1. Copyright © 2007 Prentice-Hall. All rights reserved 1 Activity-Based Costing and Other Cost Management Tools Chapter 24

2. Copyright © 2007 Prentice-Hall. All rights reserved 2 Objective 1 Develop activity-based costs (ABC)

3. Copyright © 2007 Prentice-Hall. All rights reserved 3 Activity-Based Costing A way to allocate indirect cost to production Focus – on activities and cost of activities Each activity has its own cost driver (factors that cause you to incur expenses) Uses a separate allocation rate for each activity Traditionally indirect costs were allocated to production as an overall rate. As indirect manufacturing costs increase because of automation, using an overall rate is not an adequate way of determining the cost of a product

4. Copyright © 2007 Prentice-Hall. All rights reserved 4 Activity-Based Costing Steps: 1. Identify each activity and estimate its total indirect cost 2. Identify cost driver for each activity and estimated total quantity of each driver’s allocation base 3. Compute cost allocation rate for each activity 4. Allocate indirect costs to cost object

5. Copyright © 2007 Prentice-Hall. All rights reserved 5 Cost Drivers - Examples 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

6. Copyright © 2007 Prentice-Hall. All rights reserved 6 E24-13E24-13 Steps: 1. Identify each activity and estimate its total indirect cost (given) –Material handling –Machine setup –Insertion of parts –Finishing

7. Copyright © 2007 Prentice-Hall. All rights reserved 7 E24-13E24-13 Steps: 2. Identify cost driver for each activity and estimated total quantity of each driver’s allocation base (given) ActivityBudgeted costAllocation base Material handling$9,000# of parts Machine setup3,400# of setups Insertion of parts48,000# of parts Finishing80,000# finished direct labor hours Total$140,400

8. Copyright © 2007 Prentice-Hall. All rights reserved 8 E24-13E24-13 Steps: 3. Compute cost allocation rate for each activity Activity Total Est. Cost Est. Quant. of Cost Allocation Base Cost Allocation Rate Mat. handling $9,000 ÷3,000 parts= $ 3 per part Machine setups $ 3,400 ÷10 setups= $340 per setup Insertion of parts $48,000 ÷3,000 parts= $ 16 per part Finishing $80,000 ÷2,000 hrs= $ 40 per hour

9. Copyright © 2007 Prentice-Hall. All rights reserved 9 E24-13E24-13 The average quantities of the cost allocation bases used per fender are: Parts: 3,000 ÷ 1,000 = 3 Setups: 10 ÷ 1,000 = 0.01 Finishing direct labor hrs: 2,000 ÷ 1,000 = 2

10. Copyright © 2007 Prentice-Hall. All rights reserved 10 E24-13E24-13 Indirect Manufacturing Cost Per Fender Activity Actual Quant of Cost Allocation Base Used per Fender Cost Alloc. Rate Cost per Fender Mat. handling 3.00  $ 3.00=$ 9.00 Machine setups 0.01  $340.00= 3.40 Insertion of parts 3.00  $ 16.00=48.00 Finishing 2.00  $ 40.00= 80.00 Total indirect cost $140.40

11. Copyright © 2007 Prentice-Hall. All rights reserved 11 E24-15E24-15 Total Budgeted Indirect Manufacturing Cost Activity Actual Quant of Cost Allocation Base Used per Fender Cost Alloc. RateTotal Mat. handling 10,000  $ 3.00=$30,000 Machine setups 30  $300.00=9,000 Insertion of parts 10,000  $ 24.00=240,000 Finishing 3,500  $ 50.00=175,000 Total budgeted indirect cost $454,000 Total parts for the year: (4 x 1,000) + (6 x 1,000) = 10,000 Total machine setups: 15 + 15 Finishing: (1 x 1,000) + (2.5 x 1,000) = 3,500

12. Copyright © 2007 Prentice-Hall. All rights reserved 12 E24-15E24-15 Indirect Manufacturing Cost Per Rim - Standard Activity Cost Allocation Rate Quant of Cost Alloc. Base Used Cost per Rim Mat. handling $3.00  4=$ 12.00 Machine setups $300 .015= 4.50 Insertion of parts $24  4=96.00 Finishing $50 x1= 50.00 Total indirect cost $162.50 Machine setups: 15/1,000 rims =.015

13. Copyright © 2007 Prentice-Hall. All rights reserved 13 E24-15E24-15 Indirect Manufacturing Cost Per Rim - Deluxe Activity Cost Allocation Rate Quant of Cost Alloc. Base Used Cost per Rim Mat. handling $3.00  6=$ 18.00 Machine setups $300 .015= 4.50 Insertion of parts $24  6=144.00 Finishing $50 x2.5= 125.00 Total indirect cost $291.50

14. Copyright © 2007 Prentice-Hall. All rights reserved 14 E24-15E24-15 Budgeted total indirect overhead cost$454,000 Budgeted direct labor hrs5,000 Single allocation rate per$454,000 direct labor hr 5,000 = $90.80

15. Copyright © 2007 Prentice-Hall. All rights reserved 15 E24-15E24-15 Indirect manufacturing cost per wheel: Standard model:2  $92.30 = $184.60 Deluxe model:3  $92.30 = $276.90 Compare these allocations with the $162.50 and $291.50 for the standard and deluxe rims respectively

16. Copyright © 2007 Prentice-Hall. All rights reserved 16 Objective 2 Use activity-based management (ABM)

17. Copyright © 2007 Prentice-Hall. All rights reserved 17 E24-16E24-16 Eason Company ABC Data Gross Profits StandardDeluxe Sale price$300.00$440.00 Direct materials30.0046.00 Direct labor45.0050.00 Indirect overhead162.50 291.50 Gross profit$62.50$52.50 Eason’s managers will produce 2,000 units of the standard model to maximize income

18. Copyright © 2007 Prentice-Hall. All rights reserved 18 E24-16E24-16 Eason Company ABC Data Gross Profits StandardDeluxe Sale price$300.00$440.00 Direct materials30.0046.00 Direct labor45.0050.00 Indirect overhead184.60 276.90 Gross profit$40.40$67.10 If they rely on the single-allocation-base data, Eason’s managers will produce the deluxe model. It will appear to maximize income Eason will earn more income by producing the standard model

19. Copyright © 2007 Prentice-Hall. All rights reserved 19 E24-17E24-17 Finishing activity cost per rim: 2.0 hrs per rim x $40 per hour = $80 per rim

20. Copyright © 2007 Prentice-Hall. All rights reserved 20 E24-17E24-17 New cost of deluxe rim: Direct materials$46.00 Direct labor50.00 Indirect costs: Materials handling18.00 Machine setups 4.50 Insertion parts144.00 Finishing 80.00 Total$342.50 Yes, the value engineering recommendation for the finishing process would reduce the cost of the deluxe model to $342.50, which is below the target cost of $350

21. Copyright © 2007 Prentice-Hall. All rights reserved 21 Objective 4 Describe a just-in-time (JIT) production system, and record its transactions

22. Copyright © 2007 Prentice-Hall. All rights reserved 22 Just-in-Time Systems Receive order from customer Schedule production Defect-free materials are delivered by suppliers just in time for production Finished product is delivered to customer

23. Copyright © 2007 Prentice-Hall. All rights reserved 23 Just-in-Time Systems cutting shaping smoothing grinding Finished Goods Work in process is not transferred from one department to another. All equipment needed to produce the product is contained in the cell. No time is wasted on moving inventory. Employees are cross- trained and work as a team with little supervision. They are responsible for quality control throughout the process

24. Copyright © 2007 Prentice-Hall. All rights reserved 24 Just-in-Time Costing “Backflush costing” Standard costing system that begins with output completed and then assigns manufacturing cost to units sold and to inventories

25. Copyright © 2007 Prentice-Hall. All rights reserved 25 Just-in-Time Costing Record cost of production when units are completed Inventory accounts – only two –Raw and In-Process Inventory –Finished Goods Inventory Manufacturing costs – only two –Direct materials –Conversion

26. Copyright © 2007 Prentice-Hall. All rights reserved 26 Exercise 24-20 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT Raw & In Process Inventory6,500 Accounts Payable6,500 Conversion Costs14,840 Various accounts14,840

27. Copyright © 2007 Prentice-Hall. All rights reserved 27 Exercise 24-20 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT Finished Goods Inventory17,600 Raw and In Process Inventory (200x$24)4,800 Conversion Costs(200x$64)12,800 Cost of Goods Sold ($88x196)17,248 Finished Goods Inventory17,248 Cost per unit = $17,600 / 200 units = $88 per unit

28. Copyright © 2007 Prentice-Hall. All rights reserved 28 Exercise 24-20 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT Cost of Goods Sold2,040 Conversion Costs2,040 Conversion Costs 14,84012,800 Bal. 2,040

29. Copyright © 2007 Prentice-Hall. All rights reserved 29 Exercise 24-20 Finished Goods 1,00017,248 Bal. 1,352 17,600

30. Copyright © 2007 Prentice-Hall. All rights reserved 30 Objective 5 Use the four types of quality costs to make decisions

31. Copyright © 2007 Prentice-Hall. All rights reserved 31 Total Quality Management Goals To provide customers with superior products and services Continuous improvement –Improve quality –Eliminate defects and waste

32. Copyright © 2007 Prentice-Hall. All rights reserved 32 Types of Quality Costs Prevention costs – avoid poor quality goods or services –Employee training –Improved materials –Preventive maintenance

33. Copyright © 2007 Prentice-Hall. All rights reserved 33 Types of Quality Costs Appraisal costs – detect poor quality goods or services –Inspection throughout production –Inspection of final product –Product testing

34. Copyright © 2007 Prentice-Hall. All rights reserved 34 Types of Quality Costs Internal failure costs – avoid poor quality goods or services before delivery to customers –Production loss caused by downtime –Rejected product units

35. Copyright © 2007 Prentice-Hall. All rights reserved 35 Types of Quality Costs External failure costs – when poor quality products are delivered to customers and company has to make things right with customer –Lost profits from lost customers –Warranty costs –Service costs at customer sites –Sales returns due to quality problems

36. Copyright © 2007 Prentice-Hall. All rights reserved 36 E24-22E24-22 Prevention costs: Training employees in TQM Training suppliers in TQM Identifying preferred suppliers who commit to on-time delivery of perfect quality materials

37. Copyright © 2007 Prentice-Hall. All rights reserved 37 E24-22E24-22 Appraisal costs: Strength testing one item from each batch of panels Avoid inspection of raw materials Internal failure costs: Avoid rework and spoilage

38. Copyright © 2007 Prentice-Hall. All rights reserved 38 E24-22E24-22 External failure costs: Avoid lost profits from lost sales due to disappointed customers Avoid warranty costs

39. Copyright © 2007 Prentice-Hall. All rights reserved 39 E24-22E24-22 Costs of Adopting New Quality Program: Prevention costs: Training employees in TQM$ 30,000 Training suppliers in TQM40,000 Identifying preferred suppliers who commit to on-time delivery of perfect quality materials 60,000 Appraisal costs: Strength testing one item from each batch of panels 70,000 Total costs of adopting new quality program$200,000

40. Copyright © 2007 Prentice-Hall. All rights reserved 40 E24-22E24-22 Costs of Not Adopting New Quality Program: Appraisal costs: Inspection of raw materials$ 50,000 Internal failure costs: Rework and spoilage.60,000 External failure costs: Lost profits from lost sales due to disappointed customers 90,000 Warranty costs 15,000 Total costs of not adopting new quality program$215,000 Clason should adopt the new quality program

41. Copyright © 2007 Prentice-Hall. All rights reserved 41 End of Chapter 24