HARBOUR TIRE COMPANY

INTRODUCTION

Though it is nearly impossible to calculate the precise cost of a manufactured product, businesses make every effort to determine the most accurate cost estimates for decision-making purposes. This case illustrates the difference in a traditional costing system using a single overhead rate and an activity-based costing system.

Direct materials and direct labor are costs that are directly traceable to the actual product and, therefore, are the simplest costs to include in product cost approximations. In contrast, overhead costs are indirect costs that cannot be readily traced to specific products so companies must allocate these costs to products on an estimated basis using either a traditional costing system or activity-based costing (Kimmel, Weygandt, & Kieso, 2016).

Traditional cost accounting systems accumulate overhead costs into one or more cost pools and then allocate the overhead costs to individual products using an allocation base such as direct labor cost or hours, machine hours, or the number of units. These allocation bases are increasingly viewed as arbitrary as they seldom represent a product’s use of resources in complex manufacturing processes (Eldenburg & Wolcott, 2011). As a result, organizations that use a traditional costing system may experience substantial product cost distortions due to the lack of correlation between the allocation bases and overhead costs (Kimmel, Weygandt, & Kieso, 2016).

Activity-based costing (ABC) is a system that allocates overhead costs to distinct tasks or activities (activity cost pools) performed in a manufacturing process. The overhead costs in the cost pools are then assigned to specific products employing cost drivers that reflect each product’s use of the activities. Thus, ABC utilizes multiple activity cost pools and cost drivers that increase the accuracy of product costs (Eldenburg & Wolcott, 2011).

COMPANY INFORMATION

Harbour Tire Company (HTC) is a manufacturing company that produces tires and manufactures over 200 different tires and sizes in its Memphis plant. In 2018, HTC automated the Memphis, Tennessee plant to take advantage of reasonably priced cutting-edge technology. Before automation, HTC used a single plantwide rate to allocate conversion costs using direct labor hours. At that time, the correlation between conversion costs and direct labor hours was 0.675. Because of the technological improvements, the number of direct labor hours was cut in half.

Alfred Olson, the Controller at HTC, was concerned with the accuracy of the assignment of product costs. Alfred had recently attended a seminar on activity-based costing and was interested in how it may improve HTC’s ability to assign indirect costs to the tires and thus may likewise enhance its pricing decisions.

James Jetter is the Chief Executive Officer (CEO) of HTC in Memphis, Tennessee. Before becoming the CEO in 2012, he served as the Chief Operating Officer (COO) for 8 years. HTC has its international headquarters in Memphis, Tennessee. Currently, HTC has three manufacturing plants in the United States, as well as a plant in Cortez, Mexico. The other two locations in the United States are in Casper, Wyoming and Cleveland, Ohio.

HTC manufactures tires in seven different tire types; all-season, light/medium truck, passenger, performance, summer, touring and winter. Additionally, HTC produces seven different brands with over 70 different models, and produces 20 different tire widths, with aspect ratios from 20 to 85, and tire diameters between 15 and 20 inches. As mentioned previously, HTC produces more than 200 different tires and sizes in the Memphis plant and employs between 2,000 to 3,000 employees during its slow and busy seasons, respectively.

As the Controller of HTC, Alfred Olson has gathered data after the automation of the Memphis manufacturing plant. He has provided this data in a Microsoft Excel spreadsheet file referred to as Data Set 1. In this data file, he has provided the total conversion costs and direct labor hours for 48 daily observations.

Data Set 1 provides enough data to do a simple regression model and/or measure the correlation between variables. Again, Alfred is concerned with the relationship between total conversion costs and direct labor hours, because of the investment in new technology. Currently, HTC allocates conversion costs using direct labor hours based on an average of the 48 observations. In other words, HTC finds the sum of the total conversion costs and direct labor hours over the 48 observations. Then HTC finds the predetermined conversion costs rate by dividing the total conversion costs by the total direct labor hours. Meanwhile, material costs are assigned directly to the tires. Direct labor costs are assigned as part of the conversion costs.

Last month, HTC manufactured 27,000 HTC/A105 and 7,000 HTC/B107 tires. HTC/A105 is a more popular tire that is produced in larger batches than HTC/B107. Additionally, the average direct materials costs for HTC/A105 and HTC/B107 are $64 and $98, respectively. While the HTC/A105 fits on a common family car or van, the HTC/B107 is not suitable for the family vehicles because it is a larger tire.

The direct labor hours used to produce HTC/A105 and HTC/B107 last month were:

HTC/A105 – 14,000 direct labor hours

HTC/B107 – 3,500 direct labor hours

Case 1 Requirements

Alfred Olson has provided you with the first data set. Also, he has informed you that HTC is currently assigning conversion costs to all tires based on the average conversion cost per direct labor hour for the 48 observations.

James Jetter, the CEO of HTC, would like to know the total product costs and unit costs for HTC/A105 and HTC/B107. In addition to the total product costs and unit costs for HTC/A105 and HTC/B107, he would also like to know the strength of the relationship between direct labor hours and total conversion costs. Has this relationship improved or weakened since automation?

Provide James Jetter with a paper summarizing your findings. This short paper should 1) summarize the information and findings of your analysis, such as production cost per tire 2) after applying your critical thinking skills, discuss your insights as to any key drivers for the different cost amounts for each tire 3) compare and discuss the results of your current correlation analysis with the correlation analysis prior to automation, and 4) discuss your suggestions on how to improve the overall calculation of total product and unit costs for the different tires.

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REFERENCES

Eldenburg, Leslie G., & Wolcott, Susan K. (2011). Cost Management: Measuring, Monitoring, and Motivating Performance (2nd ed.). John Wiley & Sons, Inc.

Kimmel, Paul D., Weygandt, Jerry J., & Kieso, Donald E. (2016). Accounting: Tools for Business Decision Making (6th ed.). John Wiley & Sons, Inc.

Observations	DLH	Total Costs
1	121,025	24,745,425
2	94,000	20,946,000
3	101,000	19,088,000
4	105,000	21,097,000
5	102,500	23,167,500
6	92,500	19,836,300
7	93,500	19,267,500
8	88,000	18,220,500
9	100,500	19,032,500
10	95,500	19,296,900
11	97,000	19,221,900
12	102,250	19,259,050
13	99,500	21,340,000
14	96,650	19,417,950
15	85,000	20,621,500
16	91,850	19,805,050
17	91,250	19,968,750
18	98,500	20,251,900
19	112,500	20,257,000
20	98,400	20,273,700
21	112,000	20,515,700
22	101,000	20,387,500
23	81,600	21,122,400
24	90,400	22,955,800
25	86,000	21,342,000
26	115,500	20,764,900
27	92,650	21,351,650
28	97,950	21,176,950
29	91,000	21,406,900
30	98,000	21,318,900
31	122,000	21,767,200
32	101,500	21,253,300
33	92,000	21,720,800
34	84,000	22,535,000
35	116,000	21,227,500
36	90,500	22,183,400
37	98,250	18,672,750
38	99,350	21,289,150
39	104,400	20,482,800
40	94,000	19,215,100
41	100,750	19,724,850
42	102,150	22,669,750
43	80,000	18,564,000
44	87,000	18,352,500
45	96,500	18,282,000
46	88,500	18,631,600
47	119,000	21,071,000
48	96,000	18,935,200