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.

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 products use of resources in complex manufacturing processes. 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.

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 products use of the activities. Thus, ABC utilizes multiple activity cost pools and cost drivers that increase the accuracy of product costs.

Drury Tire Company (DTC) is a manufacturing company that produces tires and manufactures over 200 different tires and sizes in its Memphis plant. In 2018, DTC automated the Memphis, Tennessee plant to take advantage of reasonably priced cutting-edge technology. Before automation, DTC 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 0.645. Because of the technological improvements, the number of direct labor hours was cut in half.

Alfred Olson, the Controller at DTC, 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 DTCs 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 DTC in Memphis, Tennessee. Before becoming the CEO in 2012, he served as the Chief Operating Officer (COO) for 8 years. DTC has its international headquarters in Memphis, Tennessee. Currently, DTC 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.

DTC manufactures tires in seven different tire types; all-season, light/medium truck, passenger, performance, summer, touring and winter. Additionally, DTC 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, DTC 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 DTC, 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, DTC allocates conversion costs using direct labor hours based on an average of the 48 observations. In other words, DTC finds the sum of the total conversion costs and direct labor hours over the 48 observations. Then DTC 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, DTC manufactured 27,000 DTC/A105 and 7,000 DTC/B107 tires. DTC/A105 is a more popular tire that is produced in larger batches than DTC/B107. Additionally, the average direct materials costs for DTC/A105 and DTC/B107 are $64 and $98, respectively. While the DTC/A105 fits on a common family car or van, the DTC/B107 is not suitable for the family vehicles because it is a larger tire.

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

DTC/A105 14,000 direct labor hours

DTC/B107 3,500 direct labor hours

Using Excel / Excel Hint Below:

Perform correlations and regression analysis using Excel.

1. Alfred Olson has provided you with the first data set. Also, he has informed you that DTC 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 DTC, would like to know the total product costs and unit costs for DTC/A105 and DTC/B107. In addition to the total product costs and unit costs for DTC/A105 and DTC/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?

Observations 1 2 3 4 5 6 7 09 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 DLH 121,025 94,000 101,000 105,000 102,500 92,500 93,500 88,000 100,500 95,500 97,000 102,250 99,500 96,650 85,000 91,850 91,250 98,500 112,500 98,400 112,000 101,000 81,600 90,400 86,000 115,500 92,650 97,950 91,000 98,000 122,000 101,500 92,000 84,000 116,000 90,500 98,250 99,350 104,400 94,000 100,750 102,150 80,000 87,000 96,500 88,500 119,000 96,000 Total Costs 24,745,425 20,946,000 19,088,000 21,097,000 23,167,500 19,836,300 19,267,500 18,220,500 19,032,500 19,296,900 19,221,900 19,259,050 21,340,000 19,417,950 20,621,500 19,805,050 19,968,750 20,251,900 20,257,000 20,273,700 20,515,700 20,387,500 21,122,400 22,955,800 21,342,000 20,764,900 21,351,650 21,176,950 21,406,900 21,318,900 21,767,200 21,253,300 21,720,800 22,535,000 21,227,500 22,183,400 18,672,750 21,289,150 20,482,800 19,215,100 19,724,850 22,669,750 18,564,000 18,352,500 18,282,000 18,631,600 21,071,000 18,935,200 37 38 39 40 41 42 43 44 45 46 47 48 Observations Setup Costs of Setups Purch Costs of Pos Labor Costs DLH Total Costs 2.000 200 125 209.45 Mitt for wichtin ALOS BI07 40 70 Tires Produced 15,000 5,000 Activities used by products and of POS of Setups 30 120 ALOS 6107 BO DUH 10,000 6,000 220 Part 1 Tradition Cost Allocation to Products and of Setups of Pos ALOS B107 DLH 2.094,500 1.256,700 Materials 600,000 350.000 Total 2,694,500 1.606.700 TC per Tire 17.63 321.M Part 2 ABC Allocation to Products and ALOS 5107 tof Setups 60,000 240,000 of POS 16,000 44,000 DUH 1.250,000 750,000 Materials 600,000 350,000 Total 1,926,000 1,384,000 TC per The 128.40 276.80 Observations 1 2 3 4 5 6 7 09 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 DLH 121,025 94,000 101,000 105,000 102,500 92,500 93,500 88,000 100,500 95,500 97,000 102,250 99,500 96,650 85,000 91,850 91,250 98,500 112,500 98,400 112,000 101,000 81,600 90,400 86,000 115,500 92,650 97,950 91,000 98,000 122,000 101,500 92,000 84,000 116,000 90,500 98,250 99,350 104,400 94,000 100,750 102,150 80,000 87,000 96,500 88,500 119,000 96,000 Total Costs 24,745,425 20,946,000 19,088,000 21,097,000 23,167,500 19,836,300 19,267,500 18,220,500 19,032,500 19,296,900 19,221,900 19,259,050 21,340,000 19,417,950 20,621,500 19,805,050 19,968,750 20,251,900 20,257,000 20,273,700 20,515,700 20,387,500 21,122,400 22,955,800 21,342,000 20,764,900 21,351,650 21,176,950 21,406,900 21,318,900 21,767,200 21,253,300 21,720,800 22,535,000 21,227,500 22,183,400 18,672,750 21,289,150 20,482,800 19,215,100 19,724,850 22,669,750 18,564,000 18,352,500 18,282,000 18,631,600 21,071,000 18,935,200 37 38 39 40 41 42 43 44 45 46 47 48 Observations Setup Costs of Setups Purch Costs of Pos Labor Costs DLH Total Costs 2.000 200 125 209.45 Mitt for wichtin ALOS BI07 40 70 Tires Produced 15,000 5,000 Activities used by products and of POS of Setups 30 120 ALOS 6107 BO DUH 10,000 6,000 220 Part 1 Tradition Cost Allocation to Products and of Setups of Pos ALOS B107 DLH 2.094,500 1.256,700 Materials 600,000 350.000 Total 2,694,500 1.606.700 TC per Tire 17.63 321.M Part 2 ABC Allocation to Products and ALOS 5107 tof Setups 60,000 240,000 of POS 16,000 44,000 DUH 1.250,000 750,000 Materials 600,000 350,000 Total 1,926,000 1,384,000 TC per The 128.40 276.80