CH 2 — Core Cost Definitions (Part 1)
CH 2 · TERMS

Direct Cost: Obvious components that can be easily traced to the product or service.

Indirect Cost: Product costs incurred in the factory that are less obvious and not easily traced to the final product. Allocated via overhead rates.

Product Cost (Inventoriable): The costs incurred to make a product and ready it for sale, including direct materials (DM), direct labor (DL), and manufacturing overhead (MOH). Flows through: WIP → Finished Goods → COGS when sold.

Period Cost: Costs that are not product costs and that are expensed on the income statement in the period they are incurred. Includes selling, general, and administrative (SG&A) expenses.

Variable Cost: Costs that are constant on a per-unit basis but change in total with the volume of activity.

Fixed Cost: A constant cost that does not change as more units are made within the available capacity. Per-unit fixed cost changes inversely with volume.

Relevant Range: A band of activity that identifies a specific relationship between activity level and the cost being measured, where fixed costs remain fixed and unit variable costs are constant.

Outside the relevant range: fixed costs may step up and variable cost per unit may change. Behavior assumptions break down.
CH 2 — Relevant Costs & Cost Behavior Traps
CH 2 · RELEVANT

Relevant Costs: Costs that relate to the specific decision being made. They differ between options, occur in the future, and are avoidable.

Sunk Costs: Already incurred and irrecoverable — NEVER relevant to any future decision. Cannot be changed by current or future actions.
Fixed costs are relevant only if they differ between alternatives. A fixed cost that is the same across all options is irrelevant.
Test: Ask (1) Is it future? (2) Does it differ between options? If both yes → relevant.
Cost Behavior Summary
Cost TypePer UnitIn Total
VariableConstantChanges with activity
FixedChanges with activityConstant (within rel. range)
MixedChangesHas both FC and VC components
Product vs. Period — Key Difference
Product CostPeriod Cost
Goes toBalance Sheet (inventory) until soldIncome Statement immediately
ExamplesDM, DL, MOHSG&A, selling, R&D
CH 3 — Cost Estimation Methods
CH 3 · ESTIMATION

Account Analysis Method: An estimation method that uses actual costs within a general ledger account to predict future costs. It requires insight and experience to identify whether a cost is fixed, variable, or mixed. Subjective — relies on manager judgment.

High-Low Method: A cost estimation method that uses actual cost relationships to make predictions of future mixed costs; this method uses two actual data points (the highest and lowest activity levels).

VC per Unit = (Cost at High Activity − Cost at Low Activity) ÷ (High Units − Low Units) FC = Total Cost at High Point − (VC per Unit × High Activity Units)
Weakness of High-Low: uses only 2 data points — ignores all other observations. Susceptible to outliers at extreme activity levels.

Regression Analysis (Least Squares): A cost estimation method, also known as least squares regression or linear regression, that uses every point in a data set in a mathematical computation designed to minimize the vertical distance among the given data points to generate a line of best fit. Most objective and accurate method.

Accuracy ranking: Regression > Account Analysis > High-Low. Regression uses ALL data; High-Low uses only 2 points.
CH 4 — Cost-Volume-Profit (CVP) Analysis
CH 4 · CVP

CVP Analysis: The analysis of the relationship between a company's revenues, costs, volume of sales, and, consequently, profit.

Core Formulas
CM per Unit = SP − VC per Unit CM Ratio = CM per Unit ÷ SP Break-Even Units = FC ÷ CM per Unit Break-Even Sales $ = FC ÷ CM Ratio Target Profit Units = (FC + Target Profit) ÷ CM per Unit
Underlying Assumptions
  • Selling price is constant per unit
  • Variable cost per unit is constant
  • Fixed costs are constant in total
  • All units produced are sold (no inventory change)
  • Single product or constant sales mix
Impact on Break-Even Point
ChangeEffect on BE
↑ Fixed Costs↑ BE (more to cover)
↑ Variable Cost↑ BE (lower CM)
↑ Selling Price↓ BE (higher CM)
CH 8 & 9 — Job Costing vs. ABC
CH 8–9 · REVIEW
CH 8 — Job Costing
  • Used for distinct, customizable products (hospitals, law firms, custom manufacturing)
  • Costs tracked per job on a job cost sheet
  • Normal costing: actual DM + actual DL + applied MOH (budgeted rate × actual driver)
Journal Entry Flow
DM purchased → Raw Materials DM issued → WIP DL incurred → WIP MOH applied → WIP Job complete → Finished Goods Units sold → COGS
CH 9 — Traditional vs. ABC

Traditional Costing: Accumulates all MOH into a single plant-wide cost pool (or few departmental pools) and allocates it using a single volume-based cost driver (e.g., DL hours or machine hours). Can inaccurately smooth out costs — overcosting high-volume, undercosting low-volume customized products.

Activity-Based Costing (ABC): Divides large overhead cost pools into smaller, highly specific activity cost pools. Uses relevant, activity-specific cost drivers → much more precise and accurate unit cost for management decision-making.

ABC limitation: costly to implement and maintain; subjective driver selection.
CH 10 — Variance Analysis Definitions
CH 10 · REVIEW

Variance / Variance Analysis: A process that identifies and calculates the difference between actual and budgeted outcomes to help organizations evaluate performance, troubleshoot issues, and take corrective action.

Flexible Budget: A "right-sized" master budget that flexes to use actual sales volumes when actual sales volumes differ from master budget sales volumes. It holds the budgeted selling prices and input costs constant to evaluate actual performance. Isolates price/efficiency variances from volume effects.

Price & Efficiency Variances
Price Variance = (AP − SP) × Actual Qty Efficiency Var = (AQ − SQ) × Std Price F = favorable (actual < standard → ↑ OI) U = unfavorable (actual > standard → ↓ OI)

Favorable (F): Indicates an outcome that causes an increase in operating income compared to the budget.

Unfavorable (U): Indicates an outcome that causes a decrease in operating income compared to the budget.

Fixed-MOH Variances (Absorption Only)
Spending Var = Actual FMOH − Budgeted FMOH Volume Var = (Actual Prod − Budgeted Prod) × Budgeted FMOH Rate F = Actual > Budgeted Production U = Actual < Budgeted Production
Variable OH Efficiency Var uses actual vs. standard driver hours × VOH rate.
CH 11 — Process Costing: FIFO vs. Weighted-Average
CH 11 · REVIEW

Equivalent Units of Production (EUP): When identical units are mass-produced in a continuous flow, incomplete units in WIP at period-end are converted into EUP — the number of physical units that could have been fully completed with the resources used.

FIFO Method

Definition: Assumes the first units started in a process are the first to finish. Strictly keeps last period's work and costs separate from this period's work and costs. EUP based only on work added in the current period.

Goods Completed: Sums three distinct layers — costs already in beginning WIP + new costs to finish that beginning WIP + costs for new units started and fully completed.

Ending Inventory: Valued using strictly the current period's cost per EU → more accurate for tracking cost fluctuations.

Weighted-Average Method

Definition: Blends and averages the actual work and costs incurred last period with the work and costs incurred this period. Ignores the degree of completion of beginning inventory and treats all units completed as if they were 100% produced in the current period.

Goods Completed: Assigns the blended, average cost per EU universally to all completed units regardless of when they were actually started.

Ending Inventory: Valued at the smoothed, blended average — can mask effects of input cost changes (inflation/deflation).

Key difference: FIFO isolates current-period costs (better for cost control); WA blends prior and current (simpler but less precise).
CH 12 — Absorption & Variable Costing: Definitions
CH 12 · DEFINITIONS

Absorption Costing: A costing method in which fixed manufacturing overhead (fixed-MOH) costs are included ("absorbed") in a unit's inventoriable cost, along with DM, DL, and variable-MOH costs, whether the unit is in inventory or Cost of Goods Sold. Required by GAAP for external reporting. Product costs are deferred on the balance sheet until the units are sold.

Variable Costing: A costing method wherein DM, DL, and variable-MOH comprise inventoriable unit costs. Used for internal decision-making purposes and is not permitted by GAAP for external reporting.

The Key Difference: Treatment of Fixed-MOH
MethodFixed-MOH TreatmentInventory IncludesGAAP?
AbsorptionProduct cost → capitalized in inventory → expensed as COGS when soldDM + DL + VMOH + FMOHYes — required
VariablePeriod cost → expensed on income statement in the period incurred, regardless of salesDM + DL + VMOH onlyNo — internal only
Why Variable Costing is better internally: clearly separates fixed/variable costs; OI only changes with sales (not production); prevents inventory manipulation; supports CVP analysis.
CH 12 — OI Relationship, Reconciliation & Volume Variance
CH 12 · FORMULAS
Operating Income Relationship
ConditionResultReason
Produced > SoldAbs OI > Var OIFMOH deferred into ending inventory (held on balance sheet)
Produced < SoldAbs OI < Var OIPrior-period FMOH released from beginning inventory onto income statement
Produced = SoldAbs OI = Var OINo inventory change — all FMOH flows through as COGS
Reconciliation Formula
Variable Costing OI + FMOH in Ending Inventory (deferred — not yet expensed) − FMOH in Beginning Inventory (released from prior period) = Absorption Costing OI Shortcut: Abs OI = Var OI + FMOH Rate × (Units Produced − Units Sold) Difference = (Change in Inventory Units) × FMOH Cost Per Unit
Fixed-MOH Volume Variance (Absorption Only)
Vol Variance = (Actual Production − Budgeted Production) × Budgeted FMOH Rate Favorable if Actual > Budgeted | Unfavorable if Actual < Budgeted | Zero if Actual = Budgeted
⚠ Trap: A manager can boost Absorption OI by overproducing — FMOH sits in ending inventory instead of hitting COGS. Variable costing eliminates this incentive.
CH 12 — Capacity Levels: Theoretical & Practical
CH 12 · CAPACITY
Theoretical Capacity

Definition: Production capacity calling for a facility's highest and best use, which assumes no downtime. It is unrealistic and results in the lowest fixed-MOH rate (highest denominator), but usually causes a large unfavorable volume variance because actual output almost never reaches theoretical max.

FMOH Rate = Budgeted FMOH ÷ Theoretical Capacity → Lowest rate (÷ biggest number) → Usually large UNFAVORABLE Vol. Var.
Practical Capacity ← RECOMMENDED

Definition: Production capacity that allows for unavoidable interruptions for things like maintenance, holiday shutdowns, and employee training. It is challenging but plausible, resulting in a moderate, stable fixed-MOH rate.

Why recommended: Sets the cost of capacity at the cost of supplying it regardless of demand. Unused capacity is explicitly identified as a separate cost — helping managers manage and reduce it, rather than hiding it in product costs.

FMOH Rate = Budgeted FMOH ÷ Practical Capacity → Moderate rate → Moderate Vol. Var.
CH 12 — Normal Capacity & the Death Spiral
CH 12 · NORMAL CAP
Normal Capacity

Definition: The production capacity needed to satisfy average customer demand over a period of time. Because it aligns with demand (which is often lower than what the factory can actually produce), it results in the highest fixed-MOH rate and unit product costs.

FMOH Rate = Budgeted FMOH ÷ Normal (Average Demand) Capacity → Highest rate (÷ smallest number)
⚠ Normal capacity hides the cost of unused capacity inside the product cost — making products appear more expensive than they really should be.
Death Spiral (Demand Spiral)

A self-reinforcing loop triggered by using Normal Capacity when demand falls:

1. Demand falls → Normal capacity decreases
2. Normal capacity ↓ → FMOH rate ↑ (same FMOH ÷ fewer units)
3. Higher FMOH rate → higher product costs
4. Higher product costs → management raises prices
5. Higher prices → demand falls further
6. → Cycle repeats and accelerates
Solution: Use Practical Capacity instead — the spiral cannot start because the denominator is fixed at realistic capacity, not demand.
Mnemonic: T → P → N = Highest denominator → Lowest denominator = Lowest FMOH rate → Highest FMOH rate
CH 12 — Capacity Levels: Full Comparison
CH 12 · CAP COMPARE
Capacity Level Textbook Definition FMOH Rate Volume Variance Best Used For
Theoretical Facility's highest & best use, assumes NO downtime — unrealistic ideal Lowest (÷ biggest denominator) Usually large Unfavorable Theoretical benchmarking only
Practical ✓ Theoretical minus unavoidable interruptions (maintenance, holidays, training) — challenging but plausible Moderate, stable Moderate Unfavorable Product costing; reveals cost of unused capacity
Normal Production capacity needed to satisfy average customer demand over time — demand-based, often well below physical capacity Highest (÷ smallest denominator) Fluctuates with demand Can trigger Death Spiral — use with caution
For all three: Budgeted FMOH Rate = Total Budgeted Fixed-MOH ÷ Budgeted Capacity Denominator Level
CH 14 — Operating Units vs. Support Departments
CH 14 · DEPT TYPES
Feature Operating Unit (Production Dept) Support Department (Service Dept)
Definition The part of a business that makes products and services available for sale to external customers; it generates revenues and incurs expenses. Departments that exist to support operating units. They are cost centers that do not earn any revenues on their own.
Revenue? Yes — sells to external customers No — cost center only
Examples Mixing, Assembly, Canning, Juices, Teas, Sports Drink departments HR, IT, Maintenance, Accounting, Legal, Janitorial, Security
Cost Treatment Costs directly form product cost Costs allocated to operating depts, then to products
Why Allocate Support Dept Costs? (FDMC)
Financial Reporting (GAAP / inventory valuation)  |  Decision-Making (see true full cost)  |  Motivate Managers (accountability for support costs consumed)  |  Cost Reimbursement (government contracts require full cost allocation)
Selecting Allocation Bases
HR / Cafeteria: # of employees  |  Maintenance / Security / Custodial: Square footage  |  IT: # of support tickets or IT labor hours  |  Accounting / Billing: Revenue/expenses or hours worked
CH 14 — Three Allocation Methods Overview
CH 14 · 3 METHODS
DSR Mnemonic: Direct → Step-Down → Reciprocal = Least Accurate → Most Accurate. Total SD costs distributed to operating depts = IDENTICAL across all three methods. Only the split between operating depts differs.
Method Textbook Definition SD-to-SD Services? Accuracy Tool
Direct The simplest method. Costs of support departments are allocated straight to operating units based on proportional usage. Costs are not allocated to other support departments. Ignored completely Least accurate Simple ratios (operating depts only)
Step-Down Allocates some support costs to other support departments, as well as to operating units. Rank first. Allocate forward. Never backwards. One direction only (sequential) More accurate Sequential allocation
Reciprocal The most detailed method. Captures the full exchange of services between all support departments and operating units simultaneously, requiring simultaneous equations to solve. Full mutual exchange — both directions Most accurate Simultaneous equations
CH 14 — Direct Method (Detail + Example)
CH 14 · DIRECT

Direct Method: The simplest method. Costs of support departments are allocated straight to operating units based on proportional usage. Costs are not allocated to other support departments.

Formula
Denominator = Sum of OPERATING DEPT driver units ONLY (NEVER include other support departments) Budgeted Rate = SD Cost ÷ Denominator Allocation = Rate × Each operating dept's driver units
⚠ #1 Trap: Including other support departments in the denominator. Direct Method → operating departments ONLY.
Example

Janitorial cost = $80,000. Driver = sq ft. Dept A = 4,000 sq ft, Dept B = 6,000 sq ft, Support Dept = 2,000 sq ft.

Denominator = 4,000 + 6,000 = 10,000 (operating depts ONLY — exclude 2,000 SD sq ft) Rate = $80,000 ÷ 10,000 = $8 per sq ft Dept A = $8 × 4,000 = $32,000 | Dept B = $8 × 6,000 = $48,000
CH 14 — Step-Down Method (Detail + Example)
CH 14 · STEP-DOWN

Step Method (Step-Down): Allocates some support costs to other support departments, as well as to operating units. You must first rank the support departments (usually by highest cost or most services provided to other SDs). You allocate the highest-ranked department's costs forward to all remaining support and operating departments. You then "step down" to the next. You never allocate backwards to a higher-ranked department.

Steps
1. Rank SDs: highest % (or $) of services to other SDs goes FIRST 2. Allocate #1 to ALL remaining open depts (other SDs + operating depts) Denominator = ALL remaining open depts' driver units 3. CLOSE that SD permanently — receives NO further allocations 4. Next SD's total cost = original cost + allocations RECEIVED from prior steps 5. Repeat until all SDs are closed and fully allocated to operating depts
⚠ Trap 1: Once closed, a SD NEVER receives further allocations.   ⚠ Trap 2: New cost for next step = original + received amounts (don't forget the add-on).
Example: IT ($60,000) goes first. Hours: Maintenance 2,000 | Assembly 8,000 | Finishing 4,000
IT Denominator = 2,000+8,000+4,000 = 14,000 (Maintenance is still open — included!) IT→Maintenance = $60,000 × 2,000/14,000 = $8,571 (NOT $0 — that's Direct Method)
CH 14 — Reciprocal Method & Common Costs
CH 14 · RECIPROCAL
Reciprocal Method

Definition: The most detailed method. Captures the full exchange of services between all support departments and operating units simultaneously, requiring simultaneous equations to solve.

Set up simultaneous equations: J = Direct_J + (J's share of P) × P P = Direct_P + (P's share of J) × J Solve for J and P (total costs incl. received). Then allocate each SD's total to ALL depts (incl. other SDs) using proportional driver units. Denominator for each SD = ALL other depts (other SDs + operating) — NOT itself.
Common Costs Definition

Common Costs: Costs that are shared among two or more parties (e.g., two roommates sharing rent, or two product lines sharing factory insurance).

Stand-Alone Method

Identifies the cost each entity would have to pay if it bore the cost alone. The total common cost is allocated based on the percentage each party would have paid (proportional sharing).

User % = User's stand-alone cost ÷ Total of ALL users' stand-alone costs Allocation = User % × Total Common Cost Most equitable — no ranking needed.
Incremental Cost Method

Ranks the users. The primary (first-ranked, highest stand-alone) user is assigned the cost up to their stand-alone amount. Any additional (incremental) cost is assigned to secondary user(s).

Primary = pays full stand-alone amount Secondary = Common Cost − Primary's share
FASB ASC 606 governs external reporting of bundled revenue from contracts with customers.
CH 17 — MCS, Centralization & Decentralization
CH 17 · MCS

Management Control System (MCS): A convergence of systems to gather and use information to aid and coordinate planning and control decisions. Can be formal or informal.

3 Key Properties (MGE): Motivation (incentivizes desired behavior) | Goal Congruence (aligns all levels with firm goals) | Effort (managers exert appropriate effort)    4 Pillars: Budgeting | Responsibility Centers | Transfer Pricing | Performance Measurement
Centralization vs. Decentralization
FeatureCentralizationDecentralization
DefinitionA structure where decision-making authority resides within a narrow scope, at the highest levels of the firm.The freedom for managers at all levels to make binding decisions without continuous interference by top management.
ProsStronger goal congruence; top-down company-wide perspective; uniformity and control.Better local responsiveness; faster decisions; increased manager motivation; more specialization; frees executives for strategy.
ConsSlower decisions; risk of bottleneck; less responsive to local needs.Suboptimal decisions (unit over firm); duplication of activities/effort.
How to achieve decentralizationN/ADelegation — moving decision-making authority to business unit managers (purchasing, accounting, shipping, customer service, sales).
CH 17 — Responsibility Centers (All 4 Types)
CH 17 · RESP CENTERS

Responsibility Center: A business unit (division, department, office) organized according to its focus or area of control. Must have Authority (power to decide) + Responsibility (owns the task) + Accountability (answers for results) = ARA.

CRPI (ascending scope): Cost Center → Revenue Center → Profit Center → Investment Center
TypeControlsTextbook DefinitionExample
Cost CenterCosts onlyCharged solely with managing costs. Managers are evaluated on their ability to operate within the budget.A factory for a sporting goods company; university payroll processing dept.
Revenue CenterRevenue onlyCharged strictly with generating revenues for the company. Evaluated on their ability to meet sales forecasts.Marketing & fan engagement group for a sports team; global sales team.
Profit CenterCosts + RevenueCharged with simultaneously generating revenues and maintaining expenses. Evaluated on their ability to meet a target profit.The pharmacy inside a Walgreens; the garden center at Lowe's.
Investment CenterCosts + Revenue + AssetsCharged with selecting which assets to use to generate a target return and then wisely reinvesting subsequent returns. Evaluated on ROI or RI.The CEO running an entire corporation (Amazon); a highly autonomous division where the manager controls asset acquisition.
CH 17 — ROI: Formula, Interpretation & Goal-Congruence Problem
CH 17 · ROI
ROI Formula
ROI = Operating Income ÷ Average Operating Assets DuPont Breakdown: ROI = Return on Sales × Investment Turnover ROI = (OI ÷ Sales) × (Sales ÷ Avg Assets) Improve ROI by: ↑ OI, ↑ Sales, or ↓ Assets
Interpretation

ROI yields the percentage of return for each dollar invested. It shows how efficiently a division uses its assets to generate profit. Popular for comparisons across divisions and firms.

Net Book Value problem: as assets depreciate, denominator ↓ → ROI mechanically ↑ even with unchanged performance — gives false sense of improvement for older divisions.
Goal-Congruence Problem with ROI
Scenario: Division's current ROI = 20%. New project's ROI = 15%. Firm's WACC = 10%.

What happens: The manager REJECTS the project (15% < 20% average) — it would dilute their ROI score — even though 15% > 10% WACC means the project is profitable for the firm.

Result: Goal incongruence — the manager's incentive (protect ROI) conflicts with the firm's goal (maximize firm value).
Advantage of ROI

Best for comparing performance across divisions or firms of different sizes because it is a percentage ratio.

CH 17 — Residual Income & EVA: Formulas & Interpretations
CH 17 · RI + EVA
Residual Income (RI)
RI = Operating Income − (Required Rate of Return × Avg Operating Assets) Accept project if RI > $0

Interpretation: RI calculates the excess of actual income earned above a firm's required rate of return. It is expressed as a dollar amount rather than a percentage. Any positive RI means the investment is generating more than the company's minimum hurdle rate.

Solves ROI goal-congruence problem: Managers accept any project with RI > $0 — aligning division goals with firm goals. The same 15% project above would show positive RI if WACC = 10%, so it gets accepted.

Economic Value Added (EVA)
EVA = After-Tax Operating Income − (After-Tax WACC × Invested Capital) Invested Capital = Total Assets − Current Liabilities (For a specific project: use purchase price of asset) Accept if EVA > $0
⚠ Trap: Invested Capital = Total Assets MINUS Current Liabilities — NOT total assets alone.

Advantage: Accounts for taxes and both debt and equity financing (via WACC). Goal-congruent like RI.

Use All Three Together
ROI: cross-division comparisons  |  RI: overcomes ROI goal-congruence failure  |  EVA: incorporates taxes & full capital structure
CH 17 — Transfer Pricing: Definition & General Guideline
CH 17 · TRANSFER TP

Transfer Pricing: The internal transaction price at which two business units within the same company exchange a good or service. Typically arises due to vertical integration. A well-designed transfer pricing system ensures goal congruence — when managers maximize their own unit's profit, those decisions naturally align with and maximize overall firm profit. Poor transfer pricing creates goal incongruence.

General Guideline — Min & Max Transfer Prices
Min Transfer Price (SELLER's Floor) = Variable Cost per unit + Opportunity Cost per unit Seller has IDLE capacity: Opportunity Cost = $0 → Min TP = Variable Cost only Seller at FULL capacity: Opportunity Cost = CM lost on foregone external sales → Min TP = VC + (External Price − VC) = External Market Price Max Transfer Price (BUYER's Ceiling) = External market price (what buyer pays outside)
⚠ Full capacity example: VC = $30, External price = $65. Min TP = $30 + ($65−$30) = $65. Seller will NOT accept below market price.
⚠ If Min TP > Max TP → no mutually beneficial internal price exists. Firm must intervene or allow external purchase.
CH 17 — Transfer Pricing Methods & Vertical Integration
CH 17 · TP METHODS
Three Transfer Pricing Methods
MethodHow SetProsCons
Cost-BasedVariable cost, full absorption cost, or cost-plus markupSimple; easy to calculate; no market data neededMay not motivate seller; can mask inefficiencies
Market-BasedExternal market price for the same or similar productObjective; best when a competitive external market exists; mimics arm's-length transactionRequires an existing market; may still create distortions if capacity differs
NegotiatedAgreed upon between seller (above Min TP) and buyer (below Max TP)Most flexible; promotes goal congruence when range exists; reflects bargaining powerTime-consuming; may lead to conflict; depends on relative power
Vertical Integration

Definition: A growth strategy where a company expands to include activities that either precede or follow the existing firm in its value chain.

Upstream (Backward) Integration: Buying a company further from the final consumer — e.g., a supplier. IKEA buying forests for lumber; Starbucks buying a coffee farm in Costa Rica.
Downstream (Forward) Integration: Buying a company one step closer to the final consumer — e.g., distribution or retail. Apple (a manufacturer) opening its own Apple Stores to sell directly to consumers.
CH 18 — Key Strategy Definitions
CH 18 · DEFINITIONS
CH 18 — Porter's Five Forces (All Five + Definitions)
CH 18 · PORTER'S

These external forces dictate how an industry and companies within it make a profit. Mnemonic: Can't Survive Neglecting Suppliers (Competition, Customers, Substitutes, New Entrants, Suppliers)

#ForceTextbook Definition
1Competitive RivalryThe existing companies within an industry and the intensity of the competition among them — intense competition lowers profitability.
2Power of Customers (Buyers)Customers create demand and have the power to influence prices and quality expectations.
3Bargaining Power of SuppliersIf suppliers "hold the cards," they can influence an industry's profits by altering the amount/quality of goods supplied or by setting trade terms favorable to them.
4Threat of SubstitutesThe threat of customers going elsewhere to satisfy their needs and wants (e.g., meal kits vs. restaurants) — limits pricing power.
5Threat of New EntrantsNew companies can enter the industry, potentially diluting existing profits by adding capacity and reducing market share.
Porter's Five Forces is used alongside SWOT Analysis to understand the full competitive environment (external) before forming strategy.
CH 18 — SWOT Analysis
CH 18 · SWOT

SWOT Analysis: A strategic planning framework used to evaluate the internal capabilities and external environment of an organization.

Internal (Within Company's Control)External (Environmental — Cannot Control)
Strengths — advantages the company already has; areas where it outperforms competitors or has unique capabilities. Opportunities — favorable external conditions in the market or environment that the company can exploit to its advantage.
Weaknesses — internal areas where the company falls short; vulnerabilities relative to competitors. Threats — external conditions that could harm the company's performance, market share, or profitability.
How SWOT and Porter's Five Forces work together: Porter's Five Forces analyzes the external competitive environment (feeds into O and T of SWOT). SWOT then matches internal capabilities (S/W) with external conditions (O/T) to form a strategy.
⚠ Exam Trap: Strengths and Weaknesses = INTERNAL. Opportunities and Threats = EXTERNAL. Don't mix them up.
CH 18 — Two Basic Strategies: Cost Leadership & Differentiation
CH 18 · STRATEGIES
Feature Cost Leadership Product Differentiation
Textbook Def. A business strategy where a company focuses on achieving economies of scale, incorporating learning curve effects, disposing of redundant assets, eliminating non-value-added activities, and/or implementing other cost efficiencies to reduce the costs of offering its products and services. A business strategy wherein the uniqueness, customization, and/or quality of a company's products and/or services sets it apart.
Competitive Advantage Lower selling prices Brand loyalty and the ability to command a price premium
Focus Eliminating waste, improving productivity, just-in-time inventory Research & development, patents, new product ideas, superior perceived value
BSC Metrics DM/DL cost variances, cycle time, defect rate, cost per unit # new products/patents, customer satisfaction, R&D spending, brand perception
Examples Walmart, Ryanair, McDonald's, IKEA Apple, BMW, Starbucks, Rolex
CH 18 — Customer Value Proposition & Compensation Types
CH 18 · CVP + COMP
Customer Value Proposition — 3 Types
TypeDescriptionStrategy
Operational ExcellenceBest total cost; reliable, convenient, no-hassleCost Leadership
Product LeadershipBest product; continuous innovation and superior qualityDifferentiation
Customer Solutions (Intimacy)Best total solution; deep relationships, customization to individual needsNiche / Relationship
Compensation Types (Textbook Definitions)
TypeDefinition
Hourly wagesBest for fewer skills, temporary, part-time, or contract positions. Overtime after threshold.
SalaryLarger skillset, long-term positions; paid for outcomes, not hours.
CommissionMotivate sales to increase revenues; based on total revenues or % of sales.
Piece rateRate paid per unit of outcome (e.g., # cars serviced or components assembled).
BonusesYear-end awards; % or sum based on overall business performance for year just ended.
Stock optionsLong-term equity incentive; canceled if not vested before employee leaves.
Incentive payShort-term forward-looking target achievement (more forward-looking than bonuses).
Short-term incentives → managers cut R&D/training/maintenance. Stock options align with long-run shareholder value.
CH 18 — BSC Definition & Financial/Nonfinancial Measures
CH 18 · BSC DEF

Balanced Scorecard (BSC): A framework for measuring organizational performance using both financial and nonfinancial performance measures. Created by Robert Kaplan and David Norton, it balances these measures while considering performance from multiple perspectives to ensure goal congruence.

Financial Measures (Lagging Indicators)

Definition: Financial performance measures that measure the results from decisions that happened in the past.

Objective: Evaluate profitability and past actions.

Examples: Gross margin, operating income, ROI, RI, standard cost variances, operating cash flows, EPS.

Nonfinancial Measures (Leading Indicators)

Definition: Nonfinancial performance measures that measure the actions the company is taking right now to drive future financial results.

Objective: Provide context to financial motives; observe metrics daily to make timely adjustments.

Examples: Average time to hire, employee turnover, product quality (defect rate), customer retention rate, net promoter score (customer referrals).

BSC "balances" lagging (financial) measures of past results with leading (nonfinancial) measures of future performance drivers.
CH 18 — BSC: Four Perspectives (FCIL) — Full Detail
CH 18 · 4 PERSPECTIVES
FCIL Mnemonic: "Firms Can Improve Learning" | Strategy Map flows BOTTOM-UP: Learning & Growth → Internal Process → Customer → Financial
PerspectiveQuestionTextbook ObjectivesExample Metrics
Financial How do we look to shareholders? Increase revenues; increase operating margins; increase cash flow. OI growth, revenue growth, cost reduction %, ROI, RI, EPS
Customer How do customers see us? Increase customer satisfaction; increase market share; increase number of new customers. Market share, customer satisfaction scores, retention rate, on-time delivery, brand perception
Internal Business Process What must we excel at internally? Decrease time from order placed to delivery; reduce rework/defects; improve efficiency. Cycle time, defect rate (% defect-free), process efficiency, throughput, # of patents
Learning & Growth ← Foundation Can we innovate and improve? Increase employee training; increase employee satisfaction; cross-train employees; empower employees to make decisions. This is the foundational perspective. Training hours, employee satisfaction, turnover rate, R&D spending, # new skills developed
CH 18 — BSC: Features of a Good BSC & Pitfalls to Avoid
CH 18 · BSC FEATURES
✓ 5 Features of a Good Balanced Scorecard
  1. Tells the story of the company's strategy through cause-and-effect relationships
  2. Communicates strategy to all members of the organization
  3. Motivates managers to take actions that result in financial performance improvements
  4. Limits the number of measures — focuses on the most critical ones; prevents information overload
  5. Highlights less-than-optimal trade-offs so managers can weigh competing objectives
⚠ 4 Pitfalls to Avoid with the BSC
  1. Don't assume cause-and-effect linkages are precise — they are hypotheses, not certainties
  2. Don't seek improvements in ALL measures simultaneously — some trade-offs are necessary and unavoidable
  3. Don't use ONLY objective (financial) measures — nonfinancial measures are essential leading indicators
  4. Don't ignore nonfinancial measures when evaluating managers and employees — they are leading indicators of future financial performance
Trade-off example: ↑ R&D spending (Learning & Growth) may ↓ short-term profitability (Financial). The BSC should highlight this trade-off, not hide it.
CH 18 — BSC Metrics by Strategy Type
CH 18 · BSC METRICS
Perspective Cost Leader Metrics Product Differentiator Metrics
Financial Operating income growth, revenue growth, cost reduction %, operating cash flow Revenue from new products, gross margin %, premium price achieved vs. competitors
Customer Market share, price vs. competition, on-time delivery rate, customer retention rate Customer satisfaction scores, brand perception/NPS, retention rate, customer referrals
Internal Business Process Cycle time (order to delivery), defect rate (% defect-free), process efficiency, throughput Product development cycle time, # of patents filed, innovation rate, # new product ideas
Learning & Growth Employee training hours, employee satisfaction score, turnover rate R&D spending %, # new technical skills developed, employee satisfaction, cross-training rate
⚠ Exam: DM/DL cost variances → Cost Leader. # patents/R&D → Differentiator. ROI → Financial (both). Employee training → Learning & Growth (both). Defect rate → Internal Process (both).
Formula Quick Reference — CH 12 Complete
CH 12 · ALL FORMULAS
Core OI Formulas
Abs OI = Var OI + FMOH Rate × (Prod − Sold) (or) Abs OI = Var OI + FMOH in EI − FMOH in BI Difference = ΔInventory Units × FMOH Rate FMOH Rate = Total Budgeted FMOH ÷ Denominator Capacity Level
Volume Variance
Vol Var = (Actual Prod − Budget Prod) × Budgeted FMOH Rate F if Actual > Budget (used more capacity) U if Actual < Budget (unused capacity) Zero if Actual = Budget
Inventory Cost by Method
AbsorptionVariable
DM✓✓
DL✓✓
VMOH✓✓
FMOH✓✗ (Period cost)
Capacity Level Rate Ranking
Theoretical → Lowest FMOH rate (÷ highest denominator) Practical → Middle rate ← RECOMMENDED Normal → Highest FMOH rate (÷ lowest denominator = demand)
Higher FMOH rate = Normal capacity. Causes Death Spiral if demand falls.
Formula Quick Reference — CH 14 Complete
CH 14 · ALL FORMULAS
Direct Method
Denom = Σ(oper. dept driver units) ONLY Rate = SD Cost ÷ Denom Alloc = Rate × Dept units ⚠ NEVER include other SDs in denominator.
Step-Down Method
Rank by highest % to other SDs → goes 1st Denom = ALL remaining OPEN depts (SDs + operating) New cost for step = Original + received ⚠ Closed SD gets NOTHING more.
Reciprocal Method
J = Direct_J + (J's share of P)×P P = Direct_P + (P's share of J)×J Solve simultaneously. Alloc each total to ALL other depts. Denom = all depts EXCEPT itself.
Common Cost Methods
Stand-Alone: User % = User SA ÷ Total SA Alloc = % × Common Cost
Incremental: Primary = full SA amount Secondary = Common − Primary
Total SD costs to operating depts = IDENTICAL across Direct, Step-Down, and Reciprocal. Only distribution between depts differs.
Formula Quick Reference — CH 17 Complete
CH 17 · ALL FORMULAS
ROI
ROI = OI ÷ Avg Assets DuPont: ROI = (OI ÷ Sales) × (Sales ÷ Assets) = ROS × Inv. Turnover Goal-congruence PROBLEM: rejects profitable projects that dilute ROI avg.
Residual Income (RI)
RI = OI − (RRR × Avg Assets) Accept if RI > $0 SOLVES ROI problem. Dollar amount (not %). Any RI > 0 = earns above required rate.
EVA
EVA = After-Tax OI − (WACC × Inv.Cap.) Inv. Capital = Total Assets − Current Liab. Accept if EVA > 0 Accounts for taxes and equity financing.
Transfer Pricing
Min TP (Seller) = VC + OC Idle: OC = $0 → Min TP = VC Full: OC = CM lost → Min TP = Ext. Market Price
Max TP (Buyer) = External Market Price Negotiated TP: anywhere between Min and Max Goal: both divisions better off
Formula Quick Reference — CH 1–11 Review
REVIEW · ALL FORMULAS
CVP (CH 4)
CM per Unit = SP − VC CM Ratio = CM ÷ SP BE Units = FC ÷ CM/unit BE $ = FC ÷ CM Ratio Target Units = (FC + Target Profit) ÷ CM per Unit
Variances (CH 10)
Price Var: (AP−SP) × Actual Qty Efficiency Var: (AQ−SQ) × Std Price FMOH Vol Var: (Act−Bud Prod) × FMOH Rate F = actual < standard U = actual > standard
High-Low (CH 3)
VC/Unit = (Hi Cost − Lo Cost) ÷ (Hi Units − Lo Units) FC = Hi Cost − (VC/Unit × Hi Units) Relevant Costs: Must be FUTURE Must DIFFER between alternatives
Process Costing & ABC Summary
FIFO: Keeps prior-period costs separate. EUP = current-period work only. More accurate for cost control.  |  WA: Blends prior + current. Simpler. Masks cost changes.  |  ABC: Multiple cost pools + drivers → more accurate than traditional single-rate → better for diverse product mixes.
Master Mnemonics & Key Traps
ALL CH · MNEMONICS
Mnemonics
DSR = Direct → Step-Down → Reciprocal (least → most accurate)
CRPI = Cost → Revenue → Profit → Investment centers
MGE = Motivation, Goal Congruence, Effort (MCS properties)
FDMC = Financial, Decision, Motivate, Cost Reimb. (why allocate)
FCIL = Financial, Customer, Internal, Learning (BSC perspectives)
ARA = Authority, Responsibility, Accountability (responsibility centers)
T→P→N = Theoretical→Practical→Normal = lowest→highest FMOH rate
CCSNS = Can't Survive Neglecting Suppliers (Porter's Five Forces)
Key Exam Traps to Avoid
⚠ Direct Method: operating depts ONLY in denominator (never other SDs)
⚠ Step-Down: closed SD never receives further allocations
⚠ EVA Invested Capital = Total Assets MINUS Current Liabilities
⚠ Absorption OI > Variable OI only when Produced > Sold
⚠ Normal capacity causes Death Spiral; Practical is recommended
⚠ Full capacity Min TP = External Market Price (not just VC)
⚠ ROI goal-congruence problem: manager rejects profitable projects to protect average ROI
⚠ SWOT: S & W = internal; O & T = external
⚠ Sunk costs are NEVER relevant to decisions
⚠ Variable costing is NOT GAAP — internal use only
ROI vs. RI vs. EVA — Side-by-Side Comparison
CH 17 · COMPARE
Feature ROI Residual Income (RI) EVA
Formula OI ÷ Avg Operating Assets OI − (RRR × Avg Assets) After-Tax OI − (WACC × Invested Capital)
Output Percentage (%) Dollar amount ($) Dollar amount ($)
Goal-Congruent? No — managers reject profitable projects that dilute their average ROI Yes — accept any project where RI > $0 (earns above required rate) Yes — accept any project where EVA > $0
Accounts for taxes? No No Yes — uses after-tax OI and WACC
Invested Capital Average operating assets Average operating assets Total Assets − Current Liabilities
Best use Comparing divisions/firms of different sizes; benchmarking Internal performance evaluation; overcomes ROI problem Accounts for full capital structure; shareholder value focus
CH 17 — Transfer Pricing: Full Decision Framework
CH 17 · TP DECISION
Step-by-Step: What is the minimum transfer price?
Seller's Situation Opportunity Cost Min TP (Seller's Floor) Implication
Has idle capacity — no external sales foregone $0 — no CM is sacrificed Variable Cost per unit Any price above VC is acceptable to seller; easy to find mutual price.
At full capacity — every internal unit displaces an external sale CM per unit = (External Price − VC) VC + CM lost = External Market Price Seller will not accept less than market price; transfer only makes sense if buyer's max TP ≥ market price.
The Negotiated TP Continuum
|---VC (idle) ---|---- Negotiated Zone ---|--- External Market Price ---| ↑ ↑ Seller minimum Buyer maximum (floor) (ceiling) If Min TP > Max TP → no mutually beneficial internal transfer price exists → Firm must intervene or allow buyer to purchase externally
Exam Day Quick-Reference: Most Tested Concepts
EXAM DAY · KEY FACTS
CH 12
  • Prod > Sold → Abs OI > Var OI
  • FMOH Rate × (Prod−Sold) = OI difference
  • Practical capacity = recommended for product costing
  • Normal capacity → death spiral risk
  • Variable costing NOT GAAP — internal only
CH 14
  • Direct Method denominator = operating depts ONLY
  • Step-Down: closed SD never receives allocation again
  • Reciprocal = most accurate (simultaneous equations)
  • Total allocated to operating depts = same across all 3 methods
  • Stand-alone: each % = user's SA ÷ total SA
CH 17
  • Investment Center = controls costs + revenue + assets
  • ROI = % (not goal congruent); RI & EVA = $ (goal congruent)
  • EVA: Invested Capital = Assets − Current Liabilities
  • Idle capacity: Min TP = VC. Full capacity: Min TP = market price
  • Vertical integration: backward = supplier; forward = distributor/retailer
CH 18
  • Porter's Five Forces: all external competitive forces
  • SWOT: S & W = internal; O & T = external
  • BSC: Kaplan & Norton; Financial/Nonfinancial (lagging/leading)
  • Strategy Map: bottom-up (L&G → Internal → Customer → Financial)
  • BSC pitfall #1: cause-and-effect links are hypotheses, not certainties
  • Cost Leadership = Operational Excellence CVP; Differentiation = Product Leadership CVP