1. Fundamentals of Cost Accounting, 4th edition Lanen/Anderson/Maher
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2. Fundamentals of Cost Management
Chapter 10
Chapter 10: Fundamentals of Cost Management
We start the study of the Fundamentals of Cost Accounting with a review and overview of information necessary for decision making.

3. Learning Objectives
LO 10-1 Describe how activity-based cost management can be used to
improve operations.
LO 10-2 Use the hierarchy of costs to manage costs.
LO 10-3 Describe how the actions of customers and suppliers affect a
firm’s costs.
LO 10-4 Use activity-based costing methods to assess customer and
supplier costs.
LO 10-5 Distinguish between resources used and resources supplied.
LO 10-6 Design cost management systems to assign capacity costs.
LO 10-7 Describe how activities that influence quality affect costs and
profitability.
LO 10-8 Compare the costs of quality control to the costs of failing to
control quality.
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.

4. Using Activity-Based Cost Management to Add Value
LO 1
Using Activity-Based Cost Management to Add Value
LO Describe how activity-based cost management can
be used to improve operations.
Activity-based costing (ABC) is a system used to assign costs to products based on the products’ use of activities, which are the discrete tasks an organization undertakes to make or deliver the product.
The value chain is the set of activities that transforms raw resources into products for customers. Activities in the value chain are the things that customers will pay for.
LO Describe how activity-based cost management can be used to improve operations.
Activity-based costing (ABC) is a system used to assign costs to products based on the products’ use of activities, which are the discrete tasks an organization undertakes to make or deliver the product. The value chain is the set of activities that transforms raw resources into products for customers. Activities in the value chain are the things that customers will pay for. Activity-based management focuses on managing activities to reduce costs. Activity-based costing focuses on activities in allocating overhead costs to products.
Activity-based management focuses on managing activities to
reduce costs.
Activity-based costing focuses on activities in allocating overhead costs to products.

5. Using Activity-Based Cost Information to Improve Processes
LO 1
Using Activity-Based Cost Information to Improve Processes
The first step in ABCM is activity analysis. We begin by analyzing the costs of key activities. Activity analysis has six steps:
Identify what the customer wants or expects from the firm’s products or services, including key features, price, and quality.
Chart, from start to finish, the company’s activities for completing the product.
Develop activity-based costing data for each activity, based on the resources used in each activity.
Classify all activities as value-added or non-value-added.
Compare the costs of each activity with the value that customers assign to it. (The value of non-value-added activities would be zero.)
Continuously improve the efficiency of all value-added activities. Eliminate or reduce non-value-added activities.
The first step in ABCM is activity analysis. We begin by analyzing the costs of key activities. Activity analysis has six steps:
Identify what the customer wants or expects from the firm’s products or services, including key features, price, and quality.
Chart, from start to finish, the company’s activities for completing the product.
Develop activity-based costing data for each activity, based on the resources used in each activity.
Classify all activities as value-added or non-value-added.
Compare the costs of each activity with the value that customers assign to it. (The value of non-value-added activities would be zero.)
Continuously improve the efficiency of all value-added activities. Eliminate or reduce non-value-added activities.

6. Using Cost Hierarchies
LO 2
Using Cost Hierarchies
LO 10-2 Use the hierarchy of costs to manage costs.
Cost Example
Supplies
Lubricating oil
Machine repair
Hierarchy Level
Volume related
Cost Driver Example
Direct labor cost
Machine-hours
Number of units
Setup costs
Material handling
Shipping costs
Batch related
Setup hours
Production runs
Number of shipments
Compliance costs
Design and
specification costs
Product related
Number of products
General plant costs
Plant admin. costs
Facility related
Direct costs
Value added
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 Costs of Customers and Suppliers
LO 3
Managing the Costs of Customers and Suppliers
LO Describe how the actions of customers
and suppliers affect a firm’s costs.
Customers affect our profitability by both their buying behavior and their effect on our costs. Information on customer profitability is important for managers, so they can make decisions that will improve firm performance.
LO Describe how the actions of customers and suppliers affect a firm’s costs.
Customers affect our profitability by both their buying behavior and their effect on our costs. Information on customer profitability is important for managers, so they can make decisions that will improve firm performance. Time spent meeting customer needs cost the company money.
Time = Money

8. Managing the Costs of Customers and Suppliers
LO 3
Managing the Costs of Customers and Suppliers
Resources cost:
Customers (and suppliers) use resources.
Some customers use more resources than others.
Think about the last time you stood in line to purchase a ticket, check in for a flight, or make a transaction in a bank. Many people ahead of you are purchasing the same service (a ticket, a flight, or a deposit), but some take longer (sometimes much longer) to complete the transaction. The additional time those customers take adds cost to the company.
Customers or suppliers that take excess time to complete transactions add cost to the company. Think about the last time you stood in line to purchase a ticket, check in for a flight, or make a transaction in a bank. Many people ahead of you are purchasing the same service (a ticket, a flight, or a deposit), but some take longer (sometimes much longer) to complete the transaction. The additional time those customers take adds cost to the company.

9. Using ABC Costing: Customers and Suppliers
LO 4
Using ABC Costing: Customers and Suppliers
LO 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.
Step 1: Identify the activities that consume resources.
Step 2: Identify the cost driver associated with each activity.
Step 3: Compute a cost rate per cost driver for each 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.
Step 4: Assign costs to customers by multiplying the cost driver
rate by the volume of cost driver units consumed by the
activity or transaction that occurred.

10. Operating Data – Red's Lumber
LO 4
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.
Process Flow of he Delivery Service

11. Cost of Customers Step 1: Identify the Activities
LO 4
Cost of Customers 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.

12. Cost of Customers Step 2: Identify the Cost Drivers
LO 4
Cost of Customers Step 2: Identify the Cost Drivers
After a discussion with the delivery supervisor, Red determines the best cost driver for entering the order is the number of orders entered, for picking the order is the number of items picked, 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.

13. Cost of Customers Step 3: Compute the Cost Driver Rates
LO 4
Cost of Customers Step 3: Compute the Cost Driver Rates
Computation of Cost Driver Rates – Red's Lumber
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 picking 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.

14. Cost of Customers Step 4: Assign Costs Using ABC
LO 4
LO 4
Cost of Customers Step 4: Assign Costs Using ABC
Cost Driver Information by Customer – Red's Lumber
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).

15. Cost of Customers Step 4: Assign Costs Using ABC
LO 4
Cost of Customers Step 4: Assign Costs Using ABC
Estimated Customer Delivery Costs – Red's Lumber
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.

16. Cost of Customers Step 4: Assign Costs Using ABC
LO 4
Cost of Customers Step 4: Assign Costs Using ABC
Summary of stage one and stage two.

17. Determining the Cost of Suppliers
LO 4
Determining the Cost of Suppliers
The analysis of customers cost also can be applied to suppliers.
Annual Data on Lumber Deliveries – Red's Lumber
The analysis of customers cost also an be applied to suppliers.

18. Determining the Cost of Suppliers
LO 4
Determining the Cost of Suppliers
Effective Purchase Price of Lumber When Late Deliveries Are Considered
Red's Lumber
Red computes the effective cost of buying from Pacific Mills based on its past delivery performance. After doing this, Red realizes that given the delivery performance, it is actually cheaper to buy from Coastal Lumber. In addition, he has a better basis to compare bids in the future. He can simply add $0.05 to the bid from Pacific Mills and $0.01 to the bid from Coastal Lumber.

19. Using and Supplying Resources
LO 5
Using and Supplying Resources
LO Distinguish between resources used
and resources supplied.
Resources used:
Cost driver rate multiplied by
the cost driver volume
Resources supplies:
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

20. Using and Supplying Resources
LO 5
Using and Supplying Resources
Traditional Income Statement
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.

21. Using and Supplying Resources
LO 5
Using and Supplying Resources
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.

22. Computing the Cost of Unused Capacity
LO 6
Computing the Cost of Unused Capacity
LO 10-6 Design cost management systems to assign capacity costs.
Actual activity:
Actual volume for the period
Theoretical capacity:
Amount of production possible under ideal
conditions with no time for maintenance,
breakdowns, or absenteeism.
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.

23. Computing the Cost of Unused Capacity
LO 6
Computing the Cost of Unused Capacity
Practical capacity:
Amount of production possible assuming only the
expected downtime for scheduled maintenance
and normal breaks and vacations.
Normal activity:
Long-run expected volume
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.

24. Managing the Cost of Quality
LO 7
Managing the Cost of Quality
LO 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.

25. What Is Quality? External View: Customer Expectations?
LO 7
What Is Quality?
External View: Customer Expectations?
Internal View: Conformance to Specification?
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. Quality also can be defined as conformance to specification, the degree to which a product or service performs as designed (or specified).

26. External View of Quality: Customer Expectations
LO 7
External View of Quality: Customer Expectations
Tangible:
– Performance
– Taste
– Functionality
Intangible:
– Customer service
– Delivery time
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.

27. Internal View of Quality: Conformance to Specifications
LO 7
Internal View of Quality: Conformance to Specifications
Conformance to Specifications
Degree to which a good or service meets specifications
The internal view of quality is conformance to specifications. Does the product meet customer tangible and intangible expectations?

28. Cost of Quality Conformance costs
LO 8
Cost of Quality
LO 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
– Materials 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

29. Cost of Quality Nonconformance costs
LO 8
Cost of Quality
Nonconformance costs
Internal failure: Costs incurred when nonconforming products
and services are detected before being
delivered to customers.
– Scrap
– Rework
– Reinspection/Retesting
External failure: Costs incurred when nonconforming products
and services are detected after being delivered
to customers.
– Warrant repairs
– Product liability
– Marketing costs
– Lost sales
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 reinspection 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.

30. Trade-Off Between Conformance and Nonconformance Costs
LO 8
Cost of Quality
Trade-Off Between Conformance and Nonconformance Costs
The ultimate goal in implementing a quality improvement program is to achieve zero defects while incurring minimal costs of quality. However, managers must make trade-offs between the four cost categories, and total costs of quality must be reduced over time. Costs of quality are often expressed as a percentage of sales.

31. Cost of Quality Report LO 8
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 3.1% 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.

32. End of Chapter 10
End of Chapter 10.