Copyright © 2014 Pearson Education 4-1

Ch 4 – Horngren et al 2014

Chapter 13: Tutorials

Cost Management Systems

and Activity-Based Costing
Presented by

Dr Noor Ajian Mohd Lair

Senior Lecturer
Mechaincal Engineering Program
Faculty of Engineering
Universiti Malaysia Sabah

Office No 43, 2nd floor

Ext: 3422 4-2
Copyright © 2014 Pearson Education
email: [email protected]
 Example: Direct Costs, Indirect Costs,
unallocated Costs and Cost Allocation:
Statement of Operating Income
Li Company’s Statement of Operating Income

Consider the statement of operating

income for Li Company in Panel A of
Exhibit 4-3. Li Company makes cabinets,
tables, and chairs. Each item in Panel A
represents accumulated totals for all
products sold for an entire reporting
period. To help make a strategic decision
regarding which of the three products to
emphasize, it would be useful to
“unbundle” these totals to find the
profitability of each product. How can we
do this?

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Direct Costs, Indirect Costs, unallocated
Costs and Cost Allocation:
Statement of Operating Income
Li Company’s Statement of Operating Income

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 Financial Statement Presentation
Balance Sheet Income Statement

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 Current Asset Sections
of Balance Sheets
Manufacturer Retailer or Wholesaler

Cash $ 4,000
Receivables 25,000
Cash $ 4,000
Subtotal $29,000
Receivables 25,000
Finished goods 32,000
Work in process 22,000
Merchandise inventory 77,000
Direct material 23,000
Other current assets 1,000
Total inventories $77,000
Total current assets $107,000
Other current assets 1,000
Total current assets $107,000

Manufacturing inventories are usually composed of three major categories: raw materials,
work in process, and finished goods. Merchandise inventories are usually composed of
the purchase cost of items, including freight in, that are acquired and then resold.
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 Inventory Sections
of Balance Sheets
Manufacturing inventories Merchandise inventories
comprise composed of purchase
three major categories: costs including freight in.

Cisco Systems, Inc. Costco Wholesale Corporation

Manufacturer Retailer or Wholesaler

Raw materials $165

Work in process 33 Merchandise inventory $5,405
Finished goods 692
Total $ 890

The difference between the balance sheet of a manufacturer and that of a merchandiser
(retailer or wholesaler) is apparent from the inventory accounts from the 2009 annual
4-7
reports of Cisco Systems and Costco Wholesale
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Education
 Income Statement Income Statement
Presentation Presentation
of Costs for a of Costs for a
Manufacturer Retailer
The manufacturer’s
cost of goods Produced
and then sold is usually The merchandiser’s
composed of the three cost of goods sold is
major categories of cost: usually composed
of the purchase
cost of items,
Direct materials
including freight-in,
that are acquired
Direct labor and then resold.

Indirect
manufacturing
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 Cost of Goods Sold Section
of Income Statements

Manufacturer Retailer or Wholesaler

Beginning finished goods

inventory $ 4,000 Beginning merchandise
Cost of goods manufactured: inventory $ 4,000
Direct materials $20,000 Purchases 40,000
Direct labor 12,000 Cost of goods available
Indirect production 8,000 40,000 for sale 44,000
Cost of goods available Less: Ending merchandise
for sale 44,000 inventory 8,000
Less: Ending finished goods 8,000 Cost of goods sold $36,000
Cost of goods sold $36,000

Manufacturing cost of goods produced and then sold, usually composed of the three major
categories of cost: direct material, direct labor, and indirect production costs. Merchandise cost of
goods sold, usually composed of the purchase cost of items, including freight in, that are acquired
and then resold. Copyright © 2014 Pearson Education 4-9
 Traditional Costing System
Until the 1990s, almost all U.S. companies
used traditional costing systems—those that
do not accumulate or report costs of
activities or processes.

Traditional costing systems often use a

single cost pool for all indirect production
costs with labor cost or labor hours as a
cost allocation base. Such systems work
well with simple production processes.

Consider a company that makes only a few

products for which direct-material and
direct-labor costs are a high percentage of
total costs. Indirect production costs are a
small percentage of total costs so the
system combines them into one cost pool
and allocates them to products using only
one cost allocation base, direct-labor hours.
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Example: Traditional Costing System

Statement of Operating Income

(External Report)

Sales $440,000

Cost of Goods Sold:

Direct materials 34,500
Direct labor 150,000
Indirect
manufacturing 220,000

Cost of Goods Sold 404,500

Gross profit $ 35,500
Corporate expenses
(unallocated) 100,000

Operating loss ($ 64,500)

Gross
Copyright © 2014 Pearson profit
Education margin 8.07%
4 - 11
 Traditional Costing System
Statement of Operating Income
Traditional Cost Allocation System
(using direct labor hours as allocation based)
Pen Cell Phone
Casings 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%

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 Example: Design of a Traditional Costing
System
Exhibit 4-8 depicts the residential and commercial customer classes (cost objects) and the resources
used to support the billing department. All the costs incurred in the billing department are indirect.
There are no direct costs or unallocated costs. The billing department currently uses a traditional
costing system that allocates all indirect production costs based on the number of account inquiries.

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Example: Activity-Based Costing (ABC) System
Exhibit 4-7 depicts a two-stage ABC system, which uses two stages of allocation to get from the
original indirect resource cost to the final product or service cost. (At this point, Lopez Plastics
uses the ABC system only for production costs, so the $100,000 of nonproduction value-chain
costs remains unallocated.) The first stage allocates indirect resource costs to activity-cost pools,
in this case two activities, processing activity and production-support activity. The second stage
allocates activity costs to the products or services. In essence, the cost objects in the first stage are
the activities, and the cost objects in the second stage are the products.

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 Example: 2nd Stage ABC for Lopez
(review page 159)
The cost allocation bases (given):
Pen Casings Cell Phone Casings
Direct-labour hours 4,500 500
Distinct Parts 5 20
The Finanfor Lopez Plastics Company’s Activity-Based Cost Allocation system. cial Reports
Pen Cell Phone
Casings Casings
Sales $440,000 $360,000 $80,000
Cost of Goods sold:
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 Supports Act 77,000 15,400 61,600
Cost of Goods Sold 404,500 301,600 102,900
Gross profit $ 35,500 $ 58,400 $(22,900)
Corporate expenses 100,000
Operating loss ($ 64,500)
Gross profit margin 8.07%
Copyright © 2014 Pearson Education 16.22% (28.63%)
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 Learning Design of an Activity-Based
Objective 9
Cost Accounting System

Determine the key Cost objectives

components of the Key activities
cost accounting Resources
system. Related cost drivers

Design of ABC system is illustrated using the AT&T billing department (used in design of
Traditional system before).

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 Design of an Activity-Based
Cost Accounting System

Key Cost
Activity Driver

Account billing Number of printed pages

Bill verification Number of accounts verified
Account inquiry Number of inquiries
Correspondence Number of letters
Other activities Number of printed pages

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 Design of an Activity-Based
Cost Accounting System
Determine relationships among
cost objectives, activities, and resources.

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%

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 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 40,000 160,000

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 Two-Stage Cost Allocation for
Billing Department Operations (Exhibit
4-10)

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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.

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 Total Cost of Each Activity in the Billing
Department (Exhibit 4-12 pp 168)

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

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 Strategic Decisions, Operational
Cost Control, and ABM

Number of Cost Driver Units for the Billing Department

Activity Total Costs ($) Total Numbers of Cost per

Driver Units Driver Unit

Account inquiry 332,872 Inquiries 25,000 13.314880

Correspondence 32,356 Letters 2,800 11.555714

Billing 153,125 Printed pages 160,000 0.957031

Verification 68,425 Accounts verified 20,000 3.421250

Other activities 100,722 Printed pages 160,000 0.629513

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Two-Stage Cost Allocation for
Billing Department Operations

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 Strategic Decisions, Operational
Cost Control, and ABM
Key Results of Activity-Based Costing Study.
Cost Per Customer Class
Residential Commercial

Resource Cost per Number of Number of

Driver Unit Driver Units Cost Driver Cost
Account inquiry $13.314880 20,000 inquiries $266,298 5,000 Inquiries $66,574
Correspondence 11.555714 1,800 letters 20,800 1,000 letters 11,556
Account Billing 0.957031 120,000 pages 114,844 40,000 pages 38,281
Bill Verification 3.421250 20,000 Accts 68,425
Other Activities 0.629513 120,000 pages 75,541 40,000 pages 25,181
Total Cost $477,483 210,017

Number of Accounts 120,000 20,000

Cost per Account (ABC) $ 3.98 10.50
Cost per Account (Traditional System) $ 4.58 6.88

Potential Improvements:
1. May outsourced commercial accounts (10.50 – more expensive) or eliminite/reduce bill
verification, account inquiry or correpondence for commercial.
2. May benchmark the cost for account acttivity against competitor then conduct process
4 - 25
improvement to reduce costs. Copyright © 2014 Pearson Education
 Ch 5 – Horngren et al 2014

Chapter 14

Relevant Information for

Decision Making with a Focus
on Pricing Decisions

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 Learning Example: Relevance of
Objective 3
Alternate Income Statements

Cordell Company makes and

sells 1,000,000 seat covers.

Total manufacturing cost is

$30,000,000, or $30 per unit.

Direct material costs are $14,000,000

Direct-labor costs are $6,000,000

Notes: Assume no begining and ending inventories.

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 Schedules of Predicted Costs

Schedule 1: Variable Costs (in thousands of dollars)

Supplies (lubricants, expendable tools, coolants, sandpaper) $ 600
Materials-handling labor (forklift operators) 2,800
Repairs on manufacturing equipment 400
Power for factory 200 $ 4,000

Schedule 2: Fixed Costs

Managers’ salaries in factory $ 400
Factory employee training 180
Factory picnic and holiday party 20
Factory supervisory salaries 1,400
Depreciation, plant, and equipment 3,600
Property taxes on plant 300
Insurance on plant 100 $ 6,000

Total indirect manufacturing costs $10,000

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 Schedules of Predicted Costs
Schedule 3: Selling Expenses (in thousands of dollars)
Variable
Sales Commission $1,400
Shipping Expenses for products sold 600 $2,000
Fixed
Advertising $1,400
Sales salaries 2,000
Other 600 $4,000
Total Selling Expenses $6,000

Schedule 4: Administrative Expenses

Variable
Some clerical wages $160
Computer time rented 40 $200
Fixed
Office supplies 200
Other salaries 400
Depreciation on office facilities 200
Public accounting fees 80
Legal fees 200
Other 720 1,800
Total indirect manufacturing costs $ 2,000

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Example: Absorption Approach for
calculating operating income
Cordell Company
Absorption Form of the Income Statement
For the Year Ended December 31, 20X1

Sales (in thousands of dollars) $40,000

Less: Manufacturing costs of good sold
Direct Materials $ 14,000
Direct Labor 6,000
Indirect Manufacturing (Schedule 1 plus 2) 10,000 30,000
Gross Margin or Gross Profit 10,000
Selling expenses (Schedule 3) $ 6,000
Administrative expenses (Schedule 4) 2,000
Total selling and administrative expenses 8,000

Operating income $2,000

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 Example: Contribution-Margin
Approach for calculating operating
income
Cordell Company
Contribution Form of the Income Statement
For the Year Ended December 31, 20X1

Sales (1,000,000 units) $40,000

Less: Variable expenses
Manufacturing $24,000
Selling and administrative 2,200 26,200
Contribution margin $13,800
Less: Fixed expenses
Manufacturing $ 6,000
Selling and administrative 5,800 11,800
Operating income $ 2,000

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 Learning Example: Special Sales
Objective 4
Orders

Cordell Company makes and

sells 1,000,000 seat covers.

Total manufacturing cost is

$30,000,000, or $30 per unit.

Cordell is offered a special order

of $26 per unit for 100,000 units.

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 Special Sales Order

Accepting the special order:

1. would not affect Cordell’s regular business.

2. would not raise any antitrust issues.
3. would not affect total fixed costs.
4. would not require additional variable selling and
administrative expenses.
5. would use some otherwise idle manufacturing capacity.

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 Special Sales Order

Only variable manufacturing costs are

affected by this particular order, at a rate of
$24 per unit ($24,000,000 ÷ 1,000,000 units).

All other variable costs and all fixed

costs are unaffected and thus irrelevant.

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 Special Sales Order

Special order sales price/unit $26

Increase in manufacturing costs/unit 24
Additional operating profit/unit $ 2

Based on the preceding analysis,

should Cordell accept the order?

$2 × 100,000 = $200,000 additional profit

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Incorrect Analysis: Misuse of Unit Cost

Faulty cost analysis can occur by misinterpreting

unit fixed costs, especially with an absorption
approach. For instance, Cordell’s managers might
erroneously use the $30 @ unit manufacturing
cost under the absorption approach.

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 Incorrect Analysis: Misuse of Unit Cost

The incorrect prediction of a $3 million increase

in costs results from multiplying 100,000 units by
$30. The fallacy in this approach is that it treats
a fixed cost (fixed manufacturing cost) as if it
were variable.

Avoid the mistake of using total unit costs as a

basis for predicting how total costs will behave.
Unit costs are useful for predicting variable costs,
but can be misleading when used to predict fixed
costs.

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Activity-Based Costing, Special Orders,
and Relevant Costs

Cordell examined its $24 million of variable

manufacturing costs and discovered two
significant activities and related cost drivers:

$21 million of processing activity that varies

directly with units produced ($14 million DM,
$6 million DL, and $1 million of variable MO)
at a rate of $21 per unit.

. . . and $3 million of setup activity that varies

with the number of production setups.
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 Confusion of Variable and Fixed Costs

For product-costing purposes, however, it is easy

to misinterpret the fixed unit manufacturing
cost—to act as if these fixed costs behave as if
they are variable costs, which is contrary to
fixed-cost behavior:

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 Activity-Based Costing, Special
Orders, and Relevant Costs

Assume that processing the additional

100,000 units will require only 5 set-ups.

What is the additional variable cost

using ABC costing?

Unit-based variable cost, 100,000 × $21 $2,100,000

Setup-based variable cost, 5 × $6,000 30,000
Total additional variable cost $2,130,000

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 The End

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