Chapter 14: Activity-based costing, JIT, quality and lean

A single overhead rate based on labour can badly distort product costs when products use resources very differently. This chapter shows more refined ways to allocate overhead, from departmental rates to activity-based costing (ABC), and how managers use the resulting costs (activity-based management). It then covers just-in-time production and costing and the four types of quality costs. The case class on Toyota adds the philosophy behind it all: lean management.

Assigning direct costs and allocating overhead

Direct materials and direct labour are traced to products; manufacturing overhead must be allocated. Smart Touch Learning adds a premium tablet to its standard model and expects:

Total manufacturing overhead is $100,000.

Single plantwide rate. The traditional and simplest approach uses one allocation base for all overhead. Estimated direct labour cost = 2,000 × 88 + 500 × 148 = $250,000, so the rate is 100,000 / 250,000 = 40% of direct labour cost. Overhead per unit: standard 88 × 40% = $35.20, premium 148 × 40% = $59.20. Total unit cost: standard 150 + 88 + 35.20 = $273.20; premium 200 + 148 + 59.20 = $407.20.

Multiple department rates. If departments work differently, each gets its own rate and base. The Assembly Department has $60,000 overhead and 20,000 machine hours: $3.00 per machine hour. The Software Department has $40,000 overhead and $31,250 of direct labour: 128% of direct labour cost. The refined system shows that the standard model costs slightly more and the premium model less than the single rate suggested.

Activity-based costing

Activity-based costing (ABC) uses the costs of activities as building blocks to allocate indirect costs. Activity-based management (ABM) focuses on the primary activities of the business and uses those cost data to make decisions that raise profits. Typical activities and their allocation bases (cost drivers):

Four steps:

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

With ABC the standard model costs 150 + 88 + 30.80 = $268.80 and the premium model 200 + 148 + 76.80 = $424.80. The plantwide rate overcosted the standard model and undercosted the premium model, which uses many more setups and tests per unit. This is the typical pattern: traditional volume-based rates shift costs from complex, low-volume products to simple, high-volume products.

Using ABC: activity-based management

• Pricing and product mix. With better costs, managers can check whether prices are right and which products earn the most gross profit. At a price of $500 the standard model earns 500 − 268.80 = $231.20 per unit; at $600 the premium model earns 600 − 424.80 = $175.20. With limited capacity the product with the highest gross profit per unit of the scarce resource should get priority.
• Cost management. Value engineering re-evaluates activities to reduce costs while still meeting customer needs, usually with cross-functional teams of marketers, engineers, production staff and accountants.
• Target pricing starts from the market: the target price is what customers are willing to pay; the target cost is the maximum full cost (develop, produce and deliver) that still earns the desired profit: target cost = target price − desired profit. Cost-based pricing works the other way round: full product cost + desired profit = sales price.
• ABM also works in service companies: a hospital can allocate overhead to a patient by activities such as room use, meals and lab tests.

Just-in-time management and costing

A just-in-time (JIT) system produces just in time for customer demand: raw materials arrive just when needed and products are finished just in time to be delivered. Buying, storing and moving inventory is expensive, so JIT keeps inventories as low as possible. Traditional production pushes large batches through the plant and builds inventory; JIT pulls production through when there is demand.

Just-in-time costing simplifies the books. Costs are recorded when units are completed rather than as they move through production; raw materials and WIP are combined into one account, Raw and in-process inventory; direct labour and overhead are combined into one account, Conversion costs. Smart Touch Learning completes 2,000 standard tablets at a standard cost of $268.80 each (150 materials + 118.80 conversion), so $237,600 of conversion costs is allocated; 1,900 are sold, so cost of goods sold is 1,900 × 268.80 = $510,720. Actual conversion costs of $239,200 exceed the allocated amount by $1,600, which is added to cost of goods sold.

Quality management systems

A quality management system (QMS) helps managers deliver quality products and services, to improve performance, customer satisfaction and profits. Quality costs fall into four types:

Spending more on prevention usually saves much more on failure costs. In the exercise Mariella spends $109,000 on design engineering (prevention); the predicted savings on inspection, defects and lost profits total $121,085, a net benefit of $12,085. Some quality costs, such as lost profits, do not appear in the accounts, so companies also use nonfinancial measures such as the number of complaints.

Case: Toyota and lean management

Lean management is a systematic method to minimise waste in a production system without sacrificing productivity. It grew out of the Toyota Production System (TPS), associated with Taiichi Ohno. Lean organisations use activity-based management, JIT and quality management, and they look at the company as a set of processes, so process costing fits them well.

The five principles of lean:

1. Value: define what is valuable from the customer's point of view.
2. Value stream: map all steps and eliminate those that add no value.
3. Flow: let the remaining steps run smoothly without interruption.
4. Pull: produce only what the customer asks for (pull instead of push), reducing inventory.
5. Perfection: keep improving by removing waste.

The seven types of waste (muda): overproduction, waiting, unnecessary transport, extra processing (more work or quality than the customer wants), excess inventory, unnecessary motion of people and defects. Lean tools: 5S (sort, set in order, shine, standardize, sustain), kaizen (continuous improvement in small steps), kanban (a visual signal system that pulls work through the process) and value stream mapping. Benefits: higher efficiency, lower costs, better quality, more satisfied customers and engaged employees. Toyota, Amazon, Nike and Intel are examples. Implementation: assess processes, train employees, start small, measure and improve, scale up.