Module 5
Cost Management and Allocation
a. Using Activity-Based Cost Management to Add Value
We’ll start with activity-based cost management (ABCM), which uses activity-
based costing data to evaluate the cost of value chain activities within the fi rm and
identify opportunities for improvement. Before diving into ABCM, let’s briefl y review
two key concepts: activity-based costing and the value chain. Recall from that activity-
based costing (ABC) is a system used to assign costs to products based on the products’
use of activities, which are the discrete tasks an organization undertakes to make or
deliver the product. Describes, in detail, how to implement ABC. Our goal in this is to
understand how to take the information derived from an ABC system and use it to
improve operations. The value chain is the set of activities that transforms raw resources
into products for customers. Value-added activities in the value chain are the things that
customers will pay for. To maximize profi ts, fi rms must manage activities and the
resources used to fund those activities to minimize costs while providing value for the
customer.
Let’s look at an example to clarify how ABC and ABCM can be used to improve
operations. Consider the cost of setting up equipment to make a batch of units. Say the
activity-based costing system indicates a cost driver rate (the predetermined overhead
rate in ABC) of $50 per setup. Managers can reduce costs in two ways. They can reduce
the number of setups that they perform, perhaps by running larger batches or by
eliminating very small-volume products. Or they can work hard to become more effi
cient at performing setups so that the cost per setup declines. Japanese automobile
manufacturer, Toyota Motor Company, became famous for the speed with which its
employees could change the tooling of machines. Their speed meant that fewer resources
were consumed in the setup activity and less productive capacity was lost to idle
changeover time. With a lower cost of setup than their U.S. competitors, they could effi
ciently run smaller batch sizes, a critical feature of Toyota’s operating strategy, which has
come to be known as lean manufacturing.
Senior managers can urge employees to reduce costs (as determined by the
activity-based costing system), but achieving cost reductions requires the company to
change either the frequency or the efficiency of an activity using activity-based cost
management. If you have been in school during a period in which education costs were
cut, you know that reducing costs requires a change in activities. When a school has to
work with fewer resources, the administration, employing ABCM, may look at canceling
classes or reducing student services. Or it may consider increasing class sizes or
introducing new technologies for instructional efficiency. The first set of options adjusts
the frequency of activity to match resources. The second set uses fewer or lower-cost
resources to improve efficiencies.
Activity analysis provides a way for organizations to think systematically about
the processes that they use to provide products to their customers. Managers working
with accountants can use the analysis to identify and eliminate activities that add costs
but not value.
Let’s apply these same concepts to a service organization by looking at a
mortgage company that processes loans. Have you ever taken out a loan? Do you wonder
why approval cannot be done instantaneously? tracks activities from the lender’s receipt
of a loan application to letting the customer know about the loan decision. Suppose that a
loan offi cer at a mortgage company currently processes 30 loan applications per month.
Increasing the effi ciency of value-added activities and eliminating non-value-added
activities can shorten the process. For example, verifying credit, bank, employment, and
other key information about the customer delays the process. Using technology can
expedite the process.
If the loan offi cer can reduce the processing time to half a month for 30 loan
applications, several good things happen. Happy customers see that their applications are
processed faster, the cost per application goes down, and the lender processes more
applications per month. The additional capacity will save the fi rm money as it expands
because it will not have to hire and train new loan offi cers. You can see from this
example that activity-based cost management applies to many different types of
organizations, including manufacturing, retail, service, nonprofi t, and governmental
agencies.
In the business world, you’ll often fi nd activity-based cost management paired
with lean manufacturing. Lean manufacturing is an approach to production that tries to s
ignifi cantly reduce production costs using solutions such as just-in-time inventory and
production, elimination of waste, and tighter quality control. The key features of lean
manufacturing fl ow naturally from careful activity analysis. Just as activity-based cost
management often prompts fi rms to begin the journey toward becoming a lean
enterprise, becoming lean often prompts fi rms to revisit their cost accounting practices.
What often emerges after fi rms adopt lean manufacturing is a new approach to cost
accounting, termed lean accounting. Lean accounting is a cost accounting system
designed around the value chain of major products and services to support lean
manufacturing. It can also refer to applying lean production methods to accounting work
itself.
Traditional manufacturing fi rms often group similar operations together. For
example, assume a bicycle manufacturer bends tubing in preparation for welding, welds
the tubing into frames, and then paints the welded frames. All of the machines used to
bend the tubing are in one area of the plant. All of the welding machines are in another
area of the plant. All of the painting equipment is in yet another area of the plant. The
workers who operate the machinery in each of the three areas often have their own
supervisor for that particular area, and the products typically come through the area in
batches. This approach often results in large work-in-process inventories. To be sure
there is enough work to keep the welders busy, the company might have a large batch of
bent tubes in inventory waiting for welding. Similarly, the company might have a lot of
welded frames in inventory waiting to be painted. Why? Because the company wants to
keep these activities going full speed.
Lean manufacturers organize differently. To ensure that a welder is ready to make
a bicycle immediately after the preceding operation of bending the tubing—and to avoid
inventory buildup—the lean manufacturer places the welding machine near the machine
that is bending tubes, and the paint work station. In short, the lean manufacturer
organizes its factory around the process fl ow of a single major product, not around
groups of similar machines. Moreover, if lean manufacturers eliminate inventories and
the material-handling functions that accompany it, many of the overhead costs disappear.
As a result, the fi rm’s accountants can more directly assign costs to the appropriate value
chain. Instead of assigning costs to the welding activity and allocating those costs to the
various types of bicycles, accountants assign costs directly to each type of bicycle.
Some costs can be associated with units of goods or services; others cannot.
Consequently, allocating all costs (such as building leases) to units is misleading if some
costs do not vary with the volume of units. As a result, management cannot effectively
manage these costs by focusing on the volume of units. For example, the costs of
machine setups are generally batch related. A machine setup is required for each new
batch of product whether the batch contains 1 unit or 1,000 units. The setup cost is not
affected by the number of units but by the number of batches.
Management can establish a hierarchy of costs, as we described. Strictly variable
costs, such as energy costs to run machines, are affected by the volume of units produced.
Naturally, any variable costs such as those for direct materials are unit-level costs. At the
other extreme are capacity-related costs, which are essentially fi xed by management’s
decisions to have a particular size of store, factory, hospital, or other facility. Although
these costs are fi xed with respect to volume, it would be misleading to give the
impression that they cannot be changed. Managers can make decisions that affect
capacity costs; such decisions just require a longer time horizon to implement than do
decisions to reduce unit-level costs.
Two middle categories of costs are affected by the way the company manages its
activities. A company that makes custom products has more product-level costs than a
company that provides limited choices. A company that schedules its work to make one
product on Monday, a second product on Tuesday, and so on through Friday has lower
batch-related costs than if it produced all fi ve products on Monday, all fi ve again on
Tuesday, and so on through the week. In practice, many of the greatest opportunities for
reducing costs through activity-based management are in these middle categories of
product- or customer-level and batch-related costs. We gave an example of a cost
hierarchy. Using such a hierarchy, managers analyze only the volume-related costs if they
make decisions that affect units, but not batches, products, customers, or capacity. If
managers make decisions that affect capacity, however, costs in all levels of the hierarchy
—volume, batch, product, and facility—will probably be affected, and activities in all
four categories should be analyzed.
b. Managing the Cost of Customers and Suppliers
We described in how different products affect fi rm costs by using resources. The
advantage of an activity-based costing system is that it refl ects the diverse uses of
resources in the product costs so managers can make better decisions about the products.
For some fi rms, however, decisions are not about the products or services but about
customers. For example, when a company decides to spend its advertising budget on
Sunday Night Football rather than 60 Minutes, it does so because it believes the
customers it attracts from one audience will be more profi table than those it might attract
from the other audience. One reason a group could be more profi table as customers is
that it would buy more product. Another reason is that one group could be less costly to
serve.
How can customers “cost” money? Think about the last time you stood in line to
purchase a ticket, check in for a fl ight, or make a transaction in a bank. Many people
ahead of you are purchasing the same service (a ticket, a fl ight, or a deposit), but some
take longer (sometimes much longer) to complete the transaction. The additional time
those customers take adds cost to the company.
Fortunately, we can apply the concepts of activity-based costing to the question of
customer costing (and therefore customer profi tability) easily. Consider Red’s Lumber
Company, introduced at the beginning of the. Red’s charges a fee for the delivery service
based on the value of the order. The current fee is 16 percent of the order value and is
designed to cover just the delivery cost. Recently, some of Red’s best customers have
reduced their purchases, and Red is concerned. He thought the customers were satisfi ed
because they had placed large orders and, although they did not order frequently, always
returned. He still has plenty of customers who generate a great deal of revenue over the
year, but he realizes that the customers who have reduced their purchases have different
buying patterns than those who continue to order the same amount. He decides to
investigate a bit to see why some customers are reducing purchases and whether he can
make some changes to reverse this trend.
Red decides to look fi rst at his costs and pricing policy. He picks two customers
(Jack’s Home Renovation and Jill’s Contracting) as representative of the types of
customers who are staying and leaving, respectively. Red prepares some summary
operating data based on the planning for next year. After preparing the data, Red realizes
that he cannot determine the cost of delivery at the customer level. He can do this only at
the store (fi rm) level. He decides to investigate even further by studying the delivery
service in more detail. Red decides to apply the concepts of activity-based costing to the
delivery service itself. Although it could also be useful in analyzing the yard’s operations,
Red decides that this analysis can wait. Following the four-step procedure described, Red
fi rst considers the activities involved with the delivery service and identifi es three major
activities: entering the order, picking the order (employees going to the yard and
gathering the individual items in the order), and delivering the order. Red identifi es a
fourth activity, which is supervising and administering delivery.
Red considered many drivers for the general administrative activity. Because it is
a miscellaneous collection of activities, he decides to use the order value. He believes that
the other three cost drivers are appropriate for the respective activities. The third step in
Red’s analysis is to compute the cost driver rates. Through interviews and an analysis of
past accounting records, Red computes the rates which are based on expected activity for
the next year.
The last step in the costing process is to assign the cost driver rates to the
individual customers. To do this, Red collects expected cost driver information on the
two sample customers, Jack and Jill. After putting together the data. Red notices
something interesting. Jack, a customer who is staying, orders the same number of items
as Jill, a customer who is leaving. However Jack makes many relatively small orders; the
sales value of an average order for Jack is about $333 (=B$50,000B÷ 150 orders). An
average order for Jill is $1,000 (= $50,000B÷ 50 orders). In addition, Jack requires
frequent deliveries, sometimes having partial orders delivered (200Bdeliveries for 150
orders).
c. Determining the Cost of Suppliers
The analysis of customer cost also can be applied to suppliers. For example, fi
rms commonly evaluate suppliers based on the price they charge for materials. What such
an evaluation policy ignores, however, is that the supplier actually provides other services
as well. A good supplier delivers the material that was ordered, on time, and of
appropriate quality. If a supplier fails to perform any one of these ancillary activities well,
the customer incurs costs to correct the failure.
Consider the case of Red’s Lumber again. Red buys lumber from two mills, Pacifi
c Mills and Coastal Lumber. Both mills almost always send the correct order and the
lumber of the right quality, but sometimes deliveries are late. When that happens, Red
has to hire temporary workers or pay his employees overtime to handle the delivery.
Because most deliveries from the two mills consist of similar products, the cost to handle
a delivery is roughly proportional to the amount of lumber in the delivery.
Red’s yard supervisor estimates that the cost of late deliveries was $34,000, based
on the cost of temporary labor, overtime wages and benefi ts, and the administrative costs
of delaying deliveries to customers. Red can use this information to manage costs by
revising his purchasing policy. Based on the data, approximately 340,000 board-feet were
delivered late (= 600,000 board-feet ordered × 50% late deliveries + 400,000 board-feet
ordered × 10% late deliveries). The cost of the late deliveries was $34,000, or $0.10 per
board-foot delivered late. Red has just received two bids for an order of lumber. Pacific
Mills bid $2.04 per board-foot and Coastal Lumber bid $2.07. Under its current
purchasing policy, Red’s Lumber would order from Pacifi c Mills because the price is
lower.
Red computes the effective cost of buying from Pacifi c Mills based on its past
delivery performance. After doing this, Red realizes that given the delivery performance,
it is actually cheaper to buy from Coastal Lumber. In addition, he has a better basis to
compare bids in the future. He can simply add $0.05 to the bid from Pacifi c Mills and
$0.01 to the bid from Coastal Lumber.
Identifying the costs of customers and pricing the services to refl ect the costs is
not suffi cient to reduce the costs that Red incurs for delivery. It is important to reduce
the resources used by the delivery activities. If, for example, Red’s customers order less
frequently because of the new pricing policy, Red has to take steps to redeploy the assets
used in the order-taking activity. Otherwise, the costs will remain the same. Red will
simply have excess capacity in the order-taking group.
In the product costing systems we have designed, the costs of all resources,
including the costs of capacity, generally have been divided by an activity measure and
included in the resulting product costs. Managers then use these product costs to make
pricing decisions, product portfolio decisions, process decisions, and so on. At the
beginning of, we indicated that this treatment could lead to the death spiral as managers
try to cover increasing reported product costs.
d. Managing the Cost of Quality
In some situations, costs go up and down proportionately with the cost driver.
Materials, energy, and piecework labor are excellent examples in a manufacturing fi rm.
Consider the delivery service at Red’s. Suppose that every time Red’s has an order to
deliver, it hires temporary workers and pays them $0.80 per item to load them into a
delivery truck. The cost driver is obviously the number of items, and the cost driver rate
is $0.80 per item. Now suppose that employees (loaders) are hired for a month for $9 per
hour. Red’s employs fi ve workers, each of whom work 8-hour days. Each of these
workers has the capacity to load 60 items per day. The cost driver might still be number
of items. The cost driver rate is computed by dividing the estimated wages of loaders for
the day by their capacity measured in items. This calculation gives a rate of $1.20 per
item [= ($9 per hour × 8 hours) ÷ 60 items]. In general, this cost driver rate could be
higher, lower, or the same as the piecework rate. We use a rate of $1.20 just to help you
recognize that a difference exists between the piecework rate and the cost driver rate
when workers are paid by the hour.
When workers are paid by the hour. Suppose that on Tuesday, the workers loaded
260 items. That means there were 40 items, or $48 (= $1.20 cost driver rate × 40 items),
of unused capacity on Tuesday. Red’s has costs of $360 computed either of two ways:
$360 = 5 workers × $9 per hour × 8-hour day $360 = $1.20 per item × 300 item capacity
Red’s supplied resources of $360 to the loading activity. Only $312 of loading resources
were used ($312 = $1.20 × 260 items actually loaded), however, leaving $48 of unused
capacity. Red knows that the fi ve workers could have loaded more items without
increasing the resources supplied to the activity. In general, activity-based costing
estimates the cost of resources used. In activity-based costing, resources used for an
activity are measured by multiplying the cost driver rate by the cost driver volume. In the
case of Red’s delivery service, resources used were $312.
The resources supplied to an activity are the expenditures or the amounts spent on
it. In the case of Red’s delivery services, the amount of resources supplied was the $360
paid to the loaders. Resources supplied is the amount that appears on fi - nancial
statements. The difference between resources used and resources supplied is unused
resource capacity. Now that we have identifi ed unused resource capacity, we show how
to report this information in a way that supports cost management. We do this by
combining the concepts of the cost hierarchy and unused resource capacity. Typical
reports show costs as line items similar to those shown for Red’s Lumber, which itemizes
the delivery costs. It is impossible for managers to distinguish resources used from
resources supplied in such reports.
A more informative report for managing capacity costs is shows. It fi rst
categorizes costs into the cost hierarchies. Managers can look at the amount of costs in
each level of the hierarchy and fi nd ways to manage those resources effectively. For
example, managers see that $400,000 of resources are supplied to batchrelated activities
such as entering and delivering orders. Managers can investigate to determine how much
of that $400,000 can be saved by changing the production process, for example, by using
flexible scheduling for the order entry clerks.
Perhaps of more interest, the report shows managers how much of the resources
for each type of cost are unused. Here’s how it works. The cost driver for picking items is
the number of items and the rate is $2 per item. (The cost driver rate includes, in addition
to labor costs, a portion of the depreciation and equipment, energy, and other costs.)
Based on the information in the income statement, Red’s spent $150,000 on picking
items. That represents 75,000 items of picking capacity (= $150,000 ÷ $2Bper item).
However, only 67,500 items were picked (= $135,000 resources usedB÷ $2 cost driver
rate). The report shows managers that $15,000 (or 7,500 items) of unused picking
resources were available.
All other things being equal, perhaps as many as 7,500 additional items could
have been picked during the year without increasing expenditures. In reality, managers
know that some unused resources are a good thing. Having some unstructured time for ad
hoc training, leisure, and thinking about ways to improve the work and work environment
can be useful for morale and productivity. Note that some costs have more unused
resources than others. The volume-related costs show 10 percent (= $15,000 ÷ $150,000)
unused resources. Many of these costs vary proportionately with output and often have
little or no unused resources. Some of the picking labor, for example, is the cost of
temporary help that is employed on an as-needed basis. Summer workers in a food
processing plant are another example of short-term labor. However, the report indicates
that one-third of the delivering orders activity costs are for unused capacity. Reporting
the capacity costs by activity and cost hierarchy helps managers identify areas for further
investigation.
The importance of managing capacity costs increases with the relative proportion
of these costs in an organization’s cost structure. Consider Northern Air Charters (NAC),
which operates a fl eet of small aircraft that fl ies tourists into remote regions for hunting,
fi shing, and backpacking trips. NAC purchased planes based on an estimated long-term
annual volume of 2,500 passengers. If every seat were fi lled on every fl ight, these
planes could carry 4,000 passengers. However, under the best practical conditions that
can be expected, the planes would be capable of carrying no more than 3,200 passengers
annually.
NAC incurs $400,000 of fi xed operating costs for depreciation, supervision, and
other items annually. It uses a traditional product costing system and computes product
cost by allocating the fi xed operating costs according to the number of passengers fl
own. Zack Stryker, NAC’s owner, is concerned about the fl uctuations in reported
product costs over the last few years. He uses the reported costs (along with information
on market conditions) to establish trip prices. For computations for the last three years.
Zack believes that these three years are representative of the business given the fl
uctuations in weather and economy.
As he considers the data, Zack notices a weird result. In poor years (such as year
3), when business is down, the cost system reports a relatively high cost. In good years
(such as year 2), when business is booming, reported product costs are relatively low.
This bothers Zack because he remembers that in year 3, he thought about lowering prices
to attract new business, but the information from the cost system suggested that he would
have to sell below cost.
What is the cause of the problem? The cost system allocates all costs to expected
volume annually. Therefore, in “bad years” (year 3), the costs are allocated among
relatively few passengers. In “good years” (year 2) the costs are spread over a larger
number of passengers. This process is sending exactly the wrong signal to Zack for his
pricing decisions. Zack knows that he could use variable costing and ignore fi xed costs
of capacity, but he is afraid he will forget about these costs. Suppose, however, that he
defi nes the allocation base so that it does not vary over time. Then the reported unit fi
xed cost would remain constant (assuming that the costs remained constant) and there
would be no perverse signal on the costs. One possibility is to use a measure of capacity
as the allocation base.
If Zack chooses to use capacity as the allocation base, he needs to decide how to
measure it. There are at least four possibilities for the base. One, the actual activity,
which is the volume actually produced this period, is used currently. It leads to the
problems just described. The highest volume is theoretical capacity, which is what could
be produced or served under ideal conditions without allowing for normal maintenance
and expected downtime. Practical capacity is the volume that could be produced allowing
for expected breaks and normal (expected) maintenance and downtime. Normal activity
is the long-run expected volume produced.
Suppose Zack chooses to compute fi xed operating cost based on normal activity.
This means that the costing system charges operations at $160 per passenger. How can
Zack use this information to help him manage capacity costs? Suppose that, as in year 1,
actual activity is 2,000 passengers. Then the cost system charges $320,000 (= 2,000
passengers × $160 per passenger). Actual fi xed costs are $400,000. The difference is
$80,000, which is a period charge for unused (excess) capacity. When this information is
reported to Zack, he can use it to decide whether this year’s volume is simply part of the
normal business cycle or whether it is part of a long-term trend downward in traffic. If
this is part of a long-term trend, Zack can take actions to reduce the capacity.
Notice that if the cost of excess capacity were included in the cost of the service
(by using actual volume), the company would still incur the $80,000 of excess capacity
cost. The problem is that in this case, the excess capacity cost is hidden from Zack
because it is included in each unit of service. Making it explicit enables him to consider
the excess capacity and what actions need to be taken to manage it. The earlier analysis
suggests that using actual activity leads to information that can distort pricing decisions.
The problem with theoretical capacity is that, by defi nition, NAC cannot achieve it. This
means that if Zack uses it as a basis for pricing, he is in danger of not recovering his
costs. To examine more closely the benefi ts of using practical capacity or normal
activity, we need to address another issue.
Notice that Northern Air Charters has the capacity to carry 3,200 passengers
annually although when buying the capacity, it expected an annual volume of 2,500
passengers. Why would NAC buy more capacity than it expected to use? There are two
general reasons. (We explore other reasons for unused capacity and the appropriate
treatment of costs in the problems.) First, NAC could be planning to expand its business
and may not want to have to buy additional capacity, for whatever reason, when it does.
A second possibility is that customers tend to “bunch” their demands. That is, demand in
some periods, the summer for example, is higher than in others, for example, the winter.
However, because NAC does not rent the aircraft daily or monthly, it has to have excess
capacity during the year to meet theBextra demand in the summer. This is called seasonal
demand and it occurs when the demand for the capacity is uneven over some period such
as the year.
These two situations are fundamentally different. In the fi rst case (planning for
expansion), NAC bought the excess capacity for its use, not that of its customers. In this
case, the better cost system to report cost would use practical capacity, or some measure
of long-term volume. Otherwise, the cost of serving customers is overstated because a
smaller fl eet of planes (at a lower cost) could have carried the passengers. Using normal
or actual activity suggests that current customers should “pay” for NAC’s unused
capacity. (Of course, the reported product cost is not what a customer pays but is the
signal that managers receive about the cost of serving a customer and could infl uence
pricing decisions.)
In the second case (fl uctuating demand), the excess capacity is for the benefi t of
the customer; it allows NAC to meet the peaks in demand in the summer. Although NAC
has the capacity to carry 3,200 passengers, NAC can achieve this volume only if the
demand is uniform over the year. We can apply the lesson of the preceding section to the
case of seasonal demand. Suppose NAC has one group of customers that wants to fl y in
the winter and another group that wants to fl y in the summer. For convenience, assume
that there are only two seasons, each of which is six months long. Also assume that
demand is uniform throughout each season.
Demand in the winter totals 800 passengers and in the summer totals 1,600
passengers. We see in this case that the reason that NAC has an annual capacity of 3,200
passengers is to serve the summer market. (An annual capacity of 3,200 passengers is
equivalent to a six-month capacity of 1,600 passengers.) How should the product costing
system assign capacity cost in order to give Zack useful signals about the cost of the
service? To answer this question, we note that the cost of unused capacity is $100,000.
That is, by spreading the 2,400 passengers out uniformly over the year, Zack could
reduce the capacity by 25 percent (= 800 passengers excess capacity ÷ 3,200 passenger
capacity) or $100,000 (= 25% × $400,000). The question is how to report the unused
capacity cost of $100,000.
The fi rst alternative is not appropriate because NAC has the unused capacity for
the benefi t of the passengers. The second and third alternatives assign some costs to the
winter customers in excess of the costs to serve those passengers. If Zack uses this cost to
make pricing decisions, he is in danger of losing those customers to competitors that do
not have excess capacity. If the costs are assigned only to the winter passengers, for
example, information from the cost system tells managers to concentrate on increasing
summer business because summer passengers are less costly. But in summer, NAC is
already at capacity. Therefore, the best solution is to assign the unused capacity costs to
the cost of serving passengers in the summer (i.e., alternative 4). These passengers
require the excess capacity. It is the summer passengers that should be assigned the cost.
It is important to remember that this analysis does not mean that Zack should raise
the price to the summer passengers. Pricing depends not only on costs but also on market
conditions. The analysis also assumes that there is no other use for the capacity in the
winter (fl ying passengers to ski resorts, for example). The key factor is what competitors
are likely to do. If all competitors must have excess capacity to meet summer demand, it
is likely that the market price will refl ect the cost of this excess capacity. If a competitor
fi nds an alternative use for the excess capacity, the market price will fall to refl ect the
lower cost of excess capacity.
e. Managing the Cost of Quality
To ensure that they produce high-quality products, many companies have adopted
total quality management (TQM) systems that support quality initiatives. However,
unless the cost accounting systems are also designed to support these initiatives,
companies are likely to fi nd that TQM has little economic benefi t. Managers are
ultimately evaluated on the cost of their activities, and costs associated with quality must
be incorporated in a way that allows managers to make decisions that consider the role of
quality and other product characteristics and that increase the value of the fi rm. Using
separate cost and quality systems has the risk that managers will work with and respond
to incorrect signals about the value of quality programs. For example, suppose that TQM
requires expenditures to train employees to improve quality but increases short-run costs.
Suppose also that the company records and reports cost increases but not quality
improvements. Given a choice between a recorded cost increase and an unrecorded
quality improvement, the manager might choose not to increase cost to improve quality.
Many discussions about the value of quality in the organization are not productive
because different managers use quality to mean different things. While we could (and
some do) write a book defi ning quality, we list here two common views of what quality
means. Neither of these views is appropriate in all situations, but when designing a cost
management system to support quality programs, you need to be sure that you know what
view of quality the system is designed to support. We consider two views of the meaning
of quality: the external and the internal view.
Customer expectations of quality refer to what customers expect from a product’s
tangible and intangible features. Tangible features include performance, taste, and
functionality; intangible features include how the product’s salespeople treat customers
and the time required to deliver the product to the customer after it is ordered. In short,
the external view is everything about the product that the customer values. It is about all
aspects of a product’s purchase and use. Although customer expectations are clearly
important in determining quality, at times they do not provide a useful guide for
managers. For example, products and services could be so new or so different that
customers have no expectations of them. In these cases, fi rms have to look inside to
evaluate quality.
Quality also can be defi ned as conformance to specification, the degree to which
a product or service performs as designed (or specifi ed). If we establish a specifi cation
that a printer will produce one page in 10 seconds, a “quality” printer will do just that (or
better). Conformance to specifi cation, of course, is also not suffi cient. We can produce a
product that is 100 percent within specifi cations that no customer wants, at any price.
Therefore, there has to be a link between the specifi cations we develop for our product
and the expectations customers have for it.
Managing costs does not only mean reducing cost. Rather, we manage costs by
ensuring that the organization is operating effi ciently given the products, customers, and
processes that comprise its activities. As with other product characteristics, quality is
something the customer values and the fi rm expends resources to ensure. One cost
management system that is designed to help managers make decisions about quality is a
so-called cost of quality system. A cost of quality system is based on the idea that a
tension exists between incurring costs to ensure that products meet the company’s defi
nition of quality and the cost incurred by not meeting that defi nition. By classifying the
fi rm’s quality-related costs into categories, managers can better manage them.
The ultimate goal in implementing a quality improvement program is to achieve
zero defects while incurring minimal costs of quality. However, managers must make
trade-offs between the four cost categories, and total costs of quality must be reduced
over time. How would Red estimate the cost of quality? He would calculate the costs
related to ensuring quality. For example, the yard supervisor performs the machine
inspections as part of her daily duties, an activity (prevention cost) that costs $22,000 per
year. Red must decide how much to spend on machine inspections versus inspecting the
fi nal boards (appraisal cost). It could be less costly to inspect the boards rather than the
saws (which takes the saws out of production).
Costs of quality are often expressed as a percentage of sales. An example of a cost
of quality report prepared for Red’s indicates that the fi rm spent $57,600 on quality
training and machine inspections (prevention costs), which represents 1.2 percent of
sales. This is the largest amount spent on quality for any of the four categories. Red’s
spent $30,000 (= 0.6 percent of sales) on appraisal costs and $36,000 (= 0.7 percent of
sales) on scrap costs. The cost of dealing with customer complaints totaled $30,000 (=
0.6 percent of sales).
Red uses the information to see how he can reduce the overall cost of quality. For
example, suppose that “scrap” occurs because lumber is cut to the wrong size. Adding an
additional check to ensure that each order is correct could reduce scrap costs. Customer
complaints refers to the cost of dealing with customers, including managerial time and
reimbursement to irate customers. Perhaps this cost could be reduced by fi nding the
source of customer complaints and dealing with the problem before it becomes a
customer complaint.
Red’s goal is to reduce the total cost of quality ($153,600) as a percentage of sales
(3.1 percent) while maximizing the value of each dollar spent on quality. Thus, he could
fi nd that spending an additional $30,000 on prevention costs will reduce the cost of scrap
by $20,000 and the cost of customer complaints by $25,000, for a total of $45,000 saved
for an additional cost of $30,000. This gives a net reduction in the cost of quality of
$15,000. As a result, the total cost of quality would be reduced to $138,600, or 2.8
percent of sales. The cost of quality report can be a valuable decision-making aid for
managers, but it is only effective if all quality costs are measured and reported. If a cost
of quality system is not comprehensive, there is a danger that decisions will be distorted
as managers focus on the costs the system includes but ignore unreported quality costs
(see the Business Application feature, “Cost Elements Included in Reported Quality
Costs”).
Because most accounting systems do not collect the cost of lost business and
other opportunity costs, a cost of quality system is likely to underestimate external failure
costs. In this case, information from the cost of quality system is likely to lead managers
to underinvest in prevention and appraisal activities because the cost of external failures
is underestimated. The graphical representation is often misinterpreted to imply that some
optimal and unchanging level of quality exists, but as competition increases and the costs
of technology decrease, both the conformance and nonconformance curves shift to the
right. This means that over time, the optimal level of quality increases. However, without
a cost management system that routinely reports the cost of quality, managers are unable
to monitor these costs at all.
f. Methods of Allocating Service Department Costs
This section describes three methods used to allocate service department overhead
costs: the direct method, the step method, and the reciprocal method. To make each
method easier to understand, we use the four departments at CCC as an example. CCC
allocates service department costs to Hilltop and Pacifi c for two purposes: (1) to
determine the cost to produce and market coal and (2) to encourage operating department
managers to monitor service department costs, that is, cross-department monitoring.
Because all CCC department managers are evaluated, in part, on the costs of their
department, they do not view the allocation of cost as a meaningless exercise.
(Performance measurement is discussed in more detail in later.) They make operating
decisions, such as pricing, based on the costs of their operations. Therefore, to the
managers in these departments, the allocated costs are as “real” as the costs of employees
and equipment.
Each service department is an intermediate cost center whose costs are recorded
as incurred and then distributed to other cost centers. We know from our discussion of
cost management systems that an important aspect of cost allocation is deciding which
allocation base to use. Because we have already spent a great deal of time on the choice
of cost allocation bases, we simply specify that CCC has determined that the best
allocation base for Information Systems is computer-hours and the best allocation base
for Administration is number of employees. For the allocation base for each service
department and the proportion of costs allocated to user departments. For example,
Information Systems’ costs are allocated on the basis of the number of computer-hours
used by each other department. During the period, Information Systems provided 100,000
hours of service to Administration, which represents 50 percent of the 200,000 total
computerhours provided. Similar methods are used to derive the percentages for
allocating Administration costs.
The direct method allocates costs directly to the fi nal user of a service (e.g.,
Hilltop Mine), ignoring intermediate users (e.g., Administration). The direct method
makes no allocations among service departments. Thus, Information Systems’ costs
attributable to the Administration Department are not allocated to Administration.
Instead, the service department costs are allocated “directly” to the user departments—
hence, the name direct method . The use of the direct method of cost allocation at CCC is
discussed here. Assume that the accounting records show that costs of $800,000 and
$5,000,000 are recorded in each service department, Information Systems (S1) and
Administration (S2), respectively. Costs are allocated directly to Hilltop Mine (P1) and
Pacifi c Mine (P2). Note that these are direct costs of service departments that become
overhead costs of the user departments.
Information Systems’ costs of $800,000 are allocated to Hilltop Mine and Pacifi c
Mine based on the number of computer-hours used by each. According to the facts,
Hilltop Mine (P1) used 20 percent and Pacifi c Mine (P2) used 80 percent of the total
Information Systems computer-hours consumed by user departments. Remember that
these are relative usages that ignore the use of Information Systems services by
Administration. Of the total of 200,000 computer-hours used, Administration uses
100,000. This means that the two user departments (Hilltop and Pacifi c Mines) used
100,000 computer-hours. Hilltop uses 20,000 hours (or 20 percent) of the 100,000, and
Pacifi c Mine uses 80,000 (or 80 percent) of the 100,000.
The step method recognizes that one service department can provide services to
others and allocates some service department costs to other service departments.
Allocations usually are made fi rst from the service department that has provided the
largest proportion of its total services to other service departments. Once an allocation is
made from a service department, no further allocations are made back to that department.
Hence, a service department that provides services to, and receives services from, another
service department has only one of these two relationships recognized. Choosing the
allocation order that we just suggested minimizes the percentage of service costs ignored
in the allocation process. (Sometimes, the allocation begins from the service department
with the largest cost. We explore this possibility in SelfStudy Question 2.) When CCC
uses the step method, it allocates costs from Information Systems to Administration but
not vice versa.
An analysis of service usage among CCC’s service departments indicates that
Information Systems supplies 50 percent of its services to the other service department,
Administration. Administration supplies 20 percent of its services to the other service
department, Information Systems.
Information Systems’ costs are allocated to Administration, but remember that
under the step method, once a service department’s costs have been allocated to other
departments, no costs can be allocated back to it. Therefore, no Administration costs will
be allocated to Information Systems. For the computation of Information Systems’ costs
allocated to the other service department at CCC. Notice that, the Administration costs
that are allocated include both the $5,000,000 costs directly incurred by Administration
and the $400,000 costs allocated from Information Systems. The effect of using the step
method is that Hilltop Mine is allocated more costs than it is with the direct method. The
reason is that Hilltop uses a larger proportion of Administration resources, and
Administration uses half of the Information Systems resources.
g. Allocation of Joint Costs
These costs include materials, labor, and manufacturing overhead (including
allocated service department overhead). As the coal is mined, two products, hi-grade and
lo-grade, emerge. (We ignore any other possible products for now.) The stage of
processing at which the two products are separated is called the split-off point. Processing
costs incurred prior to the split-off point are the joint costs . Managers often are interested
in another issue. Should a product be sold at the split-off point or processed further?
Rather than selling lo-grade coal at the split-off point, should CCC process it further to
produce a higher quality of coal (mid-grade coal)? The higher-quality coal requires
additional processing costs, but the sales price for mid-grade coal is higher than that for
lo-grade coal sold at the split-off point.
When a single raw material is converted into products sold by two or more
departments, the cost of the raw material must be allocated to the products involved. For
example, if different groups at CCC are responsible for selling hi-grade coal and lo-grade
coal, the cost of mining coal could be allocated to these groups to compute group profi t.
Manufacturing companies must allocate joint costs to determine the inventory value of
the products that result from the joint process. When companies are subject to rate
regulation, the allocation of joint costs can be a signifi cant factor in determining the
regulated rates. Crude oil and natural gas are usually produced from a common well. In
recent years, energy price policies and gas utility rates have been based in part on the
allocation of the joint costs of crude oil and natural gas.
When the allocation of costs can impinge on the fi nancial fortunes of opposing
parties, both sides critically review the allocation method. For example, neither an
insurance company nor an insured party wishes to pay more or receive less than is fair.
Executives and employees of one department object to a cost of goods sold fi gure that
they believe is overstated for their department but understated for another department.
Both buyers and sellers of regulated products or services are affected by pricing, and
neither wishes to give the other an advantage. Each of these cases involves opposing
interests. As always, any cost allocation method contains an element of arbitrariness. No
allocation method is beyond dispute. Consequently, allocation methods must be clearly
stated before they are implemented.
h. Joint Cost Allocation Methods
The net realizable value method allocates joint costs to products based on their net
realizable values at the split-off point. The net realizable value is the estimated sales
value of each product at the split-off point. If the joint products can be sold at the split-off
point, the market value or sales price should be used for this allocation. If the products
require further processing before they are marketable, it could be necessary to estimate
the net realizable value at the split-off point. This approach is called the estimated net
realizable value, sometimes referred to as the netback or workback method . Normally,
when a market value is available at the split-off point, it is preferable to use that value
rather than the estimated net realizable value method. If the market value is not available,
the net realizable value at the split-off point is estimated by taking the sales value after
further processing and deducting the additional processing costs. Joint costs are then
allocated to the products in proportion to their net realizable values at the split-off point.
We use the terms “net realizable value” and “estimated net realizable value” to
emphasize that we are attempting to determine the value of the products at the splitoff
point. The difference is that in the former case (net realizable value), we can sell the
product at the split-off point, so we do not have to estimate a value. You will see similar
terms used in practice and textbooks, such as “sales value at split-off.” As always with
cost accounting terminology, it is important that you understand the concept referred to
by the term and not just memorize the term itself. We fi rst consider an example of the
net realizable method, and then we discuss the estimated net realizable value method in
more detail. From the information in, we know that CCC produces hi-grade and lo-grade
coal. In March, joint mining costs (materials, labor, and overhead) totaled $270,000. Hi-
grade and lo-grade coal have a $750,000 total sales value at the split-off point. Hi-grade
has a $300,000 sales value, or 40 percent of the total, and lo-grade’s value is $450,000, or
60 percent of the total. We assume for the purpose of this example that no additional
processing is required after the split-off point to process either grade of coal.
In the previous example, we assumed that no further processing was required after
the split-off point. Not all joint products can be sold at the split-off point, however.
Additional processing could be required before a product is marketable. When no sales
values exist for the outputs at the split-off point, the estimated net realizable values
should be determined by taking the sales value of each product at the fi rst point at which
it can be marketed and deducting the processing costs that must be incurred after the
split-off point. The resulting estimated net realizable value is used for joint cost allocation
in the same way as an actual market value at the split-off point.
Suppose that CCC management fi nds excellent opportunities to sell a refi ned
product, mid-grade coal, but selling it requires that CCC do additional processing to the
lo-grade coal that comes from the mine. Also assume that no market exists for this lo-
grade coal. This additional processing costs $50,000 for the mid-grade coal produced in
March, after which it could be sold for $550,000. The hi-grade coal could still be sold at
the split-off point for $300,000. For the allocation of the joint cost of $270,000 to hi-
grade and mid-grade coal using the estimated net realizable value method. First, we
compute the estimated net realizable values at split-off for hi-grade and mid-grade coal,
which are $300,000 and $500,000, respectively. Next we multiply the ratio of each
product’s net realizable value to the total estimated net realizable value by the joint cost.
To determine the portion of the joint cost allocated to hi-grade coal, for example, the
computations are ($300,000 ÷ $800,000) times the joint cost of $270,000 (37.5% ×
$270,000 = $101,250).
The physical quantities method of allocation is often used when output product
prices are highly volatile. This method is also used when signifi cant processing occurs
between the split-off point and the fi rst point of marketability or when product prices are
not set by the market. The latter situation could occur when regulators set prices or in
cost-based contract situations, for example. Using the physical quantities method, joint
costs are assigned to products based on a physical measure. This could be volume,
weight, or any other common measure of physical characteristics. Many companies
allocate joint costs incurred in producing oil and gas on the basis of energy equivalent
(BTU content). They use this method because the products are typically measured in
different physical units (gas by thousand cubic feet, oil by barrel), although oil and gas
often are produced simultaneously from the same well. Moreover, the price of most gas is
regulated so that relative market values are artifi cial.
Let’s return to the original CCC example; the company only produces hi-grade
and lo-grade coal. Assume that relative market values at the split-off point are not
available and for every $270,000 of joint costs in processing coal, we obtain 15,000 tons
of hi-grade and 30,000 tons of lo-grade coal. For the allocation of joint costs using the
physical quantities method. A total of 45,000 tons is produced. Joint costs are allocated to
hi-grade coal by dividing tons of it (15,000) by the total units mined (45,000) and
multiplying the result by total joint costs ($270,000). Thus, $90,000 in joint costs is
allocated to hi-grade coal.
The “jointness” of joint production processes makes it impossible to separate the
portion of joint costs attributable to one product from another on a cause-and-effect basis.
As a result, allocating joint costs is always somewhat arbitrary, although it is often done
in practice. If allocated joint costs are used for decision-making purposes, they should be
used only with full recognition of their limitations. Accountants and managers realize that
no one allocation method is appropriate for all situations.
i. Deciding Whether to Sell Goods Now or Process Them Further
Many companies have opportunities to sell partly processed products at various
production stages. Management must decide whether it is more profi table to sell the
output at an intermediate stage or to process it further. In such a sell-orprocess-further
decision, the relevant data to be considered are (1) the additional revenue after further
processing and (2) the additional costs of processing further. This is simply an application
of the differential analysis approach discussed. Returning to our original example,
suppose that CCC can sell lo-grade coal for $450,000 at the split-off point or process it
further to make a new product, mid-grade coal. The additional processing costs would be
$50,000, and the revenue from midgrade coal produced in March would be $550,000.
Should the company sell lo-grade coal or process it further?
CCC’s profi t will be $50,000 higher if lo-grade coal is processed further into
mid-grade coal. It is important to note that the allocation of the $270,000 joint costs
between hi-grade and lo-grade coal is irrelevant. The $100,000 additional revenue from
processing beyond the split-off point justifi es the expenditure of $50,000 for additional
processing, regardless of the way joint costs are allocated. The only costs and revenues
relevant to the decision are those that result from it . Total joint costs incurred prior to the
split-off point are not affected by the decision to process further after the split-off point.
j. Deciding What to Do with By-Products
By-products play a significant role in various industries, serving as additional
outputs derived from primary production processes. These secondary outputs, although
often smaller in quantity or value compared to the main products, can still hold
considerable utility and economic value. One prominent example is found in the mining
sector, where coal dust emerges as a common by-product of coal extraction. While coal
dust might not constitute the primary focus of mining operations, its utilization as a
component in low-quality fuel production underscores its importance in resource
optimization and waste reduction efforts.
Similarly, in the realm of petroleum refining, kerosene stands out as a notable by-
product arising from the production of gasoline. Despite being secondary to the primary
objective of gasoline manufacturing, the extraction and utilization of kerosene
demonstrate the multifaceted nature of industrial processes, wherein diverse outputs can
be harnessed for various purposes, thereby enhancing overall efficiency and
sustainability.
Beyond the realms of energy production, the textile industry also exemplifies the
generation of valuable by-products. Advertisements promoting carpet and cloth mill ends
at discounted rates highlight the utilization of surplus materials originating from textile
manufacturing processes. These mill ends, although secondary to the main textile
products, present an opportunity for cost-effective consumption, thereby contributing to
the circular economy and minimizing waste generation within the industry.
Moreover, the agricultural sector offers numerous examples of valuable by-
products derived from primary production activities. For instance, in the processing of
fruits and vegetables, residual peels, seeds, and pulp often emerge as valuable secondary
outputs. These by-products can be repurposed for various applications, such as animal
feed, organic fertilizers, or even in the production of biofuels, thereby maximizing
resource utilization and minimizing environmental impact.
In essence, by-products represent a crucial aspect of modern industrial processes,
embodying the principles of resource efficiency, sustainability, and economic
optimization. By recognizing the inherent value of these secondary outputs and
implementing strategies for their efficient utilization, industries can not only minimize
waste generation but also unlock new avenues for innovation and value creation.
In March, Carlyle Coal Company exemplified the complexities of joint
production processes, producing not only 15,000 tons of high-grade coal and 30,000 tons
of low-grade coal but also 3,000 tons of coal dust. This latter output, often considered a
by-product, holds its own economic significance, even if it is relatively minor compared
to the main products. Understanding how to account for and optimize the utilization of
such by-products is crucial for maximizing profitability and efficiency within industrial
operations.
The sale of coal dust, totaling $15,000, demonstrates a tangible revenue stream
derived from the utilization of this by-product. However, the incorporation of these
revenues into the overall cost and revenue analysis requires careful consideration.
Provides insights into two distinct methods of accounting for the contribution of
by-products to the joint production process. Method 1, as illustrated in Panel A, involves
reducing the joint cost by the net realizable value of the by-product. In this case, the
$270,000 in joint costs incurred by Carlyle Coal Company is offset by the $15,000
generated from the sale of coal dust. Consequently, $255,000 ($270,000 - $15,000) is
allocated to the production of high-grade and low-grade coal. This method directly
impacts the computation of gross margins for the main products, reflecting a
redistribution of costs based on the utilization of the by-product.
On the other hand, Method 2, depicted in Panel B of, maintains the gross margins
of the major products unaffected by the presence of the by-product. Instead, the gross
margin for the by-product is determined solely by its revenue, independent of any
adjustments to the joint cost allocation. This approach provides a straightforward means
of accounting for the contribution of by-products without altering the cost structures
associated with the main products.
By analyzing the implications of these different accounting methods, Carlyle Coal
Company can make informed decisions regarding cost allocation, pricing strategies, and
resource utilization. Moreover, understanding the economic value of by-products allows
companies to explore opportunities for further optimization, such as exploring alternative
markets or value-added processing techniques for by-product utilization.
In summary, the inclusion of by-products in joint production processes introduces
nuances in cost accounting and revenue analysis. By adopting appropriate accounting
methods and leveraging the economic potential of by-products, companies like Carlyle
Coal Company can enhance profitability, minimize waste, and promote sustainable
business practices in line with evolving market demands and regulatory requirements.
Accounting for by-products introduces complexities that extend beyond mere cost
allocation and revenue recognition, especially when considering the timing of processing
costs and sales. A common scenario arises when the cost of processing by-products is
incurred in one accounting period, yet the actual sale of these by-products occurs in a
subsequent period. This temporal misalignment necessitates careful management of by-
product processing costs and highlights the importance of inventory tracking and
valuation until the eventual sale takes place.
To address this challenge, companies may opt to maintain an Additional By-
Product Cost account to capture the processing costs associated with by-products until
they are sold. This approach allows for the deferral of these costs until the revenue from
the sale of the by-products is realized, ensuring a more accurate representation of
financial performance across accounting periods. However, this method requires diligent
record-keeping and adherence to accounting standards to ensure compliance and
transparency in financial reporting.
Alternatively, some companies choose a simplified approach to by-product
accounting, opting to expense the processing costs in the period they are incurred and
recording the total revenue from the sale of by-products when realized. While this
method may seem to violate the principle of matching revenues and expenses in the same
accounting period, it offers practical advantages by streamlining accounting processes
and reducing administrative burdens. Moreover, the materiality of the amounts involved
in many cases renders the impact on financial statements negligible, mitigating concerns
regarding potential distortions in financial reporting.
It's important to note that while these methods provide practical solutions to the
complexities of by-product accounting, they may not fully align with accounting
principles and standards. Variations of these methods are prevalent in practice, reflecting
the diverse approaches adopted by companies to address specific operational and
reporting needs. Given the relatively minor nature of by-products in comparison to main
products, alternative accounting methods are unlikely to have a significant impact on
financial statements for both internal decision-making and external reporting purposes.
In conclusion, by-products present unique challenges in accounting, particularly
regarding the timing of processing costs and sales. Companies must carefully evaluate
various accounting methods to ensure compliance with standards while balancing
practical considerations and administrative efficiency. Ultimately, the chosen approach
should provide a transparent and accurate representation of financial performance,
reflecting the economic realities of by-product utilization within the broader context of
operational activities.
