1. 4 - 1 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 1

2. 4 - 2 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 2 Chapter 4 Cost Management Systems and Activity-Based Costing

3. 4 - 3 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 3 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.

4. 4 - 4 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 4 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).

5. 4 - 5 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 5 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 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.

6. 4 - 6 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 6 Cost A cost is a sacrifice or giving up of resources for a particular purpose. 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.

7. 4 - 7 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 7 Cost Object A cost object (objective) is anything for which a separate measurement of costs is desired. CustomersDepartments Processing orders Product Service

8. 4 - 8 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 8 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.

9. 4 - 9 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 9 Cost Accounting System Cost accumulation: Collecting costs by some “natural” classification such as materials or labor Cost assignment: Tracing costs to one or more cost objectives Learning Objective 2

10. 4 - 10 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 10 Cost Accounting System Cost accumulation Cost assignment to cost objects CabinetsDesksTables Material costs (metals) Finishing Department Activity CabinetsDesksTables Machining Department Activity 1. Departments 2. Activities 3. Products

11. 4 - 11 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 11 Direct and Indirect 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.

12. 4 - 12 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 12 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. Learning Objective 4

13. 4 - 13 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 13 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.

14. 4 - 14 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 14 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.

15. 4 - 15 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 15 Cost Pool 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. Individual costs allocated to cost objects using a single cost-allocation base.

16. 4 - 16 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 16 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.

17. 4 - 17 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 17 Cost Assignment Direct costs are physically traced to a cost object. Indirect costs are allocated using a cost-allocation base.

18. 4 - 18 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 18 Unallocated Costs Some costs lack an identifiable relationship to a cost object. Often it is best to leave such costs unallocated. These unallocated costs are recorded but not assigned to any cost object. An unallocated cost for one company may be an allocated cost or even a direct cost for another.

19. 4 - 19 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 19 Li Company’s Statement of Operating Income Statement of Operating Income

20. 4 - 20 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 20 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. Learning Objective 5 Manufacturing companies classify production costs as either (1) direct material, (2) direct-labor, or (3) indirect production costs

21. 4 - 21 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 21 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.

22. 4 - 22 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 22 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.

23. 4 - 23 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 23 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.

24. 4 - 24 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 24 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.

25. 4 - 25 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 25 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.

26. 4 - 26 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 26 Merchandising Company (Retailer or Wholesaler) Merchandise Purchases Merchandise Inventory Sales -Cost of Goods Sold (Expenses) - Selling Expenses - Administrative Expenses Period Costs Gross Margin Operating Income Product (Inventoriable) Costs Expiration Financial Statement Presentation: Merchandising Companies Learning Objective 6

27. 4 - 27 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 27 Current Asset Sections of Balance Sheets 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 Manufacturer Cash $ 4,000 Receivables 25,000 Merchandise inventory 77,000 Other current assets 1,000 Total current assets $107,0 00 Retailer or Wholesaler

28. 4 - 28 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 28 Inventory Sections of Balance Sheets Raw materials $165 Work in process 33 Finished goods 692 Total $ 890 Cisco Systems, Inc. Manufacturer Merchandise inventory $5,405 Costco Wholesale Corporation Retailer or Wholesaler Manufacturing inventories comprise three major categories: Merchandise inventories composed of purchase costs including freight in.

29. 4 - 29 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 29 Manufacturing Company Direct Material Purchases Finished Goods Inventory Sales - Cost of Goods Sold (Expenses) - Selling Expenses and Administrative Expenses Period Costs Gross Margin Operating Income Product (Inventoriable) Costs Expiration Financial Statement Presentation: Manufacturing Companies Work-in- Process Inventory Direct Material Inventory Direct Labor Indirect Production

30. 4 - 30 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 30 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

31. 4 - 31 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 31 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.

32. 4 - 32 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 32 Cost of Goods Sold Section of Income Statements Beginning finished goods inventory $ 4,000 Cost of goods manufactured: Direct materials $20,000 Direct labor 12,000 Indirect production 8,000 40,000 Cost of goods available for sale 44,000 Less: Ending finished goods 8,000 Cost of goods sold $36,000 Manufacturer Beginning merchandise inventory $ 4,000 Purchases 40,000 Cost of goods available for sale 44,000 Less: Ending merchandise inventory 8,000 Cost of goods sold $36,000 Retailer or Wholesaler

33. 4 - 33 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 33 Types of Costing Systems Learning Objective 7 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.

34. 4 - 34 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 34 Traditional Costing System

35. 4 - 35 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 35 Traditional Costing System 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 8.07% 1.25% 38.75%

36. 4 - 36 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 36 ABC System

37. 4 - 37 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 37 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. Nonvalue-added costs are costs that can be eliminated without affecting a product’s value to the customer. Learning Objective 8

38. 4 - 38 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 38 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.

39. 4 - 39 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 39 Benefits of Activity-Based Costing and Management Systems  set an optimal product mix  estimate profit margins of new products  determine consumption of shared resources  keep pace with new product techniques Companies adopt ABC systems to:

40. 4 - 40 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 40 Benefits of Activity-Based Costing and Management Systems (cont.)  keep pace with technological changes  decrease costs associated with bad decisions  take advantage of reduced cost of ABC  Systems due to computer technology Companies adopt ABC systems to:

41. 4 - 41 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 41 Design of a Traditional Costing System

42. 4 - 42 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 42 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

43. 4 - 43 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 43 Design of an Activity-Based Cost Accounting System Account billing Bill verification Account inquiry Correspondence Other activities Number of printed pages Number of accounts verified Number of inquiries Number of letters Number of printed pages Key Activity Cost Driver

44. 4 - 44 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 44 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% Determine relationships among cost objectives, activities, and resources. Design of an Activity-Based Cost Accounting System

45. 4 - 45 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 45 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 40,000160,000

46. 4 - 46 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 46 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.

47. 4 - 47 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 47 Strategic Decisions, Operational Cost Control, and ABM Outsourcing Reducing operating costs Identifying nonvalue-added activities Improving both strategic and operational decisions

48. 4 - 48 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 48 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 Strategic Decisions, Operational Cost Control, and ABM Number of Cost Driver Units for the Billing Department

49. 4 - 49 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 49 Two-Stage Cost Allocation for Billing Department Operations

50. 4 - 50 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 50 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 Total traceable costs for the 5 activity cost pools. Strategic Decisions, Operational Cost Control, and ABM

51. 4 - 51 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 4 - 51 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.