MANAGEMENT ACCOUNTING Pearson Education Limited 2008 Cheryl S

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

3 -2 Measuring and analysing product costs (Planning) Chapter 3 Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

3 -3 Objectives • 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 Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

3 -4 Activities and Product Costs Products require activities Activities consume resources Resources have costs Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

3 -5 Estimating Product Costs For Planning Decisions Planning decisions are improved with better estimates of product costs 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 Management Accounting Mc. Watters, Zimmerman, Morse The cost of using resources to provide a product or service is called the product or service cost © Pearson Education Limited 2008

3 -6 The Product-mix Decision The choice of what products and services to offer is known as the product-mix decision In order to decide the product-mix it is necessary to balance The benefits of the product The costs of providing the product If the benefits exceed the costs a product is included in the product -mix Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

3 -7 Pricing Decision Prices are affected by Customers Competition Product Costs If a price is too high the result will be low customer demand If a price is too low the result will reduce organizational value Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

3 -8 Pricing Decision Activities supporting only one product generate direct product costs Activities supporting multiple products generate indirect product costs Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

3 -9 Direct Product Costs Production costs include both direct and indirect costs Direct costs are easily traced to a given product Direct costs include direct materials and direct labour Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

3 -10 Indirect Product Costs Numerical Example 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. 04/30 g 0. 02 Pickles 15 grams £ 0. 06/30 g 0. 03 Labour 1 minute £ 6/hour 0. 10 Total Direct cost/sandwich Management Accounting Mc. Watters, Zimmerman, Morse £ 0. 65 © Pearson Education Limited 2008

3 -11 Indirect Product Costs Indirect Costs cannot be traced directly to individual products Facility-Level Costs Unit-Level Costs Indirect costs are also called Indirect Costs overhead costs Product. Level Costs Management Accounting Mc. Watters, Zimmerman, Morse Batch-Level Costs © Pearson Education Limited 2008

3 -12 Indirect Product Costs Unit-Level Costs that vary with the number of units produced Batch. Level Costs associated with production of multiple units of the same product that are produced together Product. Level Costs Fixed with respect to the number of units and batches produced, but vary with the number of products Facility. Level Costs Fixed with respect to the number of units, batches, and products or services produced Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

3 -13 Indirect Product Costs Numerical Example The indirect costs of Bended Knee Skateboards are as follows Support Function Level Amount (£) Administrative Facility 90, 000 Purchasing Batch 50, 000 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 Production: Total Management Accounting Mc. Watters, Zimmerman, Morse Splitting the indirect costs among the flat and moulded skateboards should recognize each of these levels of indirect costs 450, 000 © Pearson Education Limited 2008

3 -14 Tracing Indirect Costs Tracing indirect costs to products is difficult The relationship between indirect costs and products is not always clear Tracing indirect costs to different products can be very costly 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 driver Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

3 -15 Tracing Indirect Costs using a Cost Driver Causes the costs of an activity 1. Identify activities that generate indirect product costs 2. Estimate costs of the activities 3. Select a cost driver for each activity 4. Estimate the cost-driver usage by all of the products 5. Calculate a cost-driver application rate 6. Trace activity costs to each product Estimated cost of each activity Estimated usage of activity cost driver Actual cost-driver usage by each product x Cost-driver application rate Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

Tracing Indirect Costs using a Cost Driver 3 -16 Numerical Example A sunglass company manufactures three different products that use the same assembly line To change Product production from one product to another Estimated resets Application Rate Traced the costs (€) machines must be reset. The activity of(€) resetting the machines is estimated to cost € 400, 000 during 1, 000/reset the year. The number Euro 50 50, 000 of resets is the cost driver. Trace costs to each product Aussie 200 1, 000/reset 200, 000 Salsa 150 usage is 50+200+150 1, 000/reset = 400 Resets 150, 000 Estimated cost driver Cost driver application rate € 400, 000/400 = € 1, 000/reset Total 400 Management Accounting Mc. Watters, Zimmerman, Morse 1, 000/reset 400, 000 © Pearson Education Limited 2008

3 -17 Activity-Based Costing (ABC) ABC is a procedure that attempts to trace the costs of different activities to products Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

3 -18 Activity-Based Costing (ABC) Numerical 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 costs. are identified Activity Estimated that costs lead to direct Cost driver. Indirect costs. Estimated usage of for (£) watering, repotting and administration 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 Calculate the Application rate for each activity Identify the level of each activity Trace indirect costs to 10 royal oaks each of which requiring one repotting each year Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

3 -19 Activity-Based Costing (ABC) Numerical Example Calculate the Application rate for each 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 Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

3 -20 Activity-Based Costing (ABC) Numerical Example Identify the level of each activity 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 costs Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

3 -21 Activity-Based Costing (ABC) Numerical Example 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) Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

3 -22 Advantages of 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 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 especially useful to organizations with a high percentage of indirect product costs Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

3 -23 Problems With 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 is more costly to implement because additional measurements and observations must be made Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

Tracing Indirect Product Costs Using a Single Cost Driver 3 -24 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 Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

Tracing Indirect Product Costs Using a Single Cost Driver 3 -25 A four step process 1. Identify and estimate all of the indirect product costs 2. Identify a cost driver to apply 3. Calculate the application rate 4. Apply indirect costs to the various products and services Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

Tracing Indirect Product Costs Using a Single Cost Driver 3 -26 Numerical Example Cascade Cleaning Service cleans 3 different buildings m 2 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 £ Supplies 50, 000 Administration 50, 000 Total 100, 000 Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

Tracing Indirect Product Costs Using a Single Cost Driver 3 -27 Numerical Example Apply the indirect costs to the different buildings using square meters (application rate £ 100, 000/200, 000 m 2) m 2 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 Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

Tracing Indirect Product Costs Using a Single Cost Driver 3 -28 Numerical Example Apply the indirect costs to the different buildings using estimated hours (application rate £ 100, 000/20, 000 hours) 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 Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

Tracing Indirect Product Costs Using a Single Cost Driver 3 -29 Numerical Example Compare the costs of the two methods M 2 Estimated indirect costs (£) Estimated Hours Estimated indirect costs (£) Anderson Office Building 50, 000 Anderson Office Building 40, 000 Carla’s Pizza 5, 000 Carla’s Pizza 30, 000 Town Hall 45, 000 Town Hall 30, 000 Total 100, 000 You can see how different allocation methods might lead to making different management decisions Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

3 -30 MANAGEMENT ACCOUNTING Measuring and analysing product costs (Planning) End of Chapter 3 Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008