Chapter 4

Cost Management Systems and

Activity-Based Costing

LEARNING OBJECTIVES:
When your students have finished studying this chapter, they should be
able to:

1. Describe the purposes of cost management systems.

2. Explain the relationship among cost, cost object, cost

accumulation, and cost assignment.

3. Distinguish between direct and indirect costs.

4. Explain the major reasons for allocating costs.

5. Identify the main types of manufacturing costs: direct materials,

direct labor, and indirect production costs.

6. Explain how the financial statements of merchandisers and

manufacturers differ because of the types of goods they sell.

7. Understand the main differences between traditional and activity-

based costing (ABC) systems and why ABC systems provide value
to managers.

8. Use activity-based management (ABM) to make strategic and

operational control decisions.
9. Describe the steps in designing an activity-based costing system
(APPENDIX 4).
CHAPTER 4: ASSIGNMENTS
CRITICAL THINKING EXERCISES

31. Marketing and Capacity Planning

32. ABC and ABM Compared
33. ABC for Product Costing and Operational Control
34. ABC and Cost Management Systems
35. ABC and Benchmarking

EXERCISES

36. Classification of Manufacturing Costs

37. Confirm Your Understanding of the Classification of
Manufacturing Costs
38. Variable Costs and Fixed Costs; Manufacturing and
Other Costs
39. Direct, Indirect, and Unallocated Costs
40. Cost Allocation in ABC
41. Activity-Based Costing
42. Two-Stage Activity-Based Costing—Stage One
43. Two-Stage Activity-Based Costing, Banking,
Benchmarking
44. Direct, Indirect, and Unallocated Costs

PROBLEMS

45. Cost Accumulation and Allocation

46. Hospital Allocation Base
47. Traditional and ABC Cost Accounting, Activity-Based
Management
48. Activity-Based Costing and Product Line Profitability
49. Activity-Based Costing and Activity-Based
Management, Automotive Supplier
50. Library Research in Activity-Based Costing or Activity-
Based Management
51. Review of Chapters 2, 3, and 4
52. Review of Chapters 2, 3, and 4
53. Review of Chapters 2, 3, and 4

CASES
 54. Multiple Allocation Bases
55. Traditional Versus ABC Systems
56. ABC and Customer Profitability in Financial Services
57. Identifying Activities, Resources, and Cost Drivers in
Manufacturing
58. Nike 10k Problem: Nike’s Cost Accounting System

EXCEL APPLICATION EXERCISE

59. Traditional Costing Versus Activity-Based Costing

COLLABORATIVE LEARNING EXERCISE

60. Internet Research, ABC, and ABM

INTERNET EXERCISE

61. Vermont Teddy Bear Factory

(http://www.vermontteddybear.com)
CHAPTER 4: OUTLINE

I. Cost Management Systems {L. O. 1}

A collection of tools and techniques that identifies how
management’s decisions affect costs. The primary purposes are 1)
aggregate measures of inventory value and cost of goods
manufactured for external reporting to investors, creditors, and
other external stakeholders; 2) cost information for strategic
management decisions; and 3) cost information for operational
control.

A. Cost Accounting Systems

All kinds of organizations need some form of cost accounting,

that part of the cost management system that measures
costs for the purposes of management decision-making and
financial reporting.

The cost accounting system typically involves two processes:

(1) Cost Accumulation—collecting costs by some “natural”
classification such as materials or labor, and (2) Cost
Allocation/Assignment—attaching costs to one or more
cost objectives. (See EXHIBIT 4-1)

B. Cost Objectives {L. O. 2}

Cost—a sacrifice or giving up of resources for a particular
purpose. Cost Object (or Cost Objective)—anything for
which managers want a separate measurement of costs (e.g.,
a product, a department, a sales region, a program, or
something else for which decisions are made).

II. Cost Terms Used for Strategic Decision Making and

Operational Control Purposes

A. Direct, Indirect, and Unallocated Costs {L.

O. 3}
 Direct Costs—identified specifically and exclusively
with a given cost objective in an economically feasible way
(tracing). Indirect Costs—not identified specifically and
exclusively with a given cost objective in an economically
feasible way. Cost allocation—to assign indirect costs to
cost objects. A cost-allocation base is some measure of
input or output that determines the amount of cost to be
allocated to a particular cost object. Managers prefer to
classify many costs as direct whenever it is “economically
feasible” because it gives them greater confidence in their
costs of products and services (i.e., less subjectivity). A
particular cost can be direct for one cost objective but
indirect for others.

B. Purposes of Cost Allocation {L. O. 4}

Four purposes of cost allocation: (1) To predict the economic
effects of strategic and operational control decisions; (2) To
provide desired motivation and to give feedback for
performance evaluation; (3) To compute income and asset
valuations for financial reporting; and (4) To justify costs or
obtain reimbursement. Allocating fixed costs usually creates
the greatest problems.

C. Methods of Cost Allocation

Allocating indirect costs is a 5-step process:

1. Accumulate indirect costs for a period of time into one or

more cost pools. A cost pool is a group of individual
costs that a company allocates to cost objects using a
single cost-allocation base.
2. Select an allocation base for each cost pool, preferably a
cost driver, that is, a measure that causes the costs in
the cost pool.
3. Measure the units of the cost-allocation base for each cost
object (e.g., a product) and compute the total units for
all cost objects (e.g., all products).
4. Determine the percentage of total cost-allocation base
units used for each cost object.
5. Multiply the percentage in step 4 by the total costs in the
cost pool to determine the cost allocated to each cost
 object.

D. Unallocated Costs

Unallocated Costs are too difficult to establish a cause-

and-effect relationship (see EXHIBIT 4-2). Unallocated costs
are costs that an accounting system records but does not
allocate to any cost object (e.g., research and development,
process design, legal expenses, accounting, information
services, and executive salaries). (See EXHIBIT 4-3.)

III. Cost Terms Used for External Reporting Purposes

A. Categories of Manufacturing Costs {L. O. 5}

Direct-Materials Costs—the acquisition costs of all
materials that are physically identified as a part of the
manufactured goods and that may be traced to the
manufactured goods in an economically feasible way.

Direct-Labor Costs—the wages of all labor that can

be traced specifically and exclusively to the manufactured
goods in an economically feasible way.

Indirect Production Costs (Indirect Manufacturing

Costs, Factory Overhead, Factory Burden, or
Manufacturing Overhead)—include all costs other than
direct material or direct labor that are associated with the
manufacturing process (e.g., power, supplies, indirect labor,
supervisory salaries, property taxes, rent, insurance, and
depreciation).

B. Product Costs and Period Costs

Product Costs—costs (e.g., direct materials, direct

labor, and factory overhead) initially identified with goods
produced or purchased for resale (i.e., inventory) and
become expenses (i.e., cost of goods sold) only when the
inventory is sold.

Period Costs—costs (e.g., selling and general administration

expenses) that are deducted as expenses during the current
 period without going through the inventory stage.

EXHIBIT 4-4 shows the flow of costs for both

merchandising companies and manufacturing companies.
Note that manufacturing companies have three categories of
inventory whereas only one is present for merchandisers.

Direct-Materials Inventory—materials on hand and

awaiting use in the production process.

Work-In-Process Inventory—goods undergoing the

production process but not yet fully completed. Costs include
appropriate amounts of the three major manufacturing costs
(i.e., direct material, direct labor, and factory overhead).

Finished-Goods Inventory—goods fully completed

but not yet sold.

C. Balance Sheet and Income Statement {L. O.

6}
Presentation of Costs

Typically, manufacturing and merchandising companies

treat selling and administrative expenses in the same
manner, but the detail of COGS differs.

Manufacturers show the manufacturing cost of goods

produced and then sold, which is composed of the three
major cost categories: direct materials, direct labor, and
factory overhead (see EXHIBIT 4-4). Merchandisers simply
show the purchased cost of items, including freight, rather
than the cost of goods manufactured and sold.

IV. Traditional and Activity-Based Cost Accounting

{L. O. 7} Systems

In the past, almost all companies used traditional costing

systems—those that do not accumulate or report costs of
activities or processes. This works well for fairly simple production
and operating systems. The business environment has become
more complex. This has led to the most significant improvement in
 cost accounting system design—activity-based costing (ABC).
Many ABC teams find it useful to develop a process map—a
schematic diagram with symbols that captures the
interrelationships between cost objects, activities, and resources
(see EXHIBIT 4-5).
A. An Illustration of Traditional (see EXHIBIT 4-6)
and ABC Systems

Activity-Based Accounting (ABA) or Activity-Based

Costing (ABC) systems first accumulate overhead costs for
each of the activities of an organization, and then assign the
costs of activities to the products, services, or other cost
objects that caused that activity. Cost Drivers are identified
for each activity to establish a cause-effect relationship
between an activity and a cost object. Traditional systems
often use only one cost driver and do not attempt to identify,
accumulate, or report costs by activities performed.

There are many variations in the design of ABC systems. In a

two-stage ABC system (see EXHIBIT 4-7), there are two
stages of allocation to get from the original resource cost to
the final product or service cost. The first stage allocates
costs to activity-cost pools. A cost pool is a group of
individual costs that is allocated to cost objectives using a
single cost driver. The second stage allocates activity costs to
the products or services. The first-stage cost drivers are
usually percentages.

V. Activity-Based Management: A Cost Management

System Tool
{L. O. 8}
Activity-based management (ABM) is using the output of an
activity-based cost accounting system to aid strategic decision-
making and to improve operational control of an organization. One
of the most useful applications of ABM is distinguishing between
value-added cost (the necessary cost of an activity that a
company cannot eliminate without affecting a product’s value to
the customer), and nonvalue-added cost (unnecessary costs
that a company tries to minimize and eliminate without affecting a
product’s value to the customer). Examples of non-value-added
costs are handling and storing inventories, and changing the setup
of production-line operations to produce a different model of the
product.

Another ABC-related technique that has gained popularity is

benchmarking (the continuous process of comparing products,
services, and activities to the best industry standards.

A. Benefits of Activity-Based Costing and Activity-Based

Management

Many organizations in the manufacturing industry and

service sector are adopting ABC systems because:

1. Fierce competitive pressure has resulted in shrinking

profit margins. Companies often do not have confidence
in the accuracy of the margins for individual products or
services.

2. Greater diversity in the types of products and services,

as well as customer classes, results in greater business
operating complexity. The consumption of a company’s
shared resources also varies substantially across
products and customers.

3. New production techniques have increased the

proportion of indirect costs.

4. The rapid pace of technological change has shortened

product life cycles. Companies do not have time to
make price or cost adjustments once they discover
costing errors.

5. The costs associated with bad decisions that result from

inaccurate cost determinations are substantial (e.g.,
lost bids and hidden losses from undercosted products).

6. Computer technology has reduced the costs of

developing and operating ABC systems.
VI. Appendix 4: Detailed Illustration of Traditional and
Activity-Based Cost Accounting Systems

The chapter presents an illustration of the use of activity-based

costing to provide more accurate costing for the Billing
Department of AT&T’s smaller customer care centers, with two
major customer classes (i.e., account inquiry and bill-printing
services).

EXHIBIT 4-8 shows the traditional costing system that has been in
use. All billing department costs are totaled and then divided by
the total number of customer inquiries (residential + commercial)
to arrive at a cost per inquiry. This amount is then multiplied by
the number of inquiries from each type of customer and divided by
the number of customers of each type to give the cost/customer.
The amounts derived are $4.58 per residential customer and $6.88
per commercial customer.

Not being satisfied with the accuracy of the amounts produced

under their traditional costing system, AT&T developed an activity-
based costing system.

A. Design of an Activity-Based Cost Accounting

{L. O. 9} System

1. Determine the key components (project scope,

cost objectives, key activities, resources, and related
cost drivers).
2. Determine the relationships among cost objects,
activities, and resources (see EXHIBIT 4-9).
3. Collect relevant data concerning costs and the
physical flow of cost-driver units among resources and
activities (see EXHIBITS 4-10 and 4-11).
4. Calculate/interpret the new activity-based cost
information (see EXHIBITS 4-12 and 4-13).

The detailed application of these steps for AT&T is

provided in the text. Of particular interest are the key results
of the study—the actual determination of the activity-based
costs. In the key results, the residential customer’s cost is
$3.98 compared to $4.58 with the traditional costing system,
and the commercial customer’s cost is $10.50 compared to
 $6.88 derived under the traditional system. This result is
common when high-volume cost objects with simple
processes are overcosted when only one volume-based cost
driver is used.

B. Strategic Decisions, Operational Cost Control,

and ABM

The conclusion of the AT&T chapter problem is summarized.