Case 1 – Absorption Costing (for Accounting course)
ENGLE TIRE COMPANY
INTRODUCTION
Though it is nearly impossible to calculate the precise cost of a manufactured product, businesses make every effort to determine the most accurate cost estimates for decision-making purposes. This case illustrates the difference in a traditional costing system using a single overhead rate and an activity-based costing system.
Direct materials and direct labor are costs that are directly traceable to the actual product and, therefore, are the simplest costs to include in product cost approximations. In contrast, overhead costs are indirect costs that cannot be readily traced to specific products so companies must allocate these costs to products on an estimated basis using either a traditional costing system or activity-based costing (Kimmel, Weygandt, & Kieso, 2016).
Traditional cost accounting systems accumulate overhead costs into one or more cost pools and then allocate the overhead costs to individual products using an allocation base such as direct labor cost or hours, machine hours, or the number of units. These allocation bases are increasingly viewed as arbitrary as they seldom represent a product’s use of resources in complex manufacturing processes (Eldenburg & Wolcott, 2011). As a result, organizations that use a traditional costing system may experience substantial product cost distortions due to the lack of correlation between the allocation bases and overhead costs (Kimmel, Weygandt, & Kieso, 2016).
Activity-based costing (ABC) is a system that allocates overhead costs to distinct tasks or activities (activity cost pools) performed in a manufacturing process. The overhead costs in the cost pools are then assigned to specific products employing cost drivers that reflect each product’s use of the activities. Thus, ABC utilizes multiple activity cost pools and cost drivers that increase the accuracy of product costs (Eldenburg & Wolcott, 2011).
COMPANY INFORMATION
Engle Tire Company (ETC) is a manufacturing company that produces tires and manufactures over 200 different tires and sizes in its Memphis plant. In 2018, ETC automated the Memphis, Tennessee plant to take advantage of reasonably priced cutting-edge technology. Before automation, ETC used a single plantwide rate to allocate conversion costs using direct labor hours. At that time, the correlation between conversion costs and direct labor hours was 0.81
5
. Because of the technological improvements, the number of direct labor hours was cut in half.
Alfred Olson, the Controller at ETC, was concerned with the accuracy of the assignment of product costs. Alfred had recently attended a seminar on activity-based costing and was interested in how it may improve ETC’s ability to assign indirect costs to the tires and thus may likewise enhance its pricing decisions.
James Jetter is the Chief Executive Officer (CEO) of ETC in Memphis, Tennessee. Before becoming the CEO in 2012, he served as the Chief Operating Officer (COO) for 8 years. ETC has its international headquarters in Memphis, Tennessee. Currently, ETC has three manufacturing plants in the United States, as well as a plant in Cortez, Mexico. The other two locations in the United States are in Casper, Wyoming and Cleveland, Ohio.
ETC manufactures tires in seven different tire types; all-season, light/medium truck, passenger, performance, summer, touring and winter. Additionally, ETC produces seven different brands with over 70 different models, and produces 20 different tire widths, with aspect ratios from 20 to 85, and tire diameters between 15 and 20 inches. As mentioned previously, ETC produces more than 200 different tires and sizes in the Memphis plant and employs between 2,000 to 3,000 employees during its slow and busy seasons, respectively.
As the Controller of ETC, Alfred Olson has gathered data after the automation of the Memphis manufacturing plant. He has provided this data in a Microsoft Excel spreadsheet file referred to as Data Set 1. In this data file, he has provided the total conversion costs and direct labor hours for 48 daily observations.
Data Set 1 provides enough data to do a simple regression model and/or measure the correlation between variables. Again, Alfred is concerned with the relationship between total conversion costs and direct labor hours, because of the investment in new technology. Currently, ETC allocates conversion costs using direct labor hours based on an average of the 48 observations. In other words, ETC finds the sum of the total conversion costs and direct labor hours over the 48 observations. Then ETC finds the predetermined conversion costs rate by dividing the total conversion costs by the total direct labor hours. Meanwhile, material costs are assigned directly to the tires. Direct labor costs are assigned as part of the conversion costs.
Last month, ETC manufactured 20,000 ETC/A105 and 5,000 ETC/B107 tires. ETC/A105 is a more popular tire that is produced in larger batches than ETC/B107. Additionally, the average direct materials costs for ETC/A105 and ETC/B107 are $55 and $80, respectively. While the ETC/A105 fits on a common family car or van, the ETC/B107 is not suitable for the family vehicles because it is a larger tire.
The direct labor hours used to produce ETC/A105 and ETC/B107 last month were:
ETC/A105 – 9,000 direct labor hours
ETC/B107 – 3,000 direct labor hours
REFERENCES
Eldenburg, Leslie G., & Wolcott, Susan K. (2011). Cost Management: Measuring, Monitoring, and Motivating Performance (2nd ed.). John Wiley & Sons, Inc.
Kimmel, Paul D., Weygandt, Jerry J., & Kieso, Donald E. (2016). Accounting: Tools for Business Decision Making (6th ed.). John Wiley & Sons, Inc.
Case 1:
Alfred Olson has provided you with the first data set. Also, he has informed you that ETC is currently assigning conversion costs to all tires based on the average conversion cost per direct labor hour for the 48 observations.
James Jetter, the CEO of ETC, would like to know the total product costs and unit costs for ETC/A105 and ETC/B107. In addition to the total product costs and unit costs for ETC/A105 and ETC/B107, he would also like to know the strength of the relationship between direct labor hours and total conversion costs. Has this relationship improved or weakened since automation?
Provide James Jetter with a short paper summarizing your findings. This short paper should 1) summarize the information and findings of your analysis, such as production cost per tire, 2) compare the results of your current correlation analysis with the correlation analysis prior to automation, and 3) discuss your suggestions on how to improve the overall calculation of total product and unit costs for the different tires.
5
>DATA SET ,000
, 52,8 0, 50
, , 5
0
,98 ,000
,888,000
,052,625
9,000
,7 ,000
,850
,875
,750
,375
5
4,875
8,100
7,600
0
0,850
Costs
5,000 Total # of Setups # of POs DLH Materials Total TC per Tire 600,000 350,000 Case 1 – Due February 20, 2022 Case 2 – Due April 3, 2022 Case 1 and Case 2 are continuous cases. That is, Case 2 will build on the results of Case 1. For case 1 you will receive an email from me which includes two files: a written case and an Excel spreadsheet. Please make sure the company name for both files match. Also, please note that not all students will receive the same Case 1 and Case 2. Before you start working on Case 1, I suggest that you go to the module created for Case 1 and Case 2. There you will find a recorded lecture that demonstrates how to perform correlations and regression analysis using Excel. You will need to be able to calculate correlations for both Case 1 and Case 2. Case 1 will reinforce the learning objectives covered in chapters 2 and 3. You should use the provided Excel file to perform your calculations and analysis. Make sure your solution is easy to follow and well organized (see Excel hint file). After completing your quantitative analysis, develop a short paper summarizing your analysis, findings, any identified issues, and suggestions or alternatives. An example outline for this paper is provided in the Case 1 and 2 Canvas module. My expectation is the paper will be no longer than 2 – 3 pages. If you provide me a draft of your paper more than 4 days before the due date, I will provide you with some initial feedback.
Case 2 will use the activity-based costing information provided in Chapter 7 and will be provided to you once you submit your final paper and Excel file for Case 1. Otherwise, I will send out Case 2 to all remaining students on Monday, February 28. The Case 1 and Case 2 module in Canvas includes a lecture of a similar ABC exercise for your reference (ABC Example – Emerson Company). As you work on these two cases, feel free to contact me with any questions. I will try to give you a timely response to your questions. Good luck! Glenn TITLE PAGE [Case Name] [Course] [Your Name] [Date] EXAMPLE OUTLINE FOR CASES 1 & 21
Observations
DLH
Total Costs
1
9
4
1
8
5
25
2
10
7
19
12
3
32
3
102,
15
21
6
4
80,000
17
5
87,000
17,888,625
6
96,500
18
7
88,500
18,184,325
8
11
20
37
9
96,000
18,606,650
10
88,200
18,6
42
11
93,500
18,854,000
12
95,000
18,8
45
13
100,500
18,8
41
14
95,500
18,870,550
15
97,000
18,907,675
16
101,150
18,917,100
17
99,500
20,7
46
18
96,650
19,068,
27
19
83,000
19,
26
20
91,850
19,
24
21
91,250
19,
36
22
98,500
19,777,050
23
110,500
19,785,375
24
99,000
19,921,275
25
109,000
19,906,775
26
101,000
19,999,375
27
81,600
20,126,550
28
80,
40
20,
39
29
86,000
20,376,500
30
115,500
20,398,050
31
92,650
20,574,050
32
97,950
20,567,150
33
91,000
20,606,925
34
98,000
20,696,675
35
120,000
20,619,150
36
101,500
20,756,850
37
92,000
20,873,100
38
82,000
21,007,375
39
116,000
21,057,775
40
90,500
21,210,675
41
98,250
18,187,375
42
105,500
21,259,100
43
104,000
21,431,000
44
105,000
19,151,500
45
106,000
20,831,825
46
100,000
21,685,650
47
99,350
20,723,050
48
104,400
20,130,600
Sheet1
Observations
Setup Costs
# of Setups
Purch Costs
# of POs
Labor Costs
DLH
Total
2,000
200
125
209.45
Material costs for each tire:
Tires Produced
A105
40
1
5,000
B107
70
Activities used by products A and B:
# of Setups # of POs DLH
A105
30
80
10,000
B107
120
220
6,000
Part 1:
Traditional Cost Allocation to Products A and B:
# of Setups # of POs DLH
Materials
TC per Tire
A105
2,094,500
600,000
2,694,500
179.63
B107
1,256,700
350,000
1,606,700
321.34
Part 2:
ABC Allocation to Products A and B:
A105
60,000
16,000
1,250,000
1,926,000
128.40
B107
240,000
44,000
750,000
1,384,000
276.80
Executive Summary
Purpose
Analysis Summary
Answer
Introduction
Facts of the Case
Questions to be Answered
Analysis and Observations
Information used in analysis
Quantitative analysis
Correlation and regression
Suggestions and/or alternatives
Conclusion
Your opinion
Basis for your opinion
Exhibits or References (if necessary)
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