Question

Suppose an organization has not implemented either activity based costing or measuring the cost of quality but believes both would be valuable to the organization. However, management is currently willing to undertake only one major change initiative. Advise management on the decision between implementing an activity based costing model or beginning to measure the cost of quality.

Answer 1

Lets understand in detail about the two major change initiatives proposed by the management.

. Activity Based Costing (ABC)

. Measuring the Cost of Quality

Activity Based Costing or ABC Analysis

Activity Based costing is a costing method that assigns overhead and indirect costs to related products and services.

This is a method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each.It involves tracing resource consumption and costing final output.

ABC has predominantly being used to support strategic decisions such as, pricing, outsourcing, identification and measurement of process improvement initiatives.

The steps in determining ABC cost:

First identify which activities are necessary to create a product.

Then seperate each activity into its own cost pool, which includes all the individual costs related to an activity- such as manufacturing.calculate the total overhed of each cost pool.

Assign each cost pool activity cost drivers, such as hours or units.

Calculate the cost driver rate by dividing the total overhead in each cost pool by the total cost drivers.

Then multiply the cost driver rate by the no.of cost drivers.

(Examples of cost drivers includes, machine setups, maintenance requests, consumed power,purchase orders, quality inspections or production orders.)

Advantages of ABC

1.It helps in accurate product costs

2.ABC identifies the real nature of cost behaviour and helps in reducing costs and activities which do not add value to the product.

3.ABC traces costs to areas of managerial responsibility, processes, customers,departments besides the product costs.

4.Better decision making and cost management.

5.Identification and use of spare capacity and cost reduction.

6.Benefits to service industry(traditional costing has generally been considered inappropriate for these organizations)

Disadvantages;

1.Expensive and complex

2.Some difficulties emerge in the implementation of ABC, such as selection of cost drivers.

3.Disadvantages to smaller firms.Those firms who use market based pricing may not favour ABC.

4.Measurements are costly and activity cost rates also needs to be updated regularly.

2.Measuring the cost of quality

According to the American Society for Quality,the total costs associated with a poor quality product or service are referred to as the cost of quality.

The "cost of quality" is not the price of creating a quality product or service.It is the cost of NOT creating quality product or service.

COQ is generally classified into 4 categories.

1.External failure cost

2.Internal failure cost

3.Inspection (appraisal)cost

4.Prevention cost.

To calculate the cost of quality how many labour hours and what kind of activities are required to prevent poor quality product or services.Preventive activities can include quality reviews and process quality evaluations.

Similarly you have to determine the resources needed to appraise your systems, products and services.This can include activities such as inspections and evaluations.Internal and external costs are waste that can be measured by reviewing defects and scrap rates.

Conclusion.

The management should select any of the above mentioned improvement initiative, considering the nature and size of the organization and the complexities involved therein.

It will be advisable to go with ABC costing method as it helps in the accurate determination of product cost and better decision making.

The level of detail and information content inherent in conventional accounting practises are often insufficient for adequate quality cost analysis and applications to continuous improvements.ABC on the other hand because of its more detailed cost data base is better suited to these needs.

Moreover ABC through the tracing of costs and more detailed analysis of activities, can facilitate the use of quality costs to acheive continuous quality improvement.