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Questions We Will Answer

Today
How 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

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 youre kidding!

Describe Bridgetons
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 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?

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 nonlabor-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:
5.6%

$4,238 $75,196 =

Manifolds:
7.1%

$6,027 $84,776 =

Doors:
6.1%

$2,731 $45,174 =

Muffler/Exhausts:
8.7%

$5,766 $66,266 =

Oil Pans:

$6,532 $79,658 =

The Outsourcing Decision


Muffler/Exhausts and Oil Pans get
outsourced
The 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


Accounts
1000 (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 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 Bridgetons approach


okay for external reporting?

Why is Bridgetons 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 =

Product Costs
Plant A:
DM
DL
MOH
Total

June
$15
$10
$5.17
$30.17

July
$15
$10

Plant B:
DM
DL
MOH
Total

June
$15
$10
$4.75
$29.75

July
$15
$10

$6
$31

$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 =

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

July

Plant A:
Fixed portion of rate
$5.00
Unused capacity in DLH 40,000
Unused capacity cost

$5.00

50,000
$200,000 $250,00
0

Plant B:
Fixed portion of rate
$6.00
Unused capacity in DLH 20,000

$6.00

Questions We Answered
Today
How 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?

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