ABC

Introduction to Management Accounting Chapter 4
Cost Management Systems and Activity-Based Costing Activity-
2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton -1 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler44 - 1
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.
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
Cost assignment to cost objects 1. Departments 2. Activities
Material costs (metals)
Machining Department Activity Activity Activity Activity Cabinets
Finishing Department Activity Activity Activity Activity Cabinets
3. Products
Desks Tables
Desks 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 Service
Departments
Processing orders
Product
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.
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. costA cost-allocation base is some measure of input or output that costdetermines the amount of cost to be allocated to a particular cost object. An ideal cost-allocation base would measure how much costof the particular cost is caused by the cost objective. Note the similarity of this definition to that of a cost driveran output driver measure that causes costs. Therefore, most allocation bases are cost drivers. drivers.
2005 Prentice Hall Business Publishing, Introduction to Management 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler - 10 4 4 - 10 2008 Prentice Hall Business Publishing, Introduction to Management AccountingAccounting 13/e, Horngren/Sundem/Stratton
Cost Allocation
Cost allocations support a companys CMSthe system CMS 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.
2005 Prentice Hall Business Publishing, Introduction to Management 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 4 11 4 - - 11 2008 Prentice Hall Business Publishing, Introduction to Management AccountingAccounting 13/e, Horngren/Sundem/Stratton
Cost Pool
A cost pool is a group of individual costs that a company allocates to cost objects using a single cost-allocation base. cost-
1. 2.
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. 3. Measure the units of the cost-allocation base used for each cost costobject and compute the total units used for all cost objects. 4. Determine the percentage of total cost-allocation base units costused for each cost object. 5. 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. cost-
Direct, Indirect, and Unallocated Costs Statement of Operating Income

Li Companys Statement of Operating Income
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.
Financial Statement Presentation Merchandising Companies

Sales
Minus
Merchandising Company (Retailer or Wholesaler)
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-inWork-inProcess Inventory

Expiration
Sales
Minus Cost of Goods Sold (Expenses) Equals Gross Margin Minus Selling Expenses and Administrative Expenses Equals Operating Income
Period Costs
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, freightthat are acquired and then resold.
All Indirect Resources $220,000
Traditional Costing System

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% $360,000 22,500 135,000 198,000 $ 4,500 Cell Phone Casings $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%
Processing Activity $135,000 + 8,000 $143,000
80% 25%
Production Support Activity $45,000 +32,000 $77,000 Cost Driver
[Direct Labor Hours]
All Unallocated Value Chain Costs $100,000
Cost Driver [Distinct Parts]
Direct Materials For Pen Casings $22,500
Direct Labor For Pen Casings $135,000
Direct Materials For Cell Phone Casings $12,000
Direct Labor For Cell Phone Casings $15,000
Sales $360,000
Sales $80,000
Unallocated $00,000
ActivityActivity-Based Cost Allocation System

External Reporting Internal Purposes Cell Pen Phone Casings Casings $360,000 22,500 135,000 128,700 15,400 $ 58,400 $80,000 12,000 15,000 14,300 61,600 ($22,900)
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%
16.22%
(28.63%)
ActivityActivity-Based Management
ABM is using the output of an activity-based activitycost accounting system to aid strategic decision making and to improve operational control. A value-added cost is the cost of an activity valuethat cannot be eliminated without affecting a products value to the customer. In contrast, nonvalue-added costs are costs nonvaluethat can be eliminated without affecting a products value to the customer.
ActivityActivity-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 ActivityManagement 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
Design of an Activity-Based ActivityCost Accounting System
Determine the key components of the cost accounting system.
Cost objectives Key activities Resources Related cost drivers

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

Determine the relationships among cost objectives,activities, and resources.
Activity Performed Resource Used to Perform Activity Account Inquiry Activity Correspondence Activity 10% 10 Billing Activity 30% 30 100 35 15 90 70 100 10 5 10 20 5 100 Verification Activity All Other Activities 20%
Total 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%
Supervisor 40% Account inquiry labor 90 Billing labor Verification labor Paper Computer 45 Telecommunications 90 Occupancy 65 Printing machines All other department resources

Collect relevant data concerning costs and the physical flow of the cost-driver units among resources and activities. costNumber of Cost Driver Units Activity Account inquiry Correspondence Bill printing Verification Other activities Cost Driver Units Inquiries Letters Printed pages Accounts verified Printed pages 120,000 Residential 20,000 1,800 120,000 Commercial 5,000 1,000 40,000 20,000 40,000 Total 25,000 2,800 160,000 20,000 160,000
Calculate and interpret the new activityactivity-based information. Determine the traceable costs for each of the activity cost pools. Determine the activity-based cost per activityaccount for each customer class

Total traceable costs for the 5 activity cost pools.
Activity Cost Pool 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 Cost (from Account slide 4-33) Inquiry Correspondence Billing Verification $ 33,600 $ 13,440* $ 3,360** $ 10,080*** 17,346 16,875 7,320 62,300 7,050 49,500 $39,375 11,250 17,800 8,900 5,852 9,400 2,750 67,100 $100,722 Other $ 6,720****
8,900
2,750
$32,356
$153,125
$68,425
*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

ActivityActivity-based cost per account for each customer class
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
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
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 nonvalueImproving both strategic and operational decisions
The End
End of Chapter 4

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Introduction to Management Accounting Chapter 4

Cost Management Systems and Activity-Based Costing Activity-

Cost Management System

Cost Management System

Cost Accounting Systems

Cost Accounting System

Collecting costs by some natural classification such as materials or labor

Tracing costs to one or more cost objectives

Cost Accounting System

Material costs (metals)

Machining Department Activity Activity Activity Activity Cabinets

Finishing Department Activity Activity Activity Activity Cabinets

Direct, Indirect, and Unallocated Costs

Four purposes of cost allocation:

Predict the economic effects of strategic and operational control decisions.

Direct, Indirect, and Unallocated Costs Statement of Operating Income

Direct Material Costs

Direct Labor Costs

Indirect Production Costs (Manufacturing Overhead)

Financial Statement Presentation Merchandising Companies

Merchandising Company (Retailer or Wholesaler)

Product (Inventoriable) Costs

Merchandise Expiration Inventory

Cost of Goods Sold (Expenses) Equals Gross Margin Minus

Selling Expenses and Administrative Expenses Equals Operating Income

Financial Statement Presentation Manufacturing Companies

Direct Material Inventory Finished Goods Inventory Work-inWork-inProcess Inventory

Current Asset Sections of Balance Sheets

Merchandise inventories Other current assets Total current assets

77,000 1,000 $107,000

Income Statement Presentation of Costs for a Manufacturer

Income Statement Presentation of Costs for a Retailer

Traditional Costing System

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

Traditional Costing System Statement of Operating Income

All Unallocated Value Chain Costs $100,000

Cost Driver [Distinct Parts]

Direct Materials For Pen Casings $22,500

Direct Labor For Pen Casings $135,000

Direct Materials For Cell Phone Casings $12,000

Direct Labor For Cell Phone Casings $15,000

ActivityActivity-Based Cost Allocation System

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

Benefits of Activity-Based Costing and ActivityManagement Systems

Design of a Traditional Costing System

Design of an Activity-Based ActivityCost Accounting System

Determine the key components of the cost accounting system.

Cost objectives Key activities Resources Related cost drivers

Design of an Activity-Based ActivityCost Accounting System

Design of an Activity-Based ActivityCost Accounting System

Design of an Activity-Based ActivityCost Accounting System

Design of an Activity-Based ActivityCost Accounting System

Design of an Activity-Based ActivityCost Accounting System

Design of an Activity-Based ActivityCost Accounting System

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

Strategic Decisions, Operational Cost Control, and ABM

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Cost objectives Key activities Resources Related cost drivers