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CHAPTER 6

CHAPTER 6. Cost Management in an Automated Business Environment ABC, ABM, and TQM. Chapter Opening. Using technology and productivity. More emphasis on cost measurement and control. Increasingly competitive global business environment. Eliminating nonvalue added activities.

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CHAPTER 6

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  1. CHAPTER 6 Cost Management in an Automated Business Environment ABC, ABM, and TQM

  2. Chapter Opening Using technology andproductivity Moreemphasis on costmeasurement andcontrol Increasinglycompetitive global business environment Eliminating nonvalue addedactivities More emphasis onquality

  3. Learning Objective To explain howactivity-based costingimproves accuracy indetermining the costof productsand services. LO1

  4. The Development of a Single Companywide Cost Driver Traditional cost systems were created whenmanufacturing processes were labor intensive. A single company-wide overhead rate,based on direct labor hours, is usedto allocate overhead to products inthese labor intensive processes.

  5. The Development of a Single Companywide Cost Driver Overhead is allocated to jobs using directlabor hours. If overhead is $120, how muchoverhead is allocated to each job?

  6. The Development of a Single Companywide Cost Driver Overhead Rate = $120 ÷ 8 direct labor hours Overhead Rate = $15 per direct labor hour Job 1 = 2 hours × $15 per hour = $30 Job 2 = 6 hours × $15 per hour = $90

  7. Labor 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. The Development of a Single Companywide Cost Driver

  8. Automation increasesoverhead from $120 to $420and reduces the Job 2 laborhours from 6 to 1. Allocatethe $420 overhead to the two jobs using direct labor. The Effects of Automation on the Selection of a Cost Driver

  9. The Effects of Automation on the Selection of a Cost Driver Overhead Rate = $420 ÷ 3 direct labor hours Overhead Rate = $140 per direct labor hour Job 1 = 2 hours × $140 per hour = $280 Job 2 = 1 hour × $140 per hour = $140

  10. The Effects of Automation on the Selection of a Cost Driver Is this reasonable? Automation benefited Job 2, but Job 1 isallocated more overhead. Clearly, we needanother cost driver to allocate overhead.

  11. Activity-Based Cost Drivers Many companies are using activity- based cost drivers to improve product costing. Activity Based Costing Level of Complexity Companywide Overhead Rate Overhead Allocation

  12. SOUP Activity-Based Cost Drivers Carver makes vegetableand tomato soup.

  13. SOUP Activity-Based Cost Drivers Allocating setup costs using a volume-basedallocation rate (number of cans) Overhead per can = $95,040 ÷ 1,188,000 cansOverhead per can = $0.08 per can Vegetable = 954,000 cans × $0.08 per can =$76,320Tomato = 234,000 cans × $0.08 per can =$18,720

  14. SOUP Activity-Based Cost Drivers Allocating setup costs using a volume-basedallocation rate (number of cans) The volume-based allocation rate overcosts the high-volume product (Vegetable @$76,320)and undercosts the low-volume product (Tomato @$18,720) .

  15. SOUP Activity-Based Cost Drivers Allocating setup costs using an activity-basedallocation rate (number of setups). Overhead per setup = $264 Vegetable = 180 setups × $264 per setup =$47,520 Tomato = 180 setups × $264 per setup =$47,520

  16. SOUP Activity-based Cost Drivers Enhance Relevance Activity-based cost drivers allocaterelevant costs ($264 per batch setup)to appropriate products. $47,520 is the cost avoided if Carver ceases production of either product, or if the setup function is outsourced.

  17. Learning Objective To identify costcenters and costdrivers in anactivity-basedcost system. LO2

  18. A C B Activity-Based Costing Activity-based costing (ABC) is a two-stage allocationprocess that employs a variety of cost drivers.

  19. Activity-Based Costing The first step is toidentify essentialactivities and costsrequired to performthe activities. Stage 1Assign costs to pools according to activities that cause costs to be incurred. Stage 2Allocate costs in the activity pools to products. Activity-based costing (ABC) is a two-stage allocationprocess that employs a variety of cost drivers.

  20. Department 1 Department 2 Traditional Two-StageCost Allocation Overhead Costs Product 1 Product 2

  21. Activity-Based Cost Allocation Overhead Costs ActivityCenter 1 ActivityCenter 2 ActivityCenter 3 Product 1 Product 2

  22. Unit-Level Activity Batch-Level Activity Overhead costs associatedwith each category are pooled togetherand allocated to products according tohow those products benefit fromthe activities. Product-Level Activity Facility-Level Activity Types of Production Activities

  23. Let’s look at anexample from theUnterman ShirtCompany. Types of Production Activities

  24. Types of Production Activities Unterman Shirt Company Overhead Rate = $5,730,000 ÷ 800,000 shirts = $7.16 per shirt (Rounded)

  25. Incurred each timea shirt is made. Incurred each time a batch ofshirts (casual or dress) is made. Supports either dressor casual shirts. Benefits the entire process,not a line of specific shirts. Types of Production Activities Unterman decides to implement ABC andcategorizes activities into four activity cost centers. Unit-levelActivities Batch-levelActivities Product-levelActivities Facility-levelActivities

  26. Unit-level Activity Center Unterman identifies the following unit-leveloverhead costs ($1,296,000 of the total $5,730,000):

  27. Unit-level Activity Center Unterman uses direct labor hours toallocate the unit-level overhead costs.

  28. Batch-level Activity Center Unterman identifies $690,000 in batch-leveloverhead costs ($690,000 of the total $5,730,000): Unterman uses number of setups toallocate the batch-level overhead costs.

  29. Product-level Activity Center Unterman identifies $1,800,000 in product-leveloverhead costs ($1,800,000 of the total $5,730,000): Unterman allocates 30% of product-level coststo dress shirts and 70% to casual shirts.

  30. Facility-level Activity Center Unterman identifies $1,944,000 in facility-leveloverhead costs ($1,944,000 of the total $5,730,000). Unterman allocates 85% facility-level coststo dress shirts and 15% to casual shirts.

  31. Learning Objective To use activity-based costing tocalculate costsof products andservices. LO3

  32. Using the Information

  33. Using the Information Traditional costing resulted in undercosting the casual shirt line and overcosting the dress shirt line.

  34. Should Untermandrop thecasual shirt line? Should Untermanincrease the priceof casual shirts? Should Untermanreducethe priceof dress shirts? Using the Information

  35. Using the Information Target pricing might be useful. Determine the price customers will pay for casualshirts, and then reduce costs so that they maybe produced and sold profitably at that price.

  36. Using the Information Unterman must determine if costs are avoidablebefore dropping the casual shirt line. Facility-level overhead costs are usually unavoidable.

  37. Downstream Costs and Upstream Costs We should consider othercosts such as sales commissionsand research and developmentcosts before making any ofthese decisions.

  38. Employee Attitudes andthe Availability of Data • ABC implementation may lead to cost-cutting measures that result in job losses. • Loss of jobs will impact . . . • Employees’ personal lives • Morale of retained employees • It may be difficult to get employ cooperationfor successful implementation under these conditions.

  39. Learning Objective To identify thecomponents ofquality costs. LO4

  40. Design Conformance Quality Total Quality Management Quality refers to the degree to which actual productsand services conform to their design specifications.

  41. Total Quality Management Costs that companies incur to assure quality conformance may be classified as: • Prevention costs • Appraisal costs • Internal failure costs • External failure costs

  42. Cost ofinternal and external failure Cost of preventionand appraisal Minimizing Total Quality Costs Objective:Minimize defects while alsominimizing all four quality cost categories.

  43. Minimizing Total Quality Costs Total Quality cost Failure cost Cost per Unit ($) Voluntary costs (Prevention and Appraisal) 0 100 Percent of Products without Defects

  44. Learning Objective To prepare andinterpret qualitycost reports. LO5

  45. Quality Cost Reports How do the costs differ from 2007 to 2008? Should Unterman spend more on preventionand appraisal in an effort to reduce failure costs?

  46. End of Chapter 6

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