Chapter 4 Activity Based Costing Lean Production and the Costs of Quality 1 Why and How do Companies Refine Their Cost Allocation Systems a Simple Cost Allocation Systems Can Lead to Cost Distortion i Cost Distortion Occurs when some products are overcosted while other products are undercosted by the cost allocation system ii By refining costing systems companies can more equitably assign indirect costs to their individual jobs products or services b Plantwide Overhead Rate Same as Predetermined MOH Rate i Estimate of Total MOH Costs Estimate of Total Amount of Allocation Base ii Same rate used throughout the plant c Departmental Overhead Rates Establishing separate manufacturing overhead rates for each department i Estimate the total MOH costs that will be incurred in each department in the coming year Estimates are known as departmental overhead cost pools ii Select an allocation base for each department and estimate the total amount that will be used during the year 1 Can use different bases for different departments iii Calculate departmental overhead rates the Departmental Allocation Base iv Allocate MOH to each department 1 Total Estimated Departmental Overhead Cost Pool Total Estimated Amount of 1 Departmental Overhead Rate x Actual Amount of Departmental Allocation d Using Activity Based Costing to Allocate Indirect Costs Base Used by Job i Activity Based Costing ABC Focuses on activities rather than departments as the fundamental cost objects Recognizes that each product manufactured may require different types and amounts of activities 1 Company indentifies its primary activities and then estimates the total MOH costs associated with each activity Known as activity cost pools a Determine how much of the total MOH relates to each activity 2 Select an allocation base for each activity and estimate the total amount that will be used during the year 3 Calculate Activity Cost Allocation Rate a Total Estimated Activity Cost Pool Total Estimated Activity Allocation Base the activates 4 Company allocates some MOH from each activity to the individual job that uses a Activity Cost Allocation Rate x Actual Amount of Activity Allocation Base Used by Job ii ABC costs are generally thought to be the most accurate because ABC takes into account 1 the specific resources each product uses and 2 the extent to which they use these resources e Cost Hierarchy i Unit Level Activities Activities and costs incurred for every unit ii Batch Level Activities Activities and costs incurred for every batch regardless of number of units in the batch iii Product Level Activities Activities and costs incurred for a particular product regardless of the number of units or batches of the product produced iv Facility Level Activities Activities and costs incurred no matter how many units batches or products are produced in the plant 2 How do Managers Use the Improved Cost Information a Activity Based Management ABM Using activity based cost information to make decisions that increases profits while satisfying customers needs i Pricing and Product Mix Decisions Reduce prices on products that cost less to make in order to be price competitive or leave the prices but try to increase demand in order to have higher profits 1 Low Volume Products Undercosted Increase Unit Cost 2 High Volume Products Overcosted Decrease Unit Cost ii Cutting Costs Once manager s identify the company s activities and their related costs managers can analyze whether all of the activities are really necessary 1 Value Added Activites Activities for which the customer is willing to pay because these activities add value to the product or service 2 Non Value Added Activites Waste Activities Activities that neither enhance the customer s image of the product or service nor provide a competitive advantage 3 Value Engineering To eliminate all waste in the system by making the company s processes as effective and efficient as possible a Increase value added activities decrease non value added activities iii Routine Planning Control Decisions Use cost of activities to create budgets iv Using ABC Outside of Manufacturing ABC can be used to allocate the cost of operating activities among product lines or service lines to figure out which are most profitable b Passing the Cost Benefit Test i Benefits of ABC ABM are higher for companies in competitive markets ii Benefits of ABC ABM are higher when the risk of cost distortion is high iii Costs of adopting ABC ABM are generally lower when the company has 1 Accounting and information system expertise to develop the system 2 IT such as bar coding optical scanning and web based data collection iv 89 of companies using ABC say it is worth the cost 3 How do Traditional and Lean Production Systems Differ a Traditional Production Systems Push Systems i Once the production schedule for the period has been determined products are pushed through the manufacturing process and then stored in finished goods inventory until sold Traditional systems often keep large inventories of raw materials work in process and finished goods on hand b Lean Production Systems i Manufacturing without waste goal is to eliminate the waste of time and money that accompanies large inventories 1 Adopt a Just In Time philosophy by purchasing materials just in time for production and then completing finished goods just in time for delivery to customers By doing so companies eliminate the waste of storing and unstoring raw materials and finished goods a Production occurs in Self Contained Cells Continuous production without interruptions or work in process inventories b Broad Employee Roles Employees do more than operate a single machine they also conduct maintenance perform setups inspect their own work and operate other machines c Small Batches Produced Just In Time d Shortened Setup Times e Shorted Manufacturing Cycle Times f Emphasis on Quality g Supply Chain Management Exchange of information with suppliers and customers to reduce costs improve quality and speed delivery of goods and services from the company s suppliers through the company itself and on to the company s end customers 4 How do Managers Improve Quality a Total Quality Management Provides customers with superior products and services Each business function in the value chain continually examines its own activities to improve quality and eliminate defects and waste i Cost of Quality Reports Categorize and list the costs incurred by the company related b Cost of
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