Questions We Will Answer TodayHow are traditional cost systems designed?What are the limitations of traditional cost systems when used for internal decision-making purposes?What is a death spiral?

Bridgeton Industries

BackgroundThe 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 AnalysisBridgeton hired a consulting firm to classify all plants products as:

Class I products should remain at present locations.Class II were to be watched closelyClass 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 youre kidding!

Describe Bridgetons existing cost system.

The Cost SystemOne budgeted plantwide overhead cost poolOne allocation base

Direct labor dollars Utilization-based denominator volume

What are the problems with this type of traditional cost system?

The ProblemsOne heterogeneous plantwide overhead cost poolOne volume-related allocation

Direct labor dollars Reliance on a utilization-based denominator volumeDisregard 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 Bridgetons 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 Bridgetons 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 graphTo 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-labor-intensive, 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 DecisionMuffler/Exhausts and Oil Pans get outsourcedThe ACF responds by making as many improvements as possible.

Compute Bridgetons 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 Accounts1000 (28.6%)1500 (13.8%)2000 (46.5%)3000 (46.5%)4000 (17.2%)5000 (17.9%)

8000 (37.0%)9000 (12.2%)11000 (37.1%)12000 (46.5%)14000 (17.9%)

The Death SpiralFixed 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 Bridgetons approach okay for external reporting?

Why is Bridgetons approach okay for external reporting?The wash effectThe segments vs. entity perspective

Handout

Utilization-Based Overhead RatesPlant AJune: ($120,000 + $500,000) 60,000 DLH = $10.33/ DLHJuly: ($100,000 + $500,000) 50,000 DLH = $12/DLH

Plant BJune: ($160,000 + $600,000) 80,000 DLH = $9.50/DLHJuly: ($180,000 + $600,000) 90,000 DLH = $8.67/DLH

Product CostsPlant A:JuneJulyDM$15$15DL$10$10MOH$5.17$ 6Total$30.17$31

Plant B:JuneJulyDM$15$15DL$10$10MOH$4.75$4.34Total$29.75$29.34

Capacity-Based Overhead RatesPlant AJune: ($200,000 + $500,000) 100,000 DLH = $7.00/DLHJuly: ($200,000 + $500,000) 100,000 DLH = $7.00/DLH

Plant BJune: ($200,000 + $600,000) 100,000 DLH = $8.00/DLHJuly: ($200,000 + $600,000) 100,000 DLH = $8.00/DLH

Product CostsPlant A:JuneJulyDM$15$15DL$10$10MOH$3.50$3.50Total$28.50$28.50Plant B:JuneJulyDM$15$15DL$10$10MOH$4.00$4.00Total$29.00$29.00

What is the unused capacity cost for each plant for each month?

Unused Capacity Costs

JuneJulyPlant A:Fixed portion of rate$5.00$5.00Unused capacity in DLH 40,000 50,000 Unused capacity cost$200,000$250,000Plant B:Fixed portion of rate$6.00$6.00Unused capacity in DLH 20,000 10,000Unused capacity cost$120,000$60,000

Questions We Answered TodayHow are traditional cost systems designed?What are the limitations of traditional cost systems when used for internal decision-making purposes?What is a death spiral?