Activity Based Costing, Lean Production, and Costs of Quality

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Chapter 4

• Activity Based Costing, Lean Production, and
  Costs of Quality

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Plantwide Overhead vs. Departmental Overhead

• Plantwide Overhead use one overhead rate for
  entire factory. May result in cost distortion
  for companies producing multiple products or
  services.
• Departmental Overhead each department within
  the factory has an overhead rate. Overhead is
  allocated to job by department. Use the same 4
  steps described in chapter 3 for each department
  to allocate overhead.

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Activity-Based Costing (ABC)

• Activity-Based Costing (ABC) is a costing method
  which attempts to provide a more accurate
  assessment of the cost of products or services
  provided.
• Difference between ABC and departmental overhead
  allocation is that ABC allocates overhead by
  activities performed to make a product or provide
  a service.

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Activity-Based Costing (ABC)

• In Activity-Based Costing, some non-manufacturing
  costs as well as manufacturing costs may be
  assigned to a product
• Activity-Based Costing is generally used as a
  supplement to a companys official (GAAP) costing
  system and is primarily used for internal
  decision making and management purposes

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Steps to Allocate Overhead Using Activity-Based
Costing

• Step 1 Identify primary activities and estimate
  overhead costs for each activity. Overhead costs
  are accumulated in activity cost pools.
• Step 2 Select an allocation base for each
  activity and estimate the total amount of the
  allocation base to be used for the year.

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Steps to Allocate Overhead Using Activity-Based
Costing (cont)

• Step 3 Calculate activity cost allocation rates
  for each activity as follows
• Total estimated activity cost pool amounts
• Total estimated activity allocation base
• Step 4 Allocate overhead for each activity to
  individual jobs as follows
• Activity cost allocation rate x Actual amount
  of allocation base used by job

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Types of Activities

1. Unit-Level performed each time a unit is
   produced. (ex workers performing a task on an
   assembly line)
2. Batch-Level performed each time a batch of
   goods or materials is handled or processed.
   (Ex-receiving of goods, handling of materials
   used to make goods, shipping) Costs are based on
   the number of batches processed rather than units
   produced.

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Types of Activities (continued)

• 3. Product-level incurred to support entire
  product line regardless of number of units
  produced (ex- advertising of product, designing
  product)
• 4. Facility-level activities and costs that keep
  the facility running (ex- depreciation of
  building, insurance, maintenance of production
  plant)

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Activity-Based Costing and Management Goals

• Better overhead cost allocation
• Improved pricing on products based on better
  cost information
• Eliminate or minimize unnecessary costs and
  non-value-added activities
• Enhance company performance and profits

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Value-Added vs. Non-Value-Added

• Value-Added Activities
• Set of activities that increase the value of the
  product or service to the customer.
• B. Non-Value Added Activities
• Activities that could be eliminated without
  effecting quality of product or service.

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Traditional Manufacturing Environment

• Generally make product prior to customer orders
• Carry inventory levels of materials and finished
  goods as buffer
• Production process moves from area to area

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Lean Production (Just-in-time) Manufacturing
Environment

• Product made just-in-time to meet customer
  demand
• Carry little or no inventory of materials or
  finished goods
• Production generally completed in one area or
  self-contained manufacturing cells
• Reduce non-value added activities and costs
  costs that do not provide more value for the
  customer

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Lean Production Management System

• 1. Materials purchased and goods made only as
  needed (smaller orders) reliable suppliers
• 2. Uniform production rate less delays and
  fluctuations
• 3. High quality limits defective units
• 4. Multi-skilled workers reduces bottlenecks,
  more flexible
• 5. Reduced non-value added costs such as storage,
  wait time and moving time

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The Costs of Quality

• Four general categories of quality costs
• Prevention costs
• Appraisal costs
• Internal failure costs
• External failure costs

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The Costs of Quality

• Prevention Costs
• Costs incurred to prevent product failure from
  occurring
• Incurred early in the value chain and include
  design and engineering as well as training,
  supervision, and the costs of quality improvement
  projects

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The Costs of Quality
Appraisal or Detection costs (incurred before
product reaches customer)

• Inspection costs
• Isolating defective products
• Testing Costs during manufacturing process
• Testing Costs final product

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The Costs of Quality

• Internal Failure Costs (incurred before product
  reaches customer)
• Incurred once the product is produced and then
  determined to be defective, but before it is sold
  to customers.
• Includes the material, labor, and other
  manufacturing costs incurred in reworking
  defective products and the costs of scrap and
  spoilage.

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The Costs of Quality

• External Failure Costs
• Incurred after a defective product is delivered
  to a customer.
• Includes the cost of repairs made under warranty,
  replacement of defective parts, product recalls,
  liability costs arising from legal actions
  against the seller, and eventually lost sales.

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End