Crimmings Products: A Teaching Case that Exposes Pitfalls Inherent in Traditional Product Costing Systems.

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  In Paper Session: Table 5

Abstract

The cost of almost every product calculated in a traditional absorption costing system is incorrect! This learning resource enables students to understand clearly why this is true.

This one-page teaching resource triggers examination of the detrimental consequences of the common practice of treating all manufacturing overhead costs as “indirect” costs. Furthermore, it highlights the linkages that exist between absorption costing and strategic costing systems such as activity-based costing (ABC). It supplements traditional accounting textbooks that do not systematically discuss those relationships (Sharma and Ratnatunga, 1997). The authors have assigned it for discussion in undergraduate and graduate Managerial Accounting courses at the point of transition from traditional absorption costing to ABC.

Except for coloring, the company’s only two products (and their unit costs) are identical. One day the Red Sphere manager makes a cost-neutral decision to lease a machine for an amount equal to the resultant direct labor cost savings. Because the cost of the lease is included in manufacturing overhead costs and direct labor cost is the allocation base, this decision leads to a surprising 50% reduction in Red’s reported cost and a 50% increase in Blue’s.

Despite common treatment of manufacturing overhead as “indirect costs,” the cost of the leased machine is a “direct cost” of producing Red Spheres - and only that product. Nonetheless, traditional absorption costing “allocates” only 20% of the machine cost to the Red Spheres. Amplifying this error, now 80% of ALL manufacturing overhead costs are allocated to Blue Spheres. In sum, students’ interest is piqued as they are faced with a traditional cost allocation method that initially appears reasonable, but provides severely distorted cost information.

This learning resource fosters evaluation of the perils of rampant and concealed allocation errors that are inherent in the design of traditional absorption costing systems. It surprises and engages students. The case activates a curious mindset that is conducive to learning how to “assign” costs more directly using activity-based costing in the ensuing class.

Authors

• Daniel J Jones, Assumption College

• Fabienne Miller, Worcester Poly Inst