© 2016 Pearson Education, Inc.

Chapter 19 Cost Management Systems: Activity-Based, Just-In-Time, and Quality Management Systems

© 2016 Pearson Education, Inc.
Learning Objectives Assign direct costs and allocate indirect costs using predetermined overhead allocation rates with single and multiple allocation bases © 2016 Pearson Education, Inc.

Learning Objectives Use activity-based costing (ABC) to compute predetermined overhead allocation rates and allocate indirect costs Use activity-based management (ABM) to make decisions Use activity-based management (ABM) in a service company © 2016 Pearson Education, Inc.

Learning Objectives Describe a just-in-time (JIT) management system and record its transactions Describe quality management systems (QMS) and use the four types of quality costs to make decisions © 2016 Pearson Education, Inc.

How Do Companies Assign and Allocate Costs?
Product costs consist of direct materials, direct labor, and manufacturing overhead. Easily traced and assigned to the product: Direct materials costs Direct labor costs Allocated to the product: Manufacturing overhead costs Product costs include (1) direct materials costs, (2) direct labor costs, and (3) manufacturing overhead costs. Direct materials costs and direct labor costs can be easily traced to products. Therefore, direct material costs and direct labor costs are assigned to products. Manufacturing overhead costs, also called indirect costs, cannot be easily traced to products. Manufacturing overhead costs are accumulated in cost pools and then allocated to products. Managers need to know product costs to make planning and control decisions. © 2016 Pearson Education, Inc.

Single Plantwide Rate A single plantwide rate is called the predetermined overhead allocation rate and is calculated before the period begins. Traditional approach of allocating manufacturing overhead Simplest method One allocation base is used and applied to all units The predetermined overhead allocation rate is the estimated overhead cost per unit of the allocation base, calculated at the beginning of the accounting period. The formula is Total estimated overhead costs / Total estimated quantity of the overhead allocation base. The allocation base is generally machine hours or direct labor hours. Sometimes total direct labor costs is used as an allocation base. © 2016 Pearson Education, Inc.

Single Plantwide Rate Predetermined overhead allocation rate formula and example: The manufacturing overhead costs can now be allocated to each model by multiplying this rate by the actual direct labor costs incurred. The first step in allocating overhead costs to products is to compute the predetermined overhead allocation rate. The predetermined overhead rate is equal to Total estimated overhead costs / Total estimated quantity of overhead allocation base. © 2016 Pearson Education, Inc.

Multiple Department Rates
What if there are two departments with different allocation bases? For example: The overhead allocation base for the Production Department is machine hours. The overhead allocation base for the Software Department is direct labor costs. Sometimes multiple departments are used to produce a product, and multiple overhead rates can then be used to allocate overhead costs to products. A modification of the overhead allocation method using a single plantwide rate is using multiple predetermined overhead allocation rates that have different allocation bases. This method is more complex, but it may be more accurate. The allocation process is the same, except now there are multiple cost pools and multiple allocation bases. Smart Touch Learning has two departments, and we calculate an overhead rate for each department. Different cost drivers, or allocation bases, are used for each department. The allocation base for the Production Department is machine hours. The allocation base for the Software Department is direct labor cost. © 2016 Pearson Education, Inc.

Production Department
The total estimated overhead costs for the Production Department are $80,000, and the total machine hours are 20,000. The total estimated overhead costs for the Production Department are $80,000. The department’s total quantity of the allocation base, machine hours, is estimated at 20,000 hours. The predetermined overhead rate is $4.00 per hour: $80,000 / 20,000 hours. The manufacturing overhead costs for the Production Department can now be allocated to each model, based on usage. © 2016 Pearson Education, Inc.

Software Department The estimated overhead costs for the Software Department are $20,000, and direct labor costs are $31,250. The total estimated overhead costs for the department are $20,000. Smart Touch Learning’s managers have compiled the following data for the Software Department’s total quantity of the allocation base: Direct labor costs are estimated at $31,250. The predetermined overhead allocation rate is 64%, which is found by dividing $20,000 / $31,250. © 2016 Pearson Education, Inc.

Total Cost To determine the unit cost of the manufacturing overhead, we divide the total cost by the number of units. We can then add the manufacturing overhead unit cost to the direct materials and direct labor unit costs to determine the total unit cost. © 2016 Pearson Education, Inc.

Analysis Now that we have completed an estimated cost per unit using two different methods, let’s compare the results. Using a more refined allocation system with multiple allocation rates shows the standard model costs slightly more than originally thought, whereas the premium model costs less than originally thought. The difference may not seem significant, but in today’s competitive market, even slight differences can have an impact. © 2016 Pearson Education, Inc.

How Is an Activity-Based Costing System Developed?
Activity based-management (ABM) Focuses on the primary activities the business performs Uses cost information to make decisions that lead to greater profits Activity-based costing (ABC) is the process of determining the cost of the activities as building blocks for allocating indirect costs to products and services. Activity-based management (ABM) uses activity-based cost information to make decisions that improve customer satisfaction while also increasing profits. Activity-based costing (ABC) focuses on the cost of activities as the building blocks for allocating indirect costs to products and services. © 2016 Pearson Education, Inc.

Step 1: Identify activities and estimate their total costs. Step 2: Identify the allocation base for each activity and estimate the total quantity of each allocation base. Step 3: Compute the predetermined overhead allocation rate for each activity. Step 4: Allocate indirect costs to the cost object. Companies like Smart Touch Learning, with diverse products, can obtain better costing information by using activity-based costing and activity-based management. Four steps are used to develop an activity-based costing system for allocating manufacturing overhead costs to products: (1) Identify activities and estimate their total costs, (2) identify the allocation base for each activity and estimate the total quantity of each allocation base, (3) compute the predetermined overhead allocation rate for each activity, and (4) allocate indirect costs to the cost object. © 2016 Pearson Education, Inc.

Step 1: Identify Activities and Estimate Their Total Costs
Identify activities used to allocate manufacturing overhead. Examples of activities include: Quality inspections—inspecting raw materials or finished products. Shipping—shipping finished products to customers Setups—setting up machines for production Purchasing—purchasing raw materials The first step in developing an activity-based costing system is to identify the activities that will be used to allocate the manufacturing overhead. Analyzing all the activities required for a product or service forces managers to think about how each activity might be improved—or whether it is necessary at all. © 2016 Pearson Education, Inc.

Step 1: Identify Activities and Estimate Their Total Costs
Exhibit 19-2 shows the difference between Smart Touch Learning’s traditional system and its ABC system. Notice that the traditional system allocates manufacturing overhead based on a single allocation base: direct labor costs. In contrast, the ABC system allocates manufacturing overhead based on three activities and their allocation bases: setup, production, and testing. © 2016 Pearson Education, Inc.

Step 2: Identify the Allocation Base for Each Activity and Estimate the Total Quantity of Each Allocation Base Smart Touch Learning determines that setup, production, and testing are the ABC allocation bases. Step 2 of an activity-based costing system is shown in this slide. We identify the allocation base for each activity and estimate the total quantity of each allocation base. Exhibit 19-3 summarizes the data for each allocation base. © 2016 Pearson Education, Inc.

Step 3: Compute the Predetermined Overhead Allocation Rate for Each Activity Step 3 of an activity-based costing system is shown in this slide. We compute the predetermined overhead rate for each activity. We use the same formula shown earlier: Total estimated overhead costs for the activity / Total estimated quantity of the allocation base for the activity. © 2016 Pearson Education, Inc.

Step 4: Allocate Indirect Costs to the Cost Object
Step 4 of an activity-based costing system is shown in this slide. To allocate indirect costs to the standard model, we need to know the quantity of the allocation base used for each activity. We multiply the predetermined overhead rate for each activity by the actual quantity of the allocation base used. © 2016 Pearson Education, Inc.

Traditional Costing Systems Compared with ABC Systems
The use of an activity-based costing (ABC) system results in a slightly different product cost per unit than shown earlier with one plantwide overhead rate. Under ABC, the product cost for the standard model is $ per unit. Using one single, plantwide overhead rate, we obtain a product cost for the standard model of $ In this example, the product costs for the standard model obtained with the different approaches used are very close. This is not always the case with different products. Activity-based costing is more accurate because ABC considers the resources (activities) each product actually uses. © 2016 Pearson Education, Inc.

How Can Companies Use Activity-Based Management to Make Decisions?
Activity-based management (ABM) uses activity-based costs to make decisions that increase profits while meeting customer needs. ABM decisions include: Pricing and product mix Cost management Activity-based management (ABM) uses activity-based costs to make different types of decisions. The decisions examined are pricing and product mix decisions and cost management decisions. © 2016 Pearson Education, Inc.

Pricing and Product Mix Decisions
Pricing decision: If the cost per unit changes, should the selling price also change? Product mix decision: Compare the gross profit of two products and sell the product with the greatest gross profit to maximize total gross profit, considering limited production capabilities. Activity-based costing can be used for pricing decisions. If the production costs per unit decrease, Smart Touch Learning must decide whether to decrease selling prices as well. Product mix decisions are assessed by comparing the gross profit of two products and maximizing profits by selling more of the product that generates the greatest profits, after taking into consideration the production capabilities of the organization. © 2016 Pearson Education, Inc.

Cost Management Decisions
Companies adopt ABC to get more accurate product costs for pricing and product mix decisions. Value engineering reevaluates activities to reduce costs while satisfying customer needs. Cross-functional teams work together, including marketers, engineers, production personnel, and accountants. Activity-based costing (ABC) can be used to reduce product costs and increase company profitability. The ABC information is used with value engineering. Value engineering involves reevaluating activities to reduce costs while satisfying customer needs. Value engineering requires cross-functional teams that include the following: marketers to identify customer needs, engineers to design products that can be produced more efficiently, production personnel to help improve manufacturing processes, and accountants to estimate costs. © 2016 Pearson Education, Inc.

Target pricing: The target price is the amount customers are willing to pay for a product or service. The target cost is the maximum cost to develop, produce, and deliver the product or service and earn the desired profit. Cost-based pricing: The full product cost is the cost to develop, produce, and deliver the product or service. Desired profit is added to this full product cost to determine sales price. The price a customer is willing to pay for a product or services is called target price. Companies set sales prices based on target prices. Target pricing starts with the sales price that customers are willing to pay and then subtracts the company’s desired profit to determine the target cost—the maximum cost to develop, produce, and deliver the product or service and earn the desired profit. Cost-based pricing starts with full product cost—the cost to develop, produce, and deliver the product or service. The full product cost is added to the desired profit to determine the sales price. © 2016 Pearson Education, Inc.

Exhibit 19-4 compares cost-based pricing with target pricing. Cost-based pricing (left column) starts with full product costs—the cost to develop, produce, and deliver the product or service. The full product cost is added to the desired profit to determine the sales price. Target pricing (right column) does just the opposite. Target pricing starts with the sales price that customers are willing to pay and then subtracts the company’s desired profit to determine the target cost—the maximum cost to develop, produce, and deliver the product or service and earn the desired profit. Notice that the target cost includes all costs, not just manufacturing costs. The company’s goal is to achieve the target cost. © 2016 Pearson Education, Inc.

Can Activity-Based Management Be Used in Service Companies?
Use the same steps to develop overhead rates used for manufacturing companies: Step 1: Identify activities and estimate their total costs. Step 2: Identify the allocation base for each activity and estimate the total quantity of each allocation base. Step 3: Compute the predetermined overhead allocation rate for each activity. Step 4: Allocate indirect costs to the cost object. Activity-based management can also be used by service companies. With regard to indirect costs, or overhead costs, the steps are the same for developing overhead allocation rates and applying them to different services or cost objects. © 2016 Pearson Education, Inc.

How Do Just-In-Time Management Systems Work?
A just-in-time management system reduces inventory costs. Raw materials and finished goods are completed just in time for delivery to customers. The cost of buying, storing, and moving inventory can be significant for companies. The cost of buying, storing, and moving inventory can be significant for companies. To reduce inventory costs, many companies use a just-in-time management systems. Companies with JIT management systems buy raw materials and complete finished goods just in time for delivery to customers. This means that inventory levels are low. A customer order triggers the purchase of raw materials and the completion of the product. © 2016 Pearson Education, Inc.

How Do Just-In-Time Management Systems Work?
Production in JIT management systems is completed in self-contained work cells, as shown in Panel A of Exhibit 19-5. © 2016 Pearson Education, Inc.

Just-in-Time Costing Just-in-time costing is a costing system that simplifies accounting for companies. Tracks costs after the units are completed Combines Raw Materials Inventory and Work-in-Process Inventory into Raw and In-Process Inventory The Conversion Costs account combines direct labor and manufacturing overhead costs. Just-in-time (JIT) costing is a costing system that starts with output completed and then assigns manufacturing costs to the units sold and to inventories. The differences between JIT costing and traditional costing are: (1) journal entries for products when the product is complete, (2) no Work-In-Process Inventory, (3) only two inventory accounts called Raw and In-Process Inventory and Finished Goods Inventory, (4) no separate accounts for direct labor costs and manufacturing overhead costs, and (5) a new account called Conversion Costs that is used to accumulate direct labor costs and manufacturing overhead costs. Raw and In-Process Inventory is a combined account for Raw Materials Inventory and Work-in-Process Inventory used in JIT management systems. The Conversions Costs account is a temporary account used in JIT management systems to accumulate direct labor and manufacturing overhead costs and then allocate the costs as units are completed. © 2016 Pearson Education, Inc.

Just-in-Time Costing Exhibit 9-6 compares traditional costing methods with just-in-time costing in regard to production activity, inventory accounts, and manufacturing cost categories. © 2016 Pearson Education, Inc.

Recording Transactions in JIT
Smart Touch Learning purchased $305,000 of raw materials on account. Next, we will take a look at the journal entries used to record transactions in a just-in-time costing system. You will notice that they are very similar to what we did for the job order costing system. First, let’s look at what happens when raw materials are purchased on account. Raw and In-Process Inventory, an asset account, is increased with a debit, and the liability, Accounts Payable, is increased with a credit. We use a new account, Raw and In-Process Inventory, instead of Raw Materials Inventory. © 2016 Pearson Education, Inc.

Smart Touch Learning incurred $255,000 for labor and overhead. Labor and overhead costs are combined into one account, called Conversion Costs. We credit the accounts involved, such as Wages Payable for wages, Accumulated Depreciation for depreciation, etc. Notice the debit to Conversion Costs instead of Work-In-Process Inventory (direct labor) and Manufacturing Overhead (indirect labor). © 2016 Pearson Education, Inc.

Smart Touch Learning completed 2,000 standard model tablets that it moved to Finished Goods Inventory. The standard cost of each tablet is $276.75, ($ direct materials + $ conversion costs). The standard cost of the tablets is assigned to Finished Goods Inventory. The Raw and In-Process Inventory is credited for the direct materials, $300,000 (2,000 completed standard model tablets × $ standard material cost per tablet). The Conversion Costs account is credited for the direct labor and indirect costs allocated to the finished tablets, $253,500 (2,000 completed standard model tablets × $ standard conversion costs per tablet). The JIT system does not track costs as the tablet moves through manufacturing. Instead, completion of the tablets triggers the accounting system to go back and move costs from Raw and In-Process Inventory (credit), allocate Conversion Costs (debit), and attach those costs to the finished products (debit). © 2016 Pearson Education, Inc.

Smart Touch Learning sold 1,900 tablets on account for $500 each, for a total of $950,000. The cost of goods sold is $525,825 (1,900 tablets × $276.75). The first journal entry shows the sale on account. The second journal entry shows the Cost of the Goods Sold associated with the sale transactions. The Cost of Goods Sold is the standard cost per tablet times the number of units sold ($ × 1,900 tablets). © 2016 Pearson Education, Inc.

Exhibit 19-7 shows Smart Touch Learning’s relevant accounts. Combining the Raw Materials Inventory account with the Work-in-Process Inventory account to form the single Raw and In-Process Inventory account eliminates detail and saves time and cost. © 2016 Pearson Education, Inc.

Adjustment The actual conversion costs incurred were $255,000. The amount of conversion costs allocated was $253,500. The difference is $1,500. The conversion costs are underallocated by $1,500 (actual costs of $255,000 – allocated costs of $253,500). The adjusting entry for underallocated conversion costs is prepared to eliminate the ending balance of $1,500 in the Conversion Costs account. To eliminate the debit balance in Conversion Costs of $1,500, we have to credit Conversion Costs for $1,500. The amount underallocated is transferred to Cost of Goods Sold using a debit. © 2016 Pearson Education, Inc.

How Do Companies Manage Quality Using a Quality Management System?
A system that help managers improve the business’s performance by providing quality products and services is called a quality management system. The goals of quality management systems are to: Improve performance Increase customer satisfaction Increase profits A quality management system is a system that helps managers improve the business’s performance by providing quality products and services. There are many quality management systems available. The common factor in all quality management systems is the desire to improve performance, which should result in increased customer satisfaction and increased profits. © 2016 Pearson Education, Inc.

The Four Types of Quality Costs
Prevention costs: Costs incurred to avoid poor-quality goods or services. Appraisal costs: Costs incurred to detect poor-quality materials, goods, or services. Internal failure costs: Costs incurred to correct goods or services before delivery to customers. External failure costs: Costs incurred after delivery to the customer has occurred. Four types of quality costs are considered in quality management systems. It is less expensive to emphasize prevention costs and appraisal costs than to deal with internal failure costs and external failure costs. Prevention costs are incurred to avoid poor-quality goods or services. Appraisal costs are incurred to detect poor-quality materials, goods, or services. Internal failure costs are incurred to detect and correct poor-quality goods or services before delivery. External failure costs are incurred after the goods or services are delivered to the customer. External failure costs are the most costly quality costs due to warranty costs, returned sales, and lost future sales. © 2016 Pearson Education, Inc.

The Four Types of Quality Costs
Exhibit 19-9 provides examples of the four types of quality costs. Most prevention, appraisal, and internal failure costs ultimately become part of the cost of the finished product. External failure causes an increase in customer service costs, or it could cause lost sales due to unhappy customers. External failure costs ultimately affect warranty expense claims or, worse, potential lawsuit liability exposure. © 2016 Pearson Education, Inc.

Quality Improvement Programs
Smart Touch is considering a quality cost improvement program. Exhibit compares the costs of implementing the quality improvement program to the costs of not undertaking the quality improvement program. The cost of implementation is $1,100,000, compared to $1,200,000 for not implementing the program. Therefore, Smart Touch Learning should implement the quality improvement program to save $100,000. However, quality costs can be hard to measure. For example, it is very hard to measure external failure costs. Lost profits due to unhappy customers do not appear in the accounting records. Therefore, quality management systems use many nonfinancial measures, such as the number of customer complaints and the volume of incoming customer-service phone calls, as means to measure success or failure. © 2016 Pearson Education, Inc.

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