11/23/2022
Lindsay & Associates
Lindsay & Associates is a public accounting firm. Each audit
engagement is treated as an individual job. The current cost
system at Lindsay & Associates identifies only one category of
direct cost – Professional labor. The others are treated as indirect
cost – Audit support.
Current cost system at Lindsay & Associates traces direct
cost to individual jobs based on the professional hours consumed
by the job. The indirect costs – Audit support, as they incur to
support the conducting of audits – are allocated to jobs based on
the professional labor hours
One of the current clients of Lindsay & Associates (Tracy
Transport) is bidding for the next year audit at the cost of $73,000.
The audit needs 800 professional hours.
The current costing system shows that the cost of the audit
amounts to $76,000. Lindsay is uncomfortable with current cost
data and decides to review the cost system
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Prof. labor cost Labor related costs
$14,400
Office staff Info. specialists Admin. Other
$2,030 $1,008 $1,252 $1,038
Nonlabor related costs
Prof. development Occupancy Phone/fax/
Prof. liability $880 $2,000 copying
insurance $1,430
$2,160 Travel & perdiem Other
$770 $392
Tracy transport
Prof. labor $50*800 = $40,000
Audit support $45*800 =$ 36,000
Total costs Prof. labor hours Cost rate
Professional labor $14,400,000 288,000 $50/H
Indirect cost $12,960,000 288,000 $45/H
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Current system assign professional labor costs to audits
based on the total numbers of professional hours
But
Do the audits have the same mix of different types of
professionals?
In addition, some support costs can be traced directly to
individual audits with a little effort
And not all items in the audit support pool are consumed
by different audits in the same proportion
Lindsay examines the activities and concludes that
at least five separate direct-cost categories can be
identified
Professional partner labor: $100/h
Professional associate labor: $40/h
Information specialists labor: $35/h
Phone/fax/copying: traced on an as-identified basis
Travel: traced on an as-identified basis
The last three categories were previously included
in indirect costs – audit support
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After interviews with professional staff, Lindsay
concludes that the indirect costs can be divided
into three subcategories with three allocation bases
that reflect reasonable usage of individual audits
Indirect cost pools Allocation base
General audit support $25 per professional labor hour
(same rate for partners and associates)
Professional liability insurance 15% of professional labor
compensation
Secretarial support $18 per professional partner labor
hour
Direct costs
Professional partner labor $100*80 $8,000
Professional associate labor $40*720 28,800
Information specialist labor $35*40 1,400
Phone/fax/copying (as identified with this audit) 800
Travel and per diem (as identified with this audit) 1,100
40,100
Indirect cost
General audit support $25*800 20,000
Professional liability insurance $36,800*15% 5,520
Secretarial support $18*80 1,440
26,960
Total cost 67,060
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Indirect AUDIT
cost pool SUPPORT
Indirect cost Professional
allocation base labor-hours
Indirect costs
Cost object
Direct costs
Direct
costs prof.
labor
Indirect AUDIT
cost pool SUPPORT
Indirect cost Professional
allocation base labor-hours
Indirect costs
Cost object
Direct costs
prof. prof.
partner associate
Direct labor labor
costs Info. fax/
specialist Travel
phone/
labor & perdiem
copying
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Indirect General Audit Prof. Insurance Secretarial
cost pool Support Liability Support
Indirect cost Professional Professional Partner
allocation base labor-hours labor-dollar labor-hours
Indirect costs
Cost object
Direct costs
prof. prof.
partner associate
Direct labor labor
costs Info. fax/
specialist Travel
phone/
labor & perdiem
copying
REFINING A COSTING SYSTEM
Direct-cost tracing
Classify as many of the total costs as direct
costs as is economically feasible
Indirect-cost pools
Expand the number of indirect-cost pools until
each of those pools is homogeneous
Cost-allocation bases
Identify an appropriate cost-allocation base for
each indirect-cost pool
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FILLING CUSTOMER NEEDS COST
THE FIRM’S MONEY
served by
Activities
activities
activities
Customer consume
resources
Costs resources
cost money Resources
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COST OBJECTS ????
Costs Assigned
to resources Resources
Assigned to
activity cost
pools
Reassigned to
Activities
cost objects
Cost objects
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ACTIVITY-BASED COSTING
As a specific approach to refining a costing
system
Focuses on activities as the fundamental
cost objects
ABC uses cost of activities as the basis for
assigning costs to other cost objects like
products, services, or customers
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TRADITIONAL COSTING SYSTEM
Functional based costing system
Major assumption: Cost consumed by cost
objects through functional departments
Single cost driver
Allocation basis is usually proportional to
volume
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TRADITIONAL COSTING SYSTEM
DIRECT DIRECT
OVERHEAD
MATERIALS LABOR
DEPARTMENTS
COST OBJECTS
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TRADITIONAL COST ACCOUNTING
Arbitrarily allocates overhead to the cost
objects
Total company’s overhead is allocated to
the products based on volume-based
measures e.g. labor hours, machine hours
Allocation assumption: relation between
overhead and the volume based measure
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ABC BASIC PREMISE
What drive costs RESOURCES
of cost objects?
Activities consume
resources ACTIVITIES
Cost objects consume
activities COST OBJECTS
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TRANSITION FROM TCA TO ABC
Traditionalcosting is based on the
assumption that cost incurred in
proportional to volume
But today management found that there are
two other major influences on cost:
complexity and diversity of operations
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ABC DIFFERENT FROM TCA
ABC systems focus on the actual activities
performed by organizational resources rather than
focus only on the location or organization of
responsibility centers
ABC is NOT to allocate common costs to
products. The goal is to measure and then price
out all the resources used for activities that support
the production and delivery of products and
services to customers
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TWO-STAGE ABC METHOD
Cost of Cost of
resource #1 resource #2
Activity #1 Activity #2 Activity #3
Cost object Cost object Cost object
#1 #2 #3
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ACTIVITY BASED COSTING
More accurate cost management
methodology
Focuses on indirect costs
Traces rather than allocates each expense
category to the particular cost object
Makes “indirect” expenses “direct”
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PRACTICE
Question 1: Manhattan company
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ACTIVITY BASED COSTING
steps
Identifying activities
Assigning costs of resources to activities
Determining the basis for assigning the cost
of activities to cost objectives [activity cost
drivers]
Determining the cost per unit of activity
[activity cost rate]
Reassigning costs from the activity to the
cost objective in the basis of the cost
objective’s consumption of activities
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ACTIVITY – THE FOCAL POINT OF
ABC
Cost of resources firstly are assigned to
activities before reassigning to cost objects
Activities can be identified by decomposing
functional areas into their constituent
activities
Identification of activities
Materiality and
Objectives of ABC system
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Activity: Any event, action, transaction, or work
sequence that causes a cost to be incurred in
producing a product or providing a service.
Activity Cost Pool: The overhead cost attributed to
a distinct type of activity.
Examples:
Purchasing materials.
Setting up machines.
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ACTIVITY COST
Activitycost – resources consumed to
perform an activity
Elements of cost
Labor; machinery; buildings materials;
supplies; equipment; and utilities
Usually not broken down by activities
Relationship between activities and
elements of cost Arbitrary allocations?
Charging in directly measurable manner or
Estimation
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TRACING ORGANIZATIONAL
EXPESENSE TO ACTIVITIES
Account billing $117,889
Labor
$109,750
Account inquiry $102,666
Telecom.
$112,500
Occupancy Bill verification $44,423
$31,160
Printing
Correspondence $17,692
$23,500
Total: $282,670 Total: $282,670
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ASSIGN ACTIVITY COST TO
PRODUCT
The first stage of the ABC system ends up
with the total cost of performing each of the
organization’s support activities
The second stage is to assign activity costs
to products by selecting activity cost drivers
that link the performance of activities to
demands made by individual products
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ACTIVITY COST DRIVER
Quantitative measure of the output of an
activity
Types of activity cost drivers
Transaction drivers
Duration drivers
Intensity drivers
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ACTIVITY COST DRIVER
transaction driver
Can be used when all outputs make
essentially the same demands on the activity
Least expensive but could be the least
accurate
Examples are
number of setups, number of receipts
Number of products supported
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ACTIVITY COST DRIVER
Duration drivers
Represent the amount of time required to
perform an activity
Overcome the disadvantage of transaction
driver
More accurate but more expensive
Examples are
Setup hours
inspection hours
labor hours
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ACTIVITY COST DRIVER
Intensity driver
Directly charge for the resources used each
time an activity is performed
The most accurate activity cost driver but
the most expensive
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COST PER UNIT OF ACTIVITY
Activity cost Cost of activity
=
driver rate Units of cost driver
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Cost of resources used during the period by the
whole organization
does not mean
The cost of resources used during the period by
all the organization’s OUTPUTS
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ABC
Contribution to Management
Cost of Resources Cost of Resources
Supplied Used
Unused
Financial ABC model
statements
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Cost of Unused Capacity
The cost of unused capacity should not be
assigned to products produced or customers
served during a period
The cost of unused capacity remains someone’s,
or some department’s responsibility
Usually you can assign the cost of unused
capacity after analyzing the decision that
authorized the level of capacity supplied
Such an assignment is done on a lump-sum basis;
it will not be assigned to individual units of
products
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Cost of Unused Capacity
If the unused capacity relates to a particular
product line then the cost of unused capacity is
assigned to that product line, where the demand
failed to materialize
In making assignment of unused capacity costs,
trace the costs at the level in the organization
where decisions are made that affect the supply of
capacity resources and the demand for those
resources
The lump-sum assignment of unused capacity
costs provides feedback to managers on their
supply and demand decisions
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ABC only provides more accurate product
cost information than TCA
Based on this cost information, managers
are able to take corrective actions and to
make better business decisions. if managers
are not able or not willing to change a
company’s policy, there is no improvement
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APPLICATION OF ABC
Overhead is high
Products are diverse: complexity, volume,
amount of direct labor
Cost of errors are high
Competition is stiff
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Limitations of Activity-Based Costing
Can be expensive to use (Cost/Benefit).
Some arbitrary allocations continue.
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ABC is not guided by financial
accounting requirements, there is
wide variation in the components
of ABC systems
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CLASSIC PEN COMPANY
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Strategic cost management
methods
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Activity-based management (ABM)
Integrated approach that focuses management’s
attention on activities with the objectives of
improving customer value and the profit achieved
by providing this value
ABM is then to enable customer needs to be
satisfied while making fewer demands on
organizational resources (i.e. cost reduction)
ABM broadly includes decisions about pricing and
product mix, cost reduction, process improvement
and product and process design
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Activity-based management (ABM)
ABM draws on ABC as its major source of
information and focuses on the efficiency and
effectiveness of key business processes and
activities
The activity-based management model, thus has
two dimensions
a cost dimension and
a process dimension
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Activity-based management (ABM)
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Process Value Analysis
Process value analysis
Fundamental to activity-based responsibility accounting
Focuses on accountability for activities rather than costs
Emphasizes the maximization of systemwide
performance instead of individual performance
Process value analysis is concerned with:
Driver analysis
Activity analysis
Performance measurement
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Process Value Analysis
Driver analysis is the effort expended to identify
the factors that are the root causes of activity
costs.
Activity analysis is the process of identifying,
describing, and evaluating the activities an
organization performs.
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Process Value Analysis
Activity analysis should produce four outcomes:
What activities are performed.
How many people perform the activities.
The time and resources are required to perform the
activities.
An assessment of the value of the activities to the
organization.
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Process Value Analysis
Value-added activities
is an activity that customers perceive as adding
usefulness or value to the product or service
they purchase
For example, painting a car would be a value-
added activity in an organization that
manufactures cars
Nonvalue-added activities
Activities are essentially those activities that
customers should not be expected to pay for
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Non-value-added costs are costs that are
caused either by non-value-added activities
or the inefficient performance of value-
added activities
Increasing the efficiency of a non-value-
added activity is not a good long-term
strategy
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Reading
The impact of ABM at Insteel industries
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Application of ABM
ABM applications can be classified into two
categories
Operational ABM and
Strategic ABM
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Operational ABM
Operational ABM enhances operational
efficiency and asset utilization and lowers
costs; its focuses are on doing things right
and performing activities more efficiently
Operational ABM applications use
management techniques such as activity
analysis, business process improvement,
total quality management, and performance
measurement
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Strategic ABM
Strategic ABM focuses on choosing appropriate
activities for the operation, eliminating
nonessential activities, and selecting the most
profitable customers
Strategic ABM applications use management
techniques such as process design, customer
profitability analysis, and value-chain analysis, all
of which can alter the demand for activities and
increase profitability through improved activity
efficiency
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ABM advantages
ABM manages activities to improve the
value of products or services to customers
and increase the firm’s competitiveness and
profitability:
Focuses on the efficiency and effectiveness of
key business processes and activities.
Improves management’s focus on the firm’s
critical success factors thereby enhancing the
firm’s competitive advantage
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Why ABM fails?
Lack of support of higher-level
management.
Failure to maintain support from higher-
level management.
Resistance to change.
Failure to integrate the new system
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Life-cycle cost management
Life-cycle costing is a method used to identify and
monitor the costs of a product throughout its life
cycle. The life cycle consists of all steps from
product design and purchase of materials to
delivery and service of the finished product
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Life-cycle cost management
Typically, product or service costs are measured
and reported for relatively short periods, such as a
month or a year. Life-cycle costing provides a
long-term perspective because it considers the
entire cost life cycle of the product or service
Cost management has traditionally focused only
on costs incurred at manufacturing stage. Life-
cycle cost management pay attention to product
design, since design decisions lock in most
subsequent life-cycle costs
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Life-cycle cost management
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Target costing
Life-cycle cost management emphasizes
cost reduction, not cost control. And target
costing becomes a particularly useful tool
for establishing cost reduction goals during
the design stage
A target cost is the difference between the
sales price needed to capture a
predetermined market share and the desired
per-unit profit
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Target costing
Target costing is a process for ensuring that
products and services are designed such that
the company can sell them cheaply and still
make a fair profit
A technique that focuses on managing costs
during a product’s planning and design
phase
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Target costing
A target cost is the difference between the
sales price needed to capture a
predetermined market share and the desired
per-unit profit
Target cost = Competitive price − Desired profit
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Target costing
Toreach the target level the firm has
various options
By integrating new manufacturing technology,
using advanced cost management techniques
such as activity-based costing
By redesigning the product or service
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