GS ACCT 2302 Chapter 19 Cost Management Systems: Activity-Based, Just-in-Time, and Quality Management Systems

Software Department The total estimated overhead costs for the Software Department are given, $20,000. Smart Touch Learning's managers have compiled the following data for the Software Department's total quantity of the allocation base, direct labor costs, for the next year:

1. Calculate predetermined overhead allocation rate. 2. Apply each model's hours x rate to determine Allocated MOH cost. AOH = estimated OH / total qty of OH allocation base = $20K / $31,250 est. direct labor costs = 64%

Single Plantwide Rate (example) The total estimated overhead costs are given, $100,000. To determine the total estimated direct labor cost, multiply the direct labor cost per unit times the estimated number of units. This must be done for both models.

1. Predetermined overhead allocation rate = Total Est. Overhead Costs Total Est. Qty of the OH Alloc Base = $100K / $250K = 40% 2. Next multiply Direct Labor cost x Allocation Rate to get Alloc. MOH cost Standard = $176K x 40% = $70.4K Premium = $74K x 40% = $29.6K Allocated manufacturing overhead cost = $100K

The Four Types of Quality Costs The four types of quality-related costs are: External failure costs ultimately affect warranty expense claims or, worse, potential lawsuit liability exposure. Prevention of poor quality is much cheaper than external failure. Businesses should invest up front in prevention and appraisal costs to reduce internal and external failure costs.

1. Prevention costs: costs incurred to avoid poor-quality goods or services. 2. Appraisal costs: costs incurred to detect poor-quality materials, goods, or services. 3. Internal failure costs: costs incurred when the company corrects poor-quality goods or services before delivery to customers. 4. External failure costs: costs incurred after the company delivers poor-quality goods or services to customers and then has to make things right with the customer.

An activity-based costing system is developed in four steps. (continued) Step 2: Identify the Allocation Base for Each Activity and Estimate the Total Quantity of Each Allocation Base Because there are multiple activities that require different resources, Smart Touch Learning will use a different allocation base for each activity. Estimated units to produce: Standard : 2000 Premium: 500

1. Setup The allocation base for setup is the number of batches. The standard model is normally produced in batches of 50 units. The premium model is normally produced in batches of 25 units. = 40 Standard batches (2000 / 50) = 20 Premium batches (500 / 25) 2. Production The allocation base for production is direct labor hours.Both models require an average of five hours of labor to assemble. = 10K hours for standard model = 2.5K hours for premium model 3. Testing The allocation base for testing is the number of testing operations performed. • The standard model units to have 7,750 tests during the year and • The premium model to have 2,250 tests, for a total of 10,000 tests.

Just-in-Time Costing JIT costing leads many companies to simplify their accounting. Just-in-time costing, also called backflush costing, seems to work backward. There are three major differences between JIT costing and traditional costing, as shown in Exhibit 19-8: 1. JIT costing does not track the cost of products from Raw Materials Inventory to Work-in-Process Inventory to Finished Goods Inventory. Instead, JIT costing waits until the units are completed to record the cost of production.

2. JIT costing combines Raw Materials Inventory and Work-in-Process Inventory accounts into a single account called Raw and In-Process Inventory. 3. Under the JIT philosophy, workers perform many tasks. Most companies using JIT combine direct labor and manufacturing overhead costs into a single account called Conversion Costs. The Conversion Costs account is a temporary account that works just like the Manufacturing Overhead account. Actual conversion costs accumulate as debits in the Conversion Costs account, and allocated conversion costs are credited to the account as units are completed. Accountants adjust any underallocated or overallocated conversion costs to Cost of Goods Sold at the end of the period, just as they do for underallocated or overallocated manufacturing overhead.

Cost Management Decisions Most companies adopt ABC to get more accurate product costs for pricing and product mix decisions. However, they often benefit more by cutting costs.

ABC and value engineering can work together. Value engineering means reevaluating activities to reduce costs while still meeting customer needs. It requires cross-functional teams that include the following: • Marketers to identify customer needs • Engineers to design products that can be produced more efficiently • Production personnel to help improve manufacturing processes • Accountants to estimate costs

An activity-based costing system is developed in four steps. (continued) Step 1: Identify Activities and Estimate Their Total Indirect Costs The first activity is setup. Before a batch of tablets can be manufactured, the machines must be properly calibrated. After the setup activity is complete, the tablets can be produced. Production is the second activity. The third activity is testing the operating system of each tablet. The managers at Smart Touch Learning then looked at the manufacturing overhead costs incurred by these three activities and estimated each activity would incur the following overhead costs during the next year:

Activity | Est. OH Cost Setup | $15K Production | $65K Testing | $20K Total = $100K

Traditional Costing Systems Compared with ABC Systems Let's compare the estimated cost per unit calculated with the three different systems. With each refinement of the costing system, from a single plantwide allocation rate to multiple department allocation rates to activity-based allocation rates, the cost per unit of the standard model increased while the cost per unit of the premium model decreased.

Activity-based costs are more accurate because ABC considers the resources (activities) each product actually uses. Allocating overhead based on labor costs distorted the cost of the premium units. This happened because the laborers working on premium units are paid more due to their advanced skills, which increased the cost of the direct labor on the premium models. However, the higher direct labor cost does not have a direct cause-and-effect relationship on the overhead costs. Other factors, such as the number of batches and the number of tests, do have an effect.

How can Companies use Activity-Based Management to Make Decisions? LO 19.3: Use activity-based management (ABM) to make decisions

Activity-based management (ABM) uses activity-based costs to make decisions that increase profits while meeting customer needs. In this section, we show how Smart Touch Learning can use ABM in making two kinds of decisions: • Pricing and product mix • Cost management

Assume Get Well Hospital wishes to allocate overhead costs to Henry Whitestone, a patient at the hospital. (continued) Assume Henry Whitestone had the following activities performed while at the hospital: Admission : 1 Staff Hour Procedures : 5 Tests Care : 20 nurse-hours

At the end of each patient's stay, the hospital would have an accurate cost of providing health care to the patient. The hospital could then use the costing information to make decisions about prices to charge the patient and also evaluate its activities and look for ways to cut costs. Activity-based management is also useful in other types of service companies, such as accounting firms wanting to know the cost of completing various tax returns, attorneys wanting to know the cost to represent various clients, and cleaning services wanting to know the cost to clean different residential and commercial buildings.

Target pricing considers full product costs in the analysis. Full product costs consider all production costs (direct materials, direct labor, and allocated manufacturing overhead) plus all non-manufacturing costs (operating expenses, such as administrative and selling expenses). Smart Touch Learning desires a 20% net profit margin on its products. What is the company's target full product cost per premium model tablet? The following is the computation: Smart Touch Learning's current full product cost does not meet the target cost.

Because Smart Touch Learning's current full product cost, $513, exceeds the target cost of $480, CEO Sheena Bright can assemble a value engineering team to identify ways to cut costs. This team analyzes each production activity and considers how to do one or both of the following: • Cut costs, given Smart Touch Learning's current production process. • Redesign the production process to further cut costs. If the team can find a way to reduce costs by $33 per unit, the difference between the target cost and the actual cost, the company will make its desired net profit.

Transaction 4 Smart Touch Learning sold 1,900 tablets on account for $500 each, for a total of $950,000. The cost of goods sold is $525,825 (1,900 tablets×$276.75). The journal entries are:

Debit: Accounts Receivable Credit: Sales Revenue Debit: Cost of Goods Sold Credit: Finished Goods Inventory (sometimes 2 separate entries)

Transaction 2 Smart Touch Learning incurred $255,000 for labor and overhead.

Debit: Conversion Costs Credit: Wages Payable, etc.

Transaction 1 Smart Touch Learning purchased $305,000 of raw materials on account.

Debit: Raw & In-Process Inventory Credit: Account Payable

Under the JIT management system, the manufacturer contracts with suppliers to deliversmall quantities of raw materials as needed.

Deliveries are small and frequent, and the suppliers must guarantee a close-to-zero defect rate. Because of the zero defect rate and quick delivery, manufacturers can hold small amounts of raw materials in the warehouse and still be assured they won't run out of raw materials and have to shut down production. Because products are made as ordered, finished goods inventories are • kept to a minimal amount. • This reduces the company's cost to store and insure inventory. • It also allows the company to minimize the resources it has invested in Raw Materials and Finished Goods Inventories. • Lastly, because the inventories are low, the risk of the inventory becoming obsolete or unsalable is very small.

Production in JIT management systems is completed in self-contained work cells, as shown in Panel A of Exhibit 19-7. A work cell is an area where everything needed to complete a manufacturing process is readily available. Each work cell includes the machinery and labor resources to manufacture a product.

Employees work in a team in the work cell and are empowered to complete the work without supervision. Workers complete a small batch of units and are responsible for inspecting for quality throughout the process. As the completed product moves out of the work cell, the suppliers deliver more raw materials to the work cell just in time to keep production moving along.

Quality costs can be hard to measure.

For example, it is very hard to measure external failure costs. Lost profits due to unhappy customers do not appear in the accounting records! Therefore, quality management systems use many nonfinancial measures, such as the number of customer complaints and the volume of incoming customer-service phone calls, as a means to measure success or failure.

Single Plantwide Rate Using a single plantwide rate is the traditional method of allocating manufacturing overhead costs and is the simplest method.

In this method, the company calculates the predetermined overhead allocation rate before the period begins by selecting one allocation base and using the same base to allocate overhead costs to all units.

Pricing and Product Mix Decisions Smart Touch Learning now knows the ABC manufacturing overhead cost per tablet. To determine which products are the most profitable, the company controller recomputes each product's total manufacturing cost and gross profit.

Last year, the manufacturing cost of the standard model tablet was $300 and the item sold for $500. With the decrease in costs, Smart Touch Learning could consider lowering the sales price. With costs of $276.75, to maintain a 40.00% gross profit percentage (which means COGS is 60%), the sales price could drop to $461.25 ($276.75 / 60%). The decrease in sales price could lead to an increase in sales volume.

Multiple Department Rates (example) Smart Touch Learning has determined the expected $100,000 in overhead costs should be split with • $80,000 accumulating in the Assembly Department cost pool and • $20,000 accumulating in the Software Department cost pool.

Management has also analyzed the expected overhead costs and separated them into two cost pools—one for each department. For example, depreciation on machinery used in the Assembly Department is accumulated in that department. The salary of the Software Department supervisor would be accumulated in that department.

Pricing and Product Mix Decisions (cont). Now let's look at the premium model. Based on research conducted by the marketing department, the company expects the premium model to sell for $600.

More accurate cost allocations using ABC indicate that the premium model will be more profitable than originally thought. The increase in gross profit from $192.80 to $207.00 is a difference of $14.20. When multiplied by the expected sales of 500 units, gross profit increases by $7,100 ($14.20 per unit×500 units).

Assembly Department The total estimated overhead costs for the Assembly Department are given, $80,000. The department's total quantity of the allocation base, machine hours, is also given, 20,000 MHr. We have the amounts needed to calculate the predetermined overhead allocation rate.

Note there are two model types. Each with their own # of Machine Hours (MHr.) 1. Calculate predetermined overhead allocation rate. 2. Apply each model's hours x rate to determine Allocated MOH cost.

Target pricing (right column) does just the opposite. Target pricing starts with the sales price that customers are willing to pay and then subtracts the company's desired net profit to determine the target cost, the maximum cost to develop, produce, and deliver the product or service and earn the desired net profit.

Notice that the target cost includes all costs, not just manufacturing costs. Then the company works backward to develop the product at the target cost. The company's goal is to achieve the target cost.

Transaction 3 Smart Touch Learning completed 2,000 standard model tablets that it moved to Finished Goods Inventory. Recall that the standard (expected) cost of each standard model tablet is $276.75, as calculated using ABC ($150.00 direct materials + $126.75 conversion costs). The debit (increase) to Finished Goods Inventory is at standard cost of $553,500 (2,000 completed standard model tablets × $276.75 per tablet).

Raw and In-Process Inventory is credited for the direct materials, $300,000 (2,000 completed standard model tablets × $150.00 standard direct material cost per tablet). Conversion Costs is credited for the direct labor and indirect costs allocated to the finished tablets, $253,500 (2,000 completed standard model tablets×$126.75 standard conversion cost per tablet).

An activity-based costing system is developed in four steps.

Step 1: Identify Activities and Estimate Their Total Indirect Costs Step 2: Identify the Allocation Base for Each Activity and Estimate the Total Quantity of Each Allocation Base Step 3: Compute the Predetermined Overhead Allocation Rate for Each Activity Step 4: Allocate Indirect Costs to the Cost Object

How Can Activity-Based Management Be Used in Service Companies? LO 19.4: Use activity-based management (ABM) in a service company

Step 1: Identify activities and estimate their total indirect costs. Step 2: Identify the allocation base for each activity and estimate the total quantity of each allocation base. Step 3: Compute the predetermined overhead allocation rate for each activity. Step 4: Allocate indirect costs to the cost object.

An activity-based costing system is developed in four steps. Step 1: Identify Activities and Estimate Their Total Indirect Costs Analyzing all the activities required for a product or service forces managers to think about how each activity might be improved—or whether it is necessary at all.

The Smart Touch Learning management team has carefully analyzed the production process. It has determined there are three activities in the production process • setup, • production, and • testing that incur the majority of the manufacturing overhead costs. Therefore, Smart Touch Learning will create three cost pools to accumulate the overhead costs. Cost pools are a collection of costs.

Multiple Department Rates A modification of the overhead allocation method using a single plantwide rate is using multiple predetermined overhead allocation rates that have different allocation bases. This method is more complex, but it may be more accurate.

The allocation process is the same, except now the Manufacturing Overhead is accumulated in multiple cost pools and allocated using multiple allocation bases. Exhibit 19-2 illustrates multiple department rates for manufacturing overhead costs. After careful analysis, Smart Touch Learning has decided that machine usage is the primary cost driver for the Assembly Department. In other words, the company feels there is a direct relationship between the number of hours the machines are used and the amount of overhead costs incurred. Therefore, it has decided to use machine hours for the allocation base for the Assembly Department. Smart Touch Learning has also decided that direct labor costs are the primary cost driver for the Software Department and has decided to use direct labor costs as the allocation base for that department.

How do Just-in-time Management Systems Work? LO 19.5: Describe a just-in-time (JIT) management system and record its transactions

The cost of buying, storing, and moving inventory can be significant for companies. To reduce inventory costs, many companies use a just-in-time (JIT) management system. Companies with JIT management systems buy raw materials and complete finished goods just in time for delivery to customers.

Activity-based management (ABM) focuses on the primary activities the business performs, determines the costs of the activities, and then uses the cost information to make decisions that will lead to improved customer satisfaction and greater profits.

The costs of the activities (rather than the overhead costs of the plant or departments) become the building blocks for allocating indirect costs to products and services.

An activity-based costing system is developed in four steps. (continued) Step 4: Allocate Indirect Costs to the Cost Object The fundamental cost pools of an activity-based costing system are the activities. Now that we have determined the cost of each activity and computed a predetermined overhead allocation rate for each activity, we can use the rates to allocate overhead costs from the cost pools to the units.

The following table shows the allocation of overhead costs and the calculation of overhead cost per unit for each model:

Cost-based pricing (left column) starts with the full product cost, the cost to develop, produce, and deliver the product or service.

The full product cost is added to the desired net profit to determine the sales price.

Assume Get Well Hospital wishes to allocate overhead costs to Henry Whitestone, a patient at the hospital. Get Well Hospital decides to use ABM and decides to allocate overhead on the basis of three activities (admission, procedures, and care).

The hospital has computed the predetermined overhead allocation rates as follows:

An activity-based costing system is developed in four steps. (continued) Step 3: Compute the Predetermined Overhead Allocation Rate for Each Activity The formula to compute the predetermined overhead allocation rate for each activity is the same as the formula used for the other methods.

The process is repeated for each activity. The predetermined overhead allocation rates for Smart Touch Learning are: Formula : Total Est. OH / Total Est. Qty of OH Allocation. Setup: $15K / 60 batches = $250 ea. batch Production: $65K / 12.5K hrs = $5.20 per DLHr Testing: $20K / 10K tests = $2 per test

Under JIT management, customer demand, in the form of a customer's order, triggers manufacturing.

The sales order "pulls" materials, labor, and overhead into production. This "demand-pull" system extends back to the suppliers of raw materials. As noted previously, suppliers make frequent deliveries of defect-free materials just in time for production.

Direct materials costs and direct labor costs can be easily traced to products.

Therefore, direct materials costs and direct labor costs are assigned to products.

How is an Activity-Based Costing System Developed? LO 19.2: Use activity-based costing (ABC) to compute predetermined overhead allocation rates and allocate indirect costs

Today's business environment involves complex production processes and personalization of products to customers' specifications which calls for more refined cost accounting. This is especially important when production includes manufacturing products that require different resources or different amounts of the various resources.

Adjustment You can see from Exhibit 19-9 that conversion costs are underallocated by $1,500 (actual costs of $255,000−allocated costs of $253,500). Underallocated and overallocated Conversion Costs are treated just like underallocated and overallocated Manufacturing Overhead.

Underallocated = Debit Bal. in Conv. Costs T-Account To Correct Debit: to Cost of Goods Sold Credit: Conversion Costs List as Adj (not a transaction) Overallocated =Credit Bal. in Conv. Costs T-Account To Correct Debit : Conversion Costs Credit : Cost of Goods Sold The Conversion Costs account is adjusted so that it has a zero balance, and the amount underallocated is transferred to Cost of Goods Sold, as follows:

Analysis Now that we have computed an estimated cost per unit using two different methods, let's compare the results.

Using a more refined allocation system with multiple allocation rates shows the standard model costs slightly more than originally thought, whereas the premium model costs less than originally thought. The differences may not seem significant, but in today's competitive market, even slight differences can make an impact.

To determine the unit cost of the manufacturing overhead, we divide each product's total manufacturing overhead cost by the associated number of units. We can then add the manufacturing overhead unit cost to the direct materials unit cost and the direct labor unit cost to determine the total unit cost. Because direct labor cost is the single allocation base for all products, Smart Touch Learning allocates far more total dollars of overhead cost to the standard model than to the premium model, $70,400 compared with $29,600. However, total dollars of overhead are spread over more tablets for the standard model, which is why the per unit cost of overhead is less for the standard model than for the premium model, $35.20 compared with $59.20.

Using a single plantwide rate is simple, but it may not be accurate. Using direct labor costs as the allocation base may distort the unit costs of the two models. For example, we know that the premium model requires workers with advanced skills who are paid at a higher rate. The higher labor cost for the premium model resulted in more overhead cost per unit being allocated to that model. Does the fact that the premium model workers earn more result in the premium model using more resources that would cause an increase in overhead costs? In

Total Cost To determine the unit cost of the manufacturing overhead, we divide the total cost by the number of units.

We can then add the manufacturing overhead unit cost to the direct materials and direct labor unit costs to determine the total unit cost.

Using a Quality Management System? LO 19.6: Describe quality management systems (QMS) and use the four types of quality costs to make decisions

We now turn our attention to a third type of management system: quality management systems. To be profitable, companies must provide customers with quality products and services. Poor-quality items cause sales to drop as customers become aware of quality issues. Additionally, defective items must either be repaired or replaced, which increases costs. The combination of decreased revenues and increased costs can be devastating for a business.

An activity is

a task, operation, or procedure such as quality inspection, warranty services, or shipping.

activity-based costing (ABC)

a technique to assign product costs based on links between activities that drive costs and the production of specific products The process of first determining the costs of the activities to then determine the cost of products and services

Manufacturing overhead costs, also called indirect costs, cannot be

cost-effectively traced to products. Because of this manufacturing overhead costs are accumulated in cost pools and then allocated to products.

As you have learned, product costs consist of

direct materials costs, direct labor costs, and manufacturing overhead costs. These costs must be traced to each product manufactured.

Quality Management Systems Quality management systems (QMS) are systems that

help managers improve the business's performance by providing quality products and services. The common factor in all quality management systems is the desire to improve performance, which should result in increased customer satisfaction and increased profits.

Examples of manufacturing overhead costs include

rent, utilities, insurance, and property taxes on the manufacturing facility; depreciation on the manufacturing equipment; indirect labor, such as production supervisors' salaries; and indirect materials, such as glue, thread, or other materials that cannot be cost-effectively traced to products.

Many companies credit JIT management for saving them millions of dollars. But JIT management systems are not without problems. With little or no inventory buffers, JIT management users lose

sales when they cannot get materials on time or when poor-quality materials arrive just in time. There is no way to make up for lost time. As a result, as noted earlier, strong relationships with quality raw materials vendors are very important to successfully implement a JIT management system. Additionally, many JIT management companies still maintain small inventories of critical materials.

The most accurate overhead allocation can be made only when total overhead costs are known—and that is not until

the end of the accounting period. But managers cannot wait that long for product cost information because knowing product cost information helps managers set a sales price for the product. Businesses must, instead, figure out a way to allocate these indirect costs during the accounting period.

Continuous improvement is

the primary goal of quality management systems, and it is monitored in many ways. Well-designed products and production processes reduce inspections, rework, and warranty claims. Investing in research and development (R&D) can generate savings in customer service. World-class companies design and build quality into their products rather than having to inspect and repair later.

Why are managers turning to value engineering? Because it gets results! Companies set sales prices based on target prices

what customers are willing to pay for the product or service. Exhibit 19-6 compares cost-based pricing with target pricing.

In this chapter, we are going to look at three types of systems companies use to manage their businesses:

• Activity-based management systems (ABM) • Just-in-time management systems (JIT) • Quality management systems (QMS) Managers use these systems to accumulate data and make informed decisions. Each system helps businesses be more productive, less costly, and more profitable.

Recording Transactions in JIT As noted previously, JIT does not use a separate Work-in-Process Inventory account. Instead, it uses only two inventory accounts:

• Raw and In-Process Inventory, which combines raw materials with work in process • Finished Goods Inventory This is the key to JIT costing. The system does not track costs as the tablets move through manufacturing. Instead, completion of the tablets triggers the accounting system to go back and move costs from Raw and In-Process Inventory (credit), allocate Conversion Costs (credit), and attach those costs to the finished products (debit).

In this chapter, we look at three different ways that businesses can allocate indirect costs:

• single plantwide rate, • multiple department rates, and • activity-based costing.