CHAPTER 6

Cost Management in an Automated

Business Environment

ABC, ABM, and TQM

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Increasinglycompetitive global

business environment

Eliminatingnonvalue added

activities

More emphasis on

quality

Moreemphasis on costmeasurement and

control

Using technology and

productivity

Chapter Opening

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Learning Objective

LO1LO1

To explain howactivity-based costingimproves accuracy indetermining the cost

of productsand services.

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Traditional cost systems were created whenmanufacturing processes were labor intensive.

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 in

these labor intensive processes.

A single company-wide overhead rate,based on direct labor hours, is usedto allocate overhead to products in

these labor intensive processes.

The Development of a Single Companywide Cost Driver

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Overhead is allocated to jobs using directlabor hours. If overhead is $120, how much

overhead is allocated to each job?

Overhead is allocated to jobs using directlabor hours. If overhead is $120, how much

overhead is allocated to each job?

The Development of a Single Companywide Cost Driver

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Overhead Rate = $120 ÷ 8 direct labor hoursOverhead Rate = $15 per direct labor hour

Job 1 = 2 hours × $15 per hour = $30Job 2 = 6 hours × $15 per hour = $90

The Development of a Single Companywide Cost Driver

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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

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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

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Overhead Rate = $420 ÷ 3 direct labor hoursOverhead Rate = $140 per direct labor hour

Job 1 = 2 hours × $140 per hour = $280Job 2 = 1 hour × $140 per hour = $140

The Effects of Automation on the Selection of a Cost Driver

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Is this reasonable?

Automation benefited Job 2, but Job 1 isallocated more overhead. Clearly, we needanother cost driver to allocate overhead.

The Effects of Automation on the Selection of a Cost Driver

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Level of C

omplexity

Overhead Allocation

Companywide Overhead

Rate

Activity BasedCosting

Many companies are using activity- based cost drivers to improve product

costing.

Activity-Based Cost Drivers

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Activity-Based Cost Drivers

Carver makes vegetableand 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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Activity-Based Cost DriversAllocating setup costs using a volume-based

allocation 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

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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Activity-Based Cost DriversAllocating setup costs using a volume-based

allocation 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) .

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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Activity-Based Cost DriversAllocating setup costs using an activity-based

allocation rate (number of setups).

Overhead per setup = $264

Vegetable = 180 setups × $264 per setup = $47,520

Tomato = 180 setups × $264 per setup = $47,520

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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6-16Activity-based Cost Drivers Enhance Relevance

Activity-based cost drivers allocaterelevant costs ($264 per batch setup)

to appropriate products.

Cost Driver Vegetable Tomato

Volume-based 76,320$ 18,720$

Activity-based 47,520 47,520

Allocation to Product

$47,520 is the cost avoided if Carver ceases production of either product,

or if the setup function is outsourced.

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Learning Objective

LO2LO2

To identify costcenters and cost

drivers in anactivity-basedcost system.

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Activity-Based Costing

A

B C

Activity-based costing (ABC) is a two-stage allocationprocess that employs a variety of cost drivers.

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Activity-Based Costing

Activity-based costing (ABC) is a two-stage allocationprocess that employs a variety of cost drivers.

Stage 1Assign costs to pools

according to activities that cause costs to be incurred.

Stage 2Allocate costs in the

activity pools to products.

The first step is toidentify essential

activities and costsrequired to perform

the activities.

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6-20Traditional Two-StageCost Allocation

Product 1 Product 2

Department 1 Department 2

Overhead Costs

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Activity-Based Cost Allocation

Overhead Costs

ActivityCenter 1

Product 1 Product 2

ActivityCenter 3

ActivityCenter 2

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Types of Production Activities

Batch-Level Activity

Product-LevelActivity

Unit-LevelActivity

Facility-LevelActivity

Overhead costs associatedwith each category are pooled togetherand allocated to products according to

how those products benefit fromthe activities.

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Let’s look at anexample from theUnterman Shirt

Company.

Types of Production Activities

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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 Labor 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 andcategorizes activities into four activity cost centers.

Unit-levelActivities

Batch-levelActivities

Product-levelActivities

Facility-levelActivities

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.

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Unit-level Activity Center

Unterman identifies the following unit-leveloverhead costs ($1,296,000 of the total $5,730,000):

Unterman identifies the following unit-leveloverhead costs ($1,296,000 of the total $5,730,000):

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Unterman uses direct labor hours toUnterman uses direct labor hours toallocate the unit-level overhead costs.allocate the unit-level overhead costs.Unterman uses direct labor hours toUnterman uses direct labor hours to

allocate the unit-level overhead costs.allocate the unit-level overhead costs.

Unit-level Activity Center

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Batch-level Activity Center

Unterman identifies $690,000 in batch-leveloverhead costs ($690,000 of the total $5,730,000):

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.

Unterman uses number of setups toallocate the batch-level overhead costs.

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Product-level Activity Center

Unterman identifies $1,800,000 in product-leveloverhead costs ($1,800,000 of the total $5,730,000):

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.

Unterman allocates 30% of product-level coststo dress shirts and 70% to casual shirts.

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Facility-level Activity Center

Unterman identifies $1,944,000 in facility-leveloverhead costs ($1,944,000 of the total $5,730,000).

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.

Unterman allocates 85% facility-level coststo dress shirts and 15% to casual shirts.

Product Line Dress Casual TotalAllocation Percentage 85% 15% 100%Allocated Overhead Cost 1,652,400$ 291,600$ 1,944,000$ Number of Shirts ÷ 680,000 ÷ 120,000 800,000 Cost Per Shirt = 2.43$ = 2.43$

Allocation of Facility-level Overhead Costs

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Learning Objective

LO3LO3

To use activity-based costing tocalculate costsof products and

services.

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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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Using the Information

Should Untermanincrease the priceof casual shirts?

Should Untermanreduce the priceof dress shirts?

Should Untermandrop the

casual shirt line?

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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.

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Using the Information

Unterman must determine if costs are avoidablebefore dropping the casual shirt line.

Facility-level overhead costs are usually unavoidable.

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We should consider othercosts such as sales commissions

and research and developmentcosts before making any of

these decisions.

Downstream Costs and Upstream Costs

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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.

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.

Employee Attitudes andthe Availability of Data

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Learning Objective

LO4LO4

To identify thecomponents ofquality costs.

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Total Quality Management

Quality

Design Conformance

Quality refers to the degree to which actual productsand services conform to their design specifications.Quality refers to the degree to which actual productsand services conform to their design specifications.

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Costs that 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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Minimizing Total Quality Costs

Cost of prevention

and appraisal

Cost ofinternal and

external failure

Objective: Minimize defects while alsominimizing all four quality cost categories.

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Minimizing Total Quality Costs

Total Quality cost

Percent of Products without Defects

Cos

t pe

r U

nit

($)

Voluntary costs (Prevention and

Appraisal)

Failure cost

0 100

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Learning Objective

LO5LO5

To prepare andinterpret quality

cost reports.

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Amount Percentage Amount Percentage Prevention Costs 106,000$ 13.87% 106,000$ 13.45% Appraisal Costs 150,000 19.63% 60,000 7.61% Internal Failure Costs 298,000 39.01% 182,000 23.10% External Failure Costs 210,000 27.49% 440,000 55.84% Total Quality Costs 764,000$ 100.00% 788,000$ 100.00%

2008 2007

Unterman Shirt CompanyQuality Cost Report

Quality Cost Reports

Should Unterman spend more on preventionand appraisal in an effort to reduce failure costs?

How do the costs differ from 2007 to 2008?

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End of Chapter 6