ACC 311 Module 4 Project One Example

One Rate or Five Pools? Traditional and Activity-Based Overhead Allocation at a Composite Truck Equipment Shop

[Student Name]

Southern New Hampshire University

ACC 311: Cost Accounting

Project One

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

One Rate or Five Pools? Traditional and Activity-Based Overhead Allocation at a Composite Truck Equipment Shop

Introduction

Kettle River Truck Equipment assigns all of its manufacturing overhead, budgeted at $1,820,000 for the year, using one rate of $35 per direct labor hour. The rate is simple, and it worked when most of the shop's work was standard plow packages for dealers. Today, custom municipal upfits make up a growing share of revenue, and the owner suspects that some city bids are less profitable than they look. This project compares the plantwide rate with an activity-based costing model for the shop's two product lines and finds that the plantwide rate undercosts each municipal truck by $300 and overcosts each dealer package by $52.50. It explains why, shows what the difference means for one city job and recommends how the shop should use the results.

The Two Product Lines

The shop expects to finish 280 municipal upfits and 1,600 dealer plow packages this year. A municipal upfit is a custom build: each city specifies its own plow, wing, spreader, hydraulics and lighting, so every job needs engineering drawings, special-order parts and several road tests. A dealer package is a standard plow, mount and control kit built in batches from stock parts. Municipal work uses about 120 direct labor hours per truck, or 33,600 hours in total; dealer packages use 11.5 hours each, or 18,400 hours, for a total of 52,000 budgeted hours.

Traditional Allocation

Table 1. Overhead Under the Plantwide Rate

Under this method each line receives overhead in proportion to its labor hours. Because municipal trucks use about 65 percent of the hours, they receive about 65 percent of the overhead.

Activity-Based Model

Interviews with the shop foreman, engineer and purchasing manager identified five activities that account for all budgeted overhead. Each pool has a driver that causes its cost to rise or fall. Engineering cost follows engineering hours; setup cost follows the number of setups on the CNC plasma table and press brake; purchasing and receiving follow purchase orders; quality inspection and road testing follow inspections; and the remaining facility and machining cost follows machine hours.

Table 3. Overhead Assigned Under Activity-Based Costing

Both systems assign the same $1,820,000; only the split changes.

Comparison and Causes

Table 4. Overhead per Unit Under Each Method

Municipal trucks consume far more of the support activities than their labor hours suggest. They use 97 percent of engineering hours, 80 percent of setups and of purchase orders, and 81 percent of inspections, but only 65 percent of labor hours. Dealer packages, by contrast, are machine-intensive: they use 65 percent of machine hours but only 35 percent of labor hours. A labor-hour rate therefore shifts support costs from the complex product to the simple one. This is the pattern that research on activity-based costing predicts. Balakrishnan et al. (2012) show that volume-based allocation distorts costs most when products differ in the batch-level and product-level activities they consume, and Banker et al. (2008) found that the benefits of activity-based costing for plant performance appear mainly where the information is used in operations, not merely recorded.

What the Difference Means for a City Job

Job 26-114, six municipal trucks bid at $372,000, showed a job cost of $315,300 and a gross margin of 15.2 percent under the plantwide rate. Under activity-based costing, overhead on the job rises by $300 per truck, or $1,800 in total, and the job cost becomes $317,100. The margin falls to $54,900, or 14.8 percent. One job moves only modestly, but across 280 municipal trucks a year the understatement is $84,000, money the shop has been bidding away without knowing it. On the dealer side the reverse holds: dealer packages carry $84,000 more overhead than they cause, which may explain why two regional dealers have begun buying plows from a competitor whose prices are about $50 lower.

Cost and Limits of the Model

Activity-based costing is not free. Kaplan and Anderson (2007) note that traditional activity-based systems often failed because interviews and time surveys were expensive to repeat and the models grew too complex to maintain. This model has only five pools and uses drivers the shop already records in its scheduling and purchasing software, so the cost of updating it once a year is modest. Its limits should be stated: driver volumes are budgets, and the engineer's estimate that municipal work uses 3,400 of 3,500 engineering hours rests on one year of timesheets.

Recommendation

The shop should keep its plantwide rate for inventory valuation and external reporting, where it is simple and acceptable, and adopt the five activity rates for two decisions: bidding municipal jobs and setting the dealer price list. For bids, the estimator should build overhead from each job's expected engineering hours, setups, purchase orders, inspections and machine hours, so that a city that requests a unique wing configuration pays for the engineering it causes. For dealers, the shop should test a price reduction of up to $50 on standard packages to win back volume. The controller should review activity costs and drivers each spring before bid season. Together these steps would bring prices closer to cost on both lines without replacing the accounting system. If the first season of activity-based bids shows that cities accept the higher prices, the shop can consider moving its inventory costing to the same model; if they do not, the owner will at least know which jobs to decline.

References

Balakrishnan, R., Labro, E., & Sivaramakrishnan, K. (2012). Product costs as decision aids: An analysis of alternative approaches (Part 1). Accounting Horizons, 26(1), 1-20. https://doi.org/10.2308/acch-50086

Banker, R. D., Bardhan, I. R., & Chen, T.-Y. (2008). The role of manufacturing practices in mediating the impact of activity-based costing on plant performance. Accounting, Organizations and Society, 33(1), 1-19. https://doi.org/10.1016/j.aos.2006.12.001

Kaplan, R. S., & Anderson, S. R. (2007). Time-driven activity-based costing: A simpler and more powerful path to higher profits. Harvard Business School Press.