Management Accounting

Chapter 3

Cost Accounting

Cost Classification
Cost Allocation
 Cost Accounting
Costing systems

Costing Systems

Job Costing Process Costing

Absorption Variable Absorption Variable

Costing* Costing** Costing Costing

*Absorption costing is a method of inventory costing in which all variable manufacturing

costs and all fixed manufacturing costs are included as inventoriable costs.

**Variable costing is a method of inventory costing in which all variable manufacturing costs
(direct and indirect) are included as inventoriable costs. All fixed manufacturing costs are
excluded from inventoriable costs and are instead treated as period costs.
Datar and Rajan (2018, p. 350)

© Prof. André Hoppe Management Accounting 3

 Cost Accounting
Costing systems: Job costing vs. process costing

Job costing Process costing

https://blog.sciencemuseumgroup.org.uk/eastlondonandford/
https://www.newswire.ca/news-releases/meyer-werft-
selects-cgi-to-advance-its-global-growth-strategy-
through-it-modernization-679130523.html

In reality: often a hybrid costing system

© Prof. André Hoppe Management Accounting 4

 Cost Accounting
Cost Classification & Cost Allocation
 Cost Classification
The purpose of a costing system

Collecting cost information and allowing classification needed for decision-making

Until now:
Fixed costs and variable costs
Purpose of the costing system: Understand cost behavior and relations
between costs, volume, and profit

→ Total costs = variable costs + fixed costs

What is new:
Direct and indirect costs relative to a cost object
Fixed and variable costs relative to a cost object

→ Total costs of a cost object = Direct variable costs + indirect variable costs
+ direct fixed costs + indirect fixed costs

© Prof. André Hoppe Management Accounting 6

 Cost Classification
Terminology

Cost object: Anything for which a measurement of costs is desired

Examples: See next slide

Direct costs: All (manufacturing) costs that are related to a cost object and can be
traced to that cost object in an economically feasible way.

Indirect costs (Overhead costs): All (manufacturing) costs that are related to a
cost object, but cannot be traced to that cost object in an economically feasible
way.

Cost pool: Grouping of individual indirect cost items

Allocation base: a systematic way to link an indirect cost or group of indirect costs
(operating costs of all welding machines) to cost objects (different products)
see Datar and Rajan (2018, pp. 127 - 129)

© Prof. André Hoppe Management Accounting 7

 Cost Classification
What is a cost object?

“A cost object is anything for which a measurement of costs is

desired…”
Datar and Rajan (2018, p. 128)

A cost object can be a …

… product
… process
… customer
… geographical region
… service
… project
.
.
.
© Prof. André Hoppe Management Accounting 8
 Cost Classification
Direct and Indirect Costs

Direct Costs
(materials and labor) Cost tracing

COST
Traditional
(single stage) OBJECT
(e.g., product
or job)
Indirect Costs Traditional
(e.g. factory overhead) (multiple stages)

ABC
Cost allocation

© Prof. André Hoppe Management Accounting 9

 Cost Allocation
Traditional Costing Systems (single stage)
 Traditional Costing Systems
Cost driver and allocation base

Cost driver
Any factor that causes a change in the cost of manufacturing
products or offering services

▪ volume-related: depend on the number of units manufactured

(e.g., labor hours, machine hours, labor costs)
→ Traditional Costing Systems

▪ non-volume-related: not depend directly by units manufactured

(e.g., number of setups, number of inspections)
→ Activity Based Costing Systems

© Prof. André Hoppe Management Accounting 11

 Traditional Costing Systems
Allocation base and overhead rate

Actual Costing
“… a costing system that traces direct costs to a cost object based on the actual direct-cost
rates times the actual quantities of the direct-cost inputs used. Indirect costs are allocated
based on the actual indirect-cost rates times the actual quantities of the cost-
allocation bases.”

Normal Costing
“… a costing system that (1) traces direct costs to a cost object by using the
actual direct-cost rates times the actual quantities of the direct-cost inputs and (2) allocates
indirect costs based on the budgeted indirect-cost rates times the actual quantities of
the cost allocation bases.” Datar and Rajan (2018, pp. 131 – 132)

total budgeted overhead

Budgeted Overhead Rate =
total budgeted amount of the cost driver

© Prof. André Hoppe Management Accounting 12

 Traditional Costing Systems
Traditional absorption costing – organization wide allocation base

Indirect wages Depreciation Indirect material

OVERHEAD OVERHEAD

Allocation base = # DLH

OH rate = $ / DLH

COST OBJECTS Product A Product B Product C

Direct costs

© Prof. André Hoppe Management Accounting 13

 Traditional Costing Systems
Example 1

STANDARD PREMIUM TOTAL

Production and sales 10,000 5,000 15,000
Direct materials (€) 2 4 40,000
Direct labor hours (hours)* 0.2 0.5 4,500
Direct labor costs (€) 1.6 4 36,000
Machine hours X 0.5 1.5 12,500
Machine hours Y 1.0 1.0 15,000
Manufacturing overhead (€) 225,000

*Cost per direct hour (€) equals 8 €

Direct material costs, direct labor hours, direct labor costs, and machine hours are per unit

© Prof. André Hoppe Management Accounting 14

 Traditional Costing Systems
Example 1 - Solution

Cost assignment of 225,000 EUR manufacturing overhead using direct

labor hours as cost driver:

Budgeted plant-wide overhade rate =

225,000 EUR manufacturing overhead

= 𝟓𝟎€ 𝑝𝑒𝑟 𝑑𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟
4,500 direct labor hours

STANDARD PREMIUM
Direct materials 2 4
Direct labor costs 1.6 4
Manufacturing overhead 10 = (0.2 x 50) 25 = (0.5 x 50)
TOTAL COSTS PER UNIT 13.6 33
TOTAL COSTS 136,000 165,000

direct labour hours

© Prof. André Hoppe Management Accounting 15

 Traditional Costing Systems
Example 2

A firm produces three products. The firm’s process consists of purchasing

materials with suppliers, processing the materials into end products A, B
and C, and packing the sales orders. The table below shows budgeted
costs and operations reports, assuming full capacity utilization:

Product A Product B Product C

Units sold 20,000 15,000 5,000
Cost of DM (€) / unit 25 23 20
Cost of DL (€) / unit 70 105 35
# of DL hours / unit 2 3 1
# of machine hours / unit 0.08 0.16 0.37
# of production batches / product type 2 4 6
# of sales orders / product type 10 18 20
# of purchase orders / product type 20 15 25

© Prof. André Hoppe Management Accounting 16

 Traditional Costing Systems
Example 2

To perform this process the firm expects to incur the indirect

costs of 1,350,000 € consisting of:

▪ Indirect wages = 330,000 €

= 13,200 indirect labor hours (ILH) x 25 €/ILH

▪ Depreciation = 850,000 €
machine 1 = 20,000 € (receipt goods)
machine 2 = 830,000 € (assembly, set-up & packaging)

▪ Indirect material and other costs = 170,000 €

© Prof. André Hoppe Management Accounting 17

 Traditional Costing Systems
Example 2

The company-wide overhead of 1,350,000 € is contained in

one cost pool. One company-wide allocation base (e.g. # of
DLH) is used to assign it to the cost objects.

Product A Product B Product C

Cost of DM / unit

Cost of DL / unit

Indirect costs / unit

Total costs / unit

© Prof. André Hoppe Management Accounting 18

 Traditional Costing Systems
Example 2 – Solution

Total # of DL hours (DLH) = 2 DLH/unit * 20,000 units

+ 3 DLH/unit * 15,000 units
+ 1 DLH/ unit * 5,000 units = 90,000 DLH
Overhead rate = 1,350,000 €/90,000 DLH = 15 €/DLH

Product A Product B Product C

Cost of DM/unit 25 € 23 € 20 €
Cost of DL/unit 70 € 105 € 35 €
Indirect costs/unit 2 DLH/unit x 3 DLH/unit x 1 DLH/unit x
15 €/DLH = 15 €/DLH = 15 €/DLH =
30 € 45 € 15 €

Total costs/unit 125 € 173 € 70 €

The cost objects that consume more labor hours, are charged with more indirect costs.
The assumption is that DLH drive indirect costs. But is this true??

© Prof. André Hoppe Management Accounting 19

 Traditional Costing Systems
Example 2 – Solution: Alternative allocation base

Product A Product B Product C

Costs/unit - traditional costing (DLH) 125 € 173 € 70 €
Costs/unit - traditional costing (DMH) 113.46 € 164.92 € 140.38 €

© Prof. André Hoppe Management Accounting 20

 Cost Allocation
Traditional Costing Systems (multiple stages)

SE KUPTOJ!!!
 Traditional Costing Systems
Cost allocation: Traditional absorption costing – organization wide allocation base

Indirect wages Depreciation Indirect material

OVERHEAD OVERHEAD

Allocation base = # DLH

OH rate = $ / DLH

COST OBJECTS Product A Product B Product C

Direct costs

© Prof. André Hoppe Management Accounting 22

 Traditional Costing Systems
Two stage allocation system

OVERHEAD
OVERHEAD
Indirect wages Depreciation Indirect material
Allocation base = # ILH Allocation base = # MH
First-stage OH rate = $ / ILH OH rate = $ / MH
direct allocation

allocation

Cost centers DEPT 1 DEPT 2

Normally depts.
Allocation base = # MH Allocation base = # DLH
OH rate = $ / DLH
Second-stage OH rate = $ / MH

allocation

COST OBJECTS Product A Product B Product C

Direct costs
© Prof. André Hoppe Management Accounting 23
 Traditional Costing Systems
Two stage allocation system

Two-stage allocation process

▪ Higher accuracy

▪ Heterogeneity of overhead intensiveness across

departments

▪ Product - department relations

© Prof. André Hoppe Management Accounting 24

 Traditional Costing Systems
Two stage allocation system – Example 1 extended

Allocate 225,000 EUR manufacturing overhead to production centers

(i.e., production, packaging, and quality department) (STEP 1):

COST DRIVER TO
MANFACTURING AREA
PRODUCTION
OVERHEAD (SQ. METRES)
COST CENTRES
Indirect wages and supervison
production department 10,000 Direct 280,000
packaging department 10,000 Direct 80,000
quality department 5,000 Direct 40,000
Lighting and heating 200,000 Area

© Prof. André Hoppe Management Accounting 25

 Traditional Costing Systems
Two stage allocation system – Example 1 extended

BUDGETED OVERHEAD RATE

200,000
=
𝟐𝟖𝟎,𝟎𝟎𝟎+𝟖𝟎,𝟎𝟎𝟎+𝟒𝟎,𝟎𝟎𝟎
= 0.50 EUR per m²

PRODUCTION COST CENTRES

OVERHEAD
PRODUCTION 150,000 (10,000 + 280,000 x0.50)
PACKAGING 50,000 (10,000 + 80,000 x 0.50)
QUALITY 25,000 (5,000 + 40,000 x 0.50)
225,000

© Prof. André Hoppe Management Accounting 26

 Traditional Costing Systems
Two stage allocation system – Example 1 extended

Calculate Production Center specific overhead rates (STEP 2):

BUDGETED
PRODUCTION PRODUCTION COST
COST DRIVER TO
COST CENTRES CENTRE OVERHEAD
COST OBJECTS (2)
OVERHEAD (1) RATES
(3) = (1) / (2)
PRODUCTION 150,000 Machine hours X 12,500 12 EUR per mh
PACKAGING 50,000 Machine hours Y 15,000 3.33 EUR per mh
QUALITY 25,000 Direct labor hours 4,500 5.56 EUR per lh

© Prof. André Hoppe Management Accounting 27

 Traditional Costing Systems
Two stage allocation system – Example 1 extended
Allocate overhead from production centers to products (STEP 3):
STANDARD PREMIUM
Direct materials 2 4
Direct labor costs 1.6 4
Production 6 (12 x 0.5) 18 (12 x 1.5)
Packaging 3.33 (3.33 x 1.0) 3.33 (3.33 x 1.0)
Quality 1.11 (5.56 x 0.2) 2.78 (5.56 x 0.5)
COST PER UNIT 14.04 32.11
TOTAL COSTS 140,400 160,550

1 Stage Allocation
COSTS PER UNIT 13.6 33
TOTAL COSTS 136,000 165,000

A premium chocolate bar consumes more overhead costs in

the production (x3) and quality (x2) department

© Prof. André Hoppe Management Accounting 28

 Traditional Costing Systems
Two stage allocation system

Shortcomings

▪ low number of cost centers

▪ low number of allocation bases

▪ low variety in allocation bases.

The allocation bases are often volume-based and arbitrary, not reflecting cause-
and-effect relations.

→ CRITICISM: traditional costing fails to track the true physical operations

that consume resources and generate costs
→ inaccurate product costs

© Prof. André Hoppe Management Accounting 29

 Cost Allocation
Activity Based Costing Systems
 Activity Based Costing Systems
The evolution of indirect costs

80%

70%
overhead costs in
% of added value
60%

50%
direct labor costs in
% of added value
40%

30%

20%
1850 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980
Source: Coenenberg (2003, p. 207), [translated from German]

© Prof. André Hoppe Management Accounting 31

 Activity Based Costing Systems
Meeting the changes in the production process

Traditional Costing
▪ beginning of 20th century
▪ DL & DM were the primary costs in firms
▪ Few indirect costs (i.e., overhead)

The allocation of overhead based on

a volume-based measure did not
lead to significant distortions in cost prices.

BUT, nowadays this method is not justified anymore due to

▪ increased overhead levels
▪ the fact that overhead is not primarily driven by volume-based
measures, but by complexity
© Prof. André Hoppe Management Accounting 32
 Refinement of Costing Systems
Cost Benefit Tradeoff and Cross Subsidization

© Prof. André Hoppe Management Accounting 33

 Activity Based Costing Systems
The basic idea

More accurate product costs due to ...

▪ ... disaggregation of overhead keys (lower aggregation

error)
▪ ... more accurate cause-and-effect relations (lower
specification error).
→ Better decision-making

▪ ... but at costs of higher complexity.

© Prof. André Hoppe Management Accounting 34

 Activity Based Costing Systems
Traditional two stage allocation system

OVERHEAD
OVERHEAD
Indirect wages Depreciation Indirect material
Allocation base = # ILH Allocation base = # MH
First-stage OH rate = $ / ILH OH rate = $ / MH
direct allocation

allocation

Cost centers DEPT 1 DEPT 2

Normally depts.
Allocation base = # MH Allocation base = # DLH
OH rate = $ / DLH
Second-stage OH rate = $ / MH

allocation

COST OBJECTS Product A Product B Product C

Direct costs
© Prof. André Hoppe Management Accounting 35
 Activity Based Costing Systems
Non-volume driven ABC system

OVERHEAD
OVERHEAD
Indirect wages Depreciation Indirect material
Resource driver # ILH # MH
Resource driver rate $ / ILH $ / MH direct allocation

COST CENTERS
Receipt goods Set up machine Automatic assembly Packaging
= ACTIVITIES

Activity driver # of purchase orders # of set ups # of machine hours # of sales orders

Activity driver rate € /purch. order € /set up € /MH € /sales order

COST OBJECTS Product A Product B Product C

Direct costs
© Prof. André Hoppe Management Accounting 36
 Activity Based Costing Systems
Basics

1) Identify the cost object/process under consideration and

the associated indirect costs (resources supplied)

2) Identify meaningful activities (activity cost pools)

2) Assign the resources (indirect costs) to the activities

3) Assign the activity costs to the cost objects

© Prof. André Hoppe Management Accounting 37

 Activity Based Costing Systems
The basic idea: Cost drivers

Old cost drivers

Volume based cost drivers:
Labour hours, machine hours …

New cost drivers

Activity based cost drivers (non volume related):
▪ Number of set ups
▪ set up time
▪ time to handle an order
▪ number of orders
▪ number of quality checks
▪ …
→ Requires the identification of homogeneous activities and a causal chain
between activities and costs.

© Prof. André Hoppe Management Accounting 38

 Activity Based Costing Systems
Nonvolume driver ABC system (Example 1 continued)

Assume that budgeted overhead of 225,000 € is caused by the following activities

(STEP 1) and activities have the following activity cost drivers:

OVERHEAD IN ACTIVITY
ACTIVITY COST DRIVERS
COST CENTRES
PURCHASING 30,000 Number of purchase orders
MACHINE SET-UP 100,000 Number of set-ups
MAINTENANCE 20,000 Machine hours X
PACKAGING 50,000 Machine hours Y
QUALITY INSPECTION 25,000 Number of first item inspections
225,000

© Prof. André Hoppe Management Accounting 39

 Activity Based Costing Systems
Nonvolume driver ABC system

The following figures are also known:

STANDARD PREMIUM TOTAL

Production and sales 10,000 5,000 15,000
Number of purchase orders 2 4 40,000
Number of set-ups 1 6 40,000
Machine hours X 0.5 1.5 12,500
Machine hours Y 1.0 1.0 15,000
Number of first item inspections 4 10 90,000

© Prof. André Hoppe Management Accounting 40

 Activity Based Costing Systems
Nonvolume driver ABC system
Allocate overhead in activity centers to cost objects by calculating the activity cost
driver rates (STEP 2):

ACTIVITY COST TOTAL AMOUNT OF

BUDGETED ACTIVITY COST
CENTRE ACTIVITY COST
DRIVER RATES
OVERHEAD DRIVER
(3) = (1) / (2)
(1) (2)
PURCHASING 30,000 40,000 0.75 € per order
MACHINE SET-UP 100,000 40,000 2.5 € per set-up
MAINTENANCE 20,000 12,500 1.6 € per machine hour X
PACKAGING 50,000 15,000 3.33 € per machine hour Y
QUALITY INSPECTION 25,000 90,000 0.28 € per inspection

© Prof. André Hoppe Management Accounting 41

 Activity Based Costing Systems
Nonvolume driver ABC system (Example 1 continued)

STANDARD PREMIUM
Direct materials 2 4
Direct labor costs 1.6 4
Purchasing 1.5 (0.75 x 2) 3 (0.75 x 4)
Machine set-up 2.5 (2.5 x 1) 15 (2.5 x 6)
Maintenance 0.80 (1.6 x 0.5) 2.40 (1.6 x 1.5)
Packaging 3.33 (3.33 x 1) 3.33 (3.33 x 1)
Quality controls 1.12 (0.28 x 4) 2.80 (0.28 x 10)
TOTAL COSTS / UNIT 12.85 34.53
TOTAL COSTS 128,500 172,650

ABC shows us which activities are the most cost intensive for each cost object

The premium chocolate bar is more complex to manufacture, and the costs
associated with this complexity is better captured by ABC.

© Prof. André Hoppe Management Accounting 42

 Activity Based Costing Systems
Cost benefit tradeoff and cross subsidization (Example 2 – continued)

Product A Product B Product C

Costs/unit - traditional costing (DLH) 125 € 173 € 70 €
Costs/unit - traditional costing (DMH) 113.46 € 164.92 € 140.38 €
Costs/unit – ABC* 111.76 € 161.5 € 156.4 €

DLH

Traditional costing: Product A (overcosted) subsidizes Product C (undercosted)

This problem, which is often observed under traditional costing, is called

cross-subsidizing: less complex products subsidize products that are more
complex to produce/sell
WHY THIS MATTERS:
If a company relies on traditional costing, it might overprice Product A (hurting sales) and underprice Product C (losing profit
or even selling at a loss).

ABC helps managers make better pricing, product mix, and process improvement decisions.
*See Appendix for detailed calculations

© Prof. André Hoppe Management Accounting 43

 Activity Based Costing Systems
Product cost accuracy & decision making

When batch-related costs are allocated to batches/jobs based on a volume-

based measure such as units produced, large-volume batches will bear a
higher fraction of these costs than low-volume batches. This is not correct.
The cost related to installing a new batch is rather constant, regardless of
the size of the batch.

Due to the use of volume-based cost allocation bases, traditional absorption

costing can overcost the high-volume (less complex) products and undercost
the low-volume (more complex) products.

This problem is called «cross-subsidizing»: products that are less complex

to produce/sell (e.g., standard products that are produced in large quantities)
subsidize products that are more complex to produce/sell (e.g., customized
products that are produced in small quantities).

© Prof. André Hoppe Management Accounting 44

 Activity Based Costing Systems
Cost hierarchy

Examples of expenses
plant management & general administr. staff
Facility-level activities
building and grounds (property taxes)
incurred to support the organization
general facilities (heating and lighting)
Product-level activities Process design for the specific product
enabling the production/sale of Product enhancements (engineering changes)
product types. Costs vary with # of product-specific marketing
separate components. Product-specific equipment

Batch-level activities Machine set-up

perfomed for each batch produced. Materials movement
The cost varies with the # of batches, Processing an order
the duration of set ups, … First-item inspection

Unit-level activities Direct labor

performed for each product unit. Cost Direct materials
consumption in proportion to the # of Machine costs
units produced. Costs vary with # of Energy costs
DLH, MH, …

© Prof. André Hoppe Management Accounting 45

 Cost Allocation
Refinement of Costing Systems (Datar & Gupta 1994)
 Refinement of Costing Systems
Implications for practice and decision-making

Well calibrated costing system is crucial for pricing of products and

the determination of margins

Unrealistic prices and margins might lead to a competitive

disadvantage

Cost Management is rated as one of the highest priorities for many

companies

Cost Management is one of the highest topic for consultant

companies

Typical cost cutting (firing employees, reduction in quality) involves

negative spillover effects (e.g., negative publicity, loss in sales)

→ Reduction of on non-value added overhead costs

© Prof. André Hoppe Management Accounting 47

 Refinement of Costing Systems
Error types in costing systems

Receipt goods Set up machine Aut. assembly Packaging

ACTIVITIES = XXX,XXX € = XXX,XXX € = XXX,XXX € = XXX,XXX €

# purchase orders # of set ups # of machine hours # of sales orders

€ X,XXX/p. order € XX,XXX/set up € XXX.XX/MH € X,XXX/s. order

Activity driver

COST OBJECTS Product A Product B Product C

Direct costs

© Prof. André Hoppe Management Accounting 48

 Refinement of Costing Systems
Error types in costing systems

Specification errors
▪ wrong specification of cost drivers (*)
Aggregation errors
▪ high aggregation of cost pools (*)
Errors in measurement in overhead cost pools (*)
▪ wrong resource driver volume assigned to each activity
Measurement errors in units of cost drivers (*)
▪ wrong total driver volume
▪ wrong driver volume assigned to each product

© Prof. André Hoppe Management Accounting 49

 Datar & Gupta (1994)
Benchmarking costing system

DEPT 1 DEPT 2
Setup Machining Setup Machining Total
Pooled costs $ 3,000 $ 8,000 $ 2,000 $ 2,000 $ 15,000
Cost driver Setup hrs. Machine hrs. Setup hrs. Machine hrs.
Cost driver rate $ 100/hr. $ 40/hr. $ 200/hr. $ 10/hr.
Cost driver usage/ 15 115 6 120
unit A
Cost driver usage / 15 85 4 80
unit B
Total driver volume 30 200 10 200
Product costs/unit A $ 1,500 $ 4,600 $ 1,200 $ 1,200 $ 8,500
Product costs/unit B $ 1,500 $ 3,400 $ 800 $ 800 $ 6,500

Assumption: The firm produces one unit of A and one unit of B.

© Prof. André Hoppe Management Accounting 50

 Datar & Gupta (1994)
Product costing – Alternative costing systems: product cost errors?
CS1: aggregation and specification error compared to benchmark CS

CS 1 Setup Process Machining Process

Pooled costs $ 5,000 $ 10,000 $ 15,000
Cost driver # of setups DLH
Cost driver rate $ 200/setup. $ 100/DHL
Cost driver usage/ unit A 10 66
Cost driver usage/ unit B 15 34
Product costs/unit A $ 2,000 $ 6,600 $ 8,600
Product costs/unit B $ 3,000 $ 3,400 $ 6,400

© Prof. André Hoppe Management Accounting 51

 Datar & Gupta (1994)
Product costing – Alternative costing systems: product cost errors?

CS1’: correction of aggregation error compared to CS1

CS1‘ Setup Process Maching Process
Dept 1 Dept 2 Dept 1 Dept 2 Total
Pooled costs $ 3,000 $ 2,000 $ 8,000 $ 2,000 $ 15,000
Cost driver # of setups # of setups DLH DLH
Cost driver rate $150/setup $400/setup $160/DLH $140/DLH
Cost driver usage/ 7 3 32 34
unit A
Cost driver usage / 13 2 18 16
unit B
Product costs/unit A $ 1,050 $ 1,200 $ 5,120 $ 1,360 $ 8,730
Product costs/unit B $ 1,950 $ 800 $ 2,880 $ 640 $ 6,270

© Prof. André Hoppe Management Accounting 52

 Datar & Gupta (1994)
Product costing – Alternative costing systems: product cost errors?

CS2: correction of specification error compared to CS1

CS 2 Setup Process Machining Process

Pooled costs $ 5,000 $ 10,000 $ 15,000
Cost driver # of setups MH
Cost driver rate $ 200/setup. $ 25/MH
Cost driver usage/ unit A 10 235
Cost driver usage/ unit B 15 165
Product costs/unit A $ 2,000 $ 5,875 $ 7,875
Product costs/unit B $ 3,000 $ 4,125 $ 7,125

© Prof. André Hoppe Management Accounting 53

 Datar & Gupta (1994)
Product costing – Alternative costing systems: product cost errors?

CS3: correction of aggregation error compared to CS2

CS 3 Setup Process Machining Process

Pooled costs $ 5,000 $ 8,000 $ 2,000 $ 15,000
Cost driver # of setups MH MH
Cost driver rate $ 200/setup. 40 10
Cost driver usage/ unit A 10 115 120
Cost driver usage/ unit B 15 85 80
Product costs/unit A $ 2,000 $ 4,600 $ 1,200 $ 7,800
Product costs/unit B $ 3,000 $ 3,400 $ 800 $ 7,200

© Prof. André Hoppe Management Accounting 54

 Datar & Gupta (1994)
Product costing – Alternative costing systems: What did we learn?

▪ Incremental “improvements” in the specification of cost drivers

and in the disaggregation of cost pools does NOT ALWAYS lead
to more accurate product costs. Incremental improvements in
cost systems are often the norm rather than the exception.

▪ There is a non-trivial probability of cross-cancellation of

specification and aggregation errors. Partial refinements in
costing systems can go together with a loss of cross-
cancellation, resulting in less accurate product costs.

▪ This situation primarily occurs when there are negative

covariations in products’ resource usages across processes,
i.e., when products that are overcosted at one cost pool are
undercosted at other cost pools and vice versa.

© Prof. André Hoppe Management Accounting 55

 Datar & Gupta (1994)
Measurement error in overhead costs

CS 1* Setup Process Machining Process

Pooled costs $ 3,800 $ 11,200 $ 15,000
Cost driver # of setups DLH
Cost driver rate $ 152/setup $ 112/DLH
Product costs/unit A $ 1,520 $ 7,392 $ 8,912
Product costs/unit B $ 2,280 $ 3,808 $ 6,088

© Prof. André Hoppe Management Accounting 56

 Datar & Gupta (1994)
Link specification, aggregation & measurement errors

▪ It is possible that firms measure overhead fairly correctly for

aggregated cost pools, but that significant errors exist at
disaggregated cost pools.

→ Disaggregation can cause increased measurement error

▪ In case of measurement error, the likelihood of product cost

errors increases with increasing diversity in cost drivers

→ Measurement error can diminish any benefits from better

specification and greater disaggregation

© Prof. André Hoppe Management Accounting 57

 Datar & Gupta (1994)
Product costing: Measurement error in units of cost driver

CS 2 Setup Process Machining Process

Pooled costs $ 5,000 $ 10,000 $ 15,000
Cost driver # of setups MH
Cost driver rate $ 200/setup. $ 25/MH
Cost driver usage/ unit A 10 220
Cost driver usage/ unit B 15 180
Product cost/unit A $ 2,000 $ 5,500 $ 7,500
Product cost/unit B $ 3,000 $ 4,500 $ 7,500

© Prof. André Hoppe Management Accounting 58

 Datar & Gupta (1994)
Product costing: Measurement error in units of cost driver

Refined costing systems with disaggregated cost pools and

diverse well-specified cost drivers can give rise to

▪ More potential error in the measurement of cost driver

volumes

▪ More potential error in the measurement of cost driver usage

by individual products

© Prof. André Hoppe Management Accounting 59

 Datar & Gupta (1994)
Product costing: Conclusion

▪ Trade off between the benefits of greater disaggregation

and better specification with the costs of increased
measurement errors in both overhead cost pools and units
of cost drivers.

▪ Although more refined costing systems often reduce

specification and aggregation errors in product costs, they
may not always do so if the individual specification and
aggregation errors in product costs of the more aggregate
costing system offset each other.

© Prof. André Hoppe Management Accounting 60

 Refinement of Costing Systems
Cost Benefit Tradeoff

LESS

© Prof. André Hoppe Management Accounting 61

 Cost Allocation
Over- and Underabsorption
 Over- and Underabsorption
Example 1

Yankee Candle produces a unique Christmas candle. The firm uses direct labor
cost to allocate manufacturing overhead. On November 1, total budgeted direct
labor cost for November is 6,000 EUR, the budgeted manufacturing overhead is
12,000 EUR.

On November 30, actual direct labor costs and actual manufacturing overhead
are known. Consider the following two scenarios:
Actual direct labor cost Actual manufacturing overhead
SCENARIO 1 5,500 € 12,000 €
SCENARIO 2 7,500 € 14,000 €

Determine the under- or over-absorption of manufacturing overhead for each

scenario.

© Prof. André Hoppe Management Accounting 63

 Over- and Underabsorption
Example 1 - Solution
1. Determine the budgeted overhead rate
budgeted manufacturing overhead
=
budgeted total direct labor costs

12,000
=
6,000

=200% of direct labor costs

2. Determine allocated manufacturing overhead and compare with actual

manufacturing overhead
Amount of under-
Actual direct Allocated Actual
or over-
labor cost Overhead overhead
absorption
(1) (2) = 200% of (1) (3)
(4) = (3) – (2)
SCENARIO 1 5,500 11,000 12,000 1,000 under-
absorption
SCENARIO 2 7,500 15,000 14,000 1,000 over-
absorption

© Prof. André Hoppe Management Accounting 64

 Over- and Underabsorption
How to treat over- and underabsorption

Three ways of disposing of under/overabsorped overhead:

1. IFRS: Write it off to the CoGS account

2. Allocate (prorate) it to WIP, FG, and CoGS accounts based on the absorbed
amounts of overhead in these categories
3. Recalculate the costs of each job using the actual end-of-year overhead rate
Here's the logic:
If you write off over-absorbed overhead to CoGS (Alt. 1), you reduce CoGS, which increases profit ->
higher taxable income.
If you prorate it (Alt. 2), a portion of that over-absorbed overhead is left in inventory (WIP or FG), so less
SUBJECT TO MANIPULATION! is deducted from CoGS now, and more costs stay on the balance sheet ==> less profit this period -->
lower taxes now.

1. You have a large over-absorbed overhead, and you want to minimize

taxes? What would you choose. Alt.1. or 2.?

2. Window dressing: see Conner Coffees (next slide)

→ Changes in inventory valuation, methods of disposal = of interest to auditors, tax

authorities

© Prof. André Hoppe Management Accounting 65

 Over- and Underabsorption
Example 2

CONNER COFFEES has sales of $ 8 million and profits before taxes of $ 625,000. The
firm has a loan outstanding at its local bank for working capital purposes.

As the loan officer reviewing this loan application, you are charged with making a
recommendation as to whether the $ 608,000 loan should be renewed for another
year. In the annual accounts you find following footnote:

Under-absorbed overhead of $ 462,000 was prorated to inventories (2/3) and cost of

goods sold (1/3).

Does the decision on how to allocate costs raise concerns about the firm’s ability to
repay debt?

© Prof. André Hoppe Management Accounting 66

 Over- and Underabsorption
Example 2 – Solution

Under-absorbed overhead allocated to inventory: 462,000 * 2/3 = 308,000

Under-absorbed overhead allocated to CoGS: 462,000 * 2/3 = 154,000

Actual profit before absorption adjustment: 625,000 + 154,000 = 779,000

Hypothetical profit if everything is allocated to CoGS: 779,000 – 462,000 =

317,000 < loan (608,000)

It does raise concerns about the ability to repay the debt, as the treatment
choice of under-absobed overhead artificially increased the profit of the
company.

Acceptable explanation for this choice: we overproduced, and the amount of

overproduced goods that caused the under-absorption could not be sold but
remain in the inventory

© Prof. André Hoppe Management Accounting 67

Here's the logic:
If you write off over-absorbed overhead to CoGS (Alt. 1), you reduce CoGS, which increases profit higher taxable income.

If you prorate it (Alt. 2), a portion of that over-absorbed overhead is left in inventory (WIP or FG), so less is deducted from CoGS now, and
more costs stay on the balance sheet less profit this period lower taxes now.

Cost Allocation
Strategic Outlook
 Strategic Outlook
Traditional Costing Systems vs. ABC

▪ ABC is not useful in case of standardized mass production.

▪ ABC is useful in case of:

▪ many indirect costs
▪ large product assortment with clear differences in the
products’ pattern of resource consumption
▪ fierce competition

ABC costs <?> ABC revenues

© Prof. André Hoppe Management Accounting 69

 Strategic Outlook
Traditional Costing Systems vs. ABC

Many manufacturing firms have experimented with ABC, but the minority
of those companies implemented it. ABC is costly, difficult to keep up to
date and not always useful. Those firms that implemented it often have
not integrated the ABC cost information into the accounting system
(and do not use it for the valuation of inventory and CoGS).

ABC systems are most often stand-alone systems for supplemental

analyses (strategic analysis of product cost data, capacity analysis),
conducted as special studies. They are often offline and updated once or
twice a year. If companies install ABC it is primarily for (strategic)
decision-making outside the accounting function.

© Prof. André Hoppe Management Accounting 70

 Strategic Outlook
Traditional Costing Systems vs. ABC

„The practice of using a single allocation base – direct labor – found in many
Japanese firms, is another example of the use of a simplistic, relatively
inaccurate (low precision) cost system. Although labor costs are a small
proportion of the total costs of many products, labor often is an important
factor in Japan because its scarcity makes it a constraining resource.
Moreover, greater use of technology frequently improves long-term
competitiveness by increasing quality, speed and flexibility. Hence Japanese
managers allocate overhead costs using a labor-cost base to focus design
engineers‘ attention on identifying opportunities to reduce the products‘ labor
content.“ Merchant and Shields (1993, p. 80)

© Prof. André Hoppe Management Accounting 71

 Strategic Outlook
Traditional Costing Systems vs. ABC

“… even though many Japanese manufacturers are aware that with increased
automation in their plants, direct labor may not have a cause-and-effect
relationship with factory overhead, they continue to use direct labor as the
principal basis to allocate overhead because they are said to believe that using
direct labor for this purpose provides organizational sub-units with an incentive
to use less labor. In other words, the use of direct labor as the major allocation
base in Japanese companies provides a direct stimulus to automate production.”
Bromwich and Bhimani (1989); Yoshikawa et al., (1989);
Wijewardena and Zoysa (1999, p. 59)

© Prof. André Hoppe Management Accounting 72

 NOT EXAM RELEVANT

Cost Allocation
What comes next?
 What Comes Next? NOT EXAM RELEVANT
A time driven component

Time Driven Activity Based Costing

R. S. Kaplan and S. R. Anderson. 2004. Time-Driven Activity-Based Costing.

Harvard Business Review
Cardinaels, E., and E. Labro. 2008. On the determinants of measurement error
in time‐driven costing. The Accounting Review 83 (3): 735-756.

Application fields
Sanac (Aveve)
Lego
Bank of America
Hospitals
.
.
.
.

© Prof. André Hoppe Management Accounting 74

Appendix Activity Based Costing
Example 2 continued
 Appendix
Example: Traditional Costing vs. ABC – Identification of activities

Receipt of goods
▪ placing purchase orders based on the production planning and based on
supplier characteristics
▪ inspection of goods received

Set up time
▪ cleaning the machine, moving new material to the machine, installing the
correct mix of plastics and ink colour before each new batch/serie, inspecting
the first outputs after a set-up

Automatic assembly
▪ automatic assembly, performing safety controls and performing maintenance

Packaging
▪ packaging of every sales order

© Prof. André Hoppe Management Accounting 76

 Appendix
Example: Traditional Costing vs. ABC – Resource Consumption

Receipt of goods
▪ Machine 1: inspect incoming goods
▪ Personnel: operate machine 1 and to check documents
▪ Material: office supplies (invoices reg. supplier A: 10,000 €)

Set up
▪ Machine 2: has to be cleaned and filled with new material
▪ Personnel: perform the set-ups and first-item inspection
▪ Material: cleansing products (invoices reg. supplier B: 30,000 €)

Automatic assembly
▪ Machine 2: perform the automatic assembly
▪ Personnel: operate, monitor, and maintain the assembly line
▪ Material: protective & maintenance devices (invoices reg. supplier C: 50,000 €)

© Prof. André Hoppe Management Accounting 77

 Appendix
Example: Traditional Costing vs. ABC – Resource Consumption

Packaging
▪ Machine 2: pack the sales orders
▪ Personnel: pack the sales orders
▪ Material: cardboard boxes, foil and tape (invoices reg. supplier D: 80,000 €)

© Prof. André Hoppe Management Accounting 78

 Appendix
Example: Traditional Costing vs. ABC

OVERHEAD = € 1,350,000 (resources supplied)

OVERHEAD € 330,000 € 850,000 € 170,000

# indirect labor Mach 1: direct alloc. direct alloc.: invoices

resource driver supplier
hours Mach 2: # MH

ACTIVITIES Receipt goods Set up machine Automatic assembly Packaging

activity driver ……………… ……………… ……………… ………………

COST OBJECTS Product A Product B Product C

Direct costs

© Prof. André Hoppe Management Accounting 79

 Appendix
Example: Traditional Costing vs. ABC

In the table below we neglect the overhead that can be allocated directly

OVERHEAD OR RESOURCES SUPPLIED

Indirect labor: 330,000 €/year Depr.machine 2: 830,000 €/year
Identification of RESOURCE DRIVERS
# of indirect labor hrs (ILH) # of machine 2 hours (MH)
PRACTICAL RESOURCE DRIVER VOLUME
13,200 ILH / year 5,850 MH / year
~=83.5% x (8 fte x 38 ILH/w x 52w/y) ~= 80% x (20 MH/d x 365 d/y)

(FYI: the practical volume of the resource drivers and the % time allocations are provided.
You don’t have the information to derive this information yourself.)

© Prof. André Hoppe Management Accounting 80

 Appendix
Example: Traditional Costing vs. ABC

Time registration, % time allocation to ASSIGN OVERHEAD TO ACTIVITIES

Interview
personnel
Receipt of goods (27.3% x 13,200 ILH) ‘driver consumption’
x (330,000 €/13,200 ILH) ‘driver rate’
= 90,000 €
Set up machine (18.2% x 13,200 ILH) x 25 €/ILH (18% x 5,850 MH) x 830,000 €/
= 60,000 € 5,850 MH
= 150,000 €
Aut. Assembly (36.3% x 13,200 ILH) x 25 €/ILH (70% x 5,850 MH) x 141.88 €/MH
= 120,000 € = € 580,000
Packaging (18.2% x 13,200 ILH) x 25 €/ILH (12% x 5,850 MH) x 141.88 €/MH
= 60,000 € = 100,000 €

(FYI: the practical volume of the resource drivers and the % time allocations are provided.
You don’t have the information to derive this information yourself.)

© Prof. André Hoppe Management Accounting 81

 Appendix
Example: Traditional Costing vs. ABC
Allocation of overhead to activities
▪ using direct allocation
▪ using resource drivers

Indirect labor Depreciation Indirect TOTAL COST

Material ACTIVITIES

Receipt of goods 90,000 € 20,000 €* 10,000 €* 120,000 €

Set up machine 60,000 € 150,000 € 30,000 €* 240,000 €

Automatic
120,000 € 580,000 € 50,000 €* 750,000 €
assembly
Packaging 60,000 € €00,000 € 80,000 €* 240,000 €
* direct allocation

© Prof. André Hoppe Management Accounting 82

 Appendix
Example: Traditional Costing vs. ABC

OVERHEAD = 1,350,000 € (resources supplied)

OVERHEAD
330,000 € 850,000 € 170,000 €

resource driver or # indirect labor 1. direct allocation direct alloc./invoices

direct allocation hours 2. # machine hours supplier

Resource driver 25 €/ILH € 141.88/MH

rate

Receipt goods Set up machine Aut. assembly Packaging

ACTIVITIES = 120,000 € = 240,000 € = 750,000 € = 240,000 €
Activity driver ? ? ? ?

Product A Product B Product C

COST OBJECTS
Direct costs
© Prof. André Hoppe Management Accounting 83
 Appendix
Rate-Based ABC: from activities to cost objects

Total Cost Activity Driver Total driver Activity Driver

Activities Volume Rate

Receipt of goods 120,000 € # purchase orders 60 2,000 €/

purchase order
Set up machine 240,000 € # set ups 12 20,000 €/set up

Automatic 750,000 € # machine hours (MH) 5,850 128.21 €/MH

assembly
Packaging 240,000 € # sales orders 48 5,000 €/
sales order
TOTAL 1,350,000 €
- the total driver volumes can be derived from the standard (i.e., budgeted) cost and operations report
(this report departs from full capacity utilization).
Total # purchase orders = 20 + 15 + 25 = 60
Total # set ups = 2 + 4 + 6 = 12
Total # MH = 0.08 MH/unit x 20,000 units + 0.16 MH/u x 15,000 units +
0.37 MH/u x 5,000 u = 5,850 MH
Total # sales orders = 10 + 18 + 20 = 48

© Prof. André Hoppe Management Accounting 84

 Appendix
Rate-Based ABC: from activities to cost objects

Receipt goods Set up machine Aut. assembly Packaging

ACTIVITIES = 120,000 € = 240,000 € = 750,000 € = 240,000 €

# purchase orders # of set ups # of machine hours # of sales orders

€ 2,000/p. order € 20,000/set up € 128.21/MH € 5,000/s. order

Activity driver

Product A Product B Product C

COST OBJECTS
Direct costs

The costs per purchase order is known. The next step is to track how many purchase orders are consumed by
product A (& B & C). With this information we can calculate the purchase order costs consumed by product A
(& B & C). Idem process for the other activity driver rates.

© Prof. André Hoppe Management Accounting 85

 Appendix
Rate-Based ABC: from activities to cost objects

▪ Allocation of activity costs to the cost objects

▪ Tracing of direct costs to the cost objects

Product A Product B Product C

Cost ‘receipt goods’/unit (20 x 2,000 €) / (15 x 2,000 €) / (25 x 2,000 €) /
20,000 = 2 € 15,000 = 2 5,000 = 10 €

Costs ‘set up’/unit (2 x 20,000 €) / (4 x 20,000 €) / (6 x 20,000 €) /

20,000 = 2 € 15,000= 5.3 € 5,000= 24 €

Costs ‘autom. (1,600 x 128.21 €) (2,400 x 128.21 €) (1,850 x 128.21) /

assembly’/unit / 20,000= 0.26 € / 15,000= 20.5 € 5,000= € 47.4 €

Costs ‘packaging’/unit (10 x 5,000 €) / (18 x 5,000 €) / (20 x 5,000 €) /

20,000 = € 2.5 € 15,000 = 6 € 5,000= € 20 €

Costs of DM/unit 25 € 23 € 20 €
Costs of DL/unit 70 € 105 € 35 €
TOTAL COSTS/unit 111.76 € 161.5 € 156.4 €

© Prof. André Hoppe Management Accounting 86

 Appendix
Rate-Based ABC: from activities to cost objects

Product A Product B Product C

Costs/unit - traditional costing (DLH) 125 € 173 € 70 €
Costs/unit - ABC 111.76 € 161.5 € 156.4 €

Traditional costing: Product A (overcosted) subsidizes Product C (undercosted)

This problem, which is often observed under traditional costing, is called

cross-subsidizing: less complex products subsidize products that are more
complex to produce/sell

© Prof. André Hoppe Management Accounting 87

 Appendix
Example: Traditional Costing

A firm produces three products. The firm’s process consists of purchasing

materials with suppliers, processing the materials into end products A, B
and C, and packing the sales orders. The table below shows budgeted
costs and operations reports, assuming full capacity utilization:

Product A Product B Product C

Units sold 20,000 15,000 5,000
Cost of DM (€) / unit 25 23 20
Cost of DL (€) / unit 70 105 35
# of DL hours / unit 2 3 1
# of machine hours / unit 0.08 0.16 0.37
# of production batches / product type 2 4 6
# of sales orders / product type 10 18 20
# of purchase orders / product type 20 15 25

© Prof. André Hoppe Management Accounting 88

 Appendix
Rate-Based ABC: from activities to cost objects

Product A Product B Product C

Costs/unit - traditional costing (DLH) 125 € 173 € 70 €
Costs/unit - traditional costing (DMH) 113.46 € 164.92 € 140.38 €
Costs/unit - ABC 111.76 € 161.5 € 156.4 €

© Prof. André Hoppe Management Accounting 89