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 0.815. 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.
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