1. Fundamentals of Cost Management
In Chapters 6 through 9 we emphasized the design of cost accounting systems and the information provided to managers for decision making. In this Chapter we explore the use of the information for managing costs.
Chapter 10
McGraw-Hill/Irwin
Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

2. Learning Objectives:
1. Explain the concept of activity-based cost management.
2. Use the hierarchy of costs to manage costs.
Describe how the actions of customers and suppliers affect a firm’s costs.
4. Use activity-based costing methods to assess customer and supplier costs.
Distinguish between resources used and resources supplied.
Design cost management systems to assign capacity costs.
Upon completion of this chapter you should be able to: 1. Explain the concept of activity-based cost management. 2. Use the hierarchy of costs to manage costs. 3. Describe how the actions of customers and suppliers affect a firm’s costs. 4. Use activity-based costing methods to assess customer and supplier costs. 5. Distinguish between resources used and resources supplied. 6. Design cost management systems to assign capacity costs. 7. Identify how activities that influence quality affect costs and profitability. And finally, 8. Compare the costs of quality control to the costs of failing to control quality.
7. Describe how activities that influence quality affect costs and profitability.
Compare the costs of quality control to the costs of failing to control quality.

3. Activity-Based Cost Management
LO1 Explain the concept of activity-based cost management.
Activity-based cost management uses activity analysis in decision making.
Activity-based costing focuses on activities in allocating overhead costs to products.
Activity-based cost management uses activity analysis in decision making. In Chapter 9 you saw that activity-based costing focuses on activities. Activity-based management, on the other hand, focuses on managing activities.
Activity-based management focuses on managing activities to reduce costs.

4. Key ways that managers add values to companies by using ABC
Obtain better information about product costs
Obtain better information about the cost of activities and processes
Activity analysis is an approach to operations control and it has 4 steps:
Identify the process objectives
Chart from start to finish the activities used to complete the product or service
Classify all activities ( value added or non value added
Continuously improve the efficiency of all value added activities and develop plan to eliminate (reduce) non value adding
Does this sounds familiar?

5. Activities that are candidates for elimination:
Storing items (JIT)
Moving items
Waiting for work (idle time)
Various activities in the production process ( that doesn’t add value)

6. Cost Hierarchy
LO2 Use the hierarchy of costs to manage costs.
Classification of cost drivers into general levels of activity; volume, batch, product and so on.
In Chapter 9 we saw that in the activity-based costing system, the first stage allocates cost to activities, not departments. Now we will see why what might seem like a small difference has important implications for cost management. Costs that are strictly volume related can be controlled by focusing on the volume of units. At the other extreme, facility related costs are capacity-related and are essentially fixed and require a longer time horizon to change than do decisions to change unit-level costs. Batch and product related costs are affected by the way managers manage activities.

7. Managing the Cost of Customers and Supplies
LO3 Describe how the actions of customers and suppliers affect a firm’s costs.
Resources cost
Customers (and suppliers) use resources
Some customers use more resources than others
Yes, it’s true, time does mean money. Customers or suppliers that take excess time to complete transactions add cost to the company.
What are the ways customers can affect a company profit wise?
Time =
Money

8. ABC and the Cost: Customers and Suppliers
LO4 Use activity-based costing methods to assess customer and supplier costs.
Use the same four-step ABC product costing process to assess customers and suppliers.
Identify the activities that consume resources and assign costs to them.
Identify the cost driver(s) associated with each activity.
Compute a cost rate per cost driver unit or transaction.
Fortunately, we can apply the concepts of activity-based costing in assessing customer and supplier costs. Remember the four-step process. First, identify activities that consume resources and assign costs to them. Second, identify the cost drivers associated with each activity. Third, compute a cost rate per cost driver unit or transaction. And finally, fourth, allocate the cost of the activities to the customer or supplier by multiplying the cost driver rate by the volume of cost driver units consumed by the transaction that occurred.
Allocate costs to customers by multiplying the cost driver rate by the volume of cost driver units consumed by the activity or transaction that occurred.

9. Example: Cost of Customers
Operating Data
Red’s Lumber
As an example, let’s look at Red’s Lumber. Red determines that he is losing customers like Jill and retaining customers like Jack. Red decides to investigate his delivery service to ascertain if his pricing policies were having a negative impact on customer retention. Currently, Red uses sales dollars to determine the charge to customers for delivery. All customers pay a 16% delivery charge. Red decides to apply activity-based costing to the delivery service. Let’s follow the four-step procedure described in Chapter 9 to the delivery service.

10. Example: Red’s Lumber – Step 1
Identify the activities
What activities consume resources for Red’s delivering service?
Process Flow of the Delivery Service
Red’s Lumber
First Red identifies the activities that consume resources. Excluding administrative activity, Red identifies three activities: entering the order into the system, gathering the individual items from the yard and loading them onto the truck, and delivering the order.
Entering Order
Loading Order
Delivering Order

11. Example: Red’s Lumber – Step 2
Identify the cost drivers and the expected volume of each cost driver.
Step 2
After a discussion with the delivery supervisor, Red determines the best cost driver for entering the order is the number of orders entered, for loading the orders is the number of items loaded and for delivering the order is the number of deliveries made. Because administration is a miscellaneous collection of activities he decides to use the order value for allocating those costs.

12. Example: Red’s Lumber – Step 3
Compute the Cost Driver Rates
Computation of Cost Driver Rates
Now, Red computes the cost driver rates. $100,000 of cost associated with entering orders divided by 10,000 orders results in a cost allocation rate of $10 per order. For loading the order, $150,000 divided by 75,000 items results in a $2 per item allocation rate. Delivery and administration costs are $24 per delivery and 5% of value, respectively.

13. Example: Red’s Lumber – Step 4
Assign costs to products
As Red looks at the activity of the two customers, Jack and Jill he notices that Jack and Jill have the same number of items with the same value delivered. However Jack, who is the type of customer who is staying with Red, makes many small orders requiring frequent deliveries. Jill, on the other hand, makes fewer orders than Jack, they are larger and require fewer deliveries than Jack. Do the math. Jack ‘s average order is $333 ($50,000/150 orders) and Jill’s average order is $1,000 ($50,000/50 orders).

14. Example: Red’s Lumber – Step 4 Continued. . .
When Red completes the fourth step in the activity-based costing exercise, he estimates the delivery costs for Jack and Jill are $10,300 and $5,700 respectively. Remember, he is currently charging both of them $8,000 (16% of $50,000). Jack, the type of customer who continues to do business with Red is costing the company. Red is retaining the higher cost customers and loosing the lower cost customers like Jill. Red can use this information to manage delivery costs. The activity-based costing analysis shows the order pattern, not the order value, drive most of the delivery costs.

15. Determine the cost of suppliers
Suppliers should be evaluated based on:
Price*
On time delivery
quality
Pacific mills
Coastal Lumber
Total
Board-feet of lumber purchased
600,000
400,000
1,000,000
average purchase price per board-feet
$2.01
$2.02
$2.014
total value of lumber purchased
$1,206,000
$808,000
$2,014,000
number of deliveries
100 60
160
percentage of late deliveries
50%
10%
35%
Cost of late deliveries is $34,000

16. Initial price per board-feet
Pacific mills
Coastal Lumber
Initial price per board-feet
$2.04
$2.07
Additional cost of late delivery per board feet
.10
Probability of late delivery
50%
10%
Expected cost of late delivery
.05
.01
Effective cost per board feet
$2.09
$2.08

17. Using and Supplying Resources
LO5 Distinguish between resources used and resources supplied.
Resources used
Cost driver rate multiplied by the cost driver volume.
Resources supplied
Expenditures or the amounts spent on a specific activity.
In some situations, costs go up and down proportionately with the cost driver. Consider the delivery service at Red’s. Suppose that every time Red has an order to cover temporary workers are hired and paid $2 per item to load the items onto the delivery truck. The cost driver is the number of items loaded, and the cost driver rate is $2 per item. Now, suppose Red hires loaders at a rate of $10 per hour and each loader can load 40 items in an eight hour day. If Red employees five workers he has the capacity to load 200 items per day. Resources are supplied for a capacity of 200 items at a cost of $400 (5 workers x $10 per hour x 8 hours a day). $400 is the amount that appears on the financial statements. If Red operates at capacity, the cost is $2 per unit to load. However, suppose that on Tuesday only 160 items were loaded. Resources used total $320 (160 items x $2 per item). Unused capacity equals $80 (40 items x $2 per item).
Unused capacity
Difference between resources used and resources supplied.

18. Example: Resources Used and Supplied
Traditional Income Statement
Red’s Lumber
Year 2
A traditional income statement reports costs as line items. Now that we have identified unused resource capacity, let’s report this information in a way that supports cost management. We do this by combining the concepts of the cost hierarchy and unused resource capacity.

19. Example: Resources Used and Supplied, Continued. . .
Activity-Based Income Statement
Red’s Lumber – Year 2
Here is a more informative report for managing capacity costs. It first categorizes costs into the cost hierarchies. Managers can look at the amount of costs in each hierarchy and find ways to manage those resources effectively. The report also shows managers how much of the resources for each type of costs are unused. Look at resources for loading. Red spent $150,000 and supplied resources for loading 75,000 items. However, only 67,500 items ($135,000 divided by $2 per item) were loaded. Red’s had unused capacity of 7,500 items or 10% of the capacity supplied.

20. Computing the Cost of Unused Capacity
LO6 Design cost management systems to assign capacity costs.
Theoretical capacity
Amount of production possible under ideal conditions with no time for maintenance, breakdowns, or absenteeism.
Practical capacity
Amount of production possible assuming only the expected downtime for scheduled maintenance and normal breaks and vacations.
In order to compute the cost of unused capacity, you must first define capacity. What capacity level do you want to use as the allocation base? Using actual activity as the allocation base results in fluctuations in cost from one period to the next as activity changes. The other extreme is theoretical capacity which is what could be produced under ideal conditions without allowing for normal maintenance and expected down time. Practical capacity is the volume that could be produced allowing for expected breaks and normal maintenance and down time. And finally, normal activity is the long-run expected volume of production. When using normal activity the cost of used capacity is charged to the product and the cost of unused capacity is charged as a period expense. This allows the manager to track the unused capacity cost and take action to reduce the capacity supplied if necessary.
Normal activity
Long-run expected volume.
Actual activity
Actual volume for the period.

21. Fixed Operating cost rate
Theoretical capacity 4000 passengers
Practical capacity 3200 passengers
Annual fixed operating cost $400,000
Fixed Operating cost
Number of passengers
Fixed Operating cost rate
Year 1
400,000
2,000
200
Year 2
2,500
160
Year 3
1,600
250

22. Managing the Cost of Quality
LO7 Describe how activities that influence quality affect costs and profitability.
Total Quality Management (TQM)
Quality as defined by the customer
Organization is managed to excel on all dimensions.
Way back in Chapter 1 we defined total quality management as a management method by which organizations seek to excel on all dimensions, with the customer ultimately defining quality. Unless cost accounting systems are designed to support TQM, companies are likely to find TQM has little economic benefit. Managers are ultimately evaluated on the cost of their activities and costs associated with quality must be incorporated in a way that allows managers to make decisions that consider the role of quality and other product characteristics.

23. Effective implementation of TQM requires five changes to traditional managerial accounting systems:
The information should include problem solving data
The workers themselves should collect the information and use it to get feedback
Information should be available quickly
Information should be more detailed
Rewards should be based on quality and customer satisfaction

24. External View of Quality: The Customer
Tangible
Performance
Taste
Functionality
Intangible
When designing a cost management system to support quality programs, you need to define quality. Two views of the meaning of quality are the external view and the internal view. The external view of quality is quality as defined by the customer. Customer expectations refer to what customers expect from a product’s tangible features and intangible features.
Customer service
Delivery time

25. Internal View of Quality
Conformance to specifications
Does the product or service do what it is designed to do?
The internal view of quality is conformance to specifications. Does the product meet customer tangible and intangible expectations?

26. External View? Quality Internal View? Both
The external view is everything about the product that the customer values. Therefore, there must be a link between the specifications developed for the product and the expectations customers have for the product.
Both

27. Cost of Quality Conformance costs
LO8 Compare the costs of quality control to the costs of failing to control quality.
Conformance costs
Prevention
Costs incurred to prevent defects in the products or services being produced.
Material Inspection
Process Control
Quality Training
Machine Inspection
Product Design
A cost of quality system classifies a firm’s quality-related cost into categories to improve managers’ ability to manage the costs. Costs are classified as conformance or nonconformance costs. Prevention costs incurred to prevent defects in products and appraisal costs incurred to detect products that do not conform to specifications are considered conformance costs.
Examples of conformance costs are prevention costs of design, inspection and employee training and appraisal costs of sampling and field testing of products. These costs are incurred to prevent defects in products and detect products that do not conform to specifications.
Appraisal
Costs incurred to detect individual units of products that do not conform to specifications.
End of Process Sampling
Field Testing

28. Cost of Quality, Continued. . .
Nonconformance costs
Internal Failure
Costs incurred when nonconforming products and services are detected before being delivered to customers.
Scrap
Rework
Re-inspecting / Re-testing
External Failure
Costs incurred when nonconforming products and services are detected after being delivered to customers.
Products failing to conform to specifications are nonconformance costs and result in internal or external failure. Either the nonconformance is detected prior to the product being delivered to the customer or after the product is delivered to the customer.
When nonconformance of a product is detected prior to the product’s delivery to the customer, scrap, rework and re-inspection costs are incurred. Costs incurred when nonconformance is detected after the product’s delivery to the customer include outlay costs of warranty repairs and product liability and opportunity costs of marketing and lost sales.
Warranty Repairs
Marketing Costs
Product Liability
Lost Sales

29. Cost of Quality Report Red’s Lumber Cost of Quality Report
For the Year Ended February 28
Costs of quality are often expressed as a percentage of sales. The cost of quality report for Red’s Lumber indicates the cost of quality was 3.07% of sales. Management can use this information to see how they can reduce the cost of quality. The cost of quality report can be a viable decision making aid for managers, but it is only effective if all quality costs are measured and reported.

30. Problem 1

32. 10-23

33. 10-37

34. 10-38

35. 10-39