1. ACTIVITY-BASED COSTING, LEAN PRODUCTION, AND THE COSTS OF QUALITY CHAPTER 4 Professor Debbie Garvin, JD; CPA – ACG2071

2. Why and How do Companies Refine their Cost Allocation Systems?  Why refine?  Mismatching resources  Cost distortion  Who can refine?  Manufacturing operations  Service companies and governmental agencies 2

3. Plantwide Overhead Rate  Using one predetermined manufacturing overhead cost rate for all operations 3 Plant wide Overhead Rate Actual Use of Allocation Base MOH Allocated to One Unit Elliptical$16 per DL hour × 10 DL hours=$160 Treadmill$16 per DL hour×10 DL hours=$160 Predetermined MOH rate = Total estimated manufacturing overhead costs Total estimated amount of the allocation base

4. Departmental Overhead Rates  Separate predetermined manufacturing overhead rates for each dept. 4 Manufacturing Plant with $1,000,000 of total estimated MOH and 2 departments Department A ($400,000 of MOH) Department B ($600,000 of MOH) $400,000 ÷ departmental allocation base yields MOH rate for this department ONLY $600,000 ÷ departmental allocation base yields MOH rate for this department ONLY Dept A is Machining Dept & Dept B is Assembly Dept. Elliptical takes 1 DL hr in Machining Dept & 9 hrs in Assembly Dept. Treadmill takes 4 DL hrs in Machining Dept & 6 DL hrs in Assembly Dept Since 2 different products take different amounts of time in 2 different depts., and 2 different depts have unequal amounts of MOH, Co. should refine its cost allocation & have separate departmental overhead rates

5. Departmental Overhead Rates Step 1) Co. estimates total MOH that will be incurred in each dept for upcoming year. These estimates are known as departmental overhead cost pools. Step 2) Co. selects allocation base for each dept & estimates ttl amount of allocation base that will be used during upcoming yr. Step 3) Co. calculates its dept O/H rates using info estimated in Steps 1 and 2 Step 4) Co. allocates some MOH from each dept to individual jobs that use those departments. 5

6. Departmental Overhead Rates  When to use  Departments incur different amounts and types of MOH  Different jobs or products use the department resources to a different extent 6

7. Departmental Overhead Rates Department Estimated Total Departmental M/O Overhead Costs Estimated Total Departmental Labor Hours Predetermined Departmental Overhead Rate Dept. A$2 million50,000 hrs$40/DL hour Dept. B$5 million250,000 hrs$20/DL hour Dept. C$3 million200,000 hrs$15/DL hour TOTAL$10 million500,000 hrs 7

8. Life Fitness Elliptical & Treadmill Plantwide Overhead Allocation Rate based on estimated total of 62,500 DLH So Plantwide POHR was estimated MOH $1m ÷ 62,500 est. DLH = $16 of MOH per 1 DLH Upon closer review: 62,500 DLH is: estimated 12,500 DLH in Machining Dept & estimated 50,000 DLH in Assembly Dept So Machining Dept POH Rate = (should be fine tuned to) $400,000 Est O/H ÷ 12,500 DLH = $32/DLH – Mach. Dept Assembly Dept POH Rate = (should be fine tuned) $600,000 Est O/H ÷ 50,000 DLH = $12/DLH – Assembly Dept. Instead of Plantwide POHR of $16/ DLH 8

9. Department Departmental Overhead Rate Actual Use of Departmental Allocation Base MOH Allocated to One Elliptical Machining$32 per DL hour × 1 DL hours=$32 Assembly$12 per DL hour×9 DL hours=108 Department Departmental Overhead Rate Actual Use of Departmental Allocation Base MOH Allocated to One Treadmill Machining$32 per DL hour × 4 DL hours=$128 Assembly$12 per DL hour×6 DL hours=72 Plant-wide Overhead Rate MOH Allocation Departmental Overhead Rates MOH Allocation Amount of Cost Distortion Elliptical$ 160$ 140$20 overcosted Treadmill$ 160$ 200$40 undercosted 9

10. Uncle Bruce’s Snacks makes potato chips, corn chips, & cheese puffs using 3 different production lines w/in same manuf plant. Currently UBS uses a single plantwide O/H rate to allocate its $3.5m annual M/O. Of this amount, $1.8m is associated w/potato chip line, $1m w/corn chip line, & $700,000 associated w/cheese puff line. UBS is currently running total of 17,500 machine hrs: 11,250 in p.c. line, 3,450 in c.c. line, & 2,800 in c.p. line. UBS considers MH to be cost driver of MO costs. 1.What is Uncle Bruce’s plantwide overhead rate? Ttl estimated MOH $3,500,000 est. MOH Ttl estimated cost driver17,500 est. Machine Hrs Plantwide POHR = $200 per machine hour = 10

11. 2.Calculate departmental overhead rates for Uncle Bruce’s three production lines. Round all answers to nearest cent. Department Overhead CostMachine HoursOverhead Rate Potato chips $1,800,000 ÷ 11,250 MH Corn chips $1,000,000 ÷ 3,450 MH Cheese puffs $ 700,000 ÷ 2,800 MH $ 160.00 $ 289.86 $ 250.00 Total $3.5m 17,500 $200/MH 11

12. 3.Which products had been overcosted by the plantwide rate? Which products had been undercosted by the plantwide rate? Plantwide Rate = $200.00 per machine hour More Accurate Departmental Rate: Potato Chips = $160.00/MH Overcosted Corn Chips = 289.86/MH Undercosted Cheese Puffs = 250.00/MH Undercosted 12

13. Activity-Based Costing  Allocates indirect costs to production  Focuses on activities and costs of activities  Separate allocation rate for each activity 13 Manufacturing Activities Machine set-up Materials Handling Fabricating Parts Supervising Assembly Inspecting Products Packaging Products

14.  Step 1: Identify & estimate indirect costs 14 ActivityMOH Costs for the ActivitySeparate Activity Cost Pools Machine Set-upIndirect labor to set-up machines $80,000 Materials HandlingForklifts, gas, operators’ wages 200,000 Fabricating PartsMachine lease payments, electricity, repairs 300,000 Supervising AssemblyProduction engineers’ labor 150,000 InspectingTesting equipment, inspection labor 170,000 PackagingPackaging equipment 100,000 $1,000,000

15. 15 ActivityAllocation baseTotal Cost Pool Predetermined O/H Cost Allocation Rate Machine Set-upNumber of set-ups - 8000$80,000$80,000 / 8000 = $10 Materials Handling Number of parts moved – 400,000 200,000200,000/ 400,000 = 0.50 per part Fabricating PartsMachine hours – 12,500300,000300,000/ 12,500 = $24 Supervising AssemblyDirect labor hours – 50,000150,000150,000 / 50,000 = $3 Inspecting Number of inspections – 34,000 170,000170,000 / 34,000 = $5 Packaging Cubic feet packaged – 400,000 100,000100,000 / 400,000 = 0.25 1,000,000 Step 2: Select an allocation base for each activity’s indirect costs. Step 3: Compute cost allocation rate for each activity

16. Calculate O/H to Allocate to each Job-Elliptical 16 Activity Activity Cost Allocation Rate Actual Use of Activity Allocation Base (collected on job) MOH Allocated to One object Machine Set-up$10 per set-up×2 set ups=$20 Materials Handling$0.50 per part×20 parts=10 Fabricating$24 per machine hour×1 machine hour=24 Supervising Assembly$3 per DL hour×9 DL hours=27 Inspecting$5 per inspection×3 inspections=15 Packaging$0.25 per cubic foot×52 cubic feet=13 Total$109 Info for Product A Elliptical

17. Activity-Based Costing Steps Compute MOH to Allocate to each Treadmill using ABC Activity Activity Cost Allocation Rate Actual Use of Activity Allocation Base (collected on job) MOH Allocated to One object Machine Set-up$10 per set-up×4 set ups=$40 Materials Handling$0.50 per part×26 parts=13 Fabricating$24 per machine hour×4 machine hour=96 Supervising Assembly$3 per DL hour×6 DL hours=18 Inspecting$5 per inspection×6 inspections=30 Packaging$0.25 per cubic foot×60 cubic feet=15 Total$212 17

18. Comparing Three O/H Cost Allocation Systems Plantwide Departmental Activity O/H Rate O/H Rates Based Costing Elliptical $160 $140 $109 Treadmill $160 $200 $212 18

19. Examples of Cost Drivers Activities:Cost Drivers: Material purchasing# of purchase orders Material handling# of parts handled Production scheduling# of batches to be scheduled Inspections of direct materials# of inspections Photocopying# of pages copied Warranty service# of service calls 19

20. Following is budgeted info compiled by Production Facility Mgr: Activity Total Est. MOH Cost Allocation Base Material handling $ 5,600 Number of parts Machine setup 6,400 Number of setups Insertion of parts 39,200 Number of parts Finishing 96,800 Finishing DLH Total $148,000 CP expects to produce 1,000 chrome wheels during yr. Wheels estimated to use 2,800 parts, require 20 setups, & consume 2,200 hrs of finishing time. 20 Central Plain uses ABC to account for its chrome wheel manuf. Process. Mgt has identified 4 manuf activities that incur MOH costs: Material handling, Machine setup, Insertion of parts & Finishing.

21. Activity Total Est. CostEst. Quant. of Cost Allocation Base Mat. handling $5,600 ÷ Machine setups 6,400 ÷ Insertion of parts 39,200 ÷ Finishing 96,800 ÷ 2,800 parts 20 setups 2,200 hrs 2,800 parts Job 420 used 250 parts, req’d 3 setups, consumed 130 finishing hrs Job 510 used 475 parts, req’d 6 setups, consumed 300 finishing hrs Estimate total quantity of each allocation base

22. Compute cost allocation rate for each activity Activity Total Est. Cost Est. Quant. of Cost Allocation Base Allocation Rate Mat. handling $5,600÷2,800 parts Machine setups 6,400÷20 setups Insertion of parts 39,200÷2,800 parts Finishing 96,800÷2,200 hrs $ 2.00/part 320.00/setup 14.00/part 44.00/hr

23.  Allocate indirect costs to cost object (compute the MO cost that should be assigned to Job 420) 23 Job 420 Material handling250 parts$ 2.00 Machine setup3 setups320.00 Insertion of parts250 parts14.00 Finishing130 finishing hours44.00 Total MOH allocated toJob 420 $10, 680 $ 500 3,500 960 5,720 Obtain actual quantity of each allocation base used by cost object (Job 420)

24. Job 510 Material handling475 parts$ 2.00 Machine setup6 setups320.00 Insertion of parts475 parts14.00 Finishing300 finishing hours44.00 Total MOH Allocated to Job 510 Compute MOH cost that should be assigned to Job 510 $ 950 1,920 6,650 13,200 $22,720 24

25. Cost Hierarchy 25

26. Cost Hierarchy Defined  Unit-level activities  Activities & costs incurred for each unit  Batch-level activities  Activities & costs incurred for each batch, regardless of # of units in batch  Product-level activities  Activities & costs incurred for particular product, regardless of number of units or batches of product produced  Facility-level activities  Activities & costs incurred no matter how many units, batches, or products are produced in the plant 26

27. Classifying Costs Within the Cost Hierarchy Co. makes variety of plastic containers using molding process. Classify each activity as: unit-level, batch-level, product-level, or facility-level. 1. Each separate container is cut from the mold once plastic has cooled and hardened. 2. Patents are obtained for each new type of container mold. 3. Plastic resins are used as the main indirect material for the containers. 4. A plant manager oversees the entire manufacturing operation. 5. The sales force incurs travel expenses to attend various trade shows throughout the country to market the containers. 27

28. Classifying Costs (cont) 6. Each container product line has a product line manager. 7. The extrusion (molding) machine is calibrated for each batch of containers made. 8. Each type of container has its own unique molds. 9. Routine maintenance is performed on the extrusion (molding) machines. 10. Rent is paid for the building that houses the manufacturing processes. 28

29. Activity-Based Management (ABM)  Using ABC information to make decisions that hopefully will increase profits while satisfying customers’ needs  Pricing and product mix  Cost cutting  Planning and control 29

30. Pricing and Product Mix Decisions  Change the prices for products after identifying the different total cost  Decide to market the higher profitability product  Shift the product mix away from less profitable products 30

31. Cutting Costs  Analyze costs in value chain  Value-added activities  Non-value added activities (waste activities)  Value-engineering  systematic method to improve the "value" of product by eliminating or reducing all non-value added activities and improving value-added activities.  Value, as defined, is ratio of function to cost. Value can be increased by either improving the function or reducing the cost.cost 31

32. Analyzing Costs in Value Chain We are local Pizza Hut. Are the following activities, which cost Co. money, value-added or non value added?  Placing customers who call to order pizza on hold?  Assembling pizzas to be delivered to customers?  Storing raw materials at closing time to be used in pizza production tomorrow?  Cost of remaking pizzas that were made incorrectly?  Delivering pizza to customer?  32

33. Planning and Control Decisions  Uses the costs of activities to create budgets  Activity-based budgeting  Compare with actual activities to see if goals are being met  33

34. Using ABC Outside of Manufacturing  Merchandising & service Cos: find the most profitable product or service  Allocate cost of all operating activities (not just production activities) among product or service lines to figure out which are most profitable  Manufacturers: allocate operating activities  Such as R&D, marketing & distribution costs (value chain activities) to different product lines for total cost  34

35. Cost Benefit Test  Do the benefits of adopting ABC/ABM exceed the costs?  ABC Systems more costly to develop & maintain than traditional costing system using 1 plantwide MOH allocation rate  Benefits are higher than costs when:  Accurate product cost information acquired  Opportunities for cost savings results in an increase in profits.  Many different products, many diff. types/amounts of resources High indirect costs High and low volume products  35

36. Costs of Adopting ABC  Generally lower when Company has  accounting and information system expertise to develop the system.  information technology already in place  Are companies glad they adopted ABC?  89% of the companies say that it was worth the cost.  On the rise  Not a cure-all, helps managers understand costs better  36

37. Signs Old System May Be Distorting Costs  Cost system may need repair when:  Managers don’t understand costs and profits Lost bids when Mgr expected to win Competitors price similar products lower  The cost system is outdated  Co. has highly diversified product lines  Co. has reengineered its manufacturing process, but not the accounting system  37

38. Traditional Production Systems  Often described as “push systems.”  Products “pushed” through manufacturing process & stored in finished goods until sold  Keep large inventories on hand  Problems:  Storage cost  Hide quality  Bottlenecks and obsolete products  Solution: Lean Productions System  38

39. Lean Production/Thinking System  Philosophy and a business strategy  Primary goal is to eliminate waste and cost  Focus of JIT:  Purchase raw materials just in time for production  Finish goods just in time for delivery  39

40. “Just-in-Time” (JIT)  Common characteristics  Starts with Value Stream Mapping Map of flow of materials & info for each product type from receipt of order to delivery  Production occurs in self-contained cells 5S Organization: Sort, set in order, shine, standardize, sustain  Broad employee roles, Small batches produced just in time “demand-pull system”  Shortened setup times, Shortened manufacturing cycle times  Emphasis on quality, Supply-chain management  40

41. Drawbacks to Lean Production System  Vulnerable when problems strike suppliers or distributors  Examples  Delays in delivery  Personnel problems – union strikes  Shortage of parts due to recalled products  Weather related issues  41

42. Total Quality Management  Goal: Provide customers with superior products and services  Continuous improvement  More investment up front to generate savings in the back end of the value chain  42

43. Four Types of Total Quality Mgt Costs  Prevention costs – avoid poor quality goods or services  Employee training  Improved materials  Preventive maintenance  Automate where possible  Appraisal costs – detect poor quality goods or services  Inspection throughout production  Inspection of final product  Product testing  43

44. Four Types of Total Quality Mgt Costs  Internal failure costs – avoid poor quality goods or services before delivery to customers  Production loss caused by downtime  Rejected product units  External failure costs – incurred after defective product is delivered  Lost profits from lost customers  Warranty costs  Service costs at customer sites  Sales returns due to quality problems  44

45. Non-Manufacturing Co.s  Service firms and merchandising companies also incur costs of quality.  Prevention  Professional training to their staff  Develop standardized service checklists  Appraisal costs  Review work continuously  Inspect before releasing  45

46. Cost of Quality Report  Identifies, categorizes and quantifies all of the costs the Co. incurs relating to quality.  Used as a frameworks for decisions  46 Prevention Costs Appraisal Costs Internal Failure Costs External Failure Costs

47. Global Fitness Cost of Quality Report  47

48. Classify Each Cost As A Prevention Cost, Appraisal Cost, Internal Failure Cost, Or External Failure Cost:  Strength-testing 1 item from each batch of products  Training employees in TQM  Toyota recalling cars due to sticking gas pedal  Identifying preferred suppliers who commit to on-time delivery of perfect quality materials  During inspection, several defective units found, & must be redone  Inspection of incoming raw materials  Servicing sold defective product at Customer Business site  48

49. Prevention Costs:Appraisal Costs: Training employees in TQM $ 30,000 Savings on Inspection of Raw Materials $ (45,000) Training suppliers in TQM 40,000 Internal Failure Costs: Savings on Rework & spoilage (55,000) Identifying preferred suppliers 60,000 External Failure Costs: Savings on Lost profits from lost sales (90,000) Appraisal costs: Strength testing products 65,000 Savings on Warranty costs (15,000) Total costs of adopting new TQM Program $195,000 (Savings) $ (205,000) Net Benefit $ 10,000 Cost $195,000 less Savings $205,000 Costs of Adopting New Quality Program Costs of Not Adopting = (Savings) 49

50. END OF SEGMENT Professor Debbie Garvin, JD; CPA – ACG2071