Chapter 14
Cost Management Systems
and Activity-Based Costing
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
4-1
Learning Objective 1
Describe the purposes of
cost management systems.
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Cost Management System
A cost-management system (CMS) is a
collection of tools and techniques that
identifies how management’s decisions
affect costs.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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What is Cost Accounting?
Cost accounting is that part of the
accounting system that measures costs
for the purposes of management decision
making and financial reporting.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Learning Objective 2
Explain the relationships
among cost, cost objective,
cost accumulation, and
cost allocation.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Cost Accounting System
Cost
Accumulation
Collecting costs by some
“natural” classification
such as materials or labor
Cost
Allocation
Tracing costs to one or
more cost objectives
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Cost Accounting System
Cost Accumulation
Cost Allocation
to Cost Objects:
1. Departments
2. Activities
RAW MATERIAL
COSTS (METALS
MACHINING
DEPARTMENT
FINISHING
DEPARTMENT
ACTIVITY ACTIVITY
ACTIVITY ACTIVITY
CABINETS
3. Products
CABINETS
DESKS
DESKS
TABLES
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
TABLES
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Cost
A cost may be defined as a sacrifice or
giving up of resources for a particular
purpose.
 Costs are frequently measured by the
monetary units that must be paid for
goods and services.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Cost Objective
What is a cost object or cost objective?
It is anything for which a separate measurement
of costs is desired.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Learning Objective 3
Distinguish among direct,
indirect, and unallocated costs.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Direct Costs
What are direct costs?
Direct costs can be identified specifically
and exclusively with a given cost
objective in an economically
feasible way.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Indirect Costs
What are indirect costs?
Indirect costs cannot be identified
specifically and exclusively with a
given cost objective in an economically
feasible way.
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What Distinguishes
Direct and Indirect Costs?
Managers prefer to classify costs as direct
rather than indirect whenever it is
“economically feasible” or “cost effective.”
 Other factors also influence whether a cost
is considered direct or indirect.
 The key is the particular cost objective.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Categories of
Manufacturing Costs
Any raw material, labor, or other input
used by any organization could,
in theory, be identified as a
direct or indirect cost
depending on the
cost objective.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Categories of
Manufacturing Costs

1
2
3
All costs which are eventually allocated
to products are classified as either…
direct materials,
direct labor, or
indirect manufacturing.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Direct Material Costs...
–
include the acquisition costs of all materials
that are physically identified as a part of the
manufactured goods and that may be traced
to the manufactured goods in an
economically feasible way.
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Direct Labor Costs...
–
include the wages of all labor that can be
traced specifically and exclusively to the
manufactured goods in an economically
feasible way.
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Indirect Manufacturing Costs...
–
or factory overhead, include all costs
associated with the manufacturing process
that cannot be traced to the manufactured
goods in an economically feasible way.
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Product Costs...
are costs identified with goods produced
or purchased for resale.
 Product costs are initially identified as part
of the inventory on hand.
 These costs, inventoriable costs, become
expenses (in the form of cost of goods sold)
only when the inventory is sold.
–
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Period Costs...
–
are costs that are deducted as expenses
during the current period without going
through an inventory stage.
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Period or Product Costs
In merchandising accounting, insurance,
depreciation, and wages are period costs
(expenses of the current period).
 In manufacturing accounting, many of these
items are related to production activities and
thus, as indirect manufacturing, are product
costs.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Period Costs – Merchandising
and Manufacturing

In both merchandising and manufacturing
accounting, selling and general
administrative costs are period costs.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Learning Objective 4
Explain how the financial
statements of merchandisers
and manufacturers differ
because of the types of goods
they sell.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Financial Statement Presentation
– Merchandising Companies
Income Statement
Sales
Balance Sheet
–
Merchandise
Inventory
Expiration
Cost of Goods Sold
(an expense)
Equals Gross Margin
–
Period
Costs
Selling and
Administrative
Expenses
Equals Operating Income
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Financial Statement Presentation
– Manufacturing Companies
Income Statement
Sales
Balance Sheet
Direct
Material
Inventory
–
Expiration
Cost of Goods Sold
(an expense)
Equals Gross Margin
–
Work-inProcess
Inventory
Finished
Goods
Inventory
Period
Costs
Selling and
Administrative
Expenses
Equals Operating Income
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Costs and Income Statements

On income statements, the detailed
reporting of selling and administrative
expenses is typically the same for
manufacturing and merchandising
organizations, but the cost of goods sold
is different.
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Cost of Goods Sold
for a Manufacturer

1
2
3
The manufacturer’s cost of goods produced
and then sold is usually composed of the
three major categories of cost:
Direct materials
Direct labor
Indirect manufacturing
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
4 - 27
Cost of Goods Sold
for a Retailer or Wholesaler

The merchandiser’s cost of goods sold is
usually composed of the purchase cost of
items, including freight-in, that are acquired
and then resold.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Learning Objective 5
Understand the main
differences between traditional
and activity-based costing
systems and why ABC systems
provide value to managers.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Traditional Cost System
Direct
Material
Resource
Direct
Labor
Resource
Direct
Trace
Direct
Trace
Products
All
Indirect
Resources
All
Unallocated
Value Chain
Costs
Cost
Driver
Unallocated
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Two-Stage Activity-Based
Cost System
Direct
Material
Resource
Direct
Labor
Resource
Direct
Trace
Direct
Trace
Other
Direct
Resources
Indirect
Resource
A
%
%
Indirect
Resource
Z
%
All
Unallocated
Value Chain
Costs
%
Activity
Activity
1
10
Cost
Cost
Driver
Driver
Products
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
Unallocated
4 - 31
Activity-Based Costing
Understanding the relationships
among activities, resources,
costs, and cost drivers is the key
to understanding ABC and how
ABC facilitates managers’
understanding of operations.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Activity-Based Costing
Example of Activities and Cost Drivers:
Activities:
Cost Drivers:
Account billing
No. of lines
Bill verification
No. of accounts
Account iniquity
No. of labor hours
Correspondence
No. of letters
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Learning Objective 6
Identify the steps involved in the
design and implementation
of an activity-based
costing system.
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Designing and Implementing an
Activity-Based Costing System
Step 1
Step 2
Determine cost of
activities, resources,
and related cost
drivers.
Develop a process-based
map representing the flow
of activities, resources, and
their interrelationships.
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Designing and Implementing an
Activity-Based Costing System
Step 3
Collect relevant data concerning costs
and the physical flow of the cost-driver
units among resources and activities.
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Designing and Implementing an
Activity-Based Costing System
Step 4
Calculate and interpret the new
activity-based information.
Using an activity-based costing system to
improve the operations of an organization
is activity-based management (ABM).
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Activity-Based Management
Activity-based management aims
to improve the value received by
customers and to improve profits
by identifying opportunities for
improvements in strategy and
operations.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
4 - 38
Activity-Based Management
A value-added cost is the cost of an activity
that cannot be eliminated without affecting
a product’s value to the customer.
 In contrast, non-value-added costs are costs
that can be eliminated without affecting a
product’s value to the customer.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Learning Objective 7
Use activity-based cost
information to improve the
operations of an organization.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Using ABC Information
Activity-based management…
provides costs of value-added and
non-value-added activities.
improves managers’ understanding of operations.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Learning Objective 8
Understand cost accounting’s
role in a company’s
improvement efforts across
the value chain.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Cost Accounting and
the Value Chain
A good cost accounting system is critical to
all value-chain functions from research and
development through customer service.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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End of Chapter 4
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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