Adams Manufacturing, Inc.: Activity-Based Costing versus Volume-Based Costing
Adams Manufacturing, Inc. manufactures cooling and heating coils for several different industries. It has two plants. Jewett City Plant (JCP) is an older, labor-intensive machine shop where skilled workers use tools to perform most of the work. Greenwich Plant (GP) is highly automated and uses computer numerically controlled (CNC) machines with a small number of highly paid workers. JCP manufactures a high tolerance coil (Pa) and finishes a second one (Pb). GP mass produces two standard coils, Pc and Pd, and performs basic operations on Pb before transferring it to JCP for finishing. Production takes place in batches. Each batch is made up of one product.
The products are sold directly to manufacturers by a technical sales force. Product Pa is a customized product manufactured to order, and requires a lot of specifications and negotiation with customers. Product Pb is a modification of the standardized products Pc and Pd. It is finished to meet each customer’s specifications, and as a result has more exacting technical specifications than Pc and Pd, and hence is finished in JCP. Products Pc and Pd are standardized products produced for stock and sold off the shelf and do not require much sales effort in writing up orders.
Each plant has six production and service departments: receiving, cutting and assembly, heat treatment, testing, packing and shipping, and repairs and maintenance (Charts 2 and 3). Exhibit 1 includes descriptions of activities in each of these departments. In addition, there are three departments—marketing, design and engineering support, and administration—at the corporate level (Chart 4).
The present accounting system is a traditional financial-reporting-driven system. Manufacturing costs are classified as material, labor, and overhead. Overhead is charged to products based on labor hours with the two plants treated as one cost center. Marketing, design and engineering support, and administration are considered period costs and not charged to products.
The President of the Company held a meeting with senior executives including VP–Finance, VP–Manufacturing, and VP–Marketing (Chart 1) to discuss the 2006 budget (Schedules 1, 2, and 3). She was unhappy with the fact that Pa’s budgeted price of $45 is below its standard cost of $48.29. However, she was not sure if the costing system, which treats both plants as one cost center, accurately determines the costs of the different products. She pointed out that GP is a machine-intensive plant while JCP is more labor-intensive. Furthermore, the products are produced in different numbers of batches (Schedule 6), and affect batch-related costs (e.g., testing and heat treatment) differently. She told VP–Finance that she has heard of an alternative costing method that uses multiple cost centers/pools and different cost bases to charge indirect costs to products. She also questioned the treatment of engineering support costs and marketing expenses as period costs. VP–Finance promised to investigate the President’s points and report back to the group.
The VP–Finance appointed you to a team to investigate the President’s concerns. He suggested that you develop and compare several volume-based costing and activity-based costing (ABC) systems to identify and recommend the system that you deem to give the most accurate product costs.
For the traditional volume-based systems use the Overhead Allocation Menu (Exhibit 4) shown at the bottom of the case to perform the following tasks:
1. Use machine hours, instead of direct labor hours, to allocate manufacturing overhead to the four products and restate the Products Budget (Schedule 1).
2. Repeat requirement 1 for each plant separately assuming direct labor hours are used to allocate manufacturing overhead in both plants. Schedule 4 reports the labor hours per unit for each product.
3. Repeat requirement 2, assuming that labor hours are used to allocate manufacturing overhead in JCP and machine hours in GP. Schedule 5 reports the machine hours per unit for each product in the two plants.
4. Use an activity-based costing system to calculate new costs and profitability of each of the four products (Schedule 1) under the system.
To design the ABC systems, you have visited the two plants where you interviewed plant managers, department supervisors, and accountants. You also analyzed expense accounts and operations data. Based on the interviews and analyses, your team prepared descriptions of activities within each of the departments in each plant (Exhibit 1). You also decided to create plant-sustaining cost pool to which you allocated factory costs that you decided could not accurately be allocated to the other departments. Finally, you prepared an analysis and description of the costs in each cost pool (Exhibit 2) and allocated the costs of the eight cost pools as shown in Schedule 9 to the different departments and to the plant-sustaining cost pool.
To complete the design of the ABC system you have to make decisions on the following:
a. Which cost driver should be used for allocating the costs of each activity to each of the products? Schedules 4 & 5 present labor hours and machine hours per unit for each product. Schedule 6 lists the number of batches for each product. Schedule 1 lists the number of units for each product.
b. Should you charge the design and engineering support and marketing expenses to products or treat them as firm-wide costs? Schedules 7 & 8 present sales personnel time distribution, and design and engineering support time distribution. If you decide to treat design and engineering and marketing as product costs, use the Allocation Menu to select the cost drivers and charge the cost to the products.
5. Write a report to the President that includes your analysis in Requirements 1-4, and state which of the four you recommend and why.