910B11 ACTIVITY-BASED COSTING AND MANAGEMENT Owen P. Hall, Charles McPeak and Samuel Seaman wrote this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Richard Ivey School of Business Foundation prohibits any form of reproduction, storage or transmission without its written permission. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Richard Ivey School of Business Foundation, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail [email protected]. Copyright © 2010, Richard Ivey School of Business Foundation Version: (A) 2010-09-10 CASE OVERVIEW The CFO at the Rubrics Corporation, a midsize hardware manufacturing firm, had become aware of the ongoing imbalance between the product’s budgeted and actual costs. The Rubrics Corporation normally allocated overhead to products using a single direct cost driver, usually direct labor hours or direct labor dollars. This practice sometimes led to inaccuracies, since indirect costs were not incurred equally across products. For example, Rubrics’ CFO had forecasted $10,000,000 in direct labor costs and $15,000,000 in overhead for a particular project last year, resulting in an overhead rate of 150 per cent. For each dollar of direct labor charged, $1.50 of overhead had been allocated. The shortcoming of this costing method was that overhead costs failed to reflect varying manufacturing intensity between products. Often referred to as smoothing, traditional costing allocates overhead costs evenly per direct labor hours or dollars. Unfortunately, direct costing can result in a discrepancy between the budgeted overhead and the actual overhead used. Often, certain products require more maintenance or floor space. Traditional costing allocates overhead based on direct expenses without compensating for a product’s greater or lesser use of overhead costs. Activity-based costing (ABC) was first introduced in the United States during the 1970s. Since then, ABC had enjoyed wide acceptance as a more accurate alternative to traditional costing, especially in manufacturing. Instead of budgeting overhead using direct cost drivers, ABC splits overhead into activity cost drivers, leading to a more tangible assignment of costs. Calculating ABC is more complicated than calculating traditional costing. Once management identifies the activity cost drivers, overhead rates are assigned per cost driver. The rates are estimated by dividing budgeted costs per driver by the anticipated resource requirements for each cost driver. For instance, rent could be allocated based on the square footage occupied by inventory in producing a given product or service. Say X Company estimates next year’s rental costs to be $30,000 for its 15,000-square-foot factory. X Company can calculate the rental overhead rate by dividing $30,000 by 15,000 to get 2. After calculating the overhead rates for each activity driver (rent, depreciation, maintenance, etc), the rates are

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applied to the individual requirements of each product. Continuing the previous example, suppose X Company manufactures two products, Y and Z, requiring 10,000 and 5,000 square feet of factory space, respectively. X Company can calculate each product’s individual use of factory rent by multiplying 10,000 and 5,000 by 2, resulting in $20,000 for Y and $10,000 for Z. The objective of ABC is to align actual consumption with specific product/service costs. The ABC approach is normally associated with multiple products or services using shared and often common indirect resources. A benefit of ABC is that products requiring higher concentrations of overhead costs are revealed, allowing management to focus attention on opportunities for reducing those costs or to price more appropriately. Activity-based costing allocates overhead to a product based on the actual amount of overhead used by that product. Whenever common resources are expended in different ways across products, a weighting mechanism is required for accurate allocation. ABC can be equally valuable in service industries. Financial institutions have diverse products and customers, resulting in cross-product, cross-customer subsidies. Often, personnel expenses represent the largest single component of non-interest expense in financial institutions. Accordingly, these costs must also be attributed more accurately to products and customers via activity-based accounting. The ABC methodology is an involved process with many steps, including: identifying direct product costs, identifying cost activities, selecting cost-allocation basis (CAB), identifying indirect costs per CAB, computing overhead rate per cost activity, calculating overhead costs based upon each product’s use of the various cost activities, and then adding direct expenses and indirect expenses to yield total product costs. Despite the complexity, the benefits of ABC can be significant: management can distinguish profitable from unprofitable products, cost controls can be established to eliminate unnecessary costs, and products can be better priced. However, prior to implementing ABC, management should consider whether the cost savings from more accurate budgeting are greater than the research costs of identifying overhead cost drivers and each product’s individual resource requirements. RUBRICS’ SITUATION The Rubrics Corporation made four products: widgets, gadgets, smidgets, and smadgets. Exhibit 1 summarizes the direct labor, overhead, and direct material costs associated with these products. Rubrics’ CFO was considering implementing an activity-based costing system as a means of improving product pricing. Exhibit 2 presents the cost allocation bases for the three main overhead cost drivers (depreciation, set-up, and rent). Exhibit 3 shows the product resource requirements by cost driver. Notice, for example, that the set-up requirement for widgets is 200 hours. Among other things, the CFO wanted to compare the overhead estimates per product based on the traditional costing and ABC methods. In addition, the CFO wanted to understand, computer or calculate the following: 1. Using the traditional costing method, compute the overhead costs per product. 2. Using the traditional costing method, compute the total costs per product. 3. Under ABC:

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a. Calculate the activity-based overhead rates per activity cost driver. b. For each product, compute the overhead costs per activity cost driver. c. Using the overhead costs from b., calculate the total costs per product.

4. Assuming ABC allocated overhead more accurately, which products were incorrectly priced using the

traditional costing method? What difficulties might result from incorrectly budgeted products? Hint: Think about how capital resources should be allocated to the most efficient opportunities.

5. What actions might be explored to deal with the mispriced products? 6. Compare assigned costs per product under both methods. Why had activity-based costing changed the

total costs assigned to each product? 7. What were two circumstances where traditional and ABC costing would likely yield similar or equal

overhead costs?

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Exhibit 1

DIRECT LABOR, OVERHEAD, AND DIRECT MATERIALS COSTS

Total direct labor $1,000,000 Total overhead $2,000,000 Overhead rate 200% of direct labor Widgets direct labor $100,000 Gadgets direct labor $300,000 Smidgets direct labor $400,000 Smadgets direct labor $200,000 Widgets direct material $100,000 Gadgets direct material $200,000 Smidgets direct material $150,000 Smadgets direct material $250,000 Units built 1,000 of each product

Exhibit 2

OVERHEAD COST DRIVERS

Cost allocation bases Total costs Quantity of CAB Depreciation $300,000 3,000 machine hours Set-up $700,000 1,000 set-up hours Rent $1,000,000 100,000 square feet

Exhibit 3

PRODUCT RESOURCE REQUIREMENTS BY COST DRIVER

Widgets Gadgets Smidgets Smadgets 500 machine hours 900 machine hours 400 machine hours 1,200 machine hours

200 set-up hours 300 set-up hours 100 set-up hours 400 set-up hours 20,000 square feet 30,000 square feet 10,000 square feet 40,000 square feet

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This document is authorized for use only by Siyu Cheng in ACCT615-01-W20-CSUSB taught by Taewoo Kim, California State University – San Bernardino from Jan 2020 to Mar 2020.