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Chapter 10: Fundamentals of Cost Management

In Chapters 6 through 9 we emphasized the design of cost accounting systems and the
information provided to managers for decision making. In this Chapter we explore the use of the
information for managing costs (Lanen, 2008).

Learning Objectives:

Upon completion of this chapter you should be able to:

1. Explain the concept of activity-based cost management.

2. Use the hierarchy of costs to manage costs.

3. Describe how the actions of customers and suppliers affect a firm’s costs.

4. Use activity-based costing methods to assess customer and supplier costs.

5. Distinguish between resources used and resources supplied.

6. Design cost management systems to assign capacity costs.

7. Identify how activities that influence quality affect costs and profitability.

8. Compare the costs of quality control to the costs of failing to control quality.

1. Explain the concept of activity-based cost management.

Activity-Based Cost Management

One distinguishing characteristic of activity based costing is that it requires information about
the activities needed to produce the product or service the organization sells. These activities
cause the firm to incur costs and the firm must manage these costs to remain profitable. In
chapter 9, we discussed the use of activity based costing to compute the costs of products and
services. We now consider the use of these methods to manage the activities to control our costs.
This approach is called activity based cost management. Activity based cost management does
not focus on the detailed calculation of product costs using activity based costing but explores
managers use of activity based costing methods to identify ways to improve operations (Lanen,

Activity-based cost management uses activity analysis in decision making. In Chapter 9 you saw
that activity-based costing focuses on activities in allocating overhead costs to products.
Activity-based management, on the other hand, focuses on managing activities to reduce costs.

Activity based management can be used to identify and eliminated activities that add costs but
not value to the product. Non – value added costs are costs of activities that could be eliminated
without reducing product quality, performing or value (Lanen, 2008).

LO2 Use the hierarchy of costs to manage costs.

Some costs can be associated with units of goods or services, others can not. Consequently,
allocating all costs (such as building leases) to units is misleading if some costs don’t vary with
volume of units. As a result management cannot effectively manage those costs be focusing on
the volume of units (Lanen, 2008).

Management can establish a hierarchy of costs, as we described in chapter 9. Strictly variable

costs such as energy costs to run machines are affected by the volume of units produced. Using a
hierarchy, managers analyze only the volume related costs if they make decisions that affect
units, but not batches, products, customers or capacity. If managers make decisions that affect
capacity, however, costs in all levels of the hierarchy -- volume, batches, product and facility –
will probably be affected and activities in all four categories should be analyzed (Lanen, 2008).

Cost Hierarchy: Classification of cost drivers into general levels of activity; volume, batch,
product and so on. Please find Exhibit 9.12.

Hierarchy Level Cost Example Cost Driver Examples

Supplies Direct labor costs

Volume related Lubricating oil Machine-hours

Machine repair Number of units

Set-up costs Set-up hours

Batch related Material handling Production runs

Shipping costs Number of shipments

Compliance costs

Product related Number of products

Design and specification costs

General plant costs Direct costs

Facility related Plant administration cost Value added


LO3 Describe how the actions of customers and suppliers affect a firm’s costs.

For some firms, however, decisions are not about the products or services but about customers
(Lanen, 2008). For example, think about the last time you stood in line to purchase a ticket,
check in for a flight or make transactions in a bank. Many people ahead of you are purchasing
the same service (a ticket, a flight or deposit) but some take longer (sometimes much longer) to
complete the transaction. The additional time those customers take adds cost to the company.

Customers and suppliers can impose costs on firms be requiring additional personnel, rework or
support activities. Activity based costing can help identify these costs.

LO4 Use activity-based costing methods to assess customer and supplier costs.

ABC and the Cost: Customers and Suppliers

Use the same four-step ABC product costing process to assess customers and suppliers (Lanen,

1. Identify the activities that consume resources and assign costs to them.

2. Identify the cost driver(s) associated with each activity.

3. Compute a cost rate per cost driver unit or transaction.

4. Allocate costs to products by multiplying the cost driver rate by the volume of cost driver
units consumed by the product.

Example: Cost of Customers

As an example, let’s look at Red’s Lumber. Red determines that he is losing customers like Jill
and retaining customers like Jack. Red decides to investigate his delivery service to ascertain if
his pricing policies were having a negative impact on customer retention. Currently, Red uses
sales dollars to determine the charge to customers for delivery. All customers pay a 16%
delivery charge. Red decides to apply activity-based costing to the delivery service. Let’s
follow the four-step procedure described in Chapter 9 to the delivery service. Please look
Exhibit 10.2.

Red’s Lumber

Exhibit 10.2 Operating Data


Jack Jill Firm

Sales $ 50,000 $ 50,000 $ 5,000,000

Cost of goods (@60%) 30,000 30,000 3,000,000

Gross margin 20,000 20,000 2,000,000

Order/Delivery Charges (@16%) 8,000 8,000 800,000

$ 50,000 (@16%

Delivery costs ? ? (800,000)

Other operating costs (1,435,000)

Operating profit $ 565,000

Example: Step 1: Identify the activities that consume resources and assign costs to them.

First Red identifies the activities that consume resources. Excluding administrative activity, Red
identifies three activities: entering the order into the system, gathering the individual items from
the yard and loading them onto the truck, and delivering the order. Please look Exhibit 10.3.

Entering Order Loading Order Delivering Order

Example: Step 2: Identify the cost driver(s) associated with each activity.

Activity Cost Driver

Entering order Number of orders entered

Loading order Number of items loaded

Delivering order Number of deliveries made

Delivery administration Order value

Example: Step 3: Compute a cost rate per cost driver unit or transaction. Please look
Exhibit 10.4

Activity Activity cost Cost Driver volume Cost Driver rate

Entering order $100,000 10,000 orders $10 per order

Loading order $150,000 75,000 items $2 per item


Delivering order $300,000 12,500 deliveries $24 per delivery

Delivery administration $250,000 $ 5,000,000 5% of value

Example: Step 4: Allocate costs to products by multiplying the cost driver rate by the
volume of cost driver units consumed by the product. Please look Exhibit 10.5

Cost Driver Jack Jill

Number of orders entered 150 50

Number of items loaded 750 750

Number of deliveries made 200 50

Order value $ 50,000 $ 50,000

Please look Exhibit 10.7

Activity Jack Jill

Entering order (@$10 per order) $1,500 $500

Loading order (@$2 per item) 1,500 1,500

Delivering order (@$24 per delivery) 4,800 1,200

Delivery administration (@5%) 2 ,500 2,500

Total delivery costs $10,300 $5700

Jack, the type of customer who continues to do business with Red is costing the company. Red is
retaining the higher cost customers and loosing the lower cost customers like Jill. Red can use
this information to manage delivery costs. The activity-based costing analysis shows the order
pattern, not the order value; drive most of the delivery costs.

LO5 Distinguish between resources used and resources supplied.

In some situations, costs go up and down proportionately with the cost driver. Materials, energy,
and piecework labor are excellent examples in a manufacturing firm (Lanen, 2008).

Using and Supplying Resources


Resources used: Cost driver rate multiplied by the cost driver volume (Lanen, 2008).

Resources supplied: Expenditures or the amounts spent on a specific activity (Lanen, 2008).

Unused capacity: Difference between resources used and resources supplied (Lanen, 2008).

Example: Resources Used and Supplied

Traditional Income Statement,

A traditional income statement reports costs as line items. Now that we have identified unused
resource capacity, let’s report this information in a way that supports cost management. We do
this by combining the concepts of the cost hierarchy and unused resource capacity. Please look
exhibit 10.10

Sales $ 5,000,000

Cost of goods (@ 60 %) $ 3,000,000

Gross margin $ 2,000,000

Delivery revenue 800,000

Delivery costs

Depreciation and equipment leases $420,000

Energy 100,000

Salaries and wages 250,000

Other Delivery costs 30,000

Total Delivery costs ( 800,000)

Less other operating costs (1,435,000 )

Operating profit $565,000

Example: Resources Used and Supplied,

Activity-Based Income Statement

Here is a more informative report for managing capacity costs. It first categorizes costs
into the cost hierarchies. Managers can look at the amount of costs in each hierarchy and
find ways to manage those resources effectively. The report also shows managers how
much of the resources for each type of costs are unused. Look at resources for loading.

Red spent $150,000 and supplied resources for loading 75,000 items. However, only 67,500
items ($135,000 divided by $2 per item) were loaded. Red’s had unused capacity of 7,500
items or 10% of the capacity supplied. Please look exhibit 10.11.

Temporary workers cost driver rate of per hour Load items Required

Five workers $2 per item $10 40 eight hour


Capacity to load Resources supplied Resources used Resources used

200 items per day $400 = ( 5 *$10*8) 160 only items $320=(160 *$2 )
were loaded

Unused capacity $80 (40 items x $2 per item)

Resources used Unused Resource Resource

Capacity supplied

Sales $5,000,0

Cost of goods (@60%) 3,000,0


Gross margin 2,000,0


Delivery revenue 800,0


Delivery costs

Volume related

Loading items $135,000 $15,000 $150,000

Batch related

Entering orders $65,000 $35,000 $100,000

Delivery orders $200,000 $100,000 $300,000

Total Batch related $265,000 $135,000 $400,000


Facility related $175,000 $75,000 $250,000

Total Delivery costs $575,000 $225,000 $800,000 ( 800,000)

Other operating costs (1,435,00


Operating profit $565,000

LO6 Design cost management systems to assign capacity costs.

Computing the Cost of Unused Capacity

In order to compute the cost of unused capacity, you must first define capacity. What capacity
level do you want to use as the allocation base? There are at least four possibilities for the bas
(Lanen, 2008).

Actual activity Theoretical capacity Practical capacity Normal activity

Actual activity: Actual activity as the allocation base results in fluctuations in cost from one
period to the next as activity changes. Or we can say actual volume for the period .

Theoretical capacity: The other extreme is theoretical capacity which is what could be produced
under ideal conditions without allowing for normal maintenance and expected down time. Or we
can say the highest volume is theoretical capacity, which is what could be produced or served
under ideal conditions without allowing for normal maintenance and expected down time.

Practical capacity: Practical capacity is the volume that could be produced allowing for
expected breaks and normal maintenance and down time.

Normal activity: normal activity is the long-run expected volume of production. When using
normal activity the cost of used capacity is charged to the product and the cost of unused
capacity is charged as a period expense. This allows the manager to track the unused capacity
cost and take action to reduce the capacity supplied if necessary.

Exhibit 10.13 for a comparison of the fixed operating cost per unit under each measure of

Capacity Fixed operating costs

Measure ( Passengers ) Rates per passengers

Theoretical capacity 4,000 $ 100


Practical capacity 3,200 $ 125

Normal activity 2,500 $ 160

Actual activity 1,600 $ 250

LO7 Describe how activities that influence quality affect costs and profitability.

Managing the Cost of Quality

Way back in Chapter 1 we defined total quality management as a management method by which
organizations seek to excel on all dimensions, with the customer ultimately defining quality.
Unless cost accounting systems are designed to support TQM, companies are likely to find TQM
has little economic benefit. Managers are ultimately evaluated on the cost of their activities and
costs associated with quality must be incorporated in a way that allows managers to make
decisions that consider the role of quality and other product characteristics (Lanen, 2008).

Effective implementation of TQM requires five changes to traditional managerial accounting


1. The information should include problem solving data such as that from quality control
charts, not just financial reports. Financial reports indicate a decline in revenue but not its

2. The workers themselves should collect the information and use it to get feedback and
solve problems. Line employees are in the best position to make adjustments to the
process to prevent quality problems.

3. The information should be available quickly (for example, daily) so workers can get
feedback quickly.

4. Information should be more detailed than that found in traditional managerial accounting

5. Rewards should be based on quality and customer satisfaction measures of performance

to obtain quality.

When designing a cost management system to support quality programs, you need to define
quality. Two views of the meaning of quality are (Lanen, 2008).

1. The external view

2. The internal view.

External View of Quality: The Customer

The external view of quality is quality as defined by the customer. Customer expectations refer
to what customers expect from a product’s tangible features and intangible features. The
external view is everything about the product that the customer values.

Tangible : Performance Taste Functionality

Intangible : Customer service Delivery time

Internal View of Quality: Conformance to specifications

The internal view of quality is conformance to specifications. Does the product meet customer
tangible and intangible expectations?

Conformance to specifications: the degree to which a product or service performs as designed

(or specifies). Therefore, there must be a link between the specifications developed for the
product and the expectations customers have for the product (Lanen, 2008).

LO8 Compare the costs of quality control to the costs of failing to control quality.

What is the cost of quality?

Cost management system that is designated to help managers make decisions about quality is so
called cost quality system (Lanen, 2008).

A cost of quality system classifies a firm’s quality-related cost into categories to improve
managers’ ability to manage the costs. Costs are classified as (Lanen, 2008).

1. Conformance costs

2. Nonconformance costs.

Conformance costs

Conformance costs, ensuring that quality conforms to the firm’s requirements involves two costs,

1. Prevention costs

2. Appraisal costs

Prevention costs

Prevention costs incurred to prevent defects in products or service being produced. The costs and
the associated activities including the following:-

Material Inspection Process Control Quality Training Machine Inspection Product Design

Appraisal costs (Detection costs)

Appraisal costs incurred to detect products that do not conform to specifications are considered
conformance costs (Lanen, 2008). Appraisal costs include these:

End of Process Sampling Field Testing

Inspecting a sample of finished goods to ensure quality Testing products in use at customer sites

Nonconformance costs

Products failing to conform to specifications are nonconformance costs. The two costs of failing
to control quality are internal failure costs and external failure costs (Lanen, 2008).

Internal Failure: Costs incurred when nonconforming products and services are detected before
being delivered to customers. They include these:

Scrap Rework Re-inspecting / Re-testing

Materials wasted in the Correcting product defects Quality control testing after
production process before the product is sold rework is performed

External Failure: Costs incurred when nonconforming products and services are detected after
being delivered to customers. They include these:

Warranty Repairs Product Liability Marketing Costs Lost Sales

Repairing defective Accepting Improving the company’s Customers will go to

products company liability image imperfect from competitors
resulting from poor product quality
product failure

Cost of Quality Report

Costs of quality are often expressed as a percentage of sales. The cost of quality report for Red’s
Lumber indicates the cost of quality was 3.07% of sales. Management can use this information
to see how they can reduce the cost of quality. The cost of quality report can be a viable decision
making aid for managers, but it is only effective if all quality costs are measured and reported.

Red’s Lumber: Cost of Quality Report: For the Year Ended February 28

Cost of quality Percent of sales

Sales = $5,000,000
Prevention costs

Quality Training $35,600

Machine Inspection 22000 57,600 1.15%

Appraisal costs

Inspect copies 30,000 0.60%

Internal Failure costs

Paper scrap 36,000 0.72%

External Failure costs

Customer complaints 30,000 0.60%

Total cost of quality $153,600 3.07%




P10-39 – A& B, P10-40 – A& B and P10-43 – A& B


Lanen , N.W. , Anderson ,W.Sh. & Maher ,W.M. ( 2008). Fundamentals of cost accounting.

New York : McGraw-Hill Irwin.