Chapter 4


Chapter 4

Cost Management Systems and Activity-Based Costing


Chapter 4 Learning Objectives

1. Describe the purposes of cost management systems.

2. Explain the relationship among cost, cost object, cost accumulation, and cost assignment.

3. Distinguish between direct and indirect costs.

4. Explain the major reasons for allocating costs.

5. Identify the main types of manufacturing costs: direct materials, direct labor, and indirect production costs.


Chapter 4 Learning Objectives

6. Explain how the financial statements of merchandisers and manufacturers differ because of the types of goods they sell.

7. Understand the main differences between traditional and activity-based costing (ABC) systems and why ABC systems provide value to managers.

8. Use activity-based management (ABM) to make strategic and operational control decisions.

9. Describe the steps in designing an activity-based costing system (Appendix 4).


Cost Management System

A cost management system (CMS) isa collection of tools and techniquesthat identifies how management’sdecisions affect costs.

LearningObjective 1

The primary purposes of a cost management system are:1.To provide cost information for strategic management decisions and operational control and 2.For measures of inventory value and cost of goods sold for financial reporting.


Cost

A cost is a sacrifice or giving up ofresources for a particular purpose.A cost is a sacrifice or giving up ofresources for a particular purpose.

Costs are frequently measured bythe monetary units that must be

paid for goods and services.


Cost Object

A cost object (objective) is anything for which a separate measurement of costs is desired.

Customers Departments

Processing orders Product

Service


Cost Accounting Systems

Cost accounting is that part of the costmanagement system that measures

costs for the purposes of managementdecision making and financial reporting.


Cost Accounting System

Costaccumulation:

Collecting costs by some“natural” classification

such as materials or labor

LearningObjective 2


Cost Accounting System

Costaccumulation

Cost assignmentto cost objects

Cabinets

Desks

Tables

Material costs(metals)

Finishing DepartmentActivity ActivityActivity Activity

Cabinets

Desks

Tables

Machining DepartmentActivity ActivityActivity Activity

1. Departments

2. Activities

3. Products


Direct and Indirect Costs

Direct costs can be identified specifically and exclusively with a given cost objective

in an economically feasible way.

LearningObjective 3

Indirect costs cannot be identified specifically and exclusively with a given cost

objective in an economically feasible way.


Cost Allocation

Cost allocation assigns indirect costs to costobjects, in proportion to the cost object’s use

of a particular cost-allocation base.

A cost-allocation base is some measure ofinput or output that determines the amount of cost to be allocated to a particular cost object.

LearningObjective 4


Cost Allocation

An ideal cost-allocation base would measure how much of the particular cost is caused by the cost objective.

Note the similarity of this definition to that of a cost driver—an output measure that causes costs. Therefore, most allocation bases are cost drivers.

Cost allocations support a company’s CMS that provides cost measurements for strategic decision making, operational control, and external reporting.


Cost Allocation

Four purposes of cost allocation:

Predict economic effects of strategic and operational

control decisions.

Provide desired motivation and feedback for

performance evaluation.

Compute income and asset valuations for financial

reporting.

Justify costs or obtain reimbursement.


Cost Pool

1. Accumulate indirect costs for a period of time.

2. Select an allocation base for each cost pool, preferably a cost driver, that is, a measure that causes the costs in the cost pool.

Individual costs allocated to cost objects using a single cost-allocation base.


Cost Pool

3. Measure the units of the cost-allocation base used for each cost object and compute the total units used for all cost objects.

4. Multiply the percentage by the total costs in the cost pool to determine the cost allocated to each cost object.


Cost Assignment

Direct costs are physically traced to

a cost object. Indirect costs are allocated

using a cost-allocation base.


Unallocated Costs

Some costs lack an identifiable relationship to a cost object. Often it is best to leave such costs unallocated.

These unallocated costs are recorded but not assigned to any cost object.

An unallocated cost for one company may be an allocated cost or even a direct cost for another.


Li Company’s Statement of Operating Income

Statement of Operating Income


Categories of Manufacturing Costs

Manufacturing operations transform raw materials, the basic materials from whicha product is made, into other goods through theuse of labor and factory facilities.

In manufacturing companies, products are frequently the cost object.

LearningObjective 5

Manufacturing companies classifyproduction costs as either (1) direct material, (2) direct-labor, or (3) indirect production costs


Categories of Manufacturing Costs

Direct materials include the acquisition costs of all materials that a company identifies

as a part of the manufactured goods.

These costs are identified inan economically feasible way.


Direct Labor Costs

Direct Labor costs include the wages of all labor that can be traced specifically and exclusively to the manufactured goods in aneconomically feasible way.

In highly automated factories with a flexible workforce, there may not be any direct-labor

costs because all workers may spend time overseeing numerous products, making it

economically infeasible to physically trace any labor cost directly to specified products.


Indirect Production Costs (Manufacturing Overhead)

Manufacturing overhead includes all costsassociated with the production process that the company cannot trace to the manufactured goods in an economically feasible way.

Depreciation , property taxes, supplies, andinsurance are examples of indirect costs ofproduction. Minor items, such as tacks or glue, and many labor costs, such as janitors and forklift operators, are considered indirect labor costs and economically infeasible to trace.


Product Costs

Product costs are costs identified with goods produced or purchased for resale.

These costs first become part of the inventory on hand, sometimes called inventoriable costs.

Inventoriable costs become expenses in the form of cost of goods sold only when the inventory is sold.


Period Costs

Period costs are deducted as expensesduring the current period withoutgoing through an inventory stage.

These costs are accumulated by departments, such as R&D, advertising,

and sales. Most of these costs are reported as selling and administrative expenses.


Merchandising Company (Retailer or Wholesaler)

Merchandise Purchases

Merchandise Inventory

Sales

-Cost of Goods

Sold (Expenses)

- Selling Expenses - Administrative

Expenses

Period Costs

Gross Margin

Operating Income

Product (Inventoriable) Costs

Expiration

Financial Statement Presentation: Merchandising Companies

LearningObjective 6


Current Asset Sectionsof Balance Sheets


Inventory Sections of Balance Sheets

Manufacturing inventories comprise

three major categories:

Merchandise inventories composed of purchase costs including freight in.


Manufacturing Company Direct

Material Purchases

Finished Goods

Inventory

Sales- Cost of Goods Sold (Expenses)

- Selling Expenses and Administrative

Expenses

Period Costs

Gross Margin

Operating Income

Product (Inventoriable) Costs

Expiration

Financial Statement Presentation: Manufacturing Companies

Work-in-Process

Inventory

Direct Material

Inventory

Direct Labor

Indirect Production


Income Statement Presentationof Costs for a Manufacturer

Direct labor

Indirect manufacturing

The manufacturer’s cost of goods producedand then sold is usually composed ofthe three major categories of cost:

Direct materials


Income Statement Presentationof Costs for a Retailer

The merchandiser’s cost of goods soldis usually composed of the purchasecost of items, including freight-in,that are acquired and then resold.


Cost of Goods Sold Section of Income Statements

Beginning finished goods inventory $ 4,000Cost of goods manufactured: Direct materials $20,000 Direct labor 12,000Indirect production 8,000 40,000Cost of goods availablefor sale 44,000 Less: Ending finished goods 8,000Cost of goods sold $36,000

Manufacturer


Types of Costing SystemsLearningObjective 7

There are many different cost accounting systems, but most of the important features of these systems can be described in terms of two general types—traditional and activity-based costaccounting systems.

Companies adopt cost accounting systems that are consistent with their management philosophies and their production and operating technologies. Changes in philosophies or technologies often prompt corresponding changes in cost accounting systems.


Traditional Costing System


Traditional Costing System Statement of Operating Income

Traditional Cost Allocation SystemPen

CasingsCell Phone

Casings

Sales $440,000 $360,000 $80,000Direct materials 34,500 22,500 12,000Direct labor 150,000 135,000 15,000Indirect manufacturing 220,000 198,000 22,000Gross profit $ 35,500 $ 4,500 $31,000Corporate expenses 100,000Operating loss ($ 64,500)Gross profit margin 8.07% 1.25% 38.75%


ABC System


ABM is using the output of an activity-based cost accounting system to aid strategic decision

making and to improve operational control.

Activity-Based Management

A value-added cost is the cost of an activitythat cannot be eliminated without affecting

a product’s value to the customer.

Nonvalue-added costs are coststhat can be eliminated without affecting

a product’s value to the customer.

LearningObjective 8


Activity-Based Management

Benchmarking is the continuous process of comparing products, services, and activities to the best industry standards.

Benchmarking is a tool to help an organization measure its competitive posture. Benchmarks can come from within the organization, from competing organizations, or from other organizations having similar processes.


Benefits of Activity-Based Costing and Management Systems

set an optimal product mix

estimate profit margins of new products

determine consumption of shared resources

keep pace with new product techniques

Companies adopt ABC systems to:


Benefits of Activity-Based Costing and Management Systems (cont.)

keep pace with technological changes

decrease costs associated with bad decisions

take advantage of reduced cost of ABC Systems due to computer technology

Companies adopt ABC systems to:


Design of a Traditional Costing System


Design of an Activity-Based Cost Accounting System

Determine the keycomponents of the

cost accountingsystem.

Cost objectivesKey activitiesResourcesRelated cost drivers

LearningObjective 9



Account billingBill verificationAccount inquiryCorrespondenceOther activities

Number of printed pagesNumber of accounts verifiedNumber of inquiriesNumber of lettersNumber of printed pages

KeyActivity

Cost Driver


Activity PerformedResource Account Used to Inquiry Correspondence Billing Verification All OtherPerform Activity Activity Activity Activity Activity Activities Total

Supervisor 40% 10% 30% 20% 100%Account inquiry labor 90 10 100%Billing labor 30 70 100%Verification labor 100 100%Paper 100 100%Computer 45 5 35 10 5 100%Telecommunications 90 10 100%Occupancy 65 15 20 100%Printing machines 5 90 5 100%All other department resources 100 100%

Determine relationships among cost objectives, activities, and resources.




Collect relevant data concerning costs and the physical flow of the cost-driver units among resources and activities.

Number of Cost Driver UnitsActivity Cost

Driver Units Residential Commercial Total

Account inquiry Inquiries 20,000 5,000 25,000

Correspondence Letters 1,800 1,000 2,800

Bill printing Printed pages 120,000 40,000 160,000

Verification Accounts verified 20,000 20,000

Other activities Printed pages 120,000 40,000160,000



Calculate and interpret the newactivity-based information.

Determine the traceable costs for each of the activity cost pools.

Determine the activity-based cost per account for each customer class.


Strategic Decisions, Operational Cost Control, and ABM

Outsourcing

Reducing operating costs

Identifying nonvalue-added activities

Improving both strategicand operational decisions


Number of Cost Driver Units

Activity Cost Driver Units Residential Commercial Total

Account inquiry Inquiries 20,000 5,000 25,000

Correspondence Letters 1,800 1,000 2,800

Billing Printed pages 120,000 40,000 160,000

Verification Accounts verified 20,000 20,000

Other activities Printed pages 120,000 40,000 160,000


Number of Cost Driver Units for the Billing Department


Two-Stage Cost Allocation for Billing Department Operations


Activity Cost Pool

Resource Account Cost Inquiry Correspondence Billing Verification Other

Supervisors $ 33,600 $ 13,440 $ 3,360 $ 10,080 $ 6,720Account inquiry labor 173,460 156,114 17,346Billing labor 56,250 16,875 $39,375Verification labor 11,250 11,250Paper 7,320 7,320Computer 178,000 80,100 8,900 62,300 17,800 8,900Telecommunication 58,520 52,668 5,852Occupancy 47,000 30,550 7,050 9,400Printers 55,000 2,750 49,500 2,750Other resources 67,100 67,100Total cost $687,500 $332,872 $32,356 $153,125 $68,425 $100,722

Total traceable costs for the 5 activity cost pools.



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Chapter 4

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Transcript of Chapter 4