1. Fundamentals of Cost Management
Chapter 10
Fundamentals of Cost Management
We start the study of the Fundamentals of Cost Management with a review and overview of information necessary for managing costs.
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Using Activity-Based Cost Management to Add Value
L.O. 1 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 management focuses on
managing activities to reduce costs.
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.
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3. Using Cost Hierarchies
L.O. 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.
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4. Managing the Costs of Customers and Suppliers
L.O. 3 Describe how the actions of customers
and suppliers affect a firm’s costs.
Information on customer profitability is
important for managers, so they can make
decisions that will improve firm performance.
Time = Money
Yes, it’s true, time does mean money.
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5. Using ABC Costing: Customers and Suppliers
L.O. 4 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.
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6. Cost of Customers Step 1: Identify the Activities
LO4
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
Enter
order
Pick
Deliver
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.
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7. Cost of Customers Step 2: Identify the Cost Drivers
LO4
Cost of Customers Step 2: Identify the Cost Drivers
Activity
Entering order
Picking order
Delivering order
Delivery administration
Cost Driver
Number of orders entered
Number of items picked
Number of deliveries made
Order value
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.
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8. Cost of Customers Step 3: Compute the Cost Driver Rates
LO4
Cost of Customers Step 3: Compute the Cost Driver Rates
Computation of Cost Driver Rates – Red's Lumber
Entering order
Picking order
Delivering order
Delivery administration
Activity
$100,000
$150,000
$300,000
$250,000
10,000 orders
75,000 items
12,500 deliveries
$5,000,000 order value
$10 per order
$ 2 per item
$24 per delivery
5% of value
Cost
Cost Driver
Volume
Rate ÷ =
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.
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9. Cost of Customers Step 4: Assign Costs Using ABC
LO4
Cost of Customers Step 4: Assign Costs Using ABC
Cost Driver Information by Customer – Red's Lumber
Number of orders
Number of items
Number of deliveries
Order value (total sales)
150
750
200
$50,000 50
Jack
Jill
Cost Driver
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).
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10. Cost of Customers Step 4: Assign Costs Using ABC
LO4
Cost of Customers Step 4: Assign Costs Using ABC
Estimated Customer Delivery Costs – Red's Lumber
Entering order $10 per order
Picking order $2 per item)
Delivering order $24 per delivery
Delivery administration
Total delivery costs
$ 1,500
1,500
4,800
2,500
$10,300
$ 500
1,200
$5,700
Jack
Jill
Activity
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 losing the lower cost customers like Jill. Red can use this information to manage delivery costs. The activity-based costing analysis shows that the order pattern, not the order value, drives most of the delivery costs.

11. Using and Supplying Resources
L.O. 5 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 $0.80 per item to load the items into a delivery truck. The cost driver is obviously the number of items , and the cost driver rate is $0.80 per item. Now suppose Red hires loaders for a month at a rate of $9 per hour. Red’s employs five workers, each of whom work 8-hour days. Each of these workers has the capacity to load 60 items per day. The cost driver might still be number of items. The cost driver rate is computed by dividing the estimated wages of loaders for the day by their capacity measured in items. This calculation gives a rate of $1.20 per item [= ($9 per hour × 8 hours) ÷ 60 items]. In general, this cost driver rate could be higher, lower, or the same as the piecework rate. We use a rate of $1.20 just to help you recognnize that a difference exists between the piece work rate and the cost driver rate when workers are paid by the hour.
Unused capacity:
Difference between resources
used and resources supplied

12. Computing the Cost of Unused Capacity
L.O. 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.

13. Computing the Cost of Unused Capacity
LO6
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
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.

14. Managing the Cost of Quality
L.O. 7 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.

15. Cost of Quality Conformance costs
L.O. 8 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

16. Cost of Quality Nonconformance costs
LO8
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.
– Warranty 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.

17. End of Chapter 10 McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.