Cost Measurement System

Cost Measurement Systems Traditional and Contemporary Approaches

Sam Houston State University ACC 564 R. Quarles Quarles, ACC 564, CMS

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Cost Measurement Systems • Should not be confused with accounting • Do not address external reporting issues • Are based on the idea of being approximately correct rather than precisely wrong • Do not provide the answer • Are not dictated by a board of wise persons in Connecticut or by a bunch of clowns in Washington Quarles, ACC 564, CMS

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Cost Measurement Systems • Cost measurement systems provide more questions and sometimes answers to questions related to strategic objectives of – Quality – Cost – Time

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Strategic Objectives • Quality – Features – Reliability • Costs involved – How much do features/reliability cost? – Can customers afford the level of quality provided? – How much does it cost to add new features or increase reliability? – How do we determine the cost of each feature or reliability element?

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Strategic Objectives • Cost – Must be measured in order to be managed – Related directly/indirectly to a product/service • Final reckoning - all costs incurred to provide product/services

– What causes costs? – Poor cost measurement may result in incorrectly leaving or remaining in a market – Cost system must identify, track, report costs of providing services or creating/delivering/supporting a product Quarles, ACC 564, CMS

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Strategic Objectives • Time – Meeting delivery deadlines – Bringing product/service to market rapidly and proper point in time – Late delivery within the firm can delay other steps and increase costs – Altering process time schedules affects costs – Cost system must identify/measure time factors and costs of delays/alterations

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Attributes of a Good Cost System • Technical Attributes – Decision Relevance • Cost data related to strategic objectives – Cost of features/reliability – Identification of causes of cost for management attention

• Provide data for decision regarding – – – – –

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What customers/markets to target Product prices/profitability plans What products to promote Levels of quality/service to provide How manage costs/allocate resources

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Attributes of a Good Cost System • Technical Attributes – Process Understanding • Help management understand work processes • Help management understand economic impact of activities that reduce/increase – Quality/Costs/Time

• Identifies costs across all steps in process - where are delays/cost multipliers • Identifies relationship between work done and cost incurred - ripple effect of activities in one area • Helps understand why work occurs and what drives costs Quarles, ACC 564, CMS

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Attributes of a Good Cost System • Behavioral Attributes – Cost data • Increases visibility of activities • Focuses attention • Communicates managerial intent

– Cost structure visibility - highlights cost drivers • Decisions on products and processes affect costs • Cost data affects decision behaviors

– Communications with operations personnel • Non-accountants tolerate but do not understand • Bookkeeping versus working Quarles, ACC 564, CMS

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Attributes of a Good Cost System • Behavioral Attributes – Employee Motivation • Cost data traditionally used to FIX BLAME – Leads to short-run decision emphasis – Cost data can be used to focus on how to work better, not who to blame

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Attributes of a Good Cost System • Cultural Attributes – Culture can emphasize blame or process improvement • Who spent the money versus is what is being done • Cross functional participation – Focus on cost objects reduces emphasis on departments – Activities necessary to produce cost cross departmental boundaries – Employees in different departments must work together to carry on activities

• Cost system should encourage process improvement and cross functional participation rather than fixing blame Quarles, ACC 564, CMS

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Attributes of a Good Cost System • Improves strategic decisions by providing data on quality, cost, and time performance • Facilitates process management by providing data on the cost of the processes (activities and operations) used, and the underlying causal relationships (drivers) that cause costs to change. • Encourages behaviors consistent with strategic objectives • Creates mindsets and values that promote a healthy and positive organizational culture. Quarles, ACC 564, CMS

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Nature of Cost Measurement Systems • Cost Measurement – Must exist separately from bookkeeping system • Emphasis on accountability for expenditures • Tracking of cost of resources PURCHASED as opposed to those USED

– Reorganizes data on resources acquired to provide strategic cost data • Not to be confused with accounting

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TYPICAL COST MEASUREMENT SYSTEM • Transformation engine that converts raw data on resources purchased into cost information about resources used Basic Cost Elements •Materials purchased •Wages and salaries •Utilities paid •Equipment purchases

The Building Blocks •Cost Objects •Cost flows/tracking procedures •Allocation rules

Output Strategic Cost Information •What products are most profitable? •What does each process step add to costs?

•Lease payments

•Which customers are profitable?

•Other expenditures

•What are the key cost drivers?

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Nature of Cost Measurement Systems • Building blocks of Cost Measurement – Cost Objects • Any item for which a measure of cost is desired – Products, customers, lines of business, markets, etc.

• Corresponds to strategic decision needs

– Tracking Procedures • Traditional Systems – Resources to Departments to Cost Objects

• Contemporary Systems – Resources to Activities to Cost Objects

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Nature of Cost Measurement Systems • Building blocks of Cost Measurement – Allocation Rules • Direct Costs – Cost of consumption of resources directly traceable to or assignable to a particular cost object » Direct labor Direct material

• Indirect Costs – Cannot be directly traced or directly attributable to a particular cost object – Must be allocated to cost objects in some consistent, logical, and informative manner

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Design of Cost Measurement Systems • Affects on Cost Systems – Mass Production • Substantial inventories leads to emphasis on inventory measurement and manufacturing product cost • Unskilled labor with authority vested in functional departmental manager - responsibility accounting – Responsibility center cost tracking

• Little product variety allows use of single allocation base for all indirect costs

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Traditional Cost Measurement • Two Approaches – Job Order and Process Costing • Job order appropriate where specific, unique jobs or batches can be identified – One of a kind or custom manufacturing

• Process costing appropriate for high volume of identical products using a continuous process – Oil refining, brewing, bread, cement, chemical manufacturing, etc.

– Resources • Period expenses: not associated with creating inventory • Product cost: creation of inventory Quarles, ACC 564, CMS

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Job Order Costing • Resource cost traced to functional areas – Resources consumed by manufacturing area will be product costs – Cost centers – Costs within cost centers • Direct materials, direct labor, common costs

– Costs within the cost center traced to specific jobs or batches • Materials by requisition sheets • Direct labor by time cards • Others allocated based on some allocation basis Quarles, ACC 564, CMS

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TRADITIONAL JOB COST SYSTEMS Building Blocks

Cost Elements Functional Costs •Materials

•Engineering

•Wages and salaries

•Purchasing

•Utility costs

•Manufacturing

•Sales commissions

•Customer Support

•Equipment purchase •Advertising •Supplies

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Manufacturing Departments

Customer Jobs

•Stamping

•Sweden

•Assembly

•Zimbabwe

•Testing

•Others

Product Inventory Cost

Cost per Heat Exchanger

•Sales/marketing •General business support

Period Expenses

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Job Order Costing • Costs traced to specific jobs or batches Exhibit 4: Analysis of Manufacturing Costs by Jobs Sweden Direct Materials Stamping Assembly Testing Direct Labor Stamping Assembly Testing Overhead Stamping Assembly Testing Total Job Cost Number of Units Current Status Cost per Unit Quarles, ACC 564, CMS

Zimbabwe

Other

384,000 108,000 54,000

192,000 72,000 18,000

2,624,000 1,020,000 228,000

5,000 5,000 24,000

3,000 26,250 16,500

242,000 718,750 109,500

48,750 292,500 97,500 $ 1,018,750 8 in process $ 127,344

32,500 146,250 29,250 $ 535,750 6 complete $ 89,292

1,543,750 4,436,250 848,250 $ 11,770,500 86

Totals 3,200,000 1,200,000 300,000 0 250,000 750,000 150,000 0 1,625,000 4,875,000 975,000 $ 13,325,000

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Process Costing • Products are not unique within a production run – Identical and therefore consume equal amounts of resources – Simple procedure is to determine costs of production runs and divide by number of units produced to determine cost per unit

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Process Costing • Complicating factor – Work in process • Beginning and ending WIP in various stages of completion • Completion as to % of cost incurrence • WIP at end of period is come % complete as to the total cost that will be incurred in its completion • Equivalent Units of Production

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Process Costing Calculation of EUP (weighted average) Units completed and transferred 1,000,000 Ending WIP 40,000 units 60% complete 24,000 __________ Equivalent Units Produced

1,024,000

Cost incurred / EUP = Cost per unit Quarles, ACC 564, CMS

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TRADITIONAL COST SYSTEMS • Reflect a management philosophy of: – Responsibility by departments or cost centers – Financial rather than operational control – After-the-fact cost control rather than cost planning • Primary focus – Manufacturing costs (same as product cost) – Inventory and labor reporting • Cost flows from department to products Quarles, ACC 564, CMS

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Traditional Systems • Weaknesses – Product cost is not the total cost of the product • Manufacturing cost only • Ignores design,creation, installation,service, etc.

– Indirect cost (overhead) significant element of total cost but no data provided of what causes these costs in relation to particular products or volumes or processes

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Cost Measurement Systems • New concepts affecting systems – TQM • Cross functional management of processes reduce emphasis on responsibility accounting

– Lean Manufacturing or TQM • Reduces/eliminates inventory issues

– World Class Competition • Identify and manage costs, not purchases

– Total Product Cost • Manufacturing cost plus all costs of getting product/service to customer Quarles, ACC 564, CMS

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Activity Based Costing – Emphasis on activities and their relationships to resources and cost objects

• Steps in ABC • Step 1: identify activities and objects used by jobs/processes • Process map • Activities are related tasks that are accomplished in order to do what the work

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Activity Based Costing • Step 2: compute the cost of activities Exhibit 12: Activity Cost for Heat Exchangers Activity or Ope ration Cost Visit prospective customers $ 83,600 Develop product specifications 608,000 Draft contract 270,000 Purchase materials 288,000 Set up stamping machines 1,176,000 Stamp steel plates 3,952,000 Build frame 756,000 Insert plates into frames 5,040,000 Attach cover 126,000 Move unit to paint shop 9,000 Paint 480,000 Test 770,000 Transport to customer site 910,000 Final assembly 702,000 Final inspection 504,000 Bill customer 8,400 Other activities 87,000 Total Activity Cost $ 15,770,000 Quarles, ACC 564, CMS

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Activity Based Costing • Step 3: determine cost drivers for each activity – Cost drivers • (activity usage drivers) must be identified • what causes the activities to cost what they do

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Activity Based Costing • Cost drivers for each activity Exhibit 13: Activity Cost for Heat Exchangers A Activity or Operation Visit prospective customers Develop product specifications Draft contract Purchase materials Set up stamping machines Stamp steel plates Build frame Insert plates into frames Attach cover Move unit to paint shop Paint Test Transport to customer site Final assembly Final inspection Bill customer Other activities Total Activity Cost Quarles, ACC 564, CMS

Cost Driver $ 83,600 Number of trips 608,000 Engineering hours 270,000 Legal staff hours 288,000 Per purchase order 1,176,000 Per production run 3,952,000 Per machine hour 756,000 Per component 5,040,000 Per plate 126,000 Attachment points 9,000 Per unit 480,000 Surface area sq ft 770,000 Per test 910,000 Per trip 702,000 Per unit 504,000 Per unit 8,400 Per bill 87,000 $ 15,770,000

B A/ B Driver Cost per Quantity Unit of Driver 22 $ 3,800 3,800 160 1,800 150 2,400 120 120 9,800 520 7,600 420 1,800 6,300 800 2,100 60 120 75 32,000 15 275 2,800 140 6,500 120 5,850 120 4,200 28 300

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Activity Based Costing

• Step 4: create cost pools for common drivers – Simplify calculations and emphasizes drivers that account for significant costs

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Activity Based Costing • Step 5: assign costs to jobs/processes based on cost drivers Exhibit 14: Cost Assigned to Jobs

Activity or Operation Visit prospective customers Develop product specifications Draft contract Purchase materials Set up stamping machines Stamp steel plates Build frame Insert plates into frames Attach cover Move unit to paint shop Paint Test Transport to customer site Final assembly Final inspection Bill customer Total Activity Cost Quarles, ACC 564, CMS

Units of Driver

Sweden Job Cost per Driver

4 $ 1,400 18 240 11 22 38 280 122 14 3,800 18 0 0 0 0

Cost Assigned

3,800 $ 15,200 160 224,000 150 2,700 120 28,800 9,800 107,800 7,600 167,200 1,800 68,400 800 224,000 60 7,320 75 1,050 15 57,000 2,800 50,400 6,500 0 5,850 0 4,200 0 300 0 $ 953,870

Zimbabwe Job Units of Cost per Cost Driver Driver Assigned

1 $ 3,800 $ 3,800 300 160 48,000 4 150 600 90 120 10,800 3 9,800 29,400 8 7,600 60,800 25 1,800 45,000 95 800 76,000 90 60 5,400 6 75 450 825 15 12,375 6 2,800 16,800 2 6,500 13,000 6 5,850 35,100 6 4,200 25,200 1 300 300 $ 383,025 33

Activity Based Costing • Step 6: determine unit product cost (Direct Material + Activity Cost) / # of units Exhibit 15: Comparison of Job Cost Sweden Total Job Cost

Zimbabwe

Cost per Unit

Total Job Cost

Cost per Unit

Activity View Material Cost Activities Cost Total Cost

546,000 953,870 1,499,870

68,250 119,234 187,484

282,000 383,025 665,025

47,000 63,838 110,838

Traditional View Direct Materials Direct Labor Manufacturing Overhead Total Cost

546,000 34,000 438,750 1,018,750

68,250 4,250 54,844 127,344

282,000 45,750 208,000 535,750

47,000 7,625 34,667 89,292

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TRADITIONAL V. CONTEMPORARY COST SYSTEMS Basic Cost Elements • • • • •

Salaries & Wages Utilities Depreciation Materials & Supplies Taxes

DEPARTMENTS

JOBS

PRODUCTS

ACTIVITIES/ OPERATIONS

JOBS

PRODUCTS

Basic Cost Elements • • • • •

Salaries & Wages Utilities Depreciation Materials & Supplies Taxes

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TRADITIONAL V. CONTEMPORARY COST SYSTEMS Engineering Activities • Write specifications • Others

Manufacturing Activities •Purchase materials •Receive and inspect materials •Move materials

•Set up machines •Stamp steel •Move stamped steel •Assemble plates •Inspection •Rework •Others

TRADITIONAL PRODUCT COST CONTEMPORARY PRODUCT COST

Marketing Activities •Generate customer order • Others

Customer Support Activities •Install exchangers • Others Business Support Activities •Investigate credit •Draft contract •Bill customer • Others

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Non-traceable Activities •Management training • Others 36

Assignment Notes • Yamazoo – Conversion Cost • The total of Direct Labor and Overhead (all manufacturing cost except Direct Materials)

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