Question

Anu Ghai was a new production analyst at RHI, Inc., a large furniture factory in North Carolina. One of her first jobs was to update the predetermined overhead allocation rates for factory production costs. This was normally done once a year, by analysing the previous year’s actual data, factoring in projected changes, and calculating a new rate for the coming year. What Anu found was strange. The activity rate for “maintenance” had more than doubled in one year, and she was puzzled how that could have happened. When she spoke with Larry McAfee, the factory manager, she was told to spread the increases out over the other activity costs to “smooth out” the trends. She was a bit intimidated by Larry, an imposing and aggressive man, but she knew something wasn’t quite right. Then one night she was at a restaurant and overheard a few employees who worked at RHI talking. They were joking about the work they had done fixing up Larry’s home at the lake last year. Suddenly everything made sense. Larry had been using factory labor, tools, and supplies to have his lake house renovated on the weekends. Anu had a distinct feeling that if she went up against Larry on this issue, she would come out the loser. She decided to look for work elsewhere.

Requirements

1. Besides spotting irregularities, like the case above, what are some other ways that ABC cost data are useful for manufacturing companies?

2. What are some of the other options that Anu might have considered?

Short answer

ABC cost data help make more focused and strategic decisions. Any irregularities in the financial activity can be reported to the company's management committee or external agencies.

Step-by-step solution

ABC costing system

ABC costing is a system of allocating overhead costs to different products or jobs based on the activity engaged by those products or jobs. This is considered the most logical way of allocation as the allocated cost represents the portion of activity done on the product or job.

Usefulness of ABC costing for manufacturing companies

ABC costing is an improved technique for allocating overhead costs. It is the most scientific method as each product or job is allocated only that portion of the cost that is associated with the activity performed. For manufacturing companies, this method is most useful.

The ways ABC cost data can be useful for manufacturing companies are as follow –

1) Cost control – Cost control is the first implication of the ABC cost data. ABC cost data provides information for all activity cost and their allocation to products or jobs. So the unnecessary cost can be easily located and reduced as per the cost target. It also helps in identifying cost-saving areas.

2) Budgeting – Budgeting is an essential financial activity for all businesses. It helps in estimating the relevant costs and incomes. Budgeting in manufacturing companies is related to estimating the material cost, labor costs, and other manufacturing-related activities.

Indirect activities in manufacturing companies are – quality inspection, supervisor, testing, etc.

So ABC data can be helpful in estimating the different costs relating to manufacturing overheads.

3) Profitability analysis – profitability analysis is another implication of ABC cost data. Profitability is not only analyzed in terms of net income but also includes a dimension of analyzing operating profit and operation cost. In manufacturing companies, it is most important to know the profitable and non-profitable production or products.

4) Pricing decisions – Last but not least application of ABC data is to assist in fixing prices. Price is fixed after taking all factors into consideration. As ABC data provide cost details for all activities relating to all products, it becomes easy to determine the price.

Other considerable options for ANU

Anu had several considerable options. Besides quitting the job an employee can inform any unethical practice in the business through the following ways –

a) Audit committee – Every public company needs to set up an audit committee. The audit committee's work is to check the regularities and irregularities in the financial transactions. Anu could have reached the audit committee anonymously and conveyed their message.

b) Upper management – upper management is the primary body for monitoring and making decisions. In case an audit committee is not there in the business, upper management can be contacted to inform any malpractices.

c) Ethical and fraud committee – Some companies also set up ethical and fraud committees to prevent any case of malpractices. They can also be approached in such situations.

d) External agencies – If the upper management is ineffective or the audit committee or any other committee is not there, external agencies like external auditors and law enforcement agencies can be informed about such malpractices.