Accounting: The Language of Business - Vol. 1 (Part 154)

We have the most crude accounting tools. It's tragic because our accounts and our national arithmetic doesn't tell us the things that we need to know.

Susan George

 Differential Analysis and Product Pricing (Part I)

by

Charles Lamson

Activity-Based Costing

As we discussed in part 152, activity-based costing may more accurately identify and trace factory overhead costs to products than total cost concept, product cost concept, or variable cost concept. The following paragraphs further discuss and illustrate how activity-based costing may provide more accurate and useful product cost data.

Exhibit 12 illustrates the activity-based costing framework for Ruiz company. In the exhibit, five activities are used in manufacturing snowmobiles and lawn mowers: fabrication, assembly, setup, quality control inspection, and engineering changes. These activities can be defined as follows:

• Fabrication---The activity of cutting excess metal in order to properly shape a product. This activity is machine intensive and, for this reason, costs more than does assembly.

•  Assembly---The activity of manually assembling machined pieces into a final product. This activity is labor intensive.

•  Setup---The activity of changing tooling in a machine to prepare for making a new product. Thus, each production run requires a setup.

•  Quality control inspections---The activity of inspecting the product for conformance to specifications.

•  Engineering changes---The activity of processing changes in design or process specifications of a product. The document that initiates the administrative process to change the requirements of a product or process is called the engineering change order (ECO).

Assume the following additional information about the two products for Ruiz Company:

• Snowmobiles: Ruiz Company estimates that the total production for snowmobiles will be 1,000 units. Snowmobiles are a new product, and the engineers are still tinkering with design changes. Thus, there are 12 engineering change orders estimated for the period. In addition, the snowmobile production run is expected to be set up 100 times during the period, or 10 units per production run (1,000 units / 100 set ups). Due to quality problems, 100 snowmobiles (10% of total production) will be quality control inspected.

• Lawnmowers: Ruiz Company estimates that the total production for lawn mowers will also be 1,000 units. Lawnmowers are a mature and stable product that has been produced by Ruiz Company for many years. Thus, Ruiz Company expects the lawnmower to have only four engineering changes for the period. Due to fewer quality problems, only four lawn mowers (0.4% of production) will be quality-control inspected. In addition, the lawnmower production run is expected to be set up 20 times during the period, or 50 units per production run (1,000 units total production / 20 setups).

The estimated activity-base quantities associated with each product reflect differences with respect to using a set up, quality control inspection, and engineering change activities, as we noted in the previous paragraphs. In addition, each product uses different amounts of machine and direct labor hours in the fabrication and assembly activities. The estimated activity base usage quantities are shown in Exhibit 13.

EXHIBIT 13 Estimated Activity- Base Usage Quantities---Ruiz Company

The activity rates for each activity can now be determined by dividing the budgeted activity cost pool by the total estimated activity base from Exhibit 13, as shown for Ruiz Company in Exhibit 14.

The product costs for the snowmobile and lawnmower are calculated by multiplying the activity rate by the associated activity base quantity for each product. The total of these cost for each product is the total factory overhead cost for that product. This amount is divided by the total number of units of that product budgeted for manufacture in the period. This result, as shown in Exhibit 15, is the factory overhead cost per unit.

EXHIBIT 15 Activity-Base Product Cost Calculations

Under the activity-based approach, each product consumed factory overhead activities in different proportions. Namely, snowmobiles consumed a large majority of the machine, machine setup, quality control inspections, and engineering change activities, while lawnmowers consumed lesser quantities of these activities. Only under the activity based approach are these differences between the products reflected in the product cost.

When differences and products are not reflected in the product costs, management strategies may be flawed. To illustrate, Arvin Meritor, Inc. conducted a special activity-based costing study after one of its best-selling axles had begun losing market share. The study found that incorrect factory overhead cost allocations had "overcosted" its highest volume axle by roughly 20%, while underestimating the cost of low volume axles by as much as 40%. Since sales prices were based on these estimated costs, Arvin Meritor had underpriced its low-volume axles and overpriced high-volume axles. Meanwhile, competitors had been attracting customers away from Arvin Meritor's best-selling, high-value axles. Mispricing the products was not a strategy that management had chosen but was the result of a lack of accurate product cost information. Without activity-based cost information, Arvin Meritor might well have been gradually squeezed out of the high-volume business because of poor product costing. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 1,009-1,012*

end