CHAPTER
7
Management Accounting
Information In The New
Business Environment
Learning Objective 1
Explain the
fundamentals of
activity-based
costing (ABC) and
activity-based
management (ABM).
Activity-Based Costing (ABC)
A method of attributing costs to
products based on:
 assigning costs of
resources to activities
 assigning costs of
activities to products
Costs
Activities
Products
Unit-Based Costing (UBC)
The traditional method of allocating costs
(manufacturing overhead) to products based on
number of units produced. If only three products are
produced (one of each), then:
$9,000
Overhead
Costs

=
Production
Departments
$3,000
Overhead
per product
Products
Relationship Between
UBC and ABC
Unit-Based Costing
(UBC)
Model of Costs
Activity-Based Costing
(ABC) Hierarchical
Product Cost Model
Costs of
Direct Materials
Costs of
Unit-Level Activities
Costs of
Direct Labor
Costs of
Batch-Level Activities
Variable Manufacturing
Overhead Costs
Costs of
Product Line Activities
Fixed Manufacturing
Overhead Costs
Costs of Facility
Support Activities
ABC—Allocating Resource Costs to
Activities
What is the hierarchical product cost model?
Facility Support Activities
Product
Costs
Product Line Activities
Batch-Level Activities
Unit-Level Activities
ABC—Allocating Resource Costs to
Activities
Facility Support Activities
Product Line Activities
Batch-Level Activities
Unit-Level Activities
 Take place each time a unit is produced
 Packing
 Assembly
 Depreciation
 Maintenance
ABC—Allocating Resource Costs to
Activities
Facility Support Activities
Product Line Activities
Batch-Level Activities
 Number of setups
 Setup hours
 Movements of materials
 Orders for nonstocked items
 Inspections
Unit-Level Activities
ABC—Allocating Resource Costs to
Activities
Facility Support Activities
Product Line Activities
 Engineering and design changes
 Warehousing of product line materials
 Production line dedicated supervisors
 Purchasing
 Receiving and shipping
Batch-Level Activities
Unit-Level Activities
ABC—Allocating Resource Costs to
Activities
Facility Support Activities
 Property taxes
 Plant security
 Landscaping
 Accounting and legal
 General administrative salaries
Product Line Activities
Batch-Level Activities
Unit-Level Activities
Cross-Subsidization
Does a hammer really cost THAT MUCH?
$9,000
Overhead

?
=
Overhead
per
product
If a UBC factory produces only three products (a
hammer, a clock, and a Ferrari) and a hammer incurs
$4 of direct labor and materials, how much will the
hammer cost if manufacturing overhead is allocated
evenly over finished products?
Cross-Subsidization
Does a hammer really cost THAT MUCH?
$9,000
Overhead

$3,000
=
3 Products
1 Hammer =
$3,004 !?
Overhead
per
product
Cross-Subsidization
Does a hammer really cost THAT MUCH?
$9,000
Overhead

=
?
Overhead
per product
Under UBC (unit-based costing), some products may be
inappropriately assigned costs that actually belong to
another product line (in this case, the hammer and clock are
obviously cross-subsidizing the Ferrari product line).
What are the Hazards of Allocating
Costs?
Product Cost Distortions
When one product is cross-subsidizing
another, it appears unprofitable to
produce and is often mistakenly
discontinued.
When facility support (common)
activity costs are allocated to
individual product lines, they may
appear unprofitable and are often
mistakenly discontinued.
Hazards of Allocating Costs
Product profitability before overhead allocation:
Hammer
Revenue
Materials
Labor
Profit
$8
2
2
$4
Clock
$20
10
5
$ 5
Ferrari
$100,000
70,000
25,000
$ 5,000
Hazards of Allocating Costs
Product profitability after
overhead allocation:
Hammer
Revenue
Materials
Labor
Overhead
Profit
$
8
2
2
3,000
$(2,996)
Clock
$
20
10
5
3,000
$(2,995)
Ferrari
$100,000
70,000
25,000
3,000
$ 2,000
In actuality, most of the $9,000 manufacturing
overhead is attributable to the Ferrari, revealing it to
be the real money loser.
Hazards of Allocating Costs
In actuality, most of the $9,000
manufacturing overhead is attributable to
the Ferrari, revealing it to be the real money
loser,
BUT because the other products are crosssubsidizing, they appear unprofitable and
will be discontinued from production.
Hammer
Revenue
Materials
Labor
Overhead
Profit
$
8
2
2
3,000
$(2,996)
Clock
$
20
10
5
3,000
$(2,995)
Ferrari
$100,000
70,000
25,000
3,000
$ 2,000
Hazards of Allocating Costs
The result?
Hammer
Revenue
Materials
Labor
Overhead
Profit
Clock
Ferrari
$100,000
70,000
25,000
8,990
$ (3,990)
Activity-Based Management (ABM)
Managing costs, quality, and timeliness of
activities through the identification and use of
Cost Drivers and Performance Measures.
Cost Drivers
Costs
Activities
Performance Measures
Products
Learning Objective 2
Describe total quality
management (TQM) and
costs of quality (COQ).
What is Total Quality
Management (TQM)?
TQM
A management philosophy focused on
increasing profitability by improving the
quality of products and processes and
increasing customer satisfaction, while
promoting the well-being and growth of
employees.
Total Quality
Management (TQM)
The Secret to Success?
The Old Way
Andrew
Carnegie
“Watch the costs
and the profits will
take care of
The New Way
themselves.”
“Watch the Quality
and the profits will
take care of
themselves.”
W. Edward
Deming
Total Quality Management (TQM)
Define SPC—Statistical Process Control
A statistical technique for identifying and
measuring the quality status of a process by
evaluating its output to determine if serious
problems exist in the process.
What are the Four
Costs of Quality (COQ)?
$
Prevention Costs
Appraisal Costs
Internal Failure Costs
External Failure Costs
Define Each Cost of Quality (COQ)
Prevention Costs:
Ensures that processes are performed correctly the first
time and that products and services meet customers’
expectations.
Appraisal Costs:
Inspecting, testing, and sampling activities performed in
order to identify and remove low-quality products and
services from the system.
Internal Failure Costs:
Expenses that occur when low-quality products and
services fail before production and delivery to customers.
External Failure Costs:
Expenses that occur when low-quality products and
services fail after production and delivery to customers.
What is the Effect of Increasing
Prevention and Appraisal Costs of
Quality (COQ)?
Prevention
&
Appraisal
=
Internal Failure
&
External Failure
Costs of Quality (COQ)
Cost in
Millions
Total Costs of Quality
Internal/External Failure Costs
Appraisal & Prevention Costs
4
3
2
1
86%
88%
90%
92%
94%
96%
98%
% production within control limits
Learning Objective 3
Describe how just-in-time (JIT)
management systems
integrate with and extend ABC
and TQM using time-based
performance measures.
What is Just-In-Time (JIT)?
• A management philosophy
that emphasizes removing all
waste of effort, time, and
inventory costs from the
organization.
• Reduces or removes needless
inventory in a production
system.
Just-In-Time (JIT)
 Define Value-Added Activities
Necessary activities in a production or
service process that customers identify
as valuable and for which they are willing
to pay.
 Define Non-Value-Added Activities
Unnecessary activities in a production or
service process that customers typically
do not see or care about and for which
they are unwilling to pay.
The Point Is . . .