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Chapter 4. Cost Management Systems and Activity-Based Costing. Chapter 4 Learning Objectives. Describe the purposes of cost management systems. 2. Explain the relationship among cost, cost object, cost accumulation, and cost assignment. 3. Distinguish between direct and indirect costs.

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chapter 4
Chapter 4

Cost Management Systems

and Activity-Based Costing

chapter 4 learning objectives
Chapter 4 Learning Objectives
  • Describe the purposes of cost management systems.
  • 2. Explain the relationship among cost, cost object, cost accumulation, and cost assignment.
  • 3. Distinguish between direct and indirect costs.
  • 4. Explain the major reasons for allocating costs.
  • 5. Identify the main types of manufacturing costs: direct materials, direct labor, and indirect production costs.
chapter 4 learning objectives1
Chapter 4 Learning Objectives
  • 6. Explain how the financial statements of merchandisers and manufacturers differ because of the types of goods they sell.
  • 7. Understand the main differences between traditional and activity-based costing (ABC) systems and why ABC systems provide value to managers.
  • 8. Use activity-based management (ABM) to make strategic and operational control decisions.
  • 9. Describe the steps in designing an activity-based costing system (Appendix 4).
cost management system
Cost Management System

Learning

Objective 1

A cost management system (CMS) is

a collection of tools and techniques

that identifies how management’s

decisions affect costs.

  • The primary purposes of a cost management system are:
  • To provide cost information for strategic management decisions and operational control and
  • For measures of inventory value and cost of goods sold for financial reporting.
slide6
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
Cost Object

A cost object (objective) is anything for which

a separate measurement of costs is desired.

Service

Customers

Departments

Processing orders

Product

cost accounting systems
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

assignment:

Tracing costs to one or

more cost objectives

Cost Accounting System

Learning

Objective 2

Two Processes

Cost

accumulation:

Collecting costs by some

“natural” classification

such as materials or labor

cost accounting system1

Cabinets

Cabinets

Desks

Desks

Tables

Tables

Cost Accounting System

Material costs

(metals)

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

direct and indirect costs
Direct and Indirect Costs

Learning

Objective 3

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.

cost allocation
Cost Allocation

Learning

Objective 4

Cost allocation assigns 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.

cost allocation1
Cost Allocation

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.

Cost allocations support a company’s CMS that provides cost measurements for strategic decision making, operational control, and external reporting.

cost allocation2
Cost Allocation
  • Four purposes of cost allocation:
  • Predict economic effects of strategic and operational
  • control decisions.
  • Provide desired motivation and feedback for
  • performance evaluation.
  • Compute income and asset valuations for financial
  • reporting.
  • Justify costs or obtain reimbursement.
cost pool
Cost Pool

Individual costs allocated to cost objects using a single cost-allocation base.

  • 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.
cost pool1
Cost Pool
  • Measure the units of the cost-allocation base used
  • for each cost object and compute the total units
  • used for all cost objects.
  • 4. Multiply the percentage by the total costs in the
  • cost pool to determine the cost allocated to each
  • cost object.
cost assignment
Cost Assignment

Direct costs are physically traced to

a cost object. Indirect costs are allocated

using a cost-allocation base.

unallocated costs
Unallocated Costs

Some costs lack an identifiable relationship

to a cost object. Often it is best to leave

such costs unallocated.

An unallocated cost for one company may be an allocated cost or even a direct cost for another.

These unallocated costs are recorded but not assigned to any cost object.

statement of operating income
Statement of Operating Income

Li Company’s Statement of Operating Income

categories of manufacturing costs
Categories of Manufacturing Costs

Learning

Objective 5

Manufacturing operations transform

raw materials, the basic materials from which

a product is made, into other goods through the

use of labor and factory facilities.

In manufacturing companies, products are

frequently the cost object.

Manufacturing companies classify

production costs as either (1) direct material,

(2) direct-labor, or (3) indirect production costs

categories of manufacturing costs1
Categories of Manufacturing 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

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.

In highly automated factories with a flexible

workforce, there may not be any direct-labor

costs because all workers may spend time

overseeing numerous products, making it

economically infeasible to physically trace any

labor cost directly to specified products.

indirect production costs manufacturing overhead
Indirect Production Costs (Manufacturing Overhead)

Manufacturing overhead includes all costs

associated with the production process that the

company cannot trace to the manufactured

goods in an economically feasible way.

Depreciation , property taxes, supplies, and

insurance are examples of indirect costs of

production. Minor items, such as tacks or

glue, and many labor costs, such as janitors and

forklift operators, are considered indirect labor

costs and economically infeasible to trace.

product costs
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

Period costs are deducted as expenses

during the current period without

going through an inventory stage.

These costs are accumulated by

departments, such as R&D, advertising,

and sales. Most of these costs are reported

as selling and administrative expenses.

financial statement presentation merchandising companies
Financial Statement Presentation: Merchandising Companies

Learning

Objective 6

Merchandising Company (Retailer or Wholesaler)

Sales

  • Cost of Goods Sold
  • (Expenses)

Product

(Inventoriable)

Costs

Merchandise Inventory

Merchandise Purchases

Expiration

Gross Margin

- Selling Expenses - Administrative Expenses

Period Costs

Operating Income

current asset sections of balance sheets

Manufacturer

Retailer or Wholesaler

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

Cash $ 4,000

Receivables 25,000

Merchandise inventory 77,000

Other current assets 1,000

Total current assets $107,000

Current Asset Sectionsof Balance Sheets
inventory sections of balance sheets

Costco Wholesale Corporation

Retailer or Wholesaler

Cisco Systems, Inc.

Manufacturer

Merchandise inventory $5,405

Raw materials $165

Work in process 33

Finished goods 692

Total $ 890

Inventory Sections of Balance Sheets

Manufacturing inventories

comprise

three major categories:

Merchandise inventories composed of purchase costs including freight in.

financial statement presentation manufacturing companies
Financial Statement Presentation: Manufacturing Companies

Manufacturing Company

Direct Material Inventory

Direct Material Purchases

Product

(Inventoriable)

Costs

Work-in-Process Inventory

Direct Labor

Sales

- Cost of Goods Sold (Expenses)

Indirect Production

Expiration

Finished Goods Inventory

Gross Margin

- Selling Expenses and Administrative Expenses

Period Costs

Operating Income

income statement presentation of costs for a manufacturer
Income Statement Presentationof Costs for a Manufacturer

The manufacturer’s 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
Income Statement Presentationof 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.

cost of goods sold section of income statements

Retailer or Wholesaler

Manufacturer

Beginning finished goods

inventory $ 4,000

Cost of goods manufactured:

Direct materials $20,000

Direct labor 12,000

Indirect production 8,000 40,000

Cost of goods available

for sale 44,000

Less: Ending finished goods 8,000

Cost of goods sold $36,000

Beginning merchandise

inventory $ 4,000

Purchases 40,000

Cost of goods available

for sale 44,000

Less: Ending merchandise

inventory 8,000

Cost of goods sold $36,000

Cost of Goods Sold Section of Income Statements
types of costing systems
Types of Costing Systems

Learning

Objective 7

There are many different cost accounting systems, but most of the important features of these systems can be described in terms of two general types—traditional and activity-based cost

accounting systems.

Companies adopt cost accounting systems that are consistent with their management philosophies and their production and operating technologies. Changes in philosophies or technologies often prompt corresponding changes in cost accounting systems.

traditional costing system statement of operating income
Traditional Costing System Statement of Operating Income

Traditional Cost Allocation System

Cell Phone

Casings

Pen

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%

activity based management
Activity-Based Management

Learning

Objective 8

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.

Nonvalue-added costs are costs

that can be eliminated without affecting

a product’s value to the customer.

activity based management1
Activity-Based Management

Benchmarking is the continuous process of comparing products, services, and activities to the best industry standards.

Benchmarking is a tool to help an organization measure its competitive posture. Benchmarks can come from within the organization, from competing organizations, or from other organizations having similar processes.

benefits of activity based costing and management systems
Benefits of Activity-Based Costing and Management Systems

Companies adopt ABC systems to:

  • set an optimal product mix
  • estimate profit margins of new products
  • determine consumption of shared resources
  • keep pace with new product techniques
benefits of activity based costing and management systems cont
Benefits of Activity-Based Costing and Management Systems (cont.)

Companies adopt ABC systems to:

  • keep pace with technological changes
  • decrease costs associated with bad decisions
  • take advantage of reduced cost of ABC
  • Systems due to computer technology
design of an activity based cost accounting system
Design of an Activity-Based Cost Accounting System

Learning

Objective 9

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

Determine the key

components of the

cost accounting

system.

design of an activity based cost accounting system1
Design of an Activity-Based Cost Accounting System

Step 1

Key

Activity

Cost

Driver

Account billing

Bill verification

Account inquiry

Correspondence

Other activities

Number of printed pages

Number of accounts verified

Number of inquiries

Number of letters

Number of printed pages

design of an activity based cost accounting system2
Design of an Activity-Based Cost Accounting System

Determine relationships among

cost objectives, activities, and resources.

Step 2

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%

design of an activity based cost accounting system3
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 system4
Design of an Activity-Based Cost Accounting System

Step 4

Calculate and interpret the new

activity-based information.

Determine the traceable costs for

each of the activity cost pools.

Determine the activity-based cost per account for each customer class.

strategic decisions operational cost control and abm
Strategic Decisions, Operational Cost Control, and ABM

Outsourcing

Reducing operating costs

Identifying nonvalue-added activities

Improving both strategic

and operational decisions

strategic decisions operational cost control and abm1
Strategic Decisions, Operational Cost Control, and ABM

Number of Cost Driver Units for the Billing Department

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

Billing 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

strategic decisions operational cost control and abm2
Strategic Decisions, Operational Cost Control, and ABM

Total traceable costs for the 5 activity cost pools.

Activity Cost Pool

Resource Account

Cost 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 cost $687,500 $332,872 $32,356 $153,125 $68,425 $100,722

slide51

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