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# BU247 Lecture Notes - Cost Driver, Profit Margin, Standard Cost Accounting

7 pages71 viewsFall 2013

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BU247 Lecture 9-10
Chapter 5 Activity Based Cost Systems
Systems that assign production costs to products important because product volume and mix
explain a large % of the costs that companies incur
If companies want to influence their costs, they must understand relationship between the volume
and mix of their products and the expenses they incur
Product costs provide the bridge between operating expenses and production output
Poorly designed product costing systems report inaccurate product costs companies may make
poor decisions on resource supply, product mix, pricing, order acceptance, & customer relationships
Product costing systems first assign direct labor/materials costs to products:
1) Calculate the cost per unit of each material (lb, kg, m2) used by a product, and the cost per hour of
each type of direct labor that processes the product
2) For each unit of product made, determine the quantity (lb, kg, m2) of each type of material used &
the quantity (# hrs) required by each type of labor
3) For each labor& material type, multiply the cost per unit/hour by the quantity used per product
4) Add all the materials and labor costs to obtain the total labor & materials cost of each product unit
With accurate records about labor time and material usage standards, and about the
standard/actual prices of each material & labor type, the product costs will be pretty accurate
Indirect expenses (shared, common costs): support the production of all products and not easily
traced to individual products in the simple way that direct materials/labor costs are
overhead allocation rate for department = Indirect cost for that department / volume of activity in
the department manufacturing companies assigned indirect costs (overhead) to production
departments in proportion to the direct labor hours worked in each department. Then, divide that
by a measure of the volume of activity in the department (ex: total direct labour/machine hours)
Under traditional costing systems, typical volume-based cost drivers include: Direct labor hours,
Machine hours, Direct labor dollars
Traditional costing system is adequate for companies with high-volume products with similar
production volumes and batch sizes, but can lead to cost distortion in an environment of high
product variety ABC has been developed to eliminate this distortion
Example
ice cream manufacturing plant at Madison Dairy

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BU247 Lecture 9-10
originally produced vanilla and chocolate ice cream, with profit margins in excess of 15% of sales
introduced strawberry ice cream sold at 10% higher prices than vanilla/chocolate
introduced mocha-almond ice cream higher price premium
New strawberry and mocha flavors were profitable, but the high-volume vanilla and choco flavors
had just broken even overall profit margin was < 2% of sales. After subtracting plant
general/administrative expenses, the plant operated at a loss.
Madison’s monthly indirect expenses are comprised of:
increase in plant’s overhead costs allocated to products based on direct labor content
currently, the cost system’s current overhead rate was 240% of direct labour cost (\$)
this standard cost system is adequate for the financial reporting role of inventory valuation but
was designed for when production operations were mostly manual, and total indirect costs were <
direct labour costs. now, production environment changed because of automation. Labour costs
fell and indirect expenses rose. cost system that was adequate before could not be giving
distorted signals about the relative profitability of the different products
many manufacturing companies use only drivers that vary directly with the volume of products
produced (direct labour dollars/hours, machine hours) for allocating production expenses to
products. but in an environment of high product variety, exclusive use of volume drivers to
first allocate the indirect and support expenses to production cost pools (see ch4)
once the traceable and allocated support expenses have been accumulated within each production
cost pool, the system allocates the pool’s costs to products on the basis of the volume cost driver for
that cost centre: direct labour, machine hours, unit produced, or materials quantity processed
example: chocolate and vanilla containers, each representing about 20% of plant’s output, would
traditional cost systems, even those with multiple production cost centres, systematically/grossly
underestimate the cost of resources required for specialty, low-volume products overestimate
the resource cost of producing high-volume, standard products