-Cost Management In An Automated Business

Cost Management in an Automated Business Environment (ABC, ABM, and TQM)Chapter 6© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillThe Development of a Single Company-Wide Cost DriverTraditional cost systems were created whenmanufacturing processes were labor intensive.A single company-wide overhead rate,based on direct labor hours, is usedto allocate overhead to products inthese labor intensive processes.© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillThe Development of a Single Company-Wide Cost DriverOverhead is allocated to jobs using directlabor hours. If overhead is $120, how muchoverhead is allocated to each job?© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillThe Development of a Single Company-Wide Cost DriverOverhead Rate = $120 ÷8 direct labor hoursOverhead Rate = $15 per direct labor hourJob 1 = 2 hours ×$15 per hour = $30Job 2 = 6 hours ×$15 per hour = $90 © The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillThe Development of a Single Company-Wide Cost DriverLabor Intensive ProcessOverhead costs are relatively small.Overhead allocations may be inaccurate,but the amounts are relatively insignificant. Automated ProcessOverhead costs are relatively large.Inaccurate overhead allocation can lead to questionable product cost information.© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillThe Effects of Automation on the Selection of a Cost DriverAutomation increasesoverhead from $120 to $420and reduces the Job 2 laborhours from 6 to 1. Allocatethe $420 overhead to thetwo jobs using direct labor. © The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillThe Effects of Automation on the Selection of a Cost DriverOverhead Rate = $420 ÷3 direct labor hoursOverhead Rate = $140 per direct labor hourJob 1 = 2 hours ×$140 per hour = $280Job 2 = 1 hour ×$140 per hour = $140 © The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillIs this reasonable?Automation benefited Job 2, but Job 1 isallocated more overhead. Clearly, we needanother cost driver to allocate overhead. The Effects of Automation on the Selection of a Cost Driver© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillUsing Activity-Based Cost DriversLevel of ComplexityOverhead AllocationCompany-wide OverheadRateActivity BasedCostingMany companies are using activity-based cost drivers to improve product costing.© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillUsing Activity-Based Cost DriversCarver makes vegetableand tomato soup.VegetableTomatoTotalNumber of Cans954,000 234,000 1,188,000 Number of Batches180 180 360 Number of Setups180 180 360 Cost per setup264$ 264$ 528$ Total overhead = 360 setups × $264 per setup = 95,040$ © The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillUsing Activity-Based Cost DriversAllocating Setup Costs Using aVolume-basedAllocation RateOverhead per can = $95,040 ÷1,188,000 cansOverhead per can = $0.08 per canVegetable = 954,000 cans ×$0.08 per can = $76,320Tomato = 234,000 cans ×$0.08 per can = $18,720 Vegetable Tomato Total Number of Cans 954,000 234,000 1,188,000 Number of Batches 180 180 360 Number of Setups 180 180 360 Cost per setup 264 $ 264 $ 528 $ Total overhead = 360 setups × $264 per setup = 95,040 $ © The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillUsing Activity-Based Cost DriversAllocating Setup Costs Using aVolume-basedAllocation RateThe volume-based allocation rate overcosts the high-volume product andunder costs the low-volume product. Vegetable Tomato Total Number of Cans 954,000 234,000 1,188,000 Number of Batches 180 180 360 Number of Setups 180 180 360 Cost per setup 264 $ 264 $ 528 $ Total overhead = 360 setups × $264 per setup = 95,040 $ © The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillUsing Activity-Based Cost DriversAllocating Setup Costs Using anActivity-basedAllocation RateOverhead per batch = $264Vegetable = 180 batches ×$264 per batch Vegetable = $47,250Tomato = 180 batches ×$264 per batch = $47,250 Vegetable Tomato Total Number of Cans 954,000 234,000 1,188,000 Number of Batches 180 180 360 Number of Setups 180 180 360 Cost per setup 264 $ 264 $ 528 $ Total overhead = 360 setups × $264 per setup = 95,040 $ © The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillActivity-based Cost Drivers Enhance RelevanceActivity-based cost drivers allocaterelevant costs ($264 batch set-up)to appropriate products.Cost DriverVegetableTomatoVolume-based76,320$ 18,720$ Activity-based47,250 47,250 Allocation to Product$47,250 is the cost avoided if Carverceases production of either product,or if the set-up function is outsourced.© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillActivity-Based CostingABCActivity-based costing (ABC) is a two-stage allocationprocess that employs a variety of cost drivers.© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillActivity-Based CostingActivity-based costing (ABC) is a two-stageallocationprocess that employs a variety of cost drivers.Stage 1Assign costs to poolsaccording to activitiesthatcause costs to be incurred.Stage 2Allocate costs in the activity pools to products.The first step is toidentify essentialactivities and costsrequired to performthe activities.© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillTraditional Two-Stage Cost AllocationDepartment 1Product 1Department 2Product 2Overhead Costs© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillActivity-Based Cost AllocationOverhead CostsActivityCenter 1Product 1Product 2ActivityCenter 3ActivityCenter 2© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillTypes of Production ActivitiesOverhead costs associatedwith each category are pooled togetherand allocated to products according tohow those products benefit fromthe activities.Unit-LevelActivityBatch-Level ActivityProduct-LevelActivityFacility-LevelActivity© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillLet’s look at anexample from theUnterman ShirtCompany. Types of Production Activities© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillTypes of Production ActivitiesTotalExpected Volume680,000 120,000 800,000 Total Overhead5,730,000$ Sales Price31.00$ 31.00$ Overhead Rate7.16$ 7.16$ Direct Material8.20 8.20 Direct Labor6.80 22.16 6.80 22.16 Gross Margin8.84$ 8.84$ Dress ShirtsCasual ShirtsProduct LinesUnterman Shirt CompanyOverhead Rate = $5,730,000 ÷800,000 shirts = $7.16 per shirt(Rounded) © The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillTypes of Production ActivitiesUnterman decides to implement ABC andcategorizes activities into four activity cost centers.Unit-levelActivitiesBatch-levelActivitiesProduct-levelActivitiesFacility-levelActivitiesIncurred each timea shirt is made.Incurred each time a batch ofshirts(casual or dress)is made.Supports either dressor casual shirts.Benefit the entire process,not a line of specific shirts.© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillUnit-level Activity CenterUnterman identifies the following unit-leveloverhead costs ($1,296,000 of the total $5,730,000):© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillUnit-level Activity CenterUnterman uses direct labor hours toallocate the unit-level overhead costs.© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillBatch-level Activity CenterUnterman identifies $690,000 in batch-leveloverhead costs ($690,000 of the total $5,730,000):Unterman uses number of setups toallocate the batch-level overhead costs.© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillProduct-level Activity CenterUnterman identifies $1,800,000 in product-leveloverhead costs ($1,800,000 of the total $5,730,000):Unterman allocates 70% product-level coststo casual shirts and 30% to dress shirts.© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillFacility-level Activity CenterUnterman identifies $1,944,000 in facility-leveloverhead costs ($1,944,000 of the total $5,730,000):Unterman allocates 85% facility-level coststo dress shirts and 15% to casual shirts.© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillUsing the Information© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillUsing the InformationTraditional costing resulted in undercostingthecasual shirt line andovercostingthe dress shirt line.© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillUsing the InformationShould Untermanincrease the priceof casual shirts?Should Untermanreducethe priceof dress shirts?Should Untermandropthecasual shirt line?© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillUsing the InformationTarget pricingmight be useful.Determine the price customers will pay for casualshirts, and then reduce costs so that they maybe produced and sold profitably at that price.© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillUsing the InformationUnterman must determine if costs are avoidablebefore dropping the casual shirt line.Facility-level overhead costs are usually unavoidable.© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillWe should consider othercosts such as sales commissionsand research and developmentcosts before making any ofthese decisions.Using the Information© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillTotal Quality ManagementLet’s change gears andlook at another topic.© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillTotal Quality ManagementQualityDesignConformanceQuality refers to the degree to which actual productsand services conform to their design specification.© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillCosts companies incur to assure quality conformance may be classified as:Prevention costs.Appraisal costs.Internal failure costs.External failure costs.Total Quality Management© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillPrevention costsInspection of materials upon deliveryInspection of production processEquipment inspectionEmployee trainingAppraisal costsFinished goods inspectionField testing of productsTotal Quality Management© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillInternal failure costs –defectsdiscovered before delivery to customers.Scrap materialsReworkReinspection of reworkLost sales resultingfrom late deliveries CostReportTotal Quality Management© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillExternal failure costs –defectsdiscovered after delivery to customers.Warranty repairsProduct liabilityMarketing costs toimprove product imageLost sales due to poorproduct qualityTotal Quality Management© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillMinimizing Total Quality CostsCost of preventionand appraisalCost ofinternal and external failureObjective:Minimize defects while alsominimizing all four quality cost categories.© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillMinimizing Total Quality CostsTotal Quality costPercent of Products without DefectsCost per Unit ($)Internal andexternalfailure costsPrevention and appraisal costs0100© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillUnterman CompanyQuality Cost ReportFor the Year Ended December 31, 2002AmountPercentage Prevention Costs106,000$ 13.87% Appraisal Costs150,000 19.63% Internal Failure Costs298,000 39.01% External Failure Costs210,000 27.49% Total Quality Costs764,000$ 100.00%Quality Cost ReportsShould Unterman spend more on preventionand appraisal in an effort to reduce failure costs?© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-HillEnd of Chapter 6I’m managingquality time!