Nobody would argue the fact that allocation of costs and budgeting are crucial activities for any business. Consequenently, a case of Rubrics Corporation is not exclusion. The company is facing considerable problems with cost allocation. The products of the firm are evidently overpriced, and the organization needs a reasonable decision to address its future budget issues, as well as leverage present misconception of costs. The case study suggests activity-based cost allocation, which is based on allocation of costs according to the activities (or resources) involved in a manufacturing process of a product. The given strategy is an essential solution for Rubrics Corporation, but chief financial officer is required to be attentive in regards to this method. Thus, the following paper focuses on a discussion of the case study from the perspective of ABC budgeting method appliance.
Calculations and Analysis
In order to speak about calculations of a standard overhead cost per product, it is necessary to admit that overhead rate is 200% of direct labor cost, which is why costs for each product should be multiplied by 2. In such way, widgets overhead cost is the following: $100, 000 x 2 = $200, 000. At the same time, gadgets’ overhead cost is $300, 000 x 2 = $600, 000. As for smidgets, their overhead cost is $400, 000 x 2 = $800, 000. Smadgets include overhead cost equal to $200, 000 x 2 = $400, 000. It is becoming increasingly apparent that such estimates are based on traditional direct costs of the products. Relevance of such estimates will be discussed further, but risk of inappropriate cost allocation is present at both margins: upper and lower (Drury, 2005). This evidence can be explained with the fact that a current overhead cost may be excessively high for low-cost products and accordingly low for high-cost items (Eckbo, 2007). As a result, the costs of the products themselves should be calculated.
Provided that direct labor and direct material comprise a price for each product without overhead rate, pure direct costs will be the following:
- Widgets: $100, 000 + $100, 000 = $200, 000.
- Gadgets: $300, 000 + $200, 000 = $500, 000.
- Smidgets: $400, 000 + $150, 000 = $550, 000.
- Smadgets: $200, 000 + $250, 000 = $450, 000.
As a consequence, total costs for each product with consideration of overhead costs are the following:
- Widgets: $200, 000 + $200, 000 = $400, 000
- Gadgets: $500, 000 + $600, 000 = $1, 100, 000.
- Smidgets: $550, 000 + $800, 000 = 1, 350, 000.
- Smadgets: $450, 000 + $400, 000 = $850, 000.
Overall, such assumption of overall cost is safe from the perspective of productivity, as a manufacturer is sufficiently provided with budget. On the other hand, such allocations may occur extremely excessive and redundant (Drury, 2005). Without doubt, such tendency adversely reflects internal cash flows and overall liquidity of finances within the company.
Activity-based cost overhead rate for overhead drivers can be presented as follows. Depreciation rate is $300, 000 : 3, 000 = 100. As for set-up, $700, 000 : 1, 000 = 700. Accordingly, rate of activity-based cost overhead for rent is $1, 000, 000 : 100, 000 = 10. In such way, rates can be used for allocating overhead costs.
Taking the given data into consideration, overhead costs per each cost driver for every single product is based on the next calculations. Depreciation cost driver for widgets will be 300, 000 x 500:3, 000 = $50, 000. Set-up for widgets is 700, 000 x 200 : 1, 000 = 14, 000. Rent for widgets will cost 1, 000, 000 : 20, 000 x 100, 000 = $200, 000. In regards to gadgets, depreciation will cost 300, 000 x 900 : 3, 000 = $90, 000. Set-up of widgets will be 700, 000 x 300 : 1, 000 = $210, 000. Rent is expected to be 1, 000, 000 x 30, 000 : 100, 000 = $300, 000. In order to speak about smadgets, depreciation will be 300, 000 x 1, 200 : 3, 000 = $120, 000. Concerning set-up for smadgets, it will be 700, 000 x 400 : 1, 000 = $280, 000. Rent for smadgets is expected to be 1, 000, 000 x 40, 000 : 100, 000 = $400, 000. Eventually, depreciation of smidgets will cost 300, 000 x 400 : 3, 000 = 40, 000. Set-up will be 700, 000 x 100 : 1, 000 = $70, 000. Rent for smidgets is supposed to be equal to 1, 000, 000 x 10, 000 : 100, 000 = $100, 000.
Overall, total costs per product are the following:
- Widgets: 50, 000 + 14, 000 + 200, 000 = $264, 000.
- Gadgets: 90, 000 + 210, 000 + 300, 000 = $600, 000.
- Smadgets: 120, 000 + 280, 000 + 400, 000 = $800, 000.
- Smidgets: 40, 000 + 70, 000 + 100, 000 = $210, 000.
It is becoming increasingly difficult to ignore the fact that all products were inappropriately priced. The company did not consider specific activity-based costs, so that approximate estimation took the upper margin of expenditures (Eckbo, 2007). Therefore, their irrelevant positioning at sales and lack (or excess) of raw material are the most explicit outcomes of a distorted allocation of costs (Drury, 2005). Such typical cases of assigning non-volume cost results in creation of volume-based products. As a result, over or underestimation of costs produces adverse effects on the overall productivity of an organization.
Addressing of such issues is usually based on various strategies for mitigating mispricing and leverage of cash flows. As a result, resale price method can be suggested: the further portions of products for sale should have an accordingly leveraged price (Livesol, 2013). At the same time, cost plus method is also often deployed to the practice as invalid allocation of costs is the initial problem. In addition, the overall reassessment of present resources and over/under production is recommended (Livesol, 2013). The results of such assessment determine adjustments for further budgeting and allocation of final prices (Livesol, 2013). The company has to take such actions initially in order to distinguish what distinct method of leveraging costs is the most applicable to the case. At any rate, measuring extents of the error is required.
A difference between direct and activity-based cost estimates is considerable owing to multiple reasons. One of such factors is that direct cost assignment presupposes a relation between volume and non-volume items. As it has already been mentioned, such correlation is irrelevant in many regards, as a risk of mispricing grows accordingly (Drury, 2005). Generally speaking, assignment of costs to a particular product does not necessarily mean that reflection on productivity will be direct (Eckbo, 2007). As for activity-based cost estimates, they are based on objective drivers of cost both specified and general (Drury, 2005). As a result, activity-based costs minimize a risk to devote low costs to high-cost products and vice versa. It is informative to note that chief financial officer is still expected to consider differences in overhead cost triggers (Drury, 2005). Various products may require the same resource to a different extent, which makes ABC budgeting require such considerations.
The first case of similar estimates with direct and ABC budgeting would be possible under circumstances of ABC using direct materials as cost overhead drivers. Nonetheless, the case study suggests that depreciation, set-up, and rent have to be taken into account (Basu, 2013). Such decision is reasonable to a particular extent, but involvement of direct raw materials is a logical consideration in that regard (Eckbo, 2007). However, a choice of cost overhead drivers may vary depending on a type of manufacture and organization as a whole. Similarity between estimates could also be traced in regards to identification of set-up cost overhead throughout direct estimation, once set-up time is almost similar for each product (Morris, Kocahulah, & Yeager, 2014). The given driver of overhead costs is the most stable, once expenditures on rent, depreciation, or direct raw materials are difficult to estimate (Eckbo, 2007). Overall, ABC budgeting would be more appropriate from the perspective of set-up time and direct raw materials only, but some exclusions are also possible.
It is appropriate to make a general comment on the fact that activity-based costs is an important consideration for a more accurate budgeting and subsequent pricing of products. Nevertheless, certain implications are still present, as the case study has demonstrated. The company is recommended to make the budgeting model more sophisticated, especially in regards to involvement of raw direct materials. A present situation with irrelevantly priced products requires and immediate reaction, which should start with assessment of financial discrepancies and potential sale outcomes. Thus, a respective method for cost leveraging is expected for a proactive deployment. On the other hand, direct cost allocation is a risky initiative, as long as pricing may deviate in both directions. The company will definitely face numerous problems with sales, management of resources, and further cost estimates. Consequently, a large presence of a generic pricing model is needed, especially for attachment of costs to the central activities of production.