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2010 CMA Part 1 Section C Cost Management

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2010 CMA Part 1 Section C
Cost Management
2010 CMA Part 1 Section C Cost Management
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Section C Cost Management
This section is 25% of the Part 1 Exam
This section focuses on the process of determining
how much it costs to produce a product and how to
control this expense.
Major topics include:
Classification of costs
Variable and absorption costing
Process costing and other types of costing methods
Overhead allocation
Service cost allocation
Operational efficiency
Business process performance
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Classification of Costs

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Classifications of Costs
The various costs that a company incurs can be
classified in different ways. These different terms
and classifications are important because they will
be the basis for a number of other topics that will be
discussed later.
These terms may be tested directly (simple
definition or classification) or indirectly (as part of a
larger question).
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Costs Based on the Level of Production
Fixed Costs do not change as the level of
production changes (example, rent) as long as the
production level remains within the relevant range.
Total fixed costs do not change, but the fixed cost per
unit decreases as production increases.
Variable Costs change in total as the level of
production changes (example, labor)
Total variable costs will change, but the variable cost per
unit will not change as production increases, as long as
the production level remains within the relevant range.
Mixed Costs have a component that is fixed and
a component that is variable. May be semi-fixed or
semi-variable.
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Variable Costs
Variable costs are costs that are incurred only
when the company produces something. If the
company produces no units, no variable costs will
be incurred.
Direct material and direct labor are usually variable costs.
As the production level increases, the total amount
of variable costs will increase, but the cost per unit
will remain the same.
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Fixed Costs
A fixed cost is a cost that does not change as the
production level changes, over the relevant range.
The relevant range is the level of production in which
fixed costs do not change.
For example, factory rent is a fixed cost as long as the
production level is within the capacity of the factory.
Once production exceeds the capacity of the factory, a
bigger factory will be needed. The rent cost will increase
in order to cover the increased factory space.
As we will cover, in most situations, fixed costs are
not relevant in the decision making process,
because they do not differ between alternatives.
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Mixed Costs
Mixed costs may be semi-variable costs or semi-
fixed costs.
A semi-variable cost has a fixed component and a
variable component. It has a basic fixed amount that
must be paid regardless of activity, even if there is no
activity. Added to that fixed amount is an amount which
varies with activity. Example: utilities.
A semi-fixed cost is fixed over a given, small range of
activity, and above that level of activity, the cost suddenly
jumps. A semi-fixed cost moves upward in a step
fashion, staying at a certain level over a small range and
then moving to the next level quickly. The range over
which it is fixed is smaller than that for a fixed cost.
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Product (or Inventoriable) Costs
Product costs are the costs of producing the
product.
The costs treated as product costs are inventoried
and carried on the balance sheet until sold. They
are called inventoriable costs.
Product costs include (with examples):
Direct labor (assembly line labor)
Direct materials (components of the product)
Manufacturing overhead
Indirect labor (maintenance costs)
Indirect materials (glues, nails)
Overhead costs (rent, electricity, utilities)
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Classifications of Product Costs
The main types of product costs in the previous
slide can be further combined to create different
cost classifications. The three classifications that
you need to be aware of are listed below:
Prime costs include direct materials and direct labor.
Manufacturing costs include prime costs and
manufacturing costs applied.
Conversion costs are manufacturing overhead and
direct labor. Conversion costs are the costs that are
required to convert the materials into the finished
product.
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Period Costs
Period costs are costs that are not involved in the
production of the product.
Period costs are expensed as they are incurred.
Examples include: general and administrative, legal
fees, marketing, accounting department
It is also possible that a company may choose to
allocate period costs to the production depts.
Period costs must be reported as period costs for
external reporting. However, for internal reporting,
companies may choose to allocate them to units
produced.
This is covered later in the topic Service Cost
Allocation.
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Other Costs and Cost Classifications
Opportunity costs are the contribution to income
that is lost because a different option was selected.
Carrying costs are the costs of carrying a unit of
inventory.
Sunk costs are costs that have already been
spent. Because they have already been spent, they
are not relevant to the decision making process.
Committed costs are costs that have not yet been
spent, but have been promised to be spent
(example, future lease payments that are owed
under an existing lease contract).
Marginal costs are the costs necessary to produce
one more unit.
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Other Costs and Cost Classifications contd
Discretionary costs are costs that do not need to
be spent in the short-term and there will be no
negative impact on the company. If they are not
spent in the long-term, however, the company may
face detrimental results. Training and advertising
are often classified as discretionary costs.
Engineered costs are costs that have a direct
relationship between the activity base and the
incurring of costs.
Imputed costs are costs that are not actually paid
but are necessary for decision making (interest is
often imputed in decision making, even when it is
not actually paid).
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Cost of Goods Sold (COGS)
The costs that were paid in order to produce (or
purchase) the goods that were sold during the
period.
It is calculated as:
Beginning finished goods inventory
+ Purchases (for a reseller) or
+ Cost of goods manufactured (for a
manufacturer)
Ending finished goods inventory
= Cost of goods sold
This ignores goods that are lost or stolen, but is
sufficient for our purposes here.
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Cost of Goods Manufactured (COGM)
This is the cost to manufacture the goods completed
during the period and transferred to finished goods.
For a manufacturing company, this is part of the COGS
formula.
The formula is:
Direct materials used*
+ Direct labor used
+ Manufacturing overhead applied
= Manufacturing Costs Incurred During the Period
+ Beginning work-in-process inventory
Ending work-in-process inventory
= Cost of goods manufactured
* Calculation on next slide
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Direct Materials Used
Direct materials used is calculated as:

Beginning direct materials inventory
+ Purchases
+ Transportation-in
Returns
Ending direct materials inventory
Direct materials used
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Variable and Absorption Costing

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Variable and Absorption Costing
Variable and absorption costing are two methods of
costing that are different in only two ways:
The treatment of fixed factory overhead (such as factory
rent), and
The presentation on the income statement of different
costs.
Variable costing is also called direct costing.
US GAAP requires the use of absorption costing for
the financial statements.
However, many accountants feel that variable
costing is a better tool to use for analysis, and
therefore variable costing is often used internally.
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Fixed Factory Costs
Under variable costing, fixed factory overheads
are treated as a period cost and are expensed as
they are incurred.
Under absorption costing, fixed factory overheads
are allocated to the units that were produced during
the period.
This means that the fixed factory overhead costs will go
first to the balance sheet as inventory and then flow to
the income statement as cost of goods sold as the units
they are attached to are sold
Over the long-term, both methods will provide the
same total net income. The difference between the
methods is a timing difference.
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Effect of Changing Inventory Levels
When inventory increases during the period
(production > sales), the absorption method
provides a higher net income because under the
absorption method, some of the fixed factory
overheads are carried on the balance sheet in
inventory and have not yet been expensed.
When inventory decreases during the period
(production < sales), the absorption method
provides a lower net income because under the
absorption method, all of the current periods fixed
factory overheads are expensed on the income
statement as well as some of the fixed factory
overheads from the previous period.
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Effect of Changing Inventory Levels contd
Note that under absorption costing, a company can
manipulate income by increasing production which
will cause more of the fixed factory overheads to be
on the balance sheet as inventory.
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Presentation Under Absorption Costing
Under absorption costing, the income statement is
broken down into components based on whether
the costs are manufacturing or nonmanufacturing

Sales revenue
COGS (incl. variable and fixed mfg. costs)
= Gross margin
Variable nonmanufacturing costs
Fixed nonmanufacturing costs
= Operating income
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Presentation Under Variable Costing
Under variable costing, the income statement is
broken down based on whether the costs are
variable or fixed

Sales revenue
Variable manufacturing costs
= Manufacturing contribution margin
Variable nonmanufacturing costs
= Contribution margin
Fixed costs (mfg. and nonmanufacturing)
= Operating income
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Variable vs. Absorption Costing
Though absorption costing is required by US
GAAP, variable costing is generally considered to
be better for decision making by management.
Fixed costs are usually not relevant in decision making,
and by excluding them from the cost of production,
companies are able to make better decisions.
Under variable costing, operating income is influenced by
the level of sales only and not based on changes in
inventory levels.
Variance analysis under absorption costing is difficult.
The impact on income of fixed costs is visible under
variable costing, because fixed costs are listed on the
income statement as expenses.
It is easier to calculate contribution for a division or
product when variable costing is used.
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Calculation of the Difference in Income
If there is (1) no beginning inventory, or if (2) the
LIFO inventory cost flow assumption is used and
ending inventory is higher than beginning
inventory, or if (3) under other cost flow assumptions,
the beginning inventory is valued at the same per
unit manufacturing cost as the current years
planned per unit manufacturing cost, the difference
in net income between the variable and absorption
costing methods is:
Fixed overhead cost per unit
Number of units of change in inventory
= Difference in income
Remember, this works only in the above situations.

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Joint Products and Byproducts

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Joint Products
Joint products are two or more products that are
produced sharing the same production process up
to what is called the split-off point.

The joint costs that are incurred prior to the split-off
point need to be allocated between or among the
joint products.

The method that should be used will be given in the
problem.
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Methods of Allocating Joint Costs
The different methods to allocate joint costs are:
Physical-unit method uses weight, volume, the number
of units or other physical measure.
Relative Sales Value method uses relative sales value
of the different products to allocate the joint costs.
Estimated Net Realizable Value (NRV) method uses
the estimated NRV of the different products.
For a product that needs additional processing before it
can be sold, NRV is calculated as the sales price minus the
costs to complete and dispose of the unit.
Constant Gross-Margin percentage NRV allocates
the joint costs so that all of the joint products have the
same gross margin percentage.

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Byproducts
A byproduct is an immaterial product that is
produced as the result of the production of the main
product.
Byproducts are by nature immaterial and are not
intentionally produced.
An example would be sawdust produced by a lumber
mill. One use for sawdust is to bond it with resins and
mold it into furniture parts, containers and various other
products.
Companies that manufacture those products buy the
sawdust from the lumber mill; so the lumber mill can make
a little money from its waste product and also avoid
sending it to a landfill.
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Byproducts contd
Byproducts are usually sold, generating some
amount of revenue.
There are two ways to account for byproducts.
1. Production method. Byproducts are inventoried in a
separate inventory account at their estimated net
realizable value. Inventoried costs allocated to the main
product are reduced by the amount allocated to the
byproduct. When the byproduct is sold, the company
recognizes no revenue or cost of goods sold but simply
debits Cash or A/R and credits Byproduct Inventory.
2. Sale method. All costs are allocated to the main
product (none to the byproduct). When the byproduct is
sold, the company debits Cash or A/R and credits
Revenue for the amount of the sale.
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Process Costing

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Process Costing
Process costing is used in a situation in which the
company produces a product in an assembly line
type of structure.
Within each department, the company must
allocate the costs of that department to the units
produced.
Again, remember that this is a mathematical
allocation in which the costs of the department are
allocated to the units that were produced.
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Types of Costs
In process costing, there are two classification of
costs that are added during the period:
Direct Materials, and
Conversion costs these are the costs of direct labor
and manufacturing overhead that are combined into one
classification (the cost to convert the raw materials into
the finished product).
There is another source of costs that must be
included in the costing process and those are the
costs that are already in the products when they
are transferred into the department.
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Steps in Process Costing
There are seven steps in process costing:
1) Determine the physical flow of goods,
2) Calculate how many units were started and
completed during the period,
3) Determine when materials are added to the
process,
4) Calculate the equivalent units produced for
materials and conversion costs,
5) Calculate the costs incurred during the period for
materials and conversion costs,
6) Calculate the cost per equivalent unit for materials
and conversion costs, and
7) Allocate the costs to EWIP and transferred out
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1. Determine the Physical Flow of Goods
This is not going to be a question on the exam, but
it is a starting point to just determine what
specifically needs to be accounted for.
This equation keeps track of the number of units
during the period.
There are two places the units can come from and
two places that they can be at the end of the
period. This is the basis of the equation.
# units in Beginning Inventory + # of units Transferred In
=
# units in Ending WIP + # of units Completed
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2. Calculate # of Units Started and Completed
This is also not going to be a specific question, but
it will be used in later calculations.
This is the number of units for which 100% of the
work was done during the period. Thus the name,
the number of units that were started and
completed during the period.

The formula for units started and completed is:

# of units Completed # of units in Beginning WIP
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3. Determine When Materials are Added
Again, this is not going to be a specific question,
but it will be used in a later step.
You need to identify if the materials are added at
the start of the process, the end of the process, or
at a specific point during the process.
Materials may be added at the beginning of the process,
at the end, at some point in the middle, or evenly
throughout the process.
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4. Calculate Equivalent Units of Production (EUPs)
This is the basis of Process Costing and it is critical
that you understand this concept and how to
calculate the number of EUPs during the period.
This calculation determines how many units would
have been completed if the company had started
and completed each unit before starting the next.
Usually companies have a number of units that are in the
process at any point in time. This leads to some units
being only partially finished at the end of the period.
In the EUP calculation, 100 units that are 25%
complete will be considered to be 25 equivalent
units.
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4. EUP Calculation contd
There are two methods of calculating the EUPs for
the period. The difference is based on the
assumption that is made regarding the units in
beginning inventory.
Under the FIFO method, it is assumed that all of the units
in beginning inventory were completed during the period
and transferred to the next process.
Therefore, the costs in beginning inventory are automatically
transferred to the next department or to finished goods.
Under the weighted average method, we do not assume
that the units in beginning inventory were finished.
Therefore, the costs and the EUPs in beginning inventory are
considered to have been spent and worked this period.
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4. EUP for Materials and Conversion Costs
There are also two calculations that will be made for
EUPs.
EUP for materials, and
EUP for conversion costs.
If materials are added evenly throughout the
process, the EUPs for materials and conversion
costs are the same.
If materials are added when the process is 50%
complete as to conversion costs and ending WIP is
only 40% complete, then 0% of the materials have
been added to the units in ending WIP. But if ending
WIP is 60% complete, then 100% of the materials
have been added to ending WIP.
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4. EUP Calculation - FIFO
Under FIFO, calculating EUPs involves three steps:
EUP needed to complete beginning WIP
1
+ Number of units started and completed
+ EUP needed to start ending WIP
2

= EUP under the FIFO method

1
the number of units in beginning inventory (1 - % complete)
2
the number of units in ending inventory (% complete)

Remember that this needs to be done for both
materials and conversion costs.
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4. EUP Calculation FIFO Materials
If the materials are added at the beginning of the
process, the EUPs for materials will be equal to
the number of units started during the period.

If the materials are added at the end of the
process, the EUPs for materials will be equal to
the number of units that were completed during
the period (WIP completed + units started and
completed). There will be no EUPs in materials in
ending WIP inventory, since those units have not
reached the end of the process yet.
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4. EUP Calculation Weighted Average
Under the Weighted Average method, the
calculation of EUPs involves two steps:

Number of units completed during the period
+ EUPs needed to start ending WIP
1

= EUPs under the Weighted Average method

1
the number of units in ending inventory (% complete)
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4. EUP Calculation Comments
Over a long period of time, the EUPs under the FIFO
method will equal the actual number of units
completed.
However, over the same period of time, the total
EUPs under the weighted average method will be
larger than the actual number of units completed.
This is because under the weighted average method, the
EUPs in ending inventory each period are included in the
next periods calculation.
For the same period, EUPs under the Weighted
Average method will never be lower than EUPs under
FIFO.
If there is no beginning inventory they will be equal.
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5. Calculation of Costs Incurred
Like the calculation of EUPs, the costs that are
included in the process for the period depends on
the method used.
Under FIFO, the costs that are included are only the
costs that were actually incurred during the period.
Under the Weighted Average method, there are two
costs to be included:
The costs actually incurred during the period, and
The costs that were associated with the units in beginning
inventory.
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6. Cost per EUP
To calculate the cost per equivalent unit, we simply
need to divide the costs for the period by the
number of equivalent units:
Cost for the Period (step #5)
Number of Equivalent Units (step #4)
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7. Allocation of Costs to the Products
Once the cost per EUP is known, it is simply a
process of multiplying the number of equivalent
units in Ending WIP by the cost per EUP.
This calculation needs to be done for both materials and
conversion costs
However, when FIFO is used, do not forget to
include the costs of BWIP along with the allocated
costs in the costs that are transferred out, either to
finished goods or to the next department.
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Spoilage in Process Costing
Spoiled units are units that are in some way
defective and not able to be transferred to the next
department.
Spoiled units are included in the calculation of
EUPs, and the cost per EUP.
Costs are then assigned to the spoiled units based
on the number of EUPs that were in the spoiled
units.
The way the costs allocated to the spoiled units will
be treated depends upon the type of spoilage for
the particular units that were spoiled whether it is
normal or abnormal spoilage.
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Treatment of Costs of Spoiled Units
There are two classifications of spoiled units:
Normal spoilage these are the units that are expected
to spoiled in the production process. The costs assigned
to normal spoilage are transferred to the next
department as part of the costs of the good units
produced.
Abnormal spoilage these are the spoiled units that are
in excess of the level of normal spoilage. The costs
assigned to abnormal spoilage are expensed on the
income statement.
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Additional Classifications of Spoilage
Below are additional terms similar to spoilage:
Shrinkage occurs when a product evaporates or losses
some quantity over time. We account for it like spoilage: if
it is normal it is charged to good units produced. If it is
abnormal it is charged to the income statement.
Rework occurs when spoiled goods are fixed and
prepared for sale. The costs incurred in rework of normally
spoiled goods should be charged to the factory overhead
account and allocated to all good units as part of factory
overhead. Costs incurred in rework of abnormally spoiled
units should be expensed.
Waste is the material that is left over after production is
complete. It is simply unused and is now unusable
materials.

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Overhead Allocation

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Introduction to Overheads
There are two broad classifications of overheads
Manufacturing overheads are necessary for the
production of the goods or services of the company.
Nonmanufacturing overheads are not associated with
the production process.
These are essentially the period costs of the company that
may be expensed as corporate costs or allocated to the
production departments.
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Manufacturing Overhead Allocation
Because there is no direct connection between the
production of a unit and the incurrence of these
costs, the manufacturing overhead costs of the
company must be allocated to the units that are
produced.
No matter what method is being used to do the
allocation, you must remember that we are simply
taking all of the overhead costs and somehow
dividing them amongst the units that were produced
during the period.
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Manufacturing Overhead Allocation continued
The categories of costs included in manufacturing
overhead are:
1. Indirect materials - materials not identifiable with a specific
product or job, such as cleaning supplies, disposable tools,
etc.,
2. Indirect labor - wages not directly attributable to production,
such as the plant superintendent, janitorial services, and
3. General manufacturing overheads - factory rent, electricity
and utilities.
Overheads may be either fixed, variable, or mixed
costs.
Fixed overheads are costs that do not change in total over
the relevant range of activity or production.
Variable overheads are costs that change in total as the
level of production changes.
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Traditional Allocation Method
Under the traditional method, the overhead costs
are allocated to individual products based on one
allocation basis.
The allocation basis is the measure that will be
used to divide the costs amongst the units.
Examples are direct labor hours, machine hours,
kilograms, components
The measure is called the activity base or allocation
basis.
At the start of the period, the company determines
an allocation rate based on the allocation basis.
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Determining the Allocation Basis
The basis that the company uses should be one
that reflects the production costs and the way
overhead costs are actually incurred.
If the company has a very automated process, machine
hours may be the allocation base.
If the production process requires a lot of manual labor,
direct labor hours may be the best allocation base.
If the different products produced vary significantly in the
number of components that go into them, number of
component parts may be the best base.
Usually a company will divide their overhead into
groups (or pools) and have a different basis for
each pool, but under the traditional method, there is
only one allocation base for each pool.
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Predetermined Rate
An estimated rate needs to be used during the
period so that the company will know how much it
costs them to produce their product so that they
can set the appropriate price.
Though this is only an estimate, if the allocation is done
reasonably, the estimate will be very close to the actual
costs.
This predetermined rate will be used throughout the
period to allocate overhead to the units that are
produced.
Any differences between the estimates used and
the actual costs will be adjusted for at the end of
the period.
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Calculating the Predetermined Rate
The predetermined overhead rate is calculated as
follows:
Budgeted Dollar Amount of Manufacturing Overhead
Budgeted Activity Level of the Allocation Base

Both of these amounts are estimates that are made
at the beginning of the period.
These budgeted amounts come from the financial
budget.
The budgeted activity level is also called the
denominator level.
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Determining the Level of Activity to Use
More difficult than the estimated costs, the company
must carefully determine the estimated level of activity.
If the company is too optimistic and estimates that
they will produce a large number of units, the
predetermined rate will be incorrectly low per unit and
their selling price will be too low. They will sell a lot of
units, but not make much money.
If the company is too pessimistic and estimates that
they will produce a small number of units, the
predetermined rate will be incorrectly high per unit and
their price will be too high. They will not sell many
units, but will make a lot of money on each unit they
sell.
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Determining the Level of Activity contd
Four options for the activity level to use in
calculating the predetermined manufacturing
overhead allocation rate:
1) Theoretical, or ideal, capacity the level if the
company produces at its most efficient level.
2) Practical, or currently attainable, capacity the
theoretical level reduced for idle and downtime.
3) Expected actual capacity, or master budget capacity
the level actually expected during the next budget
period based on actual demand.
4) Normal capacity the average level that will be
achieved over 2-3 years, including seasonal and
cyclical changes.
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Determining the Level of Activity contd
At the end of the accounting period, variances that
result from differences between the actual
overhead incurred and the overhead applied must
be resolved as part of the closing activities.
Three ways this can be done:
Prorated among ending work in process, ending finished
goods, and cost of goods sold for the period, or
100% closed out to cost of goods sold, or
Less commonly, all amounts restated using actual cost
allocation rates rather than the budgeted cost application
rates.
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Determining the Level of Activity contd
If 100% of the variances are closed out to cost
of goods sold, the use of master budget capacity
or normal capacity will lead to the highest net
income of these choices.
If variances are prorated among inventories
and cost of goods sold or if the amounts are
restated using actual rates, the choice of the
denominator level for allocating manufacturing
costs during the period will have no effect on the
end-of-period financial statements.
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Allocating the Costs to the Units
Once the predetermined rate has been calculated,
the process of allocating overhead to the units is
relatively simple.
This is done by multiplying the predetermined rate
by a given number of units of the allocation basis
that were either actually used or that were
supposed to be used in the production of each unit.
There are 3 different ways of determining how
many units of the allocation base were used in
each unit, i.e. 3 different costing systems.
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Types of Costing System
The amount of manufacturing overhead allocated
to each unit of product depends upon the costing
system that the company uses.
Standard costing system predetermined overhead
rate is multiplied by the standard number of the
allocation base that should be used in producing one
unit of product.
Normal or extended normal costing system
predetermined overhead rate is multiplied by the actual
number of the allocation base that was used in
producing one unit of product.
Actual costing system actual manufacturing
overhead costs are allocated to the units. This costing
system does not use predetermined rates.
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Comparison of the Three Costing Systems
The following points should be noted when
comparing the three costing systems:
1. All three costing systems record the cost of inventory
based on actual output.
2. Direct labor and direct materials are treated the same
under normal and actual costing.
3. Normal and standard costing use the same overhead
rate.
4. Standard costing is typically used with a flexible budget
system. Standard costing is based on the inputs (i.e.,
direct materials, direct labor and factory overhead) that
should have been used for the actual output produced.

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The Process of Accounting for Overhead
When monies are actually spent for overheads, the
journal entry is
Dr Factory overhead control X
Cr Cash (or accounts payable) X

When the overhead is allocated, the journal entry is
Dr Work-in-process inventory X
Cr Factory overhead control X
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Over and Underapplied Overhead
The factory overhead control account has actual
amounts going into it (debits) and budgeted amounts
coming out and being applied to production (credits).
The difference between these two amounts is the
amount of overhead that was underapplied or
overapplied.
A debit ending balance in the factory overhead
control account means overhead was underapplied
(credits were less than debits).
A credit ending balance in the factory overhead
control account means overhead was overapplied.
(credits were greater than debits).
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Over and Underapplied Overhead contd
This is the difference between the amount of
overhead applied and the actual costs incurred.
The formula to determine this is
Actual costs incurred
Factory overhead applied during the period
= Under (over) applied factory overhead
If it is immaterial, the difference can be cleared to
cost of goods sold.
If it is material, it should be allocated to work-in-
process, finished goods and cost of goods sold.
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Multiple Allocation Bases
It is very unlikely that there will be one allocation
basis for a company that will accurately reflect how
overhead is incurred.
Therefore, most companies will use multiple
allocation bases.
When there are multiple allocation bases, the
process of allocating overhead is exactly the same
as we have done it will just be done a number of
times.
Activity-based costing (covered next) is an example
of the use of multiple allocation bases.
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Activity Based Costing (ABC)
In ABC the allocation bases that are used are
determined by looking at what are the activities that
cause costs to be incurred (called cost drivers).
Examples of these activities are:
Moving the goods from one point in the factory to
another.
A machine breaking.
Performing a quality inspection.
The costs that are associated with each of these
activities are allocated to that activity and a rate
(cost) per activity is calculated in the same way as
the predetermined rate was calculated earlier.
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Activity-Based Costing (ABC) contd
ABC allocates indirect and fixed costs to individual
products or product lines based on the value-added
activities that go into each product.
ABC provides an appropriate allocation of indirect
costs and overhead, compared to traditional
volume-based cost driven systems which
understate the costs per unit of products with low
sales volumes or high degrees of complexity.
ABC is most useful when overhead accounts for
the majority of manufacturing costs.
ABC is frequently used with TOC production
planning.
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Non-value Adding Activities
After all of the activities that cause costs to be
incurred are identified, they can be divided into two
categories:
Value adding activities add value to the end product
that a customer is willing to pay for.
Non-value adding activities cause costs to be incurred
but do not provide anything of value that the customer
would be willing to pay for.
Non-value adding activities should be reduced and
eliminated if possible because this will reduce
costs without the company having to reduce the
selling price (since it has not reduced the value of
the product by reducing or eliminating them).
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Categories of Activities
Another breakdown of the activities is based on
how specific the activity is to a specific unit or to the
factory as a whole:
1. Unit-level activities are performed for each unit
produced examples, hours of work or inspection.
2. Batch-level activities occur each time a batch is
produced examples, machine setup, purchasing,
scheduling, materials handling and batch inspection.
3. Product-sustaining activities are incurred in order to
support the production of a different product from what is
currently produced examples, product design,
engineering changes.
4. Facility-sustaining activities are incurred to support
production in general examples, security, maintenance,
plant management and depreciation of the factory.
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Advantages and Disadvantages of ABC
Some of the advantages of ABC are:
ABC provides a more accurate product cost, which is
useful in pricing and strategic decisions.
By identifying the activities that cause costs to be
incurred, ABC enables management to identify activities
that do not add value to the final product.
Some of the disadvantages of ABC are:
Not everything can be allocated strictly on a cost driver
basis. This is particularly true in respect to facility-
sustaining costs.
It is expensive and time consuming to implement and
maintain.
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ABC Questions
A common form of question is to require you to
calculate the cost per unit under a traditional
method and under ABC.
You need to remember that ABC is exactly the
same as the traditional method in the way you
calculate your answer. What is different is that
under ABC you will need to do the mathematical
process 3 or 4 times instead of just once.
Therefore, the key to an ABC problem is to go
slowly and carefully and not to rush through the
calculations, as a mistake in any one of the
calculations will give you an incorrect answer.
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Job-Order Costing
Job-order costing is used when each item the
company produces is unique and identifiable from
all others.
Examples of companies that use job-order costing
are:
Audit firms, law firms, ship-building companies, and
companies that produce something that is large and/or
hand-made, such as a custom furniture maker.
A job-order costing question is no different from a
standard overhead allocation question.
This is because direct materials and labor are assigned
directly to each project. But, in order to price properly, the
company must allocate overhead to each project.
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Life-Cycle Costing
In life-cycle costing a company does not determine
the production cost in the short-term sense of the
production of one unit.
The company takes a much longer view to the cost of
production and attempts to allocate all of the research
and development, marketing, development, after-sale
service costs and any other cost that is associated with
this product during its entire life cycle.
This longer-term view is of particular importance
when the product has significant R&D costs (or
other nonproduction costs such as after sale
service costs). For the product to be profitable over
its life, these costs also need to be covered by the
sales revenue.
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Life-Cycle Costing contd
Life-cycle costing is different versus costing methods
because it treats pre-production and after-sale costs
as product costs.
Other methods treat these costs as period expenses that
are expensed as incurred.
Under other methods, these pre-production and after-sale
costs are not taken into account to determine the
profitability of a product or product line.
All of the costs in the life cycle of the company can
be broken down into three categories:
1. Upstream costs (before production)
2. Manufacturing costs
3. Downstream costs (after production)
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Service Cost Allocation
If a company chooses to allocate the costs of one
service department (accounting, finance, etc) to
multiple users, there are two methods that can be
used to allocate the costs:
1. Single-rate method: does not separate fixed costs of
the service department from the variable costs. All
costs It puts all of the costs into one cost pool and
allocates the costs using one rate per unit of single
allocation base.
2. Dual-rate method: breaks the cost of each service
department into two pools, a variable cost pool and a
fixed cost pool. It allocates each cost pool using a
different cost allocation base.
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Service Cost Allocation contd
If a company chooses to allocate the costs of
multiple service departments (accounting, finance,
general administration) there are three methods
that can be used to allocate the costs to the
production departments:
1. Direct method,
2. Step method
3. Reciprocal method.
The differences among these methods is how they
treat the services that are provided from one
service department to the other service
departments.
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The Direct Method
Under the Direct method, we ignore any services
that are provided between the service departments.
The costs of the service departments are allocated
directly and only to the production departments.
No service costs are allocated to other service
departments.
The costs of the different service departments may
be allocated to the production departments using
different allocation bases.
The cafeteria costs may be allocated based on number
of people.
The advertising department costs may be allocated
based on level of sales.
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The Step Method
Under the Step method, we take into account some of
the services that are provided to other service
departments.
There must be an order in which we allocate the costs
of the service departments.
A popular way (but not the only way) is to determine
the order according to the percentage of each
departments services that are provided to other service
departments.
The department that provides the highest percentage of
its services to other service departments is allocated first.
The costs of this service department are allocated to the
other service departments and the production
departments
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The Step Method contd

The costs of the service department that provides the
second highest % of its services to other service
departments are then allocated to the remaining service
departments and the production departments.
The costs that are allocated for the second department
include the second service departments share of the
costs allocated to it by the first service department.
No costs are allocated back to the first service
department.
Once a service department has had its costs allocated,
no costs will be allocated to it from other service
departments.
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The Reciprocal Method
Under the Reciprocal method, we recognize all of
the services that are provided to the other service
departments.
This process uses multiple equations, with one
equation for each service department.
When the equations are solved, the answer is the
amount of money that needs to be allocated to all
of the other departments, including the other
service departments.
The reciprocal method is the most theoretically
correct method to use.
However, a company will need to balance the additional
costs required in doing this against the benefits that are
received.
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Estimating Fixed Costs
Sometimes costs are mixed costs or the fixed costs
are not segregated from the variable costs in the
historical information available. When we need to
separate fixed costs from variable costs for
analysis, budgeting or costing purposes, there are
two methods that can be used:
1. The High-Low points method
2. Regression Analysis


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Estimating Fixed Costs Contd
The high-low points method uses the highest and
lowest values of the cost driver within the range of
values. The steps to calculate the fixed costs are:
1. Calculate the Variable Cost Per Unit: divide the difference
between the highest and lowest costs by the difference
between the highest and lowest production volumes:

Difference in Costs/Difference in Units = Variable Cost per Unit

2. Multiply the variable cost per unit by the unit volume at
either the highest or lowest production level to get the
total variable cost at that level.
3. Subtract the total variable cost from the total cost at that
level to get the fixed cost.

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Estimating Fixed Costs Contd
Simple regression analysis can be used to find the
fixed cost and the variable cost per unit when you
have:
an independent variable such as production in units
a dependent variable such as total production costs.
the relationship between the two variables is consistent
refer to the forecasting section of the text book for further
details regarding regression analysis

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Operational Efficiency

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Just-In Time Systems
Just-in-time (JIT) inventory systems are based on a
manufacturing philosophy that combines purchasing,
production and inventory control into one function.
This reduces the level of inventory that is held within
the company at all stages of production, and lowers
the cost of carrying the inventory.
The main idea of JIT is that nothing is produced until
the next process in the assembly line needs it.
JIT is a pull system rather than a push
system. Since nothing is produced until it is
needed, nothing is produced until a customer orders
it.
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Implementing JIT
To implement the JIT approach and minimize
inventory storage, the factory must be reorganized
to permit what is known as lean production
Each worker knows how to operate all machines
and can perform supporting tasks within that cell,
which lessens downtime resulting from breakdowns
or employee absences.

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Implementing JIT contd
Because inventory levels are kept low in a JIT
system, the company must have a relationship with
its suppliers to make certain that they make
frequent deliveries of smaller amounts of inventory.
It is also critical that inventory be of the required quality,
because there are no extras to use in place of defective
units.
Although a cost reduction strategy focused on the
elimination of waste is universally applicable, JIT
implementation is not appropriate for high-mix
manufacturing environments, which often have
thousands of products and dozens of work centers.
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Kanban
Kanban, a Japanese term for visual record, is a
simple parts movement system or an inventory
system in which cards or tickets are used to keep
track of inventory and its movement.
Originally developed at Toyota in the 1960s, Kanban is
part of a JIT system and its purpose is to manage the
flow on a manufacturing assembly line.
At the core of the Kanban concept is that the
supplier delivers components to the production line
on an as needed basis, signaled by receipt of a
card and empty container, eliminating storage in
the production area.
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Kanban contd
This is a chain process where orders flow from one
process to another, so production of components is
pulled to the production line, rather than the pushed
(as is done in the traditional forecast-oriented
system).
It should be mentioned that Kanban can go beyond
being a simple JIT technique because it can also
support industrial reengineering and HR
management.
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Materials Requirements Planning (MRP)
MRP is an approach that uses computer software to
help manage a manufacturing process. It is a system
for ordering and scheduling of dependent demand
inventories.
Dependent demand is demand for items that are
components, or subassemblies, used in the production of
a finished good. The demand for them is dependent upon
the demand for the finished good.
MRP is a push inventory management system.
Finished goods are manufactured for inventory on
the basis of demand forecasts. MRP makes it
possible to have the needed materials available
when they are needed and where they are needed.
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MRP contd
When demand forecasts are made by the sales
group, the MRP software breaks out the finished
products to be produced into the required
components and determines total quantities to be
ordered of each component.
It is also determined when each component should be
ordered, based upon information about inventory of each
component already on hand, vendor lead times and other
parameters that are input into the software.
Once the quantities and the timing have been worked
out, the required cash to pay for the parts can be
planned for. MRP can be used to reduce cash
needed by the organization, which in turn improves
profitability and ROI.
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MRP Calculations
MRP uses the following information in order to
determine what outputs will be necessary at each
stage of production and when to place orders for
each needed component:
1. Demand forecasts for finished goods;
2. A Bill of Materials for each finished product. The Bill of
Materials gives all the materials, components, and
subassemblies that are required for the product;
3. The quantities of the materials, components, and finished
products inventory presently on hand.
Although MRP is done by computers, it is important
to know how the software does its work in order to be
certain that the output from the MRP software is
correct and to troubleshoot problems.
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Outsourcing
When a company outsources, an external company
performs one or some of its internal functions.
By outsourcing certain functions to a specialist,
management can free up resources within the
company in order to focus on the primary
operations of the company.
It may also be cheaper to outsource a function to a
company that specializes in an area than it is to run
and support that function internally.
The disadvantage of outsourcing is that the
company loses direct control over these functions.
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Theory of Constraints
Theory of Constraints says that there are only a few
areas in which changes in one units performance will
bring about a meaningful change in overall profitability.
Those areas where changes can impact overall
profitability are called constraints.
If you want to improve profitability, you need to identify
the constraints and focus on them. Theory of
Constraints focuses on local measurements that are
linked directly to performance measures such as net
profit, return on investment, and cash flow.
A technique that improves speed in manufacturing by
increasing throughput contribution, decreasing
investments and decreasing operating costs.
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TOC Terms and Concepts
Some important concepts in TOC are listed below:
Throughput is product produced and shipped.
Throughput time is the time that elapses between the
receipt of a customers order and the shipment of the order.
Throughput contribution is revenue minus totally variable
(i.e., direct materials) cost for a given period of time.
The rate at which contribution dollars are being earned
the amount earned for product produced and shipped
during one hour, one day, one month, etc.
Theory of Constraints assumes that operating costs are
fixed costs because it regards them as difficult to change in
the short run.

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TOC Terms and Concepts contd
Some important concepts in TOC are listed below
(contd):
Operating costs are equal to all operating costs other than
direct materials or any other strictly variable costs incurred
to earn throughput contribution margin. Operating costs
include salaries and wages, rent, utilities, and depreciation.
Inventory costs are limited to costs that are strictly
variable, called super-variable and these are usually only
direct materials. All other costs, even direct labor, are
considered operating, or fixed, costs.
Investments equal the sum of costs in direct materials,
work-in-process and finished goods inventories, R&D, and
costs of equipment and buildings.
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Bottlenecks and Drum-Buffer-Rope Systems
The application of TOC to production is called Drum-
Buffer-Rope.
The bottleneck is the part of the process that has
the smallest amount of capacity relative to its load
and is therefore the slowest part.
The Drum-Buffer-Rope system is used to resolve
the conflict between having enough work in the
system to make sure the bottleneck keeps running
while at the same time limiting the amount of work-
in-process inventory buildup.
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The Drum-Buffer-Rope System
In DBR terminology, the drum is the bottleneck or
the constraint, because it provides the beat that
the entire operation must march to.
In order to protect the throughput of the entire factory, the
bottleneck, or drum, must be protected from running out
of material to process.
The buffer is a minimum level of work-in-process
inventory provided as protection against delays that
would delay the drum.
The buffer protects the drum resource from problems that
might occur upstream that might delay materials from
reaching the drum.

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The Drum-Buffer-Rope System contd
The rope is the schedule for releasing materials to
the floor to begin processing, so that they will reach
the drum at just the right time.
The rope limits the amount of inventory in the system.
Material is released only at the rate that the drum can
consume, and the rope keeps it from being released
too soon.
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Managing the Bottleneck in TOC
The steps that can followed to manage the
bottleneck are:
1. Recognize that the bottleneck operation determines
throughput contribution of the system as a whole,
and identify the bottleneck by determining where
requirements exceed availability.
2. Calculate the best use of the bottleneck to maximize
contribution.
3. Maximize the flow through the bottleneck by using the
drum-buffer-rope (DBR) system.
4. Increase the production capabilities of the bottleneck
by adding capacity.
5. Analyze the system to see if there are improvements
to make through redesigning or reordering.
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Business Process Performance

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The Value Chain
The value chain describes the companys chain of
activities for transforming inputs into the outputs that
customers value.
Primary activities (business functions) that add value
to a product or service are:
R & D
Production
Marketing, Sales and Distribution
Customer Service
Support activities are:
Infrastructure
Information Systems
Materials Management
Human Resources
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Value Chain Analysis
Value chain analysis helps an organization gain
competitive advantage by identifying what activities
add value to customers.
The organization can increase the related benefits
of value-added activities and reduce non-value
added activities.
Three steps in value chain analysis:
Identify activities that add value to the end product.
Identify the cost driver(s) for each activity.
Build competitive advantage by either increasing value to
the customer or reducing the costs of production.
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Business Process Reengineering
Management disassembles its business processes
and, starting from scratch, redesigns its entire
processes to achieve company objectives.
The steps in business process reengineering are:
1. The organization identifies what it does better than
the competition. These are its distinctive
competencies. By identifying them, the organization
understands what activities are vital to its success.
2. Management determines what processes it uses in its
efforts to generate a product or service that have value.
Thereafter management is enabled to determine the
degree of value for each process. This effort can
uncover low value processes to discard.
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Benchmarking Process Performance
One of the best ways to achieve superior
performance and competitive advantages for a firm
is to identify and adopt best practices. This can be
done through benchmarking.
Benchmarking is the process of measuring the
organization against the products, practices and
services of its most efficient global competitors.
This process involves continuously striving to
imitate the performance of the best companies in
the world. By meeting these higher standards, the
organization is able to create a competitive
advantage over its competitors.

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Benchmarking Process Performance Contd
The steps to follow to benchmark a companys
business processes are:
Identify the critical success factors for the business and
the processes to benchmark. Critical success factors are
the aspects of the companys business that are essential
to its competitive advantage.
Set up a team to do best practice analysis and document
the best practices for the processes that are used in
performing the firms critical success factor activities.
The team will need to identify what areas need
improvement and how they will accomplish this
improvement by utilizing the experience of the
benchmarked company.

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Activity Based Management (ABM)
Activity-based management is a means of
performing value chain analysis and business
process engineering. Activity-based management
uses activity analysis and activity-based costing
data to improve the value of the companys
products and services.
Activity-based management is divided into
operational ABM and strategic ABM.
1. Operational ABM uses ABC data to improve efficiency.
2. Strategic ABM uses ABC data to make strategic
decisions about what products or services to offer and
what activities to use to provide those products and
services.
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Kaizen
The term Kaizen is a Japanese work that means
improvement. As used in business, it implies
continuous improvement, or slow but consistent
incremental improvements in all areas of operations.
Kaizen says that improvement is always possible.
The goal is to attain the ideal standard, even when
practical standards are being attained.
Implementing ideal standards and quality
improvements is the heart of the kaizen concept.
Kaizen challenges people to imagine the ideal
condition and strive to make the necessary
improvements to achieve that ideal.
.
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The Costs of Quality
There are two main difference in the classifications
of the costs of quality.
Each of these two classifications can be broken
down into two further classifications of the cost of
quality.
Cost of Conformance
Prevention Costs
Appraisal Costs
Costs of Nonconformance
Internal Failure
External Failure
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Costs of Conformance
These are the costs of making sure that the unit is
produced properly and according to all design
specifications.
Prevention costs are the costs of trying to prevent a
defect from occurring.
Include quality training and planning costs, equipment
maintenance costs, supplier training and confirmation
costs, and information systems costs.
Appraisal costs are the costs of assessing whether a
unit was produced properly or not.
Include testing and inspections, quality audits and internal
quality programs.
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Costs of Nonconformance
These are the costs that are incurred after a
defective unit has been produced. These costs are
further classified based on who finds the defect
the company or the customer.
Internal failure costs are the costs of fixing the defect
when the defect is discovered by the company.
Include rework, scrap, tooling and downtime and expediting
costs.
External failure costs are the costs of fixing the defects
when the defect is discovered by the customer.
Include warranty costs, product liability costs, the loss of
customer goodwill and, potentially, environmental costs.
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Opportunity Cost of Quality
There may also be a large cost associated with not
producing a product of quality.
Money and time must be spent fixing the initial product,
More customer service is necessary after the sale to fix
defective products. These resources could be used
elsewhere in the company.
Customers are less likely to repurchase from the
company, and
Customers are less likely to recommend the company.
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Quality of Design
Quality of design refers to how well a product or
service meets the needs and wants of its
customers.
If there is a demand for a particular feature on a
product, or a particular service, and a manufacturer
or service company is supplying its product without
that feature, there is a problem.
Not providing what the customer wants is a quality-
of-design failure.
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Total Quality Management (TQM)
Total Quality Management (TQM) an approach
committed to customer satisfaction and continuous
improvement.
TQMs goals are to both reduce costs and improve
quality.
Objectives of TQM:
Enhanced and consistent quality of the product or service
Timely and consistent responses to customer needs
Elimination of non-value adding work or processes to
lower costs
Quick adaptation and flexibility in response to customers
shifting requirements.
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Core Principles of TQM
Certain core principles, or critical factors, are
common to all TQM systems:
They have the support and active involvement of top
management.
They have clear and measurable objectives.
They recognize quality achievements in a timely manner.
They continuously provide training in TQM.
They strive for continuous improvement (Kaizen).
They focus on satisfying their customers expectations
and requirements.
They involve all employees.
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TQM is Not a Short-Term Project
TQM is something that requires the commitment of
top management and implementation throughout
an organization.
Part of this pursuit of excellence is a focus on
continuing education. Employees at all levels
participate regularly in continuing education and
training in order to promote and maintain a culture
of quality.
In TQM, the role of quality manager is not limited to
a special department; instead, every person in the
organization is responsible for finding errors and
correcting any problems as soon as possible.
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Methods of Analyzing Quality Problems
Control chart records observations of an
operation taken at regular intervals. The sample is
used to determine whether all the observations fall
within the specified range to determine whether the
process is in statistical control or out of control.
Histogram a bar graph that represents the
frequency of events in a set of data to help see
patterns in it.
Pareto diagram a type of histogram illustrating
the Pareto Principle: 20% of the causes account
for 80% of the problems.
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Methods of Analyzing Quality Problems contd
Cause-and-effect diagram, or Ishikawa diagram
organizes causes and effects visually to sort out
root causes and identify relationships between
causes.
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TQM and Activity Based Costing
A TQM system is most compatible with an Activity
Based Costing (ABC) system.
An ABC system identifies costs with activities and makes
the costs of quality, such as costs to correct poor quality,
more apparent.
If an ABC system is in place, most of the cost information
needed for TQM is already being captured.
A company that uses ABC will continuously identify non-
value added activities that can be reduced or
eliminated and ensure that necessary activities value
added activities are carried out efficiently.
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Quality Management and Productivity
While it may seem that producing a quality product
is more difficult and time consuming, in fact,
companies that focus on quality are more
productive than other companies.
This is because the company will have:
A reduction in the number of defective units. This in
turn reduces the amount of time, material and effort
wasted on unusable output as well as time spent fixing
salvageable defective units.
A more efficient manufacturing process.
A commitment to doing it right the first time.