Cost Management in an Automated Business Environment ABC, ABM, and TQM

1. Cost Management in an Automated Business Environment ABC, ABM, and TQM

2. The Development of a Single Company-Wide Cost Driver Traditional cost systems were created whenmanufacturing processes were labor intensive. A single company-wide overhead rate,based on direct labor hours, is usedto allocate overhead to products inthese labor intensive processes.

3. The Development of a Single Company-Wide Cost Driver Overhead is allocated to jobs using directlabor hours. If overhead is $120, how muchoverhead is allocated to each job?

4. The Development of a Single Company-Wide Cost Driver Overhead Rate = $120 ÷ 8 direct labor hours Overhead Rate = $15 per direct labor hour Job 1 = 2 hours × $15 per hour = $30 Job 2 = 6 hours × $15 per hour = $90

5. Labor 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 Development of a Single Company-Wide Cost Driver

6. Automation increasesoverhead from $120 to $420and reduces the Job 2 laborhours from 6 to 1. Allocatethe $420 overhead to the two jobs using direct labor. The Effects of Automation on the Selection of a Cost Driver

7. The Effects of Automation on the Selection of a Cost Driver Overhead Rate = $420 ÷ 3 direct labor hours Overhead Rate = $140 per direct labor hour Job 1 = 2 hours × $140 per hour = $280 Job 2 = 1 hour × $140 per hour = $140

8. The Effects of Automation on the Selection of a Cost Driver Is this reasonable? Automation benefited Job 2, but Job 1 isallocated more overhead. Clearly, we needanother cost driver to allocate overhead.

9. Using Activity-Based Cost Drivers Many companies are using activity- based cost drivers to improve product costing. Activity Based Costing Level of Complexity Company-wide Overhead Rate Overhead Allocation

10. SOUP Using Activity-Based Cost Drivers Carver makes vegetableand tomato soup.

11. SOUP Using Activity-Based Cost Drivers Allocating Setup Costs Using aVolume-basedAllocation 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

12. SOUP Using Activity-Based Cost Drivers Allocating Setup Costs Using aVolume-basedAllocation Rate The volume-based allocation rate overcosts the high-volume product andunder costs the low-volume product.

13. SOUP Using Activity-Based Cost Drivers Allocating 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

14. SOUP Activity-based Cost Drivers Enhance Relevance Activity-based cost drivers allocaterelevant 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.

15. A C B Activity-Based Costing Activity-based costing (ABC) is a two-stage allocationprocess that employs a variety of cost drivers.

16. Activity-Based Costing The first step is toidentify essentialactivities and costsrequired to performthe activities. Stage 1Assign costs to pools according to activities that cause costs to be incurred. Stage 2Allocate costs in the activity pools to products. Activity-based costing (ABC) is a two-stage allocationprocess that employs a variety of cost drivers.

17. Department 1 Department 2 Traditional Two-Stage Cost Allocation Overhead Costs Product 1 Product 2

18. Activity-Based Cost Allocation Overhead Costs ActivityCenter 1 ActivityCenter 2 ActivityCenter 3 Product 1 Product 2

19. Unit-Level Activity Batch-Level Activity Overhead costs associatedwith each category are pooled togetherand allocated to products according tohow those products benefit fromthe activities. Product-Level Activity Facility-Level Activity Types of Production Activities

20. Let’s look at anexample from theUnterman ShirtCompany. Types of Production Activities

21. Types of Production Activities Unterman Shirt Company Overhead Rate = $5,730,000 ÷ 800,000 shirts = $7.16 per shirt (Rounded)

22. 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. Types of Production Activities Unterman decides to implement ABC andcategorizes activities into four activity cost centers. Unit-levelActivities Batch-levelActivities Product-levelActivities Facility-levelActivities

23. Unit-level Activity Center Unterman identifies the following unit-leveloverhead costs ($1,296,000 of the total $5,730,000):

24. Unit-level Activity Center Unterman uses direct labor hours toallocate the unit-level overhead costs.

25. Batch-level Activity Center 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.

26. Product-level Activity Center Unterman identifies $1,800,000 in product-leveloverhead costs ($1,800,000 of the total $5,730,000): Unterman allocates 30% of product-level coststo dress shirts and 70% to casual shirts.

27. Facility-level Activity Center 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.

28. Using the Information

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

30. Should Untermandrop thecasual shirt line? Should Untermanincrease the priceof casual shirts? Should Untermanreducethe priceof dress shirts? Using the Information

31. Using the Information 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.

32. Using the Information Unterman must determine if costs are avoidablebefore dropping the casual shirt line. Facility-level overhead costs are usually unavoidable.

33. Using the Information We should consider othercosts such as sales commissionsand research and developmentcosts before making any ofthese decisions.

34. Let’s change gears andlook at another topic. Total Quality Management

35. Design Conformance Quality Total Quality Management Quality refers to the degree to which actual productsand services conform to their design specification.

36. Total Quality Management Costs companies incur to assure quality conformance may be classified as: • Prevention costs. • Appraisal costs. • Internal failure costs. • External failure costs.

37. Total Quality Management • Prevention costs • Inspection of materials upon delivery • Inspection of production process • Equipment inspection • Employee training • Appraisal costs • Finished goods inspection • Field testing of products

38. CostReport Total Quality Management • Internal failure costs – defects discovered before delivery to customers. • Scrap materials • Rework • Reinspection of rework • Lost sales resultingfrom late deliveries

39. Total Quality Management • External failure costs – defects discovered after delivery to customers. • Warranty repairs • Product liability • Marketing costs toimprove product image • Lost sales due to poorproduct quality

40. Cost ofinternal and external failure Cost of preventionand appraisal Minimizing Total Quality Costs Objective:Minimize defects while alsominimizing all four quality cost categories.

41. Minimizing Total Quality Costs Total Quality cost Prevention and appraisal costs Cost per Unit ($) Internal andexternalfailure costs 0 100 Percent of Products without Defects

42. Quality Cost Reports Should Unterman spend more on preventionand appraisal in an effort to reduce failure costs?