Chapter 10

Fundamentals of
Cost Management

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Using Activity-Based Cost

Management to Add Value
L.O. 1 Explain the concept of activity-based cost management.
Activity-based cost management uses
activity analysis in decision making.
Activity-based costing focuses on activities
in allocating overhead costs to products.
Activity-based management focuses on
managing activities to reduce costs.

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Using Cost Hierarchies

L.O. 2 Use the hierarchy of costs to manage costs.
Hierarchy Level

Cost Example

Cost Driver Example

Volume related

Supplies
Lubricating oil
Machine repair

Direct labor cost

Machine-hours
Number of units

Batch related

Setup costs
Material handling
Shipping costs

Setup hours
Production runs
Number of shipments

Product related

Compliance costs
Design and
specification costs

Number of products

Facility related

General plant costs

Plant admin. costs

Direct costs
Value added
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Managing the Costs of Customers

and Suppliers
L.O. 3 Describe how the actions of customers
and suppliers affect a firms costs.

Information on customer profitability is

important for managers, so they can make
decisions that will improve firm performance.

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Using ABC Costing:

Customers and Suppliers
L.O. 4 Use activity-based costing methods
to assess customer and supplier costs.
Use the same four-step ABC product costing
process to assess customers and suppliers.
Step 1:

Identify the activities that consume resources.

Step 2:

Identify the cost driver associated with each activity.

Step 3:

Compute a cost rate per cost driver for each unit

or transaction.

Step 4:

Assign costs to customers by multiplying the cost driver

rate by the volume of cost driver units consumed by the
activity or transaction that occurred.
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LO
4

Cost of Customers
Step 1: Identify the Activities
What activities consume resources
for Reds delivering service?
Process Flow of the Delivery Service Red's Lumber
Enter
order

Pick
order

Deliver
order

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LO
4

Cost of Customers
Step 2: Identify the Cost Drivers
Activity

Entering order
Picking order
Delivering order
Delivery administration

Cost Driver
Number of orders entered
Number of items picked
Number of deliveries made
Order value

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LO
4

Cost of Customers
Step 3: Compute the Cost Driver Rates
Computation of Cost Driver Rates Red's Lumber
Activity

Entering order
Picking order
Delivering order
Delivery administration

Activity
Cost
$100,000
$150,000
$300,000
$250,000

Cost Driver
Volume

10,000 orders
75,000 items
12,500 deliveries
$5,000,000 order value

Cost Driver
Rate
=
=
=
=

$10 per order

$ 2 per item
$24 per delivery
5% of value

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LO
4

Cost of Customers
Step 4: Assign Costs Using ABC
Cost Driver Information by Customer Red's Lumber
Cost Driver

Jack

Jill

Number of orders
150
50
Number of items
750
750
Number of deliveries
200
50
Order value (total sales) $50,000 $50,000

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LO
4

Cost of Customers
Step 4: Assign Costs Using ABC
Estimated Customer Delivery Costs Red's Lumber
Activity

Jack

Entering order (@ $10 per order

$ 1,500
Picking order (@ $2 per item)
1,500
Delivering order (@ $24 per delivery
4,800
Delivery administration
2,500
Total delivery costs
$10,300

Jill

$ 500
1,500
1,200
2,500
$5,700

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Using and Supplying Resources

L.O. 5 Distinguish between resources used
and resources supplied.

Resources used:
Cost driver rate multiplied by
the cost driver volume
Resources supplies:
Expenditures or the amounts
spent on a specific activity
Unused capacity:
Difference between resources
used and resources supplied
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Computing the Cost of Unused Capacity

L.O. 6 Design cost management systems to assign capacity costs.
Actual activity:
Actual volume for the period
Theoretical capacity:
Amount of production possible under ideal
conditions with no time for maintenance,
breakdowns, or absenteeism.

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LO
6

Computing the Cost of Unused Capacity

Practical capacity:
Amount of production possible assuming only the
expected downtime for scheduled maintenance
and normal breaks and vacations.
Normal activity:
Long-run expected volume

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Managing the Cost of Quality

L.O. 7 Describe how activities that influence
quality affect costs and profitability.

Quality as defined by the customer

Organization is managed to excel on all dimensions

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Cost of Quality
L.O. 8 Compare the costs of quality control
to the costs of failing to control quality.

Prevention: Costs incurred to prevent defects in the

products or services being produced
Materials inspection
Process control
Quality training
Machine inspection
Product design
Appraisal:

Costs incurred to detect individual units of

products that do not conform to specifications
End-of-process sampling
Field testing
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LO
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Cost of Quality
Internal failure:

Costs incurred when nonconforming products

and services are detected before being
delivered to customers.
Scrap
Rework
Reinspection/Retesting

External failure:

Costs incurred when nonconforming products

and services are detected after being delivered
to customers.
Warranty repairs
Product liability
Marketing costs
Lost sales
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End of Chapter 10

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.