© Pearson Education Limited 2008 MANAGEMENT ACCOUNTING Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse

© Pearson Education Limited 2008

MANAGEMENT ACCOUNTINGMANAGEMENT ACCOUNTING

Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. MorseCheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse

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© Pearson Education Limited 2008Management Accounting McWatters, Zimmerman, Morse

Measuring and analysing product Measuring and analysing product costs (Planning)costs (Planning)

Chapter 3

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ObjectivesObjectives

• Identify activities of the organization related to the different products and services of the organization

• Teat products as cost objects for the purpose of making product-mix and pricing decisions

• Estimate the direct costs of a product or service• Identify different levels of indirect product costs• Trace indirect costs using a cost driver• Use activity-based costing to estimate the cost of a product or

service• Recognize costs and benefits of using activity-based costing • Estimate product costs using a single cost driver

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Activities and Product CostsActivities and Product Costs

Products requireactivities

Products requireactivities

Activities consumeresources

Activities consumeresources

Resources havecosts

Resources havecosts

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Estimating Product CostsEstimating Product CostsFor Planning DecisionsFor Planning Decisions

Planning decisions are improved with better estimates of product costs

Planning decisions are improved with better estimates of product costs

The costs and benefits of different decisions must be estimated

The costs and benefits of different decisions must be estimated

The item to be costed is called the cost objective – the

primary cost objects are the products or services provided

by an organization

The item to be costed is called the cost objective – the

primary cost objects are the products or services provided

by an organization

The cost of using resources to provide a product or service is called the product or service

cost

The cost of using resources to provide a product or service is called the product or service

cost

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The Product-mix DecisionThe Product-mix Decision

The benefits of the product

The costs of providing the product

In order to decide the product-mix it is necessary to balance

In order to decide the product-mix it is necessary to balance

If the benefits exceed the costs a product is included in the product -mix

If the benefits exceed the costs a product is included in the product -mix

The choice of what products and services to offer is known as the product-mix decision

The choice of what products and services to offer is known as the product-mix decision

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Pricing DecisionPricing Decision

Customers Competition ProductCosts

Prices are affected byPrices are affected by

If a price is too high the result will be low customer demandIf a price is too high the result will be low customer demand

If a price is too low the result will reduce organizational valueIf a price is too low the result will reduce organizational value

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Pricing DecisionPricing Decision

Activities supporting only one product generate direct product costs

Activities supporting only one product generate direct product costs

Activities supporting multiple products generate indirect product costs

Activities supporting multiple products generate indirect product costs

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Direct Product CostsDirect Product Costs

Direct costsare easily traced to

a given product

Direct costsare easily traced to

a given product

Production costs include both direct and indirect costs

Production costs include both direct and indirect costs

Direct costsinclude direct materials

and direct labour

Direct costsinclude direct materials

and direct labour

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Indirect Product CostsIndirect Product CostsNumerical ExampleNumerical Example

Ben’s Deli uses the following estimates to determine the direct cost of making a sandwich

Ben’s Deli uses the following estimates to determine the direct cost of making a sandwich

Item Quantity per sandwich

Purchase Price Cost

(Quantity per Sandwich x Purchase price)

Meat 100 grams £4.00/kg £0.40

Roll 1 £1.20/dozen 0.10

Mustard 15 grams £0.04/30g 0.02

Pickles 15 grams £0.06/30g 0.03

Labour 1 minute £6/hour 0.10

Total Direct cost/sandwich £0.65

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Indirect Product CostsIndirect Product Costs

Indirect Costs cannot be traced directly to individual products

Indirect Costs cannot be traced directly to individual products

Unit-Level Costs

Unit-Level Costs

Batch-Level Costs

Batch-Level Costs

Facility-Level Costs


Product-Level CostsProduct-

Level Costs

Indirect CostsIndirect CostsIndirect costs

are also calledoverhead costs

Indirect costs are also calledoverhead costs

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Indirect Product CostsIndirect Product Costs

Unit-Level Costs

Unit-Level Costs

Costs that vary with the number of units produced

Costs that vary with the number of units produced

Batch-Level Costs

Batch-Level Costs

Costs associated with production of multiple units of the same product

that are produced together

Costs associated with production of multiple units of the same product

that are produced together

Product-Level Costs

Product-Level Costs

Fixed with respect to the number of units and batches produced, but vary

with the number of products

Fixed with respect to the number of units and batches produced, but vary

with the number of products



Fixed with respect to the number of units, batches, and products or

services produced

Fixed with respect to the number of units, batches, and products or

services produced

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Indirect Product CostsIndirect Product CostsNumerical ExampleNumerical Example

The indirect costs of Bended Knee Skateboardsare as follows

The indirect costs of Bended Knee Skateboardsare as follows

Support Function Level Amount (£)

Administrative Facility 90,000

Purchasing Batch 50,000

Production:

Warehousing Batch 18,000

Cutting Unit 50,000

Gluing Unit 10,000

Setting up moulds Batch 55,000

Painting Unit 35,000

Assembly Unit 42,000

Marketing Product 100,000

Total 450,000

Splitting the indirect costs

among the flat and moulded skateboards

should recognize each of these

levels of indirect costs

Splitting the indirect costs

among the flat and moulded skateboards

should recognize each of these

levels of indirect costs

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Tracing indirect costs to different products can be

very costly

Tracing indirect costs to different products can be

very costly

Tracing Indirect CostsTracing Indirect Costs

Tracing indirect costs to products is difficult

Tracing indirect costs to products is difficult

One method of estimating the indirect costs of a product is to choose some characteristic of the different products that causes

the indirect costs

One method of estimating the indirect costs of a product is to choose some characteristic of the different products that causes

the indirect costs

The characteristic is called a cost driverThe characteristic is called a cost driver

The relationship between indirect costs and products

is not always clear

The relationship between indirect costs and products

is not always clear

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Tracing Indirect Costs using a Tracing Indirect Costs using a Cost DriverCost Driver

1. Identify activities that generate indirectproduct costs

2. Estimate costs of the activities3. Select a cost driver for each activity4. Estimate the cost-driver usage by all of the

products5. Calculate a cost-driver application rate6. Trace activity costs to each product

1. Identify activities that generate indirectproduct costs

2. Estimate costs of the activities3. Select a cost driver for each activity4. Estimate the cost-driver usage by all of the

products5. Calculate a cost-driver application rate6. Trace activity costs to each product

Causes thecosts of anactivity

Causes thecosts of anactivity

Estimated cost of each activityEstimated usage of activity cost driver

Estimated cost of each activityEstimated usage of activity cost driver

Actual cost-driver usage by each product x Cost-driver application rateActual cost-driver usage by each product x Cost-driver application rate

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Tracing Indirect Costs using a Tracing Indirect Costs using a Cost DriverCost Driver

Numerical ExampleNumerical Example

A sunglass company manufactures three different products that use the same assembly line

To change production from one product to another the machines must be reset. The activity of resetting the machines is estimated to cost €400,000 during the year. The number of

resets is the cost driver. Trace costs to each product

A sunglass company manufactures three different products that use the same assembly line

To change production from one product to another the machines must be reset. The activity of resetting the machines is estimated to cost €400,000 during the year. The number of

resets is the cost driver. Trace costs to each product

Estimated cost driver usage is 50+200+150 = 400 ResetsCost driver application rate €400,000/400 = €1,000/resetEstimated cost driver usage is 50+200+150 = 400 ResetsCost driver application rate €400,000/400 = €1,000/reset

Product Estimated resets Application Rate (€)

Traced costs (€)

Euro 50 1,000/reset 50,000

Aussie 200 1,000/reset 200,000

Salsa 150 1,000/reset 150,000

Total 400 1,000/reset 400,000

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Activity-Based Costing (ABC)Activity-Based Costing (ABC)

ABC is a procedure thatattempts to trace the costs of different

activities to products

ABC is a procedure thatattempts to trace the costs of different

activities to products

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Activity-Based Costing (ABC)Activity-Based Costing (ABC) Numerical ExampleNumerical Example

A tree nursery is considering a change of product mix in its inventory

The manager wants to estimate the product cost of different types of tree. There are no activities that lead to direct costs. Indirect costs are identified

for watering, repotting and administration

A tree nursery is considering a change of product mix in its inventory

The manager wants to estimate the product cost of different types of tree. There are no activities that lead to direct costs. Indirect costs are identified

for watering, repotting and administration

Calculate the Application rate for each activityIdentify the level of each activity

Trace indirect costs to 10 royal oaks each of which requiring one repotting each year

Calculate the Application rate for each activityIdentify the level of each activity


Activity Estimated costs (£)

Cost driver Estimated usage of cost driver

Watering 50,000 Number of trees 500,000

Repotting 100,000 Number of repots 200,000

Administration 75,000 Number of different types of trees 500

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Calculate the Application rate for each activityCalculate the Application rate for each activity

Activity Application Rate

Watering 50,000/500,000 £0.10/tree

Repotting 100,000/200,000 £0.50/repot

Administration 75,000/500 £150/type of tree

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Identify the level of each activityIdentify the level of each activity

Watering and Repotting are unit level activities as their cost drivers vary with the number of units

Watering and Repotting are unit level activities as their cost drivers vary with the number of units

Administration is a product-level activity as each product receives the same amount of indirect costsAdministration is a product-level activity as each

product receives the same amount of indirect costs

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Activity Application rate Usage Costs (£)

Watering £0.10/tree 100 10.00

Repotting £0.50/repot 100 50.00

Administration £150/type of tree 1 150.00

Total annual indirect costs 210.00

The estimated cost per royal oak is £210/100 royal oaks (£2.10 each tree)

The estimated cost per royal oak is £210/100 royal oaks (£2.10 each tree)

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Advantages of ABCAdvantages of ABC

ABC is most beneficial in estimating accurate product costs for organizations with multiple products

and services

ABC is most beneficial in estimating accurate product costs for organizations with multiple products

and services

ABC is more beneficial in firms where products and services use overhead activities in different ways

ABC is more beneficial in firms where products and services use overhead activities in different ways

ABC is especially useful to organizations with a high percentage of indirect product costs

ABC is especially useful to organizations with a high percentage of indirect product costs

ABC seeks to improve the tracing of indirect costs to products by recognizing the different levels of activities

that lead to indirect product costs

ABC seeks to improve the tracing of indirect costs to products by recognizing the different levels of activities

that lead to indirect product costs

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ABC does not always achieve a n accurate estimate of the cost of making a product

ABC does not always achieve a n accurate estimate of the cost of making a product

ABC ignores the difference between the fixed and variable costs of an activity

ABC ignores the difference between the fixed and variable costs of an activity

ABC is more costly to implement because additional measurements and observations

must be made

ABC is more costly to implement because additional measurements and observations

must be made

Problems With ABCProblems With ABC

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If planning decisions are not sensitive to the

accuracy of the estimate of indirect product costs

If planning decisions are not sensitive to the

accuracy of the estimate of indirect product costs

Then using a single cost driver to trace all indirect

product costs is often sufficient

Then using a single cost driver to trace all indirect

product costs is often sufficient

Tracing Indirect Product CostsTracing Indirect Product CostsUsing a Single Cost DriverUsing a Single Cost Driver

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Tracing Indirect Product CostsUsing a Single Cost Driver

A four step process

1. Identify and estimate all of the indirect product costs

2. Identify a cost driver to apply3. Calculate the application rate4. Apply indirect costs to the various

products and services

A four step process

1. Identify and estimate all of the indirect product costs

2. Identify a cost driver to apply3. Calculate the application rate4. Apply indirect costs to the various

products and services

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Cascade Cleaning Service cleans 3 different buildingsCascade Cleaning Service cleans 3 different buildings



m2 Estimated hours of cleaning time

Anderson Office Building 100,000 8,000

Carla’s Pizza 10,000 6,000

Town Hall 90,000 6,000

Total 200,000 20,000

The company has the following indirect costs The company has the following indirect costs

£

Supplies 50,000

Administration 50,000

Total 100,000

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Apply the indirect costs to the different buildings using square meters (application rate £100,000/200,000m2)

Apply the indirect costs to the different buildings using square meters (application rate £100,000/200,000m2)



m2 Application rate Estimated indirect costs (£)

Anderson Office Building 100,000 0.50 50,000

Carla’s Pizza 10,000 0.50 5,000

Town Hall 90,000 0.50 45,000

Total applied costs 100,000

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Apply the indirect costs to the different buildings using estimated hours

(application rate £100,000/20,000hours)

Apply the indirect costs to the different buildings using estimated hours

(application rate £100,000/20,000hours)



Estimated Hours

Application rate (£)

Estimated indirect costs (£)

Anderson Office Building 8,000 5.00 40,000

Carla’s Pizza 6,000 5.00 30,000

Town Hall 6,000 5.00 30,000

Total applied costs 100,000

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Compare the costs of the two methodsCompare the costs of the two methods



M2 Estimated indirect costs (£)

Anderson Office Building

50,000

Carla’s Pizza 5,000

Town Hall 45,000

Total 100,000

You can see how different allocation methods might lead to making different management decisions

You can see how different allocation methods might lead to making different management decisions

Estimated Hours Estimated indirect costs (£)

Anderson Office Building

40,000

Carla’s Pizza 30,000

Town Hall 30,000

Total 100,000

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MANAGEMENT ACCOUNTING MANAGEMENT ACCOUNTING

Measuring and analysing Measuring and analysingproduct costs (Planning)product costs (Planning)

End of Chapter 3

Documents

© Pearson Education Limited 2008 MANAGEMENT ACCOUNTING Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse