Introduction to Cost Flows

&
Activity-Based Costing
Systems

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 Period and Inventoriable Costs
Period Costs:
- All costs incurred to generate revenue in a specific time period
except costs of goods sold
- Little evidence of future benefit, therefore expensed in the period
incurred
Inventoriable Costs: the accumulation of all costs to manufacture or
purchase inventory for resale
Production Costs: specific costs to purchase and transform raw
materials into finished product using labour and equipment
Consist of Cost of goods sold (COGS) and Cost of goods manufactured
(COGM)
COGS: costs incurred to manufacture products that have been sold
COGM: costs of goods transferred to inventory, whether sold or not
Production costs are inventoried on the balance sheet and transferred
to COGS only when the product is sold

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 Direct and Indirect Costs
Direct Cost: Can be traced to a cost object
The existence of the object causes the direct cost
Direct materials (DM) costs are inventoriable costs
incurred to acquire production materials
Direct labour (DL) costs are inventoriable costs for
production labour; part of COGM/COGS
Indirect Cost: cannot be traced to a cost object
Manufacturing overhead: all indirect inventoriable
costs
Indirect costs are allocated (or assigned) to cost
object

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 Direct & Indirect Cost Examples
Direct cost examples:
DM: Raw materials, parts, freight-in, customs
duties
DL: Assembly line workers
Indirect cost examples:
Indirect manufacturing labour: Supervisor,
overtime, idle time
Indirect manufacturing overhead:
maintenance supplies, lubricants
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 Factors Affecting Direct/Indirect
Cost Classification
Materiality of the cost to total cost per unit
of output
Availability of information-gathering
technology

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Costs in a Merchandising Company

Balance Sheet Income Statement

Revenue

Merchandise Merchandise
Cost of Goods Sold
Purchases Inventory

Gross Margin
Inventoriable
(Product) Period Marketing and
Costs Costs Administrative Costs

Operating Income

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 Costs in a
Manufacturing Company

Balance Sheet
Direct Income Statement
Materials
Material
Inventory
Purchases
Revenue
Direct Work in Finished
Labour Process Goods Cost of Goods Sold
Inventory Inventory
Indirect
Manufacturing Gross Margin
Costs
Period Marketing and
Inventoriable Costs Administrative Costs
(Product)
Costs
Operating Income

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 Example 1:
Consider the following data for a corporation regarding its operations for
2013 (assume no beginning or ending inventories). Breakeven point (in
sales dollars) is $120,000. Only period costs are selling and administrative
expenses.

Sales $160,000
Fixed factory overhead $34,000
Gross margin $48,000
Total Contribution margin $72,000

1. Compute Fixed selling and administrative expenses for 2013:

2. Compute net income for 2013:

3. Compute variable selling and administrative expenses for 2013:

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 Cost Drivers and
Cost Management
A Cost driver causes a cost
If quantity of cost driver changes, the cost will
change
Production costs are driven by the number of
products produced, labour costs, number of setups
required
Cost management is actions undertaken to
control and reduce costs while satisfying
customers
The efficient management of cost-drivers only in
value-added activities
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 Different Costs for Different
Purposes
Example: A product cost is the sum of costs
assigned to a product for a specific purpose,
such as:
To identify and manage cost-control problems
For product pricing and product emphasis
Require detailed information to ensure appropriate pricing
For contracting with government agencies
Ensure nonallowable costs are excluded (e.g. marketing)
Must remain within terms of contracts
For financial Statements
Under GAAP, only inventoriable manufacturing costs are
included in COGS
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Example 2:
In July 2012, Novus Entertainment Inc. accused Shaw
Communications Inc. of conducting predatory pricing practices,
only in areas in which both companies provided HDTV, Internet,
and home phone services. For example, Shaw charged $9.95 per
month to customers who rented two HD boxes/PVRs providing
over 200 digital channels. This pricing was offered only in
Vancouver and Burnaby, including high-rise condominiums where
many of Novuss longstanding customers live.
Suppose you have been retained by Novuss legal team as an
expert in cost allocation, what costs would you argue should be
included in Shaws costs of providing HDTV, Internet, and home
phone services to the disputed markets in Vancouver and
Burnaby?

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 Traditional Costing System

Traces Direct Material costs to the Cost

Object
Traces Direct Labour Costs to the Cost
Object
"Pools" all other Manufacturing Costs into
"Indirect Costs" and Allocates them to the
Cost Object using some "Base (normally
a single allocation base).
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 Cost Assignment Errors or Problems:
1. "Peanut-Butter" Costing:
Costs are "spread" uniformly over all of the units or jobs.
An example would be where the entire class goes out for
dinner and the bill is split on a per person basis.
2. Under- Or Over-costing:
Costing causes some products to be over-costed and
others to be under-costed.
Effects on decision-making such as Setting selling
prices, Add/drop a product line, Etc.
3. Product Cross-Subsidization:
Customers' reactions: Purchase the product that is
subsidized and ignore the others.

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From Traditional Costing to Activity-
Based Costing (ABC)
Traditional overhead allocation:
OH Allocation Rate = Budgeted overhead cost pool
Budgeted amount of cost driver
Allocates total overhead using one allocation
rate: the peanut butter approach
ABC is generally perceived to produce
superior costing figures due to the use of
multiple cost drivers across multiple levels

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 Activity-based costing (ABC costing)
A form of refining a costing system

Purpose: Underlying structure of operations looked at in greater detail

for more understanding of how resources are used and, hence,
more accurate costing.

Results of using ABC costing:

1. More indirect cost pools than the traditional approach
2. More cost drivers used as cost allocation bases that are not
output unit-level cost drivers
3. More frequent use of non-financial variables as cost allocation
bases

Features
Activities associated with indirect costs examined: key or major
activities Identified.
[activity an event, task, or unit of work with a specified purpose]

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 Cost Hierarchy
The separation of one indirect cost pool into
many cost pools according to the level at
which activities contribute to producing
output:
Unit-level (output-level)
Batch-level
Product-sustaining-level
Facility-sustaining-level

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 Cost Hierarchies
Output unit-level costs
Costs relating to individual units of output, such as
indirect material costs
Batch-level costs
Costs relating to batches of output, such as set-up
charges
Product-sustaining costs
Costs relating to the support of a particular product,
such as product design costs
Facility-sustaining costs
Costs relating to the organization as a whole

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 Example 3:
Stanley Corp. manufactures two models of its roasting pans, a standard
and a deluxe model. Three activities have been identified as cost
drivers. The related costs pools and the cost driver usage are given
below:
Number Number of Number
Product of Setups Components of Orders
------- ------ ---------- ------
Standard 12 8 440
Deluxe 16 14 750

Costs per pool $30,000 $76,000 $14,000

If activity-based costing is used, then the total amount of overhead

allocated to the deluxe model would be:

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A road contractor has been using miles of road constructed as a cost
driver. Based on last years costs, he estimated that he can build a road
for $ 3 million per mile. The county has recently asked him for an
estimate to build 20 miles of road.

Before making his bid based on his $3 million per mile estimate, he goes
to his accountant for advice. The accountant has analyzed last years
cost much differently. She has divided last years cost into different
activities, chosen a cost driver, and measured its usage last year. Her
estimates follow:
Activity Costs($000,000) Cost Driver Cost Driver Usage

Surveying 10 Hours 200,000 hours

Excavating 200 Tons of earth moved 2,000,000 tons
Bridges 120 Number of bridges 60 bridges
Grading 80 Number of miles 200 miles
Gravel 30 Tons of gravel 750,000 tons
Paving 160 Number of miles 200 miles

The costs from the last year appear to be good estimates of costs in the
coming year. The 20 miles of county road up for bid will require 30,000
hours of surveying, 300,000 tons of earth moved, 10 bridges, and 80,000
tons of gravel.

Allowing for a 10% profit what should be the road contractors bid using
the $3 million per mile cost driver? What is wrong with using miles as a
cost driver? Allowing for a 10% profit, what should be the road
contractors bid using the multiple cost drivers suggested by the
accountant? 19
 Tell-Tale Signs of Need to
Consider ABC
1. Significant amounts of costs are allocated
using one or two cost pools
2. All or most of the costs are identified as
output unit-level costs
3. Products make diverse demands on
resources
4. Main products show little profit while
secondary products show large profits
5. Complex products appear to be profitable
while simple products appear to be losing
money
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 Benefits of ABC Systems
Promotes the use of activity-based
management (ABM) within the organization
ABM focuses managements attention on the
activities that cause costs to be incurred
Results in
performing activities more efficiently
eliminating activities that do not add value
improving product design
Eventually leads to improved operations and
processes, satisfied customers, and increased
profits
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 Comparing Alternative Costing
Systems
ABC System requires a large amount of
information
Financial and non-financial
ABC generally results in:
Better product and pricing decisions
Reduced costs
Performing activities more efficiently
Eliminating activities that do not add value
Improving product design
Satisfying and retaining customers
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 Using ABC to Improve Profits
More accurate information provides a
sounder basis for both operating and
strategic decisions:
Product and pricing decisions
Cost reduction decisions
Process decisions
Design decisions
Planning and managing activities

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