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THE GRADUATE SCHOOL OF HEALTH SCIENCE, MANAGEMENT AND PEDAGOGYSouthwestern University
Villa Aznar, Urgello St., Cebu City, 6000 Philippines
Managerial Accounting
Submitted by: J Walter T. PalacioSubmitted to: Rolito Canene
Midterm & Final Requirements
Part I. Fundamentals of Managerial Accounting and Cost
Accumulation System
We all know that basic accounting procedures involves three
main financial statements the balance sheet, income statement,
and cash flow statement. These statements are prepared for andprovided to users external to the organization such as
shareholders, bankers, and government. Accounting focused on
the external user is known as financial accounting. The term
accounting covers many different types of accounting on the
basis of the group or groups served. Accounting information
typically provided to users internal to the organization is
another type which is known as managerial accounting.
Managerial accounting serves the needs of users within the
organization, such as managers. In order to achieve
organizational objectives, the management team is responsible
for planning, directing, motivating, and controlling the
activities of the business. Managerial accounting will show
how accounting information can and should be used by management
to carry out its mandate on a more efficient and effective
basis. In many organizations, most of the accounting is
performed to generate the financial statements required by
external users. As an entity develops and grows, managers need
information to help them manage the organization. Sometimes,
this information can be obtained from the financial accounting
system. In some organizations, whole new systems are designed to
meet the needs of the managers.
Managerial accounting is defined as the process ofidentifying, measuring, analyzing, interpreting, and
communicating financial information to the manager/s for the
pursuit of an organizations goals. Managerial accounting
information includes the following:
Information on the costs of an organizations product and
service.
Budgets.
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Performance reports.
Other information which assist managers in their planning
and control activities.
Organizations, large or small have managers and that person is
responsible for making plans, resources, directing personnel,
and controlling operations. Basically, managers carry out three
major activities namely planning, directing and motivating,
controlling, and improving.
Cost is part in managerial accounting. Having a clear
perspective about it would help give a person better
understanding about the subject. A cost may be defined as the
sacrifice made, usually measured by the resources given up, to
achieve a particular purpose. Step in studying managerial
accounting is to gain an understanding of the various types of
costs incurred by organizations and how those costs are actively
managed.
Cost accumulation system or management in general is the
organized collection of cost data via a set of procedures or
systems. Cost classification is the grouping of all
manufacturing costs into various categories in order to meet the
needs of management.
A figure indicating the total cost of production provides
little useful information about a companys operations, since
the volume of production (and therefore cost) varies from period
to period. Thus, some common denominator, such as unit costs,
must be available in order to compare various volumes and costs.Unit cost figures can be readily computed by dividing the total
cost of goods manufactured by the number of units produced. Unit
costs are stated in the same terms of measurement used for units
of output, such as cost per ton, per gallon, per foot, per
assembly, and so on. This is where cost management implies.
Cost management is defined as "the establishment of programs
that regularly analyze purchase requirements and suppliers to
identify lowest total cost and maximize total value to the
company. The development of a savings forecast by commodity is
necessary to define budget parameters for building cost-of-goods
structures." When we say strategic cost management it is aboutscrutinizing every process within your organization, knocking
down departmental barriers, understanding your suppliers'
business, and helping improve their processes".
An expense is defined as the cost incurred when an asset is
used up or sold for the purpose of generating revenue. The
terms product cost and period cost are used to describe the
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timing with which various expenses are recognized, an important
issue in both managerial and financial accounting.
A product cost is a cost assigned to goods that were either
purchased or manufactured for resale. The product cost is used
to value the inventory of manufactured goods or merchandise
until the goods are sold. All costs that are not product costs
are called period costs and are recognized as expenses during
the time period as incurred.
All costs that are not product costs are called period
costs and are recognized as expenses during the time period as
incurred.
Mass customization has been defined as the ability to
design and manufacture customized products at mass production
efficiency and speed. Customization and mass customization are
often justified because different customers can give differentvalues to the same product.
Manufacturing is the use of machines, tools and labor
to produce goods for use or sale. The term may refer to a range
of human activity, from handicraft to high tech, but is most
commonly applied to industrial production, in which raw
materials are transformed into finished goods on a large scale.
Such finished goods may be used for manufacturing other, more
complex products, such as aircraft, household appliances or
automobiles, or sold to wholesalers, who in turn sell them to
retailers, who then sell them to end users the "consumers". Inmanufacturing, raw material is transformed with the help of
labor and machinery.
Manufacturing entails costs. Manufacturing cost is the
cumulative total of resources that are directly used in the
process of making various goods and products. In some formulas,
the cost of manufacturing includes the expenses associated with
the purchase of raw materials. At other times, the cost for raw
materials is excluded. In general, factors such as labor,
equipment operation, and the general overhead for maintaining
the production facility are common components that are includedin determining the overall manufacturing costs.
Since the goal of most production companies is to earn a
profit by selling goods manufactured and sold by the company,
paying close attention to the overall manufacturing
cost/manufacturing cost flow (direct materials, direct labor,
and manufacturing overhead) is extremely important. By
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monitoring the various elements that make up the cost for
manufacturing, it is possible to ensure that available resources
are being used to best advantage, and thus earning the highest
amount of return on each unit that is sold at the current price.
Multi-product firms have to account for costs that can be
tied to a product, direct costs. They also have to account for
indirect costs not directly measurable (e.g., electricity). A
'cost object' can be a product, service, process or any items
which management requires cost information. The way that costs
are assigned depends on their nature. A direct cost is easily
traceable with a high degree of accuracy and indirect, or
overhead, cost cannot be easily identifiable with a particular
object.
Product costs are costs allocated to a product; this is not
just physical products. All other costs are period costs. Such
costs are expenses to the income statement in the period theyare incurred. Product costs are recognized as an expense in the
income statement only when the product is sold. Prior to sale
the cost of products is shown as an asset (work in progress or
finished good) due to the accrual principle.
Following are the three broad elements of cost:
1. Material
The substance from which a product is made is known as
material. It may be in a raw or a manufactured state. It can bedirect as well as indirect.
a. Direct MaterialThe material which becomes an integral part of a
finished product and which can be conveniently assigned to
specific physical unit is termed as direct material. Following
are some of the examples of direct material:
o All material or components specifically purchased,produced or requisitioned from stores
o Primary packing material (e.g., carton, wrapping,cardboard, boxes etc.)
o Purchased or partly produced componentsDirect material is also described as process
material, prime cost material, production material, stores
material, constructional material etc.
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b.Indirect MaterialThe material which is used for purposes ancillary to
the business and which cannot be conveniently assigned to
specific physical units is termed as indirect material.
Consumable stores, oil and waste, printing and stationery
material etc. are some of the examples of indirect material.
Indirect material may be used in the factory, office
or the selling and distribution divisions.
2. Labor
For conversion of materials into finished goods, human
effort is needed and such human effort is called labor. Labor
can be direct as well as indirect.
a.Direct LaborThe labor which actively and directly takes part in
the production of a particular commodity is called direct labor.
Direct labor costs are, therefore, specifically and conveniently
traceable to specific products.
Direct labor can also be described as process labor,
productive labor, operating labor, etc.
b.Indirect LaborThe labor employed for the purpose of carrying out
tasks incidental to goods produced or services provided, is
indirect labor. Such labor does not alter the construction,
composition or condition of the product. It cannot be
practically traced to specific units of output. Wages of
storekeepers, foremen, timekeepers, directors fees, salaries of
salesmen etc, are examples of indirect labor costs.
Indirect labor may relate to the factory, the office
or the selling and distribution divisions.
3. Expenses
Expenses may be direct or indirect.
a.Direct Expenses
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These are the expenses that can be directly,
conveniently and wholly allocated to specific cost centers or
cost units. Examples of such expenses are as follows:
y Hire of some special machinery required for a particularcontract
y Cost of defective work incurred in connection with aparticular job or contract etc.
Direct expenses are sometimes also described as
chargeable expenses.
b.Indirect ExpensesThese are the expenses that cannot be directly,
conveniently and wholly allocated to cost centers or cost units.
Examples of such expenses are rent, lighting, insurance chargesetc.
4. Overhead
The term overhead includes indirect material, indirect
labor and indirect expenses. Thus, all indirect costs are
overheads.
A manufacturing organization can broadly be divided into
the following three divisions:
y Factory or works, where production is doney Office and administration, where routine as well as policy
matters are decided
y Selling and distribution, where products are sold andfinally dispatched to customers
Overheads may be incurred in a factory or office or
selling and distribution divisions. Thus, overheads may be of
three types:
a.Factory Overheads
They include the following things:
y Indirect material used in a factory such as lubricants,oil, consumable stores etc.
y Indirect labor such as gatekeeper, timekeeper, worksmanagers salary etc.
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y Indirect expenses such as factory rent, factory insurance,factory lighting etc.
b.Office and Administration OverheadsThey include the following things:
y Indirect materials used in an office such as printing andstationery material, brooms and dusters etc.
y Indirect labor such as salaries payable to office manager,office accountant, clerks, etc.
y Indirect expenses such as rent, insurance, lighting of theoffice.
c.Selling and Distribution OverheadsThey include the following things:
y Indirect materials used such as packingmaterial, printing and stationery material etc.
y Indirect labor such as salaries of salesmen andsales manager etc.
y Indirect expenses such as rent, insurance,advertising expenses etc.
The stages in the allocation of overheads to products are
as follows;
1) Identify overhead costs collected from production andservice cost centers and apportion as appropriate and
possible.
2) Once identified allocate to production departments.3) Allocate overheads to a single product by dividing the
number of products into the total overhead. The resulting
sum can then be applied as cost to the product.
Total Overheads of a Production Costs Centre ($s)/Level of
Activity (units)
Predetermined overhead absorption rates are estimates offuture expenditures. Estimates are used because some overhead
costs are not known for some time until after they have incurred
(e.g., electricity). Normal costing is where the cost object is
determined using the actual costs for the direct the direct
costs and a predetermined rate for the allocation of indirect
costs.
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Functional-based cost accounting classifies all costs as
either fixed or variable in relation to changes in the volume of
units produced.
Activity-based costing tries to capture changes in
technology by apportioning overheads to product costs taking
into account activity and transactions that drive the cost. An
activity cost pool is where the costs of an activity under the
ABC system are accumulated. Drives are factors that cause
changes in the use of resources. The focus in ABC is managing
activities instead of costs.
Absorption costing is where the cost of inventories is
determined in order to include an appropriate share of variable
and fixed costs. Fixed costs are allocated on the basis of
normal operating capacity. In variable costing, only the
production costs are used.
Using absorption costing, production overhead costs are
included as a product cost whereas in variable costing they are
treated as a period cost. This leads to different values of
inventory and therefore different net profit figures.
The difference in profits derived from the application of
the two methods can be reconciled by the following:
Fixed Overhead Absorption Rate x Movement of Inventories in a
period = Difference in Profits
Part II. Cost Management Systems, Activity-Based Costing, and
Activity-Based Management
Activity-based cost management is an accounting method used
by companies which allocates overhead costs for each activity
based on the specific circumstances of each activity. This is in
contrast to the common method of allocating costs based solely
on the hours spent manufacturing a product or catering to a
specific customer. The main advantage of activity-based cost
management is that it provides a truer representation of the
worth of each specific activity conducted by a business, thusreducing wasteful overhead costs. It can be a difficult process
to implement, but, used effectively, can save a company a
significant amount of money.
As a business grows, the costs of maintaining and operating
that business usually grow in kind. When these costs grow,
companies must have accounting practices in place to allocate
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the necessary funds for each specific business activity. These
activities can include either the manufacturing of a specific
product or the cultivation of a specific client. By using
activity-based cost management, a company can separate these
activities according to the actual costs incurred and their
importance in the company's operations.
For example, imagine a company that has to account for the
manufacturing of two specific products. Product A is produced at
low cost but at a high volume, meaning that a lot of hours are
spent on it. On the other hand, Product B is only rarely
produced, but it requires a great deal of technical expertise
and it costs the company a significant amount to produce a
single unit. A traditional accounting approach might allocate
more overhead to Product A based on the amount produced and the
time spent. Activity-based cost management would account for the
fact that Product B requires a much-more cost-intensive approach
and would allocate costs for it accordingly.
In the same manner, a company that serves clients in some
manner can also allocate costs accordingly based on activity-
based cost management. Imagine a law firm dealing with many
clients that pay less in retainer fees but require more man
hours of labor than a few high-paying clients that only call on
the firm in rare occasions. An activity-based approach would see
the worth of the higher-paying clients, since the man hours
spent serving them might not represent the costs associated with
that time.
Some companies shy away from activity-based cost management
because it can be a much more intricate process that simply
divvying up overhead based on the hours spent on an activity.
Several well-known international companies have benefitted from
this approach though, saving on overhead costs in the process.
Software programs devoted to activity-based allocation of costs
can make implementation the technique a bit easier.
Activity-Based Costing Sample Data:
Mode l Board Mode ll Board Mode lll BoardProduction: Units 10,000 20,000 4,000
Runs 1 run of 10,000 4 runs of 5,000 each 10 runs of 400 eachDirect Material:(raw boards and components) 50.00 90.00 20.00Direct Labor:(not including setup time) 3 hrs/board 4 hrs/board 2 hrs/boardSetup time 10 hrs/run 10 hrs/run 10 hrs/run
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Machine time 1 hr/board 1.25 hrs/board 2 hrs/board
Direct labor and setup labor costs is 20.00 per hour, including fringe benefits.
Product Cost,TVBPCS Mode l Board Mode ll Board Mode lll Board
Direct Marerial(raw boards , component) 50.00 90.00 20.00Direct Labor(not including setup time) 60.00(3hrat20) 80.00(4hrat20) 40.00(2hrat20)Manufacturing overhead 99.00(3hrat33) 132.00(4hrat33) 66.00(2hrat33)Total 209.00 302.00 126Calculation of predetermine overhead rate:
Budget manufacturing overhead 3,894,000Direct labor, budgeted hours:Made 1 10,000 units x 3 hours 30,000Mode ll 20,000 units x 4 hours 80,000
Mode lll 4,000 units x 2 hours 8,000Total direct labor hours 118,000 hrs
Activity-Based Cost Identification of Activity Cost Pools:Overhead Costs
Total budgeted cost 3,894,000
Activity Cost PoolsUnit Level Batch Level Product Sustaining Facility Level-Machinery -Setup -Engineering -Facility1,212,600 3,000 700,000 507,400
Receiving/Inspection-200,000Material handling-600,000Quality Assurance-421,000Packaging/shipping-250,000
Activity-Based Costing: Machinery Cost Pool
Stage 1 Various overhead costs Maintenance Lubricationrelated to machinery Depreciation Electricity
Computer Calibration
Activity cost pool Machinery cost poolTotal budgeted cost 1,212,600
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Stage 2Allocation to product lines Total budgetedBased on production of engineering cost = 700,000Engineering transaction
25% of 45% of 30% of
transactions transactions transactions
Cost assignment: Mode 1 Mode 2 Mode 3Cost allocated to each 25%x700,000 45%x700,000 30%x700,000Product line/number 10,000 unit 20,000units 4,000 unitsOf units of each product = 17.5 per unit = 15.75 per units =52.5 per unit
Activity-Based Costing: Facility Cost PoolStage 1Various overhead costs
Related to facilities Plant depreciation Property taxesand general operation Plant management InsurancePlant maintenance Security
Activity Cost Facility cost poolpool Total budgeted cost = 507,400
Stage 2Calculation of Total budgeted facilities cost 507,400pool rate Total budgeted direct labor hrs 118,000
= 4.30/direct-labor hr
Cost assignment: Mode 1 Mode 2 Mode 3Pool rate/direct-labor 4.30/direct-labor hr 4.30/direct-labor hr 4.30/direct-labor hrHr x Direct-labor hrs x 3 hr per unit x 4 hr per unit 2 hr per unitPer unit 12.9 per unit 17.2 per unit 8.60 per unit
Part III. Planning and Control
As business environments have become increasingly dynamic
and competitive, it has become increasingly important formanagers to develop coherent, internally and logically
consistent business strategies and to have tools and models
which provide useful information to support strategic decision-
making, planning and control. In response to these needs, there
have been many important developments, in both management
accounting research and practice that focus on the use of
accounting data and related information regarding strategy and
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operations for these purposes. Some of the most important
developments in strategic planning and control have been: (a)
the balanced scorecard, a comprehensive set of performance
measures designed to assist managers in implementing competitive
strategies and monitoring performance with respect to them (see
Kaplan and Norton 2000), (b) strategic variance/profitability
analysis, systems which decompose measures of budgeted versus
actual net income into variances which managers can relate
logically to a firm's or strategic business unit's (SBU's)
mission and business strategy and therefore use to analyze
performance from a strategic
perspective (Shank and Govindarajan 1993; Simons 2000), (c)
profit-linked performance measurement systems, models which
decompose measures of changes in profitability over time into
measures of changes in constructs such as productivity and price
recovery, which can be logically linked to a firm's/SBU's
mission and business strategy and analyzed from those
perspectives (American Productivity Center (APC; now theAmerican Productivity and Quality Center) 1981; Banker, Chang
and Majumdar 1993; Banker, Datar and Kaplan 1989; Banker and
Johnston 1989), and (d) levers of control, a comprehensive
framework for organizing and employing management control
systems to promote strategic objectives.
THE DESIGN OF STRATEGIC COST MANAGEMENT AND CONTROL SYSTEMS
If management accounting information systems are to be
useful for strategic purposes, that is, to help managers
increase the likelihood that they can achieve their strategicgoals and objectives, their designs and use must follow from
firms' missions and competitive strategies. In Porter's
framework, strategy should follow from an analysis of the
determinants of the nature and intensity of competition: the
firm's/SBU's bargaining over its consumers and suppliers,
threats from new entrants and substitute products (barriers to
entry and exit), and the intensity of rivalry in product
markets. To generate a sustainable competitive advantage, a
strategy must: (a) establish a unique market position based on
low cost leadership, product differentiation, or a workable
combination of the two, with an appropriate scope of markets(broad or focused/niche); (b) be differentiated from
competitors' strategies, through unique product variety, ability
to satisfy customer needs, and/or access to particular customer
segments; and (iii) employ chains of complementary, value-adding
activities which are difficult for competitors to replicate.
The chosen strategy, in turn: (1) determines the SBU's critical
success factors, such as delivering superior product and service
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quality and achieving high price recovery for SBUs pursuing
differentiation strategies, or achieving economies of scale,
improving productivity and delivering threshold product and
service quality at low prices for SBUs pursuing low cost
leadership strategies, and (2) informs choices regarding the
design of products and configuration of operations which drive
costs and revenues. For a set of performance measures to exhibit
content validity in a strategic context, then, it must measure
constructs related to the mission and strategic framework, the
selected strategies, the firm's/SBUs' critical success factors,
and operating choice variables.
In addition, the constructs, and their measures, must be
causally linked. Performance measurement systems should
explicitly incorporate models of profit-generating processes,
so, when managers take actions the models suggest will improve
performance along one or more dimensions, the intended
improvements are likely to materialize. Thus, the models shouldincorporate relationships over time as well as contemporaneous
relationships and linkages capturing cause-and-effect
relationships between constructs and measures of performance
throughout the firm (horizontally and vertically; aggregated to
disaggregated; across the entire value chain). Finally, the
measures should also have 'good' theoretical and empirical
measurement properties (see, for example, Johnston and Banker
2000a,b).
STRATEGIC VARIANCE ANALYSIS
Shank and Govindarajan (1993) decompose profit variances
into mutually exclusive, collectively exhaustive sets of
variances which capture the separate impacts of key underlying
causal factors, for example, deviations between actual and
budgeted sales volumes and mixes, market sizes and shares,
manufacturing costs, contribution margins, and discretionary
costs. Conceptualizing mission in terms of profitability and a
build, hold or harvest perspective and strategy in terms of low
cost leadership or product differentiation, Shank and
Govindarajan show that, by analyzing the variances with explicit
reference to a firm's/SBU's mission and business strategy, theycan determine the extent to which deviations between actual and
budgeted performance are or are not consistent with the mission
and strategy and identify specific dimensions of performance
which need improvement. Analyzing the variances without
reference to mission and strategy can be uninformative or
misleading.
Simons (2000) decomposes profit variances into
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effectiveness variances (market size, market share, selling
prices, and product volume and mix variances) and efficiency
variances (materials and labor price and efficiency,
discretionary and committed cost spending variances, and/or
activity-based cost variances). Simons points out that
effectiveness variances are of particular importance to business
units pursuing differentiation strategies and efficiency
variances to units pursuing low cost, high volume strategies.
PROFIT-LINKED PERFORMANCE MEASUREMENT SYSTEMS
Profit-linked models decompose measures of return-on-
investment and net income into measures of productivity, price
recovery, capacity utilization, and other managerially relevant
dimensions of performance. Practitioners led the development
efforts, with models which decompose measures of profitability
into measures of productivity and price recovery (APC 1981;
Miller 1984, 1987). Academics have contributed by refining andextending the models from the perspectives of management
accounting, business strategy and the economic theory of
production, showing how the models can be used to analyze cross-
sectional differences and time-series changes in performance in
the context of changing competitive environments and strategies,
and examining the measures' mathematical, economic and empirical
properties (see, for example: Banker, Chang and Majumdar 1993,
1996; Banker, Datar and Kaplan 1989; Banker and Johnston 1989;
Grifell-Tatj and Lovell 1999; Johnston and Banker 2000a,b).
COST ESTIMATIONCost estimation is the determination of cost behavior in a
way of analyzing historical data concerning costs and activity
levels.
Diagram:
Cost estimation Cost behavior Cost prediction
The process of The relationship Using knowledgedetermining between cost and of cost behavior tocost behavior. activity. Forecast the level
of Cost at a particularOften focuses on level of activity.historical data. Focus is on the
future.
Cost Behavior Patterns is also called cost functions.
y Variable Costs change in total in direct proportion to a
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change in activity level. As the activity level changes,
total variable cost increase in direct proportion to the
change in activity level but the variable cost per unit
remains constant.
yStep-Variable Costs a nearly variable cost that increasein small step instead of continuously and usually include
inputs that are purchased and used in relatively small
increment.
y Fixed Costs remain unchanged in total as the activitylevel varies. As the activity level increases, total fixed
cost does not change but unit fixed cost declines.
y Step-Fixed Costs some cost remain fixed over a wide rangeof activity but jump to a different amount for the activity
levels outside that range.
y Semi-variable Cost a mixed cost that has both a fixed anda variable component.
y Engineered Cost bears a definitive physical relationshipto the activity measure.
y Committed Cost result from an organizations ownership oruse of facilities and its basic organization structure.
y Discretionary Cost arises as a result of a managementdecision to spend a particular amount of money for some
purpose.
Using Cost Behavior Patterns to Predict Costs:
A sales forecast is made for each month during the budget year.Cost Item Cost Prediction
(15,000 dozen of items per month)Direct material 12,500Direct labor 10,000
Overhead: Facilities Costs 30,000Indirect labor 15,000Delivery trucks 6,000Utilities 2,500
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SHIFTING COST STRUCTURE IN THE CONTEMPORARY MANUFACTURING
ENVIRONMENT
Fixed costs are becoming more prevalent in many industries
due to two factors such as: Automation is replacing labor to an
increasing extent and labor unions have been increasingly
successful in negotiating agreements that result in a relatively
stable workforce. This makes management less flexible in
adjusting a firms workforce to the desired level of production.
Advanced manufacturing environment is emerging and costs
were largely variable have become fixed, most becoming committed
fixed costs.
COST BEHAVIOR IN THE INDUSTRIES:
In manufacturing firms, production quantity, direct
labor hours and machine hours are common cost drivers. Direct
material and direct labor costs are usually considered variable
costs. Other variable costs include some manufacturing over headcost such as indirect material and indirect labor. Fixed
manufacturing costs are generally the cost of creating
production capacity.
In merchandising firms, the activity base is sales
revenue. The cost of merchandise sold is a variable cost. Most
labor costs are fixed or step-fixed costs.
Cost behavior in one industry is not necessarily
transferable to another industry.
COST ESTIMATION
- is the process of determining how a particular costbehaves.
Cost Estimation Methods
y Account-Classification Method of cost is also calledaccount analysis involves a careful examination of the
organization ledger accounts.
y Visual-Fit Method - The cost is semi-variable or analysthas no clear idea about the behavior of a cost item, it is
helpful to use this method to plot recent observations of
the cost at various activity levels. Historical data forthe companys utility cost is the basis to help visualize
the relationship between cost and level of activity to be
presented in scatter diagram.
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Sample diagram:
Companys utility costs: (per dozen)
Month Utility cost/month Items sold/month
January 5,100 75,000
February 5,300 78,000
March 5,650 80,000
April 6,300 92,000
May 6,400 98,000
June 6,700 108,000
July 7,035 118,000
August 7,000 112,000
September 6,200 95,000
October 6,100 90,000
November 5,600 85,000
December 5,900 90,000
HIGH LOW METHOD
Semi-variable cost approximation is computed using exactly
two data points. Its activity levels are chosen from the
available data set. The associated cost levels are used to
compute the variable and fixed cost components as follows:
Difference between the costs correspondingVariable cost of items = to the highest and lowest activity levels
(by dozen) Difference between the highestand lowest activity levels
= 7,035 5,100 = 1,935118,000 75,000 = 43,000
= .045 per dozen
ENGINEERING METHOD OF COST ESTIMATION
-A completely different method of cost estimation is to
study the process that results in cost incurrence and called as
engineering method of cost estimation. In a manufacturing firm,
a detailed study is made of the production technology,
materials, and labor used in the manufacturing process rather
than asking what the cost of material was last period. The
engineering approach is to ask how much material should beneeded and how much it should cost.
COST-VOLUME-PROFIT ANALYSIS
Examines the behavior of total revenues, total costs, and
operating income as changes occur in the output level, selling
price, variable costs or fixed costs.
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Assumptions of CVP Analysis:
y revenues change in relation to production and salesy costs can be divided in variable and fixed categoriesy revenues and costs behave in a linear fashiony costs and prices are knowny if more than one product exists, the sales mix is constanty we can ignore the time value of money
CONTRIBUTION MARGIN
Contribution margin is equal to the difference between
total revenue and total variable costs.
Contribution margin per unit
Selling price - Variable cost per unit
Contribution margin percentage
Contribution margin per unit / selling price per unit
Total forPer Unit 2 units %
Revenue $200 $400 100%Variable costs 120 240 60%Contribution margin $80 $160 40%
CONTRIBUTION MARGIN INCOME STATEMENT
Income statement that groups line items by cost behavior to
highlight the contribution margin.
Packages Sold0 1 2 25 40
Revenue $0 $200 $400 $5,000 $8,000Variable costs 0 120 240 3,000 4,800Contribution margin 0 80 160 2,000 3,200Fixed costs 2,000 2,000 2,000 2,000 2,000Operating income $(2,000) $(1,920) $(1,840) $0 $1,200
BREAK-EVEN POINT
y Quantity of output where total revenues equal total costs.y Point where operating income equals zero.
Breakeven point in units Breakeven point in dollars=Fixed costs / Contribution margin per unit =Fixed costs / contribution margin %=$2,000 / $80 =$2,000 / 40%= 25 units = $5,000
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COST-VOLUME-PROFIT GRAPH
TARGET OPERATING INCOMEFor most firms in the private sector, the main objective is not to breakeven
Convert after-tax desired net income to its before-tax equivalent operating income
Target operating income:=Target net income / (1 - tax rate)
Target Unit Sales:= (Fixed costs + Target operating income)
/ Contribution margin per unit
Target Dollar Sales:= (Fixed costs + Target operating income)
/ Contribution margin %
SENSITIVITY ANALYSIS
y sensitivity analysis is a what-if technique that examineshow a result will change if the original predicted data are
not achieved or if an underlying assumption changes
y What will happen to operating income if volume declines by5%?
y What will happen to operating income if variable costsincrease by 10% per unit?
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y sensitivity analysis broadens managements perspectivesabout possible outcomes
CVP helps managers assess the risks and potential benefits
of adopting alternative cost structures.
Example: Alternative rental arrangements
REVENUE MIX
Revenue mix (or sales mix) is the relative combination of
quantities of products or services that make up total revenue.
Ex:
Sales mix of Do-All : Superword = 2 : 1
Breakeven point in units
= 30 units 20 units of Do-All
10 units of Superword
MULTIPLE COST DRIVERS
In many cases there may be multiple cost drivers.
Do-All Software Example
Variable costs: $40 per software package sold$15 per invoice issued
Operating income= Revenue ($40 x packages sold) ($15 x invoices issued) Fixed costs
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In cases where there are multiple cost drivers there are
multiple breakeven points.
CONTRIBUTION MARGIN & GROSS MARGIN
Merchandising Sector
Manufacturing Sector
DECISION MODELS AND UNCERTAINTY
y Managers make predictions and decisions in a world ofuncertainty.
y Estimate events that are likely to occur and assignprobabilities to each outcome.
y Probability distribution describes the likelihood of eachmutually exclusive and collectively exhaustive set of
events (must add to 1.00).
y Expected value is a weighted average of the outcomes withthe probability of each outcome serving as the weight.
Contribution Margin Format
Revenues $200Variable costs:Cost of goods sold $120Other variable 43 163Contribution margin 37Fixed costs:Cost of goods sold 5
Other fixed 19 24Operating income $13
Gross Margin FormatRevenues $200Cost of goods sold (120+5) 125Gross margin 75Operating costs (43+19) 62Operating income $13
Contribution Margin Format
Revenues $1,000Variable costs:Manufacturing $250
Non-manufacturing 270 520Contribution margin 480Fixed costs:Manufacturing 160Non-manufacturing 138 298O eratin income 182
Gross Margin Format
Revenues $1,000
Cost of goods sold (250+160) 410Gross margin 590Non-manufacturing (270+138) 408Operating income $182
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Uncertainty Example
Proposal A: Spy Novel
Expected value= (0.1x$300,000) + (.02x$350,000) + (.04x$400,000) + (0.2x$450,000) + (0.1x$500,000)= $400,000
RESPONSIBILITY ACCOUNTING
Responsibility accounting is an underlying concept of
accounting performance measurement systems. The basic idea is
that large diversified organizations are difficult, if not
impossible to manage as a single segment, thus they must be
decentralized or separated into manageable parts. These parts or
segments are referred to as responsibility centers that include:
1) revenue centers, 2) cost centers, 3) profit centers and 4)
investment centers. This approach allows responsibility to be
assigned to the segment managers that have the greatest amount
of influence over the key elements to be managed. These elementsinclude revenue for a revenue center (a segment that mainly
generates revenue with relatively little costs), costs for a
cost center (a segment that generates costs, but no revenue), a
measure of profitability for a profit center (a segment that
generates both revenue and costs) and return on investment (ROI)
for an investment center (a segment such as a division of a
company where the manager controls the acquisition and
utilization of assets, as well as revenue and costs).
Controllability Concept
An underlying concept of responsibility accounting is
referred to as controllability. Conceptually, a manager should
only be held responsible for those aspects of performance that
he or she can control. In my view, this concept is rarely, if
ever, applied successfully in practice because of the system
variation present in all systems. Attempts to apply the
controllability concept produce responsibility reports where
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each layer of management is held responsible for all subordinate
management layers as illustrated below.
Advantages and Disadvantages
Responsibility accounting has been an accepted part of
traditional accounting control systems for many years because it
provides an organization with a number of advantages. Perhaps
the most compelling argument for the responsibility accounting
approach is that it provides a way to manage an organization
that would otherwise be unmanageable. In addition, assigning
responsibility to lower level managers allows higher level
managers to pursue other activities such as long term planning
and policy making. It also provides a way to motivate lower
level managers and workers. Managers and workers in an
individualistic system tend to be motivated by measurements thatemphasize their individual performances. However, this emphasis
on the performance of individuals and individual segments
creates what some critics refer to as the "stovepipe
organization." Others have used the term "functional silos" to
describe the same idea. Consider 9-6 Exhibit below. Information
flows vertically, rather than horizontally. Individuals in the
various segments and functional areas are separated and tend to
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ignore the interdependencies within the organization. Segment
managers and individual workers within segments tend to compete
to optimize their own performance measurements rather than
working together to optimize the performance of the system.
Summary and Controversial Question
An implicit assumption of responsibility accounting is that
separating a company into responsibility centers that are
controlled in a top down manner is the way to optimize the
system. However, this separation inevitably fails to consider
many of the interdependencies within the organization. Ignoring
the interdependencies prevents teamwork and creates the need for
buffers such as additional inventory, workers, managers and
capacity. Of course, a system that prevents teamwork and creates
excess is inconsistent with the lean enterprise concepts ofjust-in-time and the theory of constraints. For this reason,
critics of traditional accounting control systems advocate
managing the system as a whole to eliminate the need for buffers
and excess. They also argue that companies need to develop
process oriented learning support systems, not financial
results, fear oriented control systems. The information system
needs to reveal the company's problems and constraints in a
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timely manner and at a disaggregated level so that empowered
users can identify how to correct problems, remove constraints
and improve the process. According to these critics, accounting
control information does not qualify in any of these categories
because it is not timely, disaggregated, or user friendly.
This harsh criticism of accounting control information leads us
to a very important controversial question. Can a company
successfully implement just-in-time and other continuous
improvement concepts while retaining a traditional
responsibility accounting control system? Although the jury is
still out on this question, a number of field research studies
indicate that accounting based controls are playing a decreasing
role in companies that adopt the lean enterprise concepts. In a
recent study involving nine companies, each company answered
this controversial question in a different way by using a
different mix of process oriented versus results oriented
learning and control information. Since each company isdifferent, a generalized answer to this question for all firms
in all situations cannot be provided.
Part IV. Using Accounting Information in Decision Making
The Managerial Accountants Role in Decision Making
Managerial Accountant
Designs and implements Cross-functional managementaccounting information teams who make production,system marketing and finance decisions
Make substantive economicdecisions affecting operations
Steps in the Decision-Making Process1.Clarify the decision problem
- The decision to be made is clear.
Accept or Reject is the decision problem
2.Specify the criterion- Once a decision problem has been clarified, the
manager should specify the criterion upon which a decision will
be made. Determining the objective of the decision
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3.Identify the alternatives- A decision involves selecting between two or more
alternatives. Determining the possible alternatives is a
critical step in the decision process
IDENTIFYING RELEVANT COSTS AND BENEFITS:
Sunk Costs are costs that have already been incurred. They
do not affect any future cost and cannot be changed by any
current or future action. Sunk costs are irrelevant to
decisions.
Example:
Book Value of Equipment that has a three year old used
to transport product from production area to storage room. The
book value of the equipment defined as the assets acquisition
cost less the accumulated depreciation to date.
Acquisition cost of older equipment-----100,000.00
Less: Accumulated depreciation----------75,000.00
Book value------------------------------25,000.00
==========
A decision to take since old equipment has one year useful life
with excessive additional variable cost. The decision is about
the replacement of the old equipment. It could be sold to 20% of
its useful life and annual cost- 80,000.
The new kind of equipment is much cheaper than the old and
cost less to operate. However, the new equipment would be
operable for only one year before it would need to be replaced.
The pertinent data of new equipment are:
Acquisition cost-----------------15,000.00
Useful life---------------------- 1 year
Salvage value after one year----- 0
Annual depreciation--------------15,000.00
Annual operating costs-----------45,000.00
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Equipment Replacement Decision: Worldwide Airways
Cost of Two Alternatives(a) (b) (c)
Do not replace Replace Differential
(Sunk Cost) old equipment old equip. costDepreciation (old) 25,000Write-off book value 25,000 0
(Relevant Data)Proceed from disposal 0 (5000) 5000Depreciation (cost) new 0 15,000 (15,000)Operating costs 80,000 45,000 35,000
Total 105,000 80,000 25,000======= ====== ========
Obsolete Inventory Decision: Worldwide Airways
Cost of Two Alternatives(a) (b) (c)
Modify and Dispose of Differential(Sunk Cost) use parts Parts cost
Asset value written off 20,000 20,000 0(Relevant Data)
Proceed from disposal 0 (17,000) 17,000Cost of modify parts 12,000 0 12,000Cost to buy new parts 0 26,000 (26,000)Total 32,000 29,000 3,000
======= ======= =======
Analysis of Special Decisions:
a. Accept or Reject a Special Offer
b. Outsource a Product or Service
c. Add or Drop a Service, Product, or Department
d. Joint Products: Sell or Process Further
Manager in all organizations periodically face major
decisions that involve cash flows over several years. Decisionsinvolving the acquisition of machinery, vehicles, buildings, or
land are examples of such decisions. Other examples include
decisions involving significant changes in a production process
or adding a major new line of products or service to the
organizations activities.
Capital-budgeting decision is a decisions involving
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cash inflows and outflows beyond the current year.
Type:
1. Acceptance-or-Rejection Decisions: managers mustdecide whether they should undertake a particular
capital investment project. In such a decision,
the required funds are available or readily
obtainable and management must decide whether the
project is worthwhile.
2. Capital-Rationing Decision: managers must decidewhich of several worthwhile projects makes the
best use of limited investment funds.
Aspect of Capital Expenditure Decision:
y Discounted-Cash-Flow Analysisa method of evaluating an investment by estimating
future cash flows and taking into consideration the
time value of money, also called capitalization of
income.
Steps in constituting net-present-value analysis:
1. Prepare a table showing the cash flows during each yearof the proposed investment.
2. Compute the present value of each cash flow, using adiscount rate that reflects the cost of acquiring
investment capital.
3. Compute the net present value, which is the sum of thepresent values of the cash flows.
4. If the net present value is equal to or greater thanzero, accept the investment proposal.
ANALYTICAL TECHNIQUE:
Discounted-Cash-Flow Analysis
The managerial accountant or controller of Mountain
view Hotel routinely advises the mayor and city council on major
capital-investment decisions. Currently under consideration in
the purchase of a new street cleaner, the controller has
estimated that the citys old street-cleaning machine would lastanother five years. A new street cleaner, which also would last
for five years, can be purchased for $50,470. It would cost the
city $14,000 less each year to operate the new equipment than it
costs to operate the old machine. The expected cost savings with
the new machine are due to lower expected maintenance costs.
Thus, the sew street cleaner will cost $50,470 and save $70,000
over its five-year life. ($70,000= 5 X $14,000 savings per
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year). Since the $70,000 in cost savings exceeds the $50,470
acquisition cost, one might be tempted to conclude that the new
machine should be purchased. However, this analysis is flawed,
since it does not account for the time value of money. The
$50,470 acquisition cost will occur now, but the cost savings
are spread over a five years period. It is a mistake to add cash
flowsoccurring at different points in time.Method:
Net-Present-Value Method
Mountainview City Government
Step 1 Time 0 Time 1 Time 2 Time 3 Time 4 Time 5
Acquisition cost $(50,470)
Annual cost saving $14 k $14 K $ 14 k $ 14 k $ 14 k
Step 2 Present value of annuity=$14,000 (3.791)
Annuity discount factor for r=.10 n=5
Present value $(50,470) $53,074
Step 3 Net present value $2,604Step 4 Accept proposal, since net present value is positive
INTERNAL-RATE-OF-RETURN METHOD
- It is an alternative discounted-cash-flow method for
analyzing investment proposals.
Internal rate of return or Time-adjusted rate of
return of an asset is the true economic return earned by the
asset over its life. An assets internal rate of return is the
discount rate that would be required in a net-present-value
analysis in order for the assets net present value to beexactly zero.
The higher the discount rate used in a net-present-
valueanalysis, the lower the present value of all future cashflows will be.
Finding the internal rate of return for the investment
proposal:
- It could be a trial and error presenting with a
different discount rates until to yields a zero net-present-
value.
where r=IRR (Internal Rate of Return)
IRR of an annuity:
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where:
Q (n,r) is the discount factor
Io is the initial outlay
C is the uniform annual receipt (C1 = C2 =....= Cn).
Example 1:
What is the IRR of an equal annual income of $20 per annum which
accrues for 7 years and costs $120?
= 6
From the tables = 4%
Economic rationale for IRR:
If IRR exceeds cost of capital, project is worthwhile, i.e. itis profitable to undertake.
Example 2:
r
10% : ( 3.791 ) ($14,000 ) - $ 50,470 = $2,604 Yields a positive NPV12% : ( 3.605 ) ($14,000 ) - $ 50,470 = $ 0 Yields a zero NPV
14% : ( 3.433 ) ($14,000 ) - $50,470 = $(2,408) Yields a negative NPV
Cash-Inflows in 5 years timeTime 0 1 2 3 4 5
cash flow $(50,470) $14,000 $14,000 $14,000 $14,000 $14,000
Initial cash outflow(acquisition cost) Equal cash inflow
( Operating CostSaving)
A cash flows exhibit a very special pattern, the rate of
return is determined in two steps:
1. Divide the initial cash outflow by the equivalentannual cash inflows.
$50,470 / 14,000= 3.605 equal to Annuity discount factor
2. Refer to the above table.
N=5 10% 12% 14%3.791 3.605 3.433
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Recovery of Investment
- Provide benefits in the future such as expected
future operating-cost saving.
- Expected future benefits must be sufficient for the
purchaser to recover the investment and earn a return on the
investment equal to or greater than the cost of acquiring
capital.
Mountainview City Gorvernment
Purchase of Street Cleaner(r=.12 n=5)
1 2 3 4 51.) unrecovered investment
at beginning of year ----------------------- 50,470 42,526 33,629 23,664 12,504
2.) Cost saving during year------------------------- 14,000 14,000 14,000 14,000 14,000
3.) Return on unrecovered 6,056 5,103 4,035 2,840 1,500investment 12% x amount in row 1
4.) Recovery of investment 7,944 8,897 9,965 11,160 12,500during year raw 2 amount minus row 3 amount
5.) Unrecovered investment at 42,526 33,629 23,664 12,504 4*end of year raw 1 amount minus row 4 amount
*There is an unrecovered investment of $4 because of accumulated
rounding errors in the table. If it had carried out each numberto cents, the table would have finished up with an unrecovered
investment of zero.
Comparing the NPV and IRR
Net-Present-Value:
1. Compute the investment proposals net present valueusing the organizations hurdle rate as the
discount rate.
2. Accept the investment proposal if its net presentvalue is equal to or greater than zero, otherwisereject it.
Internal-Rate of Return:
1. Compute the investment proposals internal rate ofreturn which is the discount rate that yields a zero
net present value for the project.
2. Accept the investment proposal it its internal rate of
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return is equal to or greater than the organizations
hurdle rate, otherwise reject it.
PROFIT MAXIMIZATION
In economics, profit maximization is the process by which a
firm determines the price and output level that returns the
greatest profit. There are several approaches to this problem.
The total revenue -- total cost method relies on the fact that
profit equals revenue minus cost, and the marginal revenue --
marginal cost method is based on the fact that total profit in a
perfect market reaches its maximum point where marginal revenue
equals marginal cost.
Basic Definitions
Any costs incurred by a firm may be classed into two
groups: fixed cost and variable cost. Fixed costs are incurred
by the business at any level of output, including none. Thesemay include equipment maintenance, rent, wages, and general
upkeep. Variable costs change with the level of output,
increasing as more product is generated. Materials consumed
during production often have the largest impact on this
category. Fixed cost and variable cost, combined, equal total
cost.
Revenue is the total amount of money that flows into the
firm. This can be from any source, including product sales,
government subsidies, venture capital and personal funds.
Average cost and revenue are defined as the total cost or
revenue divided by the amount of units output. For instance, if
a firm produced 400 units at a cost of 20000 USD, the average
cost would be 50 USD.
Marginal cost and revenue, depending on whether the
calculus approach is taken or not, are defined as either the
change in cost or revenue as each additional unit is produced,
or the derivative of cost or revenue with respect to quantity
output. For instance, taking the first definition, if it costs a
firm 400 USD to produce 5 units and 480 USD to produce 6, themarginal cost of the sixth unit is approximately 80 dollars,
although this is more accurately stated as the marginal cost of
the 5.5th unit due to linear interpolation. Calculus is capable
of providing more accurate answers if regression equations can
be provided.
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Total Cost-Total Revenue Method
To obtain the profit maximizing output quantity, we start
by recognizing that profit is equal to total revenue minus total
cost. Given a table of costs and revenues at each quantity, we
can either compute equations or plot the data directly on a
graph. Finding the profit-maximizing output is as simple as
finding the output at which profit reaches its maximum. That is
represented by output Q in the diagram.
There are two graphical
ways of determining that Q is
optimal. Firstly, we see that
the profit curve is at its
maximum at this point (A).
Secondly, we see that at the
point (B) that the tangent on
the total cost curve (TC) isparallel to the total revenue
curve (TR), the surplus of
revenue net of costs (B,C) is
the greatest. Because total
revenue minus total costs is
equal to profit, the line
segment C,B is equal in
length to the line segment
A,Q.
Computing the price at which to sell the product requiresknowledge of the firm's demand curve. The price at which
quantity demanded equals profit-maximizing output is the optimum
price to sell the product.
Marginal Cost-Marginal Revenue Method
If total revenue and total cost figures are difficult to
procure, this method may also be used. For each unit sold,
marginal profit equals marginal revenue minus marginal cost.
Then, if marginal revenue is greater than marginal cost,
marginal profit is positive, and if marginal revenue is lessthan marginal cost, marginal profit is negative. When marginal
revenue equals marginal cost, marginal profit is zero. Since
total profit increases when marginal profit is positive and
total profit decreases when marginal profit is negative, it must
reach a maximum where marginal profit is zero - or where
marginal cost equals marginal revenue. This intersection of
marginal revenue (MR) with marginal costs (MC) is shown in the
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next diagram as point A. If the industry is competitive (as is
assumed in the diagram), the firm faces a demand curve (D) that
is identical to its Marginal revenue curve (MR), and this is a
horizontal line at a price determined by industry supply and
demand. Average total costs are reprsented by curve ATC. Total
economic profits are represented by area P,A,B,C. The optimum
quantity (Q) is the same as the optimum quantity (Q) in the
first diagram.
Profit Maximization - The Marginal Approach
If the firm is operating in a non-competitive market, minor
changes would have to be made to the diagrams.
Modes of Operation
It is assumed that all firms are following rational
decision-making, and will produce at the profit-maximizing
output. Given this assumption, there are four categories in
which a firm's profit may be considered.
A firm is said to be making an economic profit when its
average total cost is greater than the price of the product at
the profit-maximizing output. The economic profit is equal to
the quantity output multiplied by the difference between the
average total cost and the price.
A firm is said to be making a normal profit when its
economic profit equals zero. This occurs where average total
cost equals price at the profit-maximizing output.
If the price is between average total cost and average
variable cost at the profit-maximizing output, then the firm is
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said to be in a loss-minimizing condition. The firm should still
continue to produce, however, since its loss would be larger if
it was to stop producing. By continuing production, the firm can
offset at least its fixed cost and part of its variable cost,
but by stopping completely they would lose equivalent to their
fixed cost.
If the price is below average variable cost at the profit-
maximizing output, the firm is said to be in shutdown. Losses
are minimized by not producing at all, since any production
would not generate returns significant enough to offset any
fixed cost and part of the variable cost. By not producing, the
firm loses only its fixed cost.