ACTIVITY-BASED COSTING AND MANAGEMENT Owen P. Hall, Charles McPeak and Samuel Seaman wrote this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Richard Ivey School of Business Foundation prohibits any form of reproduction, storage or transmission without its written permission. Reproduction of this material is not covered under authorization by any reproduction nights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Richard Ivey School of Business Foundation, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca. Copyright 2010, Richard lvey School of Business Foundation Version: (A) 2010-09-10 CASE OVERVIEW The CFO at the Rubrics Corporation, a midsize hardware manufacturing firm, had become aware of the ongoing imbalance between the product's budgeted and actual costs. The Rubrics Corporation normally allocated overhead to products using a single direct cost driver, usually direct labor hours or direct labor dollars. This practice sometimes led to inaccuracies, since indirect costs were not incurred equally across products. For example, Rubrics' CFO had forecasted $10,000,000 in direct labor costs and $15,000,000 in overhead for a particular project last year, resulting in an overhead rate of 150 per cent. For each dollar of direct labor charged, $1.50 of overhead had been allocated. The shortcoming of this costing method was that overhead costs failed to reflect varying manufacturing intensity between products. Often referred to as smoothing, traditional costing allocates overhead costs evenly per direct labor hours or dollars. Unfortunately, direct costing can result in a discrepancy between the budgeted overhead and the actual overhead used. Often, certain products require more maintenance or floor space. Traditional costing allocates overhead based on direct expenses without compensating for a product's greater or lesser use of overhead costs. Activity-based costing (ABC) was first introduced in the United States during the 1970s. Since then, ABC had enjoyed wide acceptance as a more accurate alternative to traditional costing, especially in manufacturing. Instead of budgeting overhead using direct cost drivers, ABC splits overhead into activity cost drivers, leading to a more tangible assignment of costs. Calculating ABC is more complicated than calculating traditional costing. Once management identifies the activity cost drivers, 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. Say X Company estimates next year's rental costs to be $30,000 for its 15,000 -square-foot factory. X Company can calculate the rental overhead rate by dividing $30,000 by 15,000 to get 2 . After calculating the overhead rates for each activity driver (rent, depreciation, maintenance, etc), the rates are a. Calculate the activity-based overhead rates per activity cost driver. b. For each product, compute the overhead costs per activity cost driver. c. Using the overhead costs from b., calculate the total costs per product. 4. Assuming ABC allocated overhead more accurately, which products were incorrectly priced using the traditional costing method? What difficulties might result from incorrectly budgeted products? Hint: Think about how capital resources should be allocated to the most efficient opportunities. 5. What actions might be explored to deal with the mispriced products? 6. Compare assigned costs per product under both methods. Why had activity-based costing changed the total costs assigned to each product? 7. What were two circumstances where traditional and ABC costing would likely yield similar or equal overhead costs? Exhibit 1 DIRECT LABOR, OVERHEAD, AND DIRECT MATERIALS COSTS Exhibit 2 OVERHEAD COST DRIVERS Exhibit 3 PRODUCT RESOURCE REQUIREMENTS BY COST DRIVER ACTIVITY-BASED COSTING AND MANAGEMENT Owen P. Hall, Charles McPeak and Samuel Seaman wrote this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Richard Ivey School of Business Foundation prohibits any form of reproduction, storage or transmission without its written permission. Reproduction of this material is not covered under authorization by any reproduction nights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Richard Ivey School of Business Foundation, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca. Copyright 2010, Richard lvey School of Business Foundation Version: (A) 2010-09-10 CASE OVERVIEW The CFO at the Rubrics Corporation, a midsize hardware manufacturing firm, had become aware of the ongoing imbalance between the product's budgeted and actual costs. The Rubrics Corporation normally allocated overhead to products using a single direct cost driver, usually direct labor hours or direct labor dollars. This practice sometimes led to inaccuracies, since indirect costs were not incurred equally across products. For example, Rubrics' CFO had forecasted $10,000,000 in direct labor costs and $15,000,000 in overhead for a particular project last year, resulting in an overhead rate of 150 per cent. For each dollar of direct labor charged, $1.50 of overhead had been allocated. The shortcoming of this costing method was that overhead costs failed to reflect varying manufacturing intensity between products. Often referred to as smoothing, traditional costing allocates overhead costs evenly per direct labor hours or dollars. Unfortunately, direct costing can result in a discrepancy between the budgeted overhead and the actual overhead used. Often, certain products require more maintenance or floor space. Traditional costing allocates overhead based on direct expenses without compensating for a product's greater or lesser use of overhead costs. Activity-based costing (ABC) was first introduced in the United States during the 1970s. Since then, ABC had enjoyed wide acceptance as a more accurate alternative to traditional costing, especially in manufacturing. Instead of budgeting overhead using direct cost drivers, ABC splits overhead into activity cost drivers, leading to a more tangible assignment of costs. Calculating ABC is more complicated than calculating traditional costing. Once management identifies the activity cost drivers, 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. Say X Company estimates next year's rental costs to be $30,000 for its 15,000 -square-foot factory. X Company can calculate the rental overhead rate by dividing $30,000 by 15,000 to get 2 . After calculating the overhead rates for each activity driver (rent, depreciation, maintenance, etc), the rates are a. Calculate the activity-based overhead rates per activity cost driver. b. For each product, compute the overhead costs per activity cost driver. c. Using the overhead costs from b., calculate the total costs per product. 4. Assuming ABC allocated overhead more accurately, which products were incorrectly priced using the traditional costing method? What difficulties might result from incorrectly budgeted products? Hint: Think about how capital resources should be allocated to the most efficient opportunities. 5. What actions might be explored to deal with the mispriced products? 6. Compare assigned costs per product under both methods. Why had activity-based costing changed the total costs assigned to each product? 7. What were two circumstances where traditional and ABC costing would likely yield similar or equal overhead costs? Exhibit 1 DIRECT LABOR, OVERHEAD, AND DIRECT MATERIALS COSTS Exhibit 2 OVERHEAD COST DRIVERS Exhibit 3 PRODUCT RESOURCE REQUIREMENTS BY COST DRIVER