Background
Bridgton Industries owns and operates an Automotive Component & Fabrication Plant (ACF). The valuation of the products produced by ACF is based on their respective degree of cost competitiveness. Products that have a cost equal to or lower than competitors’ manufacturing costs are considered to be of the greatest value to the company. ACF’s manufacturing costs include Direct Material, Direct Labor, and the respective allocation of the plant’s collective overhead.
The overhead and direct labor dollars for model years 1987 through 1990 are stated, as presented in the Harvard Business School 9-190-085 case study. For the 1987 model year, overhead was applied to the products as a percentage of direct labor cost for the production of the respective product. This overhead percentage was calculated “at a budget time” and then applied throughout the 1987 production year.
Trends for Model Years
The overhead and direct labor data were used to calculate the actual applied overhead percentage rate for the years 1987 through 1990. The following assumptions were made for calculating the applied overhead percentage rate for the respective model year and analyzing the trend: The same method that was used for calculating and allocating the overhead percentages in 1987 was used for the remaining model years.
- Costs of materials and labor were recognized in the same period as the sales.
- Since there were no major capital purchases for new equipment during the timeframe of the study we have assumed that there were no major improvements made to automation efficiency and as a result, any changes to the reported costs for direct labor can be attributed to changes in production quantities.
- No significant increase in production line workers; however there is a notable increase in the amount of non-production workers. There were no major differences noted between the model years 1987 and 1988. The same product lines were in operation for both years.
The 1989 model year saw a substantial increase in the costs associated with the production of the plant. It was noted that two of the plant’s product lines were outsourced in the 1989 model year. The outsourcing of these product lines resulted in the allocation of the full amount of the overhead to a fewer number of products, thereby producing a substantial increase in the remaining product costs. There were no major differences noted between the model years 1989 and 1990, as a result of the plant operating under the same business structure for both years. The overhead allocation rates for model years 1987 through 1990 were assigned per product as a factor of the direct labor dollar.
The trend associated with this allocation strategy is that there is an increase in per product costs for the remaining products produced in the plant following the outsourcing of a product line. The increase in cost is a result of the increase in the overhead percentage rate applied to the products.
Flaws of the Current Cost System
The product costs consist of both a variable cost and a fixed (overhead) cost. The variable costs reported in this cost system are appropriate; however, the fixed costs are not reported in association with the specific products. The current cost system allocates overhead costs once a year, as a function of direct labor dollars. This allocation strategy results in:
- Inaccurate allocation due to products at various levels of automation
- No incentive to reduce the cost of materials A situation where a reduction in production will result in less overhead allocated to the respective product
- Lack of incentive for employees to continually reduce their costs throughout the year as a result of the annual calculation of overhead allocation.
Assuming that the company’s goal is to maximize profits, the current cost system is not an appropriate tool for strategic planning. The ambiguity of the overhead costs per product makes it difficult to accurately analyze the cause and effect relationships of changes and/or improvements to a specific product line. If the cost system reported sales volume and/or price we would be able to conduct an activity analysis to determine an appropriate cost function to determine the best cost driver for each product.
Manifold Recommendation
Based on Current Cost System If we assume that the 1991 products, prices, sales volumes, materials costs and overhead are unchanged from 1990 and that there are no process improvements that would lead to a reduction in the direct labor of a product, it can be inferred that the company’s profits would be identical to those of 1990. However, if the same is assumed with the exception of the outsourcing of the manifold product, it can be assumed that there will be a substantial increase in the overhead allocated to the remaining products. In 1989 the company outsourced the production of the muffler/exhaust and oil pans.
These products represented approximately 50% of the company’s direct labor costs. In 1990, the manifold product represents approximately 50% of the company’s direct labor costs. It can be assumed that a similar change in overhead allocation as seen from 1988 to 1989 would be seen from 1990 to 1991. If the manifold product is outsourced, the overhead will be reallocated to the remaining products, the fuel tanks, and the doors. As a result, these products will undergo a burden percentage of 706% per direct labor dollar. This analysis indicates that the product should not be outsourced, as a result of the contribution and ending profit.
In addition, keeping the production of the manifolds in the facility allows for the allocation of the company’s overhead over three products. This results in a lower production cost for each of the products. Past history illustrates that the company outsourced the muffler/exhaust and oil pans despite the fact that their margins (not including overhead) were 47% and 50% respectively. The current product classification system is based on the product’s respective degree of cost competitiveness, not the product’s contribution margin. This classification system categorizes the manifolds as a Class III product and therefore they are candidates to be outsourced.
Recommendations
ACF should first separate out the individual elements of the overhead accounts and then reconsider the cost drivers associated with each overhead accounts. The plant needs to determine an appropriate link between the overhead and the products. Once cost drivers are established for the individual elements of the overhead, ACF should determine the activity level for each project, with respect to the drivers, and assign the overhead as a function of the project’s activity level. An example of the recommendations for correction to overhead allocation. In addition, a detailed correction for the allocation of overhead account number 8000 is as follows:
- Account 8000 Includes both depreciation (on a straight-line basis) and property taxes.
- Allocation of this overhead account based on direct labor dollars results in an inaccurate allocation. An example of this would be the deprecation of equipment used in one production line being allocated to another.
- This account should be separated into equipment specific depreciation overheads and overall plant property tax overhead.
- Depreciation for a specific piece of equipment could be allocated based on the use of the product of the equipment. The driver for this allocation could be machine hours.
This would allow for the allocation of one piece of equipment over several products. Property tax overhead could be allocated based on a driver that takes into account the amount of floor space required for the production of the respective product, with shared space being divided equally among products. A product-specific allocation of the overhead expenses will allow for an accurate analysis of the cause and effect relationships of changes and/or improvements to a specific product line. It is also recommended that the Bridgeton Industries considers a change in the Classification System to take into account the opportunity cost associated with the production of multiple products at the ACF plant. The Classification System needs to assess the impact on future profits/production opportunities that result in the reallocation of overhead from an outsourced product.
In addition, if Bridgeton Industries decides to outsource a product, the resulting increase in production capacity needs to be utilized in another manner (examples additional production of current products, corporate administration, renting of space, etc).
