Introduction to Managerial Accounting - PowerPoint

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					Introduction to Managerial
Accounting
EMBA 5401 Fall 2007
The Role of Accounting
Role         Users                  Decisions               Preferred Characteristics
Managerial   Internal Managers      Planning                Measure Inputs and Outputs
                                    Control                 Timeliness
                                                            Identify Responsibility
                                                            Forward-Looking
Financial    Shareholders           Investment              Verifiable
             Creditors              Credit                  Measure Organizational Value
             Other External                                 Measure Risk of Organization
             Users                                          Consistent with GAAP
Tax          Taxing Authorities     Tax Liability           Verifiable
                                                            Measure Past Income



                              Mugan - EMBA 5401 Fall 2007                                2
Managerial Accounting
   Process of
       Identifying
       Measuring
       Analyzing
       Interpreting
       Communicating
        information in pursuit of a company’s goals
       Managerial accountants – business partners/consultants in
        companies
       Provides information to managers

                           Mugan - EMBA 5401 Fall 2007              3
Managerial Accounting Objectives
   Provide information for planning and decision
    making – be a part of it
   Assist managers in daily control of operations
   Motivate the managers and other employees
    towards the company goals-goal congruence
   Performance measurement of managers
   Strategic planning – determine competitive
    position and long-run success of the company
                     Mugan - EMBA 5401 Fall 2007     4
Characteristics
   Internal – manager oriented
   Future looking – planning
   Involves estimates
   More timely and relevant data necessary
   Adaptive to changing business environment
   Cross-functional – brings together production,
    marketing, managerial accountants and other
    key personnel
                     Mugan - EMBA 5401 Fall 2007     5
Management accounting system
   To control costs
   To measure and improve productivity
   To devise improved production process
   To decide on new products
   To decide on obsolete products
   To decide on prices
   To respond to rival products (Johnson and
    Kaplan, 1987)
                    Mugan - EMBA 5401 Fall 2007   6
Cost Management Perspective
   Provide highest quality service/goods with lowest
    possible cost
   Objectives:
       Determine cost of resources consumed in company’s
        activities
       Eliminate non-value added activities as much as possible
       Determine efficiency and effectiveness of all major activities
       Identify and evaluate new activities that can improve the
        performance of the company

                            Mugan - EMBA 5401 Fall 2007             7
Strategic Cost Management
   Value chain
       Get raw materials and other resources
       Research and development – including quality assessment
       Product design
       Production
       Marketing
       Distribution
       Customer service
   Should understand the value chain
   Cost drivers in activities
   Managing the cost relationships to a company’s advantage – strategic cost
    management

                               Mugan - EMBA 5401 Fall 2007                      8
     Making Planning Decisions
                                                      How should we
     What customers                                    finance our
    should we target?                                  operations?


What price should
  we charge?
                                                       What products or
                                                       services should we
                                                            provide?
          Which projects
         should we choose?
                        Mugan - EMBA 5401 Fall 2007                    9
Cost – Benefit Analysis
   Cost- using resources to achieve a benefit
   Benefits- aspects of a decision that help the
    organization
   Analysis: the process of analyzing alternative
    decisions to determine which decision has the
    greatest benefit relative to its cost


                    Mugan - EMBA 5401 Fall 2007   10
Discussion Question
   A finance professor and a marketing professor were
    recently comparing notes on their perceptions of
    corporations. The finance professor claimed that the
    goal of a corporation should be to maximize the value
    to the shareholders. The marketing professor claimed
    that the goal of a corporation should be to satisfy
    customers.
   What are the similarities and differences in these goals?
    Zimmerman, 2003; p.24

                        Mugan - EMBA 5401 Fall 2007       11
Types of                   The opportunity cost is the monetary amount
                           associated with the next best use of the
Costs                      resource.

    differential costs- (benefits) – costs or benefits that
     change between/among alternatives
    Irrelevant costs -Costs that don’t change are
     irrelevant to the decision
    Choose the alternatives where differential benefits
     exceed differential costs
    Opportunity costs
    Sunk costs
    Controllable /avoidable costs/discretionary costs

    Costs occurred in the past; cannot be changed now.
                             Mugan - EMBA 5401 Fall 2007             12
 Problems in Identifying and Measuring
 Benefits
               How do I measure
                 the benefit of
              employee training?
  How do I                                      What is the
measure the                                 monetary benefit of
 benefit of                                 a happy customer?
 improved
  quality?                   What is the
                              monetary
                            benefit of an
                              improved
                                working
                          environment?
                   Mugan - EMBA 5401 Fall 2007              13
   Problems in Identifying and
   Measuring Costs
How do I measure                                  What is the cost of
 the cost of poor                                   a dissatisfied
     quality?                                        customer?




 What is the cost                                        How do I
  of postponing                                         measure the
    this year’s                                        cost of setting
     training                                           my price too
    program?                                               high?
                    Mugan - EMBA 5401 Fall 2007                         14
Classifications of Costs
   Behavior – how costs react to changes in underlying
    cost driver
       Variable or Fixed
   Function – related to production or sales
       Product or Period
       Product costs –
           Direct Material
           Direct Labor
           Factory Overhead
   Traceability (cost of tracing cost to a cost driver
    directly should be lower than the benefits.

                               Mugan - EMBA 5401 Fall 2007   15
Non-manufacturing Costs
     Marketing or                                    Administrative
     Selling Costs                                      Costs




 Costs necessary to get                               All executive,
  the order and deliver                            organizational, and
      the product.                                   clerical costs.



                     Mugan - EMBA 5401 Fall 2007                      16
Product Costs Versus Period Costs

    Product costs include direct                   Period costs include all
     materials, direct labor, and                     marketing or selling
      manufacturing overhead.                              costs and
                     Cost of Good Sold
                                                            administrative costs.
  Inventory
                                                                  Expense

              Sale


                      Income                                      Income
  Balance
                     Statement                                   Statement
   Sheet

                              Mugan - EMBA 5401 Fall 2007                           17
Product Cost Flows
                                                         Work
            Raw Materials                             In Process

         Beginning raw                        Direct materials
           materials inventory
     +   Raw materials
           purchased
     =   Raw materials
           available for use
           in production
     –   Ending raw materials
           inventory
     =   Raw materials used
           in production

                        Mugan - EMBA 5401 Fall 2007                18
Product Cost Flows
                                                    Work
            Raw Materials                        In Process

         Beginning raw                    Beginning work in
           materials inventory               process inventory
     +   Raw materials                    Direct materials         Prime Costs
           purchased                    + Direct labor
     =   Raw materials                  + Mfg. overhead
           available for use            = Total manufacturing
                                                                 Conversion Costs
           in production                     costs
     –   Ending raw materials
           inventory
     =   Raw materials used
           in production


                          Mugan - EMBA 5401 Fall 2007                            19
Product Cost Flows
                                                         Work
           Raw Materials                              In Process

        Beginning raw                       Beginning work in
          materials inventory                 process inventory
    +   Raw materials
          purchased                        Direct materials
    =   Raw materials                    + Direct labor
          available for use              + Mfg. overhead
          in production                  = Total manufacturing
    –   Ending raw materials                  costs
          inventory
    =   Raw materials used
          in production
                        Mugan - EMBA 5401 Fall 2007                20
Product Cost Flows
                                                        Work
      Raw Materials                                  In Process

   Beginning raw                               Beginning work in
     materials inventory        +                 process inventory
 + Raw materials                +         +    Total manufacturing
     purchased                  =                 costs
 = Raw materials                          =    Total work in
     available for use                            process for the
     in production                                period
                                           –   Ending work in
                                                  process inventory
                                          =    Cost of goods
                                                  manufactured

                           Mugan - EMBA 5401 Fall 2007                21
Product Cost Flows
               Work
            In Process                           Finished Goods

        Beginning work in                     Beginning finished
           process inventory                    goods inventory
    +   Manufacturing costs                + Cost of goods
           for the period                       manufactured
    =   Total work in process              = Cost of goods
           for the period                       available for sale
    –   Ending work in                      - Ending finished
           process inventory                    goods inventory
    =   Cost of goods                         Cost of goods
           manufactured                         sold


                        Mugan - EMBA 5401 Fall 2007                  22
Manufacturing Cost Flows
                           Balance Sheet             Income
     Costs                  Inventories             Statement
                                                    Expenses
Material Purchases          Raw Materials


   Direct Labor                    Work in
                                   Process
  Manufacturing
    Overhead                                          Cost of
                                  Finished
                                                      Goods
                                   Goods
                                                       Sold

   Selling and             Period Costs             Selling and
  Administrative     Mugan - EMBA 5401 Fall 2007   Administrative
                                                              23
Graphical Analysis of Activity Costs and Rate of Output
                                                Curvilinear Total
   Total                                          Cost Curve
  Dollars



                                         Marginal Costs are the costs to produce one
                                               more additional unit of output=slope.




                                                        Output
     Start-up Normal          Exceeding
      Range Operations         Capacity
                          Mugan - EMBA 5401 Fall 2007                            24
                                                                The relevant range
          Relevant Range                                        is the portion of the
                                                               curvilinear total cost
 Total                                                           curve that appears
Dollars     Relevant                                                in the normal
             Range                            Total               operations area.
                                              Cost


            }
                                                      Output
   Start-    Normal          Exceeding
    up      Operation         Capacity
   Range       s

                        Mugan - EMBA 5401 Fall 2007                              25
The Linearity Assumption and the Relevant
Range
                                  Economist’s      A straight line
                                                      closely
                                 Curvilinear Cost approximates a
                                    Function        curvilinear
                                                          variable cost
                                                         line within the
                Relevant
   Total Cost




                                                        relevant range.
                 Range
                                          Accountant’s Straight-Line
                                           Approximation (constant
                                             unit variable cost)


                     Mugan - EMBA 5401 Fall 2007   Activity          26
Cost Classifications for Predicting
Cost Behavior
       By reaction to changes in the level of activity
                 within the relevant range.
       Total variable costs change when activity changes.
       Total fixed costs remain unchanged when activity
        changes.




                        Mugan - EMBA 5401 Fall 2007          27
Mugan - EMBA 5401 Fall 2007   28
Cost Classifications for Predicting
Cost Behavior
            Behavior of Cost (within the relevant range)
  Cost               In Total                                       Per Unit

 Variable   Total variable cost changes                   Variable cost per unit remains
             as activity level changes.                    the same over wide ranges
                                                                    of activity.
  Fixed       Total fixed cost remains               Average fixed cost per unit goes
             the same even when the                  down as activity level goes up.
               activity level changes.




                            Mugan - EMBA 5401 Fall 2007                              29
Extent of Variable Costs
The proportion of variable costs differs across organizations. For
example . . .

       A public utility with                        A manufacturing company
      large investments in                            will often have many
       equipment will tend                                variable costs.
          to have fewer
         variable costs.

                                                    A merchandising company
        A service company                             usually will have a high
     will normally have a high                      proportion of variable costs
    proportion of variable costs.                       like cost of sales.


                               Mugan - EMBA 5401 Fall 2007                         30
Examples of Variable Costs
   Merchandising companies – cost of goods sold.
   Manufacturing companies – direct materials,
    direct labor, and variable overhead.
   Merchandising and manufacturing companies –
    commissions, shipping costs, and clerical costs
    such as invoicing.
   Service companies – supplies, travel, and
    clerical
                    Mugan - EMBA 5401 Fall 2007   31
Types of Fixed Costs

     Committed                                       Discretionary
 Long-term, cannot be                         May be altered in the short-
 significantly reduced                        term by current managerial
                                                      decisions
   in the short term.

      Examples                                         Examples
    Depreciation on                                  Advertising and
    Equipment and                                     Research and
   Real Estate Taxes                                  Development

                       Mugan - EMBA 5401 Fall 2007                       32
Mixed Costs

                     Y
 Total Mobile Phone Cost




                                                                               Fixed Monthly
                                                                               Phone Charge

                                                                   X          Fixed Monthly
                           Activity (minutes)                                 Phone Charge

                                                Mugan - EMBA 5401 Fall 2007                    33
Mixed Costs
                                                The total mixed cost line can be expressed
                                                as an equation: Y = a + bX

                                                Where:            Y = the total mixed cost
                                                                  a = the total fixed cost (the
                           Y                                          vertical intercept of the line)
                                                                  b = the variable cost per unit of
 Total Mobile Phone Cost




                                                                      activity (the slope of the line)
                                                                  X = the level of activity



                                                                                   Variable
                                                                               Cost per minute


                                                                                Fixed Monthly
                                                                   X
                           Activity (minutes)                                   Phone Charge

                                                Mugan - EMBA 5401 Fall 2007                        34
The Scattergraph Method
                      Plot the data points on a graph
            Y              (total cost vs. activity).
        20

                   * *               * ** *
                                    **
 Cost




        10       * *

        0                                                 X
             0    1         2              3          4
                      Activity - output
                        Mugan - EMBA 5401 Fall 2007           35
The Scattergraph Method
                  Draw a line through the data points with about an
            Y    equal numbers of points above and below the line.
        20

                   * *               * ** *
                                    **
 Cost




        10       * *

        0                                                 X
             0    1         2              3          4
                         Activity - output
                        Mugan - EMBA 5401 Fall 2007               36
The Scattergraph Method
                  Use one data point to estimate the total level of activity and the total
                                                 cost.
          Y Total cost = TL11
        20

                      * *                     * ** *
                                             **
 Cost




        10          * *
                  Intercept = Fixed cost: TL 10

          0                                                         X
              0         1            2              3          4
                                  Activity - output

 Activity 0.8 units              Mugan - EMBA 5401 Fall 2007                             37
The Scattergraph Method
 Make a quick estimate of variable cost per unit and determine the cost
                               equation.

      Total Cost at 0.8 units                                       11 TL
      Less: Fixed cost                                              10 TL
      Estimated total variable cost 0.8 units                       1 TL

                                            TL1
         Variable cost per unit =                          = TL1.25/ unit of output
                                            0.8

                       Y = TL10 + TL1.25X

Total cost                                                 Number of units
                             Mugan - EMBA 5401 Fall 2007                              38
The High-Low Method
 Assume the following hours of maintenance work and the total maintenance costs for six months.



                                                                                 High
                                                                                 level of
                                                                                 activity




                                                                                  Low
                                                                                  level of
                                                                                  activity




                                    Mugan - EMBA 5401 Fall 2007                              39
Product Cost Estimation:
Technique Classification
and Methodology Review
Niazi. Dai1. Balabani. Seneviratne
Journal of Manufacturing Science and
Engineering MAY 2006, Vol. 128,563-575   Mugan - EMBA 5401 Fall 2007   40
Product Cost Estimation:
Technique Classification
and Methodology Review
Niazi. Dai1. Balabani. Seneviratne
Journal of Manufacturing Science and
Engineering MAY 2006, Vol. 128,563-575   Mugan - EMBA 5401 Fall 2007   41
Product Cost Estimation:
Technique Classification
and Methodology Review
Niazi. Dai1. Balabani. Seneviratne
Journal of Manufacturing Science and
Engineering MAY 2006, Vol. 128,563-575   Mugan - EMBA 5401 Fall 2007   42
Assigning Costs to Cost Objects

 Direct costs                               Indirect costs
    Costs that can be                            Costs that cannot be easily
     easily and conveniently                       and conveniently traced to
     traced to a unit of product                   a unit of product or other
     or other cost object.                         cost object.
    Examples: direct material                    Example: manufacturing
     and direct labor                              overhead



                         Mugan - EMBA 5401 Fall 2007                       43
Cost Classifications for Decision Making
   Every decision involves a choice between at
    least two alternatives.

   Only those costs and benefits that differ between
    alternatives are relevant in a decision. All other
    costs and benefits can and should be ignored.


                     Mugan - EMBA 5401 Fall 2007   44
Differential Costs and Revenues
  Costs and revenues that differ among
               alternatives.
   Example: You have a job paying TL 1,500 per month
   in your hometown. You have a job offer in a
   neighboring city that pays TL 2,000 per month. The
   commuting cost to the city is TL 300 per month.

              Differential revenue is:
             TL2,000 – TL1,500 = TL500

                 Differential cost is:
                           TL 300
                     Mugan - EMBA 5401 Fall 2007        45
Opportunity Costs
 The potential benefit that is given up when one alternative
  is selected over another.


 Example: If you were not attending this
 program, you could save TL 10,000 per year.
 Your opportunity cost?




                        Mugan - EMBA 5401 Fall 2007            46
Sunk Costs
 Sunk costs have already been incurred and cannot be changed
   now or in the future. They should be ignored when making
                           decisions.
  Example: You bought an automobile that cost
  TL10,000 two years ago. The TL10,000 cost is sunk
  because whether you drive it, park it, trade it, or sell
  it, you cannot change the TL10,000 cost.



                      Mugan - EMBA 5401 Fall 2007        47
Summary of the Types of Cost
Classifications

   Financial reporting
   Predicting cost behavior
   Assigning costs to cost objects- products-
    determining unit costs
   Decision making


                     Mugan - EMBA 5401 Fall 2007   48
The Contribution Format




   Used primarily for                              Used primarily by
   external reporting.                              management.
                     Mugan - EMBA 5401 Fall 2007                       49
Idle Time
    Machine                                   Material
  Breakdowns                                 Shortages

                Power
               Failures

        The labor costs incurred
      during idle time are ordinarily
        treated as manufacturing
                overhead.
               Mugan - EMBA 5401 Fall 2007               50
Overtime
 The overtime premiums for all factory
workers are usually considered to be part
      of manufacturing overhead.




                Mugan - EMBA 5401 Fall 2007   51
Unit Costs
   Direct Material- determined as actual usage of
    materials or by engineering estimates (standard costs)
   Direct Labor- determined as actual usage of materials
    or by engineering estimates (standard costs)
   MOVH – common production costs assigned to each
    unit
       Traditional
       ABC
   Unit cost = DM + DL + MOVH per unit
                        Mugan - EMBA 5401 Fall 2007      52
Labor Fringe Benefits
Fringe benefits include employer paid costs for
    insurance programs, retirement plans,
supplemental unemployment programs, Social
Security, Medicare, workers’ compensation and
             unemployment taxes.

  Some companies                                      Other companies treat
 include all of these                                      fringe benefit
       costs in                                         expenses of direct
   manufacturing                                      laborers as additional
      overhead.         Mugan - EMBA 5401 Fall 2007
                                                        direct labor costs.53
How to allocate indirect costs to
products MOVH
   Depends on the nature of products and production
    system
   Traditional- direct labor hours (DLH); number of units
    produced;
   Automation and computer technology have increased
    the indirect costs in many organizations
   Activity-Based Costing (ABC)- a procedure that
    attempts to provide a more precise indirect cost
    allocation
                       Mugan - EMBA 5401 Fall 2007      54
    Numerical Example- Unit Cost
   THD Company produces 4,000 units of Product A and 20,000
    units of Product B each year.
   Direct Material for Product A is TL 10; Product B 15
   Total indirect product costs are TL 900,000, and total direct
    labor hours(DLH) are 50,000.
   Product A requires 2.5 DLH and Product B requires 2.0 DLH
    to produce.
   Direct labor cost per hour TL 30
                                                     Continue
                         Mugan - EMBA 5401 Fall 2007          55
 Numerical Example
 Management at THD believes that indirect costs
are actually caused by the following five activities:
                                                 Estimated
        Activity                                   Costs
         Machine setups                          255,000 TL
         Quality inspections                     160,000 TL
         Production orders                        81,000 TL
         Machine-hours worked                    314,000 TL
         Material receipts                        90,000 TL
          Total                                  900,000 TL


                   Mugan - EMBA 5401 Fall 2007                56
Unit Cost - Traditional
THD uses DLH as the basis
1.determine the allocation of MOVH per unit =
   predetermined overhead rate(PDOR) PDOR=
   Total Overhead/ Total DLH
2. determine MOVH per unit = PDOR x DL Cost
   per hour
3. add DM,DL and MOVH per unit

                  Mugan - EMBA 5401 Fall 2007   57
PDOR and MOVH
Total Overhead                                                900,000 TL
Direct Labor Hours:
Product A - 2.5 DlH                               10000
Product B - 2 DLH                                 40000
Total Direct Labor Hours                          50000
Predetermined Overhead Rate                                          18 TL per DLH

Manufacturing Overhead per unit of A        2.5 DLH                  45 TL per unit
Manufacturing Overhead per unit of B         2 DLH                   36 TL per unit




                                Mugan - EMBA 5401 Fall 2007                           58
Unit Costs – Traditional

 UNIT COSTS                                               Product A Product B
 Direct Material                                                  10        15
 Direct Labor ( DLH x 30 TL / DLH)                                75        60
 Manufacturing Overhead                                           45        36
   Unit Cost                                                    130        111




                            Mugan - EMBA 5401 Fall 2007                          59
Numerical Example-MOVH by ABC
   The following activity data was supplied by
             the management of THD


       Activity                 Total                Product A   Product B
Machine setups                    5,000                  3,000       2,000
Quality inspections               8,000                  5,000       3,000
Production orders                   600                    200         400
Machine-hours worked             40,000                 12,000      28,000
Material receipts                   750                    150         600




                       Mugan - EMBA 5401 Fall 2007                           60
Numerical Example-MOVH by ABC
 This activity data can be used to develop application
          rates for each of the five activities.

                                                Total        Rate per
             Activity            Costs      Transactions   Transaction
      Machine setups           255,000 TL ÷        5,000 =        51 TL
      Quality inspections        160,000 ÷         8,000        ?




                            Mugan - EMBA 5401 Fall 2007                   61
Numerical Example-MOVH by ABC

                                                  Total             Rate per
         Activity          Costs              Transactions        Transaction
  Machine setups         255,000 TL       ÷          5,000    =          51 TL
  Quality inspections      160,000        ÷          8,000    =         20.00
  Production orders          81,000       ÷             600   =        135.00
  Machine-hours worked     314,000        ÷         40,000    =           7.85
  Material receipts          90,000       ÷             750   =        120.00



                         Mugan - EMBA 5401 Fall 2007                             62
Numerical Example-MOVH by ABC
     Now that we have calculated the application rates, we
      use the rates to assign indirect costs to Product A.

            Activity        ABC Rate               Usage        Amount
   Machine setups              51 TL ×                3,000 =   153,000 TL
   Quality inspections         20.00 ×                5,000         ?




                         Mugan - EMBA 5401 Fall 2007                         63
Numerical Example-MOVH by ABC
    Now that we have calculated the application rates, we
     use the rates to assign indirect costs to Product A.

                 Activity             ABC Rate            Usage          Amount
        Machine setups                    51 TL   ×          3,000   =   153,000 TL
        Quality inspections               20.00   ×          5,000   =     100,000
        Production orders                135.00   ×            200   =       27,000
        Machine-hours worked               7.85   ×         12,000   =       94,200
        Material receipts                120.00   ×            150   =       18,000
        Total indirect costs assigned                                    392,200 TL
        Number of units produced                                     ÷        4,000
        Indirect product costs per unit-MOVH                                  98 TL




                            Mugan - EMBA 5401 Fall 2007                               64
Numerical Example-MOVH by ABC
  MOVH costs for a unit of Product B
           Activity             ABC Rate                   Usage          Amount
  Machine setups                    51 TL       ×             2,000   =   102,000 TL
  Quality inspections               20.00       ×             3,000   =       60,000
  Production orders                135.00       ×               400   =       54,000
  Machine-hours worked               7.85       ×            28,000   =     219,800
  Material receipts                120.00       ×               600   =       72,000
  Total indirect costs assigned                                           507,800 TL
  Number of units produced                                            ÷       20,000
  Indirect product costs per unit-MOVH                                         25 TL



                             Mugan - EMBA 5401 Fall 2007                               65
Reconciliation check


              Reconciliation                        Amount
   Indirect costs assigned to Product A            $ 392,200
   Indirect costs assigned to Product B              507,800
   Total indirect costs assigned                   $ 900,000




                     Mugan - EMBA 5401 Fall 2007               66
Unit Costs – Using ABC


 UNIT COSTS                                           Product A Product B
 Direct Material                                              10        15
 Direct Labor ( DLH x 30 TL / DLH)                            75        60
 Manufacturing Overhead                                    98.05     25.39
   Unit Cost                                              183.05    100.39




                            Mugan - EMBA 5401 Fall 2007                      67
Comparison of Unit Costs


                                   Traditional Using ABC
 Product A                                  130     183.05
 Product B                                  111     100.39




             Mugan - EMBA 5401 Fall 2007                     68
    Advantages of ABC
Activity-based costing is very useful in firms . . .

    With multiple
    products and
      services.
                 That have products
                and services that use
                  indirect activities
                  in different ways.
                                                      That have a high
                                                    percentage of indirect
                                                        product costs.
                      Mugan - EMBA 5401 Fall 2007                            69
Problems With ABC
                                  Proper identification
                                   of cost drivers is
                                       difficult.
   ABC ignores the
 difference between
the fixed and variable
 costs of an activity.
                           ABC is more costly
                           because additional
                           measurements and
                           observations must
                               be made.
                 Mugan - EMBA 5401 Fall 2007              70
Quality of Conformance

   When the overwhelming majority of
  products produced conform to design
     specifications and are free from
                 defects.



              Mugan - EMBA 5401 Fall 2007   71
Prevention and Appraisal Costs
                                                     Support activities
    Prevention                                      whose purpose is to
      Costs                                        reduce the number of
                                                         defects



                                                 Incurred to identify
                                                 defective products
   Appraisal Costs                             before the products are
                                                       shipped


                     Mugan - EMBA 5401 Fall 2007                          72
Internal and External Failure Costs
                                              Incurred as a result of
  Internal Failure
                                                identifying defects
       Costs                                 before they are shipped



                                                Incurred as a result of
   External Failure                               defective products
        Costs                                     being delivered to
                                                      customers



                      Mugan - EMBA 5401 Fall 2007                         73
Examples of Quality Costs
                                                      Appraisal Costs
    Prevention Costs
                                           • Testing & inspecting
• Quality training
                                             incoming materials
• Quality circles
                                           • Final product testing
• Statistical process
                                           • Depreciation of testing
  control activities
                                             equipment


                                             External Failure Costs
  Internal Failure Costs
                                           • Cost of field servicing &
• Scrap
                                             handling complaints
• Spoilage
                                           • Warranty repairs
• Rework
                                           • Lost sales

                        Mugan - EMBA 5401 Fall 2007                      74
Distribution of Quality Costs
    When quality of conformance is low,
   total quality cost is high and consists
   mostly of internal and external failure.

          Companies can reduce their total
             quality cost by focusing on
         prevention and appraisal. The cost
        savings from reduced defects usually
         swamps the costs of the additional
          prevention and appraisal efforts.


                     Mugan - EMBA 5401 Fall 2007   75
                                      Ventura Company
                                      Quality Cost Report
                                       For Years 1 and 2
                                                     Year 2                     Year 1
                                               Amount       Percent*        Amount Percent*
Prevention costs:
    Systems development                     $     400,000      0.80% $ 270,000          0.54%
    Quality training                              210,000      0.42%   130,000          0.26%
    Supervision of prevention activities           70,000      0.14%    40,000          0.08%
    Quality improvement                           320,000      0.64%   210,000          0.42%
Total prevention cost                           1,000,000      2.00%   650,000          1.30%

Appraisal costs:
                                                                                                   Quality cost
    Inspection
    Reliability testing
                                                  600,000
                                                  580,000
                                                               1.20%
                                                               1.16%
                                                                              560,000
                                                                              420,000
                                                                                        1.12%
                                                                                        0.84%
                                                                                                 reports provide
    Supervision of testing and inspection
    Depreciation of test equipment
                                                  120,000
                                                  200,000
                                                               0.24%
                                                               0.40%
                                                                               80,000
                                                                              140,000
                                                                                        0.16%
                                                                                        0.28%
                                                                                                  an estimate of
Total appraisal cost                            1,500,000      3.00%        1,200,000   2.40%      the financial
Internal failure costs:                                                                           consequences
     Net cost of scrap                            900,000      1.80%          750,000   1.50%
     Rework labor and overhead                  1,430,000      2.86%          810,000   1.62%         of the
     Downtime due to defects in quality           170,000      0.34%          100,000   0.20%
     Disposal of defective products               500,000      1.00%          340,000   0.68%       company’s
Total internal failure cost                     3,000,000      6.00%        2,000,000   4.00%
                                                                                                  current defect
External failure costs:
    Warranty repairs                              400,000      0.80%     900,000         1.80%         rate.
    Warranty replacements                         870,000      1.74% 2,300,000           4.60%
    Allowances                                    130,000      0.26%     630,000         1.26%
    Cost of field servicing                       600,000      1.20% 1,320,000           2.64%
Total external failure cost                     2,000,000      4.00% 5,150,000          10.30%
Total quality cost                          $   7,500,000     15.00% $ 9,000,000        18.00%
                                                        Mugan - EMBA 5401 Fall 2007                          76

* As a percentage of total sales. In each year sales totaled $50,000,000.
                    Quality Cost Reports: Graphic Form
                             $10                                                                                                          20
                                                                       Quality
                              9                                                                                                           18
                                                                       reports




                                                                                                  Quality Cost as a Percentage of Sales
                              8                                                                                                           16
                                                                      can also
Quality Cost (in millions)




                              7                                                                                                           14

                              6
                                    External
                                    Failure
                                                        External
                                                         Failure
                                                                          be                                                              12
                                                                                                                                                External
                                                                                                                                                Failure
                                                                                                                                                                    External
                                                                                                                                                                     Failure

                              5
                                                                      prepared                                                            10

                              4                         Internal
                                                                          in                                                              8                         Internal

                              3     Internal
                                                        Failure
                                                                       graphic                                                            6     Internal
                                                                                                                                                                    Failure

                                    Failure                                                                                                     Failure
                              2
                                                       Appraisal
                                                                        form.                                                             4
                                                                                                                                                                   Appraisal
                                   Appraisal                                                                                                   Appraisal
                              1                                                                                                           2
                                   Prevention          Prevention                                                                              Prevention          Prevention
                              0                                                                                                           0
                                       1                   2        Mugan - EMBA 5401 Fall 2007                                                    1                   2        77
                                                Year                                                                                                        Year
Product Life Cycle




                                        Mugan - EMBA 5401 Fall 2007               78
     http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf
                                   Mugan - EMBA 5401 Fall 2007               79
http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf
            Introduction                  Growth               Maturity      Decline




                                   Mugan - EMBA 5401 Fall 2007                         80
http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf
http://www.ee.unb.ca/powereng/courses/E
E2703/EE2703_DetailedDesign2.pdf


                                          Mugan - EMBA 5401 Fall 2007   81
http://www.ee.unb.ca/powereng/courses/E
E2703/EE2703_DetailedDesign2.pdf


                                          Mugan - EMBA 5401 Fall 2007   82
Uses of Quality Cost Information
  Help managers see the
 financial significance of
         defects.

        Help managers identify the
        relative importance of the
            quality problems.

                         Help managers see
                      whether their quality costs
                       are poorly distributed.
                      Mugan - EMBA 5401 Fall 2007   83
ISO 9000 Standards
   ISO 9000 standards have become an international
  measure of quality. To become ISO 9000 certified, a
             company must demonstrate:

       1. A quality control system is in use, and the
          system clearly defines an expected level of
          quality.
       2. The system is fully operational and is
          backed up with detailed documentation of
          quality control procedures.
       3. The intended level of quality is being
          achieved on a sustained basis.
                       Mugan - EMBA 5401 Fall 2007      84
Appendix
       Least-Squares
      Regression Using
       Microsoft Excel.


           Mugan - EMBA 5401 Fall 2007   85
Simple Regression Analysis
Example
 Matrix, Inc. wants to
  know its average
    fixed cost and
variable cost per unit.
Using the data to the
right, let’s see how to
do a regression using
   Microsoft Excel.
                    Mugan - EMBA 5401 Fall 2007   86
Simple Regression Using Excel
You will need three pieces of
   information from your
   regression analysis:
1. Estimated Variable Cost per
   Unit (line slope)
2. Estimated Fixed Costs (line
   intercept)
3. Goodness of fit, or R2

To get these three pieces
    information we will need to
    use three different Excel
    functions.
LINEST, INTERCEPT, & RSQ
                           Mugan - EMBA 5401 Fall 2007   87
Simple Regression Using Excel
             Place your cursor in
             cell F4 and press the
              = key. Click on the
             pull down menu and
             scroll down to “More
                 Functions . . .”




             Mugan - EMBA 5401 Fall 2007   88
Simple Regression Using Excel
                                           Scroll down to the
                                               “Statistical”,
                                             functions. Now
                                             scroll down the
                                                statistical
                                           functions until you
                                                 highlight
                                                “LINEST”


             Mugan - EMBA 5401 Fall 2007                    89
Simple Regression Using Excel




 1. In the Known_y’s box enter C4:C19 for the range.
 2. In the Known_x’s box enter D4:D19 for the range.

                    Mugan - EMBA 5401 Fall 2007        90
Simple Regression Using Excel
                                                     Here is the
                                                   estimate of the
                                                  slope of the line.



 1. In the Known_y’s box enter C4:C19 for the range.
 2. In the Known_x’s box enter D4:D19 for the range.

                    Mugan - EMBA 5401 Fall 2007                   91
                         Excel
Simple Regression Using you cursor in cell
                    With
                                           F5, press the = key
                                            and go to the pull
                                             down menu for
                                            special functions.
                                          Select Statistical and
                                              scroll down to
                                               highlight the
                                         INTERCEPT function.


                Mugan - EMBA 5401 Fall 2007                  92
Simple Regression Using Excel
                                                    Here is the
                                                  estimate of the
                                                   fixed costs.




 1. In the Known_y’s box enter C4:C19 for the range.
 2. In the Known_x’s box enter D4:D19 for the range.
                    Mugan - EMBA 5401 Fall 2007                 93
Simple Regression Using Excel
                                           Finally, we will
                                           determine the
                                            “goodness of
                                            fit”, or R2, by
                                           using the RSQ
                                               function.




             Mugan - EMBA 5401 Fall 2007                      94
Simple Regression Using Excel

                                                    Here is the
                                                  estimate of R2.




  1. In the Known_y’s box enter C4:C19 for the range.
  2. In the Known_x’s box enter D4:D19 for the range.
                    Mugan - EMBA 5401 Fall 2007                95

				
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