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Activity-Based Costing, Lean Operations, and the Costs of Quality

Chapter 4

Objective 1

Develop and use departmental overhead rates to allocate indirect costs

Why and How do Companies Refine Their Cost Allocation Systems?

Why refine?

Mismatching resources

Cost distortion

Who can refine?

Manufacturing operations

Service companies and governmental agencies

Plantwide Overhead Rate – example in textbook

Using one predetermined manufacturing overhead rate for all operations

Predetermined MOH rate =

Total estimated manufacturing overhead costs Total estimated amount of the allocation base

Predetermined MOH rate =

$1,000,000 62,500 DL hours

= $16 per DL hour

Plantwide Overhead Rate

Using one predetermined manufacturing overhead rate to allocate MOH to units

Plantwide

Overhead Rate

Actual Use of

Allocation Base

MOH

Allocated to

One Unit

Elliptical

$16 per DL hour

10 DL hours

$160

Treadmill

$16 per DL hour

10 DL hours

$160

Departmental Overhead Rates

Separate predetermined manufacturing overhead rates for each department

Manufacturing Plant with $1,000,000 of total estimated MOH and 2 departments
Machining Department ($400,000 of MOH)	Assembly Department ($600,000 of MOH)
$400,000 ÷ departmental allocation base yields a MOH rate for this department ONLY	$600,000 ÷ departmental allocation base yields a MOH rate for this department ONLY

Departmental Overhead Rates

When to use

Departments incur different amounts and types of MOH

Different jobs or products use the department resources to a different extent

Departmental Overhead Rates – Example on pages 182 - 187

Department	Total Departmental Manufacturing Overhead Costs	Total Departmental Labor Hours	Departmental Overhead Rate
Machining	$400,000	12,500 hrs
Assembly	$600,000	50,000 hrs
TOTAL	$1,000,000

Departmental Overhead Rates – Example on pages 182 - 187

Department	Total Departmental Manufacturing Overhead Costs	Total Departmental Labor Hours	Departmental Overhead Rate
Machining	$400,000	12,500 hrs	$400,000/12,500 = $32/DLH
Assembly	$600,000	50,000 hrs	$600,000/50,000 = $12/DLH
TOTAL	$1,000,000

Departmental Overhead Rates Example - Exhibit 4-8 (p.186) – Ellipticals

Department	Departmental Overhead Rate		Actual Use of Departmental Allocation Base		MOH Allocated to One Elliptical
Machining	$32 per DL hour	×	1 DL hours	=
Assembly	$12 per DL hour	×	9 DL hours	=
	Total

Departmental Overhead Rates Example - Exhibit 4-8 (p.186) – Ellipticals

Department	Departmental Overhead Rate		Actual Use of Departmental Allocation Base		MOH Allocated to One Elliptical
Machining	$32 per DL hour	×	1 DL hours	=	$32
Assembly	$12 per DL hour	×	9 DL hours	=	108
	Total				$140

Departmental Overhead Rates Example - Exhibit 4-9 (p.186) - Treadmills

Department	Departmental Overhead Rate		Actual Use of Departmental Allocation Base		MOH Allocated to OneTreadmill
Machining	$32 per DL hour	×	4DL hours	=
Assembly	$12 per DL hour	×	6DL hours	=
	Total

Departmental Overhead Rates Example - Exhibit 4-9 (p.186) - Treadmills

Department	Departmental Overhead Rate		Actual Use of Departmental Allocation Base		MOH Allocated to OneTreadmill
Machining	$32 per DL hour	×	4DL hours	=	$128
Assembly	$12 per DL hour	×	6DL hours	=	72
	Total				$200

Departmental Overhead Rates Example - Exhibit 4-11 (p.187)

	Plantwide Overhead Rate MOH Allocation (from Exhibit 4-2)	Departmental Overhead Rates MOH Allocation (from Exhibit 4-10)	Amount of Cost Distortion
Elliptical	$ 160	$ 140	$20 overcosted
Treadmill	$ 160	$ 200	$40 undercosted

Now turn to S4-3

S4-3 - Compute Departmental Overhead Rates

What is Gerbig’s plantwide overhead rate?

$3,762,000 manufacturing overhead

17,100 machine hours

= $220 per machine hour

Total estimated manufacturing overhead costs Total estimated amount of the allocation base

S4-3 (cont.)

Calculate the departmental overhead rates for Gerbig’s three production lines. Round all answers to the nearest cent.

Department	Overhead Cost	Machine Hours	Overhead Rate
Potato chips	$2,147,000	11,300 MH
Corn chips	$959,000	2,600 MH
Cheese puffs	$ 656,000	3,200 MH

$190.00

$368.85

$205.00

S4-3 (cont.)

Which products had been overcosted by the plantwide rate? Which products had been undercosted by the plantwide rate?

Plantwide Rate = $220.00 per machine hour

Departmental Rate:

Potato

Chips

= $190.00

Overcosted

Corn Chips

= 368.85

Undercosted

Cheese

Puffs

= 205.00

Overcosted

Objective 2

Develop and use activity-based costing (ABC) to allocate indirect costs

Activity-Based Costing

Allocates indirect costs to production

Focuses on activities and costs of activities

Separate allocation rate for each activity

Manufacturing

Activities

Machine Setup

Materials

Handling

Fabricating

Parts

Supervising

Assembly

Inspecting

Products

Packaging

Products

Activity	MOH Costs for the Activity	Total Activity Cost Pool
Machine Setup	Indirect labor to set up machines	$80,000
Materials Handling	Forklifts, gas, operators’ wages	200,000
Fabricating Parts	Machine lease payments, electricity, repairs	300,000
Supervising Assembly	Production engineers’ labor	150,000
Inspecting	Testing equipment, inspection labor	170,000
Packaging	Packaging equipment	100,000
		$1,000,000

Activity-Based Costing Steps

Step 1: Identify and estimate indirect costs

Activity-Based Costing Steps

Step 2: Select an allocation base for each activity

Activity	Allocation base	Total Cost Pool	Total Estimated Amount of Allocation Base
Machine Setup	Number of setups	$80,000	8,000 setups
Materials Handling	Number of parts moved	200,000	400,000 parts
Fabricating Parts	Machine hours	300,000	12,500 machine hours (MH)
Supervising Assembly	Direct labor hours	150,000	DL hours
Inspecting	Number of inspections	170,000	Inspections
Packaging	Cubic feet packaged	100,000	Cubic feet
		$1,000,000

Activity-Based Costing Steps

Step 3: Compute cost allocation rate for each activity

Activity	Allocation base	Total Cost Pool	Cost Allocation Rate
Machine Set-up	Number of set-ups	$80,000	$80,000 / 8000 = $10 per setup
Materials Handling	Number of parts moved	200,000	200,000/ 400,000 = $0.50 per part
Fabricating Parts	Machine hours	300,000	300,000/ 12,500 = $24 per MH
Supervising Assembly	Direct labor hours	150,000	150,000 / 50,000 = $3 per DLH
Inspecting	Number of inspections	170,000	170,000 / 34,000 = $5 per inspection
Packaging	Cubic feet packaged	100,000	100,000 / 400,000 =$0.25 per cubic foot
		1,000,000

Step 4: Allocate some manufacturing overhead for each activity to the individual jobs that use the activities.

Activity-Based Costing Steps

Info for 1 Elliptical

Activity

Activity Cost

Allocation

Rate

Actual Use of

Activity

Allocation Base (collected

on job)

MOH Allocated

to One

object

Machine Setup

$10 per setup

2 setups

$20

Materials

Handling

$0.50 per part

20 parts

Fabricating

$24 per machine

hour

1 machine hour

Supervising

Assembly

$3 per DL hour

9 DL hours

Inspecting

$5 per inspection

3 inspections

Packaging

$0.25 per cubic

foot

52 cubic feet

Total

$109

Step 4: Allocate some manufacturing overhead for each activity to the individual jobs that use the activities.

Activity-Based Costing Steps

Info for 1 Treadmill

Activity

Activity Cost

Allocation

Rate

Actual Use of

Activity

Allocation Base (collected

on job)

MOH Allocated

to One

object

Machine Setup

$10 per setup

4 setups

$40

Materials

Handling

$0.50 per part

26 parts

Fabricating

$24 per machine

hour

4 machine hour

Supervising

Assembly

$3 per DL hour

6 DL hours

Inspecting

$5 per inspection

6 inspections

Packaging

$0.25 per cubic

foot

60 cubic feet

Total

$212

Examples of Cost Drivers

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

Now turn to E4-36B ABC Example

E4-36B ABC Example

Step 1: Identify each activity and estimate the total indirect costs of each activity.

Material handling $6,400

Machine setup $9,000

Insertion of parts $54,400

Finishing $89,700

E4-36B Example (cont.)

Step 2: Select an allocation base for each activity and estimate the total that will be used during the year.

Activity	Total Est. Cost		Est. Quant. of Cost Allocation Base
Mat. handling	$6,400	÷	3,200 parts
Machine setups	$9,000	÷	25 setups
Insertion of parts	$54,400	÷	3,200 parts
Finishing	$89,700	÷	2,300 hrs

E4-36B Example (cont.)

Step 3. Compute cost allocation rate for each. activity

Activity	Total Est. Cost		Est. Quant. of Cost Allocation Base	Allocation Rate
Mat. handling	$6,400	÷	3,200 parts
Machine setups	9,000	÷	25 setups
Insertion of parts	54,400	÷	3,200 parts
Finishing	89,700	÷	2,300 hrs

$ 2.00/part

$360.00/setup

$17.00/part

$39.00/hr

E4-36B Example (cont.)

Step 4. Allocate some manufacturing overhead from each activity to the individual jobs that use the activities.

Job 420
Material handling	250 parts	$ 2.00	$ 500
Machine setup	3 setups	360.00	1,080
Insertion of parts	250 parts	17.00	4,250
Finishing	130 finishing hours	39.00	5,070
Total			$10,900

E4-36B Example (cont.)

Step 4. Allocate some manufacturing overhead from each activity to the individual jobs that use the activities.

Job 420
Material handling	250 parts	$ 2.00	$ 500
Machine setup	3 setups	360.00	1080
Insertion of parts	250 parts	17.00	4,250
Finishing	130 finishing hours	39.00	5,070
Total			$10,900

Job 510
Material handling	425 parts	$ 2.00	$850
Machine setup	6 setups	360.00	2,160
Insertion of parts	425 parts	17.00	7,225
Finishing	320 finishing hours	39.00	12,480
Total			$22,715

Cost Hierarchy

Now turn to S4-9

S4-9 Classifying Costs Within the Cost Hierarchy

Each container is cut from the mold once the plastic has cooled and hardened.
Patents are obtained for each new type of container mold.
Plastic resins are used as the main direct material for the containers.
A plant manager oversees the entire manufacturing operation.
The sales force incurs travel expenses to attend various trade shows throughout the country to market the containers.

Unit-level

Product-level

Facility-level

S4-9 (cont.)

Each container product line has a product line manager.
The extrusion machine is calibrated for each batch of containers made.
Each type of container has its own unique molds.
Routine maintenance is performed on the extrusion machines
Rent is paid for the building that houses the manufacturing processes.

Facility-level

Product-level

Batch-level

Objective 3

Understand the benefits and limitations of ABC/ABM systems

Activity-Based Management (ABM)

Using ABC information to make decisions

Pricing and product mix

Cost cutting

Planning and control

Pricing and Product Mix Decisions

Change the prices for products after identifying the different total cost

Decide to market the higher profitability product

Shift the product mix away from less-profitable products

Cutting Costs

Analyze costs in value chain

Value-added activities

Non–value-added activities

Value-added vs. non–value-added

Planning and Control Decisions

Uses the costs of activities to create budgets

Compare with actual activities to see if goals are being met

Using ABC Outside of Manufacturing

Merchandising and service: find the most profitable product or service

Manufacturers: allocate operating activities

Sustainability and Refined Costing Systems

Environmental overhead should be allocated to different activities that drive their costs.

Creates better transparency

Cost Benefit Test

Do the benefits of adopting ABC/ABM exceed the costs?

Benefits are higher for companies in competitive markets:

Accurate product cost information is essential

ABM can pinpoint cost savings opportunities

Benefits are higher when risk of cost distortion high:

Many different products, many different types/amounts of resources

High indirect costs

High- and low-volume products

Costs of Adopting ABC

Generally lower with

Accounting and information system expertise to develop the system

Information technology

Are companies glad they adopted ABC?

89% of the companies say that it was worth the cost

Not a cure-all, helps managers understand costs better

Signs the Old System May Be Distorting Costs

Cost system may need repair when

Managers don’t understand costs and profits

Bids are lost when expected to win

Win bids expected to lose

Competitors price similar products much higher or much lower

The cost system may be outdated if there is a diversified product line

Objective 4

Describe lean operations

Traditional Production Systems

Keep large inventories on hand

Problems:

Storage cost

Hide quality

Bottlenecks and obsolete products

Solution: Lean Productions System

Lean Thinking

Philosophy and a business strategy

Primary goal: eliminate waste and cost

Focus of JIT

Purchase raw materials just in time for production

Finish goods just in time for delivery

Lean Production/Just-in-Time

Common characteristics of Just-in-Time (JIT)

Production occurs in self-contained cells

Broad employee roles

Small batches produced just in time – “demand-pull system”

Shortened setup times

Shortened manufacturing cycle times

Emphasis on quality

Supply-chain management

Drawbacks to Lean Production Systems

Vulnerable when problems strike suppliers or distributors

Examples

Delays in delivery

Personnel problems – union strikes

Shortage of parts due to recalled products

Weather related issues

Sustainability and Lean Thinking

Both seek to reduce waste

Lean focus on internal

Green focus on external

Lean and Green

Objective 5

Describe and use the cost of quality framework

Total Quality Management

Goal: Provide customers with superior products and services

Continuous improvement

More investment up front to generate savings in the back end of the value chain

Four Types of Quality Costs

Prevention costs – avoid poor quality goods or services

Employee training

Improved materials

Preventive maintenance

Appraisal costs – detect poor quality goods or services

Inspection throughout production

Inspection of final product

Product testing

Four Types of Quality Costs (cont.)

Internal failure costs – avoid poor quality goods or services before delivery to customers

Production loss caused by downtime

Rejected product units

External failure costs – incurred after defective product is delivered

Lost profits from lost customers

Warranty costs

Service costs at customer sites

Sales returns due to quality problems

Non-Manufacturing Costs of Quality

Service firms and merchandising companies also incur costs of quality

Prevention

Professional training to their staff

Develop standardized service checklists

Appraisal costs

Review work continuously

Inspect before releasing

Cost of Quality Report

Identifies, categorizes, and quantifies all of the costs it incurs relating to quality.

Calculate the percentage of total costs of quality that are incurred in each cost category

Use as a framework for decisions

Prevention Costs

Appraisal Costs

Internal Failure Costs

External Failure Costs

Exhibit 4-27

Now turn to E4-34A

E4-34A

Prevention costs

Training employees in TQM

Training suppliers in TQM

Identifying preferred suppliers who commit to on-time delivery of perfect quality materials

E4-34A (cont.)

Appraisal costs

Strength testing one item from each batch of panels

Avoid inspection of raw materials

Internal failure costs

Avoid rework and spoilage

E4-34 (cont.)

External failure costs

Avoid lost profits from lost sales due to disappointed customers

Avoid warranty costs

E4-34A (cont.)

Costs of Adopting New Quality Program:
Prevention costs:
Training employees in TQM	$ 29,000
Training suppliers in TQM	33,000
Identifying preferred suppliers	59,000
Appraisal costs:
Strength testing	64,000
Savings on inspection of raw materials	(51,000)

E4-34A (cont.)

Quality report (continued from prior slide):
Internal failure costs:
Savings on rework and spoilage	(65,000)
External failure costs:
Savings on formerly lost profits	(92,000)
Savings on warranty costs	(16,000)
Net (Benefit)	($39,000)

End of Chapter 4