cost management in an automated business environment (abc, and tqm) chapter 6

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

Chapter 6

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada6-2

The Development of a Single Company-Wide Cost Driver

Traditional cost systems were created whenmanufacturing processes were labour intensive.

Traditional cost systems were created whenmanufacturing processes were labour intensive.

A single company-wide overhead rate,based on direct labour hours, is used

to allocate overhead to products inthese labour intensive processes.

A single company-wide overhead rate,based on direct labour hours, is used

to allocate overhead to products inthese labour intensive processes.



Overhead is allocated to jobs using directlabour hours. If overhead is $120, how much

overhead is allocated to each job?

Overhead is allocated to jobs using directlabour hours. If overhead is $120, how much

overhead is allocated to each job?



Overhead Rate = $120 ÷ 8 direct labour hoursOverhead Rate = $15 per direct labour hour

Job 1 = 2 hours × $15 per hour = $30Job 2 = 6 hours × $15 per hour = $90


The Development of a Single Company-Wide Cost DriverLabour 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.


The Effects of Automation on the Selection of a Cost Driver

Automation increasesoverhead from $120 to $420

and reduces the Job 2 labourhours from 6 to 1. Allocate

the $420 overhead to the two jobs using direct labour.



Overhead Rate = $420 ÷ 3 direct labour hoursOverhead Rate = $140 per direct labour hour

Job 1 = 2 hours × $140 per hour = $280Job 2 = 1 hour × $140 per hour = $140


Is this reasonable?

Automation benefited Job 2, but Job 1 isallocated more overhead. Clearly, we needanother cost driver to allocate overhead.



Using Activity-Based Cost Drivers

Level of C

omplexity

Level of C

omplexity

Overhead Allocation

Company-wide Overhead

Rate

Activity BasedCosting

Many companies are using activity- based cost drivers to improve product

costing.


Using Activity-Based Cost Drivers

Carver makes vegetableand tomato soup.

Vegetable Tomato Total

Number of Cans 954,000 234,000 1,188,000

Number of Batches 180 180 360

Number of Setups 180 180 360

Cost per setup 264$ 264$ 528$

Total overhead = 360 setups × $264 per setup = 95,040$


Using Activity-Based Cost DriversAllocating Setup Costs Using aVolume-based Allocation Rate

Overhead per can = $95,040 ÷ 1,188,000 cansOverhead per can = $0.08 per can

Vegetable = 954,000 cans × $0.08 per can = $76,320Tomato = 234,000 cans × $0.08 per can = $18,720


Number of Cans 954,000 234,000 1,188,000






Using Activity-Based Cost DriversAllocating Setup Costs Using aVolume-based Allocation Rate

The volume-based allocation rate overcosts the high-volume product and

under costs the low-volume product.


Number of Cans 954,000 234,000 1,188,000






Using Activity-Based Cost DriversAllocating Setup Costs Using anActivity-based Allocation Rate

Overhead per batch = $264

Vegetable = 180 batches × $264 per batch Vegetable = $47,250Tomato = 180 batches × $264 per batch = $47,250


Number of Cans 954,000 234,000 1,188,000






Activity-based Cost Drivers Enhance Relevance

Activity-based cost drivers allocaterelevant costs ($264 batch set-up)

to appropriate products.

Cost Driver Vegetable Tomato

Volume-based 76,320$ 18,720$

Activity-based 47,250 47,250

Allocation to Product

$47,250 is the cost avoided if Carver ceases production of either product,

or if the set-up function is outsourced.


Activity-Based Costing

A

B C

Activity-based costing (ABC) is a two-stage allocationprocess that employs a variety of cost drivers.


Activity-Based Costing

Activity-based costing (ABC) is a two-stage allocationprocess that employs a variety of cost drivers.

Stage 1Assign costs to pools

according to activities that cause costs to be incurred.

Stage 2Allocate costs in the

activity pools to products.

The first step is toidentify essential

activities and costsrequired to perform

the activities.


Traditional Two-Stage Cost Allocation

Department 1

Product 1

Department 2

Product 2

Overhead Costs


Activity-Based Cost Allocation

Overhead Costs

ActivityCenter 1

Product 1 Product 2

ActivityCenter 3

ActivityCenter 2


Types of Production Activities

Overhead costs associatedwith each category are pooled togetherand allocated to products according to

how those products benefit fromthe activities.

Unit-LevelActivity

Batch-Level Activity

Product-LevelActivity

Facility-LevelActivity


Let’s look at anexample from theUnterman Shirt

Company.




Total

Expected Volume 680,000 120,000 800,000 Total Overhead 5,730,000$

Sales Price 31.00$ 31.00$ Overhead Rate 7.16$ 7.16$ Direct Material 8.20 8.20 Direct Labour 6.80 22.16 6.80 22.16 Gross Margin 8.84$ 8.84$

Dress Shirts Casual Shirts

Product Lines

Unterman Shirt Company

Overhead Rate = $5,730,000 ÷ 800,000 shirts = $7.16 per shirt (Rounded)



Unterman decides to implement ABC andcategorizes activities into four activity cost centers.

Unit-levelActivities

Batch-levelActivities

Product-levelActivities

Facility-levelActivities

Incurred each timea shirt is made.

Incurred each time a batch ofshirts(casual or dress)is made.

Supports either dressor casual shirts.

Benefit the entire process,not a line of specific shirts.


Unit-level Activity Center

Unterman identifies the following unit-leveloverhead costs ($1,296,000 of the total $5,730,000):

Unterman identifies the following unit-leveloverhead costs ($1,296,000 of the total $5,730,000):


Unit-level Activity Center

Unterman uses direct labour hours toallocate the unit-level overhead costs.

Unterman uses direct labour hours toallocate the unit-level overhead costs.


Batch-level Activity Center

Unterman identifies $690,000 in batch-leveloverhead costs ($690,000 of the total $5,730,000):

Unterman identifies $690,000 in batch-leveloverhead costs ($690,000 of the total $5,730,000):

Unterman uses number of setups toallocate the batch-level overhead costs.

Unterman uses number of setups toallocate the batch-level overhead costs.


Product-level Activity Center

Unterman identifies $1,800,000 in product-leveloverhead costs ($1,800,000 of the total $5,730,000):

Unterman identifies $1,800,000 in product-leveloverhead costs ($1,800,000 of the total $5,730,000):

Unterman allocates 70% product-level coststo casual shirts and 30% to dress shirts.

Unterman allocates 70% product-level coststo casual shirts and 30% to dress shirts.


Facility-level Activity Center

Unterman identifies $1,944,000 in facility-leveloverhead costs ($1,944,000 of the total $5,730,000):

Unterman identifies $1,944,000 in facility-leveloverhead costs ($1,944,000 of the total $5,730,000):

Unterman allocates 85% facility-level coststo dress shirts and 15% to casual shirts.

Unterman allocates 85% facility-level coststo dress shirts and 15% to casual shirts.


Using the Information



Traditional costing resulted in undercosting the casual shirt line and overcosting the dress shirt line.



Should Untermanincrease the priceof casual shirts?

Should Untermanreduce the priceof dress shirts?

Should Untermandrop the

casual shirt line?



Target pricing might be useful.

Determine the price customers will pay for casualshirts, and then reduce costs so that they maybe produced and sold profitably at that price.



Unterman must determine if costs are avoidablebefore dropping the casual shirt line.

Facility-level overhead costs are usually unavoidable.


We should consider othercosts such as sales commissions

and research and developmentcosts before making any of

these decisions.



Total Quality Management

Let’s change gears andlook at another topic.



Quality

Design Conformance

Quality refers to the degree to which actual productsand services conform to their design specification.


Costs companies incur to assure quality conformance may be classified as: Prevention costs. Appraisal costs. Internal failure costs. External failure costs.



Prevention costs-incurred to avoid non conforming products Inspection of materials upon delivery Inspection of production processEquipment inspectionEmployee training



Appraisal costs-incurred to identify nonconforming products that were not avoided via the prevention cost expenditures.Finished goods inspectionField testing of products



Internal failure costs – defects discovered before delivery to customers.Scrap materialsReworkReinspection of reworkLost sales resulting

from late deliveries Cost

Report



External failure costs – defects discovered after delivery to customers.Warranty repairsProduct liabilityMarketing costs to

improve product imageLost sales due to poor

product quality



Minimizing Total Quality Costs

Cost of prevention

and appraisal

Cost ofinternal and

external failure

Objective: Minimize defects while alsominimizing all four quality cost categories.


Minimizing Total Quality Costs

Total Quality cost

Percent of Products without Defects

Cos

t pe

r U

nit

($)

Internal andexternal

failure costs

Prevention and appraisal costs

0 100


Unterman CompanyQuality Cost Report

For the Year Ended December 31, 2002Amount Percentage

Prevention Costs 106,000$ 13.87% Appraisal Costs 150,000 19.63% Internal Failure Costs 298,000 39.01% External Failure Costs 210,000 27.49% Total Quality Costs 764,000$ 100.00%

Quality Cost Reports

Should Unterman spend more on preventionand appraisal in an effort to reduce failure costs?


End of Chapter 6

I’m managingquality time!

cost management in an automated business environment (abc, and tqm) chapter 6

Documents

cost driver slide

mcgrawhill ryerson limited

overhead allocations

cost driver automation

activity based cost

inaccurate overhead

cost management

direct labour hour job