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Direct material and direct labor are easily traced to a product or service. Overhead,
on the other hand, must be accumulated over a period and allocated to the products
manufactured or services rendered during that time. Cost allocation refers to
the assignment of an indirect cost to one or more cost objects using some reasonable
basis. This section of the chapter discusses underlying reasons for cost
allocation, use of predetermined overhead rates, separation of mixed costs into
variable and fixed elements, and capacity measures that can be used to compute
predetermined overhead rates.
Why Overhead Costs Are Allocated
Many accounting procedures are based on allocations. Cost allocations can be made
over several time periods or within a single time period. For example, in financial

Product costs are related to the products or services that generate an entity’s revenues.
These costs can be separated into three components: direct material, direct
labor, and production overhead.6 A direct cost is one that is distinctly traceable

to a specified cost object. A cost object is anything of interest or useful informational
value, such as a product, service, department, division, or territory. Costs
that must be allocated or assigned to a cost object using one or more predictors
or cost drivers are called indirect (or common) costs. Different cost objects may
be designated for different decisions. As the cost object changes, the costs that are
direct and indirect to it may also change. For instance, if a production division is
specified as the cost object, the production division manager’s salary is direct. If,
instead, the cost object is a sales territory and the production division operates in
more than one territory, the production division manager’s salary is indirect.

As discussed earlier in this chapter, accountants assume that costs are linear rather
than curvilinear. Because of this assumption, the general formula for a straight line

can be used to describe any type of cost within a relevant range of activity. The
straight-line formula is

If a cost is entirely variable, the a value in the formula will be zero. If the cost is
entirely fixed, the b value in the formula will be zero. If a cost is mixed, it is necessary
to determine formula values for both a and b.
HIGH-LOW METHOD
The high-low method analyzes a mixed cost by first selecting two observation
points in a data set: the highest and lowest levels of activity, if these points are
within the relevant range. Activity levels are used because activities cause costs to
change and not the reverse. Occasionally, operations may occur at a level outside
the relevant range (a rush special order may be taken that requires excess labor
or machine time) or distortions might occur in a normal cost within the relevant
range (a leak in a water pipe goes unnoticed for a period of time). Such nonrepresentative
or abnormal observations are called outliers and should be disregarded

Accountants describe a given cost’s behavior pattern according to the way its total
cost (rather than its unit cost) reacts to changes in a related activity measure. Every
cost in an organization will change if activity levels are shifted to extremes or if
the time span is long enough. However, a total cost may be observed to behave
within a period in relation to limited changes in an associated activity measure.
Activity measures include production, service and sales volumes, hours of machine
time used, pounds of material moved, and number of purchase orders sent. To properly identify, analyze, and use cost behavior information, a time frame must
be specified to indicate how far into the future a cost should be examined, and a
particular range of activity must be assumed. For example, the standard-sized container
of polyethylene material for WF&B to make a production run might increase
by $1 next year but by $5 by the year 2010. If WF&B’s management is planning
for next year, the $1 increase is relevant but the $5 increase is not. The assumed

The balance sheet and income statement are two financial statements prepared by
a company. The balance sheet is a statement of unexpired costs (assets) and equities
(liabilities and owners’ capital); the income statement is a statement of revenues
and expired costs (expenses and losses). The concept of matching revenues
and expenses on the income statement is central to financial accounting. The matching
concept provides a basis for deciding when an unexpired cost becomes an expired
cost and is moved from an asset category to an expense or loss category.
Expenses and losses differ in that expenses are intentionally incurred in the
process of generating revenues, and losses are unintentionally incurred in the context
of business operations. Cost of goods sold and expired selling and administrative
costs are examples of expenses. Costs incurred for damage related to fires,
for abnormal production waste, and for the sale of a machine at below book value
are examples of losses.
Costs can also be classified as either product or period costs. Product costs
are related to making or acquiring the products or providing the services that directly

A cost management system is composed of three primary elements: motivational
elements, information elements, and reporting elements. These elements are detailed
in Exhibit 2–10. The elements as a whole must be internally consistent, and
the individually selected elements must be consistent with the strategies and missions
of the subunits. Different aspects of these elements may be used for different
purposes. For example, numerous measures of performance can be specified,
but only certain measures will be appropriate for specific purposes.


Motivational Elements
Performance measurements are chosen so as to be consistent with organizational
goals and objectives and to “drive” managers toward designated achievements.
These measurements, which are discussed in depth in Chapters 20 and 21, may
be quantitative or nonquantitative, financial or nonfinancial, and short-term or longterm.
For example, if a subunit is expected to generate a specified dollar amount

Once the organizational “big picture” has been established, managers can assess
internal specifics related to the design of a cost management system. A primary
consideration is the firm’s cost structure. Traditionally, cost structure has been
defined in terms of how costs change relative to changes in production or sales
volume.
As firms have become increasingly dependent on automated technology, it has
become more difficult to control costs through sales and production. Many technology
costs are associated with plant, equipment, and infrastructure investments
that provide the capacity to produce goods and services. Higher proportions of
these costs exist in industries that depend on technology for competing on the
bases of quality and price. Manufacturing and service firms have aggressively
adopted advanced technology. The data shown in Exhibit 2–8 reveal the effects of
technology on the efficiency of particular industries.10 Sales per employee traditionally

Knowledge of the organization’s mission and core competencies is a key consideration
in the design of a cost management system. The mission provides a longterm
goal toward which the organization wishes to move. If the mission that the
entity wishes to achieve is unknown, it does not matter what information is generated
by the cost management system—or any other information system!
As discussed in Chapter 1, in pursuing the business mission, companies may
avoid or confront competition. For example, companies may try to avoid competition
by attempting to be more adept in some way than other entities. The generic
paths a company may take to avoid competition include differentiation and cost
leadership.8
In the current global environment, it is often difficult to maintain a competitive
advantage under either a differentiation or cost leadership strategy. Competitors
are becoming skilled at duplicating the specific competencies that gave rise to
the original competitive advantage. For many companies, the key to success in
the future may be to confront competition by identifying and exploiting temporary

In designing and revising a cost management system, managers and accountants
must be attuned to the unique characteristics of their firms. A generic cost management
system cannot be “pulled off the shelf” and applied to any organization.
Each firm warrants a cost management system that is tailored to its situation. However,
some overriding factors are important in designing a cost management system.
These factors are depicted in Exhibit 2–6 and are described in this section.
Organizational Form, Structure, and Culture
An entity’s legal nature reflects its organizational form. Selecting the organizational
form is one of the most important decisions business owners make. This
choice affects the costs of raising capital, operating the business (including taxation
issues), and, possibly, litigating. The available organizational form alternatives
have increased remarkably in recent years.
The most popular form for large, publicly traded businesses is the corporation.

A cost management system (CMS) consists of a set of formal methods developed
for planning and controlling an organization’s cost-generating activities relative to
its short-term objectives and long-term strategies. Business entities face two major
challenges: achieving profitability in the short run and maintaining a competitive
position in the long run. An effective cost management system must provide managers
the information needed to meet both of these challenges.
Exhibit 2–4 summarizes the differences in the information requirements for organizational
success in the short run and long run. The short-run requirement is
that revenues exceed costs—the organization must make efficient use of its resources
relative to the revenues that are generated. Specific cost information is
needed and must be delivered in a timely fashion to an individual who is in a position
to influence the cost. Short-run information requirements are often described
as relating to operational management.

A cost management system is part of an overall management information and control
system. Exhibit 2–2 illustrates the types of information needed in an organization for individuals to perform their managerial functions. The exhibit also demonstrates
the demand from external parties for information from the firm. A management
information system (MIS) is a structure of interrelated elements that collects, organizes,
and communicates data to managers so they may plan, control, make decisions,
and evaluate performance. A MIS emphasizes satisfying internal demands
for information rather than external demands. In most modern organizations, the
MIS is computerized for ease of access to information, reliability of input and processing,
and ability to simulate outcomes of alternative situations.
As Exhibit 2–2 illustrates, the accounting personnel are charged with the task
of providing information to interested external parties such as creditors, the government
(for mandatory reporting to the Internal Revenue Service, Securities and
Exchange Commission, and other regulatory bodies), and suppliers, in regard to
payments and purchases. External intelligence is also gathered from these parties

When setting strategy, managers must consider the opportunities and threats provided
by the entity’s customers, competition, and environment and must analyze
those opportunities and threats relative to the entity’s strengths and weaknesses.
Such an analysis is the first part of the model shown in Exhibit 1–10. Next, management
must consider the impact the selected strategies will have on organizational
stakeholders. In a profit-oriented business, strategies should promote a primary
goal of profit generation so that customers are served effectively, shareholders
can obtain wealth maximization, employees can retain their jobs and increase their
personal human capital, and creditors can be paid. Therefore, management must
consider the financial implications of its chosen strategies.
Profitability is typically achieved by delivering to customers the products and
services they desire, on time, and at reasonable prices. Profit measurement is one
function of the accounting information system. To best assess financial implications
of organizational strategies, detailed, short-term tactical plans should be prepared
in the form of a budget. If the projected financial results are unacceptable, management

An organization operating in a competitive market structure may choose to avoid
competition through differentiation or cost leadership.21 A company choosing a differentiation
strategy distinguishes its product or service from that of competitors
by adding enough value (including quality and/or features) that customers are willing
to pay a higher price. Differentiation is often related to the product or service,
distribution system, or advertising. The accompanying News Note illustrates a
slightly different version of differentiation strategy: including substantially fewer
features and charging higher prices!


Competition may also be avoided by establishing a position of cost leadership,
that is, by becoming the low-cost producer/provider and, thus, being able
to charge low prices that emphasize cost efficiencies. In this strategy, competitors
cannot compete on price and must differentiate their products/services from the
cost leader.
In today’s business environment, maintaining a competitive advantage by avoiding

Going global, implementing employee empowerment, and investing in new forms
of capital are all decisions that require organizational change. An organization’s
ability to change depends heavily on its organizational culture.
Organizational culture is the set of basic assumptions about the organization,
its goals, and its business practices. Culture describes an organization’s norms in
internal and external, as well as formal and informal, transactions.
Culture refers to the values, beliefs, and attitudes that permeate a business.
If strategy defines where a company wants to go, culture determines how—
maybe whether—it gets there. Every business has some kind of culture, just because
it’s an organization of human beings. But most businesses never give the
topic a second thought. Their culture is to do things the way they always have
or the way everybody else does them.
A few companies, by contrast, have explicit, highly distinctive cultures—
strong, focused cultures that stick out from the crowd like the Grateful Dead at
a marching-band convention. [For example, Southwest Airlines is] famous for

In addition to organizational structure, an organization’s strategy is influenced by
its core competencies. A core competency is any critical function or activity in
which one organization seeks a higher proficiency than its competitors, making it
the root of competitiveness and competitive advantage. “Core competencies are
different for every organization; they are, so to speak, part of an organization’s
personality.”15 Technological innovation, engineering, product development, and
after-sale service are some examples of core competencies. The Japanese electronics
industry is viewed as having a core competency in miniaturization of electronics.
MCI and Disney believe they have core competencies, respectively, in communications
and entertainment. The accompanying News Note further examines
core competencies.


But core competencies are likely to change over time. Consider that Rolls-
Royce plc, once one of the most respected names in luxury automobiles, sold its
motorcar division in 1972. Company management decided its priority should be

Because each organization is unique, even those in the same industries employ
different strategies that are feasible and likely to be successful. Exhibit 1–8 provides
a model of the major factors that influence an organization’s strategy. These
factors include organizational structure, core competencies, organizational constraints,
organizational culture, and environmental constraints.
Organizational Structure
An organization is composed of people, resources other than people, and commitments
that are acquired and arranged to achieve specified goals and objectives


Goals are desired results expressed in qualitative terms. For example, a typical
goal of profit-oriented firms is to maximize shareholder wealth. Goals are also likely
to be formulated for other major stakeholders, such as customers, employees, and
suppliers. In contrast, objectives are quantitatively expressed results that can be
achieved during a pre-established period or by a specified date. Objectives should
logically be used to measure progress in achieving goals. For example, one of ABN

In responding to the challenges of e-commerce and globalization, managers must
consider the organization’s mission and, correspondingly, the underlying strategy
that links its mission to actual activities. An organization’s mission statement
should (1) clearly state what the organization wants to accomplish and (2) express
how that organization uniquely meets its targeted customers’ needs with its products
and services. As indicated in the following News Note, a mission statement
should be an organizational road map.
The mission statement may, and most likely should, be modified over time.
Not adapting the mission statement probably means the organization is stagnating
and not facing the ever-changing business environment. For instance, Hibernia Corporation’s
mission statement in 1994 was “to be recognized by 1996 as the best
provider of financial services throughout Louisiana.” By 1997, the mission statement
was “By 1999, we will be recognized by our customers, employees, and
shareholders as the best financial services company in each of our markets.”11 Only
three years yet a dramatic difference: the corporation had engaged in multiple bank

In contrast to laws, ethical standards represent beliefs about moral and immoral
behaviors. Because beliefs are inherently personal, some differences in moral perspectives
exist among all individuals. However, the moral perspective is generally
more homogeneous within a given society than it is across societies. In a business
context, ethical standards are norms for individual conduct in making decisions
and engaging in business transactions. Also, many professions have established
ethical standards for their practitioners such as those promulgated by the IMA

In general, ethical standards for business conduct are higher in most industrialized
and economically developed countries than in less developed countries. But
the standards and their enforcement vary greatly from one industrialized country
to another. Thus, because of the tremendous variations, companies should develop
internal norms for conduct (such as a code of ethics) to ensure that certain behaviors
are consistent in all of its geographical operating segments. There must
also be respect for local customs and traditions if they do not violate the accepted

There is no question that globalization is occurring and at a remarkably rapid rate.
But operating in foreign markets may create situations that vary dramatically from
those found only in domestic markets. Considerations about risk, legal standards,
and ethical behaviors can be vastly dissimilar between and among different foreign
markets.
RISK CONSIDERATIONS
Numerous risks exist in any business environment. But when a business decides
to enter markets outside its domicile, it needs to carefully evaluate the potential
risks. Some of the risks depend on the level of economic development of the country
in which operations are being considered; these risks often include political and


currency risks. Political risks include the potential for expropriation or nationalization
of assets and the potential for change in business, legal or tax treatment under
new political leadership.
Currency risks can cause widely unpredictable results. For example, ABN AMRO
acquired 40 percent of Banco Real, Brazil, for $2.1 billion; Brazil’s currency devaluation