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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.
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Chapter Overview
I. USING ACTIVITY-BASED COST MANAGEMENT TO ADD VALUE
• Using Activity-Based Cost Information to Improve Processes
• Using Activity-Based Cost Management in a Service Setting
• Lean Manufacturing and Activity-Based Cost Management
• Using Cost Hierarchies
III. DETERMINING THE COST OF SUPPLIERS
• Capturing the Cost Savings
IV. MANAGING THE COST OF CAPACITY
• Using and Supplying Resources
• Computing the Cost of Unused Capacity
• Assigning the Cost of Unused Capacity
• Seasonal Demand and the Cost of Unused Capacity
V. MANAGING THE COST OF QUALITY
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Chapter Outline
LO 10-1 Describe how activity-based cost management can be used to
improve operations.
USING ACTIVITY-BASED COST MANAGEMENT TO ADD VALUE
• Activity-based cost management (ABCM) is an approach that uses activity-based costing
data to evaluate the cost of value-chain activities and to identify opportunities for
improvement.
o First, some key concepts:
▪ Activity-based costing (ABC) is a system used to assign costs to products based on
the products’ use of activities, which are the discrete tasks an organization undertakes
to make or deliver the product.
▪ The value chain is the set of activities that transforms raw resources into products for
customers.
o ABC and ABCM can be used to improve operations:
▪ Better information about product costs helps managers make decisions about pricing
and whether to keep or drop products.
▪ Better information about the cost of activities and processes helps managers gain
useful information previously buried in the accounting systems.
• Using Activity-Based Cost Information to Improve Processes
o The first step in ABCM is activity analysis, which has six steps:
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▪ Develop activity-based costing data for each activity, based on the resources used in
each activity.
• This changing of operational processes to improve performance, often after
examining activity-based costing data to determine opportunities for
improvement, is called process reengineering.
• Generally, the following types of activities are candidates for elimination because,
from the perspective of the customer, they do not add value to the product:
Storing materials items
Moving items
Waiting for work
• Using Activity-Based Cost Management in a Service Setting
• The key features of lean manufacturing flow naturally from careful activity
analysis. Just as activity-based cost management often prompts firms to begin the
journey toward becoming a lean enterprise, becoming lean often prompts firms to
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o What often emerges after firms adopt lean manufacturing is a new approach to cost
accounting, termed lean accounting.
▪ Lean accounting is a cost accounting system designed around the value chain of
major products and services to support lean manufacturing. It can also refer to
applying lean production methods to accounting work itself.
o Traditional manufacturing firms often group similar operations together.
▪ This approach often results in large work-in-process inventories. Why? Because the
company wants to keep these activities going full speed.
o Lean manufacturers organize differently.
LO 10-2 Use the hierarchy of costs to manage costs.
• Using Cost Hierarchies
o Managers can establish a hierarchy of costs to manage them effectively.
o 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.
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▪ 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.
LO 10-3 Describe how the actions of customers and suppliers affect a firm’s
costs.
MANAGING THE COST OF CUSTOMERS AND SUPPLIERS
• The 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.
o For some firms, however, decisions are not about the products or services but about
customers.
LO 10-4 Use activity-based costing methods to assess customer and supplier
costs.
• Using Activity-Based Costing to Determine the Cost of Customers and Suppliers
o The concepts of activity-based costing can be applied to the question of customer costing
(and therefore customer profitability) easily.
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representative of the types of customers who were staying and who were leaving,
respectively, and followed the four-step procedure:
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▪ Step 1: Identify activities (Entering the order, Picking the order, Delivering the order,
and Supervising and administering delivery).
• Exhibit 10.2 shows some summary operating data based on the planning for next
year.
▪ Step 3: Compute the cost driver rates (= Activity cost in a cost pool ÷ Cost driver
volume)
• Exhibit 10.4 shows the computation for cost driver rates for each of the four
activities.
Activity costs for each activity ÷ Cost driver volume = Cost driver rate
▪ Step 4: Assign the delivery cost to individual customers using cost driver rates and
their consumption of activity volumes.
• Exhibit 10.7 shows the estimated delivery costs for both of the customers.
▪ AnjanaRed 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.
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Customers who cost more to deliver to, on the other hand, will stay.
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• From the cost driver information, it turns out that the order patterns, not the order
values, drive most of the cost of delivery. AnjanaRed 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.
• Determining Why the Cost of Customers Matter
See Demonstration Problem
DETERMINING THE COST OF SUPPLIERS
• The analysis of customer cost can be applied to suppliers.
o Firms usually evaluate suppliers based on the price alone, ignoring other services
provided as well.
▪ Exhibit 10.8 shows the annual data on food and restaurant supplylumber deliveries.
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▪ When information such as the estimated total cost of late delivery, the estimated units
of late delivery, and 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.
• Additional cost of late delivery per unit =
Estimated total cost of late deliveries
Estimated units of late deliveries
• Capturing the Cost Savings
o 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.
LO10-5 Distinguish between resources used and resources supplied.
MANAGING THE COST OF CAPACITY
• Using and Supplying Resources
o 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.
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o Inn 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 used on that day = $4 per computer × 140 computers assembled = $560
Unused resource capacity on that day = $640 – $560 = $80
o Since the traditional income statement only shows resources supplied, a more informative
report for managing capacity costs will include the following in an activity-based income
statement.
▪ Exhibit 10.10 shows a traditional income statement. A more informative report for
managing capacity costs is shown in Exhibit 10.11.
Some unused resource capacity is a good thing because it can be used for ad
hoc training, leisure, and thinking about ways to improve the work and work
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LO 10-6 Design cost management systems to assign capacity costs.
• Computing the Cost of Unused Capacity
o The importance of managing capacity costs increases with the relative proportion of these
costs in an organization’s cost structure.
o Allocation of fixed operating costs (supervision, depreciation, maintenance, and so on) to
products depends on how the allocation base (the denominator number in terms of
“capacity”) is defined.
o The discussion in the text features Northern Air Charters (NAC), which operates a fleet
of small aircraft that flies tourists into remote regions for hunting, fishing, and
backpacking trips.
▪ Exhibit 10.12 shows the fixed operating costs rates for three years (including one in
which business is down and one in which business is booming).
▪ If capacity is chosen as the allocation base, the manager needs to decide how to
measure it. There are four different definitions of capacity as the allocation base:
▪ Exhibit 10.13 shows capacity and cost driver measures of capacity.