Cost Management in an Automated

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Nov 5, 2013 (3 years and 5 months ago)

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

Chapter 6

Copyright
©

2003 McGraw
-
Hill Ryerson Limited, Canada

6
-
2

The Development of a Single
Company
-
Wide Cost Driver

Traditional cost systems were created when

manufacturing processes were labour intensive.

A single company
-
wide overhead rate,

based on direct labour hours, is used

to allocate overhead to products in

these labour intensive processes.

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6
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3

The Development of a Single
Company
-
Wide Cost Driver

Overhead is allocated to jobs using direct

labour hours. If overhead is $120, how much

overhead is allocated to each job?

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4

The Development of a Single
Company
-
Wide Cost Driver

Overhead Rate = $120
÷

8 direct labour hours

Overhead Rate = $15 per direct labour hour


Job 1 = 2 hours
×

$15 per hour = $30

Job 2 = 6 hours
×

$15 per hour = $90

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6
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5

The Development of a Single
Company
-
Wide Cost Driver

Labour 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.


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6
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6

The Effects of Automation on the
Selection of a Cost Driver

Automation increases

overhead from $120 to $420

and reduces the Job 2 labour

hours from 6 to 1. Allocate

the $420 overhead to the


two jobs using direct labour.

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7

The Effects of Automation on the
Selection of a Cost Driver

Overhead Rate = $420
÷

3 direct labour hours

Overhead Rate = $140 per direct labour hour


Job 1 = 2 hours
×

$140 per hour = $280

Job 2 = 1 hour
×

$140 per hour = $140

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6
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8

Is this reasonable?

Automation benefited Job 2, but Job 1 is

allocated more overhead. Clearly, we need

another cost driver to allocate overhead.

The Effects of Automation on the
Selection of a Cost Driver

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6
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9

Using Activity
-
Based Cost Drivers

Overhead Allocation


Company
-
wide

Overhead

Rate

Activity Based

Costing

Many companies
are using activity
-

based cost drivers
to improve product
costing.

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6
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10

Using Activity
-
Based Cost Drivers

Carver makes vegetable

and 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
$

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6
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11

Using Activity
-
Based Cost Drivers

Allocating Setup Costs Using a

Volume
-
based

Allocation Rate


Overhead per can = $95,040
÷

1,188,000 cans

Overhead per can = $0.08 per can

Vegetable = 954,000 cans
×

$0.08 per can =
$76,320

Tomato = 234,000 cans
×

$0.08 per can =
$18,720


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
$

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©

2003 McGraw
-
Hill Ryerson Limited, Canada

6
-
12

Using Activity
-
Based Cost Drivers

Allocating Setup Costs Using a

Volume
-
based

Allocation Rate

The volume
-
based allocation rate over

costs the high
-
volume product and

under costs the low
-
volume product.

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
$

Copyright
©

2003 McGraw
-
Hill Ryerson Limited, Canada

6
-
13

Using Activity
-
Based Cost Drivers

Allocating Setup Costs Using an

Activity
-
based

Allocation Rate

Overhead per batch = $264

Vegetable = 180 batches
×

$264 per batch
Vegetable =
$47,250

Tomato = 180 batches
×

$264 per batch =
$47,250

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
$

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©

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6
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14

Activity
-
based Cost Drivers Enhance
Relevance

Activity
-
based cost drivers allocate

relevant 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.

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15

Activity
-
Based Costing

A

B

C

Activity
-
based costing (ABC) is a two
-
stage allocation

process that employs a variety of cost drivers.

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16

Activity
-
Based Costing

Activity
-
based costing (ABC) is a
two
-
stage

allocation

process that employs a variety of cost drivers.

Stage 1

Assign costs to pools


according to
activities

that


cause costs to be incurred.

Stage 2

Allocate costs in the

activity pools to products.

The first step is to

identify essential

activities and costs

required to perform

the activities.

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Traditional Two
-
Stage Cost
Allocation

Department 1

Product 1

Department 2

Product 2

Overhead Costs

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Activity
-
Based Cost Allocation

Overhead Costs

Activity

Center 1

Product 1

Product 2

Activity

Center 3

Activity

Center 2

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Types of Production Activities

Overhead costs associated

with each category are pooled together

and allocated to products according to

how those products benefit from

the activities.

Unit
-
Level

Activity

Batch
-
Level

Activity

Product
-
Level

Activity

Facility
-
Level

Activity

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20

Let’s look at an

example from the

Unterman Shirt

Company.

Types of Production Activities

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6
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21

Types of Production Activities

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)

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Types of Production Activities

Unterman decides to implement ABC and

categorizes activities into four activity cost centers.

Unit
-
level

Activities

Batch
-
level

Activities

Product
-
level

Activities

Facility
-
level

Activities

Incurred each time

a shirt is made.

Incurred each time a batch of

shirts(casual or dress)is made.

Supports either dress

or casual shirts.

Benefit the entire process,

not a line of specific shirts.

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Unit
-
level Activity Center

Unterman identifies the following unit
-
level

overhead costs ($1,296,000 of the total $5,730,000):

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Unit
-
level Activity Center

Unterman uses direct labour hours to

allocate the unit
-
level overhead costs.

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25

Batch
-
level Activity Center

Unterman identifies $690,000 in batch
-
level

overhead costs ($690,000 of the total $5,730,000):

Unterman uses number of setups to

allocate the batch
-
level overhead costs.

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Product
-
level Activity Center

Unterman identifies $1,800,000 in product
-
level

overhead costs ($1,800,000 of the total $5,730,000):

Unterman allocates 70% product
-
level costs

to casual shirts and 30% to dress shirts.

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Facility
-
level Activity Center

Unterman identifies $1,944,000 in facility
-
level

overhead costs ($1,944,000 of the total $5,730,000):

Unterman allocates 85% facility
-
level costs

to dress shirts and 15% to casual shirts.

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28

Using the Information

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Using the Information

Traditional costing resulted in
undercosting

the


casual shirt line and

overcosting

the dress shirt line.

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30

Using the Information

Should Unterman

increase the price

of casual shirts?

Should Unterman

reduce

the price

of dress shirts?

Should Unterman

drop

the

casual shirt line?

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6
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31

Using the Information

Target pricing

might be useful.

Determine the price customers will pay for casual

shirts, and then reduce costs so that they may

be produced and sold profitably at that price.

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Using the Information

Unterman must determine if costs are
avoidable

before dropping the casual shirt line.

Facility
-
level overhead costs are usually unavoidable.


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We should consider other

costs such as sales commissions

and research and development

costs before making any of

these decisions.


Using the Information

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34

Total Quality Management

Let’s change gears and

look at another topic.

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Total Quality Management

Quality

Design

Conformance

Quality refers to the degree to which actual products

and services conform to their design specification.

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Costs companies incur to assure quality
conformance may be classified as:



Prevention costs.



Appraisal costs.



Internal failure costs.



External failure costs.

Total Quality Management

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Prevention costs
-
incurred to avoid non
conforming products


Inspection of materials upon delivery


Inspection of production process


Equipment inspection


Employee training

Total Quality Management

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Appraisal costs
-
incurred to identify
nonconforming products that were not
avoided via the prevention cost
expenditures.


Finished goods inspection


Field testing of products

Total Quality Management

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Internal failure costs


defects


discovered before delivery to customers.


Scrap materials


Rework


Reinspection of rework


Lost sales resulting

from late deliveries

Cost

Report

Total Quality Management

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External failure costs


defects


discovered after delivery to customers.


Warranty repairs


Product liability


Marketing costs to

improve product image


Lost sales due to poor

product quality

Total Quality Management

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41

Minimizing Total Quality Costs

Cost of
prevention

and appraisal


Cost of

internal and
external failure

Objective:

Minimize defects while also

minimizing all four quality cost categories.

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Minimizing Total Quality Costs

Total Quality cost

Percent of Products without Defects

Cost per Unit ($)

Internal and

external

failure costs

Prevention and
appraisal costs

0

100

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Unterman Company
Quality Cost Report
For the Year Ended December 31, 2002
Amount
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 prevention

and appraisal in an effort to reduce failure costs?

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6
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44

End of Chapter 6

I’m managing

quality time!