Cost Acc P6

PAN African eNetwork
Project
Master of Finance and Control
Cost Accounting
Semester - II
Dr N.N.Sengupta
Copyright © Amity University

1
Activity-Based Costing and
Activity-Based Management

Learning Objective 1
Explain undercosting
and overcosting of
products and services.
Undercosting and
Overcosting Example
Jose, Roberta, and Nancy order
separate items for lunch.
Jose’s order amounts to $14
Roberta consumed 30
Nancy’s order is 16
Total $60
What is the average cost per lunch?
Undercosting and
Overcosting Example
$60 ÷ 3 = $20
Jose and Nancy Roberta is

are overcosted. undercosted.
Present three guidelines for

refining a costing system.
Existing Single Indirect-
Cost Pool System Example
Kole Corporation manufactures a normal lens

(NL) and a complex lens (CL).
Kole currently uses a single indirect-cost rate
job costing system.
Cost objects: 80,000 (NL) and 20,000 (CL).
Normal Lenses (NL)

Direct materials $1,520,000
Direct mfg. labor 800,000
Total direct costs $2,320,000
Direct cost per unit: $2,320,000 ÷ 80,000 = $29
Complex Lenses (CL)

Direct materials $ 920,000
Direct mfg. labor 260,000
Direct cost per unit: $1,180,000 ÷ 20,000 = $59
INDIRECT-COST All Indirect Costs
POLL $2,900,000
INDIRECT 50,000 Direct

COST-ALLOCATION Manufacturing
BASE Labor-Hours
$58 per Direct

Manufacturing
Labor-Hour
COST OBJECT: Indirect Costs

NL AND CL
LENSES Direct Costs
DIRECT
COSTS
Direct
Direct
Manufacturing
Materials Labor
Kole uses 36,000 direct manufacturing

labor-hours to make NL and 14,000 direct
manufacturing labor-hours to make CL.
How much indirect costs are allocated
to each product?
NL: 36,000 × $58 = $2,088,000
CL: 14,000 × $58 = $812,000
What is the total cost of normal lenses?
Direct costs $2,320,000 +
Allocated costs $2,088,000 = $4,408,000
What is the cost per unit?
$4,408,000 ÷ 80,000 = $55.10
What is the total cost of complex lenses?

Direct costs $1,180,000 + Allocated costs
$812,000 = $1,992,000
What is the cost per unit?
$1,992,000 ÷ 20,000 = $99.60
Normal lenses sell for $60 each and
complex lenses for $142 each.
Normal Complex
Revenue $60.00 $142.00
Cost 55.10 99.60
Income $ 4.90 $ 42.40
Margin 8.2% 29.9%
Refining a Costing System
Direct-cost tracing
Indirect-cost pools
Cost-allocation basis
1. Design of Products and Process

The Design Department designs the molds
and defines processes needed (details of
the manufacturing operations).
2. Manufacturing Operations
Lenses are molded, finished,
cleaned, and inspected.
3. Shipping and Distribution
Finished lenses are packed and
sent to the various customers.
Distinguish between the

traditional and the
activity-based costing
approaches to designing
a costing system.
Activity-Based Costing System
Fundamental Assignment to Other

Cost Objects Cost Objects
Activities Cost of:
• Product
• Service
Costs of Activities • Customer
A cross-functional team at Kole

Corporation identified key activities:
Design products and processes.
Set up molding machine.
Operate machines to manufacture lenses.
Maintain and clean the molds.
Set up batches of finished lenses for shipment.

Distribute lenses to customers.
Administer and manage all processes.
Activity
Indirect Cost Design Setup Shipping
Pool
Cost Parts- No. of

Square Setup No. of
Allocation Shipments
Base feet Hours
Product Lenses Lenses Lenses

Cost
Objects NL CL Other
NL CL
Quantity produced 80,000 20,000
No. produced/batch 250 50
Number of batches 320 400
Setup time per batch 2 hours 5 hours
Total setup-hours 640 2,000
Total setup costs are $409,200.
What is the setup cost per setup-hour?

$409,200 ÷ 2,640 hours = $155
What is the setup cost per
direct manufacturing labor-hour?
$409,200 ÷ 50,000 = $8.184
Allocation using direct labor-hours:

NL: $8.184 × 36,000 = $294,624
CL: $8.184 × 14,000 = $114,576
Total $409,200
Allocation using setup-hours:
NL: $155 × 640 = $ 99,200
CL: $155 × 2,000 = $310,000
Total $409,200
Describe a four-part
cost hierarchy.
Cost Hierarchies
A cost hierarchy is a categorization

of costs into different cost pools.
Cost drivers bases (cost-allocation bases)
Degrees of difficulty in determining
cause-and-effect relationships
Cost Hierarchies
ABC systems commonly use a

four-part cost hierarchy to
identify cost-allocation bases:
1. Output unit-level costs
2. Batch-level costs
3. Product-sustaining costs
4. Facility-sustaining costs
Output Unit-Level Costs
These are resources sacrificed

on activities performed on each
individual unit of product or service.
Energy
Machine depreciation
Repairs
Batch-Level Costs
These are resources sacrificed on

activities that are related to a group
of units of product(s) or service(s)
rather than to each individual unit
of product or service.
Setup-hours
Procurement costs
Product-Sustaining Costs
These are often called service-sustaining

costs and are resources sacrificed on
activities undertaken to support
individual products or services.
Design costs
Engineering costs
Facility-Sustaining Costs
These are resources sacrificed on

activities that cannot be traced to
individual products or services but
support the organization as a whole.
General administration
– rent – building security
Cost products or services using

activity-based costing.
Implementing
Activity-Based Costing
Step 1 Step 2
Identify cost objects. Identify the direct costs
of the products.
NL Direct material
CL Direct labor
Mold cleaning and
maintenance
Implementing
Cleaning and maintenance costs of

$360,000 are direct batch-level costs.
Why?
Because these costs consist of workers’
wages for cleaning molds after each
batch of lenses is run.
Implementing
Normal Lenses (NL)

Cost Hierarchy
Description Category
Direct materials Unit-level $1,520,000
Direct mfg. labor Unit-level 800,000
Cleaning and maint. Batch-level 160,000
Implementing
Complex Lenses (CL)
Cost Hierarchy
Description Category
Direct materials Unit-level $ 920,000
Direct mfg. labor Unit-level 260,000
Cleaning and maint. Batch-level 200,000
Implementing
Step 3
Select the cost-allocation bases to use for
allocating indirect costs to the products.
(1) (2) (3)
Activity Cost Hierarchy Total Costs
Design Product-sustaining $450,000
Setups Batch-level $409,200
Operations Unit-level $637,500
Implementing
Step 4
Identify the indirect costs associated
with each cost-allocation base.
Overhead costs incurred are assigned
to activities, to the extent possible, on
the basis of a cause-and-effect relationship.
Implementing
Step 5
Compute the rate per unit.
(1) (5)
NL CL Total
Setup-hours: 640 2,000 2,640
$409,200 ÷ 2,640 = $155
Implementing
Step 6
Compute the indirect costs allocated
to the products.
NL: $155 × 640 = $ 99,200
CL: $155 × 2,000 = 310,000
Total $409,200
Implementing
Step 7
Compute the costs of the products.
NL and CL would show three
direct cost categories.
1. Direct materials
2. Direct manufacturing labor
3. Cleaning and maintenance
Implementing
NL and CL would show six indirect cost pools.
1. Design
2. Molding machine setups
3. Manufacturing operations
4. Shipment setup
5. Distribution
6. Administration
Use activity-based
costing systems for
activity-based management.
Activity-Based Management
ABM describes management decisions that use

activity-based costing information to satisfy
customers and improve profits.
Product pricing and mix decisions
Cost reduction and process improvement decisions
Design decisions
Product Pricing and
Mix Decisions
ABC gives management insight into the cost

structures for making and selling diverse products.
It provides more accurate product cost
information and more detailed information
on costs of activities and the drivers of those costs.
Cost Reduction and Process
Improvement Decisions
Manufacturing and distribution personnel use

ABC systems to focus on cost-reduction efforts.
Managers set cost-reduction targets in terms of
reducing the cost per unit of the cost-allocation base.
Design Decisions
Management can identify and evaluate new designs

to improve performance by evaluating how product
and process designs affect activities and costs.
Companies can work with their customers to
evaluate the costs and prices of alternative designs.
Compare activity-based costing

systems and department-
costing systems.
ABC and Department
Indirect-Cost Rates
Many companies have evolved their
costing system from using a single
cost pool to using separate indirect-cost
rates for each department:
Design
Manufacturing
Distribution
ABC and Department
Indirect-Cost Rates
Why?
Because the cost drivers of resources in each
department or subdepartment differ from the
single, company-wide, cost-allocation base.
ABC systems are a further refinement of
department costing systems.
Evaluate the costs and benefits

of implementing activity-based
costing systems.
Benefits of ABC Systems
Significant amounts of indirect costs are

allocated using only one or two cost pools.
All or most costs are identified
as output unit-level costs.
Products make diverse demands on
resources because of differences in
volume, process steps, batch size,
or complexity.
Products that a company is well-suited to

make and sell show small profits while
products for which a company is less
suited show large profits.
Complex products appear to be very
profitable and simple products
appear to be losing money.
Operations staff have significant

disagreements with the accounting
staff about the costs of manufacturing
and marketing products and services.
Limitations of ABC Systems
The main limitations of ABC are the

measurements necessary to
implement the system.
ABC systems require management
to estimate costs of activity pools
and to identify and measure cost
drivers for these pools.
Limitations of ABC Systems
Activity-cost rates also need to be

updated regularly.
Very detailed ABC systems are costly
to operate and difficult to understand.
ABC In Service and
Merchandising Companies
The general approach to ABC in the

service and merchandising areas is very
similar to the approach in manufacturing.
Costs are divided into homogeneous cost
pools and classified as output unit-level,
batch-level, product- or service-sustaining,
and facility-sustaining costs.
ABC In Service and
Merchandising Companies
The cost pools correspond to key activities.

Costs are allocated to products or customers
using activity drivers or cost-allocation
bases that have a cause-and-effect
relationship with the cost in the cost pool.
Target Costing
If you cannot find the time to do it

right, how will you find the time to
do it over?

General Concept
• Target cost is the cost that can be incurred

while still earning the desired profit
– Selling price – desired profit = target cost
• The customer sets the price
– Profit must be achieved through cost control

Target Costing Characteristics
• Contradicts the traditional approach:

design product, determine cost, set price
• Intense customer focus
– What do they want?
– How much will they pay for it?
• Can we make a profit on it?
• Want answers to these questions before
committing to the project

• Cost control from the beginning

– 70-90% of costs are committed to at the
design stage
– Focus on product and process design to
engineer out costs from the beginning
• Saves costly changes later on

• Product, manufacturing process, delivery

process designed simultaneously
– Ensures features customers demand, but
within acceptable cost parameters
– Eliminates the temptation to add costly
features
• Customers may not value the added features
– Forces consideration of manufacturability
• Reduces the need for subsequent changes

• Cost control at all phases of the product life

cycle
– Design
– Production
– Delivery/setup
– Customer’s cost of ownership
• Emphasizes future sales instead of current cost
savings
– Service and repair
– Disposal and recycling

Cross-Functional Team
• Marketing • Distribution
• Design/engineering • Service/support
• Manufacturing • Cost accounting
• Purchasing • Finance
– Including suppliers • Legal
Target Costing Process
• Two stage process

– Establish the target cost
• Market research
• Product planning, concept development stages
– Achieve the target cost
• Value engineering, continuous improvement
• Design stage
– Continuous improvement in later stages

Establishing the Target Cost
• Determine the product and its market

– Who is the target market?
– What do they want?
– What do competitors offer?
• Introduce concept or prototype
– Evolutionary or revolutionary?
– Refine until it meets customer needs

• Determine the selling price

– Must be acceptable to the customer
– Must be able to withstand competition
– Techniques
• Existing price +/- value of features added or
deleted
• Consensus of focus group
• Price predicted to achieve a desired market share

• Determine the required profit

– Return on sales
• Desired return
• Historical return for similar products
• Industry average for similar products
– Return on sales will fluctuate over the life of
the product
• Price and costs fluctuate

Unit Selling Price Establishing the Target Cost
Product Life Stage

Gradual decline as volume

increases
Competitors enter market,

straining supply of resources
Unit Cost
Unexpected events affect

cost of resources
Product Life Stage

• Unit price, cost and profit are almost

meaningless because they fluctuate
– Life cycle totals are more meaningful
Total expected revenue throughout product life

- Total desired profit throughout product life
Total target cost

Achieving the Target Cost
• Must include the features the customer

wants while maintaining cost at or below
target
– Want to meet the customers needs, but not
exceed them
• Eliminating desired features will result in an
undesirable product
• Adding unwanted features will increase cost
– Failing to keep cost at or below target will
result in unacceptable profits
• Rank customer requirements (exhibit 1)
– What does the customer want?
• How important is each function to the customer?
– What do we and our competitors currently
offer?
• Competitive evaluation (exhibit 1)
– Do our current product features meet the customer
needs?
» Are the customers’ needs met, unmet or
exceeded?
– What can we learn from our competitors’ products?

• Determine the cost gap between current

cost and allowable cost
– Current cost is based on
• Currently used components
• Current suppliers
• Current manufacturing processes
• Current distribution network
• Etc.

• Decompose the cost gap (exhibit 2)

– Life cycle decomposition
• Cost reduction goals are divided among the
functions in the product’s life cycle
– Design/engineering
– Manufacturing
– Sales/distribution
– Service/support
– General administration
– Value chain decomposition

• Cost reduction targets are divided among internal and
external activities
– Internal costs
» Labor, overhead, selling and administrative costs,
etc.
– External costs
» Components and services acquired from suppliers,
etc.
» Often represent a large proportion of total cost

• Perform value engineering to design out

costs without sacrificing needed features
– Perform a cost analysis of major components
and activities
• List components or activities and their functions
• Calculate a cost breakdown (exhibit 3)
– Determine the current cost of each component or
activity and convert to percentage of total cost
» Costs include materials, labor, overhead, etc.

• Relate the components to customer

requirements (exhibit 4)
– Develop Quality-Function-Deployment matrix
• Indicates which components have the greatest
impact on customer requirements
– Develop a functional ranking (exhibit 5)
• Indicates the importance of each component to the
customer
– Based on the component’s contribution to providing
the desired functions

– Identify components for cost reduction

• Calculate a value index for each major component
(exhibit 6)
– Component cost as a percentage of total cost
divided by the component’s relative importance to
the customer
– Index greater than 1
» Disproportionately high cost in relation to its
importance
» Implies cost reduction should be considered
– Do not manage by the numbers alone
– Generate cost reduction ideas

• Eliminate over-engineering
• Eliminate, replace, combine, rearrange
– Seek ways to accomplish the goal at less cost
• Consider the process as well as the product
– More efficient manufacturing processes
– Better logistics
– Etc.

– Test the ideas

• Will they be effective?
• Are they technologically feasible?
• Is there a domino effect?
– Construct a component interaction matrix (exhibit 7)
– Do activities interact?
– Estimate the achievable costs
• Use activity-based costing, cost tables, etc.

Make the Decision
Begin
Value engineering
Repeat Achieve
Yes No Close No
value target
enough?
engr.? cost?
Yes Yes
No
Abort
project
Release design
for production
Copyright@ Amity University

Organizational Impact
• Positives • Negatives
– Customer focus – Too much customer
– Cross-functional focus
integration – Potential
– Open sharing of organizational
information conflict
– Better process – Too much pressure
understanding to attain targets
– Longer development
times

Responsibility Centers
Cost Centers
Managers are held accountable for controlling
costs.
Profit Centers
Managers are held accountable for costs
and making decisions that impact revenues
favorably.

Responsibility Centers
Investment Centers
Managers are held accountable for costs
and revenues and are also held accountable
for the efficient use of assets.

Responsibility Accounting
for Cost Centers
COST CENTERS IN A UNIVERSITY
UNIVERSITY COLLEGE
College of Dept. of Marketing

College of Business
Engineering
College of Arts
and Sciences
Dept. of Accounting
Dept. of Management
Responsibility Accounting
for Cost Centers
COST CENTERS IN A UNIVERSITY
DEPARTMENT
Department
of
Accounting

Responsibility
Accounting for
Profit Centers
In a profit center, the unit manager has the

responsibility and the authority to make
decisions that affect both costs and revenues.

Profit centers may be
divisions, departments,
or products.

Responsibility
Accounting for
Investment Centers
In an investment center, the unit manager has the
responsibility and the authority to make decisions
that affect not only costs and revenues but also
the assets invested in the center.

Rate of Return on Investment (ROI)
Revenues

Profit
Profit
Margin
Investment
Turnover

The profit margin

indicates the rate of profit
The on each sales dollar.
investment
turnover
indicates
the rate of
sales on Profit
each dollar Margin
Investment
of invested Turnover
assets.
ROI = Income from operation Sales

x
Sales Invested assets
$ 70,000 $560,000
ROI = x
$560,000 $350,000
ROI = 12.5% x 1.6 = 20%

ROI = Income from operation Sales

x
Sales Invested assets
Profit Inventory
Margin Turnover
Northern Central Southern
Profit Margin Division Division Division
Income from operations $ 70,000 $ 84,000 $ 75,000
Revenues (Sales) $560,000 $672,000 $750,000
Profit margin 12.5% 12.5% 10.0%
Investment Turnover
Revenues (Sales) $560,000 $672,000 $750,000
Invested assets $350,000 $700,000 $500,000
Investment turnover 1.6 .96 1.5
Return on Investment (ROI)
Income from operations $ 70,000 $ 84,000 $ 75,000
Invested assets $350,000 $700,000 $500,000
Rate of return on investment 20% 12% 15%

Minimum
Income Acceptable
– Residual
from Rate of =
Income
Operations Return on
Assets

The balance scorecard is a set of
financial and nonfinancial measures
that reflect multiple performance
dimensions of a business.

Innovation and
Learning
• R&D investment
• R&D pipeline
• Skills and training
• Time to market
Customer Internal
• Satisfaction Process
• Loyalty • Efficiency
• Perception • Quality
• Time
Financial
• ROI
• Residual income
• Profit
• Cost
• Sales
Transfer Pricing

Transfer Pricing
When divisions transfer products or
render services to each other, a transfer
pricing is used to charge for the products
or services
Benefits of Transfer Pricing
1. Divisions can be evaluated as profit or

investment centers.
2. Divisions are forced to control costs
and operate competitively.
3. If divisions are permitted to buy
component parts wherever they can find
the best price (either internally or
externally), transfer pricing will allow a
company to maximize its profits.

Commonly Used Transfer Prices
1. Market price approach sets the price at

which the product transferred could be sold
to outside buyers.
2. Negotiated price approach allows
decentralized managers to agree
(negotiate) among themselves.
3. Cost price approach (variable or full)
uses a variety of cost concepts for setting
the transfer price.

Commonly Used Transfer Prices
Variable Cost Full Cost Market Price

per Unit $10 per Unit $13 per Unit $20
Negotiated Price
Transfer Pricing—Negotiated Price Approach
Assumptions
1.Division M produces a product with a variable
cost of $10 per unit. Division M has unused
capacity.
2.Division N purchases 20,000 units of the same
product at $20 per unit from an outside source.
If the division managers agree on a price of
$15 per unit, how much will each
division’s income increase?

Value Analysis is….
• “an organized team study of functions to

creatively generate alternatives which will
satisfy the users needs at the lowest initial
and/or life-cycle cost”

Value Analysis is NOT…..
• A COST CUTTING PROGRAM!!!!

– Cost cutting programs cut costs
regardless of how they affect the
product.
– Any product can be cut in costs!
• JUST A HURDLE TO JUMP
THROUGH

Value Analysis IS about…..
• Sound, Defensible, Value-based Decision

Making
• Providing essential functions for an
appropriate cost
• Benefit to Cost Relationships and working
both sides of the equation.
• Managing the Decision Points
• Making better decisions!!!

Why do Value Analysis…..?
To improve benefit or reduce cost….
Value Analysis Job Plan
• Information Phase (Investigation)

• Functional Analysis Phase (Analysis)
• Creativity Phase (Speculation)
• Evaluation Phase
• Development Phase
• Recommendation Phase (Presentation)
• Implementation Phase

CBA Purpose.......
• To simplify, clarify and unify

decisionmaking
• To quantify non-monetary
benefits or advantages

Life Cycle Cost is….
“Life cycle costing is the development of all

significant cost of ownership of an item,
system, or facility, over a specified length
of time”

Thank You
Please forward your query
To: nnsengupta@gmail.com
CC: manoj.amity@panafnet.com
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PAN African eNetwork

Copyright © Amity University

Copyright © Amity University

Jose and Nancy Roberta is

Present three guidelines for

Kole Corporation manufactures a normal lens

Normal Lenses (NL)

Complex Lenses (CL)

INDIRECT 50,000 Direct

$58 per Direct

COST OBJECT: Indirect Costs

Kole uses 36,000 direct manufacturing

What is the total cost of complex lenses?

1. Design of Products and Process

Distinguish between the

Fundamental Assignment to Other

A cross-functional team at Kole

Set up batches of finished lenses for shipment.

Cost Parts- No. of

Product Lenses Lenses Lenses

What is the setup cost per setup-hour?

Allocation using direct labor-hours:

A cost hierarchy is a categorization

ABC systems commonly use a

These are resources sacrificed

These are resources sacrificed on

These are often called service-sustaining

These are resources sacrificed on

Cost products or services using

Cleaning and maintenance costs of

Normal Lenses (NL)

ABM describes management decisions that use

ABC gives management insight into the cost

Manufacturing and distribution personnel use

Management can identify and evaluate new designs

Compare activity-based costing

Evaluate the costs and benefits

Significant amounts of indirect costs are

Products that a company is well-suited to

Operations staff have significant

The main limitations of ABC are the

Activity-cost rates also need to be

The general approach to ABC in the

The cost pools correspond to key activities.

If you cannot find the time to do it

Copyright © Amity University

• Target cost is the cost that can be incurred

Copyright © Amity University

• Contradicts the traditional approach:

Copyright © Amity University

• Cost control from the beginning

Copyright © Amity University

• Product, manufacturing process, delivery

Copyright © Amity University

• Cost control at all phases of the product life

Copyright © Amity University

• Two stage process

Copyright © Amity University

• Determine the product and its market

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• Determine the selling price

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• Determine the required profit