Activity-Based Costing and Other Cost Management Tools

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Chapter 18

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Develop activity-based costs (ABC)

Use activity-based management (ABM) to achieve target costs

Describe a just-in-time (JIT) production system, and record its transactions

Use the four types of quality costs to make decisions

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Develop activity-based costs (ABC)

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More accurate method to attach costs to products

Refines the way indirect costs are allocated to production

Focuses on costs incurred by each production activity

Activity costs become the building blocks for allocating costs to products and services

Each activity has its own cost driver

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Activity-based costing

Divides production process into activities

Assigns costs to products based on how much the product USES those activities

Cost drivers

Activity that drives the cost to being accumulated

Examples

Quality inspections–number of inspections

Warranty Services–number of service calls

Shipping–number of pounds

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Traditional system

Uses a plant-wide manufacturing overhead allocation rate

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ABC system

Uses a separate allocation rate for each activity

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Under traditional system:

The gross profit for specialty DVD is $20 per DVD—five times as high as the $4 gross profit for the Excel DVD

Management may decide to produce more specialty DVDs

Under ABC:

Costs are more accurate

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Day, Corp. is considering the use of activity-based costing. The following information is provided for the production of two product lines:

Day plans to produce 400 units of Product A and 375 units of

Product B.

1. Compute the ABC indirect manufacturing cost per unit for each product.

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Setup = $106,000 / 200 = $530.00 per set-up

Maintenance = $55,000 / 4000 = $13.75 per machine hour

Set-up

Machine

Maintenance

530.00 x 20 =

13.75 x 1,600 =

A

$10,600 530.00 x 180 =

22,000 13.75 x 2,400

B

$95,400

33,000

Divide by # units

Cost per unit

32,600

÷ 400

$81.50

128,400

÷ 325

342.40

1. The indirect manufacturing cost for Product A is:

$81.50

2. The indirect manufacturing cost for Product B is:

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$342.40

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Use activity-based management (ABM) to achieve target costs

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Uses ABC to make decisions

Increase profits while meeting customer needs

Types of decisions:

Pricing and product mix

Provides a more accurate cost of products

Determines the profitability of products

Cutting cost

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Reevaluating activities to reduce costs

Requires cross-functional teams

Marketers—identify customer needs

Engineers—design more efficient products

Accountants—estimate costs

Setting sales prices based on target prices

Targeting what customers are willing to pay

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Cost-based:

Full cost

+ Desired profit

Sales Price

Target based:

Target price

- Desired profit

Target Cost

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Consider all production costs:

Direct materials

Direct labor

Allocated manufacturing overhead

Plus all nonmanufacturing costs (operating expenses):

Administrative

Selling expenses

To determine target costs and target profits.

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Target Cost

Full Cost

Assemble team to:

Cut costs, given current production process

Redesign the production process to further cut costs

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Company decides to redesign setup to reduce the setup cost per batch

Estimated total cost saving is $160,000

Number of batches stay the same

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Revised Cost

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Accel, Corp., makes two products: C and D. The following data have been summarized:

Product C Product D

Direct materials cost per unit

Direct labor cost per unit

Indirect manufacturing cost per unit

$ 700

300

?

$ 2,000

100

?

Indirect manufacturing cost information includes the following:

Activity

Setup

Machine maintenance

Allocation Rate

$1,500/per setup

$ 12/per hour

Product C

38 setups

1,400 hours

Product D

75 setups

4,000 hours

The company plans to manufacture 150 units of each product.

1. Calculate the product cost per unit for Products C and D using activity-based costing.

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Set-up

Machine

Maintenance

Divide by # units

Cost per unit

1,500.00 X 38 =

12.00 X 1,400 =

C D

$57,000 1,500.00 X 75 = $112,500

16,800 12.00 X 4,000 = 48,000

73,800

÷ 150

$492

160,500

÷ 150

1,070.00

Direct materials cost per unit

Direct labor cost per unit

Indirect manufacturing cost per unit

Product cost per unit

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Product C

$ 700

300

492

$ 1,492

Product D

$ 2,000

100

1,070

$ 3,170

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In Short Exercise 18-5, Accel Corp. desires a 25% target profit after covering all costs.

1. Considering the total costs assigned to the Products C and D in S18-5, what would Accel have to charge the customer to achieve that profit?

Direct materials cost per unit

Direct labor cost per unit

Indirect manufacturing cost per unit

Product cost per unit

Product C

$ 700

300

492

$ 1,492

Product D

$ 2,000

100

1,070

$ 3,170

Total costs divided by (100% - target profit) =

$1,492 ÷ 0.75 =

$ 1,989.33

Total costs divided by (100% - target profit) =

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$3,170 ÷ 0.75 =

$ 4,226.67

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Describe a just-in-time (JIT) production system, and record its transactions

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Materials purchased and goods completed “just in time” for delivery

Deliveries are small and frequent

Suppliers must guarantee a defect rate close to zero

Finished goods inventories are kept to a minimal amount

Reduces company’s cost to store and insure inventory

Minimizes investment the company has in its inventories

Lowers risk of the inventory becoming obsolete or unsalable

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Production completed in work cells

Area where resources are readily available

Employees work in a team without supervision

Goods completed in small batches that are inspected for quality

As completed products move out, suppliers deliver more materials

Traditional systems

Production moves to various departments

Work must be moved, between departments wasting time and money

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Lost sales if materials do not arrive on time or if the materials are of poor-quality

Strong relations with vendors of quality materials essential

Some JIT companies have small inventories of critical materials

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Also called “backflush costing”

Starts with completed products and then assigns manufacturing costs to units sold and inventory

Recording production activity

Inventory accounts

Manufacturing costs

Traditional

Build costs as products move through three inventory accounts

Materials inventory

Work in process

Finished goods

Direct materials

Direct labor

Manufacturing overhead

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Just-in-Time

Record costs when units are completed

Raw and in-process inventory

Finished goods

Direct materials

Conversion costs

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JIT does not use a separate Work in process inventory account

Only two inventory accounts:

Raw and in-process inventory

Finished goods inventory

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Consider the following characteristics of either a JIT production system or a traditional production system.

a.

Products are produced in large batches.

Traditional

b. Large stocks of finished goods protect against lost sales if customer demand is higher than expected.

Traditional

c.

Suppliers make frequent deliveries of small quantities of raw materials.

JIT

d. Employees do a variety of jobs, including maintenance and setups as well as operating machines.

JIT

1. Indicate whether each is characteristic of a JIT production system or a traditional production system.

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Consider the following characteristics of either a JIT production system or a traditional production system.

e.

Machines are grouped into self-contained production cells or production lines.

JIT

f.

Machines are grouped according to function. For example, all cutting machines are located in one area.

Traditional

g. The final operation in the production sequence “pulls” parts from the preceding operation.

JIT

h. Each employee is responsible for inspecting his or her own work.

JIT

i.

Management works with suppliers to ensure defect-free raw materials.

JIT

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Use the four types of quality costs to make decisions

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JIT more vulnerable to production shutdowns

Critical element–defect free direct materials

Solution

Monitor activities to improve quality and eliminate defects and waste

Total Quality Management (TQM)

Goal of continuous improvement

Well-designed products reduce inspections, rework, and warranty claims

Design and build quality into the product

Research & development investments can generate savings in marketing and customer service

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1. Prevention costs—spent to avoid poor-quality goods or services

2. Appraisal costs—spent to detect poor-quality goods or services

3. Internal failure costs—incurred when the company detects and corrects poor-quality goods or services before delivery to customers

4. External failure costs—spent after the company delivers poor-quality goods or services

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Prevention costs occur in the R&D stage of the value chain

Appraisal and internal failure costs occur in production

External failure occurs in customer service or results from lost sales due to an unhappy customer

Prevention much cheaper than external failure

Deciding whether to adopt a new quality program involves comparing costs versus benefits

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How to decide:

Classify each cost into one of the four categories

Total the estimated cost per category

Total estimated cost reductions

Decide whether to undertake or not

Costs versus benefits

Quality costs can be hard to measure:

Measure in nonfinancial terms

Number of customer complaints

Volume of incoming customer-service phone calls

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Sammy, Inc. manufactures motor scooters. Consider each of the following examples of quality costs.

1. Preventive maintenance on machinery.

P

2. Direct materials, direct labor, and manufacturing overhead costs incurred to rework a defective scooter that is detected in-house through inspection.

IF

3. Lost profits from lost sales if company’s reputation was hurt because customers previously purchased a poor-quality scooter.

EF

4. Costs of inspecting raw materials, such as chassis and wheels.

A

1. Indicate which of the following quality cost categories each example represents.

● P Prevention costs ● A Appraisal costs

● IF Internal failure costs ● EF External failure costs

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Sammy, Inc., manufactures motor scooters. Consider each of the following examples of quality costs.

5. Working with suppliers to achieve on-time delivery of defect-free raw materials.

P

6. Cost of warranty repairs on a scooter that malfunctions at customer’s location.

EF

7. Costs of testing durability of vinyl.

A

8. Cost to re-inspect reworked scooters.

IF

1. Indicate which of the following quality cost categories each example represents.

● P Prevention costs ● A Appraisal costs

● IF Internal failure costs ● EF External failure costs

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Activity-based costing (ABC) focuses on activities. The costs of those activities become the building blocks for measuring (allocating) the costs of products and services. The total production process and the related costs are divided among the various production activities.

A cost driver for the activity is identified, and a rate per activity is calculated. The costs are then allocated to individual products based on the amount of products’ USE of each activity.

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Activity-based management (ABM) uses activity-based costs to make decisions that increase profits while meeting customer needs.

Most companies adopt ABC to get better product costs for pricing and product-mix decisions.

However, they often benefit more by cutting costs. Target pricing takes the sales price and subtracts desired profit to determine the target cost of manufacturing.

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ABC and value engineering work together to re-evaluate activities with the goal of reducing manufacturing overhead costs to meet the target cost. By reducing costs, companies can maintain desired profit levels.

Just-in-time (JIT) systems streamline manufacturing and accounting by developing relationships with suppliers, resulting in no need for the company to maintain large supplies of raw materials on hand. Defect-free raw materials arrive JIT to the work cell for production.

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Because of the more efficient production process, the accounting is streamlined to match it. Only two inventory accounts need to be kept—Raw and inprocess inventory and Finished goods inventory.

Labor and overhead are tracked in a temporary account—Conversion costs—where they are allocated to products as they are completed.

The four types of quality related costs are prevention, appraisal, internal failure, and external failure costs. Quality improvement programs that reduce internal and external failure costs by more than the increased cost to prevent or appraise the product are smart total quality management

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Copyright

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Printed in the United States of America.

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