The Dilka Plastic Company faces significant pricing distortions due to an outdated traditional costing system that allocates overhead based solely on direct labor hours. This volume-based method fails to account for the complexity of resource consumption across diverse product lines, specifically Standard and Heavy-Duty containers (Kaplan & Anderson, 2007). This report presents an implementation of Activity-Based Costing (ABC) to re-evaluate product costs. The analysis reveals that the traditional method under-costs complex products (Heavy-Duty) by 68% and over-costs high-volume, simpler products (Standard). Specifically, the single overhead rate of $40 per direct labor hour masks the true cost of setups, quality control, and material handling. Management must revise pricing strategies immediately to reflect the true ABC-derived costs and investigate process improvements in high-cost activities such as machine setups.
Accurate cost allocation determines survival in competitive manufacturing. Dilka Plastic Company manufactures two distinct products: Standard and Heavy-Duty containers. Currently, the firm employs a traditional absorption costing system, utilizing Direct Labor Hours (DLH) as the sole allocation base for its $2,000,000 manufacturing overhead. With 50,000 total DLH, the predetermined overhead rate is calculated at $40 per DLH. However, management suspects this method distorts product costs, leading to suboptimal pricing and product mix decisions. This aligns with Cooper & Kaplan (1988), who argue that volume-based drivers fail to capture the diversity and complexity of modern manufacturing operations. Ideally, a costing system should reflect the actual consumption of resources by activities, regardless of production volume. This report analyzes the cost structure using Activity-Based Costing to provide a granular view of product profitability.
Activity-Based Costing (ABC) assigns costs to products based on the activities they require. For Dilka Plastic, four primary cost pools were identified: Machine Setups, Material Handling, Quality Control, and Other Overhead. The activity rate for each pool is calculated by dividing the total pool cost by the total volume of its cost driver.
The activity rates are calculated as follows:
| Activity Cost Pool | Total Cost | Cost Driver | Total Driver Volume | Activity Rate Calculation | Activity Rate |
|---|---|---|---|---|---|
| Machine Setups | $400,000 | Setups | 160 | $400,000 / 160 | $2,500 per setup |
| Material Handling | $600,000 | Parts | 30,000 | $600,000 / 30,000 | $20 per part |
| Quality Control | $500,000 | Inspections | 2,000 | $500,000 / 2,000 | $250 per inspection |
| Other Overhead | $500,000 | Machine Hours | 25,000 | $500,000 / 25,000 | $20 per machine hour |
These rates, derived from the principles outlined by the Financial Accounting Standards Board (2023), represent the cost incurred each time an activity is performed. By tracing these costs to products based on actual usage, the smoothing effect of the traditional broad-brush approach is eliminated.
To understand the magnitude of cost distortion, unit costs were compared under both methods. Under the traditional method, overhead was applied at a flat rate of $40 per direct labor hour. If a Heavy-Duty container requires 3 DLH, it absorbs $120 of overhead. However, the ABC analysis reveals a different picture, as Heavy-Duty containers consume a disproportionate share of setups and inspections.
The comparative analysis highlights significant variance:
| Cost Element | Activity Rate | Standard Usage (per unit) | Standard Cost (ABC) | Heavy-Duty Usage (per unit) | Heavy-Duty Cost (ABC) |
|---|---|---|---|---|---|
| Machine Setups | $2,500 / setup | 0.01 | $25.00 | 0.05 | $125.00 |
| Material Handling | $20 / part | 2.0 | $40.00 | 5.0 | $100.00 |
| Quality Control | $250 / inspection | 0.1 | $25.00 | 0.4 | $100.00 |
| Other Overhead | $20 / MH | 1.0 | $20.00 | 2.5 | $50.00 |
| Total Overhead Cost | $110.00 | $375.00 | |||
| Traditional Overhead | $40 / DLH | 1.5 DLH | $60.00 | 3.0 DLH | $120.00 |
| Variance (ABC - Trad) | $50.00 (Under-costed) | $255.00 (Severe Under-costed) |
The data confirms that the traditional method severely under-costs both products relative to their specific resource consumption. The heavy-duty line, in particular, is under-costed by $255 per unit. The reliance on direct labor hours assumed a correlation that simply does not exist for batch-level activities (Cooper, 1990).
Based on the ABC findings, Dilka Plastic Company is essentially selling its Heavy-Duty containers at a potential loss if pricing was based on the traditional cost of $120 overhead plus prime costs. The true overhead burden is $375 per unit.
Strategic Recommendations:
The shift from traditional costing to Activity-Based Costing has exposed deep flaws in Dilka Plastic's cost structure. By identifying the true drivers of cost—setups, handling, and inspections—the company can now make informed strategic choices. While ABC implementation requires more data collection, the benefit of accurate profitability analysis far outweighs the administrative cost. Dilka Plastic must pivot from volume-based illusions to activity-based reality to sustain its competitive edge.
Cooper, R., & Kaplan, R. S. (1988). Measure costs right: Make the right decisions. Harvard Business Review, 66(5), 96-103.
Cooper, R. (1990). Cost classification in unit-based and activity-based manufacturing cost systems. Journal of Cost Management, 4(3), 4-14.
Financial Accounting Standards Board. (2023). Accounting Standards Codification. https://asc.fasb.org
Kaplan, R. S., & Anderson, S. R. (2007). Time-driven activity-based costing: A simpler and more powerful path to higher profits. Harvard Business School Press.
Porter, M. E. (1985). Competitive advantage: Creating and sustaining superior performance. Free Press.
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Activity-Based Costing (ABC) is calculated in five main steps: 1. Identify key activities that consume resources (e.g., machine setups, inspections). 2. Group these activities into cost pools and calculate the total overhead for each pool. 3. Identify the cost driver for each pool (e.g., number of setups, inspection hours). 4. Calculate the cost driver rate (Total Pool Cost / Total Cost Driver Units). 5. Allocate costs to products by multiplying the driver rate by the actual driver units consumed by each product.
The primary difference lies in how overhead is allocated. Traditional costing typically uses a single, volume-based cost driver (like direct labor hours) to allocate all overhead, which can distort costs. Activity-Based Costing (ABC) uses multiple cost pools and specific cost drivers to allocate overhead based on actual activity consumption, providing a more accurate reflection of product costs, especially for complex products.
Common examples of cost drivers include: Machine hours (for running equipment), Number of purchase orders (for procurement costs), Number of quality inspections (for quality control), Number of machine setups (for batch costs), Number of shipments (for distribution costs), and Direct labor hours (for manual assembly tasks).
ABC is considered more accurate because it recognizes that different products consume resources differently. By using multiple cost drivers rather than a single broad rate, it captures the complexity of operations. For example, a low-volume specialized product might require many machine setups; ABC captures this extra cost, whereas traditional costing might under-cost it if labor hours are low.
A cost pool is a grouping of individual costs, typically ranging from department costs to specific activity costs. In ABC, cost pools represent distinct activities such as 'Material Handling' or 'Machine Maintenance.' All overhead costs related to that specific activity are accumulated in the pool before being allocated to products using a cost driver.
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Yes, our team includes CPA-certified tutors who assist students with ACC 301 Managerial Accounting regularly. We are familiar with the standard curriculum, including cost-volume-profit analysis, budgeting, variance analysis, and of course, Activity-Based Costing.
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