C H A P T E R 7 Management Accounting Information In The New Business Environment Management Accounting Information In The New Business Environment

Explain the fundamentals of activity-based costing (ABC) and activity-based management (ABM). Learning Objective 1

Activity-Based Costing (ABC) A method of attributing costs to products based on: Costs Activities Products 4 assigning costs of resources to activities 4 assigning costs of activities to products

Unit-Based Costing (UBC) The traditional method of allocating costs (manufacturing overhead) to products based on number of units produced. If only three products are produced (one of each), then: Costs Production Departments Products $9,000 Overhead $3,000 Overhead per product =

Relationship Between UBC and ABC Unit-Based Costing (UBC) Model of Costs Activity-Based Costing (ABC) Hierarchical Product Cost Model Costs of Direct Materials Costs of Direct Labor Variable Manufacturing Overhead Costs Costs of Unit-Level Activities Fixed Manufacturing Overhead Costs Costs of Batch-Level Activities Costs of Product Line Activities Costs of Facility Support Activities

What is the hierarchical product cost model? Facility Support Activities Product Line ActivitiesBatch-Level ActivitiesUnit-Level Activities Product Costs Common Costs ABC—Allocating Resource Costs to Activities

Facility Support Activities Product Line Activities Unit-Level Activities 4Take place each time a unit is produced 4Packing 4Assembly 4Depreciation 4Maintenance Batch-Level Activities

Unit-Level Activities ABC—Allocating Resource Costs to Activities Facility Support Activities Batch-Level Activities 4Number of setups 4Setup hours 4Movements of materials 4Orders for nonstocked items 4Inspections Product Line Activities

Batch-Level Activities Unit-Level Activities ABC—Allocating Resource Costs to Activities Product Line Activities 4Engineering and design changes 4Warehousing of product line materials 4Production line dedicated supervisors 4Purchasing 4Receiving and shipping Facility Support Activities

4Property taxes 4Plant security 4Landscaping 4Accounting and legal 4General administrative salaries Product Line Activities Batch-Level Activities Unit-Level Activities ABC—Allocating Resource Costs to Activities

Does a hammer really cost THAT MUCH? If a UBC factory produces only three products (a hammer, a clock, and a Ferrari) and a hammer incurs $4 of direct labor and materials, how much will the hammer cost if manufacturing overhead is allocated evenly over finished products? Cross-Subsidization $9,000 Overhead ? Overhead per product =

Does a hammer really cost THAT MUCH? Cross-Subsidization $9,000 Overhead $3,000 Overhead per product 3 Products $3,004 !? 1 Hammer = =

Does a hammer really cost THAT MUCH? Cross-Subsidization $9,000 Overhead ? Overhead per product Under UBC (unit-based costing), some products may be inappropriately assigned costs that actually belong to another product line (in this case, the hammer and clock are obviously cross-subsidizing the Ferrari product line). =

When one product is cross-subsidizing another, it appears unprofitable to produce and is often mistakenly discontinued. When facility support (common) activity costs are allocated to individual product lines, they may appear unprofitable and are often mistakenly discontinued. Product Cost Distortions What are the Hazards of Allocating Costs?

$8 $20 $100, , ,000 $4 $ 5 $ 5,000 Revenue Materials Labor Profit Hazards of Allocating Costs Product profitability before overhead allocation: Hammer Clock Ferrari

Hazards of Allocating Costs Product profitability after overhead allocation: Revenue Materials Labor Overhead Profit $ 8 $ 20 $100, , ,000 3,000 3,000 3,000 $(2,996)$(2,995)$ 2,000 Hammer Clock Ferrari In actuality, most of the $9,000 manufacturing overhead is attributable to the Ferrari, revealing it to be the real money loser.

In actuality, most of the $9,000 manufacturing overhead is attributable to the Ferrari, revealing it to be the real money loser, BUT because the other products are cross- subsidizing, they appear unprofitable and will be discontinued from production. $ 8 $ 20 $100, , ,000 3,000 3,000 3,000 $(2,996)$(2,995)$ 2,000 Revenue Materials Labor Overhead Profit Hazards of Allocating Costs Hammer Clock Ferrari

$100,000 70,000 25,000 8,990 $ (3,990) Revenue Materials Labor Overhead Profit Hazards of Allocating Costs The result?

Costs Activities Products Activity-Based Management (ABM) Managing costs, quality, and timeliness of activities through the identification and use of Cost Drivers and Performance Measures. Cost Drivers Performance Measures

Describe total quality management (TQM) and costs of quality (COQ). Learning Objective 2

A management philosophy focused on increasing profitability by improving the quality of products and processes and increasing customer satisfaction, while promoting the well-being and growth of employees. What is Total Quality Management (TQM)? TQM

The Old Way The Secret to Success? Andrew Carnegie The New Way W. Edward Deming Total Quality Management (TQM) “Watch the Quality and the profits will take care of themselves.” “Watch the costs and the profits will take care of themselves.”

Define SPC—Statistical Process Control Total Quality Management (TQM) A statistical technique for identifying and measuring the quality status of a process by evaluating its output to determine if serious problems exist in the process.

Prevention Costs Appraisal Costs Internal Failure Costs External Failure Costs $ What are the Four Costs of Quality (COQ)?

Prevention Costs: Ensures that processes are performed correctly the first time and that products and services meet customers’ expectations. Appraisal Costs: Inspecting, testing, and sampling activities performed in order to identify and remove low-quality products and services from the system. Internal Failure Costs: Expenses that occur when low-quality products and services fail before production and delivery to customers. External Failure Costs: Expenses that occur when low-quality products and services fail after production and delivery to customers. Define Each Cost of Quality (COQ)

Internal Failure & External Failure Prevention & Appraisal = What is the Effect of Increasing Prevention and Appraisal Costs of Quality (COQ)?

Total Costs of Quality Internal/External Failure Costs Appraisal & Prevention Costs % production within control limits Costs of Quality (COQ) 86% 88% 90% 92% 94% 96% 98% Cost in Millions

Learning Objective 3 Describe how just-in-time (JIT) management systems integrate with and extend ABC and TQM using time-based performance measures.

What is Just-In-Time (JIT)? A management philosophy that emphasizes removing all waste of effort, time, and inventory costs from the organization. Reduces or removes needless inventory in a production system.

Just-In-Time (JIT) 4Define Value-Added Activities Necessary activities in a production or service process that customers identify as valuable and for which they are willing to pay. 8Define Non-Value-Added Activities Unnecessary activities in a production or service process that customers typically do not see or care about and for which they are unwilling to pay.

The Point Is...