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Introduction to Management Accounting

Chapter 4

Cost Management Systems


and Activity-Based Costing

Learning
Objective 1

Cost Management System

A cost management system (CMS) is


a collection of tools and techniques
that identifies how managements
decisions affect costs.

Cost Management System


The primary purposes of a cost
management system are to provide...

cost information for strategic


management decisions,
cost information for
operational control, and
measure of inventory value and cost
of goods sold for financial reporting.

Cost Accounting Systems


Cost accounting is that part of the cost
management system that measures
costs for the purposes of management
decision making and financial reporting.

Learning
Objective 2

Cost Accounting System

Cost
accumulation:

Collecting costs by some


natural classification
such as materials or labor

Cost
assignment:

Tracing costs to one or


more cost objectives

Cost Accounting System


Cost
accumulation

Material costs
(metals)

Cost assignment
to cost objects
1. Departments
2. Activities

Machining Department
Activity Activity
Activity Activity
Cabinets

3. Products

Finishing Department
Activity Activity
Activity Activity
Cabinets

Desks

Desks
Tables

Tables

Cost
A cost is a sacrifice or giving up of
resources for a particular purpose.

Costs are frequently measured by


the 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
Service

Processing orders

Product

Learning
Objective 3

Direct, Indirect, and Unallocated Costs

Direct costs can be identified specifically and exclusively


with a given cost objective in an economically feasible way.

Indirect costs cannot be identified specifically and exclusively


With a given cost objective in an economically feasible way.

Unallocated costs are recorded but


not assigned to any cost object.

Learning
Objective 4

Cost Allocation

Cost allocation is used to assign indirect costs to cost objects, in proportion


to the cost objects use of a particular cost-allocation base.
A cost-allocation base is some measure of input or output that
determines the amount of cost to be allocated to a particular cost object.
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 driveran output
measure that causes costs. Therefore, most allocation bases are cost drivers.

Cost Allocation
Cost allocations support a companys CMSthe system
providing cost measurements for strategic decision making,
operational control, and external reporting.

Four purposes of cost allocation:

Predict the economic effects of strategic and operational control decisions.

Provide desired motivation and to give feedback for performance evaluation.


Compute income and asset valuations for financial reporting.
Justify costs or obtain reimbursement.

Cost Pool
A cost pool is a group of individual costs that a company
allocates to cost objects using a single cost-allocation base.

1.
2.
3.
4.
5.

Accumulate indirect costs for a period of time.


Select an allocation base for each cost pool, preferably a cost driver,
that is, a measure that causes the costs in the cost pool.
Measure the units of the cost-allocation base used for each cost
object and compute the total units used for all cost objects.
Determine the percentage of total cost-allocation base units
used for each cost object.
Multiply the percentage by the total costs in the cost pool to
determine the cost allocated to each cost object.

Cost Allocation
Direct costs are physically traced to a cost object.

Indirect costs are allocated using a cost-allocation base.

Direct,
Indirect,
Unallocated
Costs
Statement
of and
Operating
Income
Li Companys Statement of Operating Income

Learning
Objective 5

Direct Material 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 in
an 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 an
economically feasible way.

Indirect Production Costs (Manufacturing Overhead)


Manufacturing overhead includes all costs
associated with the production process
that the company cannot be traced to
the manufactured goods in an
economically feasible way.

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 expenses


during the current period without
going through an inventory stage.

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31

Learning
Objective 6

Financial Statement Presentation


Merchandising Companies

Merchandising Company
(Retailer or Wholesaler)

Sales
Minus

Product
(Inventoriable)
Costs

Merchandise
Purchases

Merchandise Expiration
Inventory

Cost of
Goods Sold
(Expenses)

Equals Gross Margin


Minus
Period
Costs

Selling Expenses and


Administrative
Expenses
Equals Operating
Income

Financial Statement Presentation


Manufacturing Companies
Manufacturing Company
Product
(Inventoriable)
Costs

Direct
Material
Purchases
Direct Labor
Indirect
Manufacturing

Direct
Material
Inventory
Finished
Goods
Inventory
Work-inProcess
Inventory

Sales
Minus
Expiration

Period
Costs

Cost of
Goods Sold
(Expenses)
Equals Gross Margin
Minus
Selling Expenses and
Administrative
Expenses
Equals Operating
Income

Current Asset Sections


of Balance Sheets
Manufacturer
Cash
$ 4,000
Receivables
25,000
Subtotal
$29,000
Finished goods 32,000
Work in process 22,000
Direct material 23,000
Total inventories
$77,000
Other current assets
1,000
Total current assets
$107,000

Retailer or Wholesaler
Cash
Receivables

4,000
25,000

Merchandise inventories
Other current assets
Total current assets

77,000
1,000
$107,000

Income Statement Presentation


of Costs for a Manufacturer
The manufacturers cost of goods produced
and then sold is usually composed of
the three major categories of cost:
Direct materials
Direct labor

Indirect manufacturing

Income Statement Presentation


of Costs for a Retailer
The merchandisers cost of goods sold
is usually composed of the purchase
cost of items, including freight-in,
that are acquired and then resold.

Learning
Objective 7

Traditional Costing System


All
Indirect
Resources
$220,000

All Unallocated
Value Chain
Costs
$100,000

Cost Driver
[Direct Labor
Hours]

Direct
Materials
For Pen
Casings
$22,500
Sales $360,000

Direct
Labor
For Pen
Casings
$135,000

Direct
Materials For
Cell
Phone
Casings
$12,000
Sales $80,000

Direct
Labor For
Cell Phone
Casings
$15,000

Unallocated $00,000

Traditional Costing System


Statement of Operating Income
Traditional Cost Allocation System
Pen
Casings

Sales
Direct materials
Direct labor
Indirect manufacturing
Gross profit
Corporate expenses
Operating loss
Gross profit margin

$440,000
34,500
150,000
220,000
$ 35,500
100,000
($ 64,500)
8.07%

Cell Phone
Casings

$360,000
22,500
135,000
198,000
$ 4,500

$80,000
12,000
15,000
22,000
$31,000

1.25%

38.75%

ABC System
Plant and
Machinery
$180,000

Engineers and
CAD Equipment
$40,000

20%
75%

All Unallocated
Value Chain Costs
$100,000

80%
25%

Processing
Activity
$135,000
+ 8,000
$143,000

Production Support
Activity
$45,000
+32,000
$77,000
Cost Driver
[Direct Labor Hours]

Direct
Materials
For Pen
Casings
$22,500

Sales $360,000

Direct
Labor
For Pen
Casings
$135,000

Cost Driver
[Distinct Parts]

Direct
Materials For
Cell
Phone
Casings
$12,000

Sales $80,000

Direct
Labor For
Cell Phone
Casings
$15,000

Unallocated $00,000

Activity-Based Cost Allocation System


External

Reporting

Sales
Direct materials
Direct labor
Processing activity
Production support activity
Gross profit
Corporate expenses
Operating loss
Gross profit margin

$440,000
34,500
150,000
143,000
77,000
$ 35,500
100,000
($ 64,500)
8.07%

Internal Purposes
Cell
Pen
Phone
Casings
Casings

$360,000
22,500
135,000
128,700
15,400
$ 58,400

16.22%

$80,000
12,000
15,000
14,300
61,600
($22,900)

(28.63%)

Learning
Objective 8

Activity-Based Management
ABM is using the output of an activity-based
cost accounting system to aid strategic decision
making and to improve operational control.
A value-added cost is the cost of an activity
that cannot be eliminated without affecting
a products value to the customer.
In contrast, nonvalue-added costs are costs
that can be eliminated without affecting
a products value to the customer.

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
Companies adopt ABC systems to:

set an optimal product mix


to estimate profit margins of new products
determine consumption of companys shared resources
keep pace with new product techniques
and technological changes
decrease the costs associated with bad decisions
take advantage of reduced cost of ABC
systems due to computer technology

Design of a Traditional Costing System

Learning
Objective 9

Design of an Activity-Based
Cost Accounting System

Determine the key


components of the
cost accounting
system.

Cost objectives
Key activities
Resources
Related cost drivers

Design of an Activity-Based
Cost Accounting System
Key
Activity

Account billing
Bill verification
Account inquiry
Correspondence
Other activities

Cost
Driver

Number or printed pages


Number of accounts verified
Number of inquiries
Number of letters
Number of printed pages

Design of an Activity-Based
Cost Accounting System
Determine the relationships among
cost objectives,activities, and resources.
Activity Performed
Resource
Used to
Perform Activity

Account
Inquiry
Activity

Supervisor
40%
Account inquiry labor
90
Billing labor
Verification labor
Paper
Computer
45
Telecommunications
90
Occupancy
65
Printing machines
All other department resources

Correspondence
Activity
10%
10

Billing
Activity

Verification
Activity

30%
30

100
35

15
90

All Other
Activities
20%

70
100
10

5
10
20
5
100

Total
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%

Design of an Activity-Based
Cost Accounting System
Collect relevant data concerning costs and the physical
flow of the cost-driver units among resources and activities.
Number of Cost Driver Units

Activity

Cost Driver Units

Account inquiry

Inquiries

Correspondence

Letters

Bill printing

Printed pages

Verification

Accounts verified

Other activities

Printed pages

Residential

Commercial

Total

20,000

5,000

25,000

1,800

1,000

2,800

120,000

40,000

160,000

20,000

20,000

40,000

160,000

120,000

Design of an Activity-Based
Cost Accounting System

Calculate and interpret the new


activity-based information.
Determine the traceable costs for
each of the activity cost pools.
Determine the activity-based cost per
account for each customer class

Design of an Activity-Based
Cost Accounting System
Total traceable costs for the 5 activity cost pools.
Activity Cost Pool
Cost (from Account
slide 4-33) Inquiry Correspondence Billing Verification
$ 33,600 $ 13,440*
$ 3,360** $ 10,080***

Resource
Supervisors
Account inquiry
labor
173,460 156,114
Billing labor
56,250
Verification labor
11,250
Paper
7,320
Computer
178,000
80,100
Telecommunication
58,520
52,668
Occupancy
47,000
30,550
Printers
55,000
Other resources
67,100
Total traceable
cost
$687,500 $332,872

Other
$ 6,720****

17,346
16,875

8,900

7,320
62,300

2,750

7,050
49,500

$32,356

$153,125

$39,375
11,250
17,800

8,900
5,852
9,400
2,750
67,100

$68,425 $100,722

*From slides 33 and 36, account inquiry activity uses 40% of the supervisor resource. So the allocation is 40% $33,600 = $13,440.
**10% $33,600
***30% $33,600
****20% $33,600

Design of an Activity-Based
Cost Accounting System
Activity-based cost per account for each customer class

Activity (Driver Units)


Account inquiry (inquiries)
Correspondence (letters)
Account billing (printed pages)
Bill verification (accounts verified)
Other activities (printed pages)

Account inquiry
Correspondence
Account billing
Bill verification
Other activities
Total cost
Number of accounts
Cost per account
Cost per account, traditional
system from slide 33

Cost per
Driver Unit
$13.314880
$11.555714
$ 0.957031
$ 3.421250
$ 0.629513

Driver Costs
Total Number of
Traceable Costs Driver Units
(from Exhibit 4-12) (From Exhibit 4-11)
(1)
(2)
$332,872
25,000 Inquiries
32,356
2,800 Letters
153,125
160,000 Printed pages
68,425
20,000 Accounts verified
100,722
160,000 Printed pages
Cost per Customer Class
Residential
Commercial
Number of
Number of
Driver Units
Cost
Driver Units
20,000 Inquiries $266,298
5,000 Inquiries
1,800 Letters
20,800
1,000 Letters
120,000 Pages
114,844 40,000 Pages
20,000 Accts.
120,000 Pages
75,541 40,000 pages
$477,483
120,000
$ 3.98
$ 4.58

Cost per
Driver Unit
(1) (2)
$13,314880
$11.555714
$ 0.957031
$ 3.421250
$ 0.629513

Cost
$ 66,574
11,556
38,281
68,425
25,181
$210,017
20,000
$ 10.50
$ 6.88

Strategic Decisions, Operational Cost


Control, and ABM
Outsourcing
Reducing operating costs
Identifying nonvalue-added activities
Improving both strategic
and operational decisions

The End

End of Chapter 4