Cost Measurement Systems

Traditional and Contemporary

Approaches

Sam Houston State University

ACC 564

R. Quarles

Quarles, ACC 564, CMS

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 Cost Measurement Systems
• Should not be confused with accounting
• Do not address external reporting
issues
• Are based on the idea of being
approximately correct rather than
precisely wrong
• Do not provide the answer
• Are not dictated by a board of wise
persons in Connecticut or by a bunch of
clowns in Washington
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 Cost Measurement Systems

• Cost measurement systems provide

more questions and sometimes
answers to questions related to
strategic objectives of
– Quality
– Cost
– Time

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 Strategic Objectives
• Quality
– Features
– Reliability
• Costs involved
– How much do features/reliability cost?
– Can customers afford the level of quality provided?
– How much does it cost to add new features or
increase reliability?
– How do we determine the cost of each feature or
reliability element?

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 Strategic Objectives
• Cost
– Must be measured in order to be managed
– Related directly/indirectly to a product/service
• Final reckoning - all costs incurred to provide
product/services
– What causes costs?
– Poor cost measurement may result in
incorrectly leaving or remaining in a market
– Cost system must identify, track, report costs of
providing services or
creating/delivering/supporting a product
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 Strategic Objectives
• Time
– Meeting delivery deadlines
– Bringing product/service to market rapidly and
proper point in time
– Late delivery within the firm can delay other
steps and increase costs
– Altering process time schedules affects costs
– Cost system must identify/measure time factors
and costs of delays/alterations

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Attributes of a Good Cost System
• Technical Attributes
– Decision Relevance
• Cost data related to strategic objectives
– Cost of features/reliability
– Identification of causes of cost for management attention
• Provide data for decision regarding
– What customers/markets to target
– Product prices/profitability plans
– What products to promote
– Levels of quality/service to provide
– How manage costs/allocate resources

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Attributes of a Good Cost System
• Technical Attributes
– Process Understanding
• Help management understand work processes
• Help management understand economic impact of
activities that reduce/increase
– Quality/Costs/Time
• Identifies costs across all steps in process - where
are delays/cost multipliers
• Identifies relationship between work done and cost
incurred - ripple effect of activities in one area
• Helps understand why work occurs and what drives
costs
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Attributes of a Good Cost System
• Behavioral Attributes
– Cost data
• Increases visibility of activities
• Focuses attention
• Communicates managerial intent
– Cost structure visibility - highlights cost drivers
• Decisions on products and processes affect costs
• Cost data affects decision behaviors
– Communications with operations personnel
• Non-accountants tolerate but do not understand
• Bookkeeping versus working
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Attributes of a Good Cost System
• Behavioral Attributes
– Employee Motivation
• Cost data traditionally used to FIX BLAME
– Leads to short-run decision emphasis
– Cost data can be used to focus on how to work better, not
who to blame

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Attributes of a Good Cost System
• Cultural Attributes
– Culture can emphasize blame or process
improvement
• Who spent the money versus is what is being done
• Cross functional participation
– Focus on cost objects reduces emphasis on departments
– Activities necessary to produce cost cross departmental
boundaries
– Employees in different departments must work together to
carry on activities
• Cost system should encourage process
improvement and cross functional participation
rather than fixing blame
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Attributes of a Good Cost System
• Improves strategic decisions by providing
data on quality, cost, and time performance
• Facilitates process management by
providing data on the cost of the processes
(activities and operations) used, and the
underlying causal relationships (drivers) that
cause costs to change.
• Encourages behaviors consistent with
strategic objectives
• Creates mindsets and values that promote a
healthy and positive organizational culture.
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Nature of Cost Measurement Systems

• Cost Measurement
– Must exist separately from bookkeeping system
• Emphasis on accountability for expenditures
• Tracking of cost of resources PURCHASED as
opposed to those USED
– Reorganizes data on resources acquired to
provide strategic cost data
• Not to be confused with accounting

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 TYPICAL COST MEASUREMENT
SYSTEM
• Transformation engine that converts
raw data on resources purchased into
cost information about resources used
Basic Cost The Building Blocks Output
Elements •Cost Objects Strategic Cost
•Cost flows/tracking procedures Information
•Materials purchased
•Allocation rules •What products are
•Wages and salaries most profitable?
•What does each
•Utilities paid process step add to
costs?
•Equipment purchases
•Which customers are
•Lease payments profitable?
•What are the key cost
•Other expenditures drivers?

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Nature of Cost Measurement Systems

• Building blocks of Cost Measurement

– Cost Objects
• Any item for which a measure of cost is desired
– Products, customers, lines of business, markets, etc.
• Corresponds to strategic decision needs
– Tracking Procedures
• Traditional Systems
– Resources to Departments to Cost Objects
• Contemporary Systems
– Resources to Activities to Cost Objects

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Nature of Cost Measurement Systems

• Building blocks of Cost Measurement

– Allocation Rules
• Direct Costs
– Cost of consumption of resources directly traceable to or
assignable to a particular cost object
» Direct labor Direct material
• Indirect Costs
– Cannot be directly traced or directly attributable to a
particular cost object
– Must be allocated to cost objects in some consistent,
logical, and informative manner

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Design of Cost Measurement Systems

• Affects on Cost Systems

– Mass Production
• Substantial inventories leads to emphasis on
inventory measurement and manufacturing product
cost
• Unskilled labor with authority vested in functional
departmental manager - responsibility accounting
– Responsibility center cost tracking
• Little product variety allows use of single allocation
base for all indirect costs

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 Traditional Cost Measurement
• Two Approaches
– Job Order and Process Costing
• Job order appropriate where specific, unique jobs or
batches can be identified
– One of a kind or custom manufacturing
• Process costing appropriate for high volume of
identical products using a continuous process
– Oil refining, brewing, bread, cement, chemical
manufacturing, etc.
– Resources
• Period expenses: not associated with creating
inventory
• Product cost: creation of inventory
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 Job Order Costing
• Resource cost traced to functional areas
– Resources consumed by manufacturing area
will be product costs
– Cost centers
– Costs within cost centers
• Direct materials, direct labor, common costs
– Costs within the cost center traced to specific
jobs or batches
• Materials by requisition sheets
• Direct labor by time cards
• Others allocated based on some allocation basis
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TRADITIONAL JOB COST SYSTEMS

Cost Elements Building Blocks

Functional Costs Manufacturing Customer Product
•Materials Departments Jobs
•Engineering Inventory
•Wages and salaries Cost
•Purchasing
•Utility costs •Stamping •Sweden
•Manufacturing
•Sales commissions •Assembly •Zimbabwe Cost per
•Customer
Heat
•Equipment Support •Testing •Others
Exchanger
purchase •Sales/marketing
•Advertising •General business Period
•Supplies support Expenses

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 Job Order Costing
• Costs traced to specific jobs or batches
Exhibit 4: Analysis of Manufacturing Costs by Jobs

Sweden Zimbabwe Other Totals

Direct Materials
Stamping 384,000 192,000 2,624,000 3,200,000
Assembly 108,000 72,000 1,020,000 1,200,000
Testing 54,000 18,000 228,000 300,000
Direct Labor 0
Stamping 5,000 3,000 242,000 250,000
Assembly 5,000 26,250 718,750 750,000
Testing 24,000 16,500 109,500 150,000
Overhead 0
Stamping 48,750 32,500 1,543,750 1,625,000
Assembly 292,500 146,250 4,436,250 4,875,000
Testing 97,500 29,250 848,250 975,000
Total Job Cost $ 1,018,750 $ 535,750 $ 11,770,500 $ 13,325,000
Number of Units 8 6 86
Current Status in process complete
Cost per Unit $ 127,344 $ 89,292
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 Process Costing

• Products are not unique within a production

run
– Identical and therefore consume equal amounts
of resources
– Simple procedure is to determine costs of
production runs and divide by number of units
produced to determine cost per unit

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 Process Costing
• Complicating factor
– Work in process
• Beginning and ending WIP in various stages of
completion
• Completion as to % of cost incurrence
• WIP at end of period is come % complete as to the
total cost that will be incurred in its completion
• Equivalent Units of Production

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 Process Costing
Calculation of EUP (weighted average)

Units completed and transferred 1,000,000

Ending WIP
40,000 units 60% complete 24,000
__________

Equivalent Units Produced 1,024,000

Cost incurred / EUP = Cost per unit

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TRADITIONAL COST SYSTEMS
• Reflect a management philosophy of:
– Responsibility by departments or cost
centers
– Financial rather than operational
control
– After-the-fact cost control rather than
cost planning
• Primary focus
– Manufacturing costs (same as product
cost)
– Inventory and labor reporting
• Cost flows from department to products
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 Traditional Systems
• Weaknesses
– Product cost is not the total cost of the
product
• Manufacturing cost only
• Ignores design,creation, installation,service, etc.
– Indirect cost (overhead) significant element
of total cost but no data provided of what
causes these costs in relation to particular
products or volumes or processes

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 Cost Measurement Systems
• New concepts affecting systems
– TQM
• Cross functional management of processes
reduce emphasis on responsibility accounting
– Lean Manufacturing or TQM
• Reduces/eliminates inventory issues
– World Class Competition
• Identify and manage costs, not purchases
– Total Product Cost
• Manufacturing cost plus all costs of getting
product/service to customer
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 Activity Based Costing
– Emphasis on activities and their relationships
to resources and cost objects
• Steps in ABC
• Step 1: identify activities and objects
used by jobs/processes
• Process map
• Activities are related tasks that are accomplished
in order to do what the work

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 Activity Based Costing
• Step 2: compute the cost of activities
Exhibit 12: Activity Cost for Heat Exchangers
Activity or Ope ration Cost
Visit prospective customers $ 83,600
Develop product specifications 608,000
Draft contract 270,000
Purchase materials 288,000
Set up stamping machines 1,176,000
Stamp steel plates 3,952,000
Build frame 756,000
Insert plates into frames 5,040,000
Attach cover 126,000
Move unit to paint shop 9,000
Paint 480,000
Test 770,000
Transport to customer site 910,000
Final assembly 702,000
Final inspection 504,000
Bill customer 8,400
Other activities 87,000
Total Activity Cost $ 15,770,000
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 Activity Based Costing
• Step 3: determine cost drivers for each
activity
– Cost drivers
• (activity usage drivers) must be identified
• what causes the activities to cost what they do

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 Activity Based Costing
• Cost drivers for each activity
Exhibit 13: Activity Cost for Heat Exchangers
A B A/ B
Driver Cost per
Activity or Operation Cost Driver Quantity Unit of Driver
Visit prospective customers $ 83,600 Number of trips 22 $ 3,800
Develop product specifications 608,000 Engineering hours 3,800 160
Draft contract 270,000 Legal staff hours 1,800 150
Purchase materials 288,000 Per purchase order 2,400 120
Set up stamping machines 1,176,000 Per production run 120 9,800
Stamp steel plates 3,952,000 Per machine hour 520 7,600
Build frame 756,000 Per component 420 1,800
Insert plates into frames 5,040,000 Per plate 6,300 800
Attach cover 126,000 Attachment points 2,100 60
Move unit to paint shop 9,000 Per unit 120 75
Paint 480,000 Surface area sq ft 32,000 15
Test 770,000 Per test 275 2,800
Transport to customer site 910,000 Per trip 140 6,500
Final assembly 702,000 Per unit 120 5,850
Final inspection 504,000 Per unit 120 4,200
Bill customer 8,400 Per bill 28 300
Other activities 87,000
Total Activity Cost $ 15,770,000
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 Activity Based Costing

• Step 4: create cost pools for common

drivers
– Simplify calculations and emphasizes drivers
that account for significant costs

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 Activity Based Costing
• Step 5: assign costs to jobs/processes based
on cost drivers
Exhibit 14: Cost Assigned to Jobs
Sweden Job Zimbabwe Job
Units of Cost per Cost Units of Cost per Cost
Activity or Operation Driver Driver Assigned Driver Driver Assigned
Visit prospective customers 4 $ 3,800 $ 15,200 1 $ 3,800 $ 3,800
Develop product specifications 1,400 160 224,000 300 160 48,000
Draft contract 18 150 2,700 4 150 600
Purchase materials 240 120 28,800 90 120 10,800
Set up stamping machines 11 9,800 107,800 3 9,800 29,400
Stamp steel plates 22 7,600 167,200 8 7,600 60,800
Build frame 38 1,800 68,400 25 1,800 45,000
Insert plates into frames 280 800 224,000 95 800 76,000
Attach cover 122 60 7,320 90 60 5,400
Move unit to paint shop 14 75 1,050 6 75 450
Paint 3,800 15 57,000 825 15 12,375
Test 18 2,800 50,400 6 2,800 16,800
Transport to customer site 0 6,500 0 2 6,500 13,000
Final assembly 0 5,850 0 6 5,850 35,100
Final inspection 0 4,200 0 6 4,200 25,200
Bill customer 0 300 0 1 300 300
Total Activity Cost $ 953,870 $ 383,025

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 Activity Based Costing
• Step 6: determine unit product cost
(Direct Material + Activity Cost) / # of units
Exhibit 15: Comparison of Job Cost
Sweden Zimbabwe
Total Job Cost Cost per Unit Total Job Cost Cost per Unit
Activity View
Material Cost 546,000 68,250 282,000 47,000
Activities Cost 953,870 119,234 383,025 63,838
Total Cost 1,499,870 187,484 665,025 110,838

Traditional View
Direct Materials 546,000 68,250 282,000 47,000
Direct Labor 34,000 4,250 45,750 7,625
Manufacturing Overhead 438,750 54,844 208,000 34,667
Total Cost 1,018,750 127,344 535,750 89,292
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TRADITIONAL V. CONTEMPORARY
COST SYSTEMS

Basic Cost Elements

• Salaries & Wages
• Utilities PRODUCTS
DEPARTMENTS JOBS
• Depreciation
• Materials & Supplies
• Taxes

Basic Cost Elements

• Salaries & Wages
• Utilities ACTIVITIES/
JOBS PRODUCTS
• Depreciation OPERATIONS
• Materials & Supplies
• Taxes

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TRADITIONAL V. CONTEMPORARY COST SYSTEMS

Engineering Activities
• Write specifications
• Others

Manufacturing Activities
•Purchase materials TRADITIONAL
•Receive and inspect materials PRODUCT
•Move materials COST
•Set up machines
•Stamp steel
•Move stamped steel CONTEMPORARY
•Assemble plates PRODUCT
•Inspection COST
•Rework
•Others

Marketing Activities
•Generate customer order
• Others
Customer Support
Activities
•Install exchangers
• Others
Business Support Activities
•Investigate credit
•Draft contract
•Bill customer
• Others

Non-traceable Activities
•Management training
• Others
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 Assignment Notes
• Yamazoo
– Conversion Cost
• The total of Direct Labor and Overhead (all
manufacturing cost except Direct Materials)

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