Activity Based Costing

Rubrics, Inc.

The Chief Financial Officer (CFO) at Rubrics Inc., a small size regional hardware manufacturing firm, has become aware of the ongoing imbalance between the products' budgeted and actual costs. In a competitive environment, an imbalance between pricing and costing can be expensive. The historical accounting approach has been to allocate overhead to products using a single direct cost driver, usually direct labor hours or direct labor dollars. This practice sometimes leads to inaccuracies since indirect costs are not incurred equally across products. For example, Rubrics' CFO forecasted $1,000,000 in direct labor costs and $2,000,000 in overhead last year, resulting in an overhead rate of 200 percent. For each dollar of direct labor charged, $2.00 of overhead was allocated. The shortcoming of this costing method is that overhead costs fail to reflect varying manufacturing intensity between products.

The firm's management is under pressure from the board to expand marketing into the global economy via the Internet. Because of the board's direction, the CFO is considering implementing ABC as a means for improving the cost assignment process, which in turn should make Rubrics more competitive on the global stage. He knows that the adoption rate of ABC in small and medium enterprises (SME's) like Rubrics has been slow in the past. Furthermore, the CFO also realizes that the ABC method is more complicated and costlier than traditional cost accounting (TCA). The CFO's first step is to identify the activity cost drivers from which 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. For example, the CFO at Rubrics Corporation estimates that next year's rental costs to be $1,000,000 for their 100,000 square foot factory. The CFO can calculate the rental overhead rate by dividing $1,000,000 by 100,000 resulting in an overhead rate of $10 per square foot. After calculating the overhead rates for each activity driver (e.g., rent, depreciation, maintenance), the rates are applied to the individual requirements of each product. 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 as in the case at Rubrics Corporation. The CFO believes that a key 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 products, more appropriately.

Despite the complexity, the CFO knows that the benefits of ABC to Rubrics can be significant. Some specific benefits include: 1) the ability to distinguish profitable from unprofitable products, 2) the opportunity to establish cost controls to eliminate unnecessary costs, and 3) the potential for improved product pricing. However, prior to implementing ABC, the CFO wishes to consider whether the cost savings from more accurate budget allocations are greater than the costs of implementing and maintaining the new system.

Rubrics Inc. produces four products: widgets, gadgets, smidgets, and smadgets. Table 1 summarizes the direct labor, overhead, and direct material costs associated with these products. Presently the aggregate overhead rate is 200 percent of direct labor.

TABLE 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

The CFO has identified three main overhead cost drivers (depreciation, set-up and rent), which are highlighted in Table 2. Also presented are the associated total costs and quantity of the cost-allocation-base (CAB) per cost driver. The CAB estimates were developed by the CFO after consulting with the production manager.

TABLE 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

Table 3 shows the product resource requirements by cost driver. Notice, for example, that the set-up requirement for Widgets is 200 hours. These estimates were also developed with the assistance of the manufacturing staff. It was during this process that the CFO discovered for himself one of the major challenges associated with ABC, namely the ongoing requirement to obtain accurate estimates on actual resource usage by product.

TABLE 3

PRODUCT RESOURCE REQUIREMENTS BY COST DRIVER

Widgets	Gadgets	Smidgets	Smadgets
500 machine hours	900 machine hours	400 machine hours	1200 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

The CFO wishes to more fully assess the benefits of the ABC strategy prior to finalizing his recommendations. Specifically, he has identified the following tasks that need to be completed.

1. Determine the overhead costs per product based on TCA.

2. Determine the total costs per product based on TCA

3. Determine using the ABC model:

1. The activity-based overhead rates per activity cost driver.
2. The overhead costs per activity cost driver for each product.
3. The total costs per product using the overhead costs developed from part b.

4. Identify which products are incorrectly priced using the TCA assuming that ABC more accurately allocated overhead. Characterize some of the difficulties that might result from incorrectly budgeted products.