Horngrenima14e ch04

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 4 - 1
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 4 - 1
Introduction to Management AccountingIntroduction to Management Accounting
Chapter 4Chapter 4
Cost Management SystemsCost Management Systems
and Activity-Based Costingand Activity-Based Costing

Cost Management SystemCost Management System
AA cost management systemcost management system (CMS) is(CMS) is
a collection of tools and techniquesa collection of tools and techniques
that identifies how management’sthat identifies how management’s
decisions affect costs.decisions affect costs.
AA cost management systemcost management system (CMS) is(CMS) is
a collection of tools and techniquesa collection of tools and techniques
that identifies how management’sthat identifies how management’s
decisions affect costs.decisions affect costs.
LearningLearning
Objective 1Objective 1

Cost Management SystemCost Management System
The primary purposes of a costThe primary purposes of a cost
management system are to provide...management system are to provide...
cost information for strategiccost information for strategic
management decisions,management decisions,
cost information forcost information for
operational control, andoperational control, and
measure of inventory value and costmeasure of inventory value and cost
of goods sold for financial reporting.of goods sold for financial reporting.

Cost Accounting SystemsCost Accounting Systems
Cost accountingCost accounting is that part of the costis that part of the cost
management system that measuresmanagement system that measures
costs for the purposes of managementcosts for the purposes of management
decision making and financial reporting.decision making and financial reporting.

Cost Accounting SystemCost Accounting System
CostCost
accumulation:accumulation:
Collecting costs by someCollecting costs by some
““natural” classificationnatural” classification
such as materials or laborsuch as materials or labor
CostCost
assignment:assignment:
Tracing costs to one orTracing costs to one or
more cost objectivesmore cost objectives
LearningLearning

CostCost
accumulationaccumulation
Cost assignmentCost assignment
to cost objectsto cost objects
CabinetsCabinets
DesksDesks
TablesTables
Material costsMaterial costs
(metals)(metals)
Finishing Department
ActivityActivity ActivityActivity
CabinetsCabinets
DesksDesks
TablesTables
Machining Department
DepartmentsDepartments
. Activities. Activities
ProductsProducts

CostCost
AA costcost is a sacrifice or giving up ofis a sacrifice or giving up of
resources for a particular purpose.resources for a particular purpose.
Costs are frequently measured byCosts are frequently measured by
the monetary units that must bethe monetary units that must be
paid for goods and services.paid for goods and services.

Cost ObjectCost Object
A cost object (objective) is anything for whichA cost object (objective) is anything for which
A separate measurement of costs is desired.A separate measurement of costs is desired.
CustomersCustomers DepartmentsDepartments
Processing ordersProcessing orders
ProductProduct
ServiceService

Direct, Indirect, and Unallocated CostsDirect, Indirect, and Unallocated Costs
Direct costs can be identified specifically and exclusivelyDirect costs can be identified specifically and exclusively
with a given cost objective in an economically feasible way.with a given cost objective in an economically feasible way.
LearningLearning
Indirect costs cannot be identified specifically and exclusivelyIndirect costs cannot be identified specifically and exclusively
With a given cost objective in an economically feasible way.With a given cost objective in an economically feasible way.
Unallocated costs are recorded butUnallocated costs are recorded but
not assigned to any cost object.not assigned to any cost object.

Cost AllocationCost Allocation
Cost allocation is used to assign indirect costs to cost objects, in proportionCost allocation is used to assign indirect costs to cost objects, in proportion
to the cost object’s use of a particular cost-allocation base.to the cost object’s use of a particular cost-allocation base.
A cost-allocation baseA cost-allocation base is some measure of input or output thatis some measure of input or output that
determines the amount of cost to be allocated to a particular cost object.determines the amount of cost to be allocated to a particular cost object.
An ideal cost-allocation base would measure how muchAn ideal cost-allocation base would measure how much
of the particular cost isof the particular cost is caused bycaused by the cost objective.the cost objective.
Note the similarity of this definition to that of a cost driver—an outputNote the similarity of this definition to that of a cost driver—an output
measure that causes costs. Therefore,measure that causes costs. Therefore, most allocation bases are cost driversmost allocation bases are cost drivers..
LearningLearning

Cost allocations support a company’s CMS—the systemCost allocations support a company’s CMS—the system
providing cost measurements for strategic decision making,providing cost measurements for strategic decision making,
operational control, and external reporting.operational control, and external reporting.
Four purposes of cost allocation:Four purposes of cost allocation:
 Predict the economic effects of strategic and operational control decisions.Predict the economic effects of strategic and operational control decisions.
 Provide desired motivation and to give feedback for performance evaluation.Provide desired motivation and to give feedback for performance evaluation.
 Compute income and asset valuations for financial reporting.Compute income and asset valuations for financial reporting.
 Justify costs or obtain reimbursement.Justify costs or obtain reimbursement.

Cost PoolCost Pool
A cost poolA cost pool is a group of individual costs that a companyis a group of individual costs that a company
allocates to cost objects using a single cost-allocation base.allocates to cost objects using a single cost-allocation base.
1.1. Accumulate indirect costs for a period of time.Accumulate indirect costs for a period of time.
2.2. Select an allocation base for each cost pool, preferably a cost driver,Select an allocation base for each cost pool, preferably a cost driver,
that is, a measure that causes the costs in the cost pool.that is, a measure that causes the costs in the cost pool.
3.3. Measure the units of the cost-allocation base used for each costMeasure the units of the cost-allocation base used for each cost
object and compute the total units used for all cost objects.object and compute the total units used for all cost objects.
4.4. Determine the percentage of total cost-allocation base unitsDetermine the percentage of total cost-allocation base units
used for each cost object.used for each cost object.
5.5. Multiply the percentage by the total costs in the cost pool toMultiply the percentage by the total costs in the cost pool to
determine the cost allocated to each cost object.determine the cost allocated to each cost object.

Direct costs are physically traced to a cost object.Direct costs are physically traced to a cost object.
Indirect costs are allocated using a cost-allocation base.Indirect costs are allocated using a cost-allocation base.

Direct, Indirect, and Unallocated CostsDirect, Indirect, and Unallocated Costs
Li Company’sLi Company’s Statement of Operating IncomeStatement of Operating Income
Statement of Operating IncomeStatement of Operating Income

Direct Material CostsDirect Material Costs
Direct materials include the acquisition costsDirect materials include the acquisition costs
of all materials that a company identifiesof all materials that a company identifies
as a part of the manufactured goods.as a part of the manufactured goods.
These costs are identified inThese costs are identified in
an economically feasible way.an economically feasible way.
LearningLearning

Direct Labor CostsDirect Labor Costs
Direct Labor costs include theDirect Labor costs include the
wages of all labor that can bewages of all labor that can be
traced specifically and exclusivelytraced specifically and exclusively
to the manufactured goods in anto the manufactured goods in an
economically feasible way.economically feasible way.

Indirect Production Costs (Manufacturing Overhead)Indirect Production Costs (Manufacturing Overhead)
Manufacturing overheadManufacturing overhead includes all costsincludes all costs
associated with the production processassociated with the production process
that the company cannot be traced tothat the company cannot be traced to
the manufactured goods in anthe manufactured goods in an
economically feasible way.economically feasible way.

Product CostsProduct Costs
Product costs are costs identified with goodsProduct costs are costs identified with goods
produced or purchased for resale.produced or purchased for resale.
These costs first become part of the inventoryThese costs first become part of the inventory
on hand, sometimes called inventoriable costs.on hand, sometimes called inventoriable costs.
Inventoriable costs become expenses in the form ofInventoriable costs become expenses in the form of
cost of goods sold only when the inventory is sold.cost of goods sold only when the inventory is sold.

Period CostsPeriod Costs
Period costs are deducted as expensesPeriod costs are deducted as expenses
during the current period withoutduring the current period without
going through an inventory stage.going through an inventory stage.
1 2 3
4 5 6 7 8 9 10
11 12 13 14 15 16 17
18 19 20 21 22 23 24
25 26 28 29 30 3127

Merchandising CompanyMerchandising Company
(Retailer or Wholesaler)(Retailer or Wholesaler)
MerchandiseMerchandise
PurchasesPurchases
InventoryInventory
InventoryInventory
SalesSalesSalesSales
MinusMinus
Cost ofCost of
Goods SoldGoods Sold
(Expenses)(Expenses)
Cost ofCost of
Selling Expenses andSelling Expenses and
AdministrativeAdministrative
ExpensesExpenses
ExpensesExpenses
PeriodPeriod
CostsCosts
Equals Gross MarginEquals Gross Margin
MinusMinus
Equals OperatingEquals Operating
IncomeIncome
ProductProduct
(Inventoriable)(Inventoriable)
CostsCosts
ExpirationExpiration
Financial Statement PresentationFinancial Statement Presentation
– Merchandising Companies– Merchandising Companies
LearningLearning

Manufacturing CompanyManufacturing Company
DirectDirect
MaterialMaterial
PurchasesPurchases
FinishedFinished
GoodsGoods
InventoryInventory
FinishedFinished
GoodsGoods
InventoryInventory
SalesSalesSalesSales
MinusMinus
Cost ofCost of
Cost ofCost of
ExpensesExpenses
ExpensesExpenses
PeriodPeriod
CostsCosts
Equals Gross MarginEquals Gross Margin
MinusMinus
Equals OperatingEquals Operating
IncomeIncome
ProductProduct
(Inventoriable)(Inventoriable)
CostsCosts
ExpirationExpiration
Financial Statement PresentationFinancial Statement Presentation
– Manufacturing Companies– Manufacturing Companies
Work-in-Work-in-
ProcessProcess
InventoryInventory
Work-in-Work-in-
ProcessProcess
InventoryInventory
DirectDirect
MaterialMaterial
InventoryInventory
DirectDirect
MaterialMaterial
InventoryInventory
Direct LaborDirect Labor
IndirectIndirect
ManufacturingManufacturing

Current Asset SectionsCurrent Asset Sections
of Balance Sheetsof Balance Sheets
CashCash $ 4,000$ 4,000
ReceivablesReceivables 25,00025,000
SubtotalSubtotal $29,000$29,000
Finished goodsFinished goods 32,00032,000
Work in process 22,000Work in process 22,000
Direct materialDirect material 23,00023,000
Total inventoriesTotal inventories $77,000$77,000
Other current assetsOther current assets 1,0001,000
Total current assetsTotal current assets $107,000$107,000
ManufacturerManufacturer
CashCash $ 4,000$ 4,000
ReceivablesReceivables 25,00025,000
Merchandise inventoriesMerchandise inventories 77,00077,000
Other current assetsOther current assets 1,0001,000
Total current assetsTotal current assets $107,000$107,000
Retailer or WholesalerRetailer or Wholesaler

Income Statement PresentationIncome Statement Presentation
of Costs for a Manufacturerof Costs for a Manufacturer
Direct laborDirect labor
Indirect manufacturingIndirect manufacturing
The manufacturer’s cost of goods producedThe manufacturer’s cost of goods produced
and then sold is usually composed ofand then sold is usually composed of
the three major categories of cost:the three major categories of cost:
Direct materialsDirect materials

Income Statement PresentationIncome Statement Presentation
of Costs for a Retailerof Costs for a Retailer
The merchandiser’s cost of goods soldThe merchandiser’s cost of goods sold
is usually composed of the purchaseis usually composed of the purchase
cost of items, including freight-in,cost of items, including freight-in,
that are acquired and then resold.that are acquired and then resold.

Traditional Costing SystemTraditional Costing SystemLearningLearning
DirectDirect
MaterialsMaterials
For PenFor Pen
CasingsCasings
$22,500$22,500
DirectDirect
MaterialsMaterials
For PenFor Pen
CasingsCasings
$22,500$22,500
DirectDirect
LaborLabor
For PenFor Pen
CasingsCasings
$135,000$135,000
DirectDirect
LaborLabor
For PenFor Pen
CasingsCasings
$135,000$135,000
DirectDirect
Materials ForMaterials For
CellCell
PhonePhone
CasingsCasings
$12,000$12,000
DirectDirect
CellCell
PhonePhone
CasingsCasings
$12,000$12,000
DirectDirect
Labor ForLabor For
Cell PhoneCell Phone
CasingsCasings
$15,000$15,000
DirectDirect
Labor ForLabor For
CasingsCasings
$15,000$15,000
Sales $360,000Sales $360,000Sales $360,000Sales $360,000 Sales $80,000Sales $80,000Sales $80,000Sales $80,000 Unallocated $00,000Unallocated $00,000Unallocated $00,000Unallocated $00,000
AllAll
IndirectIndirect
ResourcesResources
$220,000$220,000
AllAll
IndirectIndirect
ResourcesResources
$220,000$220,000
All UnallocatedAll Unallocated
Value ChainValue Chain
CostsCosts
$100,000$100,000
Value ChainValue Chain
CostsCosts
$100,000$100,000
Cost DriverCost Driver
[Direct Labor[Direct Labor
Hours]Hours]

Traditional Costing SystemTraditional Costing System
Statement of Operating IncomeStatement of Operating Income
Traditional Cost Allocation SystemTraditional Cost Allocation System
PenPen
CasingsCasings
CasingsCasings
SalesSales $440,000$440,000 $360,000$360,000 $80,000$80,000
Direct materialsDirect materials 34,50034,500 22,50022,500 12,00012,000
Direct laborDirect labor 150,000150,000 135,000135,000 15,00015,000
Indirect manufacturingIndirect manufacturing 220,000220,000 198,000198,000 22,00022,000
Gross profitGross profit $ 35,500$ 35,500 $ 4,500$ 4,500 $31,000$31,000
Corporate expensesCorporate expenses 100,000100,000
Operating lossOperating loss ($ 64,500)($ 64,500)
Gross profit marginGross profit margin 8.07%8.07% 1.25%1.25% 38.75%38.75%

ABC SystemABC System
DirectDirect
MaterialsMaterials
For PenFor Pen
CasingsCasings
$22,500$22,500
DirectDirect
MaterialsMaterials
For PenFor Pen
CasingsCasings
$22,500$22,500
DirectDirect
LaborLabor
For PenFor Pen
CasingsCasings
$135,000$135,000
DirectDirect
LaborLabor
For PenFor Pen
CasingsCasings
$135,000$135,000
DirectDirect
CellCell
PhonePhone
CasingsCasings
$12,000$12,000
DirectDirect
CellCell
PhonePhone
CasingsCasings
$12,000$12,000
DirectDirect
Labor ForLabor For
CasingsCasings
$15,000$15,000
DirectDirect
Labor ForLabor For
CasingsCasings
$15,000$15,000
Sales $360,000Sales $360,000Sales $360,000Sales $360,000 Sales $80,000Sales $80,000Sales $80,000Sales $80,000 Unallocated $00,000Unallocated $00,000Unallocated $00,000Unallocated $00,000
Plant andPlant and
MachineryMachinery
$180,000$180,000
Plant andPlant and
MachineryMachinery
$180,000$180,000
Value Chain CostsValue Chain Costs
$100,000$100,000
Value Chain CostsValue Chain Costs
$100,000$100,000
[Direct Labor Hours][Direct Labor Hours]
[Distinct Parts][Distinct Parts]
Engineers andEngineers and
CAD EquipmentCAD Equipment
$40,000$40,000
Engineers andEngineers and
CAD EquipmentCAD Equipment
$40,000$40,000
ProcessingProcessing
ActivityActivity
$135,000$135,000
+ 8,000+ 8,000
$143,000$143,000
Production SupportProduction Support
ActivityActivity
$45,000$45,000
+32,000+32,000
$77,000$77,000
75% 25%
20% 80%

Activity-Based Cost Allocation SystemActivity-Based Cost Allocation System
SalesSales $440,000$440,000 $360,000$360,000 $80,000$80,000
Direct materialsDirect materials 34,50034,500 22,50022,500 12,00012,000
Direct laborDirect labor 150,000150,000 135,000135,000 15,00015,000
Processing activityProcessing activity 143,000143,000 128,700128,700 14,30014,300
Production support activityProduction support activity 77,00077,000 15,40015,400 61,60061,600
Gross profitGross profit $ 35,500$ 35,500 $ 58,400 ($22,900)$ 58,400 ($22,900)
Corporate expensesCorporate expenses 100,000100,000
Operating lossOperating loss ($ 64,500)($ 64,500)
Gross profit marginGross profit margin 8.07%8.07% 16.22% (28.63%)16.22% (28.63%)
ExternalExternal
ReportingReporting
Internal PurposesInternal Purposes
PenPen
CasingsCasings
CellCell
PhonePhone
CasingsCasings

ABM is using the output of an activity-basedABM is using the output of an activity-based
cost accounting system to aid strategic decisioncost accounting system to aid strategic decision
making and to improve operational control.making and to improve operational control.
Activity-Based ManagementActivity-Based Management
AA value-added costvalue-added cost is the cost of an activityis the cost of an activity
that cannot be eliminated without affectingthat cannot be eliminated without affecting
a product’s value to the customer.a product’s value to the customer.
In contrast,In contrast, nonvalue-added costsnonvalue-added costs are costsare costs
that can be eliminated without affectingthat can be eliminated without affecting
a product’s value to the customer.a product’s value to the customer.
LearningLearning

Activity-Based ManagementActivity-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.

Benefits of Activity-Based Costing andBenefits of Activity-Based Costing and
Management SystemsManagement Systems
 set an optimal product mixset an optimal product mix
 to estimate profit margins of new productsto estimate profit margins of new products
 determine consumption of company’s shared resourcesdetermine consumption of company’s shared resources
 keep pace with new product techniqueskeep pace with new product techniques
 and technological changesand technological changes
 decrease the costs associated with bad decisionsdecrease the costs associated with bad decisions
 take advantage of reduced cost of ABCtake advantage of reduced cost of ABC
 systems due to computer technologysystems due to computer technology
Companies adopt ABC systems to:Companies adopt ABC systems to:

Design of a Traditional Costing SystemDesign of a Traditional Costing System

Design of an Activity-BasedDesign of an Activity-Based
Determine the keyDetermine the key
components of thecomponents of the
cost accountingcost accounting
system.system.
Cost objectivesCost objectives
Key activitiesKey activities
ResourcesResources
Related cost driversRelated cost drivers
LearningLearning

Account billingAccount billing
Bill verificationBill verification
Account inquiryAccount inquiry
CorrespondenceCorrespondence
Other activitiesOther activities
Number or printed pagesNumber or printed pages
Number of accounts verifiedNumber of accounts verified
Number of inquiriesNumber of inquiries
Number of lettersNumber of letters
Number of printed pagesNumber of printed pages
KeyKey
ActivityActivity
CostCost
DriverDriver

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%
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 the relationships amongDetermine the relationships among
cost objectives,activities, and resources.cost objectives,activities, and resources.
Determine the relationships amongDetermine the relationships among
cost objectives,activities, and resources.cost objectives,activities, and resources.

Collect relevant data concerning costs and the physicalCollect relevant data concerning costs and the physical
flow of the cost-driver units among resources and activities.flow of the cost-driver units among resources and activities.
Collect relevant data concerning costs and the physicalCollect relevant data concerning costs and the physical
flow of the cost-driver units among resources and activities.flow of the cost-driver units among resources and activities.
Number of Cost Driver UnitsNumber of Cost Driver Units
ActivityActivity Cost Driver Units ResidentialCost Driver Units Residential CommercialCommercial TotalTotal
Account inquiryAccount inquiry InquiriesInquiries 20,00020,000 5,0005,000 25,00025,000
CorrespondenceCorrespondence LettersLetters 1,8001,800 1,0001,000 2,8002,800
Bill printingBill printing Printed pages 120,000Printed pages 120,000 40,00040,000 160,000160,000
VerificationVerification Accounts verifiedAccounts verified 20,00020,000 20,00020,000
Other activitiesOther activities Printed pagesPrinted pages 120,000120,000 40,00040,000 160,000160,000
Number of Cost Driver UnitsNumber of Cost Driver Units
ActivityActivity Cost Driver Units ResidentialCost Driver Units Residential CommercialCommercial TotalTotal
Account inquiryAccount inquiry InquiriesInquiries 20,00020,000 5,0005,000 25,00025,000
CorrespondenceCorrespondence LettersLetters 1,8001,800 1,0001,000 2,8002,800
Bill printingBill printing Printed pages 120,000Printed pages 120,000 40,00040,000 160,000160,000
VerificationVerification Accounts verifiedAccounts verified 20,00020,000 20,00020,000
Other activitiesOther activities Printed pagesPrinted pages 120,000120,000 40,00040,000 160,000160,000

Calculate and interpret the newCalculate and interpret the new
activity-based information.activity-based information.
Determine the traceable costs forDetermine the traceable costs for
each of the activity cost pools.each of the activity cost pools.
Determine the activity-based cost perDetermine the activity-based cost per
account for each customer classaccount for each customer class

Activity Cost Pool
Cost (from Account
Resource slide 4-33) 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 traceable costs for the 5 activity cost pools.Total traceable costs for the 5 activity cost pools.

Driver Costs
Total Number of
Traceable Costs Driver Units Cost per
(from Exhibit 4-12) (From Exhibit 4-11) Driver
Unit
Activity (Driver Units) (1) (2) (1) ÷
(2)
Account inquiry (inquiries) $332,872 25,000 Inquiries
$13,314880
Correspondence (letters) 32,356 2,800 Letters
$11.555714
Account billing (printed pages) 153,125 160,000 Printed pages $
0.957031
Bill verification (accounts verified) 68,425 20,000 Accounts verified $
3.421250
Other activities (printed pages) 100,722 160,000 Printed pages $ 0.629513
Cost per Customer Class
Residential Commercial
Cost per Number of Number of
Driver Unit Driver Units Cost Driver Units
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
Activity-based cost per account for each customer classActivity-based cost per account for each customer class

Strategic Decisions, Operational CostStrategic Decisions, Operational Cost
Control, and ABMControl, and ABM
OutsourcingOutsourcing
Reducing operating costsReducing operating costs
Identifying nonvalue-added activitiesIdentifying nonvalue-added activities
Improving both strategicImproving both strategic
and operational decisionsand operational decisions

End of Chapter 4End of Chapter 4
The EndThe End

Horngrenima14e ch04

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