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Activity Based Costing, Lean Production, and Costs of Quality


Chapter 4 Activity Based Costing, Lean Production, and Costs of Quality ACG 2071 - Spring 2011 * ACG 2071 - Spring 2011 * Plantwide Overhead vs. Departmental Overhead ... – PowerPoint PPT presentation

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Title: Activity Based Costing, Lean Production, and Costs of Quality

Chapter 4
  • Activity Based Costing, Lean Production, and
    Costs of Quality

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
  • 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.

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
  • Difference between ABC and departmental overhead
    allocation is that ABC allocates overhead by
    activities performed to make a product or provide
    a service.

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

Steps to Allocate Overhead Using Activity-Based
  • 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.

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

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

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

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

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.

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

Lean Production (Just-in-time) Manufacturing
  • Product made just-in-time to meet customer
  • 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

Lean Production Management System
  • 1. Materials purchased and goods made only as
    needed (smaller orders) reliable suppliers
  • 2. Uniform production rate less delays and
  • 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

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

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

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

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

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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