Activity-based costing Activity-based costing (or ABC) is an attempt to identify a more accurate method of allocating overheads to products/services. In a later book by the authors of Relevance Lost, Kaplan and Cooper (1997) described how activity-based cost (ABC) systems: emerged in the mid-1980s to meet the need for accurate information about the cost of resource demands by individual products, services, customers and channels. ABC systems enabled indirect and support expenses to be driven, first to activities and processes, and then to products, services, and customers. The systems gave managers a clearer picture of the economics of their operations (p. 3). ABC uses cost pools to accumulate the cost of significant business activities and then assigns the costs from the cost pools to products based on cost drivers, which measure each product’s demand for activities. Cost pools accumulate the cost of business processes, irrespective of the organizational structure of the business. The costs that correspond to the formal organization structure may still be accumulated for financial reporting purposes through a number of cost centres, but this will not be the method used for product costing. For example, the purchasing process can take place in many different departments, as we saw illustrated in Figure 9.1 in Chapter 9. A stores-person or computer operator may identify the need to restock a product. This will often lead to a purchase requisition, which must be approved by a manager before being passed to the purchasing department. Purchasing staff will have negotiated with suppliers in relation to quality, price, and delivery and will generally have approved suppliers and terms. A purchase order will be raised. The supplier will deliver the goods against the purchase order and the goods will be received into the store. The paperwork (a delivery note from the supplier and a goods received note) will be passed to the accounting department to be matched to the supplier invoice and payment will be made to the supplier. This business process cuts across several departments. ABC collects the costs for the purchasing process in a cost pool, irrespective of the cost centre or department which incurred the cost. The next step is to identify a cost driver. The cost driver is the most significant cause of the activity for each cost pool. In the purchasing example, the causes of costs are often recognized as the number of suppliers and/or the number of purchase orders. Cost drivers enable the cost of activities to be assigned from cost pools to cost objects (products/services). Rates are calculated for each cost driver and overhead costs are applied to products/ services on the basis of the cost driver rates. There are no rules about what cost pools and cost drivers should be used, as this will be contingent on the circumstances of each business and the choices made by its accountants. Examples of cost pools and drivers are: Cost pool Cost driver Purchas.

1. Activity-based costing
Activity-based costing (or ABC) is an attempt to identify a
more accurate method of allocating overheads to
products/services. In a later book by the authors of Relevance
Lost, Kaplan and Cooper (1997) described how activity-based
cost (ABC) systems:
emerged in the mid-1980s to meet the need for accurate
information about the cost of resource demands by individual
products, services, customers and channels. ABC systems
enabled indirect and support expenses to be driven, first to
activities and processes, and then to products, services, and
customers. The systems gave managers a clearer picture of the
economics of their operations (p. 3).
ABC uses cost pools to accumulate the cost of significant
business activities and then assigns the costs from the cost
pools to products based on cost drivers, which measure each
product’s demand for activities.
Cost pools accumulate the cost of business processes,
irrespective of the organizational structure of the business. The
costs that correspond to the formal organization structure may
still be accumulated for financial reporting purposes through a
number of cost centres, but this will not be the method used for
product costing. For example, the purchasing process can take
place in many different departments, as we saw illustrated in
Figure 9.1 in Chapter 9. A stores-person or computer operator
may identify the need to restock a product. This will often lead
to a purchase requisition, which must be approved by a manager
before being passed to the purchasing department. Purchasing
staff will have negotiated with suppliers in relation to quality,
price, and delivery and will generally have approved suppliers
and terms. A purchase order will be raised. The supplier will
deliver the goods against the purchase order and the goods will
be received into the store. The paperwork (a delivery note from
the supplier and a goods received note) will be passed to the

2. accounting department to be matched to the supplier invoice and
payment will be made to the supplier. This business process
cuts across several departments.
ABC collects the costs for the purchasing process in a cost pool,
irrespective of the cost centre or department which incurred the
cost. The next step is to identify a cost driver.
The cost driver is the most significant cause of the activity for
each cost pool. In the purchasing example, the causes of costs
are often recognized as the number of suppliers and/or the
number of purchase orders. Cost drivers enable the cost of
activities to be assigned from cost pools to cost objects
(products/services). Rates are calculated for each cost driver
and overhead costs are applied to products/ services on the basis
of the cost driver rates. There are no rules about what cost pools
and cost drivers should be used, as this will be contingent on
the circumstances of each business and the choices made by its
accountants. Examples of cost pools and drivers are:
Cost pool
Cost driver
Purchasing
No. of purchase orders
Sales order entry
No. of sales orders
Material handling
No. of set-ups (i.e. batches)
Scheduling
No. of production orders
Machining
Machine hours (i.e. not labour hours)
For example, a rate will be calculated for each cost driver (e.g.
purchase order, set-up) and assigned to each product based on
how many purchase orders and set-ups the product has
consumed. The more purchase orders and set-ups a product
requires, the higher the overhead cost applied to it will be. ABC
does not mean that direct labour hours or machine hours or the
number of units produced are ignored. Where these are the

3. significant cause of activities for particular cost pools, they are
used as the cost drivers for those cost pools.
Using the same example as for absorption costing, assume for
our two products that there are two cost pools: purchasing and
scheduling. The driver for purchasing is the number of purchase
orders and the driver for scheduling is the number of production
orders. Costs are collected by an activity-based accounting
system (which uses a coding structure to identify the cost pool
as well as the cost centre) into cost pools and the measurement
of cost drivers takes place, identifying how many activities are
required for each product. The cost per unit of activity is the
cost pool divided by the cost drivers, as shown in Table 13.4.
Table 13.4 Overhead accumulated in cost pools and allocated by
cost drivers.
Cost pool and driver
Total cost
Product A
Product B
Purchasing
£40,000
No. of purchase orders
4,000
3,000
1,000
(£10 each)
£30,000
£10,000
Scheduling
£60,000
No. of production orders
100

4. 75
25
(£600 each)
£45,000
£15,000
Total overhead
£100,000
£75,000
£25,000
Number of Pages: 1 (Double Spaced)
Number of sources: 2
Writing Style: APA
Type of document: Essay
Academic Level:Undergraduate
Language Style: English (U.S.)
Allow night calls: No
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Order Instructions: Attached
Week 4 Discussion [WLOs: 1, 2, 3] [CLOs: 3, 4, 5]<

5. This week our main discussion will focus on explaining and
evaluating the theory of virtue ethics as discussed in Chapter 5
of the textbook. Your instructor will be choosing the discussion
question and posting it as the first post in the main discussion
forum. The requirements for the discussion this week include
the following:
You must begin posting by Day 3 (Thursday).
You must post a minimum of four separate posts on at least
three separate days (e.g., Wednesday, Friday, and Saturday, or
Thursday, Friday, and Sunday, or Thursday, Saturday, and
Monday, etc.).
The total combined word count for all of your posts, counted
together, should be at least 600 words, not including references.
You must answer all the questions in the prompt and show
evidence of having read the resources that are required to
complete the discussion properly (such as by using quotes,
referring to specific points made in the text, etc.
Aristotle on 'Flourishing'
Aristotle says that the virtues are necessary for humans to attain
happiness, but he means this in terms of something we might
call “flourishing” or “living well”, which he considers quite
different than simply feeling good.
Thus, according to Aristotle some people might feel that they
are happy, but because they lack the virtues they are not truly
flourishing. However, imagine someone that is deceitful,
selfish, greedy, self-indulgent, and yet enjoys great pleasure and
appears to be quite happy.

6. Is someone like this “flourishing” or not?
Explain your answer this by referring to this week’s readings
and media, and if possible provide examples from real life
and/or from literature, film, TV, etc.
Required Resources
Text
Thames, B. (2018). How should one live? An introduction to
ethics and moral reasoning (3rd ed.). Retrieved from
https://content.ashford.edu
Chapter 5: Virtue Ethics: Being a Good Person
5.1: Introduction
5.2: What Is Virtue Ethics?
5.3: Virtues and Moral Reasoning
5.4: The Nicomachean Ethics
5.5: Objections to Virtue Ethics
Conclusion & Summary
Primary Sources: Selections from Nichomachean Ethics by
Aristotle, Translated by W. D. Ross
Recommended Resources
Text
Thames, B. (2018). How should one live? An introduction to

7. ethics and moral reasoning (3rd ed.). Retrieved from
https://content.ashford.edu
Chapter 5: Virtue Ethics: Being a Good Person
Going Deeper: Pleasure and Pain: Aristotle Versus
Utilitarianism
Going Deeper: The Situationist Critique
Article
Hursthouse, R., & Pettigrove, G. (2016, December 8). Virtue
ethics. Retrieved from http://plato.stanford.edu/entries/ethics-
virtue/
This resource is an excellent overview of virtue ethics,
including some of the major criticisms and how virtue ethicists
have responded to them. This article may assist you in your
Week 4 Discussion and Week 4 Symposium.
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Multimedia
Annas, J. (2014, March 26). Episode 57: Julia Annas discusses
virtue ethics (M. Teichman, Interviewer, & D. Jagannathan,
Interviewer) [Audio podcast]. Retrieved from
https://lucian.uchicago.edu/blogs/elucidations/2014/03/26/episo
de-57-julia-annas-discusses-virtue-ethics/
A leading classical philosophy scholar and virtue ethicist
discusses virtue ethics in an informative and interesting
interview. This podcast may assist you in your Week 4

8. Discussion and Week 4 Symposium.
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CHAPTER 9
Accounting and Information Systems
This chapter considers the use of accounting information
systems. We look at different methods of data collection and
different types of information systems, with a particular focus
on enterprise resource planning systems. The chapter also
reviews the importance of a horizontal business process
perspective on organizational functioning, rather than a vertical,
hierarchical, or functional business unit perspective. The
chapter concludes with an overview of the importance of
systems design and internal controls for information systems.
Introduction to accounting and information systems
An information system is a system that collects information and
presents it, usually in summarized form, for management. Data
is a set of raw facts. Information is different from data because
it has been made usable by some form of summarization and/or
analysis. For example, daily sales data can be summarized and
analysed as trends by customer and/or product/service in a
monthly sales analysis report and thereby become meaningful
management information which can be used for decision
making.
Organizations will typically have an information systems (IS)
strategy which follows the organizational business strategy and
determines the long-term information requirements of the
business. The IS strategy provides an ‘umbrella’ for different
information technologies to help ensure that appropriate
information is acquired, retained, shared, and available for use
in strategy implementation. The IS strategy can be distinguished
from the information technology (IT) strategy which defines the
specific systems that are required to satisfy the information

9. needs of the organization, including the hardware, software, and
operating systems. The third element is the information
management (IM) strategy which is concerned with ensuring
that the necessary information is being provided to users. This
includes the type of database that is used, data warehousing,
and reporting systems.
Information is an essential tool of management, but it needs to
be relevant, timely, accurate, complete, concise, and
understandable. The benefits of quality information that meets
these criteria may include improved decision making, better
customer service, improved product/service quality, enhanced
productivity, and reduced staffing and waste. However, the
collection, processing, analysis, and reporting of information is
an expensive process (e.g. the cost of hardware, software
development, staff time), and organizations need to ensure that
the value of the information obtained is greater than the cost of
providing that information.
An accounting information system is one that uses technology
to capture, store, process, and report accounting information.
However, in this chapter we consider accounting to be only one
component, albeit an important one, of management information
systems.Methods of data collection
Most data collection in organizations takes place as a by-
product of transaction recording through computer systems,
which have automated tasks that were carried out before
computers by manual processing of documents and entries into
journals and ledgers (Chapter 3 described the recording of
financial transactions).
Computer systems have substantially automated routine tasks
with multiple aspects of a transaction being carried out
simultaneously. For example, credit sales typically incorporate
the whole process of delivering goods (or services) by
producing a delivery docket that accompanies goods, reducing
inventory, producing an invoice, updating the receivables
(debtor) records to show the amount owed by customers,
producing a sales analysis by customer/product, and calculating

10. the gross profit margin on the sale by deducting the cost of
sales. This information is transferred into the general ledger,
where along with all other similar transactions it is summarized
and reported as sales and gross profit.
Retailers make extensive use of electronic point of sale (EPOS)
technology which uses bar code scanning to reduce inventory,
price goods and calculate margins, and print a cash register
listing for the customer. Over a time period (day, week, or
month) the outputs from such a system include a detailed
analysis of business volume (e.g. number of customers, number
of items sold, scanning time at the checkout), sales analysis by
product, product profitability, and inventory reorder
requirements. Additional benefits of EPOS include information
about peak sales times during each day, products that may need
to be discounted, and sales locations that may need to be
expanded. More recently, supermarkets have introduced self-
scan units where customers scan, pack, and pay for their own
purchases without the need for a checkout operator. In many
stores, a single member of staff can supervise up to a dozen
self-scan terminals, a significant labour cost saving for
supermarkets. Even small businesses like restaurants can take
advantage of modern point of sale terminals that are relatively
inexpensive and can enable business owners to monitor
customer seating, generate orders for the kitchen, price goods
and calculate bills, and provide detailed management reporting
on inventory, sales trends, etc.
The use of electronic funds transfer at point of sale (EFTPOS –
whether debit or credit cards) means that customers do not have
to pay cash (which is expensive for retailers to deal with due to
security requirements) but can automatically transfer funds from
their bank account (or credit card) to the retailer’s bank
account, thereby eliminating further transactions. ‘Pay pass’ or
‘pay wave’ technology allows customers to merely pass their
card over a terminal to pay for smaller value purchases without
the need to enter account and PIN details, saving time for staff
taking customer money. Some banks now provide their merchant

11. customers with demographic data on customer spending using
debit/credit cards, including number of transactions and average
spend by customer age, gender, place of residence, etc.
The increase in e-commerce for business-to-consumer (B2C)
sales means that for many products and services, purchasing
over the internet enables customers to carry out the data
processing previously carried out by a retailer’s own employees.
Companies such as Amazon and iTunes save costs by not
needing expensive retail premises or staff taking customer
orders. Customers order and pay online. All the retailer has to
do is ship the goods (and for iTunes, Apple doesn’t even have to
do that as the customer downloads the purchased product). For
business-to-business (B2B), electronic data interchange (EDI)
enables supplier and customer systems to be linked by a
common data format so that purchase orders raised by the
customer are automatically converted into sales orders on the
supplier. For example, in the automotive industry, orders from
the major vehicle assemblers are placed on suppliers using EDI.
EDI transactions enable the supplier to confirm their ability to
meet the order by online means. The use of EDI enables
automatic generation of invoicing by the supplier, tracing of
deliveries by the logistics supplier, and receipt of goods by the
vehicle assembler, ultimately leading to payment to the supplier
(for a case study, see Berry and Collier, 2007).
An important part of data collection is collecting the financial
details of a transaction. Also important is capturing as much
information as possible about the transaction from a non-
financial perspective. An example of this is the information
collected from customers through retail credit cards, store
loyalty cards, frequent flyer, and similar programmes. These
enable retailers to maintain a detailed knowledge of their
customers’ purchasing habits to enable targeted promotional
campaigns aimed at specific customers.
Another source of data is that which is available from and about
suppliers. For example, in the automotive industry, the large
vehicle assemblers collect vast quantities of information about

12. their suppliers’ costs: their cost of labour; the cost of
manufacturing equipment and its capacity; the cost of raw
materials such as steel. Much of this information is publically
available but retaining it in an organization’s information
system supports subsequent negotiations between the
automotive assembler’s purchasing department and its suppliers.
By using this information, buyers can check the reasonableness
of supplier prices for component parts, as buyers can perform
their own checks on what it should cost to produce the same
components. This more strategic use of accounting information
is described further in Chapter 18.
Of course, the more that is expected of an information system,
the more data has to be collected, stored, and reported.
Accounting is one type rather than the only type of information
that is collected. In Chapter 4, we saw that Balanced Scorecard-
type performance measurement systems collate and report
information about customers, business processes, and
innovation to supplement financial performance measures.
Therefore, organizations need to capture information from their
marketing, purchasing, production, distribution, and human
resource activities. Information about key factors such as
customer satisfaction, cycle times (from order to delivery),
quality, waste, and on-time delivery need to be part of an
information system and integrated with and reported together
with financial information for management purposes.
Big data
Large volumes of information are now available from public
sources. The term ‘big data’ refers to very large and complex
data sets, which can be seen in the massive data resources of the
internet and the results provided by search engines such as
Google, or data held on Facebook. Organizations are able to
access this information (for a fee) to enable targeted marketing.
According to IBM (2012), 90% of the data in the world today
has been created in the last two years. This data comes from, for
example, sensors used to gather climate information, posts to
social media sites, digital pictures and videos, purchase

13. transaction records, and mobile phone signals.
Strategic intelligence and learning are more feasible with the
advent of technologies to access ‘big data’. It is now possible to
collect extensive data about potential customers through their
interaction with a business’s website and through interaction
with social media such as Facebook and Twitter. This data can
be mined to learn about customers, competitors, and
products/services. Parise, Iyer, and Vesset (2012) distinguish
social analytics (non-transactional, social data) from
performance management (business intelligence using
transactional data). In non-transactional data, Parise, Iyer, and
Vesset describe the use of social metrics to help inform
managers about the success of their external and internal social
marketing campaigns and the ability to calculate a ‘digital
footprint’.
However, big data faces the problem of how to analyse multiple
pictures to devise the optimum strategy. Buytendijk (2010) has
emphasized the limitations of analytics in performance
measurement because, as he explains, strategy is concerned with
satisfying the often differing expectations of different
stakeholders. Developing strategy is full of dilemmas and
analytical thinking is only partly helpful in dealing with these
dilemmas. Rather than analysis, Buytendijk emphasizes the
importance of synthesis, the process of taking multiple,
sometimes contradictory, ideas and bringing them together to
create a single picture.
From an accounting perspective, while these sources of data can
provide valuable information, it can come at a significant cost
to the business. A cost-benefit analysis needs to be conducted to
ensure that the value to the business of this information exceeds
its cost of acquisition, storage, and analysis.Types of
information system
There are various types of information system.
Transaction processing systems collect source data about each
business transaction, for example customer orders, sales,
purchases, inventory movements, payments, and receipts.

14. Transaction processing reports are important for control and
audit purposes but provide little usable management
information. Data from transaction processing systems is
predominantly financial in nature. The most common form of
delivering management information to users has been the ‘hard
copy’ report, a computer-generated report that may list
transactions (a transaction report or audit trail), exceptions (an
exception report, such as product sales below a predetermined
price level), or a summarized report (e.g. a sales analysis) for a
period.
Management information systems (MIS) may extend from
financial to non-financial information and typically are more
oriented to support management decisions. For example,
displays of key performance data with graphical representation
are becoming increasingly common. Traffic lights
(red/amber/green) draw attention to those aspects of
performance that are meeting target (green), those that are in
need of urgent attention (red), and those that need to be
considered as they are borderline (amber). However, these
systems do not integrate accounting, manufacturing, and
distribution systems. Market research carried out by Oracle
(2011) identified criticisms by respondents including an over-
reliance on spreadsheets, working with out-of-date data from
multiple ‘silos’ of information, and a lack of data sharing
between departments.
An enterprise resource planning (ERP) system helps to integrate
data flow and access to information over the whole range of a
company’s activities. ERP systems typically capture transaction
data for accounting purposes, together with operational,
customer, and supplier data which are then made available
through data warehouses against which custom-designed reports
can be produced. ERP systems take a whole-of-business
approach. ERP system data can be used to update performance
measures in a Balanced Scorecard system (Chapter 4) and can
be used for activity-based costing (Chapter 13), shareholder
value analysis (Chapter 2), strategic planning, customer

15. relationship management, and supply chain management
(Chapter 18). ERP systems are a development of earlier material
requirements planning (MRP), distribution requirements
planning (DRP), and manufacturing resource planning (MRP2)
systems.
Strategic enterprise management systems (SEM) are a type of
ERP system that provide support for the strategic management
process. They are based on data stored in a data warehouse
which is then used by a range of analytical tools. An SEM can
be an important driver of organizational performance as it
enables faster and better decision making at all organizational
levels.
Decision support systems (DSS) go a step further and contain
data analysis models that provide the ability for managers to
simulate scenarios or ask ‘What if?’ questions so that different
options can be considered to aid in decision making. DSS may
be contained in a spreadsheet or in a complex software package.
Executive information systems (EIS) are systems used for
decision support which incorporate access to summarized data,
often in graphical form, to enable senior managers to evaluate
information about the organization and its environment. An EIS
utilizes a ‘drill-down’ facility to move from aggregated data
down to a more specific and detailed level (e.g. customer,
product, business unit). Information is typically also available
from external sources, for example public databases. Ease of
use is an important feature so that enquiries can be made
without a detailed knowledge of the underlying data structures.
Expert systems store data relevant to a specialist area and are
populated with knowledge gained from experts which is retained
in a structured format or knowledge base. Expert systems
provide solutions to problems that require discretionary
judgement. Users access data through a graphical user interface
(GUI) to ask questions of the system, which prompts the user
for more information. Various rules are then applied by the
expert system to make decisions. The best example of an expert
system is that used for credit approval. Information is entered to

16. the system in response to prompts, such as postcode, telephone
number, age, employment history, which is compared with
confidential data held by credit reference agencies on a large
number of similar applicants to make an automated judgement
about an applicant’s creditworthiness and the allocation of a
credit limit.
In this chapter, we will use the term ‘enterprise resource
planning’ (ERP) systems to refer to information systems that are
not limited to accounting but integrate different functional areas
of the business and take a business process perspective. The
best-known examples of these systems include SAP and Oracle.
These systems can be extended with tools such as Business
Intelligence (or BI) or tools that enable SEM, DSS, EIS, or
expert applications. ERP systems avoid ‘information silos’ that
provide limited and specialist information to narrow groups of
managers. Often these silos (typical of older transaction
processing or MIS systems) are based on different software
packages, use different databases, and do not always report
timely, accurate, or consistent data to users. Although different
modules exist in an ERP (e.g. customer order entry, inventory,
invoicing, accounts receivable, management reporting), these
are all integrated so that each module provides consistent
information to users.
While an ERP system makes reporting easy in terms of the
hierarchical or vertical structure of organizations, as reflected
in the traditional organization chart, increasingly businesses are
looking at the horizontal business processes that cut across
departmental structures.
Business processes
We typically think of an organization in terms of its
hierarchical structure: a head office with departments
responsible for marketing, production, and administration; or a
business unit structure with autonomous units responsible for
particular products/services or geographic territories. Financial
information about the hierarchical structure is important for
internal financial reporting, comparing actual with budget

17. performance and holding managers accountable for the
performance of their departments or business units.
However, an organization can also be thought of as a collection
of processes or activities that when combined form part of the
value chain (see Chapter 11) delivering value to customers. The
hierarchical perspective is based on functions carried out such
as selling or accounting, with different specialists responsible
for each. The business process perspective is a horizontal rather
than a vertical perspective on the organization, where the focus
is on how things are done to satisfy customer demand, with
more emphasis on generalists rather than specialists. One
example of a business process starts with accepting a
customer’s order and ends with delivering it to the customer,
including the accounting transaction of invoicing the customer.
Another business process is that of placing an order with a
supplier through to receiving the goods or services and making
payment to the supplier.
Flowcharting and process mapping are commonly used methods
for representing business processes. Process maps are graphical
representations of business processes showing the activities and
flows of data between activities and the areas responsible for
carrying out those activities. These can be simple or complex.
Figure 9.1 shows a simplified example of a process map for
processing a customer order and its computer entry through the
physical picking of goods from a warehouse to dispatch and
invoicing. To satisfy the customer, this needs to be an effective,
seamless, and error-free process. However, in this example five
separate departments are involved (Sales, Order Processing,
Warehouse, Transport, and Accounting). As we will see in
Chapter 13, accounting systems generally capture costs for
departments (i.e. at the vertical or hierarchical level), but what
is more important in terms of cost, efficiency, and quality is the
cost of the business process itself, and the need to streamline
that business process as much as possible.
Figure 9.1 Customer order processing.

18. Business process re-engineering (or BPR) is defined as ‘the
fundamental rethinking and radical design of business processes
to achieve dramatic improvements in critical contemporary
measures of performance, such as cost, quality, service, and
speed’ (Hammer and Champy, 1993).This approach can lead to
improvements that eliminate duplication and waste and identify
gaps where failures in quality, delivery, or service can occur. A
continual re-evaluation of business processes can lead to
continuous improvement, increased competitiveness, and
profitability. ERP systems take a business process perspective
and can help to re-engineer those processes to be more efficient
and effective.
A business process perspective enables a different view of cost
than the traditional approach to departments or
product/services. Activity-based costing systems (see Chapter
13) provide a means by which costs can be accumulated both for
hierarchical reporting purposes and on a horizontal or business
process basis in relation to business activities. This means that,
using Figure 9.1 as an example, in addition to accumulating
costs for each of the five departments, we could produce total
costs for customer order processing, and in an ERP system, link
this to non-financial data such as the number of customer
orders, number of picking slips, number of inventory items, and
number of deliveries to produce useful analytical data about the
cost of these activities.
Information systems design and controls
The sheer volume of data now available to organizations and the
variety of types of information systems that can be utilized
make the design of information systems to meet the needs of the
business particularly important. This is particularly so when the
complexity of accounting for both the hierarchical
organizational structure and the business processes is required.
Organizations will frequently need to improve or change their
ERP systems to meet changing customer demand or
environmental constraints. However, there is a significant risk
in the development of these systems that the system does not

19. meet user needs, is late, or costs more than was estimated.
Therefore, it is important to have strong controls over
information systems design. This is necessary even where
proven ERP systems such as SAP and Oracle are introduced as
these systems will usually require customization to meet an
organization’s specific needs.
The key elements of project management for information
systems are:
· specification of requirements and obtaining top management
support;
· project organization: defining the roles and responsibilities of
the steering committee and project manager;
· resource planning – both staff and money;
· quality control and progress monitoring;
· user participation and involvement.
A steering committee should monitor the system implementation
and have overall responsibility to ensure that the system meets
requirements in terms of quality, time, and cost. Systems
development projects should comprise four distinct stages:
· Feasibility study stage: there should be a clear understanding
about the objectives of the new system, the deliverables, its
cost, and time to completion.
· System design stage: data security and levels of authorization
need to be built into the system design. During this stage, the
internal auditor should review system documentation, interfaces
with other systems, and acceptance of design by all in the
project team, especially users.
· Testing stage: comprehensive testing by systems development
staff, programmers, users, and internal auditors.
· Implementation stage: a review of training and documentation,
file conversion, and operational issues, e.g. staffing and
supervision.
An implementation plan will cover parallel running, where the
new system is operated in conjunction with the existing system
until such time as the new system is proven to work by
reconciling outputs from both systems; and ensuring that users

20. are satisfied with the new system and are confident about
discontinuing the existing system. If there is a changeover
without parallel running, then testing prior to implementation
becomes more important and additional monitoring may be
needed during the early stages of implementation. A post-
implementation review of the new system should also be carried
out to establish whether the system is operating as intended and
to confirm that user needs are being satisfied.
As organizations increasingly rely on their ERP systems,
information system controls are essential to ensure the security
of data and the reliability of information once an information
system is operational. There are four main types of controls in
relation to information systems:
1. Security controls: the prevention of unauthorized access,
modification, or destruction of stored data. Recruitment,
training, and supervision need to be in place to ensure the
competency of those responsible for programming and data
entry. Access controls, e.g. through passwords, provide security
over unauthorized access to data.
2. Application controls are designed for each individual
application, such as payroll, accounting, and inventory control.
The aim of application controls is to prevent, detect, and correct
transaction processing errors.
3. Network controls have arisen in response to the growth of
distributed processing and e-commerce and the need for
protection against hacking and viruses. A firewall comprises a
combination of hardware and software located between the
company’s private network (intranet) and the public network.
4. Contingency controls are relied upon if other controls fail;
there must be a back-up facility and a contingency plan to
restore business operations as quickly as possible (e.g. a
business continuity or disaster recovery plan).Conclusion
This chapter has shown the important role that information
systems play in planning, decision making, and control. We
have not limited ourselves to purely accounting systems here
but have focused on the role of enterprise resource planning

21. systems (ERP, such as Oracle and SAP) which increasingly play
a key role in providing financial and non-financial information
for managers. In using ERP systems, organizations are able to
refocus on business processes rather than the hierarchical
organizational structures that are more allied with externally
oriented financial reporting. We have also looked at the
importance of the design of information systems to ensure they
can meet organizational needs.References
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supply chains: processes, organisation for uncertainty and
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Manifesto for Business Revolution. London: Nicholas Brealey.
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(accessed August 2014).
Oracle (2011). Performance management: An incomplete
picture. The Oracle Report.
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ext=Y&p_dlg_id=10077790&src=7038701&Act=29 (accessed
August 2014, sign up to Oracle is required which is free of
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Parise, S., Iyer, B., and Vesset, D. (2012). Four strategies to
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strategies-to-capture-and-create-value-from-big-data (accessed
August 2014).
CHAPTER 13
Overhead Allocation Decisions
This chapter explains how accountants determine the costs of
products/services through differentiating product and period
costs, and direct and indirect costs. The chapter emphasizes the

22. overhead allocation problem: how indirect costs are allocated to
determine product/service profitability and assist in pricing
decisions. In doing so, it contrasts variable costing, absorption
costing, and activity-based costing. The chapter includes an
overview of contingency theory, a comparison between Western
and international approaches to management accounting, and a
consideration of the behavioural consequences of accounting
choices.Cost classification
In this chapter we are concerned with developing what we have
simply referred to in earlier chapters as ‘overhead’ (or what in
North American companies is commonly referred to as
‘burden’). Overhead is defined in the CIMA official
terminology as ‘Expenditure on labour, materials or services
that cannot be economically identified with a specific saleable
cost unit’ (CIMA, 2005, p. 15). Overheads are also called
indirect costs. We first consider the classification of product
and period costs, and then direct and indirect costs.
Product and period costs
The first categorization of costs made by accountants is between
period and product. Period costs relate to the accounting period
(year, month). Product costs relate to the cost of goods (or
services) produced. This distinction is particularly important to
the link between management accounting and financial
accounting, because the calculation of profit is based on the
separation of product and period costs. However, the value
given to inventory is based only on product costs, a requirement
of accounting standards. The IFRS accounting standard on
Inventories (see Chapter 6), IAS2, requires that the cost of
stock should:
comprise that expenditure which has been incurred in the
normal course of business in bringing the product or service to
its present location and condition. Such costs will include all
related production overheads.
Although Chapters 10, 11, and 12 introduced the concept of the
contribution (sales less variable costs), as we saw in Chapter 6

23. there are two types of profit: gross profit and net profit:
gross profit=sales−cost of salesgross profit=sales−cost of sales
The cost of sales is the product (or service) cost. It is either:
· the cost of providing a service; or
· the cost of buying goods sold by a retailer; or
· the cost of raw materials and production costs for a product
manufacturer.
net(or operating)profit=gross profit−expensesnet(or
operating)profit=gross profit−expenses
Expenses are the period costs, as they relate more to a period of
time than to the production of products/services. These will
include all the other (marketing, selling, administration, IT,
human resources, finance, etc.) costs of the business, i.e. those
not directly concerned with buying, making, or providing goods
or services, but supporting that activity.
To calculate the cost of sales, we need to take into account the
change in inventory, to ensure that we match the income from
the sale of goods with the cost of the goods sold. As we saw in
Chapter 6, inventory (or stock) is the value of goods purchased
or manufactured that have not yet been sold.
net(or operating)profit=gross profit−expensescosnet(or
operating)profit=gross profit−expensescos
for a retailer, or:
cost of sales=opening stock+cost of production−closing
stockcost of sales=opening stock+cost of production−closing
stock
for a manufacturer. For a service provider, there can be no
inventory of services provided but not sold, as the production
and consumption of services take place simultaneously, so:
cost of sales=cost of providing the services that are soldcost of
sales=cost of providing the services that are sold
As we know, sales, cost of sales, gross profit, expenses, and
operating profit are all shown in the Income Statement. Product
costs are those that appear under cost of sales, while period
costs are those that are deducted from gross profit to arrive at
net or operating profit. While the valuation of inventory is

24. prescribed by accounting standards, there are no such rules as to
how gross profit is calculated and the distinction between
product and period costs varies across different businesses. For
example, in most large retail chains, the cost of sales reported
in Income Statements includes not only the cost of the goods
sold but also all the costs of the supermarkets (store rental, staff
costs, etc.) in which we shop. Period costs include the
distribution centres that hold the bulk of inventory and the head
office functions. One reason for this is to avoid competitors
knowing what the mark-up or margin (see Chapter 10) is on the
company’s sales. In service businesses, there is no requirement
to show gross profit and there is considerable variation in how
service businesses report.
Therefore, when we speak of ‘overheads’ we are not always
sure what costs are included for any particular company.
Perhaps a more meaningful distinction is that between direct
and indirect costs.
Direct and indirect costs
Accounting systems typically record costs in terms of line
items. As we saw in Chapter 3, line items reflect the structure
of an accounting system around accounts for each type of
expense, such as raw materials, salaries, rent, and advertising.
Production costs (the cost of producing goods or services) may
be classed as direct or indirect. Direct costs are readily
traceable to particular products/services. Indirect costs are
necessary to produce a product/service, but are not able to be
readily traced to particular products/services. Any cost may be
either direct or indirect, depending on its traceability to
particular products/services. Because of their traceability, direct
costs are nearly always variable costs because these costs
increase or decrease with the volume of production. However,
as we saw in Chapter 12, direct labour is sometimes treated as a
fixed cost. Indirect costs may be variable (e.g. electricity) or
fixed (e.g. rent). Indirect costs are often referred to as
overheads.

25. Direct materials are traceable to particular products through
material issue documents. For a manufacturer, direct material
costs will include the materials bought and used in the
manufacture of each unit of product. They will clearly be
identifiable from a bill of materials: a detailed list of all the
components used in production (see Chapter 11). There may be
other materials of little value that are used in production, such
as screws, adhesives, and cleaning materials, which do not
appear on the bill of materials because they have little value and
the cost of recording their use would be higher than the value
achieved. These are still costs of production, but because they
are not traced to particular products they are indirect material
costs.
While the cost of materials will usually only apply to a retail or
manufacturing business, the cost of labour will apply across all
business sectors. Direct labour is traceable to particular
products or services via a time-recording system. It is the
labour directly involved in the conversion process of raw
materials to finished goods or the cost of providing a service
(the cost of labour was introduced in Chapter 12). Direct labour
will be clearly identifiable from an instruction list or routing, a
detailed list of all the steps required to produce a good or
service. In a service business, direct labour will comprise those
employees providing the service that is sold, such as the
recording of chargeable hours in professional service firms like
accountants, lawyers, architects, and consultants. In a call
centre, for example, the cost of those employees making and
receiving calls is a direct cost. Other labour costs will be
incurred that do not appear on the routing, such as supervision,
quality control, health and safety, cleaning, and maintenance.
These are still costs of production, but because they are not
traced to particular products, they are indirect labour costs.
Other costs are incurred that may be direct or indirect. For
example, in a manufacturing business, the depreciation of
machines (a fixed cost) used to make products may be a direct
cost if each machine is used for a single product (because the

26. cost will be traceable) or an indirect cost if the machine is used
to make many products (because it may be more difficult to
trace the depreciation cost applicable to different products). The
electricity used in production (a variable cost) may be a direct
cost if it is metered to particular products or indirect if it
applies to a range of products. A royalty paid per unit of a
product/ service produced or sold will be a direct cost. The cost
of rental of premises, typically relating to the whole business,
will be an indirect cost.
Prime cost is an umbrella term used to refer to the total of all
direct costs. Overhead is divided into those overheads that are
involved in production (i.e. indirect product costs) and those
that are associated more with marketing and sales, finance, and
administration (which are period rather than product costs).
Production overhead is the total of all indirect material and
labour costs and other indirect costs,
i.e. all production costs other than direct costs. This distinction
applies equally to the production of goods and services.
Non-production overheads (such as marketing, sales,
distribution, finance, IT, administration) are period costs and
are not included in production overhead. They are typically
deducted from gross profit in the calculation of net profit. A
simple way to think about the distinction is to imagine a factory
and office complex. These are generally separated by a large
wall. The office on one side has nicely dressed people working
at desks. On the other side of the wall, people work with
machines and wear overalls. This is a bit simplistic, but it does
help to understand the distinction. Production overheads relate
to the factory side of the wall, and non-production overheads to
the office side. Hence, a factory manager and his production
clerks who sit in the factory will be classed as production
overhead. This distinction is not so straightforward where there
is no factory, in which case each business will make its own
distinction between product (or service) and period costs.
Distinguishing between production and non-production costs
and between materials, labour, and overhead costs as direct or

27. indirect is contingent on the type of product/service and the
particular production process used in the organization.
Contingency theory is described later in this chapter. There are
no strict rules, as the classification of costs depends on the
circumstances of each business and the decisions made by the
accountants in that business. Consequently, unlike financial
accounting, there is far greater variety between businesses –
even in the same industry – in how costs are treated for
management accounting purposes.
We do need to be careful when using the term ‘overhead’ to
ensure that people we are talking to use the term in the same
way, as its use may change from business to business and even
from situation to situation. When we use the term, it may be
limited to production overheads, or may comprise all the
overheads of a business, both production and non-production. In
this chapter, we will define overheads as comprising indirect
product costs, i.e. those costs of production not readily
traceable to products/services.