motivational environment changes as well which may have direct impact
on the productivity of men and efficiency of using materials and
machines.

4.5 Human behavior and cost accounting

4.5.1 The management accounting system involves people. They receive data
and provide information. People do not necessarily respond the same
way on the same information they receive. They have different ways of
handling data and give various meanings to the data simply because
they are people. People do not necessary send information they ought
to send. All of these may result to misinformation and
miscommunication.

4.6 Information and responsibility accounting

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8 Understanding Management Information Module 1

4.6.1 A responsibility center is a segment of an enterprise headed by a

manager who is responsible for its performance. Responsibility
accounting identifies the investment, revenues, and expenses assigned
and controlled by a manager in a segment to monitor and assess the
performance of each part of an organization.

4.6.2 If a manager is to be held answerable (ie, accountable) on the

performance of the segment, then he should be given the right
information to make decisions accordingly.

4.6.3 The content of the information should be correlated with the level of
details and frequency of report to be provided within the overriding
principle of cost-benefit analysis.

4.7 Emerging needs for cost and management accounting

4.7.1 Strategic management accounting has been emerging as the new and
vibrant field of management accounting.

4.7.2 Strategic management accounting (SMA) considers external and

internal influences in its information systems, as well as financial and
non-financial data, in order to arrive at the most meaningful basis of
decisions. It also emphasizes future orientation and goal congruence.

4.7.3 The SMA should be able to provide information with respect to variety of
informational needs such as product profitability, customer profitability,
pricing decisions, the value of market share, capacity expansion, brand
values, competitor's costs, financial effect of competitor's responses,
shareholders' wealth, cash flows, effects of acquisitions and mergers,
introduction of new technology, and decisions to leave or enter a
business, among others.

4.7.4 This emerging needs for management accounting has been propelled by
the continuing changes in management philosophy, processes, and
techniques. Total quality management, activity-based management,
balanced scorecard, continuous improvement, product life-cycle costing
and analysis, learning curve analysis, enterprise resources planning,
materials resources planning, computer-aided manufacturing, flexible
manufacturing systems, value chain analysis, and many more have to be
totally considered in redefining the meaning and usefulness of
management accounting. These topics are discussed more extensively
in chapters 11 and 12.

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5.0 UNIT COSTS, COST CENTERS, AND PROFIT CENTERS

5.1 Costs should be controlled within the entire organization. Costs should be
accumulated in each organizational segment (i.e. per department, per
geographical area, per product, per division, and other segment classification)
9
5.2 Costs per organizational segment should be accurately identified for standard-
setting, planning, controlling, reporting, and performance evaluation. These
organizational segments are called as responsibility centers.

5.3 For evaluation purposes, responsibility centers may be classified as:

a. cost centers
b. revenue centers
c. profit centers
d. investment centers.

5.4 Costs centers are those that are managed by a person who has the authority to
control costs only. Examples are maintenance department, information
technology department, accounting department, and similar departments.

5.5 Revenue centers are those that are managed by a person who has the authority
to control the generation of revenues. An example is product A sales
department.

5.6 Profit centers are those that are managed by a person who has the authority to
control the generation of profit and the incurrence of costs. Examples are
product A manager, regional manager, and the like.

5.7 Investment centers are those that are managed by a person who has the
authority to control costs, generate revenues, and control the entire wealth
generation of an investment particularly entrusted to hum by the corporation.

6.0 Cost Concepts

6.1 To reduce costs, we have to understand them. We have to know their nature
and behavior to control them. Following is a discussion of the various concepts
of costs.

6.2 Cost of sales, operating expenses, and losses

6.2.1 Traditionally, we look at costs according to their functional classifications,

according to the place and purpose of their use. Costs of goods
manufactured are those incurred in acquiring or producing goods and
resources. Examples are direct materials, direct labor and factory
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10 Understanding Management Information Module 1
overhead. Costs of goods sold are those production costs related to the
units sold. Expenses are those incurred in selling goods, distributing

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Module 1 Understanding Management Information 11

goods and managing a business. Examples are selling expenses and

administrative expenses. Both costs and expenses give benefits to the
business. These characteristics technically segregate costs and
expenses from losses. Losses do not give any benefit to the business.
Examples of losses are: loss on sales of equipment, loss on inventory
obsolescence, loss on shortages, spoilage, and loss on uncollectibles.

6.3 Relevant and irrelevant costs

6.3.1. Costs that are useful in making decisions are relevant costs. Those that
are not useful are irrelevant. Relevant costs have two characteristics.
They differ from one alternative to another (i.e., differential costs) and
they deal about the future (i.e., future costs).

6.3.2 Managers have at least two alternatives when making a decision,

otherwise there is no decision to be made because there is no other
choice. When a cost differs from one alternative (or option) to another,
that cost is a differential cost. When a cost remains the same regardless
of a choice to be made, that cost is irrelevant, it does not differ from one
alternative to another. Let us say, you are deciding on whether to make
or buy a part of a product. If you buy, you pay the purchase price; if you
make, you do not pay the purchase price. The purchase price is a
differential cost and is therefore a relevant cost in this particular decision.
Let us say further that if we make the part, we have to pay the plant
manager a monthly salary of P100,000, while if we buy the part we still
have to pay the plant manager his salary. The plant manager's salary
does not differ, and is therefore, an irrelevant cost in the decision of
making or buying a part.

6.3.3 Relevant costs are not only differential costs. They are future costs.
Those costs that are not incurred in the future are irrelevant. Past costs,
sunk costs, historical costs are irrelevant costs in making a decision
because they can no longer be changed. Remember, management deals
about the future not the past. The future could be influenced or directed,
while the past cannot.

6.4 Controllable and non-controllable costs

6.4.1 Another way of classifying costs relates to the degree of authority given
to a manager. Controllable costs are those which incurrence or non-
incurrence, can be influenced or decided upon by a manager. The
influence or decision-making power of a manager depends on the scope,
nature, and extent of authority granted to him by the organization. The
concept of controllability is related to the organizational structure of an
organization. The organizational structure reflects the manner on how

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 12 Understanding Management Information Module 1

the business strategy is to be undertaken. Structures vary from

organization to another. Below is an example of a traditional
organizational chart:

6.4.2 Workers 1, 2 and 3 are controlled by managers, highlighted in the

presented structure. They are controlled by the Manager 2, Vice-
President 2, and eventually, the Chief Executive Officer. Workers 1, 2,
and 3 are not controlled by Manager 1, Manager 3, and Vice-Presidents
1 and 3.

6.5 Direct product costs and indirect product costs

6.5.1 Direct product costs are those that are directly identified with finished
goods or services or those that are directly attributable in the process of
making goods or services (i.e., converting materials into finished goods).
There are only three costs of production: direct materials, direct labor,
and factory overhead. Direct materials and direct labor are direct
product costs. Factory overhead is an indirect product cost.

6.6 Direct departmental costs and indirect departmental costs

6.6.1 Direct departmental costs are those that are directly identified with the
department, process, segment, or activity. They may be variable or fixed
costs.

6.6.2 Indirect departmental costs are those that are not directly identified with
a department. They are sometimes referred to as “allocated costs”,
“common costs”, or plainly “unavoidable costs”. The litmus test on
whether a cost is direct or indirect to a department is when the
department ceases its operations, direct department costs are
eliminated, while indirect departmental costs are continuously incurred.

6.6.3 Examples of direct departmental costs are salaries of a department

manager, salaries of personnel assigned to the department, supplies
purchased and used, rental of equipment directly used in departmental
activities, utilities (e.g., electricity and water) which are directly identified
with a department, telecommunications, indirect materials, indirect labor,
and depreciation of equipment used in the department. Examples of
indirect departmental costs (or allocated costs) are salaries of executives
in the central office, other central administrative costs such as
advertising, systems review and development, interest expenses,
training, research and development, real estate property taxes, and
allocated depreciation of non-current assets.

6.7 Opportunity costs and imputed costs

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6.7.1 Opportunity costs are those benefits foregone or sacrificed from one
alternative in favor of another alternative. In every decision, there is
always an alternative (or choice) not followed but could be followed to
give benefits to the organization. The benefits given up in favor of
another choice is opportunity costs. Say, a business is deciding whether
to invest in Project X (with 15% return on investment) or Project Y (with
20% return on investment). Either way there is an opportunity cost. If
the business has decided to invest in project X, its opportunity costs is
the 20% benefit from investing in project Y. If the business decides to
invest in project Y, its opportunity cost is the 15% benefit from investing
in project X.

6.7.2 Imputed costs are those costs not incurred but are implied in a given
decision. Say, a business uses its own cash in buying equipment. If the
business borrows from a bank to buy the equipment, it should pay an
interest rate of 15% per annum. The imputed rate of using its own
money instead of borrowing is, clearly, equivalent to the amount of the
15% interest rate that should have been paid had the money been
borrowed.

6.7.3 Opportunity costs and imputed costs are not recorded in the financial
accounting record because they are not actually incurred, they are only
theoretical. Though, they are relevant in making a decision.

6.8 Out-of-pocket costs and non-cash costs

6.8.1 Out-of-pocket costs (OPCs) are those that are incurred and are paid in
cash. OPCs require cash payments. All costs that are paid in cash are
out-of-pocket costs. Those that are not paid in cash are non-cash costs.

6.9 Sunk costs and future costs

6.9.1 Sunk costs are those that have been incurred in the past and can no
longer be changed. They represent commitments made by the business
in the past and are to be continued in the future. They are constant and
not differential. They are historical and irrelevant.

6.9.2 Future costs are to be incurred in the coming periods. They are relevant
and are of value in making decisions. They affect the future where the
manager should plan, organize, direct and control. They are sometimes
called planned costs, budgeted costs, or estimated costs.

6.10 Incremental costs and marginal costs

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6.10.1 Incremental costs represent a total increase in costs. Marginal cost is an

increase in cost per unit. Decremental costs are decreases in costs.

6.11 Fixed costs and variable costs

6.11.1 The classification of costs as to fix or variable refers to their behavior as

they relate to the changes in the level of production and sales. In this
analysis, it assumed that production and sales are equal.

6.11.2 Fixed costs are those that remain constant regardless of the change in
the level of production and sales, but changes on a per unit basis.
Variable costs change in total in direct proportion to changes in the level
of production and sales but is constant on a per unit basis.

6.11.3 Fixed costs could either be committed or discretionary.

Committed fixed costs are those which incurrence has been committed
by the business in the past by reason of contract, acquisition, or
agreement. Examples are rental expense, interest expense, insurance
expense, executive salaries, depreciation expense, patent amortization,
real estate, property taxes and salaries of production executives.
Discretionary (or engineered) fixed costs are those which incurrence
is assured but the amount may change depending on the discretion or
value judgment of the manager. Examples are advertising expense,
research and development costs, executive training costs, salaries of
security guards and janitors, and repairs and maintenance of buildings
and grounds. For academic purposes, all fixed costs, whether
committed or discretionary, should be treated as constant in total but
changes per unit.

Variable costs vary directly in proportion to the change in the level of

production and sales hence, total variable costs change. That is, if sales
increase by 10%, total variable costs also change by 10%. If sales
decrease by 12%, total variable costs also decrease by 12%. Notice, that
there is a direct (or complete) proportion in the changes of variable costs
and sales. Examples of variable costs are direct materials, direct labor,
and variable overhead and variable expenses. Examples of variable
overhead are factory supplies, indirect materials, indirect labor, and
repairs. Examples of variable expenses are delivery expense,
salesmen's commissions, packaging costs, and supplies.

6.11.4 Fixed costs and variable costs are normally expressed in their constant
terms. Hence, fixed costs are normally expressed in total, and variable
costs are expressed on a per unit basis.

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7.0 COSTS SENSITIVITY

7.1 Let us study deeper the behavior of costs in relation to the changes in the level of
production and sales. Say,

Total fixed costs

P 200,000.00
Unit variable costs
20.00

7.2 What will happen to fixed costs and variable costs, per total and per unit, if
production levels are zero, 5,000 units, 10,000 units, and 15,000 units.

7.3 The costs sensitivity matrix is presented below:

7.4. The behavior of costs in relation to changes in the level of production and sales
are as graphically presented on the slide.

7.5 Please observe that the behavior of total cost is linear. That is, it depicts a
straight line. Of special interest is the behavior of unit fixed costs where it
decreases as production increases, and increases as production decreases. It
explains why fixed costs are related to volume. Unit variable cost is, however,
constant, regardless of volume levels, therefore independent of volume. Variable
costs are directly affected by its rate. The summary of costs behavior may be
expressed as follows:

- done -

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EXERCISES

1. Cost accounting information. Present several examples of managerial

accounting information that could help a manager make each of the following
decisions:
A. A manufacturing company is currently making a part that is a production
headache. The firm is deciding whether to abandon production and buy the
part from an outside supplier.
B. An operator of fast-food restaurants is deciding whether to open a new store
in Dallas.

Answer:
Note: Many correct answers are possible.

A. The cost of each alternative (make vs. buy) would be needed along with
information about suppliers that pertains to reliability and product quality
(e.g., testimonials from a supplier's current customers that cite any problems
with on-time deliveries, product stockouts, or abnormally high spoilage rates
of purchased goods). Given the company is currently making the part, what
would happen to the facilities if the firm begins to purchase from outside
suppliers? Could the facilities be subleased, used for other profitable
products, or downsized (with equipment being sold)? What would happen to
existing employees—would there be any layoffs and how much would the
company save?

B. The manager needs information about construction or leasing costs along

with figures that focus on subsequent operating costs. Also, projected sales,
market share figures, and data about competitors would be helpful.

2. Cost Centers vs. Profit Centers: Analysis of Operations, Manager Behavior

\/Wireless, Inc., provides a variety of telecommunications services to residential

and commercial customers from its massive campus-like headquarters in
suburban Orlando. For a number of years, the firm's maintenance group has
been org anized as a cost center, rendering services free of charge to the
company's user departments (sales, billing, accounting, marketing, research, and
so forth).

Requests for maintenance have grown considerably, and demand is approaching

the point where quality and timeliness of services provided is becoming an issue.
As a result, management is studying whether the maintenance operation should
be converted from a cost center to a profit center, with users to be billed for
services performed.

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Module 1 Understanding Management Information 17

Required:
A. Differentiate between a cost center and a profit center. How is each of these
centers evaluated?
B. What will likely happen to the number of user service requests if the
company makes the switch to a profit-center form of organization? Why?
C. Assume that a user department has requested a particular service, one that
is time consuming and costly to perform. The maintenance group's actual
cost incurred in providing this service is P17, 800, and the user has agreed to
pay P20, 800 if the switch to a profit center is made. If this case is fairly
typical within the firm, which of the two forms of organization (cost center or
profit center) will result in a more responsive, service-oriented maintenance
group for \/Wireless? Why?

Answer:
A. Cost centers and profit centers are different types of responsibility units
within an organization. \/Vith a cost center, a manager is held accountable for
the amount of cost incurred; in contrast, with a profit center, managers are
evaluated on the amount of profit generated, namely, revenues minus
expenses.

B. The number of service requests is likely to drop because users will now be
charged for services provided. In cases where services are free, users
sometimes use and abuse the privilege.

C. The profit center form of organization will probably result in a more service-
oriented maintenance group. The profit-center manager would be willing to
perform services as long as capacity is available and revenues exceed
expenses. Naturally, the added profit is viewed favorably, and the quality of
services may actually increase. On the other hand, if organized as a cost
center, providing additional service will likely result in higher costs, which
could be viewed unfavorably in performance evaluations.

3. Definition of Cost Terms

Briefly define and discuss the terms in each of the pairs that follow.
A. Direct and indirect costs
B. Direct materials and indirect materials
C. Manufacturing overhead and direct labor

Answer:
A. Direct costs are logically and practically related (i.e., easily traceable) to a
particular cost object. An indirect cost, on the other hand, is not. Whether a
cost is direct or indirect depends on the cost object under consideration. A
cost may be easily traceable to a company, for example, but not easily traced
to a department of that firm.

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B. Direct materials form an integral part of the finished product and, at the same
time, are easily traced to that product. Indirect materials, which are part of
manufacturing overhead, generally do not meet these guidelines. Note,
though, that some indirect material may be easily traced to the product (e.g.,
five squirts of wood glue in a piece of furniture) but it may be too costly to do
so.

C. Manufacturing overhead consists of indirect materials, indirect labor, plant

depreciation, factory utilities, and other factory-related costs. This cost
component reflects all manufacturing costs other than direct materials and
direct labor. Direct labor, in contrast, consists of wages of those employees
who work directly on the goods in production (machine operators, assembly-
line workers, and so forth).

4. Eastside Manufacturing produces small electric engines. Identify the following

costs as direct materials (DM), direct labor (DL), manufacturing overhead (MOH),
or a period cost (PC). Also indicate whether the cost is variable (V} or fixed (F)
with respect to behavior.

A. Commissions paid to salespeople

B. Straight-line depreciation on the factory building
C. Salary of the plant supervisor
D. Wages of the assembly-line workers
E. Machine lubricant used in production activities
F. Engine casings used in production activities
G. Advertising placed in trade journals
H. Lease payments for the president's automobile
I. Property taxes paid on the factory facilities

Answer:
A. PC, V
B. MOH, F
C. MOH, F
D. DL, V
E. MOH, V
F. DM, V
G. PC, F
H. PC, F
I. MOH, F

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Module 1 Understanding Management Information 19

5. Identification of Product Costs and Period Costs, Cost Behavior

Consider the following items:

A. Tomatoes used in the manufacture of Heinz ketchup

B. Administrative salaries of executives employed by Southwest Airlines
C. Wages of assembly-line workers at a Ford plant
D. Marketing expenditures of the Los Angeles Dodgers baseball club
E. Commissions paid to Coca-Cola's salespeople
F. Straight-line depreciation on manufacturing equipment owned by Dell
Computer
G. Shipping charges incurred by Office Depot on out-going orders
H. Speakers used in Sony home-theater systems
I. Insurance costs related to a Mary Kay Cosmetics' manufacturing plant

Required:
Complete the table that follows and classify each of the costs listed as (1) a
product or period cost and (2) a variable or fixed cost by placing an "X" in the
appropriate column.

Product or Period Cost Variable or Fixed Cost

Item Product Period Variable Fixed
A
B
C
D
E
F
G
H

Answer:
Product or Period Cost Variable or Fixed Cost
Item Product Period Variable Fixed
A X X
B X
C X
D X X
E X X
F X
G X
H X X
I X X

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 20 Understanding Management Information Module 1

6. KC Manufacturing, which began operations on January 1 of the current year,

produces an industrial scraper that sells for P325 per unit. Information related to
the current year's activities follows.

Number of scrapers produced

20,000
Number of scrapers sold
17,000
Variable costs per unit:
Direct materials
P25
Direct labor
35
Manufacturing overhead 60
Annual fixed costs:
Manufacturing overhead P400,000
Selling and administrative 140,000

KC carries its finished-goods inventory at the average unit cost of production.

There was no work in process at year-end.

Required:
A. Compute the company's average unit cost of production.
B. Determine the cost of the December 31 finished-goods inventory.
C. Compute the company's cost of goods sold.
D. If next year's production increases to 23,000 units and general cost behavior
patterns do not change, what is the likely effect on:
1. The direct-labor cost of P35 per unit? Why?
2. The fixed manufacturing overhead cost of P400,000? Why?

Answer:
A. Fixed manufacturing overhead per unit:
P400,000 + 20,000 scrapers produced = P20

Average unit manufacturing cost:

Direct materials
P 25
Direct labor
35
Variable manufacturing overhead
60
Fixed manufacturing overhead
20
Average unit cost
P140

B. Production (units) 20,000

Sales (units) 17,000
Ending finished-goods inventory (units) 3,000 3,000
units x P140 = P420,000

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Module 1 Understanding Management Information 21

C. Finished goods, Jan. 1 P ---

Add: Cost of goods manufactured (20,000 units x P140) 2,800,000
Cost of goods available for sale P2,800,000
Deduct: Finished goods, Dec. 31 420,000
Cost of goods sold P2 380 000

D. 1
No change. Direct labor is a variable cost, and the cost per unit will
remain constant.
2
No change. Despite the increase in the number of units produced, this
is a fixed cost, which remains the same in total.

7. The following information relates to the Rounin Manufacturing Company.

Direct materials P 50,000
Indirect materials 10,000
Direct labor 60,000
Indirect labor 9,000
Factory overhead (excluding indirect and indirect labor) 25,000

Required: Compute the prime costs, conversion costs, and product cost.

8. The financial statements of Mother Goose Company included these items:

Marketing costs 160,000
Direct labor cost 245,000
Administrative costs 145,000
Direct materials used 185,000
Fixed factory overhead costs 155,000
Variable factory overhead costs 125,000

Compute:
1. Prime cost
2. Conversion cost
3. Total inventoriable/product cost
4. Total period cost

9. Product Costs and Period Costs, Cost Flows

Manufacturers have established a cost classification called product costs. Define

the term "product cost" and note where these costs appear in the financial
statements. Be specific.

Answer:
Product costs are costs that relate to the manufacturing process and consist of
direct materials, direct labor, and manufacturing overhead. Simply stated, these
are costs incurred to make a product.

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 22 Understanding Management Information Module 1

Product costs are attached to the units produced (i.e., work in process) and, thus,
inventoried on the balance sheet. These costs are later charged to finished
goods when the goods are completed. Another transfer occurs when the finished
units are sold, with the costs now transferred to cost of goods sold on the income
statement.

10. Behavior of Fixed and Variable Costs

In discussing the operation of his automobile, a doctor once observed that

gasoline is a fixed cost because the cost per gallon is relatively stable.
Insurance, on the other hand, is a variable cost because the cost per mile varies
inversely with the number of miles driven. Comment on the doctor's observation.

Answer:
The doctor's observations are incorrect, as gasoline is a variable cost and
insurance is a fixed cost. Gasoline cost will increase with the number of miles
driven, whereas insurance outlays will remain the same. The doctor seems to
have confused the "total" perspective, as defined by accountants, with the notion
of per-unit cost behavior.

11. Blanche Corporation estimated its unit costs of producing and selling 20,000
units per month as follows:
Direct materials used 30.00
Direct labor 20.00
Variable manufacturing overhead 15.00
Fixed manufacturing overhead 10.00
Variable marketing costs 3.00
Fixed marketing costs 4.00
Estimated unit cost 82.00

Compute:
1. Total variable costs per month.
2. Total fixed costs per month.

12. Economic Characteristics of Costs

The following terms are used to describe various economic characteristics of

costs:

Opportunity cost
Differential cost
Out-of-pocket cost
Marginal cost
Sunk cost
Average cost

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Module 1 Understanding Management Information 23

Required:
Choose one of the preceding terms to characterize each of the amounts
described below. Each term may be used only once.

A. The cost of including one extra child in a day-care center.

B. The cost of merchandise inventory purchased five years ago. The goods are
now obsolete.
C. The cost of feeding 300 children in a public school cafeteria is P450 per day,
or P1.50 per child per day. What economic term describes this P1.50 cost?
D. The management of a high-rise office building uses 3,000 square feet of
space in the building for its own administrative functions. This space could
be rented for P30,000. What economic term describes this P30,000 of lost
rental revenue?
E. The cost of building an automated assembly line in a factory is P700,000; a
manually operated assembly line would cost P250,000. What economic term
is used to describe the P450,000 variation between these two amounts?
F. Refer to the preceding question and assume that the firm is currently building
the assembly line for P700,000. What economic term is used to describe the
P700,000 construction cost?

LO: 10 Type: N

Answer:
A. Marginal cost
B. Sunk cost
C. Average cost
D. Opportunity cost
E. Differential cost
F. Out-of-pocket cost

13. Classify the following items as direct or indirect materials

1. Gold in making jewelry
2. Sandpaper — furniture making
3. Paper used in printing books
4. Milk to make ice cream
5. Water to make ice
6. Seats to be installed in a car
7. Leather to make gloves
8. Tape measure used by tailors
9. Flour used in making bread
10. Pineapple in a fruit cocktail

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 24 Understanding Management Information Module 1

14. Classify the following as either manufacturing (M), selling (S), or administrative
(A)
1. Factory supplies
2. Advertising
3. Rent on factory building
4. Freight-out
5. President's salary
6. Cost of machine breakdown
7. Legal expenses
8. Samples
9. Bad debts
10. Travel expenses of salesmen

15. Classify the following selected costs by completing the table below., (a) Variable
or fixed (b) Product or Period costs (c) Direct or indirect in relation to units of
product.
1. Wood is used in the manufacture of the tables, at a cost P 100 per table.
2. The tables are assembled by workers, at a cost of P 40 per table.
3. Workers assembling the tables are supervised by a factory supervisor
who is P 25,000 per month.
4. Electrical costs of P-20 per machine hour are incurred in the factory in
the manufacture of the tables. (4 machine hours per table)
5. The depreciation cost of the machines used in the manufacture of the
tables is P40,000 a year.
6. The salary of the president of the company is P 100,000 a month.
7. The company spends P250,000 per year to advertise its products.
8. Salespersons are paid a commission of P300 for each table sold
9. Rent paid for the factory building is P 20,000 a month.
10. Insurance premiums paid for the general office is P 15,000 a year.

(a) V or F (b) Product or Period (c) D or I

1. Wood
2. Salary — workers
3. Supervisor's salary
4. Electrical costs
5. Depreciation-machines
6. President' salary
7. Advertising expense
8. Sales commissions
9. Rent expense
10. Insurance premiums

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Module 1 Understanding Management Information 25

16. Classify each of the following costs of Bug Company in two ways: (a) as variable
/) fixed costs (F); (b) as inventoriable costs (I) or period costs (P):
(a) V or F (b) I or P
Example: Direct labor V I
1. Salary of company controller
2. Fire insurance on factory building
3. Lubricants for machines
4. Direct materials used
5. Factory rent
6. Sales commissions
7. Overtime premium of machine operators
8. Straight-line depreciation of factory equipment
9. Straight-line depreciation of trucks used for
delivery of sales to customers
10. Salary of factory supervisor

17. Responsibility Accounting: Controllability and Centers

Branson Corporation manufactures decorative, sculpted accessories that are

sold by interior decorators and home furnishing stores. The following situation
concerns two Branson employees: Deborah Philbun, head of the company's
Billing Department, and Gary Bitner, the firm's general manager.

Philbun's Billing Department makes heavy use of hourly employees and is

evaluated as a cost center. Understanding the need for prompt collection of
receivables, Philbun strives to run a first-class operation. Philbun also
understands the need to contribute in a big way to Branson's financial
performance so she continually strives to minimize Billing Department expenses.

Unfortunately, Philbun experienced a heated discussion with Bitner several

weeks ago, the subject being the shoddy operation that she is running. Bitner
complained loudly about the lack of timely billings to customers and the general
lack of attention to detail, as many complaints have surfaced about erroneous
invoices and customer statements.

Required:
A. What is meant by the term "responsibility accounting?"
B. What measure(s) of performance would companies normally use to evaluate
a cost-center manager?
C. Does Bitner have a valid reason to be upset with Philbun? Given the nature
of the Billing Department, did Deborah err in her quest to minimize
expenses? Explain.
D. Is it likely that the Billing Department could be evaluated as a profit center?
Why*

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 26 Understanding Management Information Module 1

Answer:
A. Responsibility accounting refers to the various concepts and tools that are
used within an organization to evaluate the performance of people and
various sub-units (such as divisions and departments). Managers are
appointed to oversee these sub-units and held accountable for items under
their control.

B. The manager of a cost center is typically evaluated on the amount of cost

incurred. The costs should be under the manager's control, and the service
provided by the center should be high.

C. Yes. Although Philbun understands the need to run a first-class operation

and contribute to Branson's overall financial performance, she may have
taken things a bit too far. A cost-center manager should strive to run an
operation that provides high-quality service at the lowest possible cost. This
does not necessarily mean cost minimization, which often results in the
elimination of key tasks (i.e., the "fine points") needed to achieve quality. It is
possible that the department's late billings and errors in invoices and
customer statements may have been caused by such eliminations.

D. No. A profit-center manager is evaluated on the basis of revenues generated

and costs incurred. The Billing Department does not produce any revenues
for Branson—it merely handles customer invoices and statements. Sales of
company products are likely the responsibility of a separate Sales
Department.

18. Fixing Responsibility

Consider the following situation:

The marketing manager of Gilroy, Inc., accepted a rush order for a nonstock item
from a valued customer. The manager filed the necessary paperwork with the
production department, and a production manager did the same with purchasing
for needed raw materials. Unfortunately, a purchasing clerk temporarily lost the
paperwork; by the time it was found, it was too late to order from Gilroy's regular
supplier. A new supplier was located that quoted a very attractive price.

The materials soon arrived and were found to be of poor quality, thus giving rise
to a favorable materials price variance, an unfavorable materials quantity
variance, and an unfavorable labor efficiency variance. These latter two
variances, as was the usual case, appeared on the production manager's
performance report for the period just ended.

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Module 1 Understanding Management Information 27

Required:
A. Given that the company uses a responsibility accounting system, should the
production manager be penalized for poor performance? Briefly discuss,
keeping in mind that a production manager is generally in a very good
position to control material usage and labor efficiency.
B. Should anything be done to correct the situation? If "yes," briefly explain.

Answer:
A. No. Although the variances appear on the production manager's
performance report and are often under his or her control, an adjustment is
needed in this case. The problem appears to be the fault of the purchasing
clerk who misplaced the paperwork. Another explanation may be that the
fault lies with the marketing department for accepting a rush order and
possibly putting a strain on the entire manufacturing system.

B. Yes. These variances should be discussed to determine who's to blame and

then cross-charged against that individual's department.

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