4-39 Direct, Indirect, and Unallocated Costs Refer to the Lopez Plastics Company example on pages 136-140 and to Exhibit 4-7. The following list gives various resources used by Lopez Plastics Company. Use the letters D,I and U to indicate how the cost of each resource would be classified with respect to products manufactured: D= direct, I= indirect, and U= unallocated. 1. Depreciation of the plant 2. Resin used to make pen casings 3. Salary of plant manager 4. Salaries of cost accountants 5. Depreciation on computers used by engineers to design cell phone casings 6. Salaries of engineers 7. Salaries of operating labor processing pen casings 8. Travel costs of purchasing agent while investigating potential new suppliers of resin CHAPTER 4 COST MANAGEMENT SYSTEMS AND ACTIVITY-BASED COSTING Exhibit 4-5 Basic Concepts for Process Maps Exhibit 4-6 shows the company's traditional cost accounting system in panel A and two financial reports based on the traditional system in panel B. Notice the three types of costs: direct, indirect, and unallocated. Direct-materials costs and direct-labor costs are shown with a symbol. The traditional costing system traces direct-materials costs and direct-labor costs to the products. It allocates the indirect production costs ($220,000) to each product in proportion to a single allocation base, the direct-labor hours consumed in making the product. Last period, the company used 4,500 and 500 direct-labor hours to make pen casings and cell phone casings, respectively, for a total of 5,000 hours. So the traditional system allocated (4,5005,000)=90% of the indirect costs to pen casings and (5005,000)=10% to cell phone casings. Finally, the system does not assign the unallocated value-chain costs ($100,000) to either product. The gross profit and gross profit margin lines for both products, shown at the bottom of the two right-hand columns of panel B, indicate that cell phone casings is the more profitable product line. When does a traditional costing system that uses only one cost driver as a basis for allocating indirect production costs, like that of Lopez Plastics, provide accurate product costs? When there is a plausible and reliable relationship between the single cost driver and all the indirect resource costs being allocated. In today's complex business environments, this is rare. Let's take a careful look at Lopez Plastics' production process to see if the traditional cost accounting system is providing the costing accuracy required for strategic decision making and operational control. Pen casings have a simple design and a simple production process. The company produces them in high volumes, using 90% of its direct-labor time. Pen casings rarely require special customer support or engineering work. This means that indirect productionsupport costs, such as design engineering of the pen casings, are small. In contrast, cell phone casings have a more complex design, and the company produces them in small volumes, accounting for only 10% of its direct-labor time. Customers who buy cell phone casings have specific design requirements that cause much production engineering work. Most of the engineering work performed at Lopez Plastics supports the production of cell phones. How significant is the cost of engineering-related work? Of the $220,000 total indirect cost, engineering-related costs are $40,000. Lopez Plastics' traditional cost system does not separately identify or report the indirect costs of the engineering activity. Instead, the $40,000 of resources used for engineering activity-such as engineer salaries and depreciation of computer-aided design (CAD) equipment-is part of the single indirect resource cost pool. The company allocates all $40,000 of these indirect costs using the cost driver direct-labor time as the cost-allocation base. Thus, it allocates only 10% of Lopez Plastics Company's Traditional Costing System and Statement of Operating Income the engineering costs to the cell phone casings. However, the fact that most of the engineering work supports production of cell phones tells us that most of the costs of engineering should be allocated to the cell phone casings. We conclude that the traditional system probably does not provide the level of costing accuracy needed. How can we improve Lopez Plastics' costing accuracy? How can we design the company's cost accounting system to better support strategic decision making and operational control? We could use an ABC system to 1) identify a cost pool for each significant production activity, including engineering activity as one cost pool; 2) assign each indirect resource cost to the appropriate cost pool; and 3) allocate the costs in each activity-cost pool to products using plausible and reliable two-stage ABC system cost drivers as allocation bases. Exhibit 4-7 depicts a two-stage ABC system, which uses two A costing system with two stages of allocation to get from the original indirect resource cost to the final product or service stages of allocation to get from cost. (At this point, Lopez Plastics uses the ABC system only for production costs, so the $100,000 theoriginalindirectresourcecosttothefinalproductorofnonproductionvalue-chaincostsremainsunallocated.)Thefirststageallocatesindirectresourcecoststotwoactivity-costpools,processingactivitycostsandproduction-supportactivitycosts.The service cost. The first stage allo- costs to two activity-cost pools, processing activity costs and production-support activity costs. The second stage allocates activity costs to the products or services. In essence, the cost objects in the cates indirect resource costs to first stage are the activities, and the cost objects in the second stage are the products. You will find a activity-cost pools. The second stage allocates activity costs to more detailed example of a two-stage ABC system in Appendix 4 on pages 145146. products or services. In the first stage, Lopez Plastics allocates the cost of two resources, (1) plant and machinery as shown in Exhibit 4-7. The cost allocated to processing is ($135,000+$8,000)=$143,000 and the cost allocated to production support is ($45,000+$32,000)=$77,000, as explained in the next two paragraphs. CHAPTER 4 - COST MANAGEMENT SYSTEMS AND ACTIVITY-BASED COSTING 139 Exhibit 4-7 Lopez Plastics Company's ABC System The cost of plant and machinery depends mostly on the square feet of space used. Processing uses 75% of the space and production support uses 25%. Therefore, we allocate 75% of the plant and machinery cost or $135,000 to the processing activity. Similarly, we allocate 25% or $45,000 to production support. The cost of engineers and CAD equipment depends mainly on the amount of time engineers spend on a product. Engineers spend, on average, about 48 minutes each hour performing production-support activities, such as designing casings. They spend the other 12 minutes supervising the processing activity. Thus, we allocate (4860)=80% of the cost of engineers and CAD equipment to the production-support activity and (1260)=20% to processing. The resulting allocations are 80%40,000=$32,000 to production support and 20%40,000=$8,000 to processing. The second stage allocates the costs of the two activities, processing and production support, to the two products, pen casings and cell-phone casings. There are several possible cost-allocation bases for the production-support activity costs, including "number of customer-generated engineering changes" and "number of distinct parts." The cost-allocation base should be a measure of the consumption of production-support activity. Let's assume this is "number of distinct parts." Suppose pen casings have only 5 distinct parts compared to 20 for cell phone casings. We would allocate [20(20+5)]$77,000=$61,600 of the production-support activity costs to cell phone casings and the remaining [5(20+5)]$77,000=$15,400 to pen casings. The ABC allocation better represents the use of engineering services than does the allocation based on the traditional system. Why? Because cell phone casings cause (2025)=80% of the production-support activity costs, but the traditional system allocates only 10% of such costs to cell phone casings. In contrast, the ABC system allocates the appropriate 80% of the production-support activity costs to cell phone casings. We will continue this example in the Summary Problem for Your Review, but first let's consider one more advantage of ABC systems. In many companies, managers try to gain cost savings by efficiently managing activities. If Lopez Plastics wants its managers to reduce the cost of producing cell phone casings, the managers will probably focus on possible cost savings in either processing or production support. They may also redesign the product to reduce direct materials costs or reengineer the production process to reduce direct-labor costs. But often the largest 4-39 Direct, Indirect, and Unallocated Costs Refer to the Lopez Plastics Company example on pages 136-140 and to Exhibit 4-7. The following list gives various resources used by Lopez Plastics Company. Use the letters D,I and U to indicate how the cost of each resource would be classified with respect to products manufactured: D= direct, I= indirect, and U= unallocated. 1. Depreciation of the plant 2. Resin used to make pen casings 3. Salary of plant manager 4. Salaries of cost accountants 5. Depreciation on computers used by engineers to design cell phone casings 6. Salaries of engineers 7. Salaries of operating labor processing pen casings 8. Travel costs of purchasing agent while investigating potential new suppliers of resin CHAPTER 4 COST MANAGEMENT SYSTEMS AND ACTIVITY-BASED COSTING Exhibit 4-5 Basic Concepts for Process Maps Exhibit 4-6 shows the company's traditional cost accounting system in panel A and two financial reports based on the traditional system in panel B. Notice the three types of costs: direct, indirect, and unallocated. Direct-materials costs and direct-labor costs are shown with a symbol. The traditional costing system traces direct-materials costs and direct-labor costs to the products. It allocates the indirect production costs ($220,000) to each product in proportion to a single allocation base, the direct-labor hours consumed in making the product. Last period, the company used 4,500 and 500 direct-labor hours to make pen casings and cell phone casings, respectively, for a total of 5,000 hours. So the traditional system allocated (4,5005,000)=90% of the indirect costs to pen casings and (5005,000)=10% to cell phone casings. Finally, the system does not assign the unallocated value-chain costs ($100,000) to either product. The gross profit and gross profit margin lines for both products, shown at the bottom of the two right-hand columns of panel B, indicate that cell phone casings is the more profitable product line. When does a traditional costing system that uses only one cost driver as a basis for allocating indirect production costs, like that of Lopez Plastics, provide accurate product costs? When there is a plausible and reliable relationship between the single cost driver and all the indirect resource costs being allocated. In today's complex business environments, this is rare. Let's take a careful look at Lopez Plastics' production process to see if the traditional cost accounting system is providing the costing accuracy required for strategic decision making and operational control. Pen casings have a simple design and a simple production process. The company produces them in high volumes, using 90% of its direct-labor time. Pen casings rarely require special customer support or engineering work. This means that indirect productionsupport costs, such as design engineering of the pen casings, are small. In contrast, cell phone casings have a more complex design, and the company produces them in small volumes, accounting for only 10% of its direct-labor time. Customers who buy cell phone casings have specific design requirements that cause much production engineering work. Most of the engineering work performed at Lopez Plastics supports the production of cell phones. How significant is the cost of engineering-related work? Of the $220,000 total indirect cost, engineering-related costs are $40,000. Lopez Plastics' traditional cost system does not separately identify or report the indirect costs of the engineering activity. Instead, the $40,000 of resources used for engineering activity-such as engineer salaries and depreciation of computer-aided design (CAD) equipment-is part of the single indirect resource cost pool. The company allocates all $40,000 of these indirect costs using the cost driver direct-labor time as the cost-allocation base. Thus, it allocates only 10% of Lopez Plastics Company's Traditional Costing System and Statement of Operating Income the engineering costs to the cell phone casings. However, the fact that most of the engineering work supports production of cell phones tells us that most of the costs of engineering should be allocated to the cell phone casings. We conclude that the traditional system probably does not provide the level of costing accuracy needed. How can we improve Lopez Plastics' costing accuracy? How can we design the company's cost accounting system to better support strategic decision making and operational control? We could use an ABC system to 1) identify a cost pool for each significant production activity, including engineering activity as one cost pool; 2) assign each indirect resource cost to the appropriate cost pool; and 3) allocate the costs in each activity-cost pool to products using plausible and reliable two-stage ABC system cost drivers as allocation bases. Exhibit 4-7 depicts a two-stage ABC system, which uses two A costing system with two stages of allocation to get from the original indirect resource cost to the final product or service stages of allocation to get from cost. (At this point, Lopez Plastics uses the ABC system only for production costs, so the $100,000 theoriginalindirectresourcecosttothefinalproductorofnonproductionvalue-chaincostsremainsunallocated.)Thefirststageallocatesindirectresourcecoststotwoactivity-costpools,processingactivitycostsandproduction-supportactivitycosts.The service cost. The first stage allo- costs to two activity-cost pools, processing activity costs and production-support activity costs. The second stage allocates activity costs to the products or services. In essence, the cost objects in the cates indirect resource costs to first stage are the activities, and the cost objects in the second stage are the products. You will find a activity-cost pools. The second stage allocates activity costs to more detailed example of a two-stage ABC system in Appendix 4 on pages 145146. products or services. In the first stage, Lopez Plastics allocates the cost of two resources, (1) plant and machinery as shown in Exhibit 4-7. The cost allocated to processing is ($135,000+$8,000)=$143,000 and the cost allocated to production support is ($45,000+$32,000)=$77,000, as explained in the next two paragraphs. CHAPTER 4 - COST MANAGEMENT SYSTEMS AND ACTIVITY-BASED COSTING 139 Exhibit 4-7 Lopez Plastics Company's ABC System The cost of plant and machinery depends mostly on the square feet of space used. Processing uses 75% of the space and production support uses 25%. Therefore, we allocate 75% of the plant and machinery cost or $135,000 to the processing activity. Similarly, we allocate 25% or $45,000 to production support. The cost of engineers and CAD equipment depends mainly on the amount of time engineers spend on a product. Engineers spend, on average, about 48 minutes each hour performing production-support activities, such as designing casings. They spend the other 12 minutes supervising the processing activity. Thus, we allocate (4860)=80% of the cost of engineers and CAD equipment to the production-support activity and (1260)=20% to processing. The resulting allocations are 80%40,000=$32,000 to production support and 20%40,000=$8,000 to processing. The second stage allocates the costs of the two activities, processing and production support, to the two products, pen casings and cell-phone casings. There are several possible cost-allocation bases for the production-support activity costs, including "number of customer-generated engineering changes" and "number of distinct parts." The cost-allocation base should be a measure of the consumption of production-support activity. Let's assume this is "number of distinct parts." Suppose pen casings have only 5 distinct parts compared to 20 for cell phone casings. We would allocate [20(20+5)]$77,000=$61,600 of the production-support activity costs to cell phone casings and the remaining [5(20+5)]$77,000=$15,400 to pen casings. The ABC allocation better represents the use of engineering services than does the allocation based on the traditional system. Why? Because cell phone casings cause (2025)=80% of the production-support activity costs, but the traditional system allocates only 10% of such costs to cell phone casings. In contrast, the ABC system allocates the appropriate 80% of the production-support activity costs to cell phone casings. We will continue this example in the Summary Problem for Your Review, but first let's consider one more advantage of ABC systems. In many companies, managers try to gain cost savings by efficiently managing activities. If Lopez Plastics wants its managers to reduce the cost of producing cell phone casings, the managers will probably focus on possible cost savings in either processing or production support. They may also redesign the product to reduce direct materials costs or reengineer the production process to reduce direct-labor costs. But often the largest