©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Introduction to Management Accounting Chapter 4 Cost Management Systems and Activity-Based Costing

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Cost Management System A cost management system (CMS) is a collection of tools and techniques that identifies how management’s decisions affect costs. Learning Objective 1

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Cost Management System The primary purposes of a cost management system are to provide... cost information for strategic management decisions, cost information for operational control, and measure of inventory value and cost of goods sold for financial reporting.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Cost Accounting System Costaccumulation: Collecting costs by some “natural” classification such as materials or labor Costassignment: Tracing costs to one or more cost objectives more cost objectives Learning Objective 2

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Cost Accounting System Costaccumulation Cost assignment to cost objects Cabinets Desks Tables Material costs (metals) Finishing Department ActivityActivity Cabinets Desks Tables Machining Department ActivityActivity 1. Departments 2. Activities 3. Products

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Cost Object A cost object (objective) is anything for which A separate measurement of costs is desired. Customers Departments Processing orders Product Service

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Direct, Indirect, and Unallocated Costs Direct costs can be identified specifically and exclusively with a given cost objective in an economically feasible way. Learning Objective 3 Indirect costs cannot be identified specifically and exclusively With a given cost objective in an economically feasible way. Unallocated costs are recorded but not assigned to any cost object.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Cost Allocation Cost allocation is used to assign indirect costs to cost objects, in proportion to the cost object’s use of a particular cost-allocation base. A cost-allocation base is some measure of input or output that determines the amount of cost to be allocated to a particular cost object. An ideal cost-allocation base would measure how much of the particular cost is caused by the cost objective. Note the similarity of this definition to that of a cost driver—an output measure that causes costs. Therefore, most allocation bases are cost drivers. Learning Objective 4

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Cost Allocation Cost allocations support a company’s CMS—the system providing cost measurements for strategic decision making, operational control, and external reporting. Four purposes of cost allocation:  Predict the economic effects of strategic and operational control decisions.  Provide desired motivation and to give feedback for performance evaluation.  Compute income and asset valuations for financial reporting.  Justify costs or obtain reimbursement.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Cost Pool A cost pool is a group of individual costs that a company allocates 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. that is, a measure that causes the costs in the 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. object and compute the total units used for all cost objects. 4.Determine the percentage of total cost-allocation base units used for each cost object. used for each cost object. 5.Multiply the percentage by the total costs in the cost pool to determine the cost allocated to each cost object. determine the cost allocated to each cost object.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Cost Allocation Direct costs are physically traced to a cost object. Indirect costs are allocated using a cost-allocation base.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Direct, Indirect, and Unallocated Costs Li Company’s Statement of Operating Income Statement of Operating Income

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Direct Material Costs Direct materials include the acquisition costs of all materials that a company identifies as a part of the manufactured goods. These costs are identified in an economically feasible way. Learning Objective 5

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Indirect Production Costs (Manufacturing Overhead) Manufacturing overhead includes all costs associated with the production process that the company cannot be traced to the manufactured goods in an economically feasible way.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Period Costs Period costs are deducted as expenses during the current period without going through an inventory stage.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Merchandising Company (Retailer or Wholesaler) Merchandise Purchases Merchandise Inventory SalesSales Minus Cost of Goods Sold (Expenses) Selling Expenses and Administrative Expenses Period Costs Equals Gross Margin Minus Equals Operating Income Product(Inventoriable)Costs Expiration Financial Statement Presentation – Merchandising Companies Learning Objective 6

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Manufacturing Company Direct Material Purchases Finished Goods Inventory SalesSales Minus Cost of Goods Sold (Expenses) Selling Expenses and Administrative Expenses Period Costs Equals Gross Margin Minus Equals Operating Income Product(Inventoriable)Costs Expiration Financial Statement Presentation – Manufacturing Companies Work-in- Process Inventory Direct Material Inventory Direct Labor Indirect Manufacturing

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Current Asset Sections of Balance Sheets Cash $ 4,000 Receivables 25,000 Subtotal $29,000 Subtotal $29,000 Finished goods 32,000 Work in process 22,000 Direct material23,000 Total inventories $77,000 Other current assets 1,000 Total current assets$107,000 Manufacturer Cash$ 4,000 Receivables 25,000 Merchandise inventories 77,000 Other current assets 1,000 Total current assets$107,000 Retailer or Wholesaler

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Income Statement Presentation of Costs for a Manufacturer Direct labor Indirect manufacturing The manufacturer’s cost of goods produced and then sold is usually composed of the three major categories of cost: Direct materials

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Traditional Costing System Learning Objective 7 DirectMaterials For Pen Casings$22,500DirectMaterials Casings$22,500 DirectLabor Casings$135,000DirectLabor Casings$135,000 Direct Materials For CellPhoneCasings$12,000Direct CellPhoneCasings$12,000 Direct Labor For Cell Phone Casings$15,000Direct Labor For Cell Phone Casings$15,000 Sales $360,000 Sales $80,000 Unallocated $00,000 AllIndirectResources$220,000AllIndirectResources$220,000 All Unallocated Value Chain Costs$100,000 All Unallocated Value Chain Costs$100,000 Cost Driver [Direct Labor Hours]

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Traditional Costing System Statement of Operating Income Traditional Cost Allocation System PenCasings Cell Phone Casings Sales$440,000$360,000$80,000 Direct materials 34,500 22,500 12,000 Direct labor 150, ,000 15,000 Indirect manufacturing 220, ,000 22,000 Gross profit$ 35,500$ 4,500$31,000 Corporate expenses 100,000 Operating loss ($ 64,500) Gross profit margin 8.07% 1.25% 38.75%

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler ABC System DirectMaterials For Pen Casings $22,500 $22,500DirectMaterials For Pen Casings $22,500 $22,500 DirectLabor For Pen Casings$135,000DirectLabor Casings$135,000 Direct Materials For CellPhoneCasings $12,000 $12,000Direct Materials For CellPhoneCasings $12,000 $12,000 Direct Labor For Cell Phone Casings$15,000Direct Labor For Cell Phone Casings$15,000 Sales $360,000 Sales $80,000 Unallocated $00,000 Plant and Machinery$180,000 Machinery$180,000 All Unallocated Value Chain Costs $100,000 All Unallocated Value Chain Costs $100,000 Cost Driver [Direct Labor Hours] Cost Driver [Distinct Parts] Engineers and CAD Equipment $40,000 Engineers and CAD Equipment $40,000 ProcessingActivity$135, ,000 $143,000 Production Support Activity$45,000+32,000$77,000 75%25% 20%80%

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Activity-Based Cost Allocation System Sales$440,000$360,000$80,000 Direct materials 34,500 22,500 12,000 Direct labor 150, ,000 15,000 Processing activity 143, ,700 14,300 Production support activity 77,000 15,400 61,600 Gross profit$ 35,500$ 58,400 ($22,900) Corporate expenses 100,000 Operating loss ($ 64,500) Gross profit margin 8.07% 16.22% (28.63%) ExternalReporting Internal Purposes Pen PenCasings Cell Phone Casings

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler ABM is using the output of an activity-based cost accounting system to aid strategic decision making and to improve operational control. Activity-Based Management A value-added cost is the cost of an activity that cannot be eliminated without affecting a product’s value to the customer. In contrast, nonvalue-added costs are costs that can be eliminated without affecting a product’s value to the customer. Learning Objective 8

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Benefits of Activity-Based Costing and Management Systems  set an optimal product mix  to estimate profit margins of new products  determine consumption of company’s shared resources  keep pace with new product techniques  and technological changes  decrease the costs associated with bad decisions  take advantage of reduced cost of ABC  systems due to computer technology Companies adopt ABC systems to:

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Design of a Traditional Costing System

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Design of an Activity-Based Cost Accounting System Determine the key components of the cost accounting system.  Cost objectives  Key activities  Resources  Related cost drivers Learning Objective 9

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Design of an Activity-Based Cost Accounting System Account billing Bill verification Account inquiry Correspondence Other activities Number or printed pages Number of accounts verified Number of inquiries Number of letters Number of printed pages KeyActivityCostDriver

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 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 % Billing labor % Verification labor % Paper % Computer % Telecommunications % Occupancy % Printing machines % All other department 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 % Billing labor % Verification labor % Paper % Computer % Telecommunications % Occupancy % Printing machines % All other department resources % Determine the relationships among Determine the relationships among cost objectives,activities, and resources. cost objectives,activities, and resources. Determine the relationships among Determine the relationships among cost objectives,activities, and resources. cost objectives,activities, and resources. Design of an Activity-Based Cost Accounting System

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Design of an Activity-Based Cost Accounting System Collect relevant data concerning costs and the physical Collect relevant data concerning costs and the physical flow of the cost-driver units among resources and activities. flow of the cost-driver units among resources and activities. Collect relevant data concerning costs and the physical Collect relevant data concerning costs and the physical flow of the cost-driver units among resources and activities. flow of the cost-driver units among resources and activities. Number of Cost Driver Units Activity Cost Driver Units Residential Commercial Total Account inquiryInquiries 20,000 5,000 25,000 Correspondence Letters 1,800 1,000 2,800 Bill printing Printed pages 120,000 40, ,000 Verification Accounts verified 20,000 20,000 Other activities Printed pages 120,000 40,000160,000 Number of Cost Driver Units Activity Cost Driver Units Residential Commercial Total Account inquiryInquiries 20,000 5,000 25,000 Correspondence Letters 1,800 1,000 2,800 Bill printing Printed pages 120,000 40, ,000 Verification Accounts verified 20,000 20,000 Other activities Printed pages 120,000 40,000160,000

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 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

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Activity Cost Pool Cost (from Account Resource slide 4-33) Inquiry Correspondence Billing Verification Other Supervisors $ 33,600 $ 13,440* $ 3,360** $ 10,080*** $ 6,720**** Account inquiry labor 173, ,114 17,346 Billing labor 56,250 16,875 $39,375 Verification labor 11,250 11,250 Paper 7,320 7,320 Computer 178,000 80,100 8,900 62,300 17,800 8,900 Telecommunication 58,520 52,668 5,852 Occupancy 47,000 30,550 7,050 9,400 Printers 55,000 2,750 49,500 2,750 Other resources 67,100 67,100 Total traceable cost $687,500 $332,872 $32,356 $153,125 $68,425 $100,722 *From slides 33 and 36, account inquiry activity uses 40% of the supervisor resource. So the allocation is 40% × $33,600 = $13,440. **10% × $33,600 ***30% × $33,600 ****20% × $33,600 Total traceable costs for the 5 activity cost pools. Design of an Activity-Based Cost Accounting System

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Driver Costs Total Number of Traceable Costs Driver Units Cost per (from Exhibit 4-12) (From Exhibit 4-11) Driver Unit Activity (Driver Units) (1) (2) (1) ÷ (2) Account inquiry (inquiries) $332,872 25,000 Inquiries $13, Correspondence (letters) 32,356 2,800 Letters$ Account billing (printed pages) 153, ,000 Printed pages $ Bill verification (accounts verified) 68,425 20,000 Accounts verified $ Other activities (printed pages) 100, ,000 Printed pages $ Cost per Customer Class Residential Commercial Cost per Number of Number of Driver Unit Driver Units Cost Driver Units Cost Account inquiry $ ,000 Inquiries $266,298 5,000 Inquiries $ 66,574 Correspondence $ ,800 Letters 20,800 1,000 Letters 11,556 Account billing $ ,000 Pages 114,844 40,000 Pages 38,281 Bill verification $ ,000 Accts. 68,425 Other activities $ ,000 Pages 75,541 40,000 pages 25,181 Total cost $477,483 $210,017 Number of accounts 120,000 20,000 Cost per account $ 3.98 $ Cost per account, traditional system from slide 33 $ 4.58 $ 6.88 Design of an Activity-Based Cost Accounting System Activity-based cost per account for each customer class

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Strategic Decisions, Operational Cost Control, and ABM Outsourcing Reducing operating costs Identifying nonvalue-added activities Improving both strategic and operational decisions

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler End of Chapter 4 The End