© 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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© Pearson Education Limited 2008Management Accounting McWatters, Zimmerman, Morse
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
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
Facility-Level Costs
Facility-Level Costs
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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© Pearson Education Limited 2008Management Accounting McWatters, Zimmerman, Morse
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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© Pearson Education Limited 2008Management Accounting McWatters, Zimmerman, Morse
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
Trace indirect costs to 10 royal oaks each of which requiring one repotting each year
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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© Pearson Education Limited 2008Management Accounting McWatters, Zimmerman, Morse
Activity-Based Costing (ABC)Activity-Based Costing (ABC) Numerical ExampleNumerical Example
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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© Pearson Education Limited 2008Management Accounting McWatters, Zimmerman, Morse
Activity-Based Costing (ABC)Activity-Based Costing (ABC) Numerical ExampleNumerical Example
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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© Pearson Education Limited 2008Management Accounting McWatters, Zimmerman, Morse
Activity-Based Costing (ABC)Activity-Based Costing (ABC) Numerical ExampleNumerical Example
Trace indirect costs to 10 royal oaks each of which requiring one repotting each year
Trace indirect costs to 10 royal oaks each of which requiring one repotting each year
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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© Pearson Education Limited 2008Management Accounting McWatters, Zimmerman, Morse
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
Tracing Indirect Product CostsTracing Indirect Product CostsUsing a Single Cost DriverUsing a Single Cost Driver
Numerical ExampleNumerical Example
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)
Tracing Indirect Product CostsTracing Indirect Product CostsUsing a Single Cost DriverUsing a Single Cost Driver
Numerical ExampleNumerical Example
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)
Tracing Indirect Product CostsTracing Indirect Product CostsUsing a Single Cost DriverUsing a Single Cost Driver
Numerical ExampleNumerical Example
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
Tracing Indirect Product CostsTracing Indirect Product CostsUsing a Single Cost DriverUsing a Single Cost Driver
Numerical ExampleNumerical Example
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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© Pearson Education Limited 2008Management Accounting McWatters, Zimmerman, Morse
MANAGEMENT ACCOUNTING MANAGEMENT ACCOUNTING
Measuring and analysing Measuring and analysingproduct costs (Planning)product costs (Planning)
End of Chapter 3