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Part 1 · Section D

Cost Management

How costs behave, how product costing systems assign them, how overhead and support costs are allocated, and how lean operations, the theory of constraints and quality programs reduce them. This section is 15% of Part 1 and heavily computational.

Begin topic 1 Costing tools

About 15 of the 100 multiple-choice questions. Estimated study time: 28 hours.

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28 hEstimated study time

Your learning path

Five topics in the IMA outline order. Topics 1–3 carry most of the calculations.

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Topic 1 of 5

Measurement concepts

How costs behave, which costs become part of inventory, and how a shared (joint) cost is split among the products it creates.

Cost behavior and classificationFixed, variable, mixed and step costs; product vs period
Cost behavior within the relevant range
Behavior Total cost Cost per unit Example
Variable Changes in proportion to activity Constant Direct materials, sales commissions
Fixed Constant Falls as activity rises Rent, salaried supervision
Mixed (semivariable) Fixed portion + variable portion Falls, but not proportionally Utilities, maintenance
Step Constant within a band, then jumps Varies Supervisors added per shift
  • Product (inventoriable) costs: direct materials, direct labor and manufacturing overhead. They become cost of goods sold when units are sold.
  • Period costs: selling and administrative costs, expensed when incurred.
  • Prime cost = direct materials + direct labor; conversion cost = direct labor + manufacturing overhead.
  • Behavior assumptions hold only within the relevant range.
Exam trapFixed cost per unit is not fixed: it falls as volume rises. Using a fixed cost per unit computed at one volume to budget a different volume is a classic error.
Absorption vs variable costingWhere fixed manufacturing overhead goes

Absorption costing (required for external reporting) treats fixed manufacturing overhead as a product cost. Variable costing (internal use) treats it as a period cost. All other costs are treated the same.

Income reconciliation
$$NI_{abs} - NI_{var} = (\text{Units produced} - \text{Units sold}) \times \text{Fixed OH per unit}$$

More precisely: fixed overhead in ending inventory − fixed overhead in beginning inventory.

Income under the two methods
Production vs sales Inventory Higher income
Production > sales Increases Absorption
Production < sales Decreases Variable
Production = sales Unchanged Equal (with constant unit costs)
Exam trapUnder absorption costing, a manager can raise reported income simply by producing more than demand. Variable costing removes this incentive, which is why it is preferred for internal evaluation.
Joint products and by-productsAllocating a cost that produces several products

A joint cost is incurred before the split-off point, where separate products become identifiable. Costs after split-off are separable. Allocation is needed for inventory and reporting, never for deciding whether to process further.

Allocation bases
$$\text{Share}_i = \text{Joint cost} \times \frac{\text{Base}_i}{\sum \text{Base}}$$

Base = physical units, sales value at split-off, or NRV (final sales value − separable costs).

Constant gross-margin method
$$\text{Joint}_i = S_i(1 - GM\%) - \text{Separable}_i$$ $$GM\% = \frac{\sum S - \text{Joint} - \sum \text{Separable}}{\sum S}$$
  • Sell or process further: process further only if incremental revenue after split-off exceeds the separable cost. Joint costs are sunk.
  • By-products (minor value) are usually accounted for by deducting their NRV from the joint cost (production method) or by recognizing their revenue when sold (sales method).
Exam trapNever include allocated joint costs in a sell-or-process-further decision. Product A above: incremental revenue $30,000 vs separable cost $20,000 → process further, whatever joint cost was allocated to it.
Instructor noteThe NRV method is the most commonly tested allocation. If the question gives sales values at split-off, use them (they are the most objective); if products are not saleable at split-off, use NRV.

Finished Measurement concepts?

Mark it complete when you can reconcile absorption and variable income and allocate joint costs four ways.

Topic 2 of 5

Costing systems

Job costing for distinct orders, process costing for continuous flows, and activity-based costing to assign overhead by what actually causes it.

Job order costingUnique jobs, job cost sheets, applied overhead

Used when products or services are distinct (custom furniture, audits, construction). Each job accumulates direct materials, direct labor and overhead applied at a predetermined rate. This is normal costing: actual direct costs plus applied overhead.

Predetermined overhead rate
$$POR = \frac{\text{Budgeted overhead}}{\text{Budgeted allocation base}}$$ $$\text{Applied OH} = POR \times \text{Actual base used}$$
Process costingEquivalent units: weighted average vs FIFO

Used for homogeneous units in continuous flow (chemicals, food, cement). Costs are accumulated by department and spread over equivalent units (EU): partially completed units expressed as whole units of work.

Weighted average
$$EU = \text{Completed} + \text{Ending WIP} \times \%$$ $$\text{Cost/EU} = \frac{\text{Beginning WIP cost} + \text{Current cost}}{EU}$$
FIFO
$$EU = EU_{WA} - \text{Beginning WIP} \times \%_{\text{done last period}}$$ $$\text{Cost/EU} = \frac{\text{Current cost}}{EU}$$
Exam trapFIFO equivalent units count only work done this period: for beginning WIP, only the work needed to finish it. The difference between WA and FIFO EU is always the work already in beginning inventory.
Exam trapIf materials are added at the end of the process, ending WIP has 0% materials, whatever its conversion percentage.
Activity-based costingCost pools, drivers and the cost hierarchy

ABC groups overhead into activity cost pools and assigns each pool using its own cost driver. It corrects the cross-subsidy created when one volume-based rate assigns batch- and product-level costs in proportion to units or hours.

  • Cost hierarchy: unit-level (machine power), batch-level (setups, purchase orders), product-sustaining (engineering changes), facility-sustaining (plant manager's salary).
  • Low-volume, complex products usually receive more overhead under ABC; high-volume simple products less.
Activity rate
$$\text{Rate}_k = \frac{\text{Cost pool}_k}{\text{Total driver quantity}_k}$$ $$\text{OH}_{product} = \sum_k \text{Rate}_k \times \text{Driver use}_k$$
Exam trapABC does not change total overhead; it changes how overhead is split. It is most valuable when overhead is large, product lines are diverse and batch sizes differ.
Life-cycle costingCosts from research to disposal

Life-cycle costing tracks all costs of a product over its life: R&D, design, production, marketing, distribution, customer service and disposal. Most of a product's cost is locked in (committed) at the design stage, even though it is incurred later.

Life-cycle profit
$$\text{Profit} = \text{Life revenue} - \sum_{\text{stages}} \text{Costs}$$
Instructor notePick the system from the product: distinct orders → job costing; identical units in continuous flow → process costing; diverse products sharing large overhead → ABC on top of either. Many firms use hybrid (operation) costing.

Finished Costing systems?

Mark it complete when you can compute equivalent units both ways and an ABC product cost.

Topic 3 of 5

Overhead costs

Choosing allocation rates, dealing with the difference between applied and actual overhead, and charging support-department costs to production.

Plant-wide vs departmental ratesOne rate or one per department

A single plant-wide rate is simple but accurate only when products use departments in similar proportions. Departmental rates, each with its own base, track products that use departments differently.

Fixed overhead rate and capacity
$$\text{Fixed rate} = \frac{\text{Budgeted fixed OH}}{\text{Denominator capacity}}$$

Theoretical > practical > normal / master-budget capacity. A higher denominator gives a lower rate.

Exam trapUsing expected (master-budget) volume as the denominator raises the rate when demand falls, which raises prices and can cut demand further: the "downward demand spiral". Practical capacity avoids this and shows unused capacity as a separate cost.
Under- and over-applied overheadClosing the difference at year end
Under/over-applied
$$\text{Actual OH} - \text{Applied OH} \begin{cases} > 0 & \text{underapplied} \\ < 0 & \text{overapplied} \end{cases}$$

Immaterial: close to COGS. Material: prorate to WIP, finished goods and COGS.

Exam trapClosing underapplied overhead to COGS increases COGS and lowers income; closing overapplied overhead does the opposite. Check the sign before choosing.
Support-department allocationDirect, step-down and reciprocal methods
Support department allocation methods
Method Services between support departments Accuracy
Direct Ignored: allocate only to producing departments Lowest; simplest
Step-down (sequential) Recognized one way: once a department is allocated, it receives nothing back Middle; result depends on the order
Reciprocal Fully recognized with simultaneous equations Highest
Reciprocal method
$$S_1 = C_1 + p_{21} S_2, \qquad S_2 = C_2 + p_{12} S_1$$

S = total (reciprocal) cost of each support department; p21 = share of S2's services used by S1. Solve, then allocate S to producing departments.

Exam trapIn the step-down method, start with the support department that provides the most service to other support departments (or the highest cost); once allocated, a department receives no further charges.
Instructor noteUse budgeted rates and a dual-rate approach (fixed costs by capacity reserved, variable costs by actual use) so that producing departments are not charged for support-department inefficiency.

Finished Overhead costs?

Mark it complete when you can run all three support-allocation methods.

Topic 4 of 5

Supply chain management

Lean and JIT remove waste, MRP and ERP plan materials, and the theory of constraints focuses improvement on the one resource that limits output.

Lean, JIT, MRP and ERPPull vs push, and the systems behind them
Supply chain approaches compared
Approach Core idea Accounting effect
Lean Remove waste (overproduction, waiting, transport, overprocessing, inventory, motion, defects); value as the customer defines it Value-stream costing replaces detailed job or process costing
JIT Pull: produce only when demand signals (kanban); minimal inventory; few reliable suppliers Backflush costing; lower carrying cost; more stockout risk
MRP Push: the production schedule and bill of materials drive purchase and production orders Inventory planned from forecasts
ERP One integrated database across purchasing, production, sales, HR and finance Real-time data; costly, long implementation
  • JIT relies on work cells, multi-skilled workers, short setups and total quality: a defect stops the line because there is no buffer stock.
  • Backflush costing skips WIP entries and assigns costs to output after production, using standard costs. It suits JIT because WIP is small.
  • Outsourcing moves an activity to an outside supplier. Weigh relevant costs (see Part 2 make-vs-buy) and also quality control, supplier dependence, confidentiality and loss of in-house skill.
Exam trapJIT does not just "reduce inventory". Its main cost saving is lower carrying cost (storage, handling, obsolescence, financing), but it raises the cost of supply interruptions. Questions often ask what must be true for JIT to work: reliable suppliers and high quality.
Theory of constraintsThroughput, bottlenecks and drum-buffer-rope

The theory of constraints treats only direct materials as truly variable in the short run. Everything else is operating expense. The goal is to maximize throughput contribution through the bottleneck.

Throughput contribution
$$T = \text{Sales} - \text{Direct materials}$$ $$\text{Rank by } \frac{T \text{ per unit}}{\text{Constraint time per unit}}$$
TOC measures
$$\text{Net profit} = T - \text{Operating expenses}$$ $$ROI = \frac{T - OE}{\text{Investment (inventory)}}$$
  1. Five focusing steps: identify the constraint; exploit it (no idle bottleneck time); subordinate everything else to it; elevate it (add capacity); repeat.
  2. Drum-buffer-rope: the drum is the bottleneck's pace; the buffer is inventory kept in front of it so it never starves; the rope releases materials only at the drum's rate.
Exam trapAn hour lost at the bottleneck is lost for the whole plant; an hour saved at a non-bottleneck is worth nothing. Improvements that speed up non-constraints only build inventory.
Capacity managementChoosing the denominator and the cost of unused capacity
  • Theoretical: 100% efficiency, no downtime. Unattainable.
  • Practical: theoretical less unavoidable downtime (maintenance, holidays). Recommended for pricing and to show idle capacity.
  • Normal: average expected use over several years, smoothing seasonal and cyclical swings.
  • Master-budget: expected use this year.
Exam trapThe larger the denominator, the lower the rate and the more likely overhead will be underapplied (an unfavorable production-volume variance).
Instructor noteIn TOC questions, ignore direct labor and overhead when ranking products, even if the question gives them; only materials are subtracted. In ordinary scarce-resource questions (Part 2), use contribution margin per constrained unit instead.

Finished Supply chain management?

Mark it complete when you can rank products at a bottleneck and explain drum-buffer-rope.

Topic 5 of 5

Business process improvement

Find which activities add value, compare processes with the best, improve them continuously and measure what poor quality costs.

Value chain and process analysisValue-added vs non-value-added activities

Porter's value chain splits a firm into primary activities (inbound logistics, operations, outbound logistics, marketing and sales, service) and support activities (infrastructure, HR, technology, procurement). Competitive advantage comes from performing activities at lower cost or in a way that differentiates.

  • Value-added activities change the product in a way the customer will pay for (machining, assembly).
  • Non-value-added: inspection, moving, waiting (queue) and storage. Reduce or eliminate them.
  • Process analysis maps each step to find bottlenecks, delays and rework. Business process reengineering is radical redesign; kaizen is small, continuous improvement.
Manufacturing cycle efficiency
$$MCE = \frac{\text{Process time}}{\text{Process} + \text{Inspection} + \text{Move} + \text{Queue time}}$$
Exam trapInspection is non-value-added even though it may be necessary. The ideal MCE is 100%: only processing time.
Benchmarking, ABM and kaizenComparing, managing activities and improving continuously
  • Benchmarking compares processes with best practice: internal (other divisions), competitive (rivals) or functional/generic (best-in-class in any industry, e.g. an airline's turnaround process for a pit crew).
  • Activity-based management uses ABC data to manage activities: cut non-value-added work, reduce cost-driver volume, redesign products to need fewer activities.
  • Kaizen costing sets targets for small, continuous cost reductions during production; target costing works before production, at design.
  • Six Sigma (DMAIC: define, measure, analyze, improve, control) targets 3.4 defects per million opportunities. ISO 9000 certifies quality-management processes, not product quality.
Exam trapABC measures activity costs; ABM uses them to make decisions. A question about reducing setups or eliminating non-value-added work is about ABM.
Cost of qualityPrevention, appraisal, internal and external failure
Cost-of-quality categories
Category When Examples
Prevention (conformance) Before production Quality training, design reviews, supplier certification, preventive maintenance
Appraisal (conformance) During/after production, before shipment Inspection, testing, quality audits
Internal failure (nonconformance) Detected before the customer Scrap, rework, downtime from defects, reinspection
External failure (nonconformance) Detected by the customer Warranty repairs, returns, recalls, lost sales and reputation
Cost of quality
$$COQ = \underbrace{P + A}_{\text{conformance}} + \underbrace{IF + EF}_{\text{nonconformance}}$$
Exam trapExternal failure is the most expensive category, and lost sales from a poor reputation are a real (opportunity) cost even though they never appear in the ledger.
Instructor noteThe modern (TQM, zero-defects) view is that prevention spending lowers total quality cost; the older view traded conformance against failure to find an "optimal" defect level above zero. The exam favors the zero-defects view.

Finished Business process improvement?

Mark it complete when you can classify quality costs and compute MCE.

Calculators

Interactive tools

Each tool is pre-filled with an example from the lessons. Change any input; the results show the method, your numbers and what they mean.

Equivalent units: weighted average vs FIFO

One process department costed both ways side by side, with the cost reconciliation.

Department data

ABC vs traditional allocator

Up to three activity pools and two products: compare a single plant-wide rate with activity-based rates.

Pools and usage

Support-department allocation

Two support departments and two producing departments, allocated by the direct, step-down and reciprocal methods.

Costs and service shares

Absorption vs variable costing reconciliation

Operating income both ways and the fixed overhead deferred in, or released from, inventory.

Units and costs

Print-ready

Formula sheet

Every formula in Cost Management on one sheet. Print it from here: the sidebar is hidden and the sheet prints black on white.

Spaced repetition

Flashcards

Recall first, then flip. Your grade schedules the next review (SM-2-lite).

Exam-style questions

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Essay section

Written-response practice

Write your answer first (aim for about 30 minutes per case), then compare it with the model answer and score yourself against the rubric. Show your calculations: the exam awards marks for method.

Key terms

Glossary

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