Chapter 4

Cost Management Systems

and Activity-Based Costing
 Chapter 4 Learning Objectives

1. 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 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).
 Learning
Objective 1 Cost Management System

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:
1.To provide cost information for strategic
management decisions and operational
control and
2.For measures of inventory value and cost
of goods sold for financial reporting.
 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

 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.
 Learning
Objective 2 Cost Accounting System

Collecting costs by some

Cost
“natural” classification
accumulation:
such as materials or labor

Cost Tracing costs to one or

assignment: more cost objectives
 Cost Accounting System

Cost Material costs

accumulation (metals)

Cost assignment
to cost objects
Machining Department Finishing Department
1. Departments
Activity Activity Activity Activity
2. Activities Activity Activity Activity Activity

Cabinets Cabinets

3. Products Desks Desks

Tables Tables
 Learning
Objective 3 Direct and Indirect 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.
 Learning
Objective 4 Cost Allocation

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 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 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

Individual costs allocated to cost objects

using a single cost-allocation base.

1. Accumulate indirect costs for a period of time.

2. 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 Pool

3. 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

Direct costs are physically traced to

a cost object. Indirect costs are allocated
using a cost-allocation base.
 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

Li Company’s Statement of Operating Income

 Learning
Objective 5 Categories of Manufacturing Costs

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 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.

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)

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 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.

These costs are accumulated by

departments, such as R&D, advertising,
and sales. Most of these costs are reported
as selling and administrative expenses.
 Learning Financial Statement Presentation:
Objective 6
Merchandising Companies
Merchandising
Company (Retailer
or Wholesaler) Sales

Product -Cost of
Merchandise Merchandise Expiration Goods Sold
(Inventoriable) Purchases
Inventory (Expenses)
Costs

Gross Margin

- Selling
Period Expenses
Costs - Administrative
Expenses

Operating
Income
 Current Asset Sections
of Balance Sheets

Manufacturer Retailer or Wholesaler

Cash $ 4,000
Receivables 25,000
Cash $ 4,000
Subtotal $29,000
Receivables 25,000
Finished goods 32,000
Work in process 22,000
Merchandise inventory 77,000
Direct material 23,000
Other current assets 1,000
Total inventories $77,000
Total current assets $107,000
Other current assets 1,000
Total current assets $107,000
 Inventory Sections
of Balance Sheets
Manufacturing inventories Merchandise inventories
comprise composed of purchase
three major categories: costs including freight in.

Cisco Systems, Inc. Costco Wholesale Corporation

Manufacturer Retailer or Wholesaler

Raw materials $165

Work in process 33 Merchandise inventory $5,405
Finished goods 692
Total $ 890
 Financial Statement Presentation:
Manufacturing Companies
Manufacturing
Company Direct
Direct
Product Material
Material
(Inventoriable)
Purchases Inventory
Costs
Direct Work-in-
Sales
Labor Process
- Cost of
Indirect Inventory Goods Sold
Production (Expenses)
Finished Expiration
Gross Margin
Goods
Inventory - Selling
Period Expenses and
Costs Administrative
Expenses
Operating
Income
 Income Statement Presentation
of 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

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

Manufacturer Retailer or Wholesaler

Beginning finished goods

inventory $ 4,000 Beginning merchandise
Cost of goods manufactured: inventory $ 4,000
Direct materials $20,000 Purchases 40,000
Direct labor 12,000 Cost of goods available
Indirect production 8,000 40,000 for sale 44,000
Cost of goods available Less: Ending merchandise
for sale 44,000 inventory 8,000
Less: Ending finished goods 8,000 Cost of goods sold $36,000
Cost of goods sold $36,000
 Learning
Objective 7 Types of Costing Systems

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
 Traditional Costing System
Statement of Operating Income

Traditional Cost Allocation System

Pen Cell Phone
Casings 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
 Learning
Objective 8 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.

Nonvalue-added costs are costs

that can be eliminated without affecting
a product’s value to the customer.
 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
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.)
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 a Traditional Costing System
 Learning Design of an Activity-Based
Objective 9
Cost Accounting System

Determine the key ➢Cost objectives

components of the ➢Key activities
cost accounting ➢Resources
system. ➢Related cost drivers
 Design of an Activity-Based
Cost Accounting System

Key Cost
Activity Driver

Account billing Number of printed pages

Bill verification Number of accounts verified
Account inquiry Number of inquiries
Correspondence Number of letters
Other activities Number of printed pages
 Design of an Activity-Based
Cost Accounting System
Determine relationships among
cost objectives, activities, and resources.

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 System

Collect relevant data concerning costs

and the physical flow of the cost-driver
units among resources and activities.

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.

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

Outsourcing

Reducing operating costs

Identifying nonvalue-added activities

Improving both strategic

and operational decisions
 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

Two-Stage Cost Allocation for
Billing Department Operations
 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
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