ABC Systems Can Still Produce Inaccurate Product Costs
Accurate Cost

Essay

ABC Systems Can Still Produce Inaccurate Product Costs
Accurate Cost Manufacturing, Inc., manufactures and sells large business equipment for the office and business markets. The primary function of Manufacturing is to provide components and subassemblies for the profit centers within the company. To maintain competitiveness, each profit center can purchase parts either from Manufacturing or from outside firms. Manufacturing operates as a cost center and charges the profit centers for the full cost of the parts. Costs are computed once a year using full absorption costing. The volume of parts used to calculate costs is provided by the profit centers to Manufacturing in August; the fiscal year begins in January. With these numbers, Manufacturing projects costs per part for the year. These cost estimates are then used throughout the year to charge the profit centers. Any over/under-absorbed overhead goes directly to the bottom line of the company, not to any of the profit centers.
Within Manufacturing there is a department called finishing. The finishing department provides a service to other Manufacturing departments and profit centers as well as generating some external sales. Types of finishing include painting and plating. The facility has large investments in fixed assets in both automation and environmental compliance for finishing. The finishing operation believes it provides value to customers through its high quality and its close location to the manufacturing departments.
During the past year, the profit centers have begun taking work away from Manufacturing and giving it to outside vendors with lower quoted costs. Manufacturing then has lower volumes and has to raise the prices on the products it is producing, causing the profit centers to send even more work out. Manufacturing feels it is caught in a death spiral.
The death spiral situation has affected finishing the most. The finishing department is currently operating at 30 percent of capacity and has facilities that are too large for the low volume of work. Table 1 summarizes the data pertaining to finishing. Fixed costs make up 71 percent of the current cost structure. Other manufacturing departments are beginning to tell finishing that they will be sending their work out to get plating and painting so as not to lose any work because of the high internal cost of finishing.
Finishing is trying to attract business from outside Accurate Cost Manufacturing. The external sales guidelines require a 35 percent profit margin applied to the full cost for all external work. With the current low level of work and high fixed costs, finishing cannot attract external sales due to cost.
In an effort to gain control of the true cost drivers of the business, the manager of the finishing operation has implemented activity-based costing. Tables 2 and 3 project the cost for products and volumes for one plating operation. The problem that the finishing manager now faces is that the manufacturing departments are about to send the 12-inch and 18-inch work to an outside shop due to lower costs.
In implementing activity-based costing, the manager thinks he has truly identified the proper system. The larger parts tend to run in smaller lot sizes and generate more paperwork. Smaller parts tend to be run in larger lot sizes and generate less paperwork.
In a recent meeting with the management of the manufacturing department and profit centers, it was stated that the installation of activity-based costing is in direct conflict with the change in the mix of work from small parts to large parts and the need to run smaller lot sizes. The manufacturing department and profit centers would like to pursue just-in-time manufacturing and further reduce the lot sizes for both small and large parts. During this meeting, the profit centers and manufacturing departments said the implementation of activity-based costing would force them to move their work out of the finishing department to outside shops. Table 1
Finishing Annual Cost Structure
$\begin{array}{|l|r|l|}\hline&Annual~Cost\\\hline \begin{array}{l}\text { Fixed asset } \\\text { depreciation }\end{array} & \$ 400,000 & \begin{array}{l}\$ 4,000,000 \text { machine } \\\text { purchased } 2 \text { years a go }\end{array} \\\hline \begin{array}{l}\text { Tank } \\\text { operations } \\\text { costs }\end{array} & 250,000 & \begin{array}{l}\text { Cost to operate tanks- } \\\text { fixed cost, not volume } \\\text { dependent }\end{array} \\\hline \begin{array}{l}\text { Tank material } \\\text { cost }\end{array} & 50,000 & \begin{array}{l}\text { Cost to operate tanks- } \\\$ 0.007575 / \text { inch }\end{array} \\\hline \text { Variable labor } \\\text { cost } & 210,000 & \begin{array}{l}\$ 10 / \text { hour } \times 21,000 \text { hours } \\\text { of operation }\end{array} \\\hline \text { Total } & \$ 910,000 & \\\hline\end{array}$
Table 2
Finishing Costs before and after Activity-Based Costing
$\begin{array}{|c|r|r|r|r|}\hline & \begin{array}{r}\text { Volume of } \\\text { Pieces per } \\\text { Year }\end{array} & \begin{array}{r}\text { Old } \\\text { Cost } \\\text { per } \\\text { Piece }\end{array} & \begin{array}{r}\text { Activity- } \\\text { Based Cost } \\\text { per Piece }\end{array} & \begin{array}{r}\text { Outside } \\\text { Cost per } \\\text { Piece }\end{array} \\\hline \begin{array}{l}3^{\prime \prime} \\\text { parts }\end{array} & 1,000,000 & \$ 0.50 & \$ 0.31 & \$ 0.30 \\\hline 6^{\prime \prime} & 200,000 & 1.00 & 1.00 & 1.10 \\\text { parts } & & & & \\\hline \begin{array}{l}12^{\prime \prime} \\\text { parts }\end{array} & 50,000 & 1.20 & 2.00 & 0.90 \\\hline 18^{\prime \prime} & 100,000 & 1.50 & 3.00 & 1.20 \\ \text { parts } & & & & \\\hline\end{array}$
Table 3 Forecasted Costs
$\begin{array}{|l|c|c|c|}\hline & \text { Old Cost } & \begin{array}{c}\text { Activity-Based } \\\text { Cost }\end{array} & \begin{array}{c}\text { Outside } \\\text { Cost }\end{array} \\\hline 3^{\prime \prime} \text { parts } & \$ 500,000 & \$ 310,000 & \$ 300,000 \\\hline 6^{\prime \prime} \text { parts } & 200,000 & 200,000 & 220,000 \\\hline 12^{\prime \prime} \text { parts } & 60,000 & 100,000 & 45,000 \\\hline 18^{\prime \prime} \text { parts } & 150,000 & 300,000 & 120,000 \\\hline \begin{array}{l}\text { Total per } \\\text { year }\end{array} & \$ 910,000 & \$ 910,000 & \$ 685,000 \\\hline\end{array}$ Required:
a. Analyze the current situation in this company. What should be done?
b. Compare and comment on the costs before and after ABC is implemented.
c. Has finishing management made a mistake by installing activity-based costing?