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Pilgrims Manufacturing, Inc.: Activity-Based Costing Versus Volume-Based Costing Pilgrims Manufacturing, Inc. manufactures cooling and heating coils for several different industries. It has two plants, Jewett City Plant (JCP) is an older, labor intensive machine shop where skilled workers use tools to perform most of the work. Greenwich Plant (GP) is highly automated and uses computer numerically controlled (CNC) machines with a small number of highly paid workers. JCP manufactures a high tolerance coil (Pa) and finishes a second one (Pb). GP mass produces two standard coils, Pc and Pd, and performs basic operations on Pb before transferring it to JCP for finishing. Production takes place in batches. Each batch is made of one product. The products are sold directly to manufacturers by a technical sales force. Product Pa is a customized product manufactured to order, and requires a lot of specifications and negotiation with customers. Product Pb is a modification of the standardized products Pc and Pd. It is finished to meet each customer's specifications, and as a result has more exacting technical specifications than Pc and Pd, and is hence finished in JCP. Products Pc and Pd are standardized products produced for stock and sold off-the-shelf and do not require much sales effort in writing up orders. Each plant has six production and service departments, receiving, cutting & assembly, heat treatment, testing, packing & shipping, and repairs & maintenance (Charts 2 and 3). Exhibit 1 includes descriptions of activities in each of these departments. In addition, there are three departments -- marketing, design & engineering support, and administration -- at the corporate level (Chart 4). The present accounting system is a traditional financial reporting driven system. Manufacturing costs are classified as material, labor, and overhead. Overhead is charged to products based on labor hours with the two plants treated as one cost center. Marketing, design & engineering support, and administration are considered period costs and not charged to products. The President of the Company held a meeting with senior executives including VP-Finance, VP-Manufacturing, and VP-Marketing (Chart 1) to discuss the 2006 budget (Schedules 1, 2, and 3). She was unhappy with the fact that Pas budgeted price of $45 is below its standard cost of $48.29. However, she was not sure if the costing system, which treats both plants as one cost center, accurately determines the costs of the different products. She pointed out that GP is a machine intensive plant while JCP is more labor intensive. Furthermore, the products are produced in different numbers of batches (Schedule 6), and affect batch-related costs (e.g. testing and heat treatment) differently. She told VP-Finance that she has heard of an alternative costing method that uses multiple cost centers/pools and different cost bases to charge indirect costs to products. She also questioned the treatment of technical support costs and marketing expenses as period costs. VP-Finance promised to investigate the President's points and report back to the group. Required: The VP-Finance appointed you as a team to investigate the President's concerns. He suggested that you develop and compare several volume-based costing and activity-based costing (ABC) systems to identify and recommend the system that you deem to give the most accurate product costs. For the traditional volume-based systems use the Overhead Allocation Menu shown at the bottom of the case to perform the following tasks: 1. Use machine hours, instead of direct labor hours, to allocate manufacturing overhead to the four products and restate the Products Budget (Schedule 1). 2. Repeat requirement 1, assuming that each plant is a separate cost center, and direct labor hours are used to allocate manufacturing overhead in both plants. Schedule 4 reports the labor hours per unit for each product. 3. Repeat requirement 2, assuming that labor hours are used to allocate manufacturing overhead in JCP and machine hours in GP. Schedule 5 reports the machine hours per unit for each product in the two plants. 4. Use an activity-based costing system to calculate new costs and profitability of each of the four products (Schedule 1) under the system. To design the ABC systems you have visited the two plants where you interviewed plant managers, department supervisors and accountants. You also analyzed expense accounts and operations data. Based on the interviews and analyses, your team prepared descriptions of activities within each of the departments in each plant (Exhibit 1). You also decided to create plant-sustaining cost pool to which you allocated factory costs that you decided couldn't accurately be allocated to the other departments. Finally, you prepared an analysis and description of the costs in each cost pool (Exhibit 2). And allocated the costs of the eight cost pools as shown in Schedule 9 to the different departments and to the plant-sustaining cost pool. To complete the design of the ABC system you have to make decisions on the following: a. Which cost driver to use for allocating the costs of each activity to each of the products? Schedules 4-5 present labor hours and machine hours per unit for each product. Schedule 6 lists the number of batches for each product. Schedule 1 lists the number of units for each product. b. Should you charge the design & engineering support and marketing expenses to products or treat them as firmwide costs? Schedules 7-8 present sales personnel time distribution, and design & engineering support time distribution. If you decide to treat design & engineering and marketing as product costs, use the Overhead Allocation Menu to select the cost drivers and charge the cost to the products. 5. Write a report to the President that includes your analysis in Requirements 1-4, and state which of the four you recommend and why. 6. (Optional). Create a worksheet and use the information provided in schedules 1-12 to allocate the overhead costs to the activities (Schedule 12 lists the costs, activities and rates). Select cost drivers to allocate the activities to the products and use that to prepare Schedule 1 Product Budget. Units Pricea Standard Costs (Schedule 3) Revenue Manufacturing costs: Direct materials Direct labor Manufacturing overhead Total manufacturing costs Gross Margin Less common costs: Design & engineering costs Marketing & sales expenses G&A Total Costs Net profit a Average estimated prices. Schedule 1 2004 Products Budget Pa Pb Pc 70000 100000 500000 $45 $30 $4 $48.29 $19.11 $2.45 Pd 1000000 $5 $2.45 Total $3,150,000 $3,000,000 $2,000,000 $5,000,000 $13,150,000 $84,000 $120,000 $840,000 $458,750 $2,470,000 $1,323,214 $3,394,000 $1,901,964 ($244,000) $1,098,036 $600,000 $243,750 $382,262 $1,226,012 $773,988 $1,200,000 $487,500 $764,524 $2,452,024 $2,547,976 $2,004,000 $2,030,000 $4,940,000 $8,974,000 $4,176,000 $500,000 $960,000 $650,000 $2,110,000 $2,066,000 Schedule 2 2004 Financial Budget JCP GP Total Sales $13,150,000 Products costs: Direct materials $104,000 $1,900,000 $2,004,000 Direct labor 1,280,000 750,000 2,030,000 Manufacturing overhead: Power & heat 160,000 270,000 430,000 Repair & maintenance 150,000 300,000 450,000 Factory expenses 75,000 125,000 200,000 Factory support 400,000 350,000 750,000 Inspection costs 110,000 150,000 260,000 Chemicals & fuel 450,000 1,200,000 1,650,000 Depreciation-equipment 200,000 600,000 800,000 Depreciation-buildings 150,000 250,000 400,000 Total manufacturing overhead 1,695,000 3,245,000 4,940,000 Total manufacturing costs $3,079,000 $5,895,000 $8,974,000 Gross margin $4,176,000 Operating expenses: Design & engineering costs 500,000 Marketing & sales expenses 960,000 G&A 650,000 Total operating expenses 2,110,000 Net profit $2,066,000 a Direct labor hours: JCP 32,000 hours @ $40 average hourly rate; GP 10,000 hours @ $75 average hourly rate. Pa $1.200 Schedule 3 Unit Standard Cost Pb $1.200 Pc $1.200 Pc $1.200 Direct materialsb Direct labor b 12.000 4.5875 0.488 0.488 Overhead a 35.285 13.232 0.765 0.765 Total 48.486 19.019 2.453 2.453 a Overhead rate = $4,940,00042,000 hours = $117.62 per direct labor hour. b Average estimated costs. Plant JCP GP Schedule 4 Labor Hours Per Unit of Product Pa Pb Pc 0.3 hours 0.11 hours .0025 hours .0065 hours Pd .0065 hours Plant JCP GP Schedule 5 Machine Hours per Unit of Product Pa Pb Pc 0.06 0.022 0.05 0.1 Plant/Product JCP GP Schedule 6 Number of Batches Pb 5 2 Pa 10 0.075 Pc Pd 2 4 Schedule 7 Marketing & Sales Time Distribution * Pa Pb Pc 35% 20% 15% *15% is not spent on any one product. Pa 35% Pd Schedule 8 Design & Engineering Time Distribution Pb Pc Pd 20% 10% 10% Pd 15% Basic R&D 25% Schedule 9 Allocation of Costs to Departments and Activities Jewett City (JCP): Expenses Power Repairs Factory Expenses Factory Support Inspection Chemicals & fuel Deprec-Equip Deprec-Bldg Total Overhead Labor Hours Machine Hours 160000 150000 75000 400000 110000 450000 200000 150000 1695000 32000 6400 Receiving 10000 15000 0 0 0 0 20000 0 45000 2000 Cutting & Assembly 60000 55000 0 0 0 0 50000 0 165000 18000 5600 Heat Treat. 20000 18000 0 0 0 450000 60000 0 548000 3000 Testing 35000 40000 0 0 0 0 50000 0 125000 3000 800 Pack. & ship. Plant Sustaining 15000 20000 10000 12000 0 75000 0 400000 0 110000 0 0 10000 10000 0 150000 35000 777000 6000 Heat treat. 15000 20000 0 0 0 1200000 80000 0 1315000 1000 Testing 70000 50000 0 0 0 0 200000 0 320000 1000 20000 Pack. & ship. Plant Sustaining 20000 20000 20000 20000 0 125000 0 350000 0 150000 0 0 25000 10000 0 250000 65000 925000 2000 20000 Greenwich (GP): Expenses Power Repairs Factory Expenses Factory Support Inspection Chemicals & fuel Deprec-Equip Deprec-Bldg Total Overhead Labor Hours Machine Hours 270000 300000 125000 350000 150000 1200000 600000 250000 3245000 10000 130000 Receiving 25000 30000 0 0 0 0 35000 0 90000 3000 Cutting, Machining & Assembly 120000 160000 0 0 0 0 250000 0 530000 3000 90000 Schedule 10 Labor and Machine Hours Per Department Jewett City: Receiving Labor Hours Machine Hours 2000 Cutting & Assembly 18000 Heat Treat Testing 3000 3000 5600 Packing & Shipping 6000 800 Greenwich: Receiving Labor Hours Machine Hours 3000 Cutting & Assembly 3000 90000 Heat Treat Testing 1000 1000 Packing & Shipping 2000 20000 20000 Schedule 11 Departmental Labor & Machine Hours per Product Jewett City: Labor hours Pa Pb Machin hours Pa Pb Receiving 2000 1312.5 687.5 Cutting & Assembly 18000 11812.5 6187.5 0 0 5600 3675 1925 Receiving 3000 75 975 1950 Cutting & Assembly 3000 75 975 1950 Heat Treat. 3000 1968.75 1031.25 Testing 3000 1968.75 1031.25 Pack. & shipping 6000 3937.5 2062.5 Total 32000 21000 11000 800 525 275 0 0 6400 4200 2200 Testing 1000 25 325 650 Pack. & shipping 2000 50 650 1300 Total 10000 250 3250 6500 20000 769 7692 11538 20000 769 7692 11538 130000 5000 50000 75000 Greenwich: Labor hours Pb Pc Pd Machine hours Pb Pc Pd 90000 3462 34615 51923 Heat Treat. 1000 25 325 650 Schedule 12 Allocation Rates of Overhead costs to Departments/Activities Jewett City: Expenses Power Repairs Factory Expenses Factory Support Inspection Chemicals & fuel Deprec-Equip Deprec-Bldg Total Overhead Labor Hours Machine Hours 160000 150000 75000 400000 110000 450000 200000 150000 1695000 32000 6400 Receiving 0.06 0.1 0 0 0 0 0.1 0 Cutting & Assembly 0.38 0.4 0 0 0 0 0.25 0 Heat Treat. 0.13 0.1 0 0 0 1 0.3 0 Testing 0.22 0.3 0 0 0 0 0.25 0 Pack. & ship. 0.09 0.1 0 0 0 0 0.05 0 2000 18000 5600 3000 3000 800 6000 Heat treat. 0.06 0.1 0 0 0 1 0.13 0 Testing 0.26 0.2 0 0 0 0 0.33 0 Pack. & ship. 0.07 0.1 0 0 0 0 0.04 0 1000 1000 20000 2000 20000 Plant Sustaining 0.13 0.1 1 1 1 0 0.05 1 Greenwich: Expenses Power Repairs Factory Expenses Factory Support Inspection Chemicals & fuel Deprec-Equip Deprec-Bldg Total Overhead Labor Hours Machine Hours 270000 300000 125000 350000 150000 1200000 600000 250000 3245000 10000 130000 Receiving 0.09 0.1 0 0 0 0 0.06 0 3000 Cutting, Machining & Assembly 0.44 0.5 0 0 0 0 0.42 0 3000 90000 Plant Sustaining. 0.07 0.1 1 1 1 0 0.02 1 Exhibit 1 Description of Departments Receiving where materials and supplies are ordered, received and forwarded to the plant floor. Cutting & Assembly (JCP) where skilled workers cut the sheet metal, inspect it for quality and precision, and assemble product Pa. Product Pb is finished in this process. Cutting, Machining & Molding (GP) where computer numerically controlled (CNC) machines are used to cut, mold and finish products Pc & Pd. Product Pb is sent unfinished to JCP. Heat Treatment where products are immersed in chemicals at high temperature for hardening. Testing where 100% of the products are tested for quality and performance. Packing & Shipping where goods are packed and shipped to customers. Repairs & Maintenance maintains machines, equipments and buildings. Exhibit 2 Description of Costs Direct materials consist of sheet metals and welding material. The quantity for each of the four products is specified. Direct labor includes wages and benefits. Workers are assigned to processes. Machine set-up time costs are also included. Power & heat includes the cost of power consumed by the machines as well as for heating and lighting. Repair & maintenance include costs associated with repairing and maintenance of machines and equipment. Factory expenses include property taxes, building up keep and sanitary costs. Factory support includes salaries & wages and benefits of non-direct labor such as plant managers, supervisors, etc. Inspection costs includes salaries and benefits of quality-inspectors who roam throughout each plant inspecting parts and machines. Chemicals & fuel includes the costs of chemicals, fuel and labor costs Depreciation-equipment depreciation costs of machines, tools and other equipment. Depreciation-buildings depreciation expenses for the two plants. The JCP also house the administrative offices. Design & engineering costs include salaries & benefits of engineers, and other costs of the Design & Engineering department. The department works on product, and factory machines development Marketing & sales expenses include salaries & benefits of sales staff, and promotions and other marketing costs. General and administrative costs include top management, accounting, personnel, and legal counsel. Exhibit 3 Potential Overhead Allocation Bases Budgeted units of output Budgeted direct labor hours Budgeted machine hours Number of batches Chart 1 Pilgrims Manufacturing, Inc. Organization Chart C EO V P F in a n c e A c c o u n t in g V P M a n u f a c t u r in g J e w e t t C it y P la n t Chart 2 JCP Layout V P M a r k e t in g G r e e n w ic h P la n t T e c h n ic a l S u p p o r t Chart 3 Greenwich Plant Chart 4 Services and Products C o r p o r a t e S e r v ic e s A d m i n is t r a t i o n M a r k e t in g & S a le s T e c h n ic a l S u p p o rt G P P la n t J C P P la n t P ro d u c t P a P ro d u c t P b P ro d u c t P b P ro d u c t P c P ro d u c t P d Overhead Allocation Menu Traditional costing Allocation base of firm or Jewett City Plant: Cost center is: the firm dir labor hrs Submit Allocation base of Greenwich Plant: dir labor hrs Activity-based costing Non-manufacturing costs: Allocation bases of the Jewett City Plant cost pools: design engr cost receiving design engr time mkt expense mkt sales time # of batches cut &Assem dir labor hrs heat treat testing # of batches dir labor hrs pack &ship plant sustain output units output units pack &ship plant sustain output units output units Allocation bases of Greenwich Plant cost pools: Submit receiving # of batches cut &Assem machine hrs heat treat # of batches testing # of batches