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Module 9

Intermediate
Management
Accounting
Week 3
Student Notes

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© 2015, Chartered Professional Accountants of Canada. All Rights Reserved.

Table of Contents
TOPIC 3.0 OVERVIEW: PROCESS COSTING, INDIRECT COST ALLOCATION SYSTEMS,
ACTIVITY-BASED COSTING SYSTEMS AND OTHER METHODS FOR DETERMINING
AND CONTROLLING COSTS ............................................................................................... 3
TOPIC 3.1 PROCESS COSTING .............................................................................................. 3
3.1-1 Process costing systems................................................................................................. 3
3.1-2 Process costing steps: Establishing physical flow and equivalent units .......................... 5
3.1-3 Process costing approaches ........................................................................................... 8
3.1-4 Weighted average cost flow assumption ......................................................................... 8
3.1-5 Spoilage ........................................................................................................................ 11
3.1-6 Transferred-in costs ...................................................................................................... 13
3.1-7 First-in first-out (FIFO) cost flow assumption ................................................................ 15
3.1-8 Hybrid and operations costing systems ........................................................................ 17
TOPIC 3.2 INDIRECT COST ALLOCATION SYSTEMS .......................................................... 19
3.2-1 Indirect cost allocation systems design ......................................................................... 19
3.2-2 Objective in indirect cost allocation system design ....................................................... 20
3.2-3 Cost allocation system improvement ............................................................................ 21
TOPIC 3.3 ACTIVITY-BASED COSTING SYSTEMS .............................................................. 24
3.3-1 Activity-based costing systems design .......................................................................... 24
3.3-2 The ABC cost hierarchy ................................................................................................ 25
3.3-3 Differences between ABC and traditional costing ......................................................... 26
3.3-4 Activity-based management .......................................................................................... 32
3.3-5 Costs and benefits of ABC and ABM ............................................................................ 32
TOPIC 3.4 OTHER METHODS FOR DETERMINING AND CONTROLLING COSTS ............. 33
3.4-1 Kaizen costing............................................................................................................... 33
3.4-2 Product life cycle costing .............................................................................................. 33

Module 9 — Intermediate Management
Accounting
TOPIC 3.0 OVERVIEW: PROCESS COSTING, INDIRECT COST ALLOCATION SYSTEMS,
ACTIVITY-BASED COSTING SYSTEMS AND OTHER METHODS FOR DETERMINING AND
CONTROLLING COSTS
This week concludes the discussion of costing systems. In Week 2, these notes discussed job
order costing systems and the accompanying journal entries to record costs. This week’s
discussion begins with process costing, which is a method of recording product costs when
identical products are produced in mass amounts. The challenge with most costing systems is
choosing a method to effectively allocate overhead to the product. This week’s material
discusses indirect costing systems and introduces activity-based costing systems as a
supplement to traditional costing systems. The material concludes with a brief discussion of
other costing systems and two additional costing methods.
TOPIC 3.1 PROCESS COSTING
3.1-1 Process costing systems
Process costing is a costing system suitable for costing the mass production of identical
products, for example, packaging soft drinks and manufacturing plastic bottles. When an
organization is making a large volume of identical products, the cost per unit calculation is
trivial. The management accountant will simply divide the total manufacturing costs by the
number of units produced to compute the cost per unit.
While this process is different from the job costing method considered in Week 2, there are
some similarities. The following are some of the similarities and differences between job order
costing systems and process costing systems.
Similarities

The purpose is to assign costs to products.

Both systems focus on direct materials, direct labour and manufacturing overhead.

Costs flow through a work-in-process account.

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Example 3. which grind and refine the mixture. The milk-sugar mixture is slowly dried until it turns into a thick. Cocoa beans are roasted in large. process costing identifies the cost per unit incurred at each step. After the beans are removed from the pods. Inside each pod are about 20-40 seeds or cocoa beans. they are placed in large heaps or piles and left for about a week. Every day. The chocolate crumb powder is used to make milk chocolate. Once the paste is inside the conche. making it smoother. tanker trucks bring fresh milk to the factory. Unit costs are calculated for each department. Costs are collected and recorded by department/process. the ideas and concepts of process costing can be fully developed in simple environments and applied to more complex situations. brown powder called chocolate crumb. This is called fermentation. pasteurized and then mixed with sugar. Costs are collected and recorded for each job. Thus. called the nib. adapted from material at hersheys.com. This new mixture is dried into a coarse. large granite rollers smooth out the gritty particles from the crumb. where it is tested.1a: Process flow at Hershey’s Cacao trees grow melon-like fruit. which is harvested by hand. However. The crumb travels through special steel rollers. describes the process of making chocolate bars.Module 9 — Intermediate Management Accounting Week 3 — Student Notes Differences Job order costing Products Cost accumulation Reporting of costs Unit costs Each product is unique. At the heart of the chocolate factory is the central blending operation. Costs are accumulated and reported on the job cost sheet. where the chocolate liquor is combined with the milk and sugar. The examples presented here deal with simple settings involving a small number of steps and departments. Process costing Each product is the same as all others. revolving roasters at high temperatures. roasted cocoa beans and separates the shell from the inside of the bean. where they are cleaned and stored. To illustrate a more detailed process flow. The crumb then becomes a thick liquid called chocolate paste. In a process costing system. Costs are reported on the department production report. which is poured into huge vats called conches. the focus is on identifying the cost of each of the steps (processes) needed to produce the final product. which brings out the rich taste and creamy texture of the chocolate. A special hulling machine then takes the dried. Unit costs are calculated for each job. Railroad cars then carry the cocoa beans to the chocolate factory. Hershey adds cocoa butter to the crumb. Milling is a grinding process that turns the nibs into liquid called chocolate liquor. taffy-like material. the following example. the product passes through numerous steps on most production lines. This process can take anywhere from 24 to 72 hours to 4 / 33 .

Finally. Now it is ready to be wrapped. the equivalent units of production for the period. Most chocolate bars are made by pouring the liquid chocolate paste into moulds. The finishing department employees sand the bat.1-2 Process costing steps: Establishing physical flow and equivalent units To apply process costing. process costing determines how many partial units are equivalent to a complete unit (called equivalent units) as a way of including incomplete work in the calculations. As you can see. stamp the bat with the company logo and apply a finish. 3. where the liquid chocolate is gently chilled into a solid candy bar.1b: Period 1 process costing steps at Pepper Bat Company Pepper Bat Company manufactures wooden baseball bats in two departments: forming and finishing. The pieces are then put on a lathe to form the bat. The paste is tempered or cooled in a controlled manner until it reaches the right texture and consistency. the cost per equivalent unit and the allocation of the costs. the management accountant needs to determine the physical flow of goods. Pepper Bat Company’s manufacturing process. This information allows managers to identify opportunities to improve cost performance. can be mixed into the paste during tempering or added directly to the moulds. vibrating ride to remove air bubbles and allow the chocolate to settle evenly. introduced in the following example. is used to illustrate the four steps in the process. they wind their way through a long cooling tunnel. The forming department employees remove lumber from stores and cut it into pieces that each measure approximately 1. The filled moulds then take a bumpy. like almonds or peanuts. Each unit of lumber yields approximately five pieces. Because work-in-process usually includes some incomplete units at the end of the accounting period. This is the insight and value of process costing. Pepper Bat Company Forming department  Cut lumber stock  Shape bat on lathe 5 / 33 Finishing department  Sand bat  Stamp bat  Apply finish . Each of these steps involves a process where costs can be incurred.Module 9 — Intermediate Management Accounting Week 3 — Student Notes complete.5 metres by 10 centimetres by 10 centimetres. there are many steps in the process of making a Hershey’s chocolate bar. Other ingredients. Example 3. The costs of all the steps in the process of making chocolate bars can be accumulated and used to determine the total cost of the product.

if there were 1. Because the units completed and transferred out are complete.Module 9 — Intermediate Management Accounting Week 3 — Student Notes The following table summarizes information for the forming department in the first period: Item Number/cost Pieces of lumber started Pieces completed Lumber cost Direct labour cost Manufacturing overhead 5.000 $65. the management accountant would say the ending work-in-process is equivalent to conversion work on 250 (25% of 1.000 5. Pepper Bat Company has two cost elements: materials (the cost of the wood) and conversion costs (the cost of labour and manufacturing overhead). Goods in beginning work-inprocess plus all units started must end up in one of three places: units completed and transferred out. The following table summarizes the physical flow at Pepper Bat Company: Forming department Physical flow Opening work-in-process Started this period Units to account for Completed and transferred out Ending work-in-process Units accounted for Physical units 0 5.000 5.000 $46. there are no equivalent units in ending inventory. The equivalent unit concept is used when there is partially completed work-in-process at the end of an accounting period. For example.000 Step 1: Determine physical flow of goods The first step in process costing is to identify the physical flow.000 physical units in ending work-in-process and 25% of the conversion was completed for those units. ending work-in-process or spoiled goods (to be discussed in Topic 3.000 0 5.1-5).000 $23. 6 / 33 .000) complete units.000 5. Since there is no ending work-in-process in this example. the equivalent units equal the physical units.000 Step 2: Calculate the equivalent units of production for the period The second step in process costing is to identify the equivalent units of production for each of the cost elements.

000 This is equal to the total costs incurred: $65.000 $ 13. Total cost per unit transferred out = $13.80 *Conversion costs consist of direct labour + manufacturing overhead.000 Labour + $46. the management accountant introduces costs into the process costing calculation and computes the cost per equivalent unit with the following result for our example: Materials Costs incurred this period Divide by equivalent units Cost per unit Conversion costs* $ 65. the management accountant allocates the total costs to account for ending work-in-process and work completed and transferred out.000 0 5.000 5.00 + 13.00 $ 69.000 overhead = $134.000 Step 3: Calculate the cost per equivalent unit for each cost category In this step.000 5.000 0 5.000 $ 13. 7 / 33 Lumber + 23.000 Manufacturing .000 5.80 Step 4: Assign costs to appropriate accounts In the final step.Module 9 — Intermediate Management Accounting Week 3 — Student Notes The management accountant would produce the following table to show this: Equivalent units Materials Conversion Units transferred out Equivalent units in ending WIP 5. The following is what the completed process costing statement would look like for Pepper Bat Company: Costs of units transferred out 5.80 = $26.80 $134.000 units × $26.000.

000 5. so work-in-process will always be 100% complete with respect to materials costs. all materials are entered at the start of production.1c: Period 2 process costing at Pepper Bat Company using the weighted average method The following information summarizes the activities in the forming department in the second period: Item Pieces of lumber started Pieces completed Lumber cost Labour cost Manufacturing overhead Materials % completion Conversion % completion Number/cost 6. Using the weighted average method.000 100% 45% Note that Pepper Bat Company now has ending inventory in work-in-process. 3. In the forming department.000 $28.1-4 Weighted average cost flow assumption First. The main difference between the two is that the weighted average method doesn’t separate the cost of the work done in the previous period from the work done in the current period. so the work on the ending inventory is deemed (by estimate) to be 45% complete.Module 9 — Intermediate Management Accounting Week 3 — Student Notes 3.000 $49. However. whereas FIFO separates the costs and units of each period. consider processing costing at Pepper Bat Company using the weighted average method. conversion takes place uniformly in this department.500 $73. the management accountant would produce the following process costing report for the second period: 8 / 33 . Example 3.1-3 Process costing approaches The two most widely used process costing approaches in Canada are the weighted average method and the first-in first-out (FIFO) method.

6165) Cost of units transferred out (5.500 500 6.891 TO CA 73.109 .000 28.500 × $25.026 $9.1667) Conversion costs (225 × $13.083 3.6165) Cost of ending WIP: Materials (500 × $12.4498 $140.000 $13.891 $6.000 49.000 $12.725 $73.Module 9 — Intermediate Management Accounting Week 3 — Student Notes Forming department Period 2 — weighted average Units transferred out Equivalent units in ending WIP (M = 500 × 100% | CC = 500 × 45%) Costs incurred during the period Cost per equivalent unit (total = $25.000 225 5.000 E 9.4498) The T-account view of the process is as follows: Work-in-process B $ 0 140.891 B = Beginning inventory CA = Costs added E = Ending inventory TO = Costs transferred to finished goods Equivalent units Conversion Materials costs 5.1667 $77.500 5.109 where 9 / 33 Finished goods 140.

2627) Cost of ending WIP: Materials (100 × $13.900 × $27.587 $ 1.083 $ $ 3.500 4.000 $ Cost per equivalent unit (total = $27.6461 $ 133.900 $62.000 E 2.900 4.6166) Conversion costs (85 × $13.000 100% 85% Forming department Period 3 — weighted average Equivalent units Conversion Materials costs 4.6461) 85 4.000 44.900 Units transferred out Equivalent units in ending WIP (End WIP = 500 Beginning WIP + 4.362 1.522 10 / 33 Finished goods 133.985 6.1d: Period 3 process costing at Pepper Bat Company The following table reports the results for Period 3: Item Number/cost Pieces of lumber started Pieces completed Lumber cost Labour cost Manufacturing overhead Materials % completion Conversion % completion 4.160 2.Module 9 — Intermediate Management Accounting Week 3 — Student Notes Example 3.522 $ B Work-in-process $9.000 $21.026 65.500 Started – 4.000 $ 68.587 TO CA 62.2627) Cost of units transferred out (4.083 62.026 $ 13.000 21.6166 $ 13.000 $44.587 .900 Completed = 100 units) (M = 100 × 100% | CC = 100 × 85%) Costs in opening WIP Costs incurred during the period 100 5.109 133.000 68.

the ending work-inprocess must be 500 units. With this information. this means abnormal spoilage would be recorded as 60 units (300 – 240). at the Pepper Bat Company. the management accountant would produce the following process costing report for Period 4: 11 / 33 .500 units started and 5. the number of good units produced and transferred out must have been 4. 5.000 $56. For example. Finally.000 $31.800).1-5 Spoilage Inherent in any manufacturing process is the potential for spoilage. Example 3. Since total spoilage was 300 units.500 5. Bats are inspected at the end of the forming process and units found to be defective (because of splits or knots in the wood) are rejected and cut up for firewood. since there were 100 units in opening inventory.800 (5.100 – 300).100 units completed. Management has established an allowance for normal spoilage equal to 5% of good units produced. The process costing model has a provision for handling spoilage related to defective units. there is a certain amount of spoilage expected due to faults in the raw material.100 300 $74. Because the normal spoilage allowance is 5% of good production.Module 9 — Intermediate Management Accounting Week 3 — Student Notes 3.000 100% 25% Since inspection occurs at the end of production in the forming department.1e: Period 4 process costing results at Pepper Bat Company Pepper Bat Company’s results for Period 4 are as follows: Item Pieces of lumber started Pieces completed Pieces found to be defective Lumber cost Labour cost Manufacturing overhead Materials % completion Conversion % completion Number/cost 5. the normal spoilage allowance for this period would be 240 units (5% × 4.

820 AS E 8.600 $ 1.000 $ 75.000 1.000 88.864 CA 74.100 – 300 Spoiled) Normal spoilage Abnormal spoilage Equivalent units in ending WIP (End WIP = 100 Beginning WIP+ 5.820 $ $ $ $ $ $ $ $ Work-in-process B $2. the spoilage rate is usually based on the good units that pass inspection rather than the good units transferred to 12 / 33 .729 2.109 8.000 31.362 74.800 Transferred out – 300 Spoiled = 500) (M = 500 × 100% | CC = 500 × 25%) Costs in opening WIP Costs incurred during the period Cost per equivalent unit (total = $30. inspection can take place at intermediate stages of production.522 152. Inspection before product completion To avoid incurring higher spoilage costs.Module 9 — Intermediate Management Accounting Week 3 — Student Notes Forming department Period 4 — weighted average Equivalent units Materials Conversion costs Units transferred out (5.864 TO 6.585 7.160 16.8727) 4.838 Finished goods 152.4575) Conversion costs (125 × $16.000 56.3302) Cost of abnormal spoilage (60 × $30.3302) Cost of good units transferred out (4.800 240 60 4.362 $ 13.800 × $30.500 Started – 4.3302) Cost of ending WIP: Materials (500 × $13. Detecting spoilage early can save additional direct materials and conversion costs that would be lost if the inspection took place at the end of the process.160 87.838 where AS = Abnormal spoilage The cost of abnormal spoilage would be charged to the income statement for the period.8727 145.225 1.279 152.800 240 60 500 5. In those cases where inspection takes place at less than 100% completion.4575 125 5.3302) Normal spoilage (240 × $30.864 1.

A small amount of materials costs are incurred for each bat at the end of the production process when conversion costs are complete. there are no materials costs associated with work-in-process.000 $1.400 $9. This is especially important when the beginning work-in-process inventory has already been inspected in the previous period.127 $152. But what about the finishing department? That department takes the partially completed bats from the forming department and completes the work by sanding the bats.800 $20.000 $11.1-6 Transferred-in costs The discussion so far has focused exclusively on the forming department. 3.864 5. Item Bats in opening inventory Bats transferred in from forming department Transferred-in costs in opening inventory Conversion costs in opening inventory Costs transferred in from forming department Bats completed Materials cost Labour cost Manufacturing overhead Conversion % completion Materials % completion 13 / 33 Number/cost 800 4. stamping them with the company logo and applying a finish.728 $1. If inspection occurs before the process is complete.Module 9 — Intermediate Management Accounting Week 3 — Student Notes the next department.000 65% 0% . Therefore. there will be fewer equivalent units associated with any costs added evenly throughout the process. In-class Problem 2 for this week’s material provides an example of a process where inspection takes place midway through the process.

992 TO CA2 21.728 + $1.000 + 1.992 In this case.128 Finished goods 175.400 0.599 1.728 152.000 Transferred out = 600 units) (600 × 100% | 600 × 0% | 600 × 65%) Costs in opening WIP Costs incurred during the period Cost per equivalent unit (total = $35.9197 18.9197) $ $ $ — 1.529 20. When calculating inventory balances.000 5.1983) $ 5.400 1.127 $9. the ending inventory on the production report is $20. TI = Transferred-in costs 1 2 $20.127* 1 * 1.9986 Cost of good units transferred out (5.9986) Conversion costs (390 × $3.127 3.Module 9 — Intermediate Management Accounting Week 3 — Student Notes Finishing department Period 4 — weighted average Equivalent units Transferred-in Conversion costs Materials costs Units transferred out Equivalent units in ending WIP (End WIP = 800 Beginning WIP + 4.864 $ 173.855 175.600 0 5.400 14 / 33 .000 × $35.864 E 20.390 20.000 390 5.1983) Cost of ending WIP: Transferred-in costs (600 × $30.127 20.992 $ $ Work-in-process B $21.400 TI 152.000 600 5.2800 $ $ $ 175.800 Started – 5.592 $ 30.000 21.128. it is common to introduce rounding differences when all decimal places for equivalent unit costs are not used.000 5.000 + $11.

The key in FIFO costing is to keep track of the costs associated with the items in opening work-in-process and to ensure those costs are part of the costs transferred out. Then the cost of the work done this period to complete the opening work-in-process ($3. Likewise. this is done by allocating all the costs in opening inventory ($9. only the equivalent units left to complete the beginning work-in-process are included in the total equivalent units for the period. The FIFO method is generally considered more accurate than the weighted average method. Following is the process costing report the management accountant would prepare for Period 3 using FIFO costing. as it spreads previous periods’ costs into the current period’s ending work-in-process inventory.Module 9 — Intermediate Management Accounting Week 3 — Student Notes 3.109) to the cost of units completed and transferred out. Pepper Bat Company had 500 units in ending inventory that were 100% complete with regard to materials and 45% complete with regard to conversion costs. as in the case of weighted average costing. As the report illustrates.026 for conversion costs. these costs should not be mixed in with the current period costs. The remaining costs are allocated partly to units started and completed in the current period and partly to the ending work-in-process inventory. Repeating the process costing exercise for the Pepper Bat Company using FIFO costing makes it possible to compare the two methods.083 for materials and $3. 15 / 33 . The costs of these ending inventories were calculated as $6. This method of process costing allocates all beginning work-in-process costs to the costs of the units completed for the period. the first-in first-out (FIFO) method of process costing (and inventory valuation) is commonly used in Canada. This means the costs are not factored into the cost-per-equivalent-unit calculation.755) is added to the opening balance of the cost of opening inventory to compute the total cost associated with the opening inventory completed and transferred out. Recall that. at the end of the second period.1-7 First-in first-out (FIFO) cost flow assumption As mentioned previously.

109 1.900 – 500 Units in opening WIP) Equivalent units in ending WIP (End WIP = 500 Beginning WIP + 4.000 $ 13.) 16 / 33 .378 1.571 * Difference is due to rounding. A simplifying assumption management accountants make is to assume that all spoilage is costed using the costs incurred in the current period.1e.7778 85 4.571 $ $ Work-in-process B $9.6555) Costs of units started and completed (4.707 $ 133.6555) 0 4.538a 9.7778) Conversion costs (85 × $13.161 2.026) Costs to complete opening WIP: Conversion costs ($275 × 13.571 TO CA 62.109 133.400 × $27.760 $ 65.000 E 2.755 120.500 Started – 4. Using the Period 4 data from Example 3.539 Finished goods 133.000 $ 13.4333) Cost of units transferred out: Costs in opening WIP ($6.083 + 3.000 21.6555 $ 3.400 100 4.000 44.Module 9 — Intermediate Management Accounting Week 3 — Student Notes Forming department Period 3 — FIFO Equivalent units Materials Conversion costs Equivalent units of work done to complete opening WIP (500 × 0% | 500 × 55%) Units started and completed (4.400 275 4.4333) Cost of ending WIP: Materials (100 × $13. (A more accurate but complicated way to handle spoilage would be to prorate the costs of spoilage based on costs in opening inventory and current costs.900 Completed = 100 units) (M = 100 × 100% | CC = 100 × 85%) Costs incurred during the period Cost per equivalent unit (total = $27. the management accountant would produce the following process costing report using FIFO.500 $ 62.

000 31. Job order costing and process costing systems have been presented as two separate systems.9261 $ 254 142.140 $ 87.291 $ 152.4545 125 5.873 TO CA 74.000 1.3807) Cost of abnormal spoilage (60 × $30.823 $ $ Work-in-process B $2.3807) Cost of units transferred out: Costs in opening WIP Costs to complete opening WIP Conversion costs (15 × 16. thereby making the organization more profitable and competitive.843 2.843 Finished goods 152.3807) Normal spoilage (240 × $30.000 $ 16.000 $ 13.700 240 60 500 5. Managers can use process costing information to find opportunities to reduce costs.700 240 60 15 4.800 Transferred out – 300 Spoiled = 500 units) (M = 500 × 100% | CC = 500 × 25%) Costs incurred during the period Cost per equivalent unit (total = $30.873 $ 1. many companies will adapt their costing systems to suit their particular 17 / 33 .823 AS E 8.3807) Cost of ending WIP: Materials (500 × $13.873 3.539 6.9261) 0 4.800 – 100 Units in opening WIP) Normal spoilage Abnormal spoilage Equivalent units in ending WIP (End WIP = 100 Beginning WIP + 5.Module 9 — Intermediate Management Accounting Week 3 — Student Notes Forming department Period 4 — FIFO Equivalent units Conversion Materials costs Equivalent units to complete the opening WIP (M = 100 × 0% | CC = 100 × 15%) Units started and completed (4.116 8.500 $ 74.500 Started – 4.9261) Cost of units started and completed (4.727 2. but in fact.700 × 30.789 7.1-8 Hybrid and operations costing systems Process costing provides important cost details about the individual components in the production process creating a product.000 56.539 152.4546) Conversion costs (125 × $16.

and thus the materials will be allocated to batches as in a job costing system. but these products also allow the customer to add other customized features. 6. 4. Thus. An operation is a standardized repetitive production method or technique. but each batch of product goes through different processes (operations). while the operations costs would be assigned to the equivalent units going through each operation as in 18 / 33 . 3. and Batch 2 is for a classic lace-up oxford dress shoe: Direct materials used Batch 1 Batch 2 Leather Rubber sole Tassels Leather Leather sole Eyelets and laces Yes No Yes Yes No No Yes No Yes No Yes Yes Operations 1. Cutting leather Stitching sole Gluing sole Tassel attachment Punching eyelets Inserting laces The materials would be assigned to each batch based on the actual materials used. The following information is available for two batches of shoes: Batch 1 is for a slip-on loafer. the production process includes different combinations of materials and operations.1f: Operations costing at Fred’s Shoes Fred’s Shoes manufactures various types of men’s shoes in batches of various styles. Thus. Operations costing systems Operations costing systems are hybrid systems where products go through standard processes (operations). 2. which fits a job order costing system. The materials used in each batch may be different from those used in other batches. which fits a process costing system. The following example illustrates a situation that calls for an operations costing system. Example 3. Hybrid costing systems Products such as computers and automobiles are manufactured with many standard components. the costs of the various operations can be accumulated by operation and assigned to batches of product using a process costing procedure.Module 9 — Intermediate Management Accounting Week 3 — Student Notes needs. These costing systems will often feature elements of both types of systems and are often called hybrid or operations costing systems. companies that produce these products will use a combination of the two systems to assign costs to inventory and cost of goods sold. 5. Depending on the product.

management accountants assign direct costs and allocate indirect costs to the product. The purpose of each of these systems is to apply costs to the product for both external reporting purposes and for internal decision-making.2-1 Indirect cost allocation systems design As discussed in Week 1.2 INDIRECT COST ALLOCATION SYSTEMS You have now learned about two major costing systems: job order costing in Week 2 and process costing in Week 3.Module 9 — Intermediate Management Accounting Week 3 — Student Notes process costing. it is assigned to that cost object. Assigning direct costs is a relatively easy task as you can identify the direct materials that go into the product and the direct labourers who spend their time making the product. Obviously. only the batches going through the operation are assigned that operation’s costs. This topic will take a closer look at indirect cost allocation systems design and introduce activity-based costing. Step 1: Identify costs as direct or indirect The first step in costing system design is to develop a method that allows a cost to be identified as direct or indirect. If the cost is indirect. TOPIC 3. if the cost is directly associated with a cost object. The following diagram provides a review of the critical design issues and choices in all costing systems: Is the cost direct? Indirect cost pool Assign cost to the appropriate cost object Design indirect cost pool structure and assign indirect cost to the appropriate cost pool. each costing system has the same basic architecture. The more challenging task is to determine how much indirect cost a product consumes. As you learned in Week 1. it is assigned to an indirect cost pool. 3. As discussed in Week 1. Indirect cost pool The various cost objects Indirect cost pool Choose the cost driver and allocation rate for each indirect cost pool and allocate the costs from each indirect cost pool to the cost objects. 19 / 33 .

Improved cost information allows the decision maker to avoid additional costs caused by faulty cost information. this focus on accountability led to an interest in designing cost centres and therefore indirect manufacturing cost pools around various departments within the plant. such as product development. This led to an interest in developing different indirect manufacturing cost pool designs and to the design and use of indirect cost pools to accumulate non-manufacturing costs. Step 3: Select appropriate cost driver(s) The third step is to select an appropriate cost driver to allocate the costs to the cost object. 3. virtually all non-manufacturing costs are charged to the income statement as current period costs. In the early part of the 20th century. Week 1 provided some initial insights into approaches to designing indirect cost pools. managers were driven by competitive issues and better technology to demand better cost information not only about the behaviour of indirect manufacturing costs but also about other indirect costs.Module 9 — Intermediate Management Accounting Week 3 — Student Notes Step 2: Design indirect cost pools The second step in costing system design is to develop the system of indirect cost pools. machining. and customer-related costs. In turn. In the past. This promotes the design and use of single plant-wide indirect cost pools to accumulate indirect manufacturing costs. the most widely accepted rationale is that it improves accuracy in budgeting and product pricing and supports efforts to identify opportunities for cost reduction. assembly. Indirect cost pools may be required for both manufacturing and non-manufacturing costs. Beginning in the 1980s. such as order taking and order processing. depending on the purpose of the cost allocation to the cost object. department managers were assigned the responsibility to control costs.2-2 Objective in indirect cost allocation system design The objective in indirect cost allocation system design is to develop better cost information to support organizational decision-making. The focus was on accumulating cost by department so that the accumulated costs could be compared to a budget or standard. In financial accounting. decision-making authority and responsibility were delegated down the organizational hierarchy. It is important that the cost driver selected have a causal relationship with the costs in the cost pool. many organizations used indirect cost pools only for manufacturing costs because their accounting systems were oriented to supporting financial accounting. and Week 2 develops these approaches in more detail. creating a need for accountability. finishing and shipping. Examples of the costs caused by bad cost information include the losses caused by:  continuing to make a product that appears to be profitable. as organizations became larger. but is not 20 / 33 . Within the factory. such as receiving.

This is not as much of a problem with direct costs. which should always be assigned directly to the appropriate cost object. the incremental cost of designing and operating a cost allocation system increases exponentially with the system’s complexity. Also. This may indicate that product cross subsidization is occurring.Module 9 — Intermediate Management Accounting Week 3 — Student Notes  inappropriate pricing in cost-plus environments. the focus here is on improving the design of the indirect cost pools. The following example illustrates how cost allocation systems can produce inaccurate and misleading cost information. causing an otherwise profitable product to be unprofitable or vice versa. As the following graph illustrates. which create cash flow problems  inappropriate product mix choices when allocating constrained capacity It is not the objective of cost allocation system improvements to increase cost accuracy at any cost.2-3 Cost allocation system improvement Various factors may indicate that a cost allocation system may be producing inaccurate information and causing inappropriate decision-making. For example. such as contract pricing  failing to recognize opportunities for process improvement  inappropriate budget projections. The accompanying graph summarizes this conventional wisdom and shows the point at which the marginal benefit and the marginal cost of increased complexity are equal. a company may find that a competitor’s prices are substantially higher or lower compared to the company’s prices or that there is little competition for a high-margin product. Increased benefit Increased cost Costing system complexity Recall that cost allocation issues arise from assigning inappropriate indirect cost pools to products on a basis that does not reflect the use of that cost. the marginal value provided by improved cost allocation system accuracy declines logarithmically. 21 / 33 . Therefore. 3.

000 Total indirect manufacturing costs Initially. the factory accountant computed a rate per machine hour as: Total indirect manufacturing costs ÷ total machine hours = $586.600 Machine hours 800 600 400 1.2a: Cost allocation system improvement at Drumbo Aerospace Drumbo Aerospace produces three products. arguing that prices seem too high based on what competitors are offering.000 ÷ 1.700 2.800 $586. the factory accountant allocated indirect manufacturing costs equally to all units of product using a rate of $37.56 The indirect manufacturing cost to be allocated to each unit of production was computed as: Machine hour rate × machine hours used by product group Number of units in the product group For example. several customers complained.56 ($586.62 The following table summarizes the indirect costs per unit allocated on the basis of units and machine hours: Product 1 2 3 Allocated based on units Allocated based on MH $37.Module 9 — Intermediate Management Accounting Week 3 — Student Notes Example 3.56 $56.56 × 400) ÷ 2.56 $30.56 $37.28 $41. The Product 1 sales manager complained that the indirect manufacturing costs should be allocated based on machine hours.62 Drumbo marked up a product’s total cost by 50% to compute its selling price.000 ÷ 15. Following up on this idea.800 machine hours = $325.600 4.300 15. which are all aircraft components.56 $37. Recently.600) per unit. the calculation for Product 3 was: ($325. as that was a more relevant cost driver for indirect manufacturing costs. 22 / 33 . The following is a summary from a recent production period: Product 1 2 3 Totals Units produced 8.300 = $56.

000 $120.Module 9 — Intermediate Management Accounting Week 3 — Student Notes After discussions with factory engineers.700 2.00 For example. which involved subjecting parts to laser and X-ray inspection  machining activities required to produce the products With this insight. the indirect manufacturing cost allocated to Product 2 is computed as follows: Total indirect manufacturing cost allocated to Product 2 = number of batches × cost driver rate per batch + number of inspection hours × cost driver rate per inspection hour + number of machine hours × cost driver rate per machine hour = 30 × 160 + 500 × 150 + 600 × 250 = $229. Product Allocated based on units Allocated based on MH Allocated based on activities 1 2 3 $37.56 $37.800 $16.37 $48.56 $56. which included moving work-in-process about the plant and setting up equipment for production runs  inspection activities.56 $37. the factory accountant believed there were three major activities in the factory:  batch-related activities.000 $450.56 $30. which shows the cost drivers and the rate per unit of each cost driver identified using this data. the factory accountant developed the following information.700 = $48. the rates using units produced and machine hours as the cost drivers are also shown. For comparison purposes. the indirect manufacturing cost to be allocated to each unit of production was computed.000 $160 $150 $250 Total cost Cost ÷ cost driver unit Finally.600 100 800 1.28 $41.800 Indirect manufacturing cost per unit of Product 2 = 229. this is shown in the following table as the activity rate.800 ÷ 4. Product Units produced Batches Inspection hours Machine hours 1 2 3 8.62 $25.300 20 30 50 100 500 200 800 600 400 Cost driver units 15.600 4.89 $60.89 23 / 33 .

Review the material on these cost determination methods to ensure you can apply them to ABC. Any of the cost estimation methods discussed in Week 1 can be used to establish and measure the relationship between the costs of an activity and the activity measure.3-1 Activity-based costing systems design Producing a product or service (the cost object) involves activities. this focus on using activities as the cost driver for indirect costs led to this approach being called activity-based costing. In activity-based costing (ABC).Module 9 — Intermediate Management Accounting Week 3 — Student Notes This approach to cost allocation recognizes that it is the activities the organization undertakes to produce goods and services that create costs. There must be a cause-and-effect relationship between the activity measures and the costs of the activities. TOPIC 3. An activity measure (or cost driver) is then used to allocate the costs to cost objects based on the amount of the activity used to produce the product or service (cost object). the cost is placed to the far right of a left-to-right horizontal arrow. An example of such a diagram identifying causes of machine setup costs is presented below: 24 / 33 . such as account analysis. purchase orders or customer calls. Various potential causes of the cost are then placed as additional arrows off this main arrow.3 ACTIVITY-BASED COSTING SYSTEMS 3. focus on the amount of time spent to perform an activity. The underlying idea is that indirect cost allocations should be based on cause-and-effect relationships. These are usually identified in groups. The costs of performing these activities are accumulated in an activity cost pool. such as time spent doing a purchase order or on a customer call. machine-related. as the cost is linked to the number of times a transaction occurs. Transaction drivers are very simple. One tool that may be used to identify causation of various costs is the cause-and-effect (fishbone) diagram. an activity is any event that causes overhead costs to be incurred. This network of lines looks like the bones in a fish. In the diagram. Then sub-causes are identified within each of these groups. Before the relationship between activity measures and costs is measured and evaluated. it may also be used to identify linkages between costs and activities when assessing the cost drivers in an activity-based costing system. While this is usually used in quality control to identify the cause of a quality defect. process/method-related or materials-related causes. high-low method or regression analysis. such as people-related. hence the name fishbone diagram. and the level of activities performed in an organization will determine the level of indirect costs in the long term. on the other hand. Duration drivers. such as the number of setups. These activity measures are usually one of two types: transaction drivers or duration drivers. which in turn create a demand for resources. the activities and related measures must be identified.

depreciation on the administrative office suite.  Batch-level costs: These costs are incurred whenever a batch or group of units is processed.  Product-sustaining costs: These costs enable a product to be produced and are incurred without regard to the number of batches or units produced. Therefore. As this cost hierarchy shows. Unit-level costs are commonly called variable manufacturing costs. Examples include advertising to support a product and developing and implementing a product design change. regardless of customers. Examples include the cost of a sales representative visiting a customer and special customer shipping requirements.  Customer-sustaining costs: These costs are incurred for specific customers in order to service those customers. batches or units. factory supplies). since there is no apparent cause-and-effect relationship with activity levels. as happens when traditional systems are allocated using budgeted overhead and a budgeted volume-related driver. Examples include setting up machines for a production run and shipping a truckload of products. products. most cost drivers for these costs are not volume related.  Facility-sustaining costs: These costs benefit all business functions and are incurred to enable an organization to continue.Module 9 — Intermediate Management Accounting Week 3 — Student Notes 3. regardless of the number of units. Examples include the fees paid to the board of directors. plant depreciation and the factory manager’s salary. accumulating these costs in a single cost pool and allocating them to products using a volume-based driver will cause costing distortions. which consists of the following elements:  Unit-level costs: These costs vary directly with the level of production (for example. These costs are not usually allocated. 25 / 33 .3-2 The ABC cost hierarchy ABC proponents have developed what is called the ABC cost hierarchy.

 In ABC systems. whereas traditional systems tend to use one pool of costs from which allocations are made to products or services (cost objects). this can cause the overhead rate to increase or decrease. In that example.3-3 Differences between ABC and traditional costing Some of the key differences between ABC and traditional costing systems are as follows:  ABC uses many cost pools. In traditional costing systems.2a (Drumbo Aerospace) illustrated how cost distortions arise. Traditional systems tend to allocate overhead costs using one volume-related allocation base. 3. idle capacity is often treated as a period cost and is not allocated to products.  ABC uses many different allocation bases (activity measures). Example 3. whereas traditional systems will only allocate manufacturing costs. To illustrate this important concept. When the activity level changes. If the costs of indirect resources are grouped together into a single indirect cost pool and allocated in proportion to some quantity measure such as units produced. The cost pools should be designed so that all costs in an indirect cost pool have the same cost driver (which has a cause-and-effect relationship with the cost). This is accomplished first by using a single rate for each product and then by using an activity-based rate. 26 / 33 . the high-volume products will tend to pick up more than their fair share of costs if resource use is not proportional to volume. machine hours or labour hours.  ABC systems will often allocate both manufacturing and non-manufacturing costs to products. consider the following example of an organization that produces Product 1 and Product 2. and costs should be allocated from that indirect cost pool to cost objects using that cost driver. distorting product costs. expensive indirect resources were used at different rates by different cost objects. Setup costs and costs of moving work-in-process about the factory must be allocated to these two products.Module 9 — Intermediate Management Accounting Week 3 — Student Notes This hierarchy can be useful in determining the cost driver when designing the cost pools in an activity-based costing system. predetermined overhead rates are determined using budgeted total overhead costs.

the cost per unit of Product 1 is half the amount of the cost per unit of Product 2. 4. costs are applied evenly over all products. In the second example.60 Using an activity-based approach Product 1 Product 2 Units 100.3a: Cost allocation system improvement with two products Using a single rate for each product Total cost Product 1 Product 2 100. Decide on activities.000 of batch costs. If these batch costs. cost pools and cost drivers.Module 9 — Intermediate Management Accounting Week 3 — Student Notes Example 3. such as labour hours or machine hours).80 $ 120. 3.000 Batch size 1.000 – $40. resulting in Product 1 being over-costed by $20. are allocated in proportion to units produced (or any volume measure.000 $120. Use the activity rate to allocate costs to the cost object (usually a product).60 $0.000 ($400 × 100) of setup costs and Product 2 creates $80. Calculate an activity rate for each activity cost pool. which are indirect manufacturing costs.40 $400 $ 80.000 $ 60.000) and Product 2 being under-costed ($60. 5. each product will be allocated $60. In summary. costs are applied to batches. Thus Product 1 creates $40.000 Cost per unit $ 60. the basic steps in establishing an ABC system are as follows: 1. Assign costs to activity cost pools.000 $0.000 100. Because the batch size for Product 1 is twice the batch size for Product 2.000 $0.000 500 Total batches 100 200 Cost/ Total Cost per batch cost unit $400 $ 40. 2. 27 / 33 .000 ($400 × 200) of setup costs.000 $0.000 In the first example. Collect cost driver information (this should have a cause-and-effect relationship with cost).000 – $80.000).000 100.000 ($60.

divide the total cost in each indirect cost pool by the total number of cost driver activity units associated with that pool. concluded that the current costing system may be deficient and ordered a study of plant costs.000 375. the regular product is allocated 75% of total indirect manufacturing cost (75% × 2.  Prices are set by marking up manufacturing cost per unit by 70%.000 for this organization.000 200.Module 9 — Intermediate Management Accounting Week 3 — Student Notes Example 3.000).000 Cost driver Material move Production runs Shipments Regular 800 100 500 Deluxe 200 60 200 Total 1.000 $ 387. is currently being allocated to units using direct labour costs based on the observation that production in the plant involves a great deal of manual assembly and is therefore labour intensive.000 $ 750.  While sales of the deluxe product continue to exceed expectations.500. which is standard practice in this industry. The study reported the following results: Indirect cost pool Materials handling Production support Shipping Cost $ 500. The first step is to compute the indirect manufacturing cost per cost driver unit.500.075.000 700.000 625.000 $ 750. To do this.000 160 700 The plant manager has asked you to recast the manufacturing cost to reflect the ABC perspective on costing.3b: Activity-based costing at DTL Company DTL Company produces two versions of a single product. sales staff are reporting difficulty in maintaining sales volumes of the regular product and have been pushing for a price decrease on the regular product. The following is a summary of the most recent period’s activities: Regular Units produced Direct materials costs Direct labour cost Indirect manufacturing cost Total manufacturing cost Manufacturing cost per unit 6.000 150.875.000 75.000 $ Investigation of these results establishes three facts:  Indirect manufacturing cost. The plant manager attended an ABC seminar.000 1. 28 / 33 .000 1.000 2.300.000 + 50. which totals $2.500.000 $ 2.50 $ Deluxe 1.000 $ 3.000)] of total direct labour cost.00 $ Total 7. Regular and Deluxe.000 300.500.000 ÷ (150.325. Since the regular product comprises 75% [150.000 50.000 $ 2.

000 With the cost per unit for each cost driver. (Take a few moments to verify the calculations for the deluxe product.000 400.125 per production run = $812.000 Production support: 100 production runs × $8.500 Shipping: 500 shipments × $1.) Regular Units produced Direct materials cost Direct labour cost Indirect manufacturing cost Allocation: Materials handling Production support Shipping Total manufacturing cost Manufacturing cost per unit $ 6.000 ÷ 160 Shipping: $700.000 $ 912.000 $ 2.3c: Activity-based costing at Gene’s Foods Gene’s Foods (GF) is a wholesale distributor of ethnic foods.000 The following is the completed table for both products. which is taken as a good measure of the activities involved in handling customer orders. you can now reallocate the indirect manufacturing costs to the two products. Indirect overhead is allocated to each customer group based on cost of merchandise sold.000 150. The following is a summary of operations for the most recent period.500 500. 29 / 33 .125 $1.42 Deluxe $ 1.500 $ 912.000 100. Example 3.000 300.500 $ 360.000 Production support: $1.000 50.000 487.000 per shipment = $500. convenience store chains and individual high-end food stores.500 200.Module 9 — Intermediate Management Accounting Week 3 — Student Notes The following is the result: Cost/unit Materials handling: $500.000 812.50 This example illustrates a common distortion where a high-volume product that puts relatively fewer demands on production activities than a lower-volume product ends up being overcosted in a volume-based allocation system like direct labour hours.000 ÷ 1. The following is the allocation for the regular product: Materials handling: 800 moves × $500 per move = $400.000 75.162.000 ÷ 700 $500 $8.300. GF has three groups of customers: supermarket chains.

750.Module 9 — Intermediate Management Accounting Week 3 — Student Notes Supermarkets Revenues Cost of merchandise sold Margin Overhead allocated Operating income Convenience stores $35.000.00% 27.57% 42.000.000.000 $ 8.000) High-end stores $25.000 $15.750.81% 24.000 $75.000.000. Patricia.34% 400 70 500 500 33.67% 42.000.55% 28. was Patricia’s concern about the sales manager’s recommendation justified? Begin this analysis by developing an activity summary like the following: Revenues Cost of merchandise sold Overhead cost pool Order taking Order picking Shipping Invoicing and adjustments 30 / 33 Supermarket amount $90.000 Convenience store % of total 23.000 For several years.000 High-end store % of total 16.00% 62.000 Shipping $11.79% 47. the sales manager has argued that GF should focus on the convenience store and high-end store segments and phase out its unprofitable supermarket business.000 $17.000.62% 32.000 $ — $90. the company president.000 $(3.000.000 $ 7.000 7.76% 300 65 250 370 25.000. primarily relating to good and bad customers.000.67% 14.000 Cost driver units — supermarkets Number of orders Order complexity measure Number of shipments Number of invoices and adjustments Cost driver units — convenience stores Cost driver units — high-end stores 500 300 400 100 65 70 300 250 500 650 370 500 $30.750.000.17% 500 100 300 650 41. Based on her intuition.000.000 Invoicing and adjustments $10.250.000.000.000.000.000 4. she has heard from various staff members.000 $28.000.66% 23.000. The study produced the following results: Cost Overhead cost pool Order taking Cost driver $7.000 Supermarket % of total 60.000 18.000 75.33% 29.000.89% .000 17. Patricia ordered a study of the overhead costs allocated to the customer groups. is hesitant about implementing this suggestion because of comments.33% High-end store amount $25.000.000 28.000 $ 3.000 Order picking $2.000.50% Convenience store amount $35.33% 23.000 Given this information.

000 $ 2. For example.578.857 4.000.000. the overhead allocations to supermarkets were determined as follows (remember that the numbers in the above table reflect Excel-level significance): 31 / 33 Order taking: 500 × 5.064 3.000 553.050 $10.833.142.667 851.276. Cost Overhead cost pool Order taking $7.200 $5. The calculations follow the same process used in the previous example.000.316 $ 3.238. while the demand for activities by the various groups differs substantially from this proxy.000.000.750. GF has been using cost of merchandise sold as a proxy for activities when allocating indirect costs.000 Order picking $2.450) High-end stores $25.095 3.276.510.33 = $2.191 2.333 595.048 2.000 17.142.64 = $851.211 $ (356.000 $ 7.19 1.646) Take the time to check your understanding of the ABC calculations by verifying the overhead allocations.096 $ 1. The pattern is that smaller customers make smaller and more frequent orders and place relatively more demands on order picking.000.000 Invoicing and adjustments $10.33 235 $8. ABC provides a different picture since the cost per unit of the cost driver can be calculated for each of the activities.667 Order picking: 100 × 8.520 $6. shipping and invoicing and adjustments.000 Shipping $11.476.456.745 5.000 $15.000 28.000.000.316 .857 Invoicing: 650 × 6.000 $ 8.434.000.000 Cost driver Number of orders Order complexity measure Number of shipments Number of invoices and adjustments Total cost driver units Cost per unit of cost driver 1.000.64 1.000.289.064 Shipping: 300 × 10.000 $ 2.473 $ (3.833.916.000.333.510.000 75.916.476.578.000 Convenience stores $35.95 = $4.95 This information can be used to complete the following revised summary of operations: Supermarkets Revenues Cost of merchandise sold Margin Overhead allocated Order taking Order picking Shipping Invoicing and adjustments Operating income $90.19 = $3.813.000.619.Module 9 — Intermediate Management Accounting Week 3 — Student Notes This confirms what Patricia has been hearing from the staff.

supply chain management and customer relationship management. 3. Strategic ABM Strategic ABM focuses on deciding the activities to be performed to reduce overall costs and improve profitability.3-4 Activity-based management Once an ABC system is in place. It is now up to Patricia to decide what to do.3-5 Costs and benefits of ABC and ABM Activity-based costing tries to model the cause-and-effect relationship between activities undertaken to produce a good or service and the cost of those activities. Operational ABM One can think of operational ABM as doing things right and strategic ABM as doing the right things. The objective is to provide improved cost information for decision-making. ABM is divided into operational and strategic management activities.Module 9 — Intermediate Management Accounting Week 3 — Student Notes Patricia’s intuition is confirmed. Typically. The value chain will be discussed in other modules in the PREP program of studies. business process reengineering. product/customer mix. The two smaller customer groups are placing excessive and costly demands on the system relative to the supermarkets. The focus is on how these activities help the organization achieve organizational goals. the focus of management changes to managing activities. would have no impact on the company’s customers or service levels. Operational ABM is focused on the efficiency of operations and includes activity management. ABC costing systems are also associated with costs that may outweigh their benefits. A big part of operational ABM is identifying and eliminating non-value-added activities and processes. These are activities that. The benefits of ABC/ABM include the following:      improved decisions from more accurate product costing and pricing increased understanding of overhead costs and cost drivers focus on managing activities to control costs focus on eliminating non-value-added activities improved product/customer profitability analysis However. There are definite benefits and costs to implementing and using such a costing system. Some of the most important costs in implementing and maintaining these systems are as follows: 32 / 33 . which drive costs and eventually profits. One approach would be to charge customers for each of the activities to try to promote less costly behaviour on their parts. It encompasses areas such as product design. if eliminated. quality management and performance measurement. Activity-based management (ABM) uses cost driver and activity (process) analysis to establish costs and activities that can be used for performance-evaluation purposes. 3.

33 / 33 . marketing/advertising costs. which means the company has to maintain two costing systems. Measurement of the various cost drivers may not be reliable or current in existing systems. Focusing on individual activities may cause the company to lose focus on strategic objectives while seeking cost savings. kaizen costing is a methodology that focuses on cost elimination. TOPIC 3. delivery costs and after-sale servicing costs. adding a new level of information-gathering costs. This can even be extended to consider the consumption cost by the consumer and the cost of disposing of or recycling the used product.4 OTHER METHODS FOR DETERMINING AND CONTROLLING COSTS 3. The cost of a product is expected to be reduced even while that product is under production.Module 9 — Intermediate Management Accounting      Week 3 — Student Notes Implementation requires an extensive and costly review of operations to establish appropriate cost pools and activities that drive those costs.4-1 Kaizen costing Kaizen is a Japanese term that means continuous improvement.4-2 Product life cycle costing This costing method includes all the costs incurred during the entire life of the product. improving the production process or realizing savings on material purchases. ABC systems may allocate non-manufacturing costs to products in ways that do not conform to product costing standards for external financial reporting (GAAP). The cost reductions may be realized in any number of ways. Thus. such as controlling spoilage. 3. analyzing profitability and determining the overall value of continuing to make the product. This costing method has great value in making product selection decisions. production costs. including research and design costs. Performance measures often remain tied to externally reported profit measures.