Introduction to Management Accounting Chapter 4 Cost Management Systems and Activity-Based Costing
Cost Management System A cost management system (CMS) is a collection of tools and techniques that identifies how management’s decisions affect costs. Learning Objective 1
Cost Management System The primary purposes of a cost management system are to provide... 1 cost information for strategic management decisions, 2 cost information for operational control, and 3 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 Learning Objective 2 Cost assignment: Tracing costs to one or more cost objectives
Cost Accounting System Cost accumulation Cost assignment to cost objects Finishing Department Activity Activity Activity Activity Machining Department Activity Activity Activity Activity 1. Departments 2. Activities 3. Products Cabinets Desks Tables Material costs (metals) Cabinets 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 Departments Processing orders Product Service
Direct, Indirect, and Unallocated Costs Direct costs can be identified specifically and exclusively with a given cost objective in an economically feasible way. Learning Objective 3 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 object’s 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 driver—an output measure that causes costs. Therefore, most allocation bases are cost drivers . Learning Objective 4
Cost Allocation Cost allocations support a company’s CMS—the system providing cost measurements for strategic decision making, operational control, and external reporting. <ul><li>Four purposes of cost allocation: </li></ul><ul><li>Predict the economic effects of strategic and operational control decisions. </li></ul><ul><li>Provide desired motivation and to give feedback for performance evaluation. </li></ul><ul><li>Compute income and asset valuations for financial reporting. </li></ul><ul><li>Justify costs or obtain reimbursement. </li></ul>
Cost Pool A cost pool is a group of individual costs that a company allocates to cost objects using a single cost-allocation base. <ul><li>Accumulate indirect costs for a period of time. </li></ul><ul><li>Select an allocation base for each cost pool, preferably a cost driver, </li></ul><ul><li>that is, a measure that causes the costs in the cost pool. </li></ul><ul><li>Measure the units of the cost-allocation base used for each cost </li></ul><ul><li>object and compute the total units used for all cost objects. </li></ul><ul><li>Determine the percentage of total cost-allocation base units </li></ul><ul><li>used for each cost object. </li></ul><ul><li>Multiply the percentage by the total costs in the cost pool to </li></ul><ul><li>determine the cost allocated to each cost object. </li></ul>
Cost Allocation Direct costs are physically traced to a cost object. Indirect costs are allocated using a cost-allocation base.
Statement of Operating Income Direct, Indirect, and Unallocated Costs Li Company’s 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. Learning Objective 5
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 Merchandising Company (Retailer or Wholesaler) Merchandise Purchases Merchandise Inventory Sales Minus Cost of Goods Sold (Expenses) Selling Expenses and Administrative Expenses Period Costs Equals Gross Margin Minus Equals Operating Income Product (Inventoriable) Costs Expiration Learning Objective 6
Financial Statement Presentation – Manufacturing Companies Manufacturing Company Direct Material Purchases Finished Goods Inventory Sales Minus Cost of Goods Sold (Expenses) Selling Expenses and Administrative Expenses Period Costs Equals Gross Margin Minus Equals Operating Income Product (Inventoriable) Costs Expiration Work-in-Process Inventory Direct Material Inventory Direct Labor Indirect Manufacturing
Current Asset Sections of Balance Sheets 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 Manufacturer Cash $ 4,000 Receivables 25,000 Merchandise inventories 77,000 Other current assets 1,000 Total current assets $107,000 Retailer or Wholesaler
Income Statement Presentation of Costs for a Manufacturer Direct labor Indirect manufacturing The manufacturer’s cost of goods produced and then sold is usually composed of the three major categories of cost: Direct materials
Income Statement Presentation of Costs for a Retailer The merchandiser’s cost of goods sold is usually composed of the purchase cost of items, including freight-in, that are acquired and then resold.
Traditional Costing System Learning Objective 7 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 All Indirect Resources $220,000 All Unallocated Value Chain Costs $100,000 Cost Driver [Direct Labor Hours]
Traditional Costing System Statement of Operating Income Traditional Cost Allocation System Pen Casings Cell Phone Casings Sales $440,000 $360,000 $80,000 Direct materials 34,500 22,500 12,000 Direct labor 150,000 135,000 15,000 Indirect manufacturing 220,000 198,000 22,000 Gross profit $ 35,500 $ 4,500 $31,000 Corporate expenses 100,000 Operating loss ($ 64,500) Gross profit margin 8.07% 1.25% 38.75%
ABC System 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 Plant and Machinery $180,000 All Unallocated Value Chain Costs $100,000 Cost Driver [Direct Labor Hours] Cost Driver [Distinct Parts] Engineers and CAD Equipment $40,000 Processing Activity $135,000 + 8,000 $143,000 Production Support Activity $45,000 +32,000 $77,000 75% 25% 20% 80%
Activity-Based Cost Allocation System External Reporting Internal Purposes Pen Casings Cell Phone Casings Sales $440,000 $360,000 $80,000 Direct materials 34,500 22,500 12,000 Direct labor 150,000 135,000 15,000 Processing activity 143,000 128,700 14,300 Production support activity 77,000 15,400 61,600 Gross profit $ 35,500 $ 58,400 ($22,900) Corporate expenses 100,000 Operating loss ($ 64,500) Gross profit margin 8.07% 16.22% (28.63%)
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 product’s value to the customer. In contrast, nonvalue-added costs are costs that can be eliminated without affecting a product’s value to the customer. Learning Objective 8
Activity-Based Management Benchmarking 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 <ul><li>set an optimal product mix </li></ul><ul><li>to estimate profit margins of new products </li></ul><ul><li>determine consumption of company’s shared resources </li></ul><ul><li>keep pace with new product techniques </li></ul><ul><li>and technological changes </li></ul><ul><li>decrease the costs associated with bad decisions </li></ul><ul><li>take advantage of reduced cost of ABC </li></ul><ul><li>systems due to computer technology </li></ul>Companies adopt ABC systems to:
Design of an Activity-Based Cost Accounting System Determine the key components of the cost accounting system. <ul><li>Cost objectives </li></ul><ul><li>Key activities </li></ul><ul><li>Resources </li></ul><ul><li>Related cost drivers </li></ul>Step 1 Learning Objective 9
Design of an Activity-Based Cost Accounting System Account billing Bill verification Account inquiry Correspondence Other activities Number or printed pages Number of accounts verified Number of inquiries Number of letters Number of printed pages Key Activity Cost Driver
Design of an Activity-Based Cost Accounting System Activity Performed Resource Account Used to Inquiry Correspondence Billing Verification All Other Perform Activity Activity Activity Activity Activity Activities Total Supervisor 40% 10% 30% 20% 100% Account inquiry labor 90 10 100% Billing labor 30 70 100% Verification labor 100 100% Paper 100 100% Computer 45 5 35 10 5 100% Telecommunications 90 10 100% Occupancy 65 15 20 100% Printing machines 5 90 5 100% All other department resources 100 100% Determine the relationships among cost objectives,activities, and resources. Step 2
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. Step 3 Number of Cost Driver Units Activity Cost Driver Units Residential Commercial Total Account inquiry Inquiries 20,000 5,000 25,000 Correspondence Letters 1,800 1,000 2,800 Bill printing Printed pages 120,000 40,000 160,000 Verification Accounts verified 20,000 20,000 Other activities Printed pages 120,000 40,000 160,000
Design of an Activity-Based Cost Accounting System Calculate and interpret the new activity-based information. Step 4 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 Activity Cost Pool Cost (from Account Resource slide 4-33) Inquiry Correspondence Billing Verification Other Supervisors $ 33,600 $ 13,440* $ 3,360** $ 10,080*** $ 6,720**** Account inquiry labor 173,460 156,114 17,346 Billing labor 56,250 16,875 $39,375 Verification labor 11,250 11,250 Paper 7,320 7,320 Computer 178,000 80,100 8,900 62,300 17,800 8,900 Telecommunication 58,520 52,668 5,852 Occupancy 47,000 30,550 7,050 9,400 Printers 55,000 2,750 49,500 2,750 Other resources 67,100 67,100 Total traceable cost $687,500 $332,872 $32,356 $153,125 $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 Total traceable costs for the 5 activity cost pools.
Design of an Activity-Based Cost Accounting System Driver Costs Total Number of Traceable Costs Driver Units Cost per (from Exhibit 4-12) (From Exhibit 4-11) Driver Unit Activity (Driver Units) (1) (2) (1) ÷ (2) Account inquiry (inquiries) $332,872 25,000 Inquiries $13,314880 Correspondence (letters) 32,356 2,800 Letters $11.555714 Account billing (printed pages) 153,125 160,000 Printed pages $ 0.957031 Bill verification (accounts verified) 68,425 20,000 Accounts verified $ 3.421250 Other activities (printed pages) 100,722 160,000 Printed pages $ 0.629513 Cost per Customer Class Residential Commercial Cost per Number of Number of Driver Unit Driver Units Cost Driver Units Cost Account inquiry $13.314880 20,000 Inquiries $266,298 5,000 Inquiries $ 66,574 Correspondence $11.555714 1,800 Letters 20,800 1,000 Letters 11,556 Account billing $ 0.957031 120,000 Pages 114,844 40,000 Pages 38,281 Bill verification $ 3.421250 20,000 Accts. 68,425 Other activities $ 0.629513 120,000 Pages 75,541 40,000 pages 25,181 Total cost $477,483 $210,017 Number of accounts 120,000 20,000 Cost per account $ 3.98 $ 10.50 Cost per account, traditional system from slide 33 $ 4.58 $ 6.88 Activity-based cost per account for each customer class
Strategic Decisions, Operational Cost Control, and ABM Outsourcing Reducing operating costs Identifying nonvalue-added activities Improving both strategic and operational decisions