Cost Accounting

Case #2,

: back to the early 1980s, established by three entrepreneurs,

Abbott, Guidry, and Scott. They recognized an opportunity in the water purification equipment industry

and created a niche manufacturing company producing high quality brass valves. With Steve Abbott's

business sense, John Scott's established rpnlttot:~-' .. manufacturing industry, and Roland Guidry's

administrative expertise; the founders 0 )ducts quickly grew their company into the

leading water purification supplier. They cllversified their product line quickly adapting the

manufacturing- skills utilized in brass valve production and began producing brass pumps and flow

controllers. sement saw it imperative to innovate and capture market share in the

manufacturllle; Vl VVa<", p~' , ..__timl components; so they invested in an engineering department tasked

with research and development of new products.

The company assembled the new components in their modern manufacturing facility using the

same equipment and labor for all three product lines. They adopted a just-in-time delivery system,

processing, packaging and shipping products upon completion. Just-in-time (JIT) production, which is

also called lean production, is a "demand-pull' manufacturing system that manufactures each component

in a production line as soon as, and only when, needed by the next step in the production linel

• In this

manufacturing process, the close coordination of the work stations ease the flow of production by

reducing inventory and wastage, decreasing set-up time, and meeting customer demand without inflating

overhead costs.

The increased competition in the industry has driven down prices forcing'

reconsider their traditional accounting system. Will a comparison of different accounting systems

illustrate how letitors can effectively maintain offering lower prices for brass pumps?

Will a comparison of their traditional costing system, a revised process costing system, and an activity

based costing (ABC) system capture the differences in gross margin percentage?

Brass' controller, is challenged with identifying "why" sustained Cv<UuulOUS aecnnes 10

gross margms. The pros and cons of each costing system will be highlighted and a recommendation will

be provided on how to best report their costs.

The costs associated with production are as follows: direct materials, direct manufacturing labor,

and manufacturing overhead. ... (M) aterial cost is based on the prices (paid) for components, and labor

cost is based on the standard times for run labor times the labor pay rate of$16 per hour. Overhead cost

is assigned to products in a two-stage process. Every $1. 00 ofrun labor cost causes $4.39 ofoverhead to

be allocated to the product to which the labor was applied. ll Gross profit margins reported in the

traditional costing system are listed below.

VALVES PUMPS FLOW CONTROLLERS

Actual Selling Price $ 57.78 $ 81.26 $ 97.07

22%

...._._-_......_-

Actual Gross Margin 35% 42%

Actual Contribution Margin $ 20.22 $ 17.88 $ 40.77 -_._-- - --- ._----~--_._.__.._--- --

Actual Unit Costs $ 37.56 $ 63.38 $ 56.30

Traditioo.al Costio.g System

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Exhibit 2

An illustration of

traditional costing system from Sloan :-icnool

of Management, Professor S Roychowdhuryiii

Normal costing assigns overhead costs in a

two-stage process. In (step I), the cost object

is identified, (step2) the direct costs of the job are identified, direct materials and direct manufacturing

labor, (step3) identifY the cost allocation bases, (step4) pool overhead costs into one cost pool (step5)

calculate the budgeted manufacturing overhead rate, (step6) allocate overhead to product, and (step7)

total manufacturing product costs. werhead based on direct labor hours used.

Peggy Alford says that use of this costing system IS ramy inexpensive and meets all necessary Generally

Accepted Accounting Principles (GAAP).

The challenge identified with use ofthe traditional costing system is that direct labor has no direct

relationship to the different overhead product costs. The broad averaging or 'peanut butter costing"

describes a particular costing approach that uses broad averages jar assigning (or spreading.. .) the cost

ojresources uniformly to cost objects (such as products or services) when the individual products or

services, in jact, use those resources in non-uniform ways"'. The cost driver