Copyright © 2008 Prentice Hall All rights reserved 5-1 Activity-Based Costing and Other Cost Management Tools Chapter 5

Copyright © 2008 Prentice Hall All rights reserved 5-2 Objective 1 Develop and use departmental overhead rates in place of a traditional plant-wide rate

Copyright © 2008 Prentice Hall All rights reserved 5-3 Traditional Plant-Wide Overhead Rate Example: Assume that Dell allocates manufacturing overhead based on direct labor (DL) hours If Dell planned to incur $10 million of overhead costs and 500,000 direct labor hours a year, its manufacturing overhead rate would be: $10 million/500,000 DL hours = $20/DL hour

Copyright © 2008 Prentice Hall All rights reserved 5-4 Departmental Overhead Rates DepartmentTotal Departmental Manufacturing Overhead Costs Total Departmental Labor Hours Departmental Overhead Rate Servers$2 million50,000 hrs$40/DL hour Desktops$5 million250,000 hrs$20/DL hour Laptops$3 million200,000 hrs$15/DL hour TOTAL$10 million500,000 hrs

Copyright © 2008 Prentice Hall All rights reserved 5-5 Sharpening the Focus from Business Functions to Departments to Activities Company-wide business functions in the value chain Departments in the production function Activities in the desktop production department R&D Design Production Marketing Distribution Customer service Servers Desktops Laptops Kitting Motherboard preparation Assembly Software downloading Testing Boxing Focus on Broad Business functions such as production Sharpen focus to: Departments with a function Further sharpen focus to: Activities within a department Single Indirect Cost rate for entire production function: “Plant-wide overhead rate” Different indirect cost rates for each department “Departmental Overhead Rates” Different indirect cost rates for each activity “Activity cost allocation rates”

Copyright © 2008 Prentice Hall All rights reserved 5-6 Objective 2 Develop activity-based costs (ABC) and use activity-based management (ABM) to make business decisions

Copyright © 2008 Prentice Hall All rights reserved 5-7 Activity-Based Costing A way to allocate indirect cost to production Focuses on activities and cost of activities Each activity has its own cost driver Uses a separate allocation rate for each activity

Copyright © 2008 Prentice Hall All rights reserved 5-8 Activity-Based Costing Steps: 1.Identify the activities 2.Estimate the total indirect costs of each activity 3.Identify the allocation base for each activity’s indirect costs (the primary cost driver) 4.Estimate the total quantity of each allocation base

Copyright © 2008 Prentice Hall All rights reserved 5-9 Activity-Based Costing Steps: 5.Compute cost allocation rate for each activity Estimated total indirect costs of activity Estimated total quantity of cost allocation base 5.Obtain actual quantity of each allocation base used by the cost object 6.Allocate indirect costs to cost object

Copyright © 2008 Prentice Hall All rights reserved 5-10 Examples of Cost Drivers Activities:Cost Drivers: Material purchasing# of purchase orders Material handling# of parts Production scheduling# of batches Quality inspections# of inspections Photocopying# of pages copied Warranty service# of service calls

Copyright © 2008 Prentice Hall All rights reserved 5-11 E5-22: Example for Using Seven Steps of Activity Based Costing Steps: 1. Identify each activity  Material handling  Machine setup  Insertion of parts  Finishing 2. Estimate the total indirect costs of each activity $12,000 3,400 48,000 80,000

Copyright © 2008 Prentice Hall All rights reserved 5-12 E5-22: Continued Steps: 3. Identify the allocation base for each activity’s indirect costs (the primary cost driver) ActivityBudgeted costAllocation base Material handling$12,000 Machine setup3,400 Insertion of parts48,000 Finishing80,000 Total$143,400 For each activity, what is the appropriate allocation base that should be applied to the budgeted cost? Hint: Think of the “cost driver” for each activity described in the previous slide.

Copyright © 2008 Prentice Hall All rights reserved 5-13 E5-22: Continued Steps: 4. Estimate the total quantity of each allocation base Activity Total Est. Cost Est. Quant. of Cost Allocation Base Mat. handling $12,000÷3,000 parts Machine setups $ 3,400÷10 setups Insertion of parts $48,000÷3,000 parts Finishing $80,000÷2,000 hrs

Copyright © 2008 Prentice Hall All rights reserved 5-14 E5-22: Continued Steps: 5. Compute cost allocation rate for each activity Activity Total Est. Cost Est. Quant. of Cost Allocation Base Cost Allocation Rate Mat. handling $12,000÷3,000 parts=$ 4 per part Machine setups $ 3,400÷10 setups=$340 per setup Insertion of parts $48,000÷3,000 parts=$ 16 per part Finishing $80,000÷2,000 hrs=$ 40 per hour

Copyright © 2008 Prentice Hall All rights reserved 5-15 E5-22: Continued 6. Obtain actual quantity of each allocation base used by the cost object–1,000 wheels 7. Allocate indirect costs to cost object Average quantities of cost allocation bases used per wheel: Parts: 3,000 ÷ 1,000 = 3 Setups: 10 ÷ 1,000 = 0.01 Finishing direct labor hrs: 2,000 ÷ 1,000 = 2

Copyright © 2008 Prentice Hall All rights reserved 5-16 E5-22: Summary of Indirect Cost Indirect Manufacturing Cost Per Wheel Activity Actual Quant of Cost Allocation Base Used per Fender Cost Alloc. Rate Cost per Wheel Mat. handling3.00x$ 4.00=$ Machine setups0.01x $340.00= 3.40 Insertion of parts3.00x $ 16.00=48.00 Finishing2.00x$ 40.00= Total indirect cost$143.40

Copyright © 2008 Prentice Hall All rights reserved 5-17 E5-26: Continued Total Budgeted Indirect Manufacturing Cost Activity Actual Quant of Cost Allocation Base Used per Fender Cost Allocation RateTotal Mat. handling10,000x$ 3.75=$37,500 Machine setups30x$300.00=9,000 Insertion of parts 10,000x $ 24.00=240,000 Finishing3,500x$ 50.00=175,000 Total budgeted indirect cost $461,500

Copyright © 2008 Prentice Hall All rights reserved 5-18 E5-26: Continued Indirect Manufacturing Cost Per Rim - Standard Activity Cost Allocation Rate Quant of Cost Alloc. Base Used Cost per Rim Mat. handling$3.75x4=$ Machine setups$300x.015= 4.50 Insertion of parts$24x 4=96.00 Finishing$50x1= Total indirect cost$165.50

Copyright © 2008 Prentice Hall All rights reserved 5-19 E5-26: Continued Indirect Manufacturing Cost Per Rim - Deluxe Activity Cost Allocation Rate Quant of Cost Alloc. Base Used Cost per Rim Mat. handling$3.75x6=$ Machine setups$300x.015= 4.50 Insertion of parts$24x 6= Finishing$50x2.5= Total indirect cost$296.00

Copyright © 2008 Prentice Hall All rights reserved 5-20 E5-26: Continued Budgeted total indirect overhead cost$461,500 Budgeted direct labor hrs5,000 Single allocation rate per$461,500 direct labor hr 5,000 = $92.30

Copyright © 2008 Prentice Hall All rights reserved 5-21 E5-26: Continued Indirect manufacturing cost per wheel: Standard model:2  $92.30 = $ Deluxe model:3  $92.30 = $276.90

Copyright © 2008 Prentice Hall All rights reserved 5-22 E5-26: Continued Enke Indirect Manufacturing Costs Per Unit Model StandardDeluxe ABC costs$165.50$ Single-rate costs$184.60$276.90

Copyright © 2008 Prentice Hall All rights reserved 5-23 Decisions Pricing and product mix Cutting costs  Value engineering – reevaluating activities to reduce costs while satisfying customer needs Routine Planning and Control Decisions  Create budgets  Evaluate workers

Copyright © 2008 Prentice Hall All rights reserved 5-24 ABC in Merchandising and Service Companies Allocate operating (period) costs among product or service lines instead of manufacturing overhead costs

Copyright © 2008 Prentice Hall All rights reserved 5-25 E5-27 Enke Company ABC Data Gross Profits StandardDeluxe Sale price$300.00$ Direct materials Direct labor Indirect overhead Gross profit$59.50$48

Copyright © 2008 Prentice Hall All rights reserved 5-26 E5-27: Continued Enke Company ABC Data Gross Profits StandardDeluxe Sale price$300.00$ Direct materials Direct labor Indirect overhead Gross profit$40.40$67.10

Copyright © 2008 Prentice Hall All rights reserved 5-27 E5-27: Continued Finishing activity cost per rim: 2.0 hrs per rim x ____ per hour = $80 per rim Remember the finishing cost noted under the Indirect Manufacturing Cost per Wheel in E5-26?

Copyright © 2008 Prentice Hall All rights reserved 5-28 E5-27: Continued New cost of deluxe rim: Direct materials$46.00 Direct labor50.00 Indirect costs: Materials handling22.50 Machine setups 4.50 Insertion parts Finishing Total$347.00

Copyright © 2008 Prentice Hall All rights reserved 5-29 Objective 3 Explain when ABC is most likely to pass the cost-benefit test

Copyright © 2008 Prentice Hall All rights reserved 5-30 Cost-Benefit Test System should be refined enough to provide accurate product costs Simple enough for managers to understand ABC and ABM pass the cost-benefit test when the benefits of adopting exceed the costs of implementation

Copyright © 2008 Prentice Hall All rights reserved 5-31 Objective 4 Describe a just-in-time (JIT) production system

Copyright © 2008 Prentice Hall All rights reserved 5-32 Just-in-Time Systems Receive order from customer Schedule production Defect-free materials are delivered by suppliers just in time for production Finished product is delivered to customer

Copyright © 2008 Prentice Hall All rights reserved 5-33 Just-in-Time Systems cutting shaping grinding smoothing Finished Goods

Copyright © 2008 Prentice Hall All rights reserved 5-34 Just-in-Time Production activities in self-contained cells Short setup times Broad employee roles Small batches produced just in time Shortened manufacturing cycle times Emphasis on quality Supply-chain management

Copyright © 2008 Prentice Hall All rights reserved 5-35 Just-in-Time Costing “Backflush costing” – records cost of production when units are completed Impacts two inventory accounts  Raw and In-Process Inventory  Finished Goods Inventory Impacts two manufacturing cost accounts  Direct materials  Conversion costs

Copyright © 2008 Prentice Hall All rights reserved 5-36 Exercise 5-35 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT (in millions) Raw & In Process Inventory6,500 Accounts Payable6,500 Conversion Costs7,420 Various accounts7,420

Copyright © 2008 Prentice Hall All rights reserved 5-37 Exercise 5-35: Continued GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT Finished Goods Inventory11,200 Raw and In Process Inventory (200x$24)4,800 Conversion Costs(200x$32)6,400 Cost of Goods Sold ($196x56)10,976 Finished Goods Inventory10,976

Copyright © 2008 Prentice Hall All rights reserved 5-38 Exercise 5-35: Continued GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT Cost of Goods Sold1,020 Conversion Costs1,020 Conversion Costs 7,4206,400 Bal. 1,020

Copyright © 2008 Prentice Hall All rights reserved 5-39 Exercise 5-35: Continued Finished Goods Inventory Beg bal 10010,976 Goods sold Bal. 324 Goods completed 11,200

Copyright © 2008 Prentice Hall All rights reserved 5-40 Objective 5 Describe the four types of quality costs and use them to make decisions

Copyright © 2008 Prentice Hall All rights reserved 5-41 Total Quality Management Goals: To provide customers with superior products and services Continuous improvement  Improve quality  Eliminate defects and waste

Copyright © 2008 Prentice Hall All rights reserved Types of Quality Costs 1. Prevention costs – avoid poor quality goods or services  Employee training  Improved materials  Preventive maintenance

Copyright © 2008 Prentice Hall All rights reserved Types of Quality Costs 2. Appraisal costs – detect poor quality goods or services  Inspection throughout production  Inspection of final product  Product testing

Copyright © 2008 Prentice Hall All rights reserved Types of Quality Costs 3. Internal failure costs – avoid poor quality goods or services before delivery to customers  Production loss caused by downtime  Rejected product units

Copyright © 2008 Prentice Hall All rights reserved Types of Quality Costs 4. External failure costs – when poor quality products are delivered to customers and company has to make things right with customer  Lost profits from lost customers  Warranty costs  Service costs at customer sites  Sales returns due to quality problems

Copyright © 2008 Prentice Hall All rights reserved 5-46 E5-33 Prevention costs: Training employees in TQM Training suppliers in TQM Identifying preferred suppliers who commit to on-time delivery of perfect quality materials

Copyright © 2008 Prentice Hall All rights reserved 5-47 E5-33: Continued Appraisal costs: Strength testing one item from each batch of panels Avoid inspection of raw materials Internal failure costs: Avoid rework and spoilage

Copyright © 2008 Prentice Hall All rights reserved 5-48 E5-33: Continued External failure costs: Avoid lost profits from lost sales due to disappointed customers Avoid warranty costs

Copyright © 2008 Prentice Hall All rights reserved 5-49 E5-33: Continued Costs of Adopting New Quality Program: Prevention costs: Training employees in TQM$ 30,000 Training suppliers in TQM40,000 Identifying preferred suppliers60,000 Appraisal costs: Strength testing 65,000 Total costs of adopting new program$195,000

Copyright © 2008 Prentice Hall All rights reserved 5-50 E5-33: Continued Costs of Not Adopting New Quality Program: Appraisal costs: Inspection of raw materials$ 45,000 Internal failure costs: Rework and spoilage.55,000 External failure costs: Lost profits from lost sales90,000 Warranty costs 15,000 Total costs of not adopting$205,000

Copyright © 2008 Prentice Hall All rights reserved 5-51 Objective 6 (Appendix) Use JIT costing to record costs in a JIT production environment

Copyright © 2008 Prentice Hall All rights reserved 5-52 Features of JIT Costing Just-in-time (JIT) costing, sometimes called backflush costing, is a costing system that starts with output completed and then assigns manufacturing costs to units sold and to finished goods inventories

Copyright © 2008 Prentice Hall All rights reserved 5-53 Four Major Differences Between JIT Costing and Traditional Job Costing 1. JIT systems wait until the units are completed to record the costs of production 2. JIT systems do not track costs attached to units in the production process; therefore, JIT systems to not need Work in Process Inventory account 3.JIT companies combine all production labor and manufacturing overhead costs into an account called Conversion Costs which are allocated to completed units 4. Standard costs are used to record inventory units

Copyright © 2008 Prentice Hall All rights reserved 5-54 Example of JIT Costing GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT Raw and In Process Inventory3,020,000 Accounts Payable3,020,000 Mintel does not use a separate Work in Process Inventory account. Instead it uses Raw and In Process Inventory and Finished Goods. Mintel has $100,000 of Raw and In Process Inventory and $900,000 of Finished Goods Inventory at July 31, and it uses JIT costing to record August transactions. 1. Mintel purchases $3,020,000 of direct materials on account

Copyright © 2008 Prentice Hall All rights reserved 5-55 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT Conversion Costs18,540,000 Various Accounts (Wages Payable and and Accumulated Depreciation on Property Plant, and Equipment)18,540, Mintel incurs $18,540,000 on labor and overhead costs

Copyright © 2008 Prentice Hall All rights reserved 5-56 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT Finished Goods Inventory21,000,000 Raw and In Process Inventory 3,000,000 Conversion Costs18,000, Mintel completed 3,000,000 circuits. The standard cost of each circuit Is $7 ($1 standard direct materials cost and $6 standard conversion cost). The debit to Finished Goods is $21,000,000 (3,000,000 completed circuits x $7.) There is no Work in Process Inventory in JIT costing, so Mintel credits: Raw and In Process Inventory $3,000,000 (3,000,000 completed circuits x $1 standard direct material cost per circuit) Conversion Costs, $18,000,000 (3,000,000 completed circuits x $6 standard conversion cost per completed circuit) for the labor and other indirect costs allocated to the finished circuits

Copyright © 2008 Prentice Hall All rights reserved 5-57 Mintel’s Major JIT Costing Accounts Raw and In Process Inventory Material Purchases Completed circuits Transferred in from In Process Inventory and Conversion Costs Standard cost of converting materials to finished goods Conversion Costs Finished Goods Converted circuits

Copyright © 2008 Prentice Hall All rights reserved 5-58 End of Chapter 5