Overview managerial accounting chapter 02

Chapter Cost Terms, Concepts, and Classifications Learning Objectives LO1 LO2 LO3 LO4 LO5 LO6 LO7 Identify and give examples of each of the three basic manufacturing cost categories Distinguish between product costs and period costs and give examples of each Prepare an income statement including calculation of the cost of goods sold Prepare a schedule of cost of goods manufactured Understand the differences between variable costs and fixed costs Understand the differences between direct and indirect costs Define and give examples of cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs LO8 (Appendix 2A) Properly account for labor costs associated with idle time, overtime, and fringe benefits LO9 (Appendix 2B) Identify the four types of quality costs and explain how they interact LO10 (Appendix 2B) Prepare and interpret a quality cost report New in this Edition • Many new In Business boxes have been added • New shorter exercises that cover a single learning objective have been created Chapter Overview A General Theme Costs can be classified in a number of ways—depending on the purpose of the classification For example, classification of costs for purposes of determining inventory valuations and cost of goods sold for external reports differs from the classification of costs that would be carried out to aid decision-making It is important to note that the classifications of costs are not mutually exclusive That is, a particular cost may be classified in many different ways—depending on the purpose of the classification B Cost Classifications for Preparing External Financial Statements (Exercises 2-1, 2-2, 2-3, 2-4, 2-10, 2-11, and 2-12.) This section of the chapter focuses on the problem of valuing inventories and determining cost of goods sold for external financial reports Before beginning this discussion, you may want to explain the difference between a manufacturing and a merchandising company Manufacturing companies convert raw materials into a product The company then sells that product either to other companies or, less commonly, directly to individuals “Manufacturing” includes restaurants, movie studios, and other service-type companies as well as the more obvious examples of manufacturing such as automobile and clothing production Merchandising companies, by contrast, buy finished products and resell the products to customers Valuing inventories and determining cost of goods sold is simple in a merchandising company, but is difficult in a manufacturing company For that reason, we concentrate on manufacturing in this section of the chapter 61 Manufacturing costs These costs are incurred to make a product Manufacturing costs are usually grouped into three main categories: direct materials, direct labor, and manufacturing overhead a Direct materials Direct materials consist of those raw material inputs that become an integral part of a finished product and can be easily traced into it Examples include the aircraft engines on a Boeing 777, the Intel processing chip in a personal computer, and the blank video cassette in a pre-recorded video b Direct Labor Direct labor consists of that portion of labor cost that can be easily traced to a product Direct labor is sometimes referred to as “touch labor” since it consists of the costs of workers who “touch” the product as it is being made c Manufacturing Overhead Manufacturing overhead consists of all manufacturing costs other than direct materials and direct labor These costs cannot be easily and conveniently traced to products Examples include miscellaneous supplies such as rivets in a Boeing 777, supervisors, janitors, factory facility charges, etc d Prime versus Conversion Costs Prime cost consists of direct materials plus direct labor Conversion cost consists of direct labor plus manufacturing overhead Non-manufacturing costs A manufacturing company incurs many other costs in addition to manufacturing costs For financial reporting purposes most of these other costs are typically classified as selling (marketing) costs and administrative costs Marketing and administrative costs are incurred in both manufacturing and merchandising firms a Marketing Costs These costs include the costs of making sales, taking customer orders, and delivering the product to customers These costs are also referred to as ordergetting and order-filling costs b Administrative Costs These costs include all executive, organizational, and clerical costs that are not classified as production or marketing costs Period vs product costs Costs can also be classified as period or product costs a Period Costs Period costs are expensed in the time period in which they are incurred All selling and administrative costs are typically considered to be period costs You should be careful to point out that the usual rules of accrual accounting apply For example, administrative salary costs are “incurred” when they are earned and not necessarily when they are paid to employees b Product Costs Product costs are added to units of product (i.e., “inventoried”) as they are incurred and are not treated as expenses until the units are sold This can result in a delay of one or more periods between the time in which the cost is incurred and when it appears as an expense on the income statement Product costs are also known as inventoriable costs The discussion in the chapter follows the usual interpretation of GAAP in which all manufacturing costs are treated as product costs Inventory valuations and Cost of Goods Sold In a manufacturing company, raw materials purchases are recorded in a raw materials inventory account These costs are 62 transferred to a work in process inventory account when the materials are released to the production departments Other manufacturing costs—direct labor and manufacturing overhead—are charged to the work in process inventory account as incurred As work in process is completed, its costs are transferred to the finished goods inventory account These costs become expenses only when the finished goods are sold Period expenses are taken directly to the income statement as expenses of the period Schedule of Cost of Goods Manufactured Because of inventories, the cost of goods sold for a period is not simply the manufacturing costs incurred during the period Some of the cost of goods sold may be for units completed in a previous period And some of the units completed in the current period may not have been sold and will still be on the balance sheet as assets The cost of goods sold is computed with the aid of a schedule of costs of goods manufactured, which takes into account changes in inventories The schedule of cost of goods manufactured is not ordinarily included in external financial reports, but must be compiled by accountants within the company in order to arrive at the cost of goods sold You should take some time to explain the cost of goods manufactured schedule since it is often difficult for students to understand C Cost Classifications to Describe Cost Behavior (Exercises 2-5 and 2-11.) Managers often need to be able to predict how costs will change in response to changes in activity The activity might be the output of goods or services or it might be some measure of activity internal to the company such as the number of purchase orders processed during a period In this chapter, nearly all of the illustrations assume that the activity is the output of goods or services In later chapters, other measures of activity will be introduced While there are other ways to classify costs according to how they react to changes in activity, in this chapter we introduce the simple variable and fixed classifications A variable cost is constant per unit of activity but changes in total as the activity level rises and falls A fixed cost is constant in total for changes in activity within the relevant range (Just about any cost will change if there is a big enough change in activity Fixed costs not change for changes in activity that fall within the “relevant range.”) When expressed on a per unit basis, a fixed cost is inversely related to activity—the per unit cost decreases when activity rises and increases when activity falls There is some controversy concerning the proper definition of the “relevant range.” Some refer to the relevant range as the range of activity within which the company usually operates We refer to the relevant range as the range of activity within which the assumptions about variable and fixed costs are valid Either definition could be used—our choice was dictated by our desire to highlight the notion that fixed costs can change if the level of activity changes enough D Cost Classifications for Assigning Costs (Exercise 2-6.) Managers often want costs to be assigned to “cost objects” such as products, customers, departments, etc for pricing or other purposes A direct cost is a cost that can be conveniently and easily traced to a particular cost object Indirect costs are everything else A cost would be considered indirect for one of two reasons: either it is impractical or it is impossible to trace the cost to the cost object Common costs For example, it is impossible to trace the factory managers’ salary in a multi-product plant to any particular product made in the plant Even if a product were dropped entirely, we would ordinarily expect the factory manager’s salary to remain the same This is an example of a “common cost” and later in the text we emphasize that such costs should not be allocated for decision-making or performance evaluation purposes 63 Variable indirect costs On the other hand, other costs are treated as indirect costs because it would not be practical to treat them otherwise For example, it would be possible to measure the precise amount of solder used on each circuit board produced at a HP plant, but it wouldn’t be worth the effort Instead, solder would typically be considered an indirect material and would be included in overhead E Cost Classifications for Decision-Making (Exercise 2-7.) Every decision involves choosing from among at least two alternatives Only those costs and benefits that differ between alternatives are relevant in making the selection This concept is explored in greater detail in the chapter on relevant costs However, decision-making contexts crop up from time to time in the text before that chapter, so it is a good idea to familiarize students with relevant cost concepts Differential Costs A differential cost is a cost that differs between alternatives The cost may exist in only one of the alternatives or the total amount of the cost may differ between the alternatives In the latter case, the differential cost would be the difference between the cost under one alternative and the cost under the other Differential costs are also called incremental costs Differential costs and opportunity costs should be the focus of decisionmaking They are the only relevant costs and all others should be ignored Opportunity Costs An opportunity cost is the potential benefit that is given up by selecting one alternative over another The concept of an opportunity cost is rather difficult for students to understand because it is not an actual expenditure and it is rarely (if ever) shown on the accounting books of an organization It is, however, a cost that must be considered in decisions Sunk Cost A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future Since sunk costs cannot be changed and therefore cannot be differential costs, they should be ignored in decision making While students usually accept the idea that sunk costs should be ignored on an abstract level, like most people they often have difficulty putting this idea into practice F Classification of Labor Costs (Appendix 2A) (Exercises 2-8 and 2-13.) Factory labor costs are classified as direct or indirect labor Direct labor is basically “touch labor.” Indirect labor is the rest of the manufacturing labor cost and it is classified as part of manufacturing overhead Examples of indirect labor include the wages and salaries of janitors, supervisors, material handlers, and maintenance workers Idle Time Some labor costs, such as idle time, are not easily identified as either direct or indirect labor Idle time represents the wages of direct labor workers who are idle due to machine breakdowns, material shortages, and so forth Typically, these costs are classified as overhead costs and are allocated across all products Overtime Premium The overtime premium paid to factory workers is usually considered to be part of manufacturing overhead It is argued that it would be unfair to charge an overtime premium against a product that happened to be scheduled for the overtime period Therefore, the overtime premium is usually added to overhead and spread among all jobs of the period It should be noted that if a company works overtime specifically because of a special request or a rush order job, the overtime premium may appropriately be charged against that particular job 64 Fringe Benefits These costs include payments made to insurance and retirement plans as well as various employee taxes such as social security Typically, companies treat these costs as manufacturing overhead However, it would be more accurate to split fringe benefits between the portion that relates to direct labor and the portion that relates to indirect labor Only those fringe benefits that relate to indirect labor should be included in manufacturing overhead; the rest should be considered as part of direct labor cost G Quality Costs (Appendix 2B) (Exercise 2-9.) The term quality has many meanings Quality can mean that a product has many features not found in other products; it can mean that it is well-designed; or it can mean that it is defect-free In this appendix, the focus is on the presence or absence of defects Quality of conformance is the degree to which the actual product or service meets its design specifications Anything that does not meet design specifications is a defect and is indicative of low quality of conformance Costs of Internal and External Failure The costs of not meeting design specifications are classified as internal failure costs and external failure costs Defects that are detected internally result in costs such as scrap or rework Defective units that are released to customers create external failure costs Examples of external failure costs include customer returns and exchanges, repairs under warranties, product recalls, and lost sales due to a reputation for selling defective products Costs of Reducing Defects There are basically only two ways to reduce defects and the resulting costs of internal and external failures Either the defects can be prevented or they can be detected and corrected a Defects can be prevented by designing products that are “robust;” that is, that are not sensitive to variations and errors in the production process Defects can also be prevented by improving production processes Statistical process control has been especially useful in driving variation out of production processes and thereby reducing defect rates Most experts believe that until the late 1980s too little attention was paid in the United States to prevention Instead, reliance was placed on detecting defects once they had occurred b Defective units can be detected before they are delivered to customers by inspecting and testing units throughout the production process This approach to reducing defects is expensive since it involves inspection labor and testing equipment Moreover, when there is no idle capacity every defective unit that must be reworked or that is scrapped uses precious capacity The resulting opportunity costs can be quite large H The Trade-Off Between Prevention and Appraisal Costs and Internal and External Failure Costs Generally speaking, companies should focus more effort on prevention and appraisal And prevention is usually better than appraisal Most authorities agree that the costs of internal and external failures have been largely hidden and as a consequence managers are unaware of the magnitude of the problem Very simple steps can often be taken to prevent defects These simple steps pay enormous dividends in terms of reducing the need for appraisal and in reducing the incidence of internal and external failures I Quality Cost Report Quality consultants claim that top managers often not pay enough attention to quality since the costs of low quality (i.e., high defect rates) are hidden by the typical cost accounting system While accounting systems often report statistics concerning 65 scrap and there may be a quality assurance department with its own budget, many of the other costs associated with defects are buried in general overhead or in other accounts A quality cost report makes these costs visible and organizes the data so as to help managers make trade-offs Since the reports are really just attention-directing devices, the numbers in the reports not have to be precise Data for the Quality Cost Report The costs of nonconformance (i.e., defects) often cut across departmental lines and are therefore somewhat difficult to collect Moreover, some of the costs of nonconformance are entirely external to the company and are not captured by the accounting system at all The most prominent example of this is the cost of lost sales Nevertheless, as we indicated above, precision is not terribly important so these measurement and identification problems should not be overemphasized All of the examples and problems in the text assume that the data collection work has already been done Format and use of the Quality Cost Report It is very helpful to sort the various quality costs into the four categories of prevention, appraisal, internal failure, and external failure costs By comparing the amounts in the various categories, managers can get some feel for what should be done For example, if the prevention and appraisal costs are very small relative to the internal and external failure costs, it is likely that not enough is being spent to prevent and detect defects If prevention costs are low relative to appraisal costs, it is likely that not enough is being spent on prevention relative to inspection Moreover, by comparing results across years, managers can track the effects of their decisions and gauge the success of quality improvement programs The future of the Quality Cost Report A company’s first quality cost report probably has the greatest effect Managers are often surprised by the magnitude of the costs associated with defects This is often enough by itself to propel the company into ambitious quality improvement programs However, unless the company’s chart of accounts is modified, compiling periodic quality cost reports is a time-consuming task Moreover, some of the most important data—the data external to the company—will almost always be missing And, while the quality cost report can help steer managers in the appropriate direction (e.g., increase prevention costs), it cannot tell managers how to go about preventing defects For these reasons, many companies stop producing quality cost reports once their quality improvement program is well-established 66 Assignment Materials Assignment Exercise 2-1 Exercise 2-2 Exercise 2-3 Exercise 2-4 Exercise 2-5 Exercise 2-6 Exercise 2-7 Exercise 2-8 Exercise 2-9 Exercise 2-10 Exercise 2-11 Exercise 2-12 Exercise 2-13 Problem 2-14 Problem 2-15 Problem 2-16 Problem 2-17 Problem 2-18 Problem 2-19 Problem 2-20 Problem 2-21 Problem 2-22 Problem 2-23 Problem 2-24 Problem 2-25 Problem 2-26 Problem 2-27 Problem 2-28 Problem 2-29 Case 2-30 Case 2-31 Topic Classifying manufacturing costs Classification of costs as period or product cost Constructing an income statement Prepare a schedule of cost of goods manufactured Classification of costs as fixed or variable Identifying direct and indirect costs Differential, opportunity, and sunk costs (Appendix 2A) Classification of overtime cost (Appendix 2B) Classification of quality costs Preparation of a schedule of COGM and COGS Classification of costs as fixed or variable and as selling and administrative or product Product cost flows; product versus period costs (Appendix 2A) Classification of labor costs Cost identification Cost classification Cost classification (Appendix 2A) Allocating labor costs (Appendix 2B) Quality cost report Classification of various costs Classification of salary cost as a period or product cost Variable and fixed costs; subtleties of direct and indirect costs (Appendix 2B) Analyzing a quality cost report Ethics and the manager Schedule of cost of goods manufactured; cost behavior Cost classification and cost behavior Schedule of cost of goods manufactured; income statement Schedule of cost of goods manufactured; income statement; cost behavior Income statement; schedule of cost of goods manufactured Working with incomplete data from the income statement and schedule of cost of goods manufactured Inventory computations from incomplete data Missing data; income statement; schedule of cost of goods manufactured Level of Difficulty Basic Basic Basic Basic Basic Basic Basic Basic Basic Basic Suggested Time 15 15 15 15 15 15 15 15 15 30 Basic Basic Basic Basic Basic Basic Basic Medium Medium Medium Medium Medium Medium Medium Medium Medium 15 30 15 30 30 30 30 60 30 15 15 45 30 60 45 60 Medium Difficult 60 60 Difficult Difficult 45 60 Difficult 60 Essential Problems:* Problem 2-14 or 2-19, Problem 2-15 or 2-16, Problem 2-24 or 2-27, Problem 2-25 Supplementary Problems:* Problem 2-20, Problem 2-21, Problem 2-23, Problem 2-26, Problem 2-28, Problem 2-29, Case 2-30, Case 2-31 Appendix 2A Essential Problems: Problem 2-17 Appendix 2B Essential Problems: Problem 2-18 Appendix 2B Supplementary Problems: Problem 2-22 *See the front of the Solutions Manual for an explanation of “Essential” and “Supplementary” problems 67 68 Chapter Lecture Notes Helpful Hint: Before beginning the lecture, show students the second segment from the first tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library This segment introduces students to many of the concepts discussed in chapter The lecture notes reinforce the concepts introduced in the video I Chapter theme: Managers need to rely upon different classifications of costs for different purposes The four main purposes emphasized in this chapter include preparing external financial reports, predicting cost behavior, assigning costs to cost objects, and making business decisions General cost classifications: Our initial focus is on manufacturing companies since their basic activities include most of the activities found in other types of business organizations Nonetheless, many of the concepts developed in this chapter apply to diverse organizations A Classifications of manufacturing costs (e.g., direct materials, direct labor, and manufacturing overhead): i Direct materials − Raw materials that become an integral part of the finished product and that can be physically and conveniently traced to it ii Direct labor − Labor costs that can be easily traced to individual units of product (also called touch labor) 69 70 TM 2-7 COST FLOWS EXAMPLE (cont’d) Computation of raw materials used in production Beginning raw materials inventory $ 10,000 + Purchases of raw materials 200,000 – Ending raw materials inventory 30,000 = Raw materials used in production $180,000 Computation of total manufacturing cost Raw materials used in production $180,000 + Direct labor 270,000 + Manufacturing overhead 420,000 = Total manufacturing costs $870,000 Computation of cost of goods manufactured Beginning work in process inventory $ 40,000 + Total manufacturing costs 870,000 – Ending work in process inventory 60,000 = Cost of goods manufactured (i.e., finished) $850,000 Computation of cost of goods sold Beginning finished goods inventory + Cost of goods manufactured (i.e., finished) – Ending finished goods inventory = Cost of goods sold $130,000 850,000 80,000 $900,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 2-8 SCHEDULE OF COST OF GOODS MANUFACTURED Ryarder Company Schedule of Cost of Goods Manufactured Direct materials: Beginning raw materials inventory Add: Purchases of raw materials Raw materials available for use Deduct: Ending raw materials inventory Raw materials used in production Direct labor Manufacturing overhead: Indirect materials Indirect labor Utilities, factory Property taxes, factory Insurance, factory Equipment rental Depreciation, factory Total overhead costs Total manufacturing costs Add: Beginning work in process inventory $ 10,000 200,000 210,000 30,000 $180,000 270,000 5,000 100,000 80,000 36,000 9,000 70,000 120,000 Deduct: Ending work in process inventory Cost of goods manufactured Cost of Goods Sold Beginning finished goods inventory Add: Cost of goods manufactured Goods available for sale Deduct: Ending finished goods inventory Cost of goods sold © The McGraw-Hill Companies, Inc., 2006 All rights reserved 420,000 870,000 40,000 910,000 60,000 $850,000 $130,000 850,000 980,000 80,000 $900,000 TM 2-9 COST CLASSIFICATIONS TO DESCRIBE COST BEHAVIOR To describe how costs react to changes in activity, costs are often classified as variable or fixed VARIABLE COSTS Variable cost behavior can be summarized as follows: In Total Variable Cost Behavior Total variable cost increases and decreases in proportion to changes in activity Per Unit Variable cost per unit is constant EXAMPLE: A company manufactures microwave ovens Each oven requires a timing device that costs $30 The per unit and total cost of the timing device at various levels of activity (i.e., number of ovens produced) would be: Cost per Timing Device $30 $30 $30 $30 Number of Ovens Produced 10 100 200 Total Variable Cost—Timing Devices $30 $300 $3,000 $6,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 2-10 FIXED COSTS Fixed cost behavior can be summarized as follows: In Total Fixed Cost Behavior Total fixed cost is not affected by changes in activity (i.e., total fixed cost remains constant even if activity changes) Per Unit Fixed cost per unit decreases as the activity level rises and increases as the activity level falls EXAMPLE: Assume again that a company manufactures microwave ovens The company pays $9,000 per month to rent its factory building The total and per unit cost of rent at various levels of activity would be: Rent Cost per Month $9,000 $9,000 $9,000 $9,000 Number of Ovens Produced 10 100 200 Rent Cost per Oven $9,000 $900 $90 $45 © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 2-11 A GRAPHIC VIEW OF COST BEHAVIOR $6,000 Total Variable Cost Total Fixed Cost $9,000 $3,000 100 200 Microwaves produced 100 200 Microwaves produced RELEVANT RANGE If activity changes enough, fixed costs may change For example, if microwave production were doubled, another factory building might have to be rented The relevant range is the range of activity within which the assumptions that have been made about variable and fixed costs are valid For example, the relevant range within which total fixed factory rent is $9,000 per month might be to 200 microwaves produced per month © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 2-12 COST CLASSIFICATIONS FOR ASSIGNING COSTS COST OBJECT A cost object is anything for which cost data are desired Examples: • Products • Customers • Departments • Jobs DIRECT COSTS A direct cost is a cost that can be easily and conveniently traced to a particular cost object Examples: • The direct costs of a Ford SUV would include the cost of the steering wheel purchased by Ford from a supplier, the costs of direct labor workers, the costs of the tires, and so on • The direct costs of a hospital’s radiology department would include X-ray film used in the department, the salaries of radiologists, and the costs of radiology lab equipment INDIRECT COSTS An indirect cost is a cost that cannot be easily and conveniently traced to a particular cost object Examples: • Manufacturing overhead, such as the factory managers’ salary at a multi-product plant, is an indirect cost of any one product • General hospital administration costs are indirect costs of the radiology lab © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 2-13 COST CLASSIFICATIONS FOR DECISION-MAKING DIFFERENTIAL COST Every decision involves choosing from among at least two alternatives Any cost that differs between alternatives is a differential cost Only the differential costs are relevant in making a decision EXAMPLE: Bill is currently employed as a lifeguard, but he has been offered a job in an auto service center in the same town The differential revenues and costs between the two jobs are listed below: Monthly salary Monthly expenses: Commuting Meals Apartment rent Uniform rental Union dues Total monthly expenses Net monthly income $1,200 Auto service center $1,500 Differential costs and revenues 30 150 450 10 640 $ 560 90 150 450 50 740 $ 760 60 0 50 (10) 100 $200 Lifeguard © The McGraw-Hill Companies, Inc., 2006 All rights reserved $300 TM 2-14 OPPORTUNITY COST An opportunity cost is the potential benefit given up when selecting one course of action over another EXAMPLE: Linda is employed in the campus bookstore and is paid $65 per day One of her friends is getting married and Linda would like to attend the wedding, but she would have to miss a day of work If she attends the wedding, the $65 in lost wages will be an opportunity cost of attending the wedding EXAMPLE: The reception for the wedding mentioned above will be held in the ballroom at the Lexington Club The manager of the Lexington Club had to decide between accepting the booking for the wedding reception or accepting a booking for a corporate seminar The hall could have been rented to the corporation for $600 The lost rental revenue of $600 is an opportunity cost of accepting the reservation for the wedding SUNK COST A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future Sunk costs are irrelevant and should be ignored in decisions EXAMPLE: Linda has already purchased a ticket to a rock concert for $35 Unfortunately, if she goes to the wedding, she will be unable to attend the concert The $35 is a sunk cost that she should ignore when deciding whether or not to attend the wedding [However, any amount she can get by reselling the ticket is NOT a sunk cost.] © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 2-15 ACCOUNTING FOR LABOR COSTS (Appendix 2A) Labor costs can be categorized as follows: Direct labor (Discussed earlier) Indirect labor (part of manufacturing overhead) Janitors Supervisors Materials handlers Engineers Night security guards Maintenance workers Other labor costs Idle time Overtime premium Labor fringe benefits IDLE TIME Idle time represents the wages of direct labor workers who are idle due to machine breakdowns, material shortages, power failures, and the like The cost of idle time is often added to manufacturing overhead EXAMPLE: An assembly line worker is idle for hours during the week due to a power failure If the worker is paid $15 per hour and works a normal 40 hour week, labor cost would be allocated as follows between direct labor and manufacturing overhead: Direct labor cost ($15 per hour × 38 hours) Manufacturing overhead cost ($15 per hour × hours) Total cost for the week © The McGraw-Hill Companies, Inc., 2006 All rights reserved $570 30 $600 TM 2-16 OVERTIME PREMIUM Any overtime premium paid to factory workers (direct as well as indirect labor) is usually considered to be part of manufacturing overhead EXAMPLE: Assume again that an assembly line worker is paid $15 per hour The worker is paid time and a half for overtime (time in excess of 40 hours per week) During a given week this employee works 46 hours and has no idle time Labor cost would be allocated as follows: Direct labor cost ($15 per hour × 46 hours) Manufacturing overhead cost ($7.50 per hour × hours) Total cost for the week $690 45 $735 LABOR FRINGE BENEFITS Labor fringe benefits are made up of employment related costs paid by the employer These costs are handled in two different ways by companies: Many companies treat all such costs as indirect labor and add them to manufacturing overhead Other companies treat that portion of fringe benefits that relates to direct labor as additional direct labor cost © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 2-17 QUALITY COSTS (Appendix 2B) • The costs of correcting defective units before they reach customers are called internal failure costs Examples: • Scrapped units • Rework of defective units • Costs that are incurred by releasing defective units to customers are called external failure costs Examples: • Costs of fixing products under warranty • Loss of sales due to a tarnished reputation • The costs of internal and external failures can be avoided by: • Preventing defects • Finding defective units before they are released The costs associated with these activities are called prevention costs and appraisal costs, respectively • Generally, prevention is the best policy It is usually far easier and less expensive to prevent defects than to fix them © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 2-18 EXAMPLES OF QUALITY COSTS (Exhibit 2B-1) © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 2-19 TRADING-OFF QUALITY COSTS (Exhibit 2B-2) © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 2-20 QUALITY COST REPORTS • Quality cost reports summarize prevention costs, appraisal costs, internal failure costs, and external failure costs that would otherwise be hidden in general overhead • Managers are often surprised by how much defects cost • The report helps identify where the biggest quality problems lie • The report helps managers assess how resources should be distributed If internal and external failure costs are high relative to prevention and appraisal costs, more should probably be spent on prevention and appraisal • Since quality cost reports are largely an attention-directing device, the costs not have to be precise • Unfortunately, the cost of lost sales due to external failures is usually excluded from the reports due to measurement difficulties © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 2-21 SAMPLE QUALITY COST REPORT (Exhibit 2B-3) © The McGraw-Hill Companies, Inc., 2006 All rights reserved