cost measurement system

Quarles, ACC 564, CMS1

Cost Measurement Systems

Traditional and Contemporary Approaches

Sam Houston State University

ACC 564

R. Quarles



• 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



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


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?



• 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



• 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


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



• 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



• 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



• 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



• 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



• 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.


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

14Quarles, ACC 564, CMS

• Transformation engine that converts raw data on resources purchased into cost information about resources used

TYPICAL COST MEASUREMENT SYSTEM

Basic Cost Elements

•Materials purchased

•Wages and salaries

•Utilities paid

•Equipment purchases

•Lease payments

•Other expenditures

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?

•Which customers are profitable?

•What are the key cost drivers?



• 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



• 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


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


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


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


•Materials

•Wages and salaries

•Utility costs

•Sales commissions

•Equipment purchase

•Advertising

•Supplies

Functional Costs

•Engineering

•Purchasing

•Manufacturing

•Customer Support

•Sales/marketing

•General business support

Manufacturing Departments

•Stamping

•Assembly

•Testing

Product Inventory

Cost

Cost per Heat

Exchanger

Building Blocks

Customer Jobs

•Sweden

•Zimbabwe

•Others

Cost Elements

Period Expenses

TRADITIONAL JOB COST SYSTEMS


Job Order Costing• Costs traced to specific jobs or batches

Exhibit 4: Analysis of Manufacturing Costs by Jobs

Sweden Zimbabwe Other TotalsDirect Materials

Stamping 384,000 192,000 2,624,000 3,200,000Assembly 108,000 72,000 1,020,000 1,200,000

Testing 54,000 18,000 228,000 300,000Direct Labor 0

Stamping 5,000 3,000 242,000 250,000Assembly 5,000 26,250 718,750 750,000

Testing 24,000 16,500 109,500 150,000Overhead 0

Stamping 48,750 32,500 1,543,750 1,625,000Assembly 292,500 146,250 4,436,250 4,875,000

Testing 97,500 29,250 848,250 975,000Total Job Cost 1,018,750$ 535,750$ 11,770,500$ 13,325,000$ Number of Units 8 6 86Current Status in process completeCost per Unit 127,344$ 89,292$


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


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


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


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


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



• 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


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


Activity Based Costing• Step 2: compute the cost of activitiesExhibit 12: Activity Cost for Heat Exchangers

Activity or Operation CostVisit prospective customers 83,600$ Develop product specifications 608,000Draft contract 270,000Purchase materials 288,000Set up stamping machines 1,176,000Stamp steel plates 3,952,000Build frame 756,000Insert plates into frames 5,040,000Attach cover 126,000Move unit to paint shop 9,000Paint 480,000Test 770,000Transport to customer site 910,000Final assembly 702,000Final inspection 504,000Bill customer 8,400Other activities 87,000

Total Activity Cost 15,770,000$



• 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


Activity Based Costing• Cost drivers for each activityExhibit 13: Activity Cost for Heat Exchangers

A B A / BDriver Cost per

Activity or Operation Cost Driver Quantity Unit of DriverVisit prospective customers 83,600$ Number of trips 22 3,800$ Develop product specifications 608,000 Engineering hours 3,800 160Draft contract 270,000 Legal staff hours 1,800 150Purchase materials 288,000 Per purchase order 2,400 120Set up stamping machines 1,176,000 Per production run 120 9,800Stamp steel plates 3,952,000 Per machine hour 520 7,600Build frame 756,000 Per component 420 1,800Insert plates into frames 5,040,000 Per plate 6,300 800Attach cover 126,000 Attachment points 2,100 60Move unit to paint shop 9,000 Per unit 120 75Paint 480,000 Surface area sq ft 32,000 15Test 770,000 Per test 275 2,800Transport to customer site 910,000 Per trip 140 6,500Final assembly 702,000 Per unit 120 5,850Final inspection 504,000 Per unit 120 4,200Bill customer 8,400 Per bill 28 300Other activities 87,000

Total Activity Cost 15,770,000$



• Step 4: create cost pools for common drivers– Simplify calculations and emphasizes drivers

that account for significant costs


Activity Based Costing• Step 5: assign costs to jobs/processes based

on cost driversExhibit 14: Cost Assigned to Jobs

Units of Cost per Cost Units of Cost per CostActivity or Operation Driver Driver Assigned Driver Driver Assigned

Visit prospective customers 4 3,800$ 15,200$ 1 3,800$ 3,800$ Develop product specifications 1,400 160 224,000 300 160 48,000Draft contract 18 150 2,700 4 150 600Purchase materials 240 120 28,800 90 120 10,800Set up stamping machines 11 9,800 107,800 3 9,800 29,400Stamp steel plates 22 7,600 167,200 8 7,600 60,800Build frame 38 1,800 68,400 25 1,800 45,000Insert plates into frames 280 800 224,000 95 800 76,000Attach cover 122 60 7,320 90 60 5,400Move unit to paint shop 14 75 1,050 6 75 450Paint 3,800 15 57,000 825 15 12,375Test 18 2,800 50,400 6 2,800 16,800Transport to customer site 0 6,500 0 2 6,500 13,000Final assembly 0 5,850 0 6 5,850 35,100Final inspection 0 4,200 0 6 4,200 25,200Bill customer 0 300 0 1 300 300

Total Activity Cost 953,870$ 383,025$

Sweden Job Zimbabwe Job



• Step 6: determine unit product cost(Direct Material + Activity Cost) / # of units

Exhibit 15: Comparison of Job CostSweden Zimbabwe

Total Job Cost Cost per Unit Total Job Cost Cost per Unit

Activity ViewMaterial Cost 546,000 68,250 282,000 47,000

Activities Cost 953,870 119,234 383,025 63,838Total Cost 1,499,870 187,484 665,025 110,838

Traditional ViewDirect Materials 546,000 68,250 282,000 47,000

Direct Labor 34,000 4,250 45,750 7,625Manufacturing Overhead 438,750 54,844 208,000 34,667

Total Cost 1,018,750 127,344 535,750 89,292


Basic Cost Elements Salaries & Wages Utilities Depreciation Materials & Supplies Taxes

Basic Cost Elements Salaries & Wages Utilities Depreciation Materials & Supplies Taxes

DEPARTMENTS JOBS

PRODUCTSACTIVITIES/

OPERATIONS

PRODUCTS

JOBS

TRADITIONAL V. CONTEMPORARY COST SYSTEMS


Non-traceable Activities•Management training• Others

Engineering Activities • Write specifications• Others

Business Support Activities•Investigate credit•Draft contract•Bill customer• Others

Marketing Activities•Generate customer order• Others

Customer Support Activities•Install exchangers• Others

CONTEMPORARYPRODUCT

COST

TRADITIONALPRODUCT

COST

Manufacturing Activities•Purchase materials•Receive and inspect materials•Move materials•Set up machines•Stamp steel•Move stamped steel•Assemble plates•Inspection•Rework•Others

TRADITIONAL V. CONTEMPORARY COST SYSTEMS


Assignment Notes

• Yamazoo– Conversion Cost

• The total of Direct Labor and Overhead (all manufacturing cost except Direct Materials)

cost measurement system

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