Questions We Will Answer Questions We Will Answer TodayToday

• How are traditional cost systems How are traditional cost systems designed?designed?

• What are the limitations of traditional What are the limitations of traditional cost systems when used for internal cost systems when used for internal decision-making purposes?decision-making purposes?

• What is a death spiral?What is a death spiral?

Bridgeton IndustriesBridgeton Industries

BackgroundBackground

• The ACF plant competes with other The ACF plant competes with other Bridgeton plants and local suppliers Bridgeton plants and local suppliers for a shrinking pool of production for a shrinking pool of production contracts.contracts.

• The ACF experienced a plant closing The ACF experienced a plant closing in the past with the shut-down of its in the past with the shut-down of its diesel engine plant.diesel engine plant.

Tell me what the consultants Tell me what the consultants did.did.

Strategic AnalysisStrategic Analysis

• Bridgeton hired a consulting firm to Bridgeton hired a consulting firm to classify all plants’ products as:classify all plants’ products as:– Class I products should remain at Class I products should remain at

present locations.present locations.– Class II were to be watched closelyClass II were to be watched closely– Class III products were outsourced or Class III products were outsourced or

dropped.dropped.

• Four criteria were supposedly used:Four criteria were supposedly used:– Quality, customer service, technical Quality, customer service, technical

capability, and cost.capability, and cost.

Where did the consultants Where did the consultants get their cost data?get their cost data?

Where did the consultants Where did the consultants get their cost data?get their cost data?

Please tell me you’re kidding!Please tell me you’re kidding!

Describe Bridgeton’s Describe Bridgeton’s existing cost system.existing cost system.

The Cost SystemThe Cost System

• One budgeted plantwide overhead One budgeted plantwide overhead cost poolcost pool

• One allocation baseOne allocation base– Direct labor dollars Direct labor dollars

• Utilization-based denominator Utilization-based denominator volumevolume

What are the problems with What are the problems with this type of traditional cost this type of traditional cost

system?system?

The ProblemsThe Problems

• One heterogeneous plantwide One heterogeneous plantwide overhead cost pooloverhead cost pool

• One volume-related allocation One volume-related allocation – Direct labor dollars Direct labor dollars

• Reliance on a utilization-based Reliance on a utilization-based denominator volumedenominator volume

• Disregard of selling & administrative Disregard of selling & administrative expensesexpenses

Should Bridgeton be Should Bridgeton be concerned about these concerned about these

limitations?limitations?

Should Bridgeton Be Should Bridgeton Be Concerned About These Concerned About These

Limitations?Limitations?• Yes! Because:Yes! Because:

– They have product diversity.They have product diversity.– The non-volume-related overhead The non-volume-related overhead

dollars are material.dollars are material.– They probably have unused capacity.They probably have unused capacity.

Compute Bridgeton’s Compute Bridgeton’s Plantwide overhead rate for Plantwide overhead rate for

1988.1988.

1988 Overhead Rate1988 Overhead Rate

$109,890 ÷ $25,294 = $4.3445 per DL$

What overhead rate did the What overhead rate did the consultants use as quoted in consultants use as quoted in

the case?the case?

What overhead rate did the What overhead rate did the consultants use as quoted in consultants use as quoted in

the case?the case?

435%, or essentially the 435%, or essentially the same overhead rate used in same overhead rate used in

Bridgeton’s traditional Bridgeton’s traditional plantwide cost system. plantwide cost system.

Why is this plantwide rate Why is this plantwide rate useless?useless?

Why is this plantwide rate Why is this plantwide rate useless?useless?

• To assume that all overhead is driven by To assume that all overhead is driven by direct labor is flawed.direct labor is flawed.– Miller and Vollmann graphMiller and Vollmann graph

• To assume that $109 million of overhead is To assume that $109 million of overhead is driven by any single volume-related driven by any single volume-related allocation base is very flawed.allocation base is very flawed.– Miller and Vollmann transactions framework Miller and Vollmann transactions framework

(quality, change, balancing, and logistical (quality, change, balancing, and logistical transactions) transactions)

• Assigning used and unused capacity costs Assigning used and unused capacity costs distorts product cost consumptiondistorts product cost consumption

What Distortions Will It What Distortions Will It Create?Create?

What Distortions Will It What Distortions Will It Create?Create?

• It will overcost labor-intensive, high It will overcost labor-intensive, high volume products and undercost non-volume products and undercost non-labor-intensive, low volume products.labor-intensive, low volume products.

• It will overcost all products to the It will overcost all products to the extent products are assigned unused extent products are assigned unused capacity costs.capacity costs.

Why do you think Why do you think Mufflers/Exhausts and Oil Mufflers/Exhausts and Oil

Pans were the first products Pans were the first products labeled Class III? labeled Class III?

Why Mufflers and Oil Pans?Why Mufflers and Oil Pans?

Fuel tanks: $4,238 ÷ $75,196 = 5.6%

Manifolds: $6,027 ÷ $84,776 = 7.1%

Doors: $2,731 ÷ $45,174 = 6.1%

Muffler/Exhausts: $5,766 ÷ $66,266 = 8.7%

Oil Pans: $6,532 ÷ $79,658 = 8.2%

The Outsourcing DecisionThe Outsourcing Decision

• Muffler/Exhausts and Oil Pans get Muffler/Exhausts and Oil Pans get outsourcedoutsourced

• The ACF responds by making as The ACF responds by making as many improvements as possible.many improvements as possible.

Compute Bridgeton’s Compute Bridgeton’s budgeted plantwide budgeted plantwide

overhead rate for 1989.overhead rate for 1989.

1989 Overhead Rate1989 Overhead Rate

$78,157 ÷ $13,537 = $5.77 per DL$

Why did the rate go up?

Compute the percent Compute the percent decrease in direct labor decrease in direct labor

dollars from 1988 to 1989.dollars from 1988 to 1989.

Percent Decrease in DL$Percent Decrease in DL$

($25,294 − $13,537) ÷ $25,294 = 46.5%

Compute the percent Compute the percent decrease in each overhead decrease in each overhead account from 1988 to 1989.account from 1988 to 1989.

Percent Decrease in MOH Percent Decrease in MOH AccountsAccounts

• 1000 (28.6%)1000 (28.6%)

• 1500 (13.8%)1500 (13.8%)

• 2000 (46.5%)2000 (46.5%)

• 3000 (46.5%)3000 (46.5%)

• 4000 (17.2%)4000 (17.2%)

• 5000 (17.9%)5000 (17.9%)

• 8000 (37.0%)8000 (37.0%)

• 9000 (12.2%)9000 (12.2%)

• 11000 (37.1%)11000 (37.1%)

• 12000 (46.5%)12000 (46.5%)

• 14000 (17.9%)14000 (17.9%)

The Death SpiralThe Death Spiral

• Fixed overhead costs are being spread Fixed overhead costs are being spread over a shrinking denominator volume.over a shrinking denominator volume.

• To make matters worse, those To make matters worse, those overhead costs that were consumed overhead costs that were consumed by products are probably being by products are probably being misallocated for reasons previously misallocated for reasons previously mentioned.mentioned.

• Well done consultants!Well done consultants!

Why is Bridgeton’s approach Why is Bridgeton’s approach okay for external reporting?okay for external reporting?

Why is Bridgeton’s approach Why is Bridgeton’s approach okay for external reporting?okay for external reporting?

• The “wash effect”The “wash effect”

• The segments vs. entity perspectiveThe segments vs. entity perspective

HandoutHandout

Utilization-Based Overhead Utilization-Based Overhead RatesRatesPlant A

June: ($120,000 + $500,000) ÷ 60,000 DLH = $10.33/ DLH

July: ($100,000 + $500,000) ÷ 50,000 DLH = $12/DLH

Plant BJune: ($160,000 + $600,000) ÷ 80,000 DLH = $9.50/DLH

July: ($180,000 + $600,000) ÷ 90,000 DLH = $8.67/DLH

Product CostsProduct Costs

Plant A: June JulyDM $15 $15DL $10 $10MOH $5.17 $ 6Total $30.17 $31

Plant B: June JulyDM $15 $15DL $10 $10MOH $4.75 $4.34Total $29.75 $29.34

Capacity-Based Overhead Capacity-Based Overhead RatesRatesPlant A

June: ($200,000 + $500,000) ÷ 100,000 DLH = $7.00/DLH

July: ($200,000 + $500,000) ÷ 100,000 DLH = $7.00/DLH

Plant BJune: ($200,000 + $600,000) ÷ 100,000 DLH = $8.00/DLH

July: ($200,000 + $600,000) ÷ 100,000 DLH = $8.00/DLH

Product CostsProduct Costs

Plant A: June JulyDM $15 $15DL $10 $10MOH $3.50 $3.50Total $28.50 $28.50

Plant B: June JulyDM $15 $15DL $10 $10MOH $4.00 $4.00Total $29.00 $29.00

What is the unused capacity What is the unused capacity cost for each plant for each cost for each plant for each

month?month?

Unused Capacity CostsUnused Capacity Costs

JuneJune JulyJuly

Plant A:Plant A:

Fixed portion of rateFixed portion of rate $5.00$5.00 $5.00$5.00

Unused capacity in DLHUnused capacity in DLH × 40,000× 40,000 × × 50,000 50,000

Unused capacity costUnused capacity cost $200,000$200,000 $250,00$250,0000

Plant B:Plant B:

Fixed portion of rateFixed portion of rate $6.00$6.00 $6.00$6.00

Unused capacity in DLHUnused capacity in DLH × 20,000× 20,000 × × 10,00010,000

Unused capacity costUnused capacity cost $120,000$120,000 $60,000$60,000

Questions We Answered Questions We Answered TodayToday

• How are traditional cost systems How are traditional cost systems designed?designed?

• What are the limitations of traditional What are the limitations of traditional cost systems when used for internal cost systems when used for internal decision-making purposes?decision-making purposes?

• What is a death spiral?What is a death spiral?