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Management Accounting: Traditional vs Activity Based Costing

Behr Paint Company manufactures and sells multiple lines of paints in various colors. Recently, with the introduction of a number of new products, management has sensed that some cost characteristics of the production process have changed. First, some of the new products require more set up time between production runs. Certain colors of paints also have different requirements to ensure a quality product. As an example, for red color paints, the production equipment must go through a thorough cleaning process to ensure all paint from prior production runs has been removed. For black color paints, the cleaning requirements are minimal since any remaining ink will blend in with the black ink. Demand is also different for some of the new products. While a higher price can be charged for some of the more exotic colors, there is less demand than for traditional black and blue color paints. Behr's traditional cost system does not show much difference in the costs allocated to different product lines (see table below), however, management intuitively believes that the more exotic colored paints inherently cost more to produce than traditional color paints. Behr has asked you, their management accountant, to propose tools that will help provide more accurate information for determining which product lines are more profitable.

(Diagram is on the attachement).

While discussing the project, Behr's production manager also told you he would like to have better tools for his entire business cycle (planning, motivating and directing, and controlling) but was unsure what would be the best tools to implement. Through the course of the conversation with the production manager, you discovered that production quantities have historically been determined by the production manager using prior year production quantities and adding a percentage based on historic growth rates. Conflict inevitably arises between the production manager and the sales and marketing department when quantities produced differ significantly from the sales orders. Also, the production manager stated that he had heard that the morale of the production and sales staffs was low. Bonuses have not been paid out the past two years and the production manager thinks it might be related to how the production process has changed (by implementing metric driven management techniques) but incentive compensation programs have not. Bonuses have historically been paid out based on sales volumes and total profitability.

Required:

Your job is to take the information provided above and make recommendations for tools and systems that would improve Behr's management accounting system capabilities. Come up with at least one tool or suggestion for all three business cycle components (planning, motivating and directing, and controlling). Describe the key inputs and outputs of these tools and how they will be used to help improve Behr's decision making capabilities and operational performance.

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Before I tell you how to approach this question, let me start by first explaining to you what the traditional cost system is and/or what led to its development.

In any production process, manufacturing companies normally incur a number of costs related to:

1) Direct Material - Material that is traceable to good or service been produced.
2) Direct Labor - Labor that is traceable to good or service been produced.
3) Overhead - All production costs other than direct materials and direct labor are lumped into this one category.

With direct material and direct labor, the costs for them can normally be directly charged to products, because physical observation can be used to measure the quantity of material consumed or the amount of labor used to produce a product or service. However, with overheads there are several different costs that fall under this category; for example, depreciation of machinery and equipment, insurance, electricity etc.; and these costs are not directly traceable to the good or service been produced. For this reason a cost accounting system was needed that allocates overhead costs to products manufactured. This led to the development of the traditional cost system.

Under the traditional cost system, overheads are assigned or allocated to goods manufactured on the basis of volume such as, the number of units produced, the direct labor hours, or the production machine hours. There is a problem with this however, because by using only machine hours (for example) to allocate manufacturing overhead to goods, it is implying that the machine hours are the underlying cause of the factory overhead. Back in days, that may have been reasonable or at least sufficient for the company's external financial statements. However, in recent decades the manufacturing overhead has been driven or caused by many other factors. For example, some customers are likely to demand additional manufacturing operations for their diverse products, whereas, other customers simply want great quantities of uniform products.
In the question given for Behr Paint, you will notice that, in order to allocate overheads to the different paint colors manufactured by the company - its plant-wide allocation rate was based on machine hours (as given in the example above).

But machine hours are not ...

Solution Summary

This solution first gives a general overview of traditional vs activity-based costing accounting systems. It tells the advantages and disadvantages of using the traditional system, as opposed to the activity-based system. Information is also provided in the solution which will help you to make recommendations as to tools and systems that Behr could use to improve its management accounting system capabilities. This is then followed by three sections on planning, motivating and directing and controlling which each tells at least one tool that may be used under each to help improve Behr's decision making capabilities and operational performance. Key references and links are also provided.

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