05
Chapter CHAPTER Overview
Traditional Costing Systems
Automation and the Need for Activity-based
Costing (ABC)
Activity-Based Costing (ABC)
Activity-Based Management (ABM)
Total Quality Management (TQM)
Indirect
Costs
Traditional Costing Systems
Traditional cost systems were created when
manufacturing processes were labor intensive.
A single company-wide overhead rate,
based on direct labor hours, is used
to allocate overhead to products in
these labor intensive processes.
Indirect
Costs
Traditional Costing Systems
Overhead is allocated to jobs using direct labor hours. If
overhead is $120, how much overhead is allocated to each
job?
Two-Step Allocation:
1. Overhead Rate =
2. OH Allocation to: Job 1 =
Job 2 =
Indirect
Costs
Traditional Costing Systems
Automated Process
Labor Intensive Process
Overhead costs are
relatively small.
Overhead costs are
relatively large.
Overhead allocations
may be inaccurate,
but the amounts are
relatively insignificant.
Inaccurate overhead
allocation can lead to
questionable product
cost information.
The Effects of Automation on
the Selection of a Cost Driver
Automation increases overhead from $120
to $420 and reduces the Job 2 labor hours
from 6 to 1. Allocate the $420 overhead to
the two jobs using direct labor.
1. Overhead Rate =
2. Job 1 =
Job 2 =
Is this reasonable?
Indirect
Costs
The Effects of Automation on
the Selection of a Cost Driver
Indirect
Costs
Is this reasonable?
.
Clearly, we need another cost driver to allocate overhead.
The Need for ABC
The Past
Small number of
products which did not
differ much in required
manufacturing support.
Labor was dominant
element in the cost
structure.
Indirect
Costs
The Present
Numerous products
with more and
complicated production
requirements.
Labor is becoming an
ever smaller part
component of total
production costs.
The Need for ABC
Indirect
Costs
More
emphasis on cost
measurement and
control
Using
technology and
productivity
Increasingly
competitive global
business
environment
Eliminating
nonvalue added
activities
More
emphasis on
quality
Indirect
Costs
Indicators of Need for ABC
Direct labor is a
small percentage
of total costs.
Product-line profit
margins are hard
to explain.
Sales are increasing,
but profits are declining.
Line managers do not
believe the product
cost reports.
Marketing does not
use costs reports for
pricing decisions.
Some products that
have reported high
profit margins are not
sold by competitors.
The Need for ABC
Indirect
Costs
If many costs are caused by non-volume-based cost
drivers, activity-based costing (ABC) should be considered.
Volume-Based Costing
All production costs
except direct materials
and direct labor are
lumped together in one
overhead cost pool.
One cost pool
Single (volume-based)
cost driver.
One application rate.
Activity-Based Costing
An effort is made to
account for as many
costs as possible as
direct costs of
production.
Several cost pools
Several (volume & activity)
cost drivers.
Multiple application rates
Activity-Based Costing
A
BC
ABC systems focus on accumulating costs into key
activities
Activity-based costing (ABC) is a two-stage allocation
process that employs a variety of cost drivers.
Stage 1
Assign costs to pools
according to activities that
cause costs to be incurred.
Stage 2
Allocate costs in the
activity pools to products.
The first step is to
identify essential
activities and costs
required to perform
the activities.
Traditional Two-Stage
Cost Allocation
Activity-Based Cost
Allocation
Overhead Costs
Department 1
Product 1
Department 2
Product 2
Overhead Costs
Activity
Center 1
Product 1
Activity
Center 2
Activity
Center 3
Product 2
The ABC Approach
Activity-Based Costing
Many companies
are using activitybased cost drivers
to improve
product costing.
Activity Based
Costing
Companywide
Overhead
Rate
Overhead Allocation
Examples of
Activities
1. Processing purchase
orders.
2. Handling materials and
parts.
3. Inspecting incoming
material and parts.
4. Setting up equipment.
5. Producing goods using
manufacturing equipment.
6. Supervising assembly
workers.
7. Inspecting finished goods.
8. Packing customer orders.
Examples of
Cost Drivers
1. Number of purchase
orders processed.
2. Number of material
requisitions.
3. Number of receipts.
4. Number of setups.
5. Number of machine
hours.
6. Number of assembly
labor hours.
7. Number of inspections.
8. Number of boxes
shipped.
Activity-Based Costing
Example of Activities and Cost Drivers:
Activities:
Cost Drivers:
Account billing
No. of lines
Bill verification
No. of accounts
Account iniquity
No. of labor hours
Correspondence
No. of letters
ABC - Activities
Unit-Level
Activity
Batch-Level
Activity
Overhead costs associated
with each category are pooled together
and allocated to products according to
how those products benefit from
the activities.
Product-Level
Activity
Facility-Level
Activity
ABC Classification of Activities
Cost/benefit analysis
Context-sensitive
Particular activities could fall into any of
the 4 hierarchical categories (inspection)
Analyze context within which activities
occur
Unterman Shirt Company
Product Lines
Dress Shirts
Casual Shirts
Expected Volume
Total Overhead
680,000
120,000
Sales Price
Overhead Rate $ 7.16
Direct Material
8.20
Direct Labor
6.80
Gross Margin
$ 31.00
Total
$ 31.00
22.16
$ 8.84
$ 7.16
8.20
6.80
800,000
$ 5,730,000
22.16
$ 8.84
Overhead Rate = $5,730,000 800,000 shirts = $7.16 per shirt
(Rounded)
Unterman Shirt Company
Unterman decides to implement ABC and
categorizes activities into four activity cost centers.
Unit-level
Activities
Incurred each time
a shirt is made.
Batch-level
Activities
Incurred each time a batch of
shirts (casual or dress) is made.
Product-level
Activities
Supports either dress
or casual shirts.
Facility-level
Activities
Benefit the entire process,
not a line of specific shirts.
Unterman Shirt Company
Unterman identifies the following unit-level
overhead costs ($1,296,000 of the total $5,730,000)
Unterman Shirt Company
Unterman uses direct labor hours to
allocate the unit-level overhead costs ($1,296,000) .
Allocation Rate = $1,296,000 / 320,000 DLH = $4.05/DLH
Unterman Shirt Company
Unterman identifies $690,000 in batch-level
overhead costs ($690,000 of the total $5,730,000)
Unterman uses number of setups to
allocate the batch-level overhead costs.
Allocation Rate = $690,000 / 2,300 setups = $300/Setup
Unterman Shirt Company
Unterman $1,800,000 identifies in product-level
overhead costs ($1,800,000 of the total $5,730,000)
Unterman allocates 30% of product-level costs
to dress shirts and 70% to casual shirts.
Allocation Rates = 30% & 70% of product cost
Unterman Shirt Company
Unterman identifies $1,944,000 in facility-level
overhead costs ($1,944,000 of the total $5,730,000)
Unterman allocates 85% facility-level costs
to dress shirts and 15% to casual shirts.
Allocation Rate = 85% & 15%
Allocation of Facility-level Overhead Costs
Product Line
Dress
Casual
Allocation Percentage
85%
15%
Allocated Overhead Cost
$ 1,652,400
$ 291,600
Number of Shirts
680,000
120,000
Cost Per Shirt
=$
2.43
=$
2.43
Total
100%
$ 1,944,000
800,000
Unterman Shirt Company
Traditional Overhead= $7.16 per shirt
Unterman Shirt Company
Overcosting or undercosting??
Traditional
ABC
Dress
$7.16
$5.29
Casual
$7.16
$17.75
Unterman Shirt Company
Should Unterman
drop the
casual shirt line?
Should Unterman
increase the price
of casual shirts?
Should Unterman
reduce the price
of dress shirts?
Unterman Shirt Company
Target pricing might be useful Determine the price
customers will pay for casual shirts, and then reduce costs
so that they may be produced and sold profitably at that
price.
Unterman must determine if costs are avoidable
before dropping the casual shirt line.
Facility-level overhead costs are usually unavoidable.
Example
Carver makes
vegetable
and tomato soup
Vegetable
Tomato
954,000
234,000
1,188,000
Number of Batches
180
180
360
Number of Setups
Cost per setup
180
264
180
264
$
360
264
Total overhead = 360 setups $264 per setup =
$
95,040
Number of Cans
$
$
Total
Example
Allocating setup costs using a volume-based
allocation rate (number of cans)
1. Overhead per can =
2.
Vegetable =
Tomato =
Allocating setup costs using an activity-based
allocation rate (number of setups).
1. Overhead per setup =
2.
Vegetable =
Tomato =
Example
Allocation to Product
Cost Driver
Vegetable
Tomato
Volume-based
Activity-based
Overcosting or undercosting??
The volume-based allocation rate
ABC
Volume-Based Costing
Misallocates OH
Distorts product cost
Overcosts the highvolume products and
undercosts the lowvolume products
Indirect
Costs
Activity-Based Costing
Better allocation
Reveals cost
distortions
ABC improves accuracy in
determining the cost
of products & services
Employee Attitudes and
the Availability of Data
ABC implementation may lead to cost-cutting
measures that result in job losses.
Loss of jobs will impact . . .
Employees personal lives
Morale of retained employees
It may be difficult to get employee cooperation
for successful implementation under these
conditions.
ABC Whats Next?
ABC and ABM
Activity-Based Management
ABM is using the output of ABC accounting system
to aid strategic decision
making and to improve operational control.
ABM aims to improve the value received by
customers and to improve profits by identifying
opportunities for improvements in strategy and
operations.
Long-term Strategic Decision Continuous Improvement
Activity-Based Management
A value-added cost is the cost of an activity
that cannot be eliminated without affecting
a products value to the customer.
In contrast, nonvalue-added costs are costs
that can be eliminated without affecting
a products value to the customer.
Non-Value-Added Costs
Our goal is to reduce or eliminate the non-value-added activities
Storage
Time
Waiting
Time
Process
Time
Move
Time
Inspection
Time
Long-term Strategic Decision Continuous Improvement
Total Quality Management
Features
Design
Conformance
Quality
Quality refers to the degree to which actual products
and services conform to their design specification.
Total Quality Management
Costs companies incur to assure quality
conformance may be classified as:
Prevention costs.
Appraisal costs.
Internal failure costs.
External failure costs.
Voluntary Cost to
Avoid Nonconformance
Failure Cost to
Correct for
Nonconformance
Total Quality Management
Prevention costs
Certifying suppliers.
Designing products with reduced defects.
Quality training.
Quality evaluations.
Process improvements.
Appraisal costs
Inspecting materials.
Inspecting machines.
Inspecting processes.
Statistical process control.
Sampling and testing.
Total Quality Management
Internal failure costs
defects
discovered before
delivery to customers.
Scrap disposal
Rework
Reinspection of rework
Delayed production
processes
Total Quality Management
External failure costs defects
discovered after delivery to customers.
Warranty repairs
Product liability
Customer complaints
Marketing costs to
improve product image
Lost sales due to poor
product quality
Quality
Cost
Report
Total Quality Management
Cost of Quality
Prevention
300,000
Appraisal
Internal failure
External failure
Prevention 270,000
Appraisal
40,000
250,000
Internal failure10,000
2
External failure
47,000
Quality Cost Report
200,000
150,000
100,000
50,000
Prevention
Appraisal
Internal failure
External failure
Quality Cost Reports
Unterman Shirt Company
Quality Cost Report
2010
2009
Amount Percentage
Amount Percentage
Prevention Costs
$ 106,000
13.87% $ 106,000
13.45%
Appraisal Costs
150,000
19.63%
60,000
7.61%
Internal Failure Costs
298,000
39.01%
182,000
23.10%
External Failure Costs
210,000
27.49%
440,000
55.84%
Total Quality Costs
$ 764,000
100.00% $ 788,000
100.00%
How do the costs differ from 2009 to 2010?
Should Unterman spend more on prevention
and appraisal in an effort to reduce failure costs?
Minimizing Total Quality Costs
Cost of
prevention
and appraisal
Cost of
internal and
external failure
Objective: Minimize defects while also
minimizing all four quality cost categories.
Minimizing Total Quality Costs
Cost per Unit ($)
Total Quality cost
Failure cost
(Internal and
external
failure costs)
Voluntary costs
(Prevention and
0
100
appraisal costs)
Percent of Products without Defects
Quality
The costs that follow appeared on Akrons quality cost report:
Warranty costs
$12,000
Raw-material inspection
7,000
Quality training
28,000
Customer complaints
2,500
Production stoppages from machine breakdowns
9,800
The sum of prevention and external failure costs is:
Quality & Six Sigma
It is an analytical method aimed at achieving
near-perfect results on a production line.
It has broadened into a general process to
define and measure a process, analyze it,
and improve it to minimize errors.