CHAPTER 6 Cost Management in an Automated Business Environment ABC, ABM, and TQM

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-2 Increasingly competitive global business environment Eliminating nonvalue added activities More emphasis on quality More emphasis on cost measurement and control Using technology and productivity Chapter Opening

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-3 Learning Objective LO1 To explain how activity-based costing improves accuracy in determining the cost of products and services.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-4 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. The Development of a Single Companywide Cost Driver

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-5 Overhead is allocated to jobs using direct labor hours. If overhead is $120, how much overhead is allocated to each job? The Development of a Single Companywide Cost Driver

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-6 Overhead Rate = $120 ÷ 8 direct labor hours Overhead Rate = $15 per direct labor hour Job 1 = 2 hours × $15 per hour = $30 Job 2 = 6 hours × $15 per hour = $90 The Development of a Single Companywide Cost Driver

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-7 Labor Intensive Process Overhead costs are relatively small. Overhead allocations may be inaccurate, but the amounts are relatively insignificant. Automated Process Overhead costs are relatively large. Inaccurate overhead allocation can lead to questionable product cost information. The Development of a Single Companywide Cost Driver

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-8 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. The Effects of Automation on the Selection of a Cost Driver

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-9 Overhead Rate = $420 ÷ 3 direct labor hours Overhead Rate = $140 per direct labor hour Job 1 = 2 hours × $140 per hour = $280 Job 2 = 1 hour × $140 per hour = $140 The Effects of Automation on the Selection of a Cost Driver

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-10 Is this reasonable? Automation benefited Job 2, but Job 1 is allocated more overhead. Clearly, we need another cost driver to allocate overhead. The Effects of Automation on the Selection of a Cost Driver

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-11 Level of Complexity Overhead Allocation Companywide Overhead Rate Activity Based Costing Many companies are using activity- based cost drivers to improve product costing. Activity-Based Cost Drivers

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-12 Activity-Based Cost Drivers Carver makes vegetable and tomato soup.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-13 Activity-Based Cost Drivers Allocating setup costs using a volume-based allocation rate (number of cans) Overhead per can = $95,040 ÷ 1,188,000 cans Overhead per can = $0.08 per can Vegetable = 954,000 cans × $0.08 per can = $76,320 Tomato = 234,000 cans × $0.08 per can = $18,720

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-14 Activity-Based Cost Drivers Allocating setup costs using a volume-based allocation rate (number of cans) The volume-based allocation rate overcosts the high-volume product $76,320) and undercosts the low-volume product $18,720).

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-15 Activity-Based Cost Drivers Allocating setup costs using an activity-based allocation rate (number of setups). Overhead per setup = $264 Vegetable = 180 setups × $264 per setup = $47,520 Tomato = 180 setups × $264 per setup = $47,520

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-16 Activity-based Cost Drivers Enhance Relevance Activity-based cost drivers allocate relevant costs ($264 per batch setup) to appropriate products. $47,520 is the cost avoided if Carver ceases production of either product, or if the setup function is outsourced.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-17 Learning Objective LO2 To identify cost centers and cost drivers in an activity-based cost system.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-18 Activity-Based Costing A B C Activity-based costing (ABC) is a two-stage allocation process that employs a variety of cost drivers.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-19 Activity-Based Costing 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.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-20 Traditional Two-Stage Cost Allocation Product 1Product 2 Department 1Department 2 Overhead Costs

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-21 Activity-Based Cost Allocation Overhead Costs Activity Center 1 Product 1Product 2 Activity Center 3 Activity Center 2

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-22 Types of Production Activities Batch-Level Activity Product-Level Activity Unit-Level Activity Facility-Level Activity Overhead costs associated with each category are pooled together and allocated to products according to how those products benefit from the activities.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-23 Let’s look at an example from the Unterman Shirt Company. Types of Production Activities

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-24 Types of Production Activities Unterman Shirt Company Overhead Rate = $5,730,000 ÷ 800,000 shirts = $7.16 per shirt (Rounded)

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-25 Types of Production Activities Unterman decides to implement ABC and categorizes activities into four activity cost centers. Unit-level Activities Batch-level Activities Product-level Activities Facility-level Activities Incurred each time a shirt is made. Incurred each time a batch of shirts (casual or dress) is made. Supports either dress or casual shirts. Benefits the entire process, not a line of specific shirts.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-26 Unit-level Activity Center Unterman identifies the following unit-level overhead costs ($1,296,000 of the total $5,730,000):

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-27 Unterman uses direct labor hours to allocate the unit-level overhead costs. Unit-level Activity Center

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-28 Batch-level Activity Center 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.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-29 Product-level Activity Center Unterman identifies $1,800,000 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.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-30 Facility-level Activity Center 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.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-31 Learning Objective LO3 To use activity- based costing to calculate costs of products and services.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-32 Using the Information

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-33 Using the Information Traditional costing resulted in undercosting the casual shirt line and overcosting the dress shirt line.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-34 Using the Information Should Unterman increase the price of casual shirts? Should Unterman reduce the price of dress shirts? Should Unterman drop the casual shirt line?

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-35 Using the Information 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.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-36 Using the Information Unterman must determine if costs are avoidable before dropping the casual shirt line. Facility-level overhead costs are usually unavoidable.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-37 We should consider other costs such as sales commissions and research and development costs before making any of these decisions. Downstream Costs and Upstream Costs

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-38 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 employ cooperation for successful implementation under these conditions. 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 employ cooperation for successful implementation under these conditions. Employee Attitudes and the Availability of Data

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-39 Learning Objective LO4 To identify the components of quality costs.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-40 Total Quality Management Quality DesignConformance Quality refers to the degree to which actual products and services conform to their design specifications.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-41 Costs that companies incur to assure quality conformance may be classified as:  Prevention costs  Appraisal costs  Internal failure costs  External failure costs Total Quality Management

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-42 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.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-43 Minimizing Total Quality Costs Total Quality cost Percent of Products without Defects Cost per Unit ($) Voluntary costs (Prevention and Appraisal) Failure cost 0100

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-44 Learning Objective LO5 To prepare and interpret quality cost reports.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-45 Quality Cost Reports Should Unterman spend more on prevention and appraisal in an effort to reduce failure costs? How do the costs differ from 2007 to 2008?

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 6-46 End of Chapter 6