MA18-35. Product Costing: Department versus Activity-Based Costing for Overhead.

Advertising Technologies, Inc. (ATI) specializes in providing both published and online advertising services for the business marketplace. The company monitors its costs based on the cost per column inch of published space printed in print advertising media and based on the cost per minute of telephone advertising time delivered on "The Ad Line," a computer-based, online advertising service. ATI has one new competitor, Tel-a-Ad, in its local teleadvertising market; and with increased competition, ATI has seen a decline in sales of online advertising in recent years. ATI's president, Beard, believes that predatory pricing by Tel-a-Ad has caused the problem. The following is a recent conversation between Robert and Jane Minnear, director of marketing for ATI.

Jane: I just received a call from one of our major customers concerning our advertising rates on "The AD Line" who said that a sales rep from another firm (it had to be Tel-A-Ad) had offered the same service at $1 per minute, which is $1.50 per minute less than our price.

Robert: It's costing about $1.27 per minute to produce that product. I don't see how they can afford to sell it so cheaply. I'm not convinced that we should meet the price. Perhaps the better strategy is to emphasize producing and selling more published ads, which we're more experienced with and where our margins are high and we have virtually no competition.

Jane: You may be right. Based on recent survey of our customers, I think we can raise the price significantly for published advertising and still not lose business.

Robert: That sounds promising; however, before we make a major recommitment to publishing, lets explore other possible explanations. I want to know how our costs compare with our competitors. Maybe we could be more efficient and find a way to earn a good return on teleadvertising.

After this meeting, Robert and Jane requested an investigation of production costs and comparative efficiency of producing published versus online advertising services. The controller, Tim Gentry, indicated that ATT's efficiency was comparable to that of its competitors and prepared the following cost data:

	Published Advertising	Online Advertising
Estimated number of production units	$200,000	$10,000,000
Selling Price	$200	$2.50
Direct product costs	$21,000,000	5,000,000
Overhead allocation*	$10,175,000	$8,325,000
Overhead per unit	$49	$0.77
Direct costs per unit	$105	$0.50
Number of customers	180,000	25,000
Number of salesperson days	28,500	3,500
Number of art and design hours	35,000	5,000
Number of creative services subcontract hours	100,000	25,000
Number of customer service calls	72,000	8,000

*Based on direct labor costs Upon examining the data, Robert decided that he wanted to know more about the overhead costs since they were such a high proportion of total production costs. He was provided the following list of overhead costs and told that they were currently being assigned to products in proportion to direct labor costs.

Selling cost	$8,000,000
Visual and audio design costs	$3,000,000
Creative services costs	$5,500,000
Customer service costs	$2,000,000

Required

After receiving the information, Robert and Jane met to look over the information. They asked you to attend. Jane asked Robert if he was sure about the overhead costs per unit how were the $49 and $0.77 calculated? They had been using $49 and $0.77 per unit for years so she said she had faith in these numbers. She was angry at Tel-a-Ad for their unethical predatory pricing.

Why would Tel-a-Ad be acting so irrationally? Should the company adopt the strategy suggested by Robert: switching from Online back to Published? What other choices does the company have besides leaving the market? What are your recommendations?

Robert and Jane heard that you knew something about Activity Based Costing, so Robert said to you: if it turns out that the ABC costs are different, if we change our report based on the above numbers from the current method to the ABC method, how much higher or lower would the net income reported under the activity-based system be than the net income that will be reported under the present, more traditional system?

Why (or why not) does it change?

If ABC is an improvement then lets use it and make last years income numbers better! Realizing that time was of the essence, Robert asked you to prepare a clear and well written report to explain competitors actions and to answer the questions and issues raised by Robert and Jane at the meeting. As you prepare your report, you realize that the ABC costs are likely to be different from the method ATI currently uses. You know Robert and Jane have faith in the current overhead costs so you will need to explain to them why your ABC costs are different.

Explain whether the differences are solely differences in accounting mechanics or are the differences real? You also realize that the selling prices are based on the costs and if the ABC costs turn out to be different, then it may impact selling prices.

How would selling prices be impacted and what other information is provided by ABC that ATI could use to address the issue of low profitability in Online Advertising?

Are additional management benefits derived from the ABC calculations than just the numbers for product costing?

Also, Robert and Jane realize that an ABC system is expensive to implement and to maintain. Can you relate the framework in the article, Is ABC Suitable for Your Company?, to this case to recommend an adoption of ABC?