Effects of using a cost management system


The today's global market place is a fast changing world where companies can no longer easily plan and control their future way. In order to survive, organizations have to have flexible strategies that will help them foresee competitive threats and grab the new opportunities as they arise. Moreover, organizations must identify and respond to the customers' needs, eliminate or decrease all unnecessary costs, and share the knowledge and best practices both inside and outside the organization. Without having the devolving power and responsibility on the front line of the organization, this cannot be effectively done. (Player, xi)

To do this, all companies first look into their most important factors that keep them running and sustaining in the market, and one of them is cost. The term itself is often-used in organizations and stands as a monetary measure of resources given up in order to obtain a good or service. However, effective managers must recognize and specify the type of the cost used too. Different types of costs are used in different situations and the cost can be viewed in different ways depending on the organizations' objective. Thus, different accounting methods and systems are used to report the costs so that managers can plan and control the decisions an organization makes.

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This report focuses on Cost Management System (CMS) including brief definition of what CMS is and why it is used, and what are the advantages of the system. Further, through examples, it highlights the importance of using the CMS, which will help managers effectively plan and control the operations in big and small organization.


As defined by most business dictionaries and in every accounting book, Cost Management System is the set of systematic procedures aimed at generating cost estimates that are accurate enough to match actual costs. (Oxford Business Dictionary) Furthermore, CMS is a method used by managers to better plan and control any decision, both short-term and long-term, that an organization makes regarding cost generating activities. Finally, the CMS is used to increase the organization's profit in short-term and improve the organization's position in long-term. (Bushman, 1)

The information provided by the system aim at three major objectives: costing of products or services, planning and control, and decision making. In order to satisfy the first objective, the information required depends from the nature of the product or service and the reason management wants to know the cost. For example, managers may need information about costs so that they can make profitability analysis, calculate the cost of goods sold, or associate particular cost with specific activity. The second objective exists because cost information is essential when managers have to decide what should be done, why and how it should be done, and how well was this done. Finally, the third objective is also important because managers deal with decision making on a daily basis for which cost information is of significant importance. For example, cost information is needed when a manager has to decide if a particular product should be outsourced or made by the company itself. (Hansen, 5)

Cost Management System is divided into two subsystems: cost accounting system (CAS) and operational control system (OCS). The CAS assigns costs to individual products or services as requested by the management. Also, the CAS assigns costs for financial reporting so that the inventory could be valued and the cost of goods sold determined. Therefore, the CAS should produce accurate product or service costs that satisfy financial reporting. On the other hand OCS is designed to provide accurate and timely feedback regarding the performance of planning and controlling activities. This subsystem focuses on the activities that should be done and how well they will be done. Moreover, OCS is trying to find ways and opportunities for improvement, and gives information to managers for continuous improvement of all business' aspects. (Hansen, 6)

Three of the common costing systems that are also types of cost management system, are the activity-based costing (ABC), job order costing, and process costing. The Managerial Accounting book states activity-based costing as "an accounting information system that identifies the various activities performed in an organization and collects costs on the basis of the underlying nature and extent of those activities". The focus of the system is on the costs needed for a product or service to be produced, performed, or distributed and it is based on the certain activities. Activity-based costing system consist of two stages of allocating costs where in the first stage costs are allocated to pools and in the second the pools are allocated to products or services. (Bushman, 1) Simply put, the ABC system is a process of assigning costs based on the relationship between costs and activities driving the costs, and it is used to answer "What Do Things Cost?". (Player, 4) This type of costing system is widely used by almost any type of organization but it's mostly used in more complex and not entirely service-based companies.

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The job-order system is the second common costing system used by companies producing limited quantities of customized products or services, in which costs are accumulated individually by job. In this costing system the costs are traced to the jobs and then divided by the number of units in the job, so that the average cost per unit could be found. (Job Order Costing System) The "job" is considered as a cost object for which costs are accumulated. It consists of one or more output units and the accumulated costs are recorded in a job order cost sheet. The job-order system is appropriate and useful for most service business like advertising and architectural firms. (Raiborn, 253)

The third costing system is the process costing which is often used by companies that produce homogeneous goods in large quantities and operate using continuous processing. In the process costing system the costs are accumulated by cost component in each department of the production and as units are transferred from one department to another, unit costs are also transferred. At the end of the production, the total production cost is collected. Examples of companies using this type of costing system are the manufacturers of many food products, bricks, paper, automobiles, and appliances. (Raiborn, 273-275)


All of the three systems explained briefly in the previous section are under the Cost Management System, and are used according to the needs and objectives of the organizations. Even though the activity-based costing is used by most of the organizations, the process-costing is used by companies producing large quantities of homogeneous products, and the job-order costing is used by companies producing limited customized products; all of them are costing systems and have several general advantages.

Some Activity Based Costing system advantages:

Easier to understand for everyone

More accurate costing of products and services, customers, distribution channels

Utilizes unit cost rather than just total cost

Integrates well with Six Sigma and other continuous improvement programs

Makes visible the non-value added activities

Supports performance management and scorecards

Enables costing of processes, supply chains, and value streams

Facilitates benchmarking

Avoids or minimizes distortions in product costing that result from arbitrary allocations of indirect costs

Generates useful information on how money is spent, if a department is cost effective, and how to benchmark oneself against others for quality improvement

Speed: an organization can quickly produce activity-based cost models using this approach (Activity Based Costing System)

Some Job-Order costing system advantages:

Ready access to all the costs incurred for each job being completed (examine each cost incurred, finding out why it happened, and determine how it can be controlled better in the future, thereby contributing to better ongoing levels of profitability)

Ongoing results for each job, track costs as they are added rather than waiting until the job has been completed - this gives a company several advantages (accounting staff can monitor job accounts to see if costs are being posted to the wrong accounts and correct them right away, company can monitor the costs incurred for longer jobs and have enough time to make changes before they close, based on the costing information revealed by the job costing system)

Changes in the cost of a job can result in negotiations with cost-plus customers who are paying for all the costs incurred, so that they are fully aware of cost overruns well in advance and are prepared to pay the additional amounts (Job Order Costing System)

By looking at the advantages presented above, it can be seen that using cost management system is a "step forward" for an organization. Given that the system collects all the necessary data and analyzes it, the managers of the organization have quick access to the data and the analyses at any time. This enables them to make quick decisions, and plan and control the organizational operations. What's most important, the CMS is a system that gives an organization a chance for continuous improvement.


Activity Based Costing Illustration

In order to implement the ABC technique several steps are followed:

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1. Identify and define activities and activity cost pools

2. When ever possible, directly trace costs to activities and cost objects.

3. Assign costs to activity cost pools

4. Calculate activity rates.

5. Assign costs to cost objects using the activity rates and activity measures.

6. Prepare management report.

To better understand the difference that ABC system makes, following is an example of using both traditional allocation system and the activity-based costing allocation system. The company produced two products, A which is complex unit and not in extremely high demand, and B which is simple unit produced in mass quantities. (Raiborn, 145)

As it can be seen from the example, for Product A the difference in the cost allocation, based on direct labor hours, between the traditional allocation system and the ABC allocation system is almost 230% (from $1.25 to $2.88). Again, for Product B the difference between the two allocation systems is 1.531% less (from $0.75 to $0.049). If this company relied on the traditional system, probably they would have understood that the Product A is underpriced and Product B overpriced. This would have lead to an increase of sales of Product A and therefore increase of costs. On the other hand, the sales of Product B would have declined resulting in low total revenue and low total overhead cost. (Raiborn, 144-146)

Job-order costing illustration

To track data when using the job-order costing system the following documents are needed: material requisition form, employee time sheets or time ticket, and job order sheet. Following is an example of how all these documents are used: (Job Order Cost System)

The Job Order Sheet is used to track the job number, customer information, general information for the job such as starting, completing and shipping date, cost information for the materials used, labor and overhead, and a total job cost summary. (Raiborn, 236)

Materials requisition form is used to specify the material types, quantities, cost per unit and total cost. It links the materials costs to jobs in process. This form is prepared so that the materials are released from the warehouse and send to the production area. (Raiborn, 235)

Time Ticket or Employee Time Sheet indicates what jobs were worked during the day and for what amount of time. (Raiborn, 237)

Since the job-order costing is mostly used by companies that make customized products, unique raw materials may be required. The raw materials are accounted in a Raw Material Inventory account. After that a materials requisition form is prepared in order to release the materials from the warehouse and send to the production area. In the materials requisition form are listed the types and quantities of materials needed for production or service. Moreover, the form links the materials to specific jobs and traces responsibility for the materials cost. As materials are issued and moved into the production area, their costs are moved from the Raw Materials Inventory to the Work in Process Inventory. If indirect materials are included in the Raw Material Inventory account, than those costs are assigned to overhead. (Raiborn, 234)

Actual overhead incurred during production is included in specific account and if actual overhead is applied to jobs, at the end of the period that overhead is divided by related measure of activity or cost driver. By multiplying the actual overhead rate with the actual measure of activity associated with each job, the actual overhead will be applied to jobs. Overhead is applied at the end of each period and the Work in Process inventory account includes the direct materials, direct labor, and overhead. The overhead is applied to this account after a job is completed and the proper product cost is transferred to Finished Goods inventory. (Raiborn, 234-241)

After the job completion, the total cost is transferred to the Finished Goods Inventory account. The job cost sheets are also moved into the Finished Goods files after the job is completed and when the goods are sold, the cost shown on the sheet is transferred to Cost of Goods Sold. (Raiborn, 240)

Following are the Job Order Cost System Cost Flows:

(Job Order Cost System)

Process Costing Illustration

As mentioned in the previous section, the process costing system is used by companies producing large number of quantities of homogenous products. So, to illustrate the system this report uses an example of company called Best Chips which manufactures potato chips. The company has 3 work areas. In the first area called preparation area, potatoes are cut and flavorings are added. The second area is called baking area and the third is packaging area. With the use of conveyor belts products are moved from one function to another. The raw materials are added in the preparation and packaging function. The labor and overhead are occurring in all functions. Following is the process flow and costs associated with Best Chip's process costing system. (Process Cost System)

Following are several steps that should be followed in order to prepare the process cost summary:

Compute whole units to account for

Compute whole units accounted for

Compute equivalent units of production per cost component (either using the Weighted average method or FIFO)

Compute total costs to account for

Compute cost per equivalent unit per cost component (either using the Weighted average method or FIFO)

Assign costs to inventories (either using the Weighted average method or FIFO) (Raiborn, 300)

After all this is done the process cost summary is done and following is an example of how the process cost summary should look like.


In the beginning, small companies are using the actual cost reporting. However, as companies grow using an integrated cost reporting system is invaluable for the company. Companies have to follow the continuous changing trends of the market and become competitive enough to sustain in it. The use of CMS goes beyond the cost budgeting and make strategic and operating decisions based on value added information. Moreover, the system assists managers in planning, controlling, and decision-making processes. It serves as a continuous improvement for the entire organization and should be regarded as best practices in the cost management.