Copyright © 2007 Prentice-Hall. All rights reserved 1 Activity-Based Costing and Other Cost Management Tools Chapter 5

Copyright © 2007 Prentice-Hall. All rights reserved 2 Objective 1 Develop departmental overhead rates and activity-based costs (ABC)

Copyright © 2007 Prentice-Hall. All rights reserved 3 Activity-Based Costing A way to allocate indirect cost to production Focus – on activities and cost of activities Each activity has its own cost driver Uses a separate allocation rate for each activity

Copyright © 2007 Prentice-Hall. All rights reserved 4 Activity-Based Costing Steps: Identify the activities Estimate the total indirect costs of each activity Identify the allocation base for each activity’s indirect costs (the primary cost driver) Estimate the total quantity of each allocation base

Copyright © 2007 Prentice-Hall. All rights reserved 5 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) 6.Obtain actual quantity of each allocation base used by the cost object 7.Allocate indirect costs to cost object

Copyright © 2007 Prentice-Hall. All rights reserved 6 Cost Drivers - examples 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 © 2007 Prentice-Hall. All rights reserved 7 E5-16 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 © 2007 Prentice-Hall. All rights reserved 8 E5-16 Steps: 3. Identify the allocation base for each activity’s indirect costs (the primary cost driver) ActivityBudgeted costAllocation base Material handling$12,000# of parts Machine setup3,400# of setups Insertion of parts48,000# of parts Finishing80,000# finished direct labor hours Total$143,400

Copyright © 2007 Prentice-Hall. All rights reserved 9 E5-16 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 © 2007 Prentice-Hall. All rights reserved 10 E5-16 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 © 2007 Prentice-Hall. All rights reserved 11 E 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 fender: Parts: 3,000 ÷ 1,000 = 3 Setups: 10 ÷ 1,000 = 0.01 Finishing direct labor hrs: 2,000 ÷ 1,000 = 2

Copyright © 2007 Prentice-Hall. All rights reserved 12 E5-16 Indirect Manufacturing Cost Per Fender Activity Actual Quant of Cost Allocation Base Used per Fender Cost Alloca- tion Rate Cost per Fender Mat. handling 3.00  $ 4.00=$ Machine setups 0.01  $ = 3.40 Insertion of parts 3.00  $ 16.00=48.00 Finishing 2.00  $ 40.00= Total indirect cost $143.40

Copyright © 2007 Prentice-Hall. All rights reserved 13 E5-17 Total Budgeted Indirect Manufacturing Cost Activity Actual Quant of Cost Allocation Base Used per Fender Cost Alloca- tion RateTotal Mat. handling 10,000  $ 3.75=$37,500 Machine setups 30  $300.00=9,000 Insertion of parts 10,000  $ 24.00=240,000 Finishing 3,500  $ 50.00=175,000 Total budgeted indirect cost $461,500

Copyright © 2007 Prentice-Hall. All rights reserved 14 E5-17 Indirect Manufacturing Cost Per Rim - Standard Activity Cost Allocation Rate Quant of Cost Alloc. Base Used Cost per Rim Mat. handling $3.75  4=$ Machine setups $300 .015= 4.50 Insertion of parts $24  4=96.00 Finishing $50 x1= Total indirect cost $165.50

Copyright © 2007 Prentice-Hall. All rights reserved 15 E5-17 Indirect Manufacturing Cost Per Rim - Deluxe Activity Cost Allocation Rate Quant of Cost Alloc. Base Used Cost per Rim Mat. handling $3.75  6=$ Machine setups $300 .015= 4.50 Insertion of parts $24  6= Finishing $50 x2.5= Total indirect cost $296.00

Copyright © 2007 Prentice-Hall. All rights reserved 16 E5-17 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 © 2007 Prentice-Hall. All rights reserved 17 E5-17 Indirect manufacturing cost per wheel: Standard model:2  $92.30 = $ Deluxe model:3  $92.30 = $276.90

Copyright © 2007 Prentice-Hall. All rights reserved 18 E5-17 Enke Indirect Manufacturing Costs Per Unit Model StandardDeluxe ABC costs$165.50$ Single-rate costs$184.60$276.90

Copyright © 2007 Prentice-Hall. All rights reserved 19 Objective 2 Use activity-based management (ABM) to make business decisions

Copyright © 2007 Prentice-Hall. All rights reserved 20 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 © 2007 Prentice-Hall. All rights reserved 21 ABC in Merchandising and Service Companies Allocate period costs among product or service lines

Copyright © 2007 Prentice-Hall. All rights reserved 22 E5-18 Enke Company ABC Data Gross Profits StandardDeluxe Sale price$300.00$ Direct materials Direct labor Indirect overhead Gross profit$59.50$48

Copyright © 2007 Prentice-Hall. All rights reserved 23 E5-18 Enke Company ABC Data Gross Profits StandardDeluxe Sale price$300.00$ Direct materials Direct labor Indirect overhead Gross profit$40.40$67.10

Copyright © 2007 Prentice-Hall. All rights reserved 24 E5-18 Finishing activity cost per rim: 2.0 hrs per rim x $40 per hour = $80 per rim

Copyright © 2007 Prentice-Hall. All rights reserved 25 E5-18 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 © 2007 Prentice-Hall. All rights reserved 26 Objective 3 Decide when ABC is most likely to pass the cost-benefit test

Copyright © 2007 Prentice-Hall. All rights reserved 27 Cost-Benefit Test When the benefits of adopting ABC/ABM exceed the costs

Copyright © 2007 Prentice-Hall. All rights reserved 28 E5-19 Indications that ABC might pass the cost- benefit test Enke produces two different products that use different amounts of the company's resources. Indirect manufacturing costs are a large portion of total costs.

Copyright © 2007 Prentice-Hall. All rights reserved 29 E5-19 Enke hired a new controller who should have the accounting expertise to develop an ABC system. Enke recently purchased bar coding information technology, which reduces the cost to keep track of allocation bases such as the number of parts.

Copyright © 2007 Prentice-Hall. All rights reserved 30 E5-19 Warning signs that Enke's old cost system was "broken”: Managers cannot explain profits—despite switching to what should have been a more profitable product mix, profits were declining. Enke was using a direct-labor-based single allocation rate system developed 20 years ago.

Copyright © 2007 Prentice-Hall. All rights reserved 31 E5-19 Enke reengineered its production process but it had not changed its accounting system (until Babin developed the new ABC system).

Copyright © 2007 Prentice-Hall. All rights reserved 32 Objective 4 Describe a just-in-time (JIT) production system, and record its manufacturing costs

Copyright © 2007 Prentice-Hall. All rights reserved 33 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 © 2007 Prentice-Hall. All rights reserved 34 Just-in-Time Systems cutting shaping smoothing grinding Finished Goods

Copyright © 2007 Prentice-Hall. All rights reserved 35 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 © 2007 Prentice-Hall. All rights reserved 36 Just-in-Time Costing “Backlash costing” – records cost of production when units are completed Inventory accounts – only two –Raw and In-Process Inventory –Finished Goods Inventory Manufacturing costs – only two –Direct materials –Conversion costs

Copyright © 2007 Prentice-Hall. All rights reserved 37 Exercise 5-22 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT (in millions) Raw & In Process Inventory6,500 Accounts Payable6,500 Conversion Costs7,420 Various accounts7,420

Copyright © 2007 Prentice-Hall. All rights reserved 38 Exercise 5-22 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 © 2007 Prentice-Hall. All rights reserved 39 Exercise 5-22 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT Cost of Goods Sold1,020 Conversion Costs1,020 Conversion Costs 7,4206,400 Bal. 1,020

Copyright © 2007 Prentice-Hall. All rights reserved 40 Exercise 5-22 Finished Goods Inventory Beg bal 10010,976 Goods sold Bal. 324 Goods completed 11,200

Copyright © 2007 Prentice-Hall. All rights reserved 41 Objective 5 Contrast the four types of quality costs and use them to make decisions

Copyright © 2007 Prentice-Hall. All rights reserved 42 Total Quality Management Goals To provide customers with superior products and services Continuous improvement –Improve quality –Eliminate defects and waste

Copyright © 2007 Prentice-Hall. All rights reserved 43 Types of Quality Costs Prevention costs – avoid poor quality goods or services –Employee training –Improved materials –Preventive maintenance

Copyright © 2007 Prentice-Hall. All rights reserved 44 Types of Quality Costs Appraisal costs – detect poor quality goods or services –Inspection throughout production –Inspection of final product –Product testing

Copyright © 2007 Prentice-Hall. All rights reserved 45 Types of Quality Costs Internal failure costs – avoid poor quality goods or services before delivery to customers –Production loss caused by downtime –Rejected product units

Copyright © 2007 Prentice-Hall. All rights reserved 46 Types of Quality Costs 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 © 2007 Prentice-Hall. All rights reserved 47 E5-24 Prevention costs: Training employees in TQM Training suppliers in TQM Identifying preferred suppliers who commit to on-time delivery of perfect quality materials

Copyright © 2007 Prentice-Hall. All rights reserved 48 E5-24 Appraisal costs: Strength testing one item from each batch of panels Avoid inspection of raw materials Internal failure costs: Avoid rework and spoilage

Copyright © 2007 Prentice-Hall. All rights reserved 49 E5-24 External failure costs: Avoid lost profits from lost sales due to disappointed customers Avoid warranty costs

Copyright © 2007 Prentice-Hall. All rights reserved 50 E5-24 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 © 2007 Prentice-Hall. All rights reserved 51 E5-24 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 © 2007 Prentice-Hall. All rights reserved 52 End of Chapter 5