25 - 1©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Activity-Based Costing and Other Cost Management Tools Chapter 25

25 - 2©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber David, Matt, and Marc: Total expenses = $900 Cost allocated = $300 per person Rent and Utilities$570 Cable TV 50 High speed Internet access 40 Groceries 240 Total$900 Refining Cost Systems

25 - 3©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Refining Cost Systems More Refined Allocation David Matt Marc Total Rent and Utilities$190$190$190$570 Cable TV 25 – Internet access – 40 – 40 Groceries – Total costs allocated$215$310$375$900 Original cost allocation Difference$(85)$ 10$ 75$ 0

25 - 4©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Sharpening the Focus: From Business Functions to Activities PANEL A—Companywide Business Functions in the Value Chain R&D Design Production Marketing Distribution Customer Service PANEL B—Production Departments/Product Lines Servers Notebook Computers Desktop Computers Inventoriable costs for financial reporting

25 - 5©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Sharpening the Focus: From Business Functions to Activities PANEL C—Activities for Desktop Product Line 1.Kitting—preparing all items for assembly 2.Motherboard preparation—snapping in CPU and memory modules 3.Assembly into chassis 4.Software downloading 5.Testing 6.Boxing Inventoriable costs for financial reporting

25 - 6©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Describe and develop activity-based costs (ABC). Objective 1

25 - 7©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Example of Activities and Cost Drivers: Activities: Material purchasing Material handling Production scheduling Quality inspections Photocopying Warranty service Cost Drivers: No. of purchase orders No. of parts No. of batches No. of inspections No. of pages copied No. of service calls Activity-Based Costing

25 - 8©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Traditional versus Activity-Based Costing Systems n Chemtech produces large quantities of “commodity” chemicals. n It also manufactures small quantities of specialty chemicals. n In the past, Chemtech’s manufacturing department has used direct labor hours as its single allocation base at a 200% rate.

25 - 9©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Traditional versus Activity-Based Costing Systems n Among its many products, the department produces Aldehyde (a commodity chemical used by producing plastics) and... n Phenylephrine Hydrochloride (PH), which is a specialty chemical. n A single customer uses PH in manufacturing blood-pressure medications.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Traditional versus Activity-Based Costing Systems Chemical Manufacturing Department Overhead Direct Labor Cost Chemical A Chemical B Chemical C Departmental Indirect Cost Pool Cost Allocation Base Product Cost Objects

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Traditional versus Activity-Based Costing Systems Chemical Manufacturing Department Overhead No. of Machine Hours Chemical A Chemical B Chemical C Departmental Indirect Cost Pool Cost Allocation Base Product Cost Objects No. of Samples Taken No. of Batches ProcessingMixingTesting Activity Indirect Cost Pool

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Chemtech Traditional Cost System Aldehyde PH Sale price per pound$10$70 Less: manufacturing cost per pound Direct materials 5 20 Direct labor 1 10 Manufacturing overhead 2 20 Gross profit per pound$ 2$20 Traditional versus Activity-Based Costing Systems

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Traditional versus Activity-Based Costing Systems n Assume that the company produced 7,000 pounds of Aldehyde and 5 pounds of PH. n What is the total labor cost per product? n 7,000 pounds × $1 = $7,000 (Aldehyde) n 5 pounds × $10 = $50 (PH) n What is the total manufacturing overhead allocated to each product?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Chemtech assigns 140 times as much overhead to Aldehyde as to PH. Chemtech assigns 140 times as much overhead to Aldehyde as to PH. Traditional versus Activity-Based Costing Systems n $7,000 × 200% = $14,000 to Aldehyde n $50 × 200% = $100 to PH

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Activity-Based Costing System Identify activities. Mixing Processing Testing Estimate the total indirect costs of each activity. Labor$150,000 Depreciation 200,000 Other 250,000 Total$600,000 Step 1Step 2

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Activity-Based Costing System Identify the primary cost driver for each activity’s indirect costs. (1)(2) (3) ActivityEstimated CostsCost Driver Mixing$600,000# of batches Processing$300,000# of hours (MH) Testing$600,000# samples Step 3

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Activity-Based Costing System Estimate the total quantity of each allocation base. (1) (4) ActivityEstimated Quantity of Cost Driver Mixing4,000 batches Processing5,000 machine hours (MH) Testing3,000 samples Step 4

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Activity-Based Costing System Compute the allocation rate for each activity. (1) (5) Activity Cost Allocation Rate Mixing$600,000 ÷ 4,000 = $150/batch Processing$300,000 ÷ 5,000 = $60/MH Testing$600,000 ÷ 3,000 = $200/sample Step 5

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Activity-Based Costing System Obtain the actual quantity of each allocation base used by each product. During the year, Chemtech produced 60 batches of Aldehyde and 1 batch of PH. The remaining batches consist of Chemtech’s other chemicals. Step 6

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Activity-Based Costing System Allocate the costs to each product. Mixing Cost Allocation: Aldehyde: 60 batches × $150 per batch = $9,000 PH: 1 batch × $150 per batch = $150 Step 7

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Activity-Based Costing System The ABC system allocates 29 times as much overhead to Aldehyde as to PH. Activity Cost Driver Units Cost Allocated to: Used By: Aldehyde PH Aldehyde PH Mixing60 batches1 batch$ 9,000$150 Processing30½ MH2 MH 1,830* 120 Testing14 samples1 sample 2, Total$13,630$470 *30½ MH × $60 per MH = $1,830

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Cost/pound Traditional ABC (Overhead)SystemSystem Aldehyde$ 2.00$ 1.95 PH$20.00$94.00 Activity-Based Costing System n What is the overhead cost per pound? n Aldehyde: $13,630 ÷ 7,000 = $1.95 n PH: $470 ÷ 5 = $94

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Aldehyde PH Sale price per pound$10.00$ Less:manufacturing cost per pound Direct materials Direct labor Manufacturing overhead Gross profit per pound$ 2.05$(54.00) Activity-Based Costing System Chemtech Gross Profit per Pound

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Use ABC data and activity-based management (ABM) to make business decisions. Objective 2

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Pricing and Product Mix Decisions Aldehyde PH Sale price per pound$10.00$70.00 Less:manufacturing cost per pound Gross profit per pound$ 2.00$20.00 Original Cost System

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Pricing and Product Mix Decisions Aldehyde PH Sale price per pound$10.00$70.00 Less:manufacturing cost per pound Gross profit per pound$ 2.05$(54.00) Activity-Based Cost System

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Pricing and Product Mix Decisions n Chemtech has three alternatives: 1 Cut the cost of PH. 2 Increase the sale price of PH. 3 Drop the PH product.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Use ABM and value engineering to achieve target costs for target pricing. Objective 3

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Cost Reduction Decisions n Value engineering means systematically evaluating activities in an effort to reduce costs while satisfying customer needs.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Target Pricing Target sale price (based on market research) – Desired profit = Target cost Traditional Cost-Based Pricing Full product cost (from entire value chain) – Desired profit = Sale price Target Pricing versus Traditional Cost-Based Pricing

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Target Pricing versus Traditional Cost-Based Pricing n Assume that the market price of aldehyde is likely to fall to $9.50 per pound. n The desired target profit is 20% of the sale price. n What is the target cost? n $9.50 – $1.90 = $7.60

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Target Pricing versus Traditional Cost-Based Pricing Current Costs Manufacturing $7.95 per pound Nonmanufacturing costs = $0.50 per pound $7.60 – $8.45 = $(0.85) Current costs must be reduced by $0.85 per pound.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Decide when ABC is most likely to pass the cost-benefit test. Objective 4

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber The Cost-Benefit Test n ABC’s benefits are higher when... – the company produces many different products that use different amounts of resources. – the company has high overhead costs. – the company produces high volumes of some products, and low volumes of other products.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber The Cost-Benefit Test n The costs of adopting ABC are lower when the company has... – accounting and information system expertise to develop the system. – information technology (bar coding, optical scanning) to record cost driver data.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Managers don’t understand costs and profits. The cost system is outdated. Signs That the Cost System May Be Broken

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Compare a traditional production system to a just-in-time (JIT) production system. Objective 5

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Traditional versus Just-in-Time Production Systems Why do traditional businesses keep large inventories? To protect against poor quality Long setup times Uncertainty

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Traditional versus Just-in-Time Production Systems Building A Cutting Department work in process Shaping Department work in process Grinding Department work in process Smoothing Department finished product

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Traditional versus Just-in-Time Production Systems Building A cutting machine shaping machine smoothing machine finished product grinding machine

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Traditional versus Just-in-Time Production Systems Traditional Production Systems: Machines are arranged by functions. Production workers operate a single machine. Large batches are produced. There are many suppliers. Just-in-Time Production Systems: Machines are arranged in operational sequence. Machine setup times are short. Workers are cross-trained and perform many tasks. Small batches are produced. There are fewer suppliers who are well coordinated.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Just-in-Time Production Systems n Companies that follow JIT have several common characteristics: – sequential arrangement of production activities – reduction of setup times – cross-training of employees – scheduling production as needed by use of a “demand pull” system

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Record manufacturing costs for a just-in-time costing system. Objective 6

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Just-in-Time Costing... – is sometimes called “backflush costing.” n It is a standard costing system that begins with output completed and then assigns manufacturing cost to units sold and to inventories. JIT Cost

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Just-in-Time Costing Example n Big Bear Company converts silicon water into integrated circuits used for various purposes. n Big Bear uses only two inventory accounts: 1 Raw and In Process (RIP) Inventory (which is a combination of direct materials and work in process) 2 Finished Goods Inventory

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Just-in-Time Costing Example n Big Bear had the following inventory values on June 30: – Raw and in process:$100,000 – Finished goods: $800,000 n During July, the following took place: n Direct materials of $3,030,000 were purchased. n $18,200,000 of actual conversion costs were incurred.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Just-in-Time Costing Example n The company produced 3,000,000 units. n The standard cost per unit was $7.00 ($1.00 for direct materials and $6.00 for conversion costs). n The company sold 2,950,000 units. n What are the journal entries?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Just-in-Time Costing Example Raw and In Process Inventory 3,030,000 Accounts Payable 3,030,000 To record purchases of raw materials Conversion Costs18,200,000 Various Accounts18,200,000 To record various conversion costs

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Finished Goods Inventory21,000,000 RIP Inventory 3,000,000 Conversion Costs18,000,000 Completed units Cost of Goods Sold20,650,000 Finished Goods Inventory20,650,000 To record 2,950,000 units sold Just-in-Time Costing Example

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Just-in-Time Costing Example RIP InventoryConversion Costs Finished Goods Inventory Cost of Goods Sold Bal. 100,000 3,030,000 3,000,000 Bal. 130,000 18,200,00018,000,000 Bal. 800,000 21,000,000 20,650,000 Bal. 1,150,000 20,650,000

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Contrast the four types of quality costs and use these costs to make decisions. Objective 7

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Total Quality Management n The goal of total quality management (TQM) is to provide customers with superior products and services. n Total quality management (TQM) describes the entire effort of improving quality throughout the organization’s value chain.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Types of Quality Costs Prevention costs are incurred to avoid inferior quality goods or services. Training personnel Evaluating potential suppliers Improved materials Preventive maintenance Improved equipment and processes

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Types of Quality Costs Appraisal costs are incurred to detect inferior quality goods or services. Inspection of incoming materials Inspection at various stages of production Inspection of final products or services Product testing

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Types of Quality Costs Internal failure costs are incurred when the company detects and corrects inferior quality goods or services before delivery to customers. Production loss caused by downtime Rework Scrap Rejected product units Disposal of rejected units

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Types of Quality Costs External failure costs are incurred when inferior quality goods or services are not detected until after delivery to customers. Profit losses from lost customers Warranty costs Service costs at customer sites Sales returns due to quality problems Product liability claims

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber End of Chapter 25