copyright © 2013 pearson education, inc. publishing as prentice hall. activity-based costing, lean...

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. 1

Activity-Based Costing, Lean Operations, and the

Costs of QualityChapter 4


Objective 1Develop and use departmental

overhead rates to allocate indirect costs


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


Plantwide Overhead Rate – example in textbook

• Using one predetermined manufacturing overhead rate for all operations

Predetermined MOH rate =Total estimated manufacturing overhead costsTotal estimated amount of the allocation base

Predetermined MOH rate =$1,000,00062,500 DL hours

= $16 per DL hour


Plantwide Overhead Rate

• Using one predetermined manufacturing overhead rate to allocate MOH to units

Plantwide 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


Departmental Overhead Rates

• Separate predetermined manufacturing overhead rates for each department

Manufacturing Plant with $1,000,000 of total estimated MOH and 2 departments

Machining Department($400,000 of MOH)

Assembly Department($600,000 of MOH)

$400,000 ÷ departmental allocation base yields a MOH rate for this department

ONLY

$600,000 ÷ departmental allocation base yields a MOH rate for this department

ONLY


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

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

Departmental Overhead Rates – Example on pages 182 - 187

DepartmentTotal Departmental

Manufacturing Overhead Costs

Total Departmental Labor Hours

Departmental Overhead Rate

Machining $400,000 12,500 hrs

Assembly $600,000 50,000 hrs

TOTAL $1,000,000


Departmental Overhead Rates – Example on pages 182 - 187

DepartmentTotal Departmental

Manufacturing Overhead Costs

Total Departmental Labor Hours

Departmental Overhead Rate

Machining $400,000 12,500 hrs $400,000/12,500 = $32/DLH

Assembly $600,000 50,000 hrs $600,000/50,000 = $12/DLH

TOTAL $1,000,000


Departmental Overhead Rates Example -Exhibit 4-8 (p.186) – Ellipticals

Department Departmental Overhead Rate

Actual Use of Departmental

Allocation Base

MOH Allocated to One

Elliptical

Machining $32 per DL hour × 1 DL hours =

Assembly $12 per DL hour × 9 DL hours =

Total


Departmental Overhead Rates Example -Exhibit 4-8 (p.186) – Ellipticals



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

Total $140


Departmental Overhead Rates Example - Exhibit 4-9 (p.186) - Treadmills



Allocation Base

MOH Allocated to

OneTreadmill

Machining $32 per DL hour × 4DL hours =

Assembly $12 per DL hour × 6DL hours =

Total


Departmental Overhead Rates Example - Exhibit 4-9 (p.186) - Treadmills



Allocation Base

MOH Allocated to

OneTreadmill

Machining $32 per DL hour × 4DL hours = $128

Assembly $12 per DL hour × 6DL hours = 72

Total $200


Departmental Overhead Rates Example - Exhibit 4-11 (p.187)

PlantwideOverhead RateMOH Allocation

(from Exhibit 4-2)

Departmental Overhead Rates MOH

Allocation(from Exhibit 4-10)

Amount of Cost Distortion

Elliptical $ 160 $ 140 $20 overcosted

Treadmill $ 160 $ 200 $40 undercosted


Now turn to S4-3


S4-3 - Compute Departmental Overhead Rates

1. What is Gerbig’s plantwide overhead rate?

$3,762,000 manufacturing overhead 17,100 machine hours

= $220 per machine hour

Total estimated manufacturing overhead costsTotal estimated amount of the allocation base


S4-3 (cont.)

2. Calculate the departmental overhead rates for Gerbig’s three production lines. Round all answers to the nearest cent.

Department Overhead Cost Machine Hours Overhead Rate

Potato chips $2,147,000 11,300 MH

Corn chips $959,000 2,600 MH

Cheese puffs $ 656,000 3,200 MH

$190.00

$368.85

$205.00


S4-3 (cont.)

3. Which products had been overcosted by the plantwide rate? Which products had been undercosted by the plantwide rate?

Plantwide Rate = $220.00 per machine hour

Departmental Rate:Potato Chips = $190.00 OvercostedCorn Chips = 368.85 UndercostedCheese Puffs = 205.00 Overcosted


Objective 2Develop and use activity-based costing

(ABC) to allocate indirect costs


Activity-Based Costing

• Allocates indirect costs to production• Focuses on activities and costs of activities• Separate allocation rate for each activity

Manufacturing Activities

Machine Setup

MaterialsHandling

FabricatingParts

SupervisingAssembly

InspectingProducts

PackagingProducts


Activity MOH Costs for the Activity Total Activity Cost Pool

Machine Setup Indirect labor to set up machines $80,000

Materials Handling Forklifts, gas, operators’ wages 200,000

Fabricating Parts Machine lease payments, electricity, repairs 300,000

Supervising Assembly Production engineers’ labor 150,000

Inspecting Testing equipment, inspection labor 170,000

Packaging Packaging equipment 100,000

$1,000,000

Activity-Based Costing StepsStep 1: Identify and estimate indirect costs


Activity-Based Costing StepsStep 2: Select an allocation base for each activity

Activity Allocation base Total Cost Pool

Total Estimated Amount of Allocation Base

Machine Setup Number of setups $80,000 8,000 setups

Materials Handling Number of parts moved 200,000 400,000 parts

Fabricating Parts Machine hours 300,000 12,500 machine hours (MH)

Supervising Assembly Direct labor hours 150,000 DL hours

Inspecting Number of inspections 170,000 Inspections

Packaging Cubic feet packaged 100,000 Cubic feet

$1,000,000


Activity-Based Costing StepsStep 3: Compute cost allocation rate for each activity

Activity Allocation base Total Cost Pool Cost Allocation Rate

Machine Set-up Number of set-ups $80,000 $80,000 / 8000 = $10 per setup

Materials Handling Number of parts moved 200,000 200,000/ 400,000 = $0.50 per

part

Fabricating Parts Machine hours 300,000 300,000/ 12,500 = $24 per MH

Supervising Assembly Direct labor hours 150,000 150,000 / 50,000 = $3 per DLH

Inspecting Number of inspections 170,000 170,000 / 34,000 = $5 per inspection

Packaging Cubic feet packaged 100,000 100,000 / 400,000 =$0.25 per cubic foot

1,000,000


Step 4: Allocate some manufacturing overhead for each activity to the individual jobs that use the activities.

Activity-Based Costing StepsInfo for 1 Elliptical

Activity Activity Cost

Allocation Rate

Actual Use of Activity Allocation Base (collected

on job)

MOH Allocated to One object

Machine Setup $10 per setup × 2 setups = $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


Step 4: Allocate some manufacturing overhead for each activity to the individual jobs that use the activities.

Activity-Based Costing StepsInfo for 1 Treadmill

Activity Activity Cost

Allocation Rate

Actual Use of Activity Allocation Base (collected

on job)

MOH Allocated to One object

Machine Setup $10 per setup × 4 setups = $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


Examples of Cost Drivers

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

26


Now turn to E4-36B ABC Example


E4-36B ABC Example

Step 1: Identify each activity and estimate the total indirect costs of each activity.– Material handling $6,400– Machine setup $9,000– Insertion of parts $54,400– Finishing $89,700


E4-36B Example (cont.)

Step 2: Select an allocation base for each activity and estimate the total that will be used during the year.

ActivityTotal Est.

CostEst. Quant. of Cost Allocation

Base Mat. handling $6,400 ÷ 3,200 partsMachine setups $9,000 ÷ 25 setupsInsertion of parts $54,400 ÷ 3,200 partsFinishing $89,700 ÷ 2,300 hrs


E4-36B Example (cont.)

Step 3. Compute cost allocation rate for each. activityActivity Total Est.

CostEst. Quant. of Cost

Allocation Base Allocation

Rate

Mat. handling $6,400 ÷ 3,200 parts

Machine setups 9,000 ÷ 25 setups

Insertion of parts 54,400 ÷ 3,200 parts

Finishing 89,700 ÷ 2,300 hrs

$ 2.00/part

$360.00/setup

$17.00/part$39.00/hr


E4-36B Example (cont.)Step 4. Allocate some manufacturing overhead from each activity

to the individual jobs that use the activities.Job 420

Material handling 250 parts $ 2.00 $ 500

Machine setup 3 setups 360.00 1,080

Insertion of parts 250 parts 17.00 4,250

Finishing 130 finishing hours 39.00 5,070

Total $10,900


E4-36B Example (cont.)Step 4. Allocate some manufacturing overhead from each activity

to the individual jobs that use the activities.Job 420

Material handling 250 parts $ 2.00 $ 500

Machine setup 3 setups 360.00 1080

Insertion of parts 250 parts 17.00 4,250


Total $10,900

Job 510

Material handling 425 parts $ 2.00 $850

Machine setup 6 setups 360.00 2,160Insertion of parts 425 parts 17.00 7,225


Total $22,715


Cost Hierarchy


Now turn to S4-9


S4-9 Classifying Costs Within the Cost Hierarchy

1. Each container is cut from the mold once the plastic has cooled and hardened.

2. Patents are obtained for each new type of container mold.

3. Plastic resins are used as the main direct 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.

Unit-level

Unit-level

Product-level

Facility-level

Facility-level


S4-9 (cont.)6. Each container product line has a product

line manager.7. The extrusion 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 machines10. Rent is paid for the building that houses

the manufacturing processes.Facility-level

Facility-level

Product-level

Product-level

Batch-level


Objective 3Understand the benefits and limitations

of ABC/ABM systems


Activity-Based Management (ABM)

• Using ABC information to make decisions– Pricing and product mix– Cost cutting– Planning and control


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


Cutting Costs

• Analyze costs in value chain– Value-added activities– Non–value-added activities

• Value-added vs. non–value-added


Planning and Control Decisions

• Uses the costs of activities to create budgets

• Compare with actual activities to see if goals are being met


Using ABC Outside of Manufacturing

• Merchandising and service: find the most profitable product or service

• Manufacturers: allocate operating activities


Sustainability and Refined Costing Systems

• Environmental overhead should be allocated to different activities that drive their costs.

• Creates better transparency


Cost Benefit Test

• Do the benefits of adopting ABC/ABM exceed the costs?

• Benefits are higher for companies in competitive markets:– Accurate product cost information is essential– ABM can pinpoint cost savings opportunities

• Benefits are higher when risk of cost distortion high:– Many different products, many different types/amounts of

resources– High indirect costs– High- and low-volume products


Costs of Adopting ABC

• Generally lower with– Accounting and information system expertise to

develop the system– Information technology

• Are companies glad they adopted ABC?– 89% of the companies say that it was worth the cost – Not a cure-all, helps managers understand costs

better


Signs the Old System May Be Distorting Costs

• Cost system may need repair when– Managers don’t understand costs and profits– Bids are lost when expected to win– Win bids expected to lose– Competitors price similar products much higher or

much lower• The cost system may be outdated if there is a

diversified product line


Objective 4Describe lean operations


Traditional Production Systems

• Keep large inventories on hand

• Problems:– Storage cost– Hide quality– Bottlenecks and obsolete products

• Solution: Lean Productions System


Lean Thinking

• Philosophy and a business strategy

• Primary goal: eliminate waste and cost

• Focus of JIT– Purchase raw materials just in time for production– Finish goods just in time for delivery


Lean Production/Just-in-Time

• Common characteristics of Just-in-Time (JIT)– Production occurs in self-contained cells– 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


Drawbacks to Lean Production Systems

• 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


Sustainability and Lean Thinking

• Both seek to reduce waste• Lean focus on internal• Green focus on external• Lean and Green


Objective 5Describe and use the cost of quality

framework


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


Four Types of Quality Costs

1. Prevention costs – avoid poor quality goods or services – Employee training– Improved materials– Preventive maintenance

2. Appraisal costs – detect poor quality goods or services– Inspection throughout production– Inspection of final product– Product testing


Four Types of Quality Costs (cont.)

3. Internal failure costs – avoid poor quality goods or services before delivery to customers– Production loss caused by downtime– Rejected product units

4. 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


Non-Manufacturing Costs of Quality

• 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


Cost of Quality Report

• Identifies, categorizes, and quantifies all of the costs it incurs relating to quality.

• Calculate the percentage of total costs of quality that are incurred in each cost category

• Use as a framework for decisionsPrevention

Costs Appraisal

Costs

Internal Failure Costs

External Failure Costs


Now turn to E4-34A


E4-34A

Prevention costs– Training employees in TQM– Training suppliers in TQM– Identifying preferred suppliers who commit to

on-time delivery of perfect quality materials


E4-34A (cont.)

Appraisal costs– Strength testing one item from each batch

of panels – Avoid inspection of raw materials

Internal failure costs– Avoid rework and spoilage


E4-34 (cont.)

External failure costs– Avoid lost profits from lost sales due to

disappointed customers– Avoid warranty costs


E4-34A (cont.)Costs of Adopting New Quality Program:

Prevention costs:Training employees in TQM $ 29,000Training suppliers in TQM 33,000Identifying preferred suppliers 59,000

Appraisal costs:Strength testing 64,000

Savings on inspection of raw materials (51,000)


E4-34A (cont.)Quality report (continued from prior slide):

Internal failure costs: Savings on rework and spoilage (65,000)

External failure costs:Savings on formerly lost profits (92,000)Savings on warranty costs (16,000)

Net (Benefit) ($39,000)


End of Chapter 4

66

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