Cost Management in an Automated Business Environment (ABC, and TQM) Chapter 6

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-2 The Development of a Single Company-Wide Cost Driver Traditional cost systems were created when manufacturing processes were labour intensive. A single company-wide overhead rate, based on direct labour hours, is used to allocate overhead to products in these labour intensive processes.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-3 The Development of a Single Company-Wide Cost Driver Overhead is allocated to jobs using direct labour hours. If overhead is $120, how much overhead is allocated to each job?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-4 The Development of a Single Company-Wide Cost Driver Overhead Rate = $120 ÷ 8 direct labour hours Overhead Rate = $15 per direct labour hour Job 1 = 2 hours × $15 per hour = $30 Job 2 = 6 hours × $15 per hour = $90

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-5 The Development of a Single Company-Wide Cost Driver Labour 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.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-6 The Effects of Automation on the Selection of a Cost Driver Automation increases overhead from $120 to $420 and reduces the Job 2 labour hours from 6 to 1. Allocate the $420 overhead to the two jobs using direct labour.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-7 The Effects of Automation on the Selection of a Cost Driver Overhead Rate = $420 ÷ 3 direct labour hours Overhead Rate = $140 per direct labour hour Job 1 = 2 hours × $140 per hour = $280 Job 2 = 1 hour × $140 per hour = $140

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-8 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

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-9 Using Activity-Based Cost Drivers Level of Complexity Overhead Allocation Company-wide Overhead Rate Activity Based Costing Many companies are using activity- based cost drivers to improve product costing.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-10 Using Activity-Based Cost Drivers Carver makes vegetable and tomato soup.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-11 Using Activity-Based Cost Drivers Allocating Setup Costs Using a Volume-based Allocation Rate 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

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-12 Using Activity-Based Cost Drivers Allocating Setup Costs Using a Volume-based Allocation Rate The volume-based allocation rate over costs the high-volume product and under costs the low-volume product.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-13 Using Activity-Based Cost Drivers Allocating Setup Costs Using an Activity-based Allocation Rate Overhead per batch = $264 Vegetable = 180 batches × $264 per batch Vegetable = $47,250 Tomato = 180 batches × $264 per batch = $47,250

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-14 Activity-based Cost Drivers Enhance Relevance Activity-based cost drivers allocate relevant costs ($264 batch set-up) to appropriate products. $47,250 is the cost avoided if Carver ceases production of either product, or if the set-up function is outsourced.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-15 Activity-Based Costing A B C Activity-based costing (ABC) is a two-stage allocation process that employs a variety of cost drivers.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-16 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.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-17 Traditional Two-Stage Cost Allocation Department 1 Product 1 Department 2 Product 2 Overhead Costs

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-18 Activity-Based Cost Allocation Overhead Costs Activity Center 1 Product 1Product 2 Activity Center 3 Activity Center 2

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-19 Types of Production Activities Overhead costs associated with each category are pooled together and allocated to products according to how those products benefit from the activities. Unit-Level Activity Batch-Level Activity Product-Level Activity Facility-Level Activity

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-20 Let’s look at an example from the Unterman Shirt Company. Types of Production Activities

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-21 Types of Production Activities Unterman Shirt Company Overhead Rate = $5,730,000 ÷ 800,000 shirts = $7.16 per shirt (Rounded)

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-22 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. Benefit the entire process, not a line of specific shirts.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-23 Unit-level Activity Center Unterman identifies the following unit-level overhead costs ($1,296,000 of the total $5,730,000):

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-24 Unit-level Activity Center Unterman uses direct labour hours to allocate the unit-level overhead costs.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-25 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.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-26 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 70% product-level costs to casual shirts and 30% to dress shirts.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-27 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.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-28 Using the Information

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-29 Using the Information Traditional costing resulted in undercosting the casual shirt line and overcosting the dress shirt line.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-30 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?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-31 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.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-32 Using the Information Unterman must determine if costs are avoidable before dropping the casual shirt line. Facility-level overhead costs are usually unavoidable.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-33 We should consider other costs such as sales commissions and research and development costs before making any of these decisions. Using the Information

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-34 Total Quality Management Let’s change gears and look at another topic.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-35 Total Quality Management Quality DesignConformance Quality refers to the degree to which actual products and services conform to their design specification.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-36 Costs companies incur to assure quality conformance may be classified as:  Prevention costs.  Appraisal costs.  Internal failure costs.  External failure costs. Total Quality Management

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-37  Prevention costs-incurred to avoid non conforming products  Inspection of materials upon delivery  Inspection of production process  Equipment inspection  Employee training Total Quality Management

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-38  Appraisal costs-incurred to identify nonconforming products that were not avoided via the prevention cost expenditures.  Finished goods inspection  Field testing of products Total Quality Management

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-39  Internal failure costs – defects discovered before delivery to customers.  Scrap materials  Rework  Reinspection of rework  Lost sales resulting from late deliveries Cost Report Total Quality Management

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-40  External failure costs – defects discovered after delivery to customers.  Warranty repairs  Product liability  Marketing costs to improve product image  Lost sales due to poor product quality Total Quality Management

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-41 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.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-42 Minimizing Total Quality Costs Total Quality cost Percent of Products without Defects Cost per Unit ($) Internal and external failure costs Prevention and appraisal costs 0100

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-43 Quality Cost Reports Should Unterman spend more on prevention and appraisal in an effort to reduce failure costs?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 6-44 End of Chapter 6 I’m managing quality time!