Cost Management Systems and Activity-Based Costing

1. Cost Management Systems and Activity-Based Costing Chapter 4

2. Learning Objective 1 • Describe the purposes of • cost management systems.

3. Cost Management System Acost management system(CMS) is a collection of tools and techniques that identifies how management’s decisions affect costs.

4. cost information for strategic management decisions, 1 cost information for operational control, and 2 aggregate measure of inventory value and cost of goods manufactured. 3 Cost Management System The primary purposes of a cost management system are to provide...

5. Learning Objective 2 • Explain the relationships • among cost, cost objective, • cost accumulation, and • cost assignment.

6. Cost Accounting Systems Costaccounting is that part of the cost management system that measures costs for the purposes of management decision making and financial reporting.

7. Cost assignment: Tracing costs to one or more cost objectives Cost Accounting System Cost accumulation: Collecting costs by some “natural” classification such as materials or labor

8. Material costs (metals) Cabinets Cabinets Desks Desks Tables Tables Cost Accounting System Cost accumulation Cost allocation to cost objects Machining Department ActivityActivity ActivityActivity Finishing Department ActivityActivity ActivityActivity 1. Departments 2. Activities 3. Products

9. 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.

10. Cost Objective What is a cost object or cost objective? It is anything for which a separate measurement of costs is desired. Customers Departments Processing orders

11. Learning Objective 3 • Distinguish among direct, • indirect, and unallocated costs.

12. Direct Costs What are direct costs? Direct costs can be identified specifically and exclusively with a given cost objective in an economically feasible way.

13. Indirect Costs What are indirect costs? Indirect costs cannot be identified specifically and exclusively with a given cost objective in an economically feasible way.

14. Direct, Indirect,and Unallocated Costs Sales $470,000 Cost of goods sold: Direct material $120,000 Indirect manufacturing 110,000 Total cost of goods sold $230,000 Gross profit $240,000 Operating expenses: Sales salaries $ 47,000 Distribution 30,000 Total operating expenses $ 77,000 Contribution to corporate expenses and profit $163,000

15. Direct, Indirect,and Unallocated Costs Cabinets Tables Chairs Cost type, Assignment method $470,000 $280,000 $100,000 $90,000 120,000 50,000 30,000 40,000 Direct, Direct trace 110,000 45,000 30,000 35,000 Indirect, Allocation – machine hours $230,000 95,000 80,000 75,000 $240,000 185,000 40,000 15,000 $ 47,000 $ 28,000 $ 10,000 $ 9,000 Direct, Direct trace 30,000 12,000 8,000 10,000 Indirect, Allocation – weight $ 77,000$ 40,000$ 18,000$19,000 $163,000 $145,000 $ 22,000 $(4,000)

16. Direct, Indirect,and Unallocated Costs Managers prefer to classify costs as direct rather than indirect whenever it is “economically feasible” or “cost effective.”

17. Categories ofManufacturing Costs Direct material costs Direct labor costs Indirect production costs

18. Direct Material Costs It includes 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.

19. Direct Labor Costs These costs include the wages of all labor that can be traced specifically and exclusively to the manufactured goods in an economically feasible way.

20. Indirect Production Costs Manufacturingoverhead includes all costs associated with the production process that the company cannot be traced to the manufactured goods in an economically feasible way.

21. Learning Objective 4 • Explain how the financial • statements of merchandisers • and manufacturers differ • because of the types • of goods they sell.

22. Product Costs and Period Costs Product costs are costs identified with goods produced or purchased for resale. Product costs first become part of the inventory on hand. These costs, inventoriable costs, become expenses only when the inventory is sold.

23. Product Costs and Period Costs Period costs are deducted as expenses during the current period without going through an inventory stage.

24. Balance Sheet Income Statement Sales – Expiration Merchandise inventory Cost of goods sold (an expense) Equals gross margin – Selling and administrative expenses Period costs Equals operating income Financial Statement Presentation– Merchandising Companies

25. Financial Statement Presentation– Manufacturing Companies Balance Sheet Income Statement Sales – Direct material inventory Expiration Cost of goods sold (an expense) Equals gross margin – Work-in- process inventory Finished goods inventory Selling and administrative expenses Period costs Equals operating income

26. 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 inventories 77,000 Other current assets 1,000 Total current assets $107,000 Current Asset Sectionsof Balance Sheets

27. 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

28. 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.

29. Learning Objective 5 • Understand the main • differences between traditional • and activity-based costing (ABC) • systems and why ABC systems • provide value to managers.

30. All indirect resources $220,000 All unallocated value chain costs $100,000 Cost driver (direct labor hours 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 $100,000 Traditional Costing System and Statement of Operating Income

31. Traditional Costing System and 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 1.25% 38.75%

32. 20% Plant & machinery $80,000 Production support $140,000 All unallocated value chain costs $100,000 40% 60% 80% Processing activity $76,000 Production support activity $144,000 Cost driver (distinct parts) Cost driver (dir. labor hrs.) 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 $100,000 Activity-Based Cost System

33. 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 Cost Allocation System

34. 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.

35. Activity-Based Management A value-added costis the cost of an activity that cannot be eliminated without affecting a product’s value to the customer. In contrast, nonvalue-added costsare costs that can be eliminated without affecting a product’s value to the customer. Benchmarking

36. Benefits of Activity-Based Costing and Management Systems ABC systems are adopted for many reasons: – set a product mix and estimate profit margins – determine the consumption of a company’s shared resources

37. Benefits of Activity-Based Costing and Management Systems – keep pace with new product techniques and technological change – decrease the costs associated with bad decisions – take advantage of reduced cost of ABC systems due to computer technology

38. Learning Objective 6 • Apply the process used to design • a cost accounting system that • includes activity-based costing.

39. Traditional Cost Accounting System Maintenance costs Shipping costs Administrative costs Quality control costs Reactor hours 1 - - - 20 Products 1 - 20 Design of an Activity-Based Cost Accounting System

40. Activity-based Cost Accounting System Reactor processing activity Thin-tank processing activity Filtration process activity Waste disposal activity Preprocess preparation activity Preparation hours Processing hours Processing hours Processing hours Batches P R T F W P R T F W P R T F W 1 20 - - - Products 1 - 20 Design of an Activity-Based Cost Accounting System

41. Design of an Activity-Based Cost Accounting System Step 1 Determine the key components of the cost accounting system. Cost objectives Key activities Resources Related cost drivers

42. Design of an Activity-Based Cost Accounting System Activity Cost Driver 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

43. Design of an Activity-Based Cost Accounting System Step 2 Determine the relationships among cost objectives, activities, and resources.

44. Basic Concepts for Process Maps Resource A Resource B Resource C Activity 1 Activity 2 Activity 3 Activity 4 Product T Product U Product V Product W Product X Example 1. Resource A is an indirect cost with respect to activities and products. Example 2. Resource B is a direct cost with respect to activity 3 but an indirect cost with respect to both products. Example 3. Resource C is a direct cost with respect to activity 4 and product X. Design of an Activity-Based Cost Accounting System

45. Design of an Activity-Based Cost Accounting System Step 3 Collect relevant data concerning costs and the physical flow of the cost-driver units among resources and activities.

46. Design of an Activity-Based Cost Accounting System Step 4 Calculate and interpret the new activity-based information.

47. Learning Objective 7 • Use activity-based cost • information to make strategic • and operational control decisions.

48. Strategic Decisions, Operational Cost Control, and ABM Outsourcing Reducing operating costs Identifying nonvalue-added activities Improving both strategic and operational decisions

49. Objective 8 • Understand why multistage ABC • systems give more value than • two-stage ABC systems for • strategic planning and • operational control. • (Appendix 4)

50. Key Attributes of MultistageABC Systems There are more than two stages of allocation. Cost behavior of resources is considered. There is a greater use of operational information such as cost drivers and consumption rates.