CRITICISMS OF ABSORPTION COST SYSTEMS: INACCURATE PRODUCT COSTS

P 11–1: Solution to Maui Seminar (15 minutes)

[Pros and cons of activity-based costing systems]

The current absorption-based accounting system has survived (evolved?) up until now and is similar to the system used by many other firms in our type of industry. The fact that we hold a competitive position in the marketplace with the current system implies that it is at least adequate and has many unseen advantages (bear and marmot).

Activity-based cost systems are advantageous in plants where the output is not homogeneous in inputs or volumes. An analysis needs to be performed to determine if product costs derived from an activity-based cost system are significantly different from product costs as currently calculated. Moreover, even if some product costs change dramatically, what organizational effects will be generated with respect to performance evaluation? Who will be the winners and losers inside the firm and whose “ox will be gored?”

Activity-based cost systems are more costly to establish and maintain than absorption-based systems. ABC usually improves the accuracy of product costs for decision making. However, in improving costing for decision management, there can be a deterioration of the accounting system for decision control. Managers’ incentive plans will have to be adjusted to accommodate the new accounting figures. Organizational conflicts are certain to occur. There will be winners and losers. In the extreme, unless performance reward systems are adjusted the firm will lose key people over the conflicts.

P 11–2: Solution to GAMMA (15 minutes)

[Calculate absorption product cost from ABC data]

Plant-wide overhead rate = $68.5 million ÷ $90 million

= $0.76111 per direct labor dollar

Cost of Explorer Model

Direct labor $121,700

Direct material 90,500

Plant overhead ($0.76111 × $121,700) 92,627

Total cost $304,827

Number of units 12,500

Product cost per unit $ 24.39

P 11–3: Solution to ABC and Volume Changes (20 minutes)

[ABC and normal costing]

a. Unit level costs vary with the number of units manufactured. Examples include direct labor, direct materials, machine costs, and energy.

Batch level costs vary not with the number of units but with the number of batches. Examples include set-ups, material movements, purchase orders, and inspections.

Product line costs vary with the number of different product lines in the factory. Examples include process engineering, product specifications, engineering change notices, and product enhancement activities.

Production sustaining costs are all remaining costs in the factory incurred to provide the capacity to produce. These costs do not vary with the number of units produced, batches processed, or product lines manufactured in the factory. Examples include plant management, building and grounds, and heating and lighting.

b. False. As long as production-sustaining costs (which are fixed with respect to all volume measures) are allocated to products based on expected or actual volume, then unit costs will vary inversely with volume. “Normal costing” must be used for each allocation base to prevent unit costs from varying with volumes. For example, batch-level costs must be allocated based on the normal number of batches over the business cycle as long as there are any fixed costs (fixed with respect to the number of batches) in batch-level costs.

P 11–4: Solution to Milan Pasta (20 minutes)

[Absorption versus activity-based costing]

a. Traditional absorption costing based on machine hours:

Spaghetti

Fettuccine

Total

Pounds produced
6,000
2,000

Machine minutes per pound
0.2
0.4

Machine minutes per day
1,200
800

2,000

Percent of time
60%
40%

100%

Inspection cost
$300
$200

$500

Inspection cost/lb.
$0.05
$0.10

Fettuccine’s inspection cost per pound of $0.10 is twice as high as spaghetti’s of $0.05 because fettuccine takes twice as much machine time per pound as spaghetti (0.4 minutes per pound vs. 0.2 minutes).

b. Activity-based costing using inspection time.

Spaghetti

Fettuccine

Total

Inspection hours
8
24

Percent inspection time
25%
75%

100%

Inspection cost
$125
$375

$500

Pounds produced
6,000
2,000

Inspection cost/lb.
$0.0208
$0.1875

Fettuccine’s per pound inspection cost is higher under ABC than absorption costing ($0.1875 vs. $0.10), whereas spaghetti’s inspection cost falls from $0.05 to $0.0208.

c. When inspection costs are allocated based on actual inspection hours, fettuccine’s cost of inspection per pound, instead of being twice as large, is now nine times larger than spaghetti’s per-pound cost. Even though inspectors spend three times more hours inspecting fettuccine (24 hours vs. 8 hours), only one-third the amount of fettuccine is produced (2,000 pounds vs. 6,000) pounds.

In this problem, inspection costs are being converted from an indirect cost to direct cost because the times of the inspectors are being metered.

P 11-5: Solution to LifeCam Medical (20 minutes)

[Converting from ABC back to a single factory-wide overhead rate]

To convert back to a single overhead rate, the total indirect costs in the three cost pools must be computed. This requires taking the total number of units produced multiplied by the total indirect (ABC) costs per unit. The following table illustrates the computation of the new, factory-wide overhead rate based on direct labor dollars.

TS1

IFOR

Xpan

Total

Allocated cost based on grams of titanium

$680.00

$425.00

$510.00

Allocated cost based on milling minutes

864.00

2,016.00

2,664.00

OH cost based on Direct labor $

121.44

209.99

258.06

Total indirect costs per unit

$1,665.44

$2,650.99

$3,432.06

Number of units

2,300

1,200

900

Total indirect costs

$3,830,512

$3,181,188

$3,088,854

$10,100,554

Number of units

2,300

1,200

900

Direct labor dollars per unit

$48.00

$83.00

$102.00

Total direct labor dollars

$110,400

$99,600

$91,800

$301,800

Overhead rate per $DL

$33.47

The three existing ABC cost pools have total costs of $10,100,544. The three product lines generate $301,800 of total direct labor. So the factory-wide overhead rate is $33.47 ($10,100,544 ÷ $301,800). Using this single overhead rate, the three product lines have the following product costs.

TS1

IFOR

Xpan

Direct Labor

$48.00

$83.00

$102.00

Direct material

85.00

130.00

185.00

Overhead

1606.45

2777.82

3413.71

Total cost per unit

$1,739.45

$2,990.82

$3,700.71

P 11–6: Solution to Astin Car Stereos (30 minutes)

[Allocating selling and distribution costs using revenue vs. ABC costing]

a. S&D expenses allocated based on sales revenue:

A90

B200

B300

Total

Revenue

$1,500,000

$1,560,000

$1,680,000

$1,620,000

$6,360,000

Manufacturing costs

1,200,000

1,170,000

1,200,000

1,080,000

4,650,000

Gross margin

300,000

390,000

480,000

540,000

1,710,000

S&D expenses

299,528

311,509

335,472

323,491

1,270,000

Net income

$ 472

$ 78,491

$ 144,528

$ 216,509

$ 440,000

b. All S&D expenses allocated using advertising and marketing budget shares:

A90

B200

B300

Total

Advertising & marketing shares

10%

20%

30%

40%

100%

S&D expenses
$127,000
$254,000
$381,000
$508,000
$1,270,000
Net income
$173,000
$136,000
$ 99,000
$ 32,000
$ 440,000

c. Advertising & marketing costs allocated using advertising & marketing budget shares, distribution & administration costs divided equally, and selling costs assigned based on gross margin.

A90

B200

B300

Total

S&D expenses:

1/2 on advertising & marketing shares

$63,500

$127,000

$190,500

$254,000

$635,000

25% assigned equally

79,375

317,500

25% on gross margin

55,702

72,412

89,123

100,263

317,500

S&D expenses

$198,577

$278,787

$358,998

$433,638

$1,270,000

net income

$101,423

$111,213

$121,002

$106,362

$ 440,000

d. This problem illustrates that the common practice among many companies of allocating selling and distribution costs based on sales revenue can distort product-line profitability analysis. Under method (a), Z7 is the most profitable and A90 the least profitable. Under method (b), A90 is the most profitable and Z7 the least profitable. Finally, under method (c), all products are of roughly equal profitability.

The critical question involves how S&D resources are consumed by the various product lines. If the ABC-type analysis in the problem is reasonably accurate, then method (c) is probably the most accurate portrayal of product-line profitability. However, this analysis does not capture the synergies (interdependencies) among the product lines. For example, A90 may be “piggy-backing” off the reputation of Z7. Likewise, the manufacturing cost of Z7 may be lower because of the learning-curve effects of producing large numbers of A90.

Remember the Coase analysis of why firms exist. Why are all four of these stereos produced by the same firm as opposed to four separate firms? Presumably there are efficiencies that allow the four to be produced and sold more cheaply in one firm than in four separate firms. There are joint costs and joint benefits. These joint costs and benefits belong to all four products, and trying to divide them up can distort product-line profitability analyses. Thus, even method (c) may not be an accurate estimate of the relative profitability of a stereo line.

P 11–7: Solution to DVDS (35 minutes)

[ABC and taxes]

Unit manufacturing costs of Basic and Custom DVDs using traditional absorption costing. Manufacturing overhead is allocated based on direct labor dollars.

Basic

Custom

Total

Quantity

60,000

70,000

Direct labor/unit

$15.00

$ 30.00

Total direct labor

$900,000

$2,100,000

$3,000,000

Percent of direct labor

30.00%

70.00%

Allocated overhead

$600,000

$1,400,000

$2,000,000

Quantity

60,000

70,000

Overhead per unit

$10.00

$20.00

Direct labor/unit

$15.00

$30.00

Direct materials/unit

40.00

80.00

Overhead/unit

10.00

20.00

Unit manufacturing cost

$65.00

$130.00

Unit manufacturing costs of Basic and Custom DVDs using ABC. Manufacturing overhead is allocated based on number of parts.

Basic

Custom

Total

Number of parts

140

160

300

Percent of parts

46.67%

53.33%

100%

Allocated overhead

$933,333

$1,066,667

$2,000,000

Quantity

60,000

70,000

Overhead per unit

$15.56

$15.24

Direct labor/unit

$15.00

$30.00

Direct materials/unit

40.00

80.00

Overhead/unit

15.56

15.24

Unit manufacturing cost

$70.56

$125.24

DVDS should not change its costing method because this will likely cause its total tax liability to increase. Custom DVDs are sold in the high tax rate country (35%) whereas Basic DVDs are sold in the low tax rate country (15%). Therefore, assuming that both countries’ tax authorities accept absorption costing as an acceptable tax method (and apparently they are using this method now), activity-based costing causes the unit manufacturing cost of Custom DVDs to fall from $130.00 to $125.24. Higher profits in the high tax rate country generate a larger tax liability. The table below calculates that ABC would cause taxes to rise by $66,667 ($401,667 – $335,000). If DVDS uses ABC for internal reporting and absorption costing for taxes, it exposes itself to charges by tax authorities that its choice of cost allocation methods for taxes (absorption costing) is being used solely to minimize taxes and has no legitimate business purpose as evidenced by the use of ABC.

Note: Switching to ABC does not necessarily cause a firm’s total tax liability to rise. ABC might cause taxes to fall in some situations (i.e., if it’s current absorption costing system is not minimizing the firm’s total tax liability). However, if the firm’s current absorption costing system has been designed to minimize its total tax liability, then one “cost” of switching to ABC is higher total taxes. The firm might want to switch to ABC if the benefits of ABC (primarily better decision making) exceed the higher tax cost.

Overhead allocated based on direct labor dollars

Basic

Custom

Revenues

$4,500,000

$9,800,000

$14,300,000

Direct labor

900,000

2,100,000

3,000,000

Direct material

2,400,000

5,600,000

8,000,000

Overhead

600,000

1,400,000

2,000,000

Income before taxes

$600,000

$700,000

$1,300,000

Income taxes

90,000

245,000

335,000

Net income

$510,000

$455,000

$965,000

Overhead allocated based on part numbers

Basic

Custom

Revenues

$4,500,000

$9,800,000

$14,300,000

Direct labor

900,000

2,100,000

3,000,000

Direct material

2,400,000

5,600,000

8,000,000

Overhead

933,333

1,066,667

2,000,000

Income before taxes

$266,667

$1,033,333

$1,300,000

Income taxes

40,000

361,667

401,667

Net income

$226,667

$671,667

$898,333

P 11–8: Solution to SPP (30 minutes)

[ABC doesn’t always capture the firm’s strategy]

a. The average cost of processing a transaction is computed as:
Average cost = $28,696,143 ÷ 280,510,000
= $0.10320
b. The new CFO is calling for an activity-based-costing approach to be applied to costing both the set-ups and transaction processing. The table below provides the computations:

Total operating costs

$28,696,143

Less:

Set-up software engineers

Annual salary + benefits

$139,000

Set-up engineering salary and benefits

$5,421,000

Additional Set-up Group costs

$8,408,143

Total Set-up Group costs

($13,829,143)

Total cost of transaction processing

$14,867,000

Number of set-ups

350

Average cost of a set-up

$39,512

Annual number of transactions processed

280,510,000

Average cost of processing a transaction

$0.05300

SPP should probably stay with the allocation method currently used in part a. Method b is more accurate because it excludes the Set-up Group’s costs of $13,829,143 from the cost of processing a transaction. The average cost of processing a transaction falls from about $0.10 per transaction in part a to about $0.05 a transaction in part b. The problem provides little information about how SPP uses the cost of processing a transaction. Hence, we do not know how changing the calculated cost of a transaction affects SPP’s cash flows. It might affect SPP’s taxes if SPP is an international firm that files multiple tax returns. But we do not know this.
SPP appears to be using price discrimination to capture more of the area under its customers demand curve. By charging a low fee for a set-up, it acquires clients who then pay SPP based on the number of transactions processed. This is the same pricing strategy followed by HP that sells printers for marginal cost, and then charges a high price for its printer cartridges. By bundling the Set-up Group’s costs into the average cost of processing a transaction, SPP reports an average cost of $0.10 per transaction, which is close to the price it charges. If method b is followed, the average cost per transaction falls to $0.05, which might cause some managers in SPP to argue for a lower price per transaction. In other words, method a is consistent with and supports SPP’s price discrimination strategy.

P 11–9: Solution to Friendly Grocer (40 minutes)

[ABC in a retail store]

a. The following statement presents the ABC-based operating incomes for the three divisions.

Canned &

Beverages

Dairy &

Meats

Packaged Foods

Total

Sales

$250.00

$470.00

$620.00

$1,340.00

Direct costs:

Cost of Goods Sold

200.00

329.00

527.00

1,056.00

Indirect costs:

Shelf space costs

22.50

31.50

36.00

90.00

Handling costs

0.00

15.00

5.00

20.00

Coupon costs

3.00

0.00

12.00

15.00

Shrinkage

1.00

21.00

6.00

28.00

Other indirect costs

11.02

18.13

29.04

58.20

Total costs

237.52

414.63

615.04

1,267.20

Operating income

$ 12.48

$ 55.37

$ 4.96

$ 72.80

The preceding indirect costs were calculated using the following allocation rates:

Canned &

Beverages

Dairy &

Meats

Packaged Foods

Shelf space costs

25%

35%

40%

Handling costs

75%

25%

Coupon costs

20%

80%

Shrinkage (given)

$21

Other indirect costs

19%*

31%

50%

* 19% = $200 ÷ $1056

b. Before this question can be answered, one must first determine how management will use the statement. Is the primary function of the statement decision management or decision control or both?

Without a more detailed description of the function of the statement, some, more general comments can be offered.

i. The revised, ABC statement has some attractive features. In particular, some of the previous indirect costs are metered more accurately to the three departments. These consist of handling, coupons, and shrinkage. These former indirect costs are now directly traced to the departments.

ii. Based on the apparently more accurate allocation of costs under the ABC system, it is tempting to argue that canned and packaged foods are really making a small profit (instead of a loss) and that dairy and meats is not making as much money as originally thought. However, the ABC report may be no better a gauge of relative profitability than the original statement for two reasons. First, a substantial portion of the indirect costs are occupancy costs which include accounting depreciation. Accounting depreciation is not the opportunity cost of shelf space. The opportunity cost of shelf space is the profits forgone by the product(s) not stocked. Second, the grocery store offers one stop shopping for the consumer — a joint product for the consumer. Thus, dropping a product line (e.g., canned and packaged goods) would likely severely affect the demand for the remaining products. Allocating joint and common costs can produce misleading information for dropping/adding product lines.

iii. If the financial statement is used for performance evaluation, then adopting the ABC report requires adjustments to the performance reward system. Without such adjustments there will be windfall gains and windfall losses among the department managers if their compensation is tied to their department’s operating income.

iv. The issue of the other indirect costs and how to allocate them remains. Is cost of goods sold the right cost driver to tax? Does this create the desired incentives?

v. One must compare the costs of tracking the cost drivers versus the benefits from ABC.

P 11-10: Solution to Houston Milling (40 minutes)

[ABC is not necessarily more accurate]

a. The table below calculates product costs using the more disaggregate data:

Houston Milling

Revised Cost Allocations Based on Disaggregated Cost Pool Data

Setup

Machining

Dept. 1

Dept. 2

Dept. 1

Dept. 2

Total

Total Cost

$3,000

$2,000

$8,000

$2,000

$15,000

Allocation base

Number of setups

Direct labor hours

Usage: A11

D43

Total

Allocation rate

$150/setup

$400/setup

$160/dl hr.

$40/dl hr.

Allocations: A11

$1,050

$1,200

$5,120

$1,360

$8,730

D43

1,950

800

2,880

640

6,270

Total

$3,000

$2,000

$8,000

$2,000

$15,000

b. With the very limited knowledge provided in this case, one cannot discuss the pros and cons of the two different allocation bases. We know nothing of how these costs are being used by Houston. Are they being used for decision making and/or control, or for tax purposes? Given that more cost drivers and cost pools are used, one is tempted to argue that the data in part (a) is a more accurate reflection of the “true” costs of A11 and D43 than the data in Table 1. But what do we mean by “true” costs? Is this the “true” historical cost of production? For what purpose are these numbers being used? Are there joint and/or common costs in the production process? If so, then allocating these costs is not a meaningful exercise. Besides, both A11 and D43 are sold to Pratt & Whitney who presumably wants to source both housings from a single supplier (Houston). Why is more “accurate” cost data important to Houston? If the cost of one product falls, the other product’s cost rises. Houston is only interested in the total profit on the P&W contract. Finally, as we will see in part (c), more complex allocations do not necessarily produce more accurate costs.

c. The table below computes the costs of A11 and D43 using setup hours and machine hours as the allocation bases.

Houston Milling

Revised Cost Allocations Using

Setup Hours and Machine Hours in Dept. 1 and 2

Dept. 1

Dept. 2

Total

Setup

Machining

Setup

Machining

Total Cost

$3,000

$8,000

$2,000

Allocation base

Setup hours

Machine hours

Setup hours

Machine hours

Usage: A11

115

120

D43

Total

200

Allocation rate

$100 per setup hr.

$40 per machine hr.

$200 per setup hr.

$10 per machine hr.

Allocations: A11

$1,500

$4,600

$1,200

$8,500

D43

1,500

3,400

800

6,500

Total

$3,000

$8,000

$2,000

$15,000

d. One thing we learn from this exercise is that the simple, more aggregate allocation scheme in Table 1 provides reasonably accurate estimates of product costs. Total allocated costs to each product vary little across the three methods. For example, in Table 1 A11 has a product cost of $8,600 compared to the most accurate estimate in part (c) of $8,500, or an error of $100. Using more disaggregated data in part (a) yields a product cost estimate of $8,730 or a difference of $230. Therefore, more cost drivers do not necessarily guarantee more accurate product cost estimates. What drives “accuracy” is whether or not the cost driver used captures the “true” cause-and-effect relation.

P 11-11: Solution to Sanchez Gadgets (40 minutes)

[Using ABC to identify unprofitable products]

This problem illustrates how considering just costs to identify unprofitable products can lead to unwise decisions because ABC incorporates only costs and not benefits of having multiple products. Moreover, ABC typically ignores the common costs associated with a direct sales force.

Based on management’s analysis of the marketing group, it seems reasonable to assign the marketing costs to the SKUs using number of SKUs, in this case ¼. Also, the inventory handling costs vary with SKUs. Dropping a SKU saves the inventory holding cost. If the direct sales force costs are assigned based on sales revenue, then the following table computes the profitability of each SKU.

SKU 1

SKU 2

SKU 3

SKU 4

Total

Wholesale price (to retailer)

$51.00

$13.00

$85.00

$7.00

Cost (including all freight)

$29.00

$8.00

$49.00

$5.00

Sales volume

12,000

25,000

8,000

30,000

ABC analysis:

Revenue

$612,000

$325,000

$680,000

$210,000

$1,827,000

Cost of goods sold (including freight)

(348,000)

(200,000)

(392,000)

(150,000)

(1,090,000)

Inventory holding cost*

(69,600)

(40,000)

(78,400)

(30,000)

(218,000)

Marketing costs (1/4th per SKU)

(33,750)

(135,000)

Direct selling cost (% of revenue)

(117,241)

(62,261)

(130,268)

(40,230)

(350,000)

Net income

$43,409

$(11,011)

$45,582

$(43,980)

$34,000

* 20% of Cost of goods sold

The problem with the above analysis is that it assumes that if SKU2 is dropped, $62,261 of direct selling costs would be eliminated, and if SKU4 is dropped, $40,230 of direct selling costs would be eliminated. However, the dollars spent on the direct sales force is unlikely to change by these amounts if these SKUs were deleted. The existing sales people will be selling fewer products. Given that they have fewer SKUs to sell, they may exert more effort selling the remaining SKUs and the sales of the remaining SKUs might increase, but by how much is difficult to estimate.

An alternative SKU profitability analysis is to focus on the direct costs and allocated marketing department costs, and to ignore the direct selling costs:

SKU 1

SKU 2

SKU 3

SKU 4

Total

Revenue

$612,000

$325,000

$680,000

$210,000

$1,827,000

Cost of goods sold (including freight)

(348,000)

(200,000)

(392,000)

(150,000)

(1,090,000)

Inventory holding cost

(69,600)

(40,000)

(78,400)

(30,000)

(218,000)

Marketing costs (1/4th per SKU)

(33,750)

(135,000)

Contribution before direct selling costs

$160,650

$51,250

$175,850

($3,750)

$384,000

Direct selling costs

(350,000)

Net income

$34,000

The first table assumes that direct selling costs vary with revenues. The second table assumes they are entirely fixed and will not vary with revenues. In the second table, we see that only SKU4 is unprofitable. If SKU4 is dropped, all of its revenues are lost, but Sanchez saves SKU4’s cost of goods sold, inventory holding costs, and ¼ of the marketing costs. The second table treats the direct selling costs as a JOINT COST. Like other joint costs, all of the direct selling costs of $350,000 must be incurred to generate sales of SKUs.

b. Based on the analysis in the second table in part (a), Sanchez should consider dropping SKU4. However, before this decision is made, management should consider the issues discussed in part (c), below.

c. The critical assumptions in the profitability methodology in the second table in part (a) is that there are no demand interdependencies among the four SKUs. That is, the analysis assumes that dropping a particular SKU does not affect the number of units sold of other SKUs. For example, the product line might contain a very popular, low-margin product. Retailers always buy this product and once they have incurred the fixed costs of making the purchase from Sanchez, they are more likely to buy other Sanchez products that can be included in the same shipment. Another critical assumption, discussed above, is that the sales force is a common or joint cost. Dropping a product does not cause the sales force size to drop or that they exert more effort on the remaining products and sell more. If the later is the case, then the analysis becomes more complicated. Suppose a SKU is dropped that has a contribution margin of 3 percent of its sales. This product comprises 10 percent of the total sales volume. Assume the remaining products have an average contribution margin of 5 percent and the sales force shifts its effort to the remaining products. If the firm has total sales of $2 million, then dropping the SKU with a 3 percent margin increases net cash flow by $6,000 ($2 million × 10% × (5%-3%)). In other words, the opportunity cost of selling the 3% percent margin SKU is the forgone sales of the 5 percent margin products. Dropping the 3 percent margin SKU results in still selling $2 million of products, but now (on average) 5 percent margin products are being sold. Notice, in this case, the cost assigned to each SKU is not the allocated cost of the sales force, but the opportunity cost of what net cash flow the sales force could generate without the product.

Neither table presented above captures the opportunity cost of the sales force shifting their selling effort to higher margin items when lower margin items are dropped.