Questions We Will Answer Today
• How are traditional cost systems
designed?
• What are the limitations of traditional cost
systems when used for internal decisionmaking purposes?
• What is a death spiral?
Bridgeton Industries
Background
• The ACF plant competes with other
Bridgeton plants and local suppliers for a
shrinking pool of production contracts.
• The ACF experienced a plant closing in the
past with the shut-down of its diesel
engine plant.
Tell me what the consultants did.
Strategic Analysis
• Bridgeton hired a consulting firm to
classify all plants’ products as:
– Class I products should remain at present
locations.
– Class II were to be watched closely
– Class III products were outsourced or
dropped.
• Four criteria were supposedly used:
– Quality, customer service, technical capability,
and cost.
Where did the consultants get
their cost data?
Where did the consultants get
their cost data?
Please tell me you’re kidding!
Describe Bridgeton’s existing
cost system.
The Cost System
• One budgeted plantwide overhead cost
pool
• One allocation base
– Direct labor dollars
• Utilization-based denominator volume
What are the problems with this
type of traditional cost system?
The Problems
• One heterogeneous plantwide overhead
cost pool
• One volume-related allocation
– Direct labor dollars
• Reliance on a utilization-based
denominator volume
• Disregard of selling & administrative
expenses
Should Bridgeton be concerned
about these limitations?
Should Bridgeton Be Concerned
About These Limitations?
• Yes! Because:
– They have product diversity.
– The non-volume-related overhead dollars are
material.
– They probably have unused capacity.
Compute Bridgeton’s Plantwide
overhead rate for 1988.
1988 Overhead Rate
$109,890 ÷ $25,294 = $4.3445 per DL$
What overhead rate did the
consultants use as quoted in the
case?
What overhead rate did the
consultants use as quoted in the
case?
435%, or essentially the same
overhead rate used in Bridgeton’s
traditional plantwide cost system.
Why is this plantwide rate
useless?
Why is this plantwide rate useless?
• To assume that all overhead is driven by direct
labor is flawed.
– Miller and Vollmann graph
• To assume that $109 million of overhead is
driven by any single volume-related allocation
base is very flawed.
– Miller and Vollmann transactions framework (quality,
change, balancing, and logistical transactions)
• Assigning used and unused capacity costs
distorts product cost consumption
What Distortions Will It
Create?
What Distortions Will It Create?
• It will overcost labor-intensive, high
volume products and undercost non-laborintensive, low volume products.
• It will overcost all products to the extent
products are assigned unused capacity
costs.
Why do you think
Mufflers/Exhausts and Oil Pans
were the first products labeled
Class III?
Why Mufflers and Oil Pans?
Fuel tanks:
$4,238 ÷ $75,196 = 5.6%
Manifolds:
$6,027 ÷ $84,776 = 7.1%
Doors:
$2,731 ÷ $45,174 = 6.1%
Muffler/Exhausts:
$5,766 ÷ $66,266 = 8.7%
Oil Pans:
$6,532 ÷ $79,658 = 8.2%
The Outsourcing Decision
• Muffler/Exhausts and Oil Pans get
outsourced
• The ACF responds by making as many
improvements as possible.
Compute Bridgeton’s
budgeted plantwide overhead
rate for 1989.
1989 Overhead Rate
$78,157 ÷ $13,537 = $5.77 per DL$
Why did the rate go up?
Compute the percent decrease in
direct labor dollars from 1988 to
1989.
Percent Decrease in DL$
($25,294 − $13,537) ÷ $25,294 = 46.5%
Compute the percent decrease in
each overhead account from
1988 to 1989.
Percent Decrease in MOH Accounts
•
•
•
•
•
•
1000
1500
2000
3000
4000
5000
(28.6%)
(13.8%)
(46.5%)
(46.5%)
(17.2%)
(17.9%)
•
•
•
•
•
8000 (37.0%)
9000 (12.2%)
11000 (37.1%)
12000 (46.5%)
14000 (17.9%)
The Death Spiral
• Fixed overhead costs are being spread
over a shrinking denominator volume.
• To make matters worse, those overhead
costs that were consumed by products are
probably being misallocated for reasons
previously mentioned.
• Well done consultants!
Why is Bridgeton’s approach okay
for external reporting?
Why is Bridgeton’s approach okay
for external reporting?
• The “wash effect”
• The segments vs. entity perspective
Handout
Utilization-Based Overhead Rates
Plant A
June: ($120,000 + $500,000) ÷ 60,000 DLH = $10.33/ DLH
July: ($100,000 + $500,000) ÷ 50,000 DLH = $12/DLH
Plant B
June: ($160,000 + $600,000) ÷ 80,000 DLH = $9.50/DLH
July: ($180,000 + $600,000) ÷ 90,000 DLH = $8.67/DLH
Product Costs
Plant A:
DM
DL
MOH
Total
June
$15
$10
$5.17
$30.17
July
$15
$10
$6
$31
Plant B:
DM
DL
MOH
Total
June
$15
$10
$4.75
$29.75
July
$15
$10
$4.34
$29.34
Capacity-Based Overhead Rates
Plant A
June: ($200,000 + $500,000) ÷ 100,000 DLH = $7.00/DLH
July: ($200,000 + $500,000) ÷ 100,000 DLH = $7.00/DLH
Plant B
June: ($200,000 + $600,000) ÷ 100,000 DLH = $8.00/DLH
July: ($200,000 + $600,000) ÷ 100,000 DLH = $8.00/DLH
Product Costs
Plant A:
DM
DL
MOH
Total
June
$15
$10
$3.50
$28.50
July
$15
$10
$3.50
$28.50
Plant B:
DM
DL
MOH
Total
June
$15
$10
$4.00
$29.00
July
$15
$10
$4.00
$29.00
What is the unused capacity cost
for each plant for each month?
Unused Capacity Costs
June
Plant A:
Fixed portion of rate
Unused capacity in DLH
Unused capacity cost
Plant B:
Fixed portion of rate
Unused capacity in DLH
Unused capacity cost
July
$5.00
× 40,000
$200,000
$5.00
× 50,000
$250,000
$6.00
× 20,000
$120,000
$6.00
× 10,000
$60,000
Questions We Answered Today
• How are traditional cost systems
designed?
• What are the limitations of traditional cost
systems when used for internal decisionmaking purposes?
• What is a death spiral?