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?

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 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-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 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%) 8000 (37.0%)

1500 (13.8%) 9000 (12.2%)
2000 (46.5%) 11000 (37.1%)
3000 (46.5%) 12000 (46.5%)
4000 (17.2%) 14000 (17.9%)
5000 (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 = $8.67/DLH
 Product Costs
Plant A: June July
DM $15 $15
DL $10 $10
MOH $5.17 $6
Total $30.17 $31

Plant B: June July

DM $15 $15
DL $10 $10
MOH $4.75 $4.34
Total $29.75 $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: June July
DM $15 $15
DL $10 $10
MOH $3.50 $3.50
Total $28.50 $28.50

Plant B: June July

DM $15 $15
DL $10 $10
MOH $4.00 $4.00
Total $29.00 $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 $5.00
Unused capacity in DLH 40,000 50,000
Unused capacity cost $200,000 $250,000
Plant B:
Fixed portion of rate $6.00 $6.00
Unused capacity in DLH 20,000 10,000
Unused capacity cost $120,000 $60,000
 Questions We Answered Today

How are traditional cost systems

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