Fundamentals of Cost Management
Chapter 10
McGraw-Hill/Irwin
Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives:
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. Describe how activities that influence quality affect costs and
profitability.
8. Compare the costs of quality control to the costs of failing to
control quality.
10-2
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
management focuses
on managing activities
to reduce costs.
10-3
Key ways that managers add values to companies
by using ABC
1. Obtain better information about product costs
2. Obtain better information about the cost of activities
and processes
Activity analysis is an approach to operations
control and it has 4 steps:
1. Identify the process objectives
2. Chart from start to finish the activities used to complete the
product or service
3. Classify all activities ( value added or non value added
4. Continuously improve the efficiency of all value added activities
and develop plan to eliminate (reduce) non value adding
10-4
Does this sounds familiar?
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)
10-5
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.
Hierarchy Level
Example Costs
Cost Driver Examples
Volume related
Supplies
Lubricating oil
Machine repair
Direct labor costs
Machine-hours
Number of units
Batch related
Set-up costs
Material handling
Shipping costs
Set-up hours
Production runs
Number of shipments
Product related
Compliance costs
Design and
specification costs
Number of products
Facility related
General plant costs
Plant administration costs
Direct costs
Value added
10-6
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
What are the ways
customers can affect
a company profit
wise?
Time =
Money
10-7
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.
1. Identify the activities that consume resources and
assign costs to them.
2. Identify the cost driver(s) associated with each
activity.
3. Compute a cost rate per cost driver unit or
transaction.
4. 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.
10-8
Example: Cost of Customers
Operating Data
Red’s Lumber
Sales
Cost of goods (@60%)
Gross margin
Order/Delivery Charges (@16%)
Delivery costs
Other operating costs
Operating profit
Jack
Jill
Firm
$ 50,000
30,000
20,000
8,000
?
$ 50,000
30,000
20,000
8,000
?
$ 5,000,000
3,000,000
2,000,000
800,000
800,000
1,435,000
$ 565,000
10-9
Example: Red’s Lumber – Step 1
Step 1 Identify the activities
What activities consume resources
for Red’s delivering service?
Process Flow of the Delivery Service
Red’s Lumber
Entering
Order
Loading
Order
Delivering
Order
10-10
Example: Red’s Lumber – Step 2
Identify the cost drivers and the
Step 2 expected volume of each cost driver.
Activity
Entering order
Loading order
Delivering order
Delivery administration
Cost Driver
Number of orders entered
Number of items loaded
Number of deliveries made
Order value
10-11
Example: Red’s Lumber – Step 3
Step 3 Compute the Cost Driver Rates
Computation of Cost Driver Rates
Activity
Entering order
Loading order
Delivering order
Delivery administration
Activity Cost
$
$
$
$
100,000
150,000
300,000
250,000
Cost Driver
Volume
Cost Driver Rate
10,000 orders
75,000 items
12,500 deliveries
$
5,000,000
$10 per order
$2 per item
$24 per delivery
5% of value
10-12
Example: Red’s Lumber – Step 4
Step 4 Assign costs to products
Cost Driver
Number of orders entered
Number of items loaded
Number of deliveries made
Order Value
Jack
Jill
150
750
200
$50,000
50
750
50
$50,000
10-13
Example: Red’s Lumber – Step 4 Continued. . .
Activity
Entering order (@$10 per order)
Loading order (@$2 per item)
Devliering order (@$24 per delivery)
Delivery administration (@5%)
Total delivery costs
Jack
$ 1,500
1,500
4,800
2,500
$10,300
Jill
$
500
1,500
1,200
2,500
$ 5,700
10-14
Determine the cost of suppliers
Suppliers should be evaluated based on:
1. Price*
2. On time delivery
3. quality
Pacific mills Coastal Lumber
Board-feet of lumber purchased
average purchase price per board-feet
total value of lumber purchased
number of deliveries
percentage of late deliveries
Total
600,000
400,000
1,000,000
$2.01
$2.02
$2.014
$1,206,000
$808,000 $2,014,000
100
60
160
50%
10%
35%
Cost of late deliveries is $34,000
10-15
Pacific mills Coastal Lumber
Initial price per board-feet
Additional cost of late delivery per board feet
Probability of late delivery
Expected cost of late delivery
Effective cost per board feet
$2.04
$2.07
.10
.10
50%
10%
.05
.01
$2.09
$2.08
10-16
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.
Unused
capacity
Difference between resources
used and resources supplied.
10-17
Example: Resources Used and Supplied
Traditional Income Statement
Red’s Lumber
Year 2
Gross margin
$ 2,000,000
Delivery revenue
800,000
Delivery costs
Depreciation and equipment leases
$ 420,000
Energy
100,000
Salaries and wages
250,000
Other delivery costs
30,000
Total delivery costs
(800,000)
Less other operating costs
Operating profit
(1,435,000)
$
565,000
10-18
Example: Resources Used and Supplied, Continued. . .
Activity-Based Income Statement
Red’s Lumber – Year 2
Unused
Resources
Resource
Resources
Used
Capacity
Supplied
Sales
$
Costs of goods (@60%)
5,000,000
(3,000,000)
Gross margin
$
Delivery revenue
2,000,000
800,000
Delivery costs
Volume Related
Loading items
$ 135,000
$
15,000
$ 150,000
$
$
35,000
$ 100,000
200,000
100,000
300,000
$ 265,000
$ 135,000
$ 400,000
175,000
75,000
250,000
575,000
225,000
800,000
Batch related
Entering orders
Delivering orders
Total batch related
Facility related
Total delivery costs
65,000
(800,000)
Other operating costs
Operating profits
(1,435,000)
$
565,000
10-19
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.
Normal activity
Long-run expected volume.
Actual activity
Actual volume for the period.
10-20
Theoretical capacity 4000 passengers
Practical capacity 3200 passengers
Annual fixed operating cost $400,000
Fixed
Operating
cost
Year 1
Year 2
Year 3
Number of
passengers
Fixed
Operating
cost rate
400,000
2,000
200
400,000
2,500
160
400,000
1,600
250
10-21
Managing the Cost of Quality
LO7 Describe how activities that influence quality affect costs and
profitability.
Quality as defined by the customer
Organization is
managed to excel on
all dimensions.
10-22
Effective implementation of TQM requires five
changes to traditional managerial accounting
systems:
1. The information should include problem solving data
2. The workers themselves should collect the information
and use it to get feedback
3. Information should be available quickly
4. Information should be more detailed
5. Rewards should be based on quality and customer
satisfaction
10-23
External View of Quality: The Customer
Tangible
Performance
Taste
Functionality
Intangible
Customer service
Delivery time
10-24
Internal View of Quality
Conformance to specifications
Does the product or
service do what it is
designed to do?
10-25
Quality
10-26
Cost of Quality
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
Appraisal
Costs incurred to detect individual units of
products that do not conform to specifications.
End of Process Sampling
Field Testing
10-27
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.
Warranty Repairs
Product Liability
Marketing Costs
Lost Sales
10-28
Cost of Quality Report
Red’s Lumber
Cost of Quality Report
For the Year Ended February 28
Costs of Quality
Percent of sales
Sales = $5,000,000
Prevention costs
Quality training
Machine inspections
$ 35,600
22,000
$ 57,600
1.15%
30,000
0.60%
36,000
0.72%
30,000
0.60%
$ 153,600
3.07%
Appraisal costs
Inspect copies
Internal failure costs
Paper scrap
External failure costs
Customer complaints
Total cost of quality
10-29
Problem 1
10-30
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10-23
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10-37
10-33
10-38
10-34
10-39
10-35