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Fundamental Managerial Accounting ConceptsThomas P. Edmonds
Bor-Yi Tsay
Philip R. Olds
Copyright © Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/IrwinMcGraw-Hill/Irwin
Fifth Edition
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CHAPTER 6Cost 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
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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Activity-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
$47,520 is the cost avoided if Carver ceases production of either product,
or if the setup function is outsourced.
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Learning Objective
LO2LO2
Identify costcenters and cost
drivers in anactivity-basedcost system.
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Activity-Based Costing
A
B C
Activity-based costing (ABC) is a two-stage allocationprocess that employs a variety of cost drivers.
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Activity-Based Costing
Activity-based costing (ABC) is a two-stage allocationprocess that employs a variety of cost drivers.
Stage 1Assign costs to pools
according to activities that cause costs to be incurred.
Stage 2Allocate costs in the
activity pools to products.
The first step is toidentify essential
activities and costsrequired to perform
the activities.
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Traditional Two-StageCost Allocation
Product 1 Product 2
Department 1 Department 2
Overhead Costs
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Activity-Based Cost Allocation
Overhead Costs
ActivityCenter 1
Product 1 Product 2
ActivityCenter 3
ActivityCenter 2
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Types of Production Activities
Batch-Level Activity
Product-LevelActivity
Unit-LevelActivity
Facility-LevelActivity
Overhead costs associatedwith each category are pooled togetherand allocated to products according to
how those products benefit fromthe activities.
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Let’s look at anexample from theUnterman Shirt
Company.
Types of Production Activities
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Types of Production Activities
Total
Expected Volume 680,000 120,000 800,000 Total Overhead 5,730,000$
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
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 livesMorale of retained employees
It may be difficult to get employee 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 livesMorale of retained employees
It may be difficult to get employee cooperationfor successful implementation under these conditions.
Employee Attitudes andthe Availability of Data
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Learning Objective
LO4LO4
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
($)
Voluntary costs (Prevention and
Appraisal)
Failure cost
0 100
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Learning Objective
LO5LO5
Prepare andinterpret quality
cost reports.
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Amount Percentage Amount Percentage Prevention Costs 106,000$ 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%
2010 2009
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 2009 to 2010?
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End of Chapter 6
