Transcript Cost Classification and Cost Behavior

Cost Classification and Cost
Behavior
EMBA 5403
Fall 2010
Mugan
Types of
Costs
The opportunity cost is the monetary amount
associated with the next best use of the
resource.
 differential costs- (benefits) – costs or
benefits that change between/among
alternatives
 Irrelevant costs -Costs that don’t
change are irrelevant to the decision
 Choose the alternatives where
differential benefits exceed differential
costs
 Opportunity costs
 Sunk costs
 Controllable
Costs
that have already /avoidable
been incurred and cannot be
costs/discretionary
costs
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changed
no matter what actionMugan
is taken
in the future.
Problems in Identifying and
Measuring Benefits
How do I measure
the benefit of
employee training?
How do I
measure the
benefit of
improved
quality?
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What is the
monetary benefit of
a happy customer?
What is the
monetary
benefit of an
improved
working
environment?
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Problems in Identifying and
Measuring Costs
How do I measure
the cost of poor
quality?
What is the cost of
a dissatisfied
customer?
How do I
measure the
cost of setting
my price too
high?
What is the cost
of postponing
this year’s
training
program?
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Classifications of Costs
 Behavior – how costs react to changes in
underlying cost driver
 Variable or Fixed
 Function – related to production or sales
 Product or Period
 Product costs –
 Direct Material
 Direct Labor
 Factory Overhead
 Traceability (cost of tracing cost to a cost
driver directly should be lower than the
benefits.
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Non-manufacturing Costs
Marketing or
Selling Costs
Administrative
Costs
Costs necessary to get
the order and deliver
the product.
All executive,
organizational, and
clerical costs.
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Product Costs Versus Period
Costs
Product costs include
direct materials, direct
labor, and
manufacturing
overhead
Cost of.Good Sold
Inventory
Period costs include
all marketing or
selling costs and
administrative
costs.
Expense
Sale
Balance
Sheet
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Income
Statement
Income
Statement
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Product Cost Flows
Work
In Process
Raw Materials
+
=
–
=
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Beginning raw
materials inventory
Raw materials
purchased
Raw materials
available for use
in production
Ending raw materials
inventory
Raw materials used
in production
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Direct materials
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Product Cost Flows
Work
In Process
Raw Materials
+
=
–
=
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Beginning raw
materials inventory
Raw materials
purchased
Raw materials
available for use
in production
Ending raw materials
inventory
Raw materials used
in production
Beginning work in
process inventory
Direct materials
+ Direct labor
+ Mfg. overhead
= Total manufacturing
costs
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Prime Costs
Conversion Costs
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Product Cost Flows
Work
In Process
Raw Materials
+
=
–
=
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Beginning raw
materials inventory
Raw materials
purchased
Raw materials
available for use
in production
Ending raw materials
inventory
Raw materials used
in production
Beginning work in
process inventory
Direct materials
+ Direct labor
+ Mfg. overhead
= Total manufacturing
costs
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Product Cost Flows
Work
In Process
Raw Materials
Beginning raw
materials inventory
+ Raw materials
purchased
= Raw materials
available for use
in production
+
+
=
+
=
–
=
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Beginning work in
process inventory
Total manufacturing
costs
Total work in
process for the
period
Ending work in
process inventory
Cost of goods
manufactured
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Product Cost Flows
Work
In Process
+
=
–
=
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Finished Goods
Beginning work in
process inventory
Manufacturing costs
for the period
Total work in process
for the period
Ending work in
process inventory
Cost of goods
manufactured
Beginning finished
goods inventory
+ Cost of goods
manufactured
= Cost of goods
available for sale
- Ending finished
goods inventory
Cost of goods
sold
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Manufacturing Cost Flows
Costs
Balance Sheet
Inventories
Material Purchases
Raw Materials
Direct Labor
Work in
Process
Manufacturing
Overhead
Selling and
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2010
Finished
Goods
Period Costs
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Income
Statement
Expenses
Cost of
Goods
Sold
Selling and
Administrative
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Graphical Analysis of Activity Costs and Rate of Output
Curvilinear Total
Cost Curve
Total
Dollars
Marginal Costs are the costs to produce one
more additional unit of output=slope.
Output
Start-up Normal
Range Operations
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Exceeding
Capacity
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Relevant Range
Relevant
Range
Total
Cost
}
Total
Dollars
The relevant range
is the portion of the
curvilinear total cost
curve that appears
in the normal
operations area.
Output
Startup
Range
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Normal
Operation
s
Exceeding
Capacity
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The Linearity Assumption and the
Relevant Range
Total Cost
A straight line
Economist’s
closely
Curvilinear Cost approximates a
Function
curvilinear
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variable cost
line within the
relevant range.
Relevant
Range
Accountant’s Straight-Line
Approximation (constant
unit variable cost)
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Activity
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Cost Classifications for
Predicting Cost Behavior
By reaction to changes in the level of
activity within the relevant range.
 Total variable costs change when activity
changes.
 Total fixed costs remain unchanged when
activity changes.
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Cost Classifications for
Predicting Cost Behavior
Behavior of Cost (within the relevant range)
Cost
In Total
Per Unit
Variable
Total variable cost changes
as activity level changes.
Variable cost per unit remains
the same over wide ranges
of activity.
Fixed
Total fixed cost remains
the same even when the
activity level changes.
Average fixed cost per unit goes
down as activity level goes up.
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Extent of Variable Costs
The proportion of variable costs differs across organizations. For
example . . .
A public utility with
large investments in
equipment will tend
to have fewer
variable costs.
A manufacturing company
will often have many
variable costs.
A merchandising company
usually will have a high
proportion of variable costs
like cost of sales.
A service company
will normally have a high
proportion of variable costs.
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Examples of Variable Costs
 Merchandising companies – cost of goods
sold.
 Manufacturing companies – direct
materials, direct labor, and variable
overhead.
 Merchandising and manufacturing
companies – commissions, shipping costs,
and clerical costs such as invoicing.
 Service companies – supplies, travel, and
clerical
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Types of Fixed Costs
Committed
Discretionary
Long-term, cannot be
significantly reduced
in the short term.
May be altered in the shortterm by current managerial
decisions
Examples
Examples
Depreciation on
Equipment and
Real Estate Taxes
Advertising and
Research and
Development
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Mixed Costs
Total Mobile Phone Cost
Y
Fixed Monthly
Phone Charge
X
Activity (minutes)
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Fixed Monthly
Phone Charge
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Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX
Where:
Total Mobile Phone Cost
Y
Y = the total mixed cost
a = the total fixed cost (the
vertical intercept of the line)
b = the variable cost per unit of
activity (the slope of the line)
X = the level of activity
Variable
Cost per minute
X
Activity (minutes)
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Fixed Monthly
Phone Charge
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The Scattergraph Method
Plot the data points on a graph
(total cost vs. activity).
Y
Cost
20
* *
* *
10
0
0
1
* ** *
**
2
3
4
X
Activity - output
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The Scattergraph Method
Y
Draw a line through the data points with about an
equal numbers of points above and below the line.
Cost
20
* *
* *
10
0
0
1
* ** *
**
2
3
4
X
Activity - output
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The Scattergraph Method
Use one data point to estimate the total level of activity and the total
cost.
Cost
Y Total cost = TL11
20
* *
* *
10
* ** *
**
Intercept = Fixed cost: TL 10
0
0
1
2
3
4
X
Activity - output
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Activity
0.8 units
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The Scattergraph Method
Make a quick estimate of variable cost per unit and determine the cost
equation.
Total Cost at 0.8 units
Less: Fixed cost
Estimated total variable cost 0.8 units
Variable cost per unit =
TL1
0.8
11 TL
10 TL
1 TL
= TL1.25/ unit of output
Y = TL10 + TL1.25X
Total cost
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Number of units
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The High-Low Method
Assume the following hours of maintenance work and the total maintenance
costs for six months.
High
level of
activity
Low
level of
activity
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Assigning Costs to Cost Objects
Direct costs
Indirect costs
 Costs that can be
easily and
conveniently traced
to a unit of product
or other cost object.
 Costs that cannot be
easily and
conveniently traced
to a unit of product
or other cost object.
 Examples: direct
material and direct
labor
 Example:
manufacturing
overhead
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Cost Classifications for Decision
Making
 Every decision involves a choice
between at least two alternatives.
 Only those costs and benefits that
differ between alternatives are
relevant in a decision. All other costs
and benefits can and should be
ignored.
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Differential Costs and Revenues
Costs and revenues that differ
among alternatives.
Example: You have a job paying TL 1,500 per month
in your hometown. You have a job offer in a
neighboring city that pays TL 2,000 per month. The
commuting cost to the city is TL 300 per month.
Differential revenue is:
TL2,000 – TL1,500 = TL500
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Differential cost is:
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TL
300
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Opportunity Costs
The potential benefit that is given up when
one alternative is selected over another.
Example: If you were not attending this
program, you could save TL 10,000 per year.
Your opportunity cost?
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Sunk Costs
Sunk costs have already been incurred and cannot
be changed now or in the future. They should be
ignored when making decisions.
Example: You bought an automobile that
cost TL10,000 two years ago. The TL10,000
cost is sunk because whether you drive it,
park it, trade it, or sell it, you cannot change
the TL10,000 cost.
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Summary of the Types of Cost
Classifications
 Financial reporting
 Predicting cost behavior
 Assigning costs to cost objectsproducts- determining unit costs
 Decision making
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Income Statement Presentation
Used primarily for
external reporting.
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Used primarily by
management.
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Idle Time
Machine
Breakdowns
Material
Shortages
Power
Failures
The labor costs incurred
during idle time are ordinarily
treated as manufacturing
overhead.
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Overtime
The overtime premiums for all factory
workers are usually considered to be part
of manufacturing overhead.
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Unit Costs
 Direct Material- determined as actual usage
of materials or by engineering estimates
(standard costs)
 Direct Labor- determined as actual usage of
materials or by engineering estimates
(standard costs)
 MOVH – common production costs assigned
to each unit
 Traditional
 ABC
 Unit cost = DM + DL + MOVH per unit
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Labor Fringe Benefits
Fringe benefits include employer paid costs for
insurance programs, retirement plans,
supplemental unemployment programs, Social
Security, Medicare, workers’ compensation and
unemployment taxes.
Some companies
include all of these
costs in
manufacturing
overhead.
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Other companies treat
fringe benefit
expenses of direct
laborers as additional
direct labor costs.
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How to allocate indirect costs to
products MOVH
 Depends on the nature of products and
production system
 Traditional- direct labor hours (DLH);
number of units produced;
 Automation and computer technology have
increased the indirect costs in many
organizations
 Activity-Based Costing (ABC)- a procedure
that attempts to provide a more precise
indirect cost allocation
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Numerical Example- Unit Cost
 THD Company produces 4,000 units of Product A
and 20,000 units of Product B each year.
 Direct Material for Product A is TL 10; Product B 15
 Total indirect product costs are TL 900,000, and
total direct labor hours(DLH) are 50,000.
 Product A requires 2.5 DLH and Product B requires
2.0 DLH to produce.
 Direct labor cost per hour TL 30
Continue
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Numerical Example
Management at THD believes that indirect costs
are actually caused by the following five activities:
Activity
Machine setups
Quality inspections
Production orders
Machine-hours worked
Material receipts
Total
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Estimated
Costs
255,000 TL
160,000 TL
81,000 TL
314,000 TL
90,000 TL
900,000 TL
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Unit Cost - Traditional
THD uses DLH as the basis
1.determine the allocation of MOVH per
unit = predetermined overhead
rate(PDOR) PDOR= Total Overhead/
Total DLH
2. determine MOVH per unit = PDOR x
DL Cost per hour
3. add DM,DL and MOVH per unit
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PDOR and MOVH
Total Overhead
Direct Labor Hours:
Product A - 2.5 DlH
Product B - 2 DLH
Total Direct Labor Hours
Predetermined Overhead Rate
Manufacturing Overhead per unit of A
Manufacturing Overhead per unit of B
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900,000 TL
10000
40000
50000
18 TL per DLH
2.5 DLH
2 DLH
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45 TL per unit
36 TL per unit
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Unit Costs – Traditional
UNIT COSTS
Direct Material
Direct Labor ( DLH x 30 TL / DLH)
Manufacturing Overhead
Unit Cost
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Product A Product B
10
15
75
60
45
36
130
111
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Numerical Example-MOVH by ABC
The following activity data was supplied by
the management of THD
Activity
Machine setups
Quality inspections
Production orders
Machine-hours worked
Material receipts
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Total
5,000
8,000
600
40,000
750
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Product A
3,000
5,000
200
12,000
150
Product B
2,000
3,000
400
28,000
600
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Numerical Example-MOVH by
ABC
This activity data can be used to develop application
rates for each of the five activities.
Activity
Machine setups
Quality inspections
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Total
Rate per
Costs
Transactions
Transaction
255,000 TL ÷
5,000 =
51 TL
160,000 ÷
8,000
?
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Numerical Example-MOVH by
ABC
Activity
Costs
Machine setups
255,000 TL
Quality inspections
160,000
Production orders
81,000
Machine-hours worked
314,000
Material receipts
90,000
Fall 2010
÷
÷
÷
÷
÷
Mugan
Total
Transactions
5,000
8,000
600
40,000
750
=
=
=
=
=
Rate per
Transaction
51 TL
20.00
135.00
7.85
120.00
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Numerical Example-MOVH by
ABC
Now that we have calculated the application rates, we
use the rates to assign indirect costs to Product A.
Activity
Machine setups
Quality inspections
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ABC Rate
51 TL ×
20.00 ×
Mugan
Usage
3,000 =
5,000
Amount
153,000 TL
?
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Numerical Example-MOVH by
ABC
Now that we have calculated the application rates, we
use the rates to assign indirect costs to Product A.
Activity
ABC Rate
Machine setups
51 TL
Quality inspections
20.00
Production orders
135.00
Machine-hours worked
7.85
Material receipts
120.00
Total indirect costs assigned
Number of units produced
Indirect product costs per unit-MOVH
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Mugan
×
×
×
×
×
Usage
3,000
5,000
200
12,000
150
=
=
=
=
=
÷
Amount
153,000 TL
100,000
27,000
94,200
18,000
392,200 TL
4,000
98 TL
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Numerical Example-MOVH by
ABC
MOVH costs for a unit of Product B
Activity
ABC Rate
Machine setups
51 TL
Quality inspections
20.00
Production orders
135.00
Machine-hours worked
7.85
Material receipts
120.00
Total indirect costs assigned
Number of units produced
Indirect product costs per unit-MOVH
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×
×
×
×
×
Usage
2,000
3,000
400
28,000
600
=
=
=
=
=
÷
Amount
102,000 TL
60,000
54,000
219,800
72,000
507,800 TL
20,000
25 TL
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Reconciliation check
Reconciliation
Indirect costs assigned to Product A
Indirect costs assigned to Product B
Total indirect costs assigned
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Mugan
Amount
$ 392,200
507,800
$ 900,000
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Unit Costs – Using ABC
UNIT COSTS
Direct Material
Direct Labor ( DLH x 30 TL / DLH)
Manufacturing Overhead
Unit Cost
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Product A Product B
10
15
75
60
98.05
25.39
183.05
100.39
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Comparison of Unit Costs
Traditional Using ABC
130
183.05
111
100.39
Product A
Product B
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Advantages of ABC
Activity-based costing is very useful in firms . . .
With multiple
products and
services.
That have products
and services that use
indirect activities
in different ways.
That have a high
percentage of indirect
product costs.
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Problems With ABC
ABC ignores the
difference between
the fixed and variable
costs of an activity.
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Proper identification
of cost drivers is
difficult.
ABC is more costly
because additional
measurements and
observations must
be made.
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Quality of Conformance
When the overwhelming majority of
products produced conform to design
specifications and are free from
defects.
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Prevention and Appraisal Costs
Prevention
Costs
Support activities
whose purpose is to
reduce the number of
defects
Appraisal Costs
Incurred to identify
defective products
before the products are
shipped
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Internal and External Failure
Costs
Internal Failure
Costs
Incurred as a result of
identifying defects
before they are shipped
External Failure
Costs
Incurred as a result of
defective products
being delivered to
customers
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Examples of Quality Costs
Appraisal Costs
Prevention Costs
• Testing & inspecting
incoming materials
• Final product testing
• Depreciation of testing
equipment
• Quality training
• Quality circles
• Statistical process
control activities
External Failure Costs
Internal Failure Costs
• Cost of field servicing &
handling complaints
• Warranty repairs
• Lost sales
• Scrap
• Spoilage
• Rework
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Distribution of Quality Costs
When quality of conformance is low,
total quality cost is high and consists
mostly of internal and external failure.
Companies can reduce their total
quality cost by focusing on
prevention and appraisal. The cost
savings from reduced defects usually
swamps the costs of the additional
prevention and appraisal efforts.
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Ventura Company
Quality Cost Report
For Years 1 and 2
Year 2
Amount
Percent*
Prevention costs:
Systems development
Quality training
Supervision of prevention activities
Quality improvement
Total prevention cost
$
400,000
210,000
70,000
320,000
1,000,000
Year 1
Amount Percent*
0.80% $ 270,000
0.42%
130,000
0.14%
40,000
0.64%
210,000
2.00%
650,000
0.54%
0.26%
0.08%
0.42%
1.30%
Appraisal costs:
Inspection
Reliability testing
Supervision of testing and inspection
Depreciation of test equipment
Total appraisal cost
600,000
580,000
120,000
200,000
1,500,000
1.20%
1.16%
0.24%
0.40%
3.00%
560,000
420,000
80,000
140,000
1,200,000
1.12%
0.84%
0.16%
0.28%
2.40%
Internal failure costs:
Net cost of scrap
Rework labor and overhead
Downtime due to defects in quality
Disposal of defective products
Total internal failure cost
900,000
1,430,000
170,000
500,000
3,000,000
1.80%
2.86%
0.34%
1.00%
6.00%
750,000
810,000
100,000
340,000
2,000,000
1.50%
1.62%
0.20%
0.68%
4.00%
0.80%
900,000
1.74% 2,300,000
0.26%
630,000
1.20% 1,320,000
4.00% 5,150,000
15.00% $ 9,000,000
Mugan
1.80%
4.60%
1.26%
2.64%
10.30%
18.00%
External failure costs:
Warranty repairs
Warranty replacements
Allowances
Cost of field servicing
Total external failure cost
Total quality cost
Fall 2010
$
400,000
870,000
130,000
600,000
2,000,000
7,500,000
* As a percentage of total sales. In each year sales totaled $50,000,000.
Quality cost
reports provide
an estimate of
the financial
consequences
of the
company’s
current defect
rate.
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Quality Cost Reports: Graphic
Form
9
Quality Cost (in millions)
8
7
6
External
Failure
External
Failure
5
Internal
Failure
4
3
Internal
Failure
2
1
0
Appraisal
Quality
reports
can also
be
prepared
in
graphic
form.
Appraisal
18
16
14
12
Prevention
1
2
Year
External
Failure
Internal
Failure
8
6
Internal
Failure
4
0
Mugan
External
Failure
10
2
Prevention
Fall 2010
20
Quality Cost as a Percentage of Sales
$10
Appraisal
Appraisal
Prevention
Prevention
1
2
Year
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Uses of Quality Cost
Information
Help managers see the
financial significance of
defects.
Help managers identify the
relative importance of the
quality problems.
Help managers see
whether their quality costs
are poorly distributed.
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ISO 9000 Standards
ISO 9000 standards have become an international
measure of quality. To become ISO 9000 certified, a
company must demonstrate:
1. A quality control system is in use, and the
system clearly defines an expected level of
quality.
2. The system is fully operational and is
backed up with detailed documentation of
quality control procedures.
3. The intended level of quality is being
achieved on a sustained basis.
Fall 2010
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Product Life Cycle
Fall 2010
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http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf
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Fall 2010
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http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf
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Introduction
Fall 2010
Growth
Maturity
Mugan
http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf
Decline
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http://www.ee.unb.ca/powereng/courses/E
E2703/EE2703_DetailedDesign2.pdf
Fall 2010
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http://www.ee.unb.ca/powereng/courses/E
E2703/EE2703_DetailedDesign2.pdf
Fall 2010
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Appendix
Least-Squares
Regression Using
Microsoft Excel.
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Simple Regression Analysis
Example
Matrix, Inc. wants to
know its average
fixed cost and
variable cost per unit.
Using the data to the
right, let’s see how to
do a regression using
Microsoft Excel.
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Simple Regression Using Excel
You will need three pieces of
information from your
regression analysis:
1. Estimated Variable Cost per
Unit (line slope)
2. Estimated Fixed Costs (line
intercept)
3. Goodness of fit, or R2
To get these three pieces
information we will need to
use three different Excel
functions.
LINEST, INTERCEPT, & RSQ
Fall 2010
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Simple Regression Using Excel
Place your cursor in
cell F4 and press the
= key. Click on the
pull down menu and
scroll down to “More
Functions . . .”
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Simple Regression Using Excel
Scroll down to the
“Statistical”,
functions. Now
scroll down the
statistical
functions until you
highlight
“LINEST”
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Simple Regression Using Excel
1. In the Known_y’s box enter C4:C19 for the range.
2. In the Known_x’s box enter D4:D19 for the range.
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Simple Regression Using Excel
Here is the
estimate of the
slope of the line.
1. In the Known_y’s box enter C4:C19 for the range.
2. In the Known_x’s box enter D4:D19 for the range.
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Simple Regression Using Excel
With you cursor in cell
F5, press the = key
and go to the pull
down menu for
special functions.
Select Statistical and
scroll down to
highlight the
INTERCEPT function.
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Simple Regression Using Excel
Here is the
estimate of the
fixed costs.
1. In the Known_y’s box enter C4:C19 for the range.
2. In the Known_x’s box enter D4:D19 for the range.
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Simple Regression Using Excel
Finally, we will
determine the
“goodness of
fit”, or R2, by
using the RSQ
function.
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Simple Regression Using Excel
Here is the
estimate of R2.
1. In the Known_y’s box enter C4:C19 for the range.
2. In the Known_x’s box enter D4:D19 for the range.
Fall 2010
Mugan
82/82