ABC Costing System

This is a recommendation letter to the controller of Piedmont Manufacturing Company.  I have been asked to advise Piedmont on the ins and outs of an Activity Based Costing system.  I got an A+ on this one.

October 4, 2010

Jay Sutherlin, Controller

Piedmont Manufacturing Company

94 N. Pecos Road

Las Vegas, Nevada 89044

Dear Mr. Sutherlin,

I am pleased to advise you on the cost-effectiveness of an activity-based costing (ABC) system for Piedmont Manufacturing Company.  In order to evaluate whether an ABC system is worthwhile for your situation, you will need to analyze the benefits of improved information and decide whether the cost of implementation, $2.5 million, is justifiable.

ABC System

This type of system assigns costs to different production units, based on the activities performed.  In your case, this means the costs of metal and wooden furniture would be calculated by how many resources, such as engineering hours and materials, are consumed by each.

Piedmont is currently using an inferior approach, volume-based costing, which exposes the risk of misleading financial information, resulting in poor management decisions.  ABC provides better information but is expensive to implement.  It must be decided whether the benefits of switching to ABC outweighs the costs.

Benefits of ABC

Switching to an ABC system increases the quality of information available to the Company.  Managers use this information to support strategic decisions regarding product lines, market segments, customer relationships, and improved processes (CMA Canada 2008, 2-3).  Therefore, it is crucial that the data is accurate and leads to the right decision-making.  The following are the main advantages of implementing an activity-based costing system:

1.  Improved Decision Making

2. Improved Measures of Profitability

3. Cost Estimation

4. Process Improvement 

5. Cost of Unused Capacity

You must decide if the improved information quality is worth the cost for your company.  In order to do so, you also need to consider the limitations of an ABC system.

Limitations of ABC

Although ABC leads to many advantages, there are a few disadvantages as well.  It is sometimes difficult to directly associate a cost to one product due to its ambiguous nature.  Product costs do not always include every related expense, like marketing and engineering costs, due to requirements of generally accepted accounting principles (GAAP).  Also, it can be very expensive to install ABC and usually requires a year or more for adequate development and implementation.  In summary, the limitations of an ABC system are as follows:   

1. Allocations
2. Omissions of cost
3. Expense and time

Once you are aware of the advantages and disadvantages of ABC, you must look at firm-specific data that supports your decision.

Cost of Implementation

I have compiled a table in Appendix A, which shows the improved quality of information resulting from the use of ABC over volume-based costing.  As the table shows, the variance in cost-estimation between systems results in a $110 difference for metal chairs and $27.50 for wooden chairs per unit.  The company is overestimating the profitability of metal chairs by $1.375 million and underestimating the profitability of wooden chairs by $1.031 million annually.  The impact on information resulting from the ABC system can lead to substantial enhancement in decision-making, cost estimation, and process improvements (Blocher, Stout, Cokins, and Chen 2008, 126-130).

The total cost of implementing this system is $2.5 million.  This is approximately 10% of this year’s revenue.  It is up to you to decide whether you think the information quality resulting from a switch to ABC is worth that much to your company.

Conclusion

I hope that the information I have provided is adequate for you to begin decision-making.  I remind you to consider the benefits of improved information compared to its cost.  Use the appendix to analyze the impact of ABC on your financial decisions, and determine whether the Company can afford to implement the new system.

Once you have evaluated all related circumstances, I advise you to meet with me to discuss your decision.  If you decide to switch to the activity-based costing system, I have additional advice about implementation processes.  Please call me at (419) 221-0008 if there are additional matters you wish to discuss.

Sincerely,

Emily Diepenbrock

Attachment

Appendix A Information based on 25,000 and 75,000 units of production for metal and wooden chairs.
Volume-Based Costing
Total Overhead (OH)	$2,000,000
Total Direct Labor Hours (DLH)	100,000
Overhead rate per DLH	$20.00
	Metal Chair	Wooden Chair
Total OH Assigned	$500,000	$1,500,000
Number of Units	5,000	20,000
Overhead Costs per unit	$100.00	$75.00
Unit selling price	$400	$200
Unit product cost:
Direct materials and labor	(200)	(80)
Factory overhead	(100)	(75)
Cost per unit	(300)	(155)
Unit Margin	$100	$45
Activity-Based Costing
Activity Consumption Driver	Cost	Activity Consumption	Activity Rate
Engineering hours	125,000	12,500	10
Number of setups	300,000	300	1,000
Machine-hours	1,500,000	150,000	10
Number of packing orders	75,000	15,000	5
Overhead Cost	Metal Chair	Wooden Chair
Engineering hours	$10.00	$3.75
Number of setups	40.00	5.00
Machine-hours	100.00	50.00
Number of packing orders	5.00	2.50
Overhead Costs per unit	$155.00	$61.25
Unit selling price	$400.00	$200.00
Unit product cost
Direct materials and labor	(200.00)	(80.00)
Factory Overhad:
Engineering	(10.00)	(3.75)
Setups	(40.00)	(5.00)
Machine running	(100.00)	(50.00)
Packing	(5.00)	(2.50)
Cost per unit	(355.00)	(141.25)
Unit Margin	$45	$59
Comparison	Metal Chair	Wooden Chair
Unit overhead cost
Volume-based	$100.00	$75.00
Activity-based	155.00	61.25
Difference	55.00	13.75
Unit margin
Volume-based	$100.00	$45.00
Activity-based	45.00	58.75
Difference	55.00	13.75
Total Difference Between Systems	$110.00	$27.50