2. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 1 Cost Management Systems and Activity- Based Costing Chapter 4

3. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 2 Learning Objective 1 Describe the purposes of cost management systems.

4. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 3 Cost Management System A cost management system (CMS) is a collection of tools and techniques that identifies how management’s decisions affect costs.

5. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 4 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 aggregate measure of inventory value and cost of goods manufactured.

6. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 5 Learning Objective 2 Explain the relationships among cost, cost objective, cost accumulation, and cost assignment.

7. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 6 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.

8. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 7 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

9. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 8 Cost Accounting System Costaccumulation Cost allocation to cost objects Cabinets Desks Tables Material costs (metals) Finishing Department ActivityActivity Cabinets Desks Tables Machining Department ActivityActivity 1. Departments 2. Activities 3. Products

10. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 9 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.

11. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 10 Cost Objective What is a cost object or cost objective? It is anything for which a separate measurement of costs is desired. CustomersDepartments Processing orders

12. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 11 Learning Objective 3 Distinguish among direct, indirect, and unallocated costs.

13. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 12 Direct Costs Direct costs can be identified specifically and exclusively with a given cost objective in an economically feasible way. What are direct costs?

14. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 13 Indirect Costs Indirect costs cannot be identified specifically and exclusively with a given cost objective in an economically feasible way. What are indirect costs?

15. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 14 Direct, Indirect, and Unallocated Costs Sales$470,000 Cost of goods sold: Direct material$120,000 Direct material$120,000 Indirect manufacturing 110,000 Indirect manufacturing 110,000 Total cost of goods sold$230,000 Gross profit$240,000 Operating expenses: Sales salaries$ 47,000 Sales salaries$ 47,000 Distribution 30,000 Distribution 30,000 Total operating expenses$ 77,000 Contribution to corporate expenses and profit$163,000 expenses and profit$163,000

16. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 15 Direct, Indirect, and Unallocated Costs $470,000$280,000$100,000$90,000 120,000 50,000 30,000 40,000Direct, Direct trace 120,000 50,000 30,000 40,000Direct, Direct trace 110,000 45,000 30,000 35,000Indirect, Allocation – 110,000 45,000 30,000 35,000Indirect, Allocation – machine hours machine hours $230,000 95,000 80,000 75,000 $240,000 185,000 40,000 15,000 $ 47,000$ 28,000$ 10,000$ 9,000Direct, Direct trace 30,000 12,000 8,000 10,000Indirect, 30,000 12,000 8,000 10,000Indirect, Allocation – weight $ 77,000$ 40,000$ 18,000$19,000 $163,000$145,000$ 22,000$(4,000) CabinetsTablesChairs Cost type, Assignment method

17. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 16 Direct, Indirect, and Unallocated Costs Managers prefer to classify costs as direct rather than indirect whenever it is “economically feasible” or “cost effective.” “economically feasible” or “cost effective.”

18. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 17 Categories of Manufacturing Costs Direct material costs Direct labor costs Indirect production costs

19. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 18 Direct Material Costs It includes 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.

20. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 19 Direct Labor Costs These costs include the wages of all labor that can be traced specifically and exclusively to the manufactured goods in an economically feasible way.

21. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 20 Indirect Production Costs 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.

22. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 21 Learning Objective 4 Explain how the financial statements of merchandisers and manufacturers differ because of the types of goods they sell.

23. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 22 Product Costs and Period Costs Product costs are costs identified with goods produced or purchased for resale. Product costs first become part of the inventory on hand. These costs, inventoriable costs, become expenses only when the inventory is sold.

24. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 23 Product Costs and Period Costs Period costs are deducted as expenses during the current period without going through an inventory stage.

25. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 24 Financial Statement Presentation – Merchandising Companies Sales Cost of goods sold (an expense) Selling and administrativeexpenses Income Statement – Equals gross margin Equals operating income – Periodcosts Expiration Merchandiseinventory Balance Sheet

26. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 25 Financial Statement Presentation – Manufacturing Companies Finishedgoodsinventory Sales Cost of goods sold (an expense) Selling and administrativeexpenses Balance Sheet Income Statement – Equals gross margin Equals operating income – Expiration Periodcosts Directmaterialinventory Work-in-processinventory

27. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 26 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 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 inventories 77,000 inventories 77,000 Other current assets 1,000 Total current assets$107,000 Retailer or Wholesaler

28. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 27 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

29. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 28 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.

30. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 29 Learning Objective 5 Understand the main differences between traditional and activity-based costing (ABC) systems and why ABC systems provide value to managers.

31. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 30 Traditional Costing System and Statement of Operating Income All indirect resources $220,000 All unallocated value chain costs$100,000 Cost driver (direct labor hours Directmaterials for pen casings$22,500Directlabor casings$135,000Direct materials for cell phone casings$12,000Direct labor for cell phone casings$15,000 Sales $360,000 Sales $80,000 Unallocated$100,000

32. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 31 Traditional Costing System and Statement of Operating Income 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 1.25% 38.75% Traditional Cost Allocation System PenCasings Cell Phone Casings

33. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 32 Activity-Based Cost System All unallocated value chain costs$100,000 Unallocated$100,000 Directmaterials for pen casings$22,500Directlabor casings$135,000Direct materials for cell phone casings$12,000Direct labor for cell phone casings$15,000 Sales $360,000 Sales $80,000 Plant & machinery $80,000 Production support $140,000 Processing activity $76,000 Production support activity $144,000 Cost driver (dir. labor hrs.) Cost driver (distinct parts) 80%20%60% 40%

34. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 33 Activity-Based Cost Allocation System External Reporting Internal Purposes Sales$440,000$360,000$80,000 Direct materials 34,500 22,500 12,000 Direct labor 150,000 135,000 15,000 Processing activity 143,000 128,700 14,300 Production support activity 77,000 15,400 61,600 Gross profit$ 35,500$ 58,400 ($22,900) Corporate expenses 100,000 Operating loss ($ 64,500) Gross profit margin 8.07% 16.22% (28.63%) PenCasings Cell Phone Casings

35. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 34 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

36. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 35 A value-added cost is the cost of an activity that cannot be eliminated without affecting a product’s value to the customer. Activity-Based Management In contrast, nonvalue-added costs are costs that can be eliminated without affecting a product’s value to the customer.

37. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 36 Benefits of Activity-Based Costing and Management Systems – set a product mix and estimate profit margins – determine the consumption of a company’s shared resources ABC systems are adopted for many reasons:

38. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 37 Benefits of Activity-Based Costing and Management Systems – keep pace with new product techniques and technological change – decrease the costs associated with bad decisions – take advantage of reduced cost of ABC systems due to computer technology

39. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 38 Learning Objective 6 Apply the process used to design a cost accounting system that includes activity-based costing.

40. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 39 Design of an Activity-Based Cost Accounting System Traditional Cost Accounting System Maintenance costs Shipping costs Administrative costs Quality control costs Products 1 - 20 Reactor hours 120 - - -

41. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 40 Design of an Activity-Based Cost Accounting System Activity-based Cost Accounting System Preprocesspreparationactivity ReactorprocessingactivityThin-tankprocessingactivityFiltrationprocessactivityWastedisposalactivity PreparationhoursProcessinghoursProcessinghoursProcessinghoursBatches PRTFW Products 1 - 20 1 PRTFW 20 PRTFW - - -

42. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 41 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

43. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 42 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 Activity Cost Driver

44. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 43 Design of an Activity-Based Cost Accounting System Determine the relationships among cost objectives, activities, and resources.

45. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 44 Design of an Activity-Based Cost Accounting System Basic Concepts for Process Maps Resource A Resource B Resource C Activity 1 Activity 2 Activity 3 Activity 4 ProductTProductUProductVProductWProductX Example 1. Resource A is an indirect cost with respect to activities and products. Example 2. Resource B is a direct cost with respect to activity 3 but an indirect cost with respect to both products. Example 3. Resource C is a direct cost with respect to activity 4 and product X.

46. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 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.

47. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 46 Design of an Activity-Based Cost Accounting System Calculate and interpret the new activity-based information.

48. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 47 Learning Objective 7 Use activity-based cost information to make strategic and operational control decisions.

49. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 48 Strategic Decisions, Operational Cost Control, and ABM Outsourcing Reducing operating costs Identifying nonvalue-added activities Improving both strategic and operational decisions

50. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 49 Objective 8 Understand why multistage ABC systems give more value than two-stage ABC systems for strategic planning and operational control. (Appendix 4)

51. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 50 Key Attributes of Multistage ABC Systems There are more than two stages of allocation. Cost behavior of resources is considered. There is a greater use of operational information such as cost drivers and consumption rates.

52. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 51 End of Chapter 4