Chapter 10 – Fundamentals of Cost Management
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Chapter 10
Fundamentals of Cost Management
Learning Objectives
1. Describe how activity-based cost management can be used to improve operations.
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. Describe how activities that influence quality affect costs and profitability.
8. Compare the costs of quality control to the costs of failing to control quality.
Chapter Outline
I. USING ACTIVITY-BASED COST MANAGEMENT TO ADD VALUE
A. Using activity-based cost information to improve processes
B. Using cost hierarchies
II. MANAGING THE COST OF CUSTOMERS AND SUPPLIERS
A. Using activity-based costing to determine the cost of customers and suppliers
B. Determining why the cost of customers matter
C. Using cost of customer information to manage costs
III. DETERMINING THE COST OF SUPPLIERS
♦ Capturing the cost savings
IV. MANAGING THE COST OF CAPACITY
A. Using and supplying resources
B. Computing the cost of unused capacity
C. Assigning the cost of unused capacity
D. Seasonal demand and the cost of unused capacity
V. MANAGING THE COST OF QUALITY
A. How can we limit conflict between traditional managerial accounting systems and
total quality management?
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B. What is quality?
1. External view: Customer expectations
2. Internal view: Conformance to specifications
C. What is the cost of quality?
1. Conformance costs
2. Nonconformance costs
D. Trade-offs, quality control and failure costs
VI. SUMMARY
Key Concepts
LO 10-1 Describe how activity-based cost management can be used to
improve operations.
♦ Activity-based costing 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.
• Activity–based cost management uses activity analysis to help management make
decisions and manage costs.
• Activity-based costing focuses on activities in allocating overhead costs to products.
Activity-based cost management focuses on managing activities to improve operations
and reduce costs.
• In two key ways activity-based costing adds value to companies:
(1) Better information about product costs helps managers make decisions about pricing
and whether to keep or drop products.
(2) Better information about the cost of activities and processes helps managers gain
useful information previously buried in the accounting systems.
• Activity-based costing uses more data than conventional costing and provides more
informed estimates of product costs.
• Implementing activity-based costing may add value to the organizations in varying
degrees. Companies that have complex production processes producing many different
products and that operate in highly competitive markets probably will benefit the most.
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• Implementing activity-based costing is costly. Implementation costs include the salaries
of accountants and other employees who develop and implement the system, additional
record-keeping costs, software costs, and, possibly, consulting costs.
• Implementing activity-based costing tends to shake up the organization by changing the
accounting rules. It can be painful for many companies.
• An activity is any discrete task that an organization undertakes to make or deliver a
product or service.
• Activity analysis (or process reengineering) is an approach to operations control and
involves four steps:
(1) Identify the process objectives defined by what the customer wants or expects from
the process.
(2) Chart, from start to finish, the activities used to complete the product or service.
(3) Classify all activities as value-added or nonvalue-added.
(4) Continuously improve the efficiency of all value-added activities and develop plans
to eliminate or reduce nonvalue-added activities.
• Activity analysis represents a systematic way for organizations to think about the
processes that they use to provide products to their customers.
• Activity-based management can be used to identify and eliminate activities that add
costs but not value to the product. Nonvalue-added costs are costs of activities that could
be eliminated without reducing product quality, performance, or value.
• Examples of nonvalue-added activities that are candidates for elimination:
(1) Storing materials, work-in–process, and finished goods inventories.
(2) Moving parts, materials, and other items around factory floor.
(3) Waiting for work in idle time.
(4) Various activities in the production process (from purchasing, to production, to
inspection, to shipping) should be investigated to identify activities that do not add
value to the finished product.
• Exhibit 10.1 shows the activity flow in loan application and demonstrates ways to
reduce customer response time, therefore increasing customer satisfaction and profits.
• By improving the production process, the firm is “buying” capacity (in the form of
faster response time, reduced processing costs, and the resulting increases in output) that
will save the firm money as it expands.
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• Activity-based management helps to reduce customer response time by identifying
activities that consume the most resources, both in dollars and time.
• By improving the efficiency of value-added activities and eliminating nonvalue-added
activities, both customer response time and costs will fall.
• Customers value a quick response to their orders, which is another important benefit of
shorter customer response time.
LO 10-2 Use the hierarchy of costs to manage costs.
♦ Managers can establish a hierarchy of costs to manage them effectively.
• Allocating all costs to units can be misleading if some costs do not vary with the
volume of units.
• Any variable costs (such as direct materials costs) are unit-level costs which are
affected by the volume of units produced.
• Capacity-related costs, at the other extreme, are essentially fixed by management’s
decisions to have a particular size of store, factory, hospital, or other facility. These costs
are fixed with respect to volume and require a longer time horizon to change than do
decision to reduce unit-level costs.
• Two middle categories of costs are batch-related costs (such as costs of machine setups)
and product/customer-level costs (such as costs of product design and costs of customer
care). These costs are affected by the way the company manages its activities and afford
the company the greatest opportunities for reducing costs through activity-based
management.
• A management decision that affects units alone requires the analysis of volume-related
activities. If management makes decisions that affect capacity, on the other hand, costs in
all levels of the hierarchy – volume, batch, product, and facility – will probably be
affected, and activities in all four categories should be analyzed.
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LO 10-3 Describe how the actions of customers and suppliers affect a
firm’s costs.
♦ One advantage of an activity-based costing system is that it reflects the diverse uses of
resources in the product costs so managers can make better decisions about the products.
♦ For some firms, decisions are not about the products or services, but about customers.
• Management’s decisions about customers, such as the choice of TV programming to
spend its advertising budget and to attract one audience over the other, will also affect
firm costs and the resulting profits associated with different groups of customers.
• One reason a group could be more profitable as customers is that it buys more product.
Another reason is that one group could be less costly to serve.
• Customers do cost money to serve. The additional time it takes to serve customers adds
cost to the company.
Example 1: Spring Valley specializes in packaging bottled water in various sizes (12
oz, 32 oz, 1 gallon, 5 gallons, etc.) and delivering them, along with cups and plates, to
its corporate clients.
Spring Valley has been losing money in the last few quarters. A recent sales report
provided some clues, as the marketing manager identified a group of new small– to
mid-size customers who share the following characteristics:
1. Their offices are scattered in suburban and rural areas. Spring Valley has to contract
a commercial carrier for the deliveries at a higher cost.
2. They tend to order smaller quantities, so the number of orders and delivers are
increased.
3. They prefer customized bottles and cups with their own logos.
4. They sometimes ask for rush orders to be delivered for special corporate functions.
All in all, these findings point to costly efforts to acquire and retain new customers
while the managers at Spring Valley study their options in terms of pricing and
providing proper incentives to its customers so that Spring Valley can become
profitable again.
• The In Action item presents a case study by looking at customer profitability in terms of
revenue and cost effects.
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LO 10-4 Use activity-based costing methods to assess customer and
supplier costs.
♦ The concepts of activity-based costing can be applied to the questions of customer costing and
customer profitability.
• The discussion of Red’s Lumber Company in the text is focused on the delivery
services and how Red (the owner) should charge the customers for the service to better
retain them. After choosing two customers as being representative of the types of
customers who were staying and who were leaving, respectively, Red followed the four-
step procedure:
(1) Identify activities (Entering the order, Picking the order, Delivering the order, and
Supervising and administering delivery),
(2) Select cost drivers for each of the activities (Number of orders entered, Number of
items picked, Number of deliveries made, and Order value, respectively),
(3) Compute the cost driver rates (= Activity cost in a cost pool ÷ Cost driver volume),
and
(4) Assign the delivery cost to individual customers using cost driver rates and their
consumption of activity volumes.
• See Exhibit 10.6 for the cost flow diagram used for the customer cost analysis.
• Red used to charge customers for the delivery services based on a fixed percentage of
the order values. The link between customers’ buying patterns and the cost of delivery
was lost. Customers who make fewer, relatively large orders and require less frequent
deliveries tend to leave because they pay a delivery charge higher than the actual cost of
delivery. Customers who cost more to deliver to, on the other hand, will stay.
• From the cost driver information, it turns out that the order patterns, not the order values,
drive most of the cost of delivery. Red can use the information from the cost of customer
system to manage costs better.
• One suggestion is to charge a flat fee regardless of the size of the order or the number of
units in the order. The customers are thus encouraged to order less frequently but in
larger amounts to save delivery costs.
• In addition, delivery services can be priced according to the cost driver rates that reflect
the consumption of delivery activities. Customers can determine the tradeoff between
delivery costs and inventory costs.
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• The cost driver rates help determine delivery pricing and cause the firm that is most
efficient at storage in the supply chain to hold the inventory. The total cost in the supply
chain can be reduced.
• The In Action box mentions Best Buy’s effort to identify distinct demographic customer
groups who are desirable and then tailor store merchandise to serve them better.
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Demonstration Problem
Windows of the World (WoW) sells and delivers new windows to construction sites in Mid-
Atlantic states. Each window is sold for $130. In addition, WoW charges a flat fee of $5 per
window for shipping and handling. Some customers are happy with the arrangement while others
are leaving. The owner of WoW, Jack, decides to take a closer look at the situation and hires a
consultant to do the job. The consultant compiles the data on shipping and handling for the
second quarter and prepares the following table:
Activity
Activity cost
Cost driver
Cost driver volume
Order entry
$24,000
Number of orders
1,200 orders
Packaging
22,500
Number of windows
15,000 windows
Delivery
30,800
Number of deliveries
1,400 deliveries
General administration
39,000
Order value
$1,950,000
Jack also provides activity data from two representative customers (Ray and Jerry), one stays and
one is leaving.
Jerry
Number of orders placed
14
Number of windows ordered
2,000
Number of deliveries made
14
Order value
$260,000
Required:
If you were the consultant, please do the following.
1. Determine the cost driver rates associated with shipping and handling activities.
2. Determine customer cost for Ray and Jerry.
3. Recommend changes to WoW’s shipping and handling pricing policy.
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Solution:
1.
Activity
Cost driver rate
Order entry
$20 per ordera
Packaging
$1.50 per windowb
Delivery
$22 per deliveryc
General administration
2% of the order valued
a $24,000 ÷ 1,200 orders.
b $22,500 ÷ 15,000 windows.
c $30,800 ÷ 1,400 deliveries.
d $39,000 ÷ $1,950,000.
2. The customer costs for Ray, who stays, and Jerry, who is leaving, are as follows.
Ray
Jerry
Order entry
$900e
$280
Packaging
3,000f
3,000
Delivery
1,210g
308
General administration
5,200h
5,200
Total shipping and handling
$10,310
$8,788
e $20 per order × 45 orders.
f $1.50 per window × 2,000 windows.
g $22 per delivery × 55 deliveries.
h 2% of the order value × $260,000 ordered.
3. Currently WoW charges customers shipping and handling a flat fee of $5 per window. It
is a volume-based measure. However, the activity analysis reveals that the number of
orders and the number of deliveries are also important and that each customer takes
advantage of the delivery service differently.
Ray and Jerry are each charged $10,000 (= $5 per windows × 2,000 windows ordered)
for shipping and handling. Ray’s orders require more activities. Ray is happy to pay
$10,000 for the attention he gets. Jerry, on the other hand, places larger order each time
and requires fewer deliveries. No wonder he is leaving. WoW should charge shipping and
handling based on customer activities to better retain customers in the future and to stay
competitive.
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Chapter 10 – Fundamentals of Cost Management
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♦ The analysis of customer cost can be applied to suppliers.
• Firms usually evaluate suppliers based on the price alone, ignoring other services
provided as well.
• A good supplier delivers the material that was ordered, on time, and of appropriate
quality. If a supplier fails to do any of these ancillary activities well, the customer incurs
costs to correct the failure.
• The discussion continues with Red’s Lumber Company buying lumber from two mills.
Late deliveries from either mill, for example, will cost Red additional expenditures of
temporary labor, overtime wages and benefits, and the administrative costs of delaying
deliveries to the final customers. A purchasing policy based on price alone will miss the
whole picture.
• When information such as
(1) the estimated total cost of late delivery,
(2) the estimated units of late delivery, and
(3) the probability of late delivery (based on past performance)
becomes available, the expected unit cost of late delivery can be added to the unit price
charged (or bid) by the supplier to arrive at the effective purchase price for each supplier.
• Specifically,
Additional cost of late delivery per unit =
Estimated total cost of late deliveries
Estimated units of late deliveries
.
Expected cost of late delivery per unit = Additional cost of late delivery per unit ×
Probability of late delivery.
Effective price per unit = Price per unit charged + Expected cost of late delivery per unit.
• See Exhibit 10.9 for an example that calculates the effective purchase price of lumber.
• Cost savings will be realized when assets are redeployed and activities reevaluated to
take advantage of the new pricing policy. Otherwise, the costs (and excess capacity) will
remain the same.
Chapter 10 – Fundamentals of Cost Management
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LO10-5 Distinguish between resources used and resources supplied.
♦ Product cost per unit includes the cost of capacity and is used to make pricing decisions,
product portfolio decisions, process decisions, and so on. When managers try to cover increasing
reported product costs due to increased capacity (and fixed costs), the death spiral (see Chapter 9)
will follow.
• In some situations, costs go up and down proportionately with the cost driver.
• In others, when workers are paid by the hour, there may be a difference between the
piecework rate and the cost driver rate.
• For example, the workers are paid $xx per computer assembled, but the cost driver rate
becomes
$yy per computer assembled =
Estimated wages of computer assemblers for a period
Estimated number of computers assembled for a period
.
• In general, activity-based costing estimates the cost of resources used. That is,
Resources used = Cost driver rate × Cost driver volume.
• Resources supplied to an activity are the expenditures or the amounts spent on the
activity. Resources supplied are the amount that usually appears on financial statements.
• The difference between resources used and resources supplied is unused resource
capacity.
Example 2: A computer manufacturer employs five workers. Each of the employees
works 8-hour days at $16 per hour and has the ability to assemble four computers per
hour, or a total of 32 computers per day. The cost driver rate is assumed to be $4 per
computer.
On a particular day, the workers assembled 140 computers.
Resources supplied per day = $16 per hour × 8-hour day × 5 workers = $640, or
$4 per computer × 160-computer capacity = $640.
Resources used on that day = $4 per computer × 140 computers assembled = $560.
Unused resource capacity on that day = $640 – $560 = $80.